Knowing how to evaluate rental properties is a must for real estate investors. The amount of profit that properties can potentially generate is key to choosing a real estate investment. There are many metrics used to analyze and evaluate rental properties. In today’s blog, we’ll discuss one of the most essential metrics: net operating income, also known as NOI. In addition to defining NOI, we’ll show you how to calculate NOI, how it is different from cash flow, and the quickest way to analyze the net operating income.
Related: How to Evaluate a Rental Property Quickly
What Is NOI?
NOI in real estate refers to the amount of annual profit an investment property generates. In other words, NOI is the difference between all the income collected and expenses. Net operating income allows real estate investors to understand the financial health and potential profitability of an investment property based on its required costs. NOI can change over time, based on the income property’s revenue and expenses. Nonetheless, the metric provides valuable information regarding whether the property will produce enough rental income to pay off debt service. As a result, it is one of the most essential metrics in real estate investing.
How to Calculate NOI
So, how to calculate NOI in real estate? As mentioned previously, the net operating income depends on real estate revenue and operating income. As such, you can calculate NOI by simply subtracting the two variables. Here is the net operating income formula:
NOI = Real Estate Revenue – Total Operating Expenses
Let’s take a closer look at the two fundamental variables in the net operating income formula.
Real Estate Revenue
The first is real estate revenue. Also known as gross rental income, it includes two factors:
1. Rental Income
Rental income is the amount of rent collected from an investment property. In the case of calculating NOI, it is assumed that a rental property is 100% occupied. Since NOI is calculated on an annual basis, you need to use annual rental income in the net operating income formula. To do this, simply multiply monthly rental income by 12. If the investment property in question has not been purchased yet, you can find its potential rental income by analyzing rental comps or using real estate tools, but more on this later.
2. Other Income
Not only does the revenue include annual rental income, but it includes other income as well. If you are investing in a multi-family property, for instance, you may have other sources of income. These could include services from parking, vending machines, laundry machines, etc.
Total Operating Expenses
The second main variable needed for calculating NOI is total operating expenses. Unlike revenue, this variable includes many factors. These consist of all necessary expenses required to maintain and run the rental property. Operating expenses, however, do not include principal and interest mortgage payments, capital expenditures, depreciation, and amortization. Here is a list of what is included for the calculation:
1. Vacancy
Vacancy is the amount of rent not collected due to vacancy loss. A rental property’s vacancy rate can be estimated using an investment property calculator.
2. Property Taxes
State and local governments set the rates of property taxes in a respective location. Generally, they are based on property value and size.
3. Insurance
Insurance, which protects investment properties from loss of income, damage, or natural disasters, is an important operating expense.
4. Repairs and Maintenance
Repairs and maintenance include any costs that keep a property in good condition. These include painting, lawn care, landscaping, or fixing appliances.
5. Property Management Fees
Property management fees paid to professional management companies for their services typically vary from 8% to 25% of monthly rental income.
6. Other Expenses (if applicable)
Total operating expenses also include other expenses, such as legal fees, marketing, advertising, and utilities.
Calculating NOI: An Example
Now that you know how to calculate NOI, let’s put the formula into practice with an example:
You own a multi-family rental property that earns $50,000 a year. It also earns $3,000 in other income. The investment property’s vacancy losses are $4,500, and its operating expenses are $6,500. What is the property’s NOI?
Gross Rental Income = $50,000 + $3,000 = $53,000
NOI = $53,000 – ($4,500 + $6,500) = $53,000 – $11,000 = $42,000
Is NOI the Same as Cash Flow?
NOI is one of the most important metrics in real estate. However, it is often confused with another metric: cash flow. So, is NOI the same as cash flow? The answer is no. To understand why, it’s important to note that NOI focuses on total operating expenses, which are expenses related to the rental property. As a result, mortgage interest and principal, income taxes, among other expenses, are not included in the NOI calculation. Cash flow, on the other hand, includes expenses related to both the rental property and real estate investor. Therefore, cash flow considers the debt service expenses that are ignored in NOI.
Debt service and income taxes are considered relative to the investor and not the property for one main reason: they vary for each real estate investor. While most investors finance rental properties using a mortgage, for instance, others buy income properties with cash. In this scenario, there is no point in including financing expenses in the net operating income formula. In essence, NOI is the net cash you earn before paying income taxes and mortgage payments. NOI tells investors how much cash they will have available in order to pay off a mortgage after operating expenses are paid. As a result, NOI acts as the first step to calculating cash flow and various forms of return on investment, such as cap rate.
How to Quickly and Accurately Calculate NOI
You now know the ins-and-outs of how to calculate NOI. Net operating income is a vital part of any real estate analysis and is a must-know for all investors. Still, it is a hassle to calculate manually. To calculate NOI with cap rate, for example, requires many different variables. It is difficult to obtain this data by hand from rental comps for one property, let alone several. Luckily, you don’t need to manually calculate NOI! With Mashvisor’s real estate investment tools, you can do it automatically in seconds. Mashvisor’s calculator focuses on cash flow. However, it allows you to adjust the expenses including income taxes and financing. So, making changes in these costs will let you see and compare the NOI vs cash flow of an investment property for sale. To see so for yourself, CLICK HERE to start your FREE trial with Mashvisor!
Related: Mashvisor Review: The Real Estate Investment Tools That You Need