Net operating income is a novelty formula that’s frequently utilized in property to quantify an industrial property’s benefit potential and fiscal wellbeing by calculating the earnings after operating expenses have been deducted. To put it differently, it measures the quantity of money flows that a house has after all required expenses are paid.
Real estate investors and lenders use this calculation to assess the cash flows of a particular property and ascertain whether it’s a great investment or creditworthy. In addition, they use this ratio to invent the first value of their house. By way of instance, they consider just how a lot of money the house can create after each the operating expenses are paid to be able to choose how precious it is and what amount they’re ready to cover this.
Since there are several distinct ways a part of the property may create income, creditors and investors will need to incorporate all earnings within their own evaluation. As an instance, a rental house may make cash from leasing apartments, charging parking fees, servicing vending machines, or even working laundry machining. All these activities contribute to the money flows of the house and expenses that are necessary.
This notion isn’t exclusive to real estate. Other industries refer to this calculation as EBIT or earnings before interest and taxes and use it to base investment decisions on as well.
Let’s take a look at how to calculate net operating income.
The net operating income formula is calculated by subtracting operating expenses from the total revenues of a property.
As I mentioned earlier, revenues include more than just rental income. This includes all revenues from a piece of real estate. Here are the most common examples of revenue sources:
- Rental income
- Parking fees
- Service charges
- Vending machines
- Laundry machines
The operating expenses in the NOI formula consist of all necessary expenses associated with the revenue-generating activities. In other words, these are all the expenses required to maintain the property and run the rental business. Here are a few examples:
- Property management fees
- Property taxes
- Repairs and maintenance
Keep in mind that there are several different expenses that are not included in this category like income taxes and interest expense.
As you can see, the net operating income equation is pretty simple, so let’s take a look at a real estate example.
Marcia owns a real estate business that purchases existing rental properties and potential rental properties. She is constantly looking for new real estate to invest in that she can either improve or run more efficiently than the current owners. Today she is evaluating two small apartment buildings that show the following items on theirannual income statement.
- 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 evaluate if either of these buildings are worth buying and judge which apartment complex is a better investment. Here’s how she would calculate it.
As you can see, the before all else apartment generates more gross revenues during the year, but it also has more expenses than the second building. Thus, the second building actually has a higher NOI than the before all else option. You might assume it’s a better investment than before all else, but there are other things we need to consider.
There’s a lot more that goes into evaluating whether a rental property is worth investing in than this calculation, but this equation gives us a good insight into the cash flows of the properties. We need to take a look at each of the expenses to see how future cash flows will be affected.
For example, assume the before all else apartment just had a new roof put on and the $20,000 of repairs will not be there in future years. Now the before all else option is a lot more attractive. This is an example of how this analysis is manipulated by management. Expenses are frontloaded or put off to a later date to make the property look less or more attractive to different investors.
That’s why real estate investors always look at the overall situation of the property and revenue potential before running this analysis.