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The Net Operating Income for Real Estate Investors, beginners and advanced.

NOI definition, formula, how to use it . Example.

last update Tuesday, October 25, 2022





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Net Operating Income Definition
The Net Operating Income (NOI) is a financial metric used by commercial real estate investors and lenders to calculate the market value or cash flow of a specific investment opportunity during a specific time period in the past or future.

Net Operating Income Formula

The net operating income is equal to operating income less operating expenditure. In other words,

NOI = Incomes - Expenses

How NOI is used by real estate investors?

There are two main scenarios where NOI is used.

1. Cash Flow Calculation 
The NOI helps investors and lenders to calculate the number of cash flows, for a specific time period from the property performance, assess the cash flows in a given property, and decide whether the property is a good performer or lendable.

Learn more about cash flow calculation in our future articles.

2. Property Value Calculation 

The second most common NOI used is to calculate property value, the value financial metric can be used as sales price, insurance quotation parameter, or loan size metric.

Learn more about loan size calculation in our future articles.

Advanced
Note #1
The property's NOI is not single and is the most important metric used by smart investors and anyone who is trying to define intrinsic value. There are more important ones: DSCR or Cash Flow.

Learn more about DSCR  in our future articles.

Note #2:
There  are some complications involved in NOI calculations,

On the income side.
Because most properties can produce income in several different ways, for example, rental income, parking fees, laundry income,  expenses reimbursements, any fees income, etc, investors and creditors must discover and incorporate all revenues into their assessments.
The future income calculation should be dynamically adjusted by the rent rate that is driven by supply/demand and that can not be obviously projected. There are demographic populations and new developments functors are playing a huge role.

On the expense side.
At the same time, expenses can be represented in many forms, for example, some properties are part of a community or association. It is important to discover and calculate all of these operations expenses involved in past or future operations.
The future expense calculation should be dynamically adjusted to the future vendor's price driven by seasonal supply/demand volatility or by inflation.

The concept of Net Operating Income works not only for real estate properties. Many companies use the same concept as a basis for investment decisions in a "regular" business, such figure is named EBIT or earnings before interest and taxes.

How Net Operating Income is calculated? NOI calculation formula.

NOI = Income - Expenses

Income
As I said earlier, revenue does not include just rental profits. We have to include all revenue streams supported by the target property. The most popular examples of revenue sources are:

  • Rental income
  • Parking fees
  • Service charges
  • Vending machines
  • Laundry machines income
  • Late payment fees
  • Utility reimbursements.

Expenses
All necessary expenses related to revenue generation activities shall be covered by the operating costs in the NOI system. In other words, all these are the required costs for the maintenance and operation of the house. Several examples are given here:

  • Property management fees
  • Insurance
  • Utilities
  • Property taxes
  • Repairs and maintenance

Remember that there are also separate costs, such as income taxes and interest payments, that are not part of this group.
As you can see, the net profit of the operator is very straightforward, so let's take a look at an example.

NOI Calculation Example

Marcia runs a real estate investment company that buys rental properties. She is also looking for an opportunity to increase the value of the property either through redevelopment or rebranding or work more effectively than current owners by increasing income or decreasing expenses. She evaluates two building performances that display in their annual income statement provided by current owners.

In-Place NOI

Building #1 Building #2
Income
Rental income $100,000.00 $50,000.00
Laundry income $0.00 $1,000.00
Total Income $100,000.00 $51,000.00
Expense
Property management fees $20,000.00 $1,000.00
Property taxes $15,000.00 $1,000.00
Repairs $20,000.00 $1,000.00
Insurance $10,000.00 $2,000.00
Total Expenses $65,000.00 $5,000.00
NOI $35,000.00 $46,000.00

Discovery:
income (#1)  > income (#2)
expenses (#1) > expenses (#2)
NOI(#1) > NOI (#2)


Marcia uses the NOI as a metric to determine what building is worth buying or a better investment. This is how she'd measure it.

As you can see, the first building produces more income but has higher costs of operation than the second one. Therefore, the second building has a higher NOI than the first one. You may presume that the investment is better than the first, but we have to remember some other things.

Analysis

There is much more to consider than this calculation, but this equation provides us with good insights into the cash flows of properties. To see if potential cash flows are impacted, we need to look at any cost.

Suppose the first apartment has a new roof built, for example, and the $20,000 upgrade will not take place in the coming years. The first choice is now even more appealing. This is an example of how management should do this research. Costs can be frontloaded or pushed to a later date so that various investors find it less or more appealing.

So, before this analysis is conducted, real estate investors always look at the total conditions of the property and income potential.


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