One of the most crucial skills every real estate investor should master is calculating Net Operating Income (NOI). As I’ve emphasized in previous articles, real estate investing is fundamentally a numbers game. This is a universal truth that bears repeating. Developing a deep understanding of the financial aspects of property investments is vital for success. Allowing emotions to influence your decisions is a surefire path to disaster. So let’s dive in!
In this article, we will define NOI, explain how it is calculated, provide a high-level example calculation, discuss the importance of NOI in determining cap rate and ultimately property value using the income approach, and compare NOI to EBITDA. As always, we’re providing a FREE downloadable Excel spreadsheet to help you grasp the concept and apply it to your own investments.
What is Net Operating Income (NOI)?
Net Operating Income, or NOI, is the income generated by a property after accounting for operating expenses but before considering financing costs, taxes, and non-cash expenses like depreciation and amortization. NOI is a critical metric for real estate investors because it reflects the property’s ability to generate cash flow from its core operations, helping investors make informed decisions when evaluating potential investments.
How to Calculate Net Operating Income
NOI = Net Effective Income – Operating Expenses
Net Effective Income is the actual income that a property generates after accounting for potential gross income, miscellaneous income, and vacancy expenses. Operating expenses include costs such as property management fees, insurance, utilities, repairs and maintenance, and property taxes. There are various perspectives on whether to include certain expenses, such as capital expenditure reserves, in the NOI calculation. However, for the purpose of this article, we will focus on a straightforward example.
Example Net Operating Income Calculation
Let’s assume you own a 10-unit apartment building with the following annual financials:
- Market rental rate per unit: $12,000
- Miscellaneous income (parking fees): $15,000
- Vacancy expense: 5% of potential gross income (PGI)
- Property management fees: $9,000
- Insurance: $3,000
- Repairs and maintenance: $5,000
To calculate the NOI, follow these steps:
- Determine the potential gross income: $12,000 (market rental rate) * 10 (# of units) = $120,000
- Solve for net effective income: $120,000 (potential gross income) + $15,000 (miscellaneous income) – $6,000 (vacancy expense * PGI) = $129,000
- Add up the annual operating expenses: $9,000 (property management) + $3,000 (insurance) + $5,000 (repairs and maintenance) = $17,000
- Solve for NOI by subtracting the operating expenses from the net effective income: $129,000 – $17,000 = $112,000
In this example, the property’s annual NOI is $112,000.
Here’s the same example calculation as above, but in Excel to help you visualize it all:
NOI’s Role in Cap Rate and Property Valuation
NOI plays a crucial role in determining a property’s capitalization rate (cap rate) and estimating its value using the income approach. While the income approach may be a new term for some, rest assured that we will address the various types of valuation techniques, including the income approach, in a subsequent article.
As a refresher, a cap rate is calculated by dividing the annual NOI by the property’s purchase price or current market value. Alternatively, you can also back into a property’s value by dividing the annual NOI by your desired cap rate:
Property Value = Annual NOI / Cap Rate
By accurately calculating NOI, real estate investors can make informed decisions regarding a property’s value and assess its potential return on investment.
NOI and EBITDA: A Comparison
You may be asking yourself, “Self, what is EBITDA?” Good question. EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, is a financial metric commonly used to evaluate a company’s operating performance. It provides a snapshot of a company’s profitability by measuring earnings before accounting for certain non-operating expenses and non-cash items. EBITDA is often used by investors and analysts to compare the financial health of different companies within the same industry. It can also be used to track a company’s performance over time.
While EBITDA focuses on a company’s operations, it shares some similarities with NOI in the context of real estate investing. Both NOI and EBITDA provide a snapshot of an investment’s profitability before accounting for financing costs, taxes, and non-cash expenses like depreciation and amortization. By focusing on the earning potential of an investment’s core operations, investors can more accurately assess the viability and profitability of the opportunity.
FREE Excel Spreadsheet for NOI Calculation
To help you master the NOI calculation and apply it to your own property investments, we’ve created a FREE Excel spreadsheet for you to download. The spreadsheet includes a step-by-step guide, an example calculation, and a customizable template for your own property analysis. Click the link below to get your copy now!
Net Operating Income (NOI) is a critical financial metric for real estate investors for myriad reasons. By accurately calculating NOI, investors can make informed decisions when comparing potential investments, estimating property values, and determining cap rates.
Use our free Excel spreadsheet to practice your NOI calculations and enhance your real estate investing skills. With a solid understanding of NOI and its implications, you’ll be better equipped to make smart investment decisions and maximize your returns.