**What Is Net Operating Income (NOI) In Real Estate?**

When I initially come across an acronym, I instinctively think about dentistry. I guess because so many have been ingrained in my brain during my lengthy training I can’t help it.

After starting this blog years ago, I quickly learned that real estate investors, like medical professionals, communicate extensively using acronyms.

When I originally learned about the phrase **NOI**, my initial thought was that this stands for “**Nighttime Oral Irrigator**” or “**Naso-Oral Infection**.” But I was wrong :).

The NOI calculation, or **net operating income**, is an *extremely* important concept to understand when evaluating real estate investments.

In this article, we’re going to discuss what it is, the best way to calculate the **Net Operating Income** formula, and go over an example of using it with an investment property to make you a better real estate investor.

**What Is NOI?**

**Net Operating Income (NOI) demonstrates the cash flow and profit potential of a rental property**. It achieves this by comparing the property’s annual income streams, minus the expenses required for its operation.

The NOI of a property is a strong indicator of its ongoing revenue but does *not* include deductions for:

- debt payments
- taxes
- depreciation
- mortgage payments
- capital expenses (CAPEX)

Because NOI doesn’t take these into account, it’s less susceptible to manipulation based on the amount of leverage used compared to other financial metrics, such as cash-on-cash return.

The net operating income calculation helps when comparing multiple properties. Unlike residential real estate, that’s priced based on comparable properties (Comps) in the area, commercial real estate is based on the NOI.

If I’m trying to decide on which apartment building to purchase, then the one with the higher NOI can help make the decision easier.

**NOI Formula**

The formula for calculating the property’s NOI is:

**Net Operating Income** = **(Gross Operating Income + Other Income) – Operating Expenses**

Let’s walk through some of the numbers to include in the formula, along with how to calculate NOI.

To more accurately calculate NOI, here are some of the different terms:

**Potential Rental Income**

The total amount of income generated if a property is occupied 100% of the time is the potential rental income. As you might expect, the likelihood of a property being rented out 100% of the time is extremely low.

**Vacancy Loss**

Vacancy loss is exactly what it sounds like. This is the potential rental income lost due to vacancy.

Vacancies can be caused by:

- tenant turnover
- eviction

Many of the real estate syndications I’ve invested in typically use a **pro forma** vacancy rate equal to 5% of the potential rental income.

**Effective Rental Income**

Subtracting vacancy loss from potential rental income gives the rental income a landlord can reasonably anticipate receiving.

**Potential rental income – vacancy loss = Effective rental income**

**Other Income**

Besides rent, property owners can bring in income from other areas such as:

- pet fees
- late fees
- laundry facilities

**Gross Operating Income (GOI)**

The GOI is the sum of other income and effective rental income.

**Total Operating Expenses**

The costs needed to operate the property including:

- taxes
- insurance
- maintenance/repairs
- property management costs

**Understanding Net Operating Income (NOI)**

As mentioned, the NOI is calculated by subtracting the property’s operational expenses from its effective gross income.

Examples of operational costs are:

- property taxes
- utilities
- repairs
- legal fees
- ongoing maintenance costs

**Capital expenditures are not included in the calculation** such as replacing the HVAC system.

Something else to consider is this: the rental income is NOT the only type of revenue properties can produce.

Other sources *could* include:

- storage
- laundry facilities
- covered parking
- snow removal
- vending machines
- wi-fi

**NOI Calculation Example**

Dr. A has a son moving off to college and wants to get him started down the “real estate investing” path. He recommended that his son purchase a four-plex to begin to “learn the ropes.”

He was able to locate one within two miles of campus. Currently, each unit rents for **$1,200** per month (**$4,800** total per month), making the Potential Rental Income $57,600 annually.

There are coin-operated laundry machines in a common area which also bring in $1,000 each year.

He factored in a 10% vacancy loss or **$5,760** per year, bringing the Gross Operating Income (GOI) to **$51,840**. Based on the current owner’s accounting, operating expenses are $12,000 each year.

**Net Operating Income = (Gross Operating Income [$51,840]) + (Other Income [$1,000]) – Operating Expenses [$12,000]**

**Net Operating Income = $40,840 annually**

**Calculations That Use NOI**

Here are 3 real estate calculations that assist investors evaluate potential deals involving NOI:

**#1. Cap rate**

Net operating income assists investors in determining the **cap rate **of a property (or capitalization rate). This is a metric used to evaluate the** profitability metric of a real estate asset** such as a mobile home park.

Typically, investors use cap rates to quickly compare the return on investment (ROI) on different types of property they may be considering buying or selling.

These may vary by:

- rental rates
- construction type
- location

A good rule of thumb to remember is:

- the
**lower the cap rate,**the**higher the value** - the
**higher the cap rate**, the**lower the value**

**Cap rate formula**

Cap rates are calculated by taking the **net operating income **and** dividing it by the market value**.

**Cap Rate = Net Operating Income (NOI) / Value**

If the NOI isn’t provided, it can be calculated by taking the income received *after* expenses have been paid **before** principal and interest payments, capital expenditures, depreciation, and amortization.

Speaking of **depreciation**, it’s one of the BEST kept **tax strategies** real estate investors utilize. To learn more, check out this video:

**#2. Debt service coverage ratio (DSCR)**

For financed properties, the NOI is used in the debt coverage ratio (DCR). Lenders use this metric to assess a borrower’s ability to generate sufficient cash flow to meet their debt payments.

It’s calculated by dividing the borrower’s net operating income (NOI) by their total debt service payments.

A DSCR of 1.0 means that the borrower has just enough cash flow to cover their debt payments, while a DSCR of less than 1.0 indicates that the borrower does not have enough cash flow to cover their debt payments.

**#3. Cash On Cash Return (CoC)**

The cash on cash return is an annual calculation of an investor’s earnings from a property relative to the initial amount they invested to acquire and operate it. In other words, it represents the return on the capital invested in a rental property.

**CoC Return = Net Operating Income (NOI) / Total Amount of Cash Invested**

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Sign up for my newsletter**FAQs**

**What’s a favorable net operating income (NOI) in real estate? **

A favorable net operating income (NOI) in real estate is the money you earn after paying all the costs of owning a property except your mortgage. If you make more money than you spend, it’s a good NOI!

** How can I determine a property’s net operating income?**

First, you need to add up all the money you make from renting it out and then subtract all the costs such as maintenance, taxes, and insurance. The result is your NOI.

** Is the mortgage payment incorporated into the NOI calculation?**

No, the mortgage payment isn’t part of the NOI calculation as it only represents the money you make and spend on the property, not the loan payments.

** What is the method for appraising a property’s value using its NOI?**

The first step is to know the NOI and the “cap rate,” which is the rate of return expected for that type of property. Divide the NOI by the cap rate, and you’ll get the property’s value.

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