Net Operating Income Formula for Real Estate Investors

theory and example

last update Sunday, August 23, 2020

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Net income is a profitability metric that is often used by the real estate investors to calculate the profit potential and financial health of the commercial property through the measurement of income after the deduction of operating expenditure. In other words, after all the required expenditures, it calculates the number of cash flows that the property has received.
This measure is used by real estate investors and creditors to assess the cash flows in a given property and to decide whether the property is good or lendable. You may use this ratio to formulate the property's original value. They look for example at how much money the property will produce after all running costs are paid to determine how good the property is and what price they will be willing to pay for it.

Because a piece of property will produce income in several different ways, investors and creditors must incorporate all revenues into their assessments. The rental property, for example, can generate money from rental apartments, parking fees, sales machines, or laundry machinery. Both of these operations contribute to the property's cash flows and the expenses involved.

This concept is not only for a property. Many companies use this as a basis for investment decisions, such figures as EBIT or earnings before interest and taxes.

Let's see how net operating profits can be measured.

Net Operating Income Calculation Formula for Real Estate Investors

The net business revenue form is measured with operating expenses subtracted from a property's total revenues. Like I said earlier, revenue does not include just rental profits. All revenues from a property are included. The most popular examples of sources of revenue are:

Rental income
Parking fees
Service charges
Vending machines
Laundry machines

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.

Example

Marcia owns a property company that buys existing properties and potential rental properties. She is also looking to invest in new real estate, in order to either develop or work more effectively than her current owners. Now, they evaluate two small apartment buildings that display their annual income statement with the following things.

Apartment #1
Rental income: $100,000
Property management fees: $20,000
Property taxes: $15,000
Repairs: $20,000
Insurance: $10,000

Apartment #2
Rental income: $50,000
Property management fees: $1,000
Property taxes: $1,000
Repairs: $1,000
Insurance: $2,000

Marcia uses the NOI equation to determine if any building is worth buying and to decide which apartment complex is a better investment. This is how she 'd measure it.

As you can see, the first apartment produces over the year more brutal revenues but also costs more than the second one. Therefore, the second building has a higher NOI than the first alternative. 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. In order 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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