Many real estate investors rely on net operating income to determine the profitability of an income-generating property. Real estate investors use NOI to calculate other financial metrics pertaining to a real estate property including the net income multiplier, cash on cash return, capitalization rate (cap rate), and total return on investment. You may be wondering how could NOI help you analyze an investment property and how to calculate net operating income for a rental property?
This article will explain what NOI is and how it should be used. We will also break down the formula for you and explain exactly how to calculate net operating income.
What Is NOI in Real Estate?
NOI in real estate refers to a method used to analyze the profitability of income-producing investments such as real estate rentals. NOI calculates the income generated by a real estate investment. It measures the amount of cash flow an investment property generates after operating expenses but before taking into account any costs from financing and income taxes. NOI excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization.
With NOI, a real estate investor can determine the capitalization rate. Determining the cap rate is essential to running an effective investment property analysis because it allows you to compare different properties quickly and easily.
NOI vs. Cash Flow
As opposed to cash flow, NOI does not take into account investment property financing fees. The net operating income measures the profitability of an investment property without taking into account expenses that are specific to the real estate investor. Income taxes and mortgage interest and payments, however, are crucial and play an important role in determining a property’s profitability. This is why as real estate investors perform in-depth analysis, they take a look at the rental property’s monthly cash flow.
How to Calculate Net Operating Income
NOI = Real Estate Revenue (or Gross Income) – Operating Expenses
Real estate revenue or gross income is the income your rental property generates, including:
- Rental Income: The amount of rent collected monthly. If you have not purchased a rental property yet, you can get an idea of what the rental income will look like by looking at real estate comps in your area.
- Other Income: In order to figure out an investment property’s net operating income, you need to know the other income it could potentially produce. Other income could be in the form of fees collected for parking or the provision of amenities related to the rental property.
Operating expenses are all the expenses necessary to maintain and run your investment property. These expenses include:
- Vacancy: The amount of rent not collected (when the investment property is left unoccupied).
- Property Taxes: Taxes levied by the county but can often include taxes paid to other entities such as school districts.
- Insurance: This fee will protect your investment property from loss of income, damage, and other weather-related damage.
- Repairs and Maintenance: All the fees that will go toward maintaining and running your rental property effectively. These include updating the electrical systems within a property, landscaping, and/or lawn care. This is estimated at 1% of property value a year.
- Property Management Fees: When hiring a property manager to manage the rental property for you, you incur a fee of about 8%-25% of the monthly rental income.
- Miscellaneous: These fees include marketing and advertising fees, legal fees, and utilities.
Here’s an Example
Here’s an example of how to calculate net operating income of a rental property.
Michael is using the NOI formula to determine whether or not he should buy an investment property. He knows the property will earn $40,000 in rental income a year. He has calculated additional income to be $3,000, vacancy losses $4,000, and operating expenses $7,000.
To calculate NOI, first, add up all real estate revenue:
$40,000 + $3,000 = $43,000
Then, subtract the vacancy losses and operating expenses:
$43,000 – ($4,000+$7,000) = $43,000 – $11,000 = $32,000
So, the NOI = $32,000
Michael can use the NOI to compare the property to others of similar attributes within the area and determine whether or not the investment property is priced right. With the NOI, moreover, Michael can better assess whether or not the property’s income will cover its operating expenses. And lastly, he can use the NOI formula to determine the cap rate (the rate of return on the investment property). In real estate investing, the cap rate is calculated by dividing the NOI by the property value.
Investment Property Analysis
You are looking into NOI and the NOI formula because you want to assess the financial standing of an investment property. Measuring the NOI is surely a good way of conducting a rental property analysis. However, it should be accompanied by assessing other metrics such as cap rate, cash flow, and cash on cash return. In order to save time and get the most accurate results, resort to Mashvisor’s investment property calculator. The tool provides real estate investors with real estate metrics used to evaluate the performance of an investment property. Mashvisor’s investment property calculator uses data analytics of traditional inputs and predictive analysis to find the best investment properties in a given residential real estate market.
The Bottom Line
Finding the NOI is important when running a rental property analysis. It will measure the amount of annual profit a rental property will generate after deducting all expenses from the total income. But again, as a real estate investor, we recommend that you look into other metrics when evaluating a property. Visit Mashvisor today to learn how our real estate rental investment calculator can help.