As a commercial real estate professional, you need to be familiar with calculating Net Operating Income, or NOI. It’s the industry-standard way to evaluate the profitability of your income-producing properties. NOI doesn’t take into consideration financing fees or income taxes, but it can give you valuable insight on how your properties are operating relative to comparable properties.
Investors need to master the NOI formula in order to make smart, profitable decisions on what to purchase. Dividing the property’s NOI by the particular market’s cap rate is a common formula used to evaluate the value of the property. All of this helps an investor decide what’s worth purchasing, and what will eventually put them in the negative.
Let’s walk through the formula for net operating income or NOI:
Start by summing up all of the regular income generated by the property. This could include residential rent, commercial rent, miscellaneous fees (such as for parking spaces), or anything else the building receives as income in the normal course of business.
Next, sum all of the operating expenses from the property. These are any expenses incurred in the normal course of operating the property and could include things like insurance, property taxes, utility fees, and annual repairs and upgrades. Importantly, financing activities (such as paying down a mortgage) and capital expenditures (like upgrading the building’s countertops) are not included in operating expenses.
Lastly, simply subtract your operating expenses from your operating income to arrive at the NOI. The formula looks as follows.
OPERATIING INCOME - OPERATING EXPENSES = NET OPERATING INCOME (NOI)
Let’s explain this formula using a real-life example.
Matthew is looking to invest in a new apartment building. He’s evaluating two separate properties – let’s call them property A and B.
Property A and B have the following expenses and income.
Property A
|
Rent |
100,000 |
|
Property Taxes |
10,000 |
|
Repairs/Updates |
15,000 |
|
Insurance |
10,000 |
Property B
|
Rent |
150,000 |
|
Property Taxes |
15,000 |
|
Repairs/Updates |
20,000 |
|
Insurance |
20,000 |
Using the net operating income formula, we can calculate the annual profitability for each property.
Property A:
100,000 - 35,000 = 65,000 NOI
Property B:
150,000 - 55,000 = 95,000 NOI
Property B may be a winner for Matthew’s investment as it has a higher NOI, but it will also likely come with a higher price tag. Property A has lower rental income, but it correspondingly has less operating expenses, which could make it a savvy investment depending on Matthew’s budget.
Not all situations are equal. Sometimes, a lower NOI can mean a better investment, depending on the capital expenditures the building requires and the market cap rate. Take into consideration the location of the property, the work it will take to manage updates, and how easy it will be to fill all your units with tenants. There are many factors that go into evaluating a real estate investment, but NOI is a good place to start.