What is NOI in Real Estate?
Net operating income (NOI) is one of the most important calculations to understand in real estate investing. It’s a basic financial formula that allows you to accurately project the profitability of an investment property after accounting for its operating expenses.
As a fundamental real estate concept, it is a powerful formula to support smart financial decision-making for turning the greatest return on your property investment.
Continue reading to better understand the power of NOI in real estate.
Covered in this article:
- What is the NOI Formula?
- Expenses Excluded from the NOI Formula
- Gross Operating Income vs Net Operating Income
- What is NOI Used For in Real Estate?
- Purchasing a Property and Developing Its Budget
- Calculating Cap Rates
- Calculating DSCR
- Calculating the Net Income Multiplier (NIM)
- How to Maximize Your NOI
- Example of NOI Optimization: Improving Air Quality in Commercial Spaces
What is the NOI Formula?
To calculate net operating income, you first need to know your gross operating income. Additionally, you must calculate all property operating costs.
The calculation for NOI is:
Net Operating Income = Total Operating Income – Operating Expenses
Total operating income includes all of the income (also known as revenue) you make from a property. This accounts for not only rental income but all the additional revenue generated on the property.
In real estate investing, total operating income is made up of:
- Rent paid by tenants and lessees
- Utility fees
- Parking fees
- Storage fees
- Late fees
- Extra amenities, such as coin laundry or vending machines
Operating expenses are the costs you pay to run your property. Operating expenses include:
- Repair and maintenance costs
- Exterior and interior renovations
- Landscaping maintenance
- Insurance premiums
- Property taxes
- Property management payroll
- Janitorial fees
In other words, your net operating income is the funds you keep while operating your investment property.
An NOI calculation is critical if you want to project and acquire a profit. Similarly, NOI allows you to objectively assess a property that might not generate profit. Knowing the NOI equips you to make necessary adjustments to maximize your profit potential.
Expenses Excluded from the NOI Formula
Several expenses are not included in the standard NOI calculation. Items that are typically excluded from net operating income calculations include:
- Large expenditure costs for major repairs
- Debt or mortgage payments
- Property depreciation
- Income taxes
- Large Tenant Improvements
Remember, real estate investors use NOI calculations as insight into a property’s value through the lens of cash flow. Excluded expenses are any costs that don’t support the overall value. For example, covering an emergency repair may come out of a property owner’s savings. Therefore, it doesn’t apply to the net operating income.
Gross Operating Income vs Net Operating Income
NOI is different from gross operating income (GOI). The two can cause some confusion in real estate, as many assume they are interchangeable in determining a property’s value.
Gross Operating Income is calculated as follows:
Gross Operating Income = Gross Potential Income – (Vacancies and Losses)
NOI and gross operating income do often coincide, however. You must generate the total calculation of GOI before formulating NOI. Another thing to remember that separates the two formulas is that NOI is calculated before income tax deductions but includes property taxes.
What is NOI Used For in Real Estate?
NOI is primarily used when a real estate investor wants to determine the expected profitability of a rental property. It’s also a common calculation when lenders are evaluating the approval process for commercial or residential loans.
Net operating income is used in several other important real estate calculations that are covered below.
Purchasing a Property and Developing Its Budget
NOI is used when purchasing a property and developing its operating budget. These two crucial financial practices help determine the property’s return on investment (ROI). To calculate the potential ROI, divide the NOI by the property’s purchasing price and then multiply that number by 100. This will give you a percentage indicating ROI.
ROI = (NOI / purchase price) x 100
Calculating Cap Rates
NOI is also used for calculating the capitalization rate (“cap rate”) of a property. A capitalization rate determines how much a real estate investor might profit or lose from making an investment. Although cap rates don’t provide exact numbers or predictability, they help investors evaluate investment risk.
To calculate a capitalization rate, divide the NOI by the present market value and then multiply that number by 100. The percentage equals your estimated cap rate.
CAP Rate = (NOI / Present Market Value) x 100
Lenders calculate a debt service coverage ratio (DSCR) to predict whether or not a property is worth financing. This calculation is most often used in commercial real estate. It compares the property’s NOI to the annual debt service in order to gauge an investor’s abilities to make mortgage payments on time. To calculate this, divide the NOI by total debt services.
DSCR = NOI / Total Debt Services
Calculating the Net Income Multiplier (NIM)
The inverse of a cap rate, called the net income multiplier (NIM), estimates the potential market value of an investment property. To calculate the net income multiplier, divide a property’s current market value by its NOI. For real estate investors, a lower NIM is ideal.
NIM = Property Market Value / NOI
How to Maximize Your NOI
Ultimately, a positive net operating income helps you get approved for loans, attract future buyers and investment partners, and maximize your ROI.
There are several approaches one can take to ensure a better NOI. One of the main methods is to cut operating expenses in order to optimize your revenue from the property. When purchasing a property, you can strategically go in for a higher ROI by maximizing your net operating income.
Consider the following ways to maximize the NOI of your real estate property.
1. Increase Rental Rates
Rent increases are the most obvious way to maximize NOI. Although tenants often prefer a stable base rent, retaining tenants through a rent increase is reasonable. There are several practices to encourage the best outcome.
- Allow rent increase negotiations. Upon negotiation, work in yearly rate increases. This way, your tenants will stay long-term and not feel forced to leave due to unreasonable financial demand.
- Cultivate community. If you own a multi-unit space, arrange community events such as quarterly BBQs or parking-lot food truck lunches. Connect business tenants with other professionals throughout the property. Tenants are less likely to leave when they feel involved in a community.
- Give plenty of notice. Provide existing tenants with at least a 6-month notice of the rental increase. This gives people enough time to adjust their budgets and find ways to pay the new base rent on time.
2. Set Higher Fees for Extra Services or Amenities
Whether you own a commercial or residential property, added amenities are a high priority for many. Extra services related to safety, security, and convenience are ideal as they ensure comfort.
- Upgrade your on-site security system. 24/7 surveillance is an attractive feature for many tenants, especially those who run businesses in high-traffic locations. Hire a security guard or install high-tech surveillance systems. You can charge tenants small monthly security fees for this added benefit.
- Provide new vending machines. With sophisticated technology today, standard vending machines are one of many options for convenience amenities. Many property owners install luxury-style, income-generating vending kiosks that offer items such as snacks and drinks, prepackaged meals, books, smartphone chargers, and more.
- Repurpose unrented space. Consider repurposing or renovating unrented space for tenant use. For example, if you have an empty basement or unused storage area, convert it into a recreational space. Upcharge tenants a monthly fee for access or simply offer a paid reservation-based waitlist. You could also create coworking areas for use.
3. Decrease the Property’s Operating Expenses
Lowering the operating costs of your property is an optimal way to maximize NOI. From energy-efficient appliances to digitally automating important tasks, there are several opportunities to set a lower operating budget.
- Prioritize preventative maintenance. Instead of reacting to maintenance issues when they become costly issues, focus on preventative maintenance. Schedule regular inspections, tune-ups, and deep cleanings to make sure all appliances and property systems function properly.
- Go green. Small everyday items can demand a lot of electricity throughout a property. Consider going green with environmentally-friendly changes such as replacing grass with astroturf, installing LED light bulbs, and switching to energy-wise appliances. Smart appliances can also save money while attracting new renters.
- Introduce digital access options. Alternative access capabilities such as code or card access minimize the need to employ extra staff.
Example of NOI Optimization: Improving Air Quality in Commercial Spaces
Understanding NOI is critical to making informed, beneficial decisions in commercial real estate.
For example, the installation of NPBI air filters at many of our properties has added immense value while making tenants feel safe. With so many interpersonal changes placed on individuals and groups post-pandemic, communal gathering spaces now pose common health concerns.
In this case, cleaner, filtered air provides tenants and future tenants with the peace of mind they desire. It ultimately improves the retention and sign-on rate of renters for various properties, especially those who favor an indoor space with clean air and less risk of COVID-19 or other air-born diseases.