What is Net Operating Income (NOI)?

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Definition:

Net operating income (NOI) is the income an income-generating piece of real estate brings in through rents and other tenant-related fees, minus operating expenses required to keep it generating income.

🤔 Understanding net operating income

Net operating income (NOI) is a term used in real estate to express the potential profitability of a property based on the amount of income it brings in each year versus the amount of expense required to keep it generating income. NOI isn’t concerned with how a building is financed — It doesn’t account for mortgage or interest payments. NOI includes income from rents, laundry, parking, or any other fees a building gathers, and subtracts expenses such as maintenance repairs, management fees, property taxes, and utilities. It also accounts for vacancies or any unpaid rent. NOI is an essential metric for real estate investors to gauge the profitability of a property.

Example

Beth is a real estate investor looking for a new apartment complex to add to her portfolio. She’s found two different complexes in desirable residential areas and looks at their NOI on their annual income statements to determine which one is the better investment.

Even though Multi-Family Complex A brings in more rent revenue, the NOI comparison shows that Multi-Family Complex B appears to be the more profitable investment.

Takeaway

Net operating income is like a fuel efficiency rating for real estate…

Just as fuel efficiency ratings will tell you how many miles different cars will go on a gallon of gas — allowing you to make a comparison between two or more cars — NOI will allow you to compare the potential profitability of two or more real estate investments. And, just as a fuel efficiency rating ignores things like a car’s price and financing terms, NOI is just one part of a bigger picture.

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What is net operating income (NOI)?

Net operating income (NOI) is a measure of profitability useful for comparing two or more potential real estate investments. NOI considers income from a commercial real estate property, minus its operating expenses. By doing so, NOI looks specifically at the profitability of a property on its own — separate from considerations such as how a property is financed. NOI compares how much it costs to own and maintain a property to how much rental income the property generates. This comparison helps give real estate investors and creditors a picture of whether the property is a good investment.

What is included in net operating income?

Net operating income includes all rent and lease payments for one year and adjusts for any vacancies or unpaid rent. Then it adds any additional income generated by the property, such as money generated by laundry and parking facilities, vending machines, and late fees. Taken together, all of these things add up to a property’s total revenue.

From total revenue, NOI subtracts all of the expenses required to run and maintain the property. These expenses can include management and janitorial services, maintenance and repair costs, property insurance, real estate taxes, and any utilities not paid by tenants. Operating expenses are defined as expenses that, were they not paid, would interfere with the ability of the property to generate revenue.

Subtracting operating expenses from the real estate revenue gives you NOI.

Why is NOI important in real estate?

Real estate investors use NOI when they are deciding whether a property might be a good investment. NOI can tell you how much money a property is likely to bring in after all of the operating expenses are considered. Operating expenses are only those expenses required for the property to be able to bring in income.

NOI is also important in real estate because as NOI increases, both property value and cash flow increases. A property’s cash flow is its NOI minus its mortgage payments. A property’s capitalization rate (cap rate) is its NOI/sales price or total value.

NOI is an essential metric in evaluating investment properties.

What is the difference between net income and net operating income?

NOI deals strictly with the amount of revenue a property generates through rents and other fees and subtracts how much it costs to keep the property generating that revenue. NOI ignores any extra cash reserves or interest on debt due to financing decisions. NOI also excludes depreciation (the distribution of the cost of tangible assets such as vehicles or machinery over their expected lifetime of use), amortization (the allocation of intangible expenses such as software or licenses over the life or license of the product), or any other expenses that will eventually have to be accounted for to find out the figure on the bottom line of a company’s income statement (its net income).

Net income (also called net earnings or net profit), on the other hand, shows the total remaining revenue after all expenses are paid. It shows a company’s overall financial health as well as its ability to manage its expenses and assets efficiently. Net income is a vital figure for investors and creditors as it gives insight into whether a company will continue to be profitable in the future, regardless of whether it has high NOI values. A company can have a high NOI on a property and a low or even negative net income once all expenses are subtracted.

What is net margin?

Net margin tries to give you an idea of the amount of profit you have leftover for each dollar of sales after deducting all expenses.

A company’s revenue is the total amount it receives from sales — or rentals in the case of commercial real estate. Net income is the amount left over after a company subtracts its operating expenses, selling, general and administrative expenses (SG&A), taxes, interest, mortgage payments, depreciation, amortization, and any other expenses.

Net income/revenue (total sales) = net margin.

For example, a company with a net income of $80,000 and a sales revenue of $400,000 would have a net margin of 20% — or 1/5th. (80/400=⅕).

Companies with high expenses and overheads such as grocery stores tend to have pretty thin net margins. Software or cloud-based SaaS companies (software as service) with limited facility, overhead, production, and supply chain costs tend to have fatter net margins.

Net margin is a significant figure used in analyzing a company’s financial health.

How is NOI different than EBITDA?

NOI and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) are two similar metrics to measure a company’s profitability based upon its business operations, but different industries use them. NOI is used in real estate. NOI looks at the profitability of an income-generating property alone by adding the income generated by the property in lease and rent and subtracting the operating expenses required to keep the property generating income. NOI doesn’t consider interest, mortgage, depreciation, or amortization.

EBITDA expands to “earnings before interest, taxes, depreciation, and amortization.” To calculate EBITDA, companies take their bottom line (net income) and re-add taxes, interest, depreciation, and amortization costs to get a different picture of the actual profitability of the company. EBITDA can serve as a decent performance benchmark when comparing companies because it doesn’t consider accounting or financing decisions.

EBITDA = Net Profit + Interest + Taxes + Depreciation + Amortization

By stripping away incidentals, both NOI and EBITDA level the playing field. NOI is useful for real estate investors comparing commercial real estate, and EBITDA is helpful for investors comparing companies’ profit-making potential.

How is NOI calculated?

The net operating income formula can be figured manually or using a spreadsheet. You’ll want to list the facts of your property for easy access, such as the number of rental units, the rent amount, and the vacancy rate.

  1. Gross Potential Rents = total units X rent X 12 months
  2. List Other Income
  3. Gross Potential Rents + Other Income = Gross Potential Income
  4. Gross Potential Income X Vacancy Rate = Effective Gross Income
  5. List Operating Expenses
  6. Add all Operating Expenses to get Total Operating Expenses
  7. Effective Gross Income - Total Operating Expenses = Net Operating Income (NOI)

To calculate NOI in a spreadsheet, we can follow a similar procedure but use formulas for ease.

  1. List Property Facts and all entries.
  2. Multiply Units X Rent X 12 months.
  3. Add Gross Potential Rents and Other Income to get Gross Potential Income.
  4. Multiply Gross Potential Income by Vacancy Rate.
  5. Subtract Vacancy from Gross Potential Income to get Effective Gross Income.
  6. List all Operating Expenses and add them to get Total Operating Expenses.
  7. Subtract Total Operating Expenses from Effective Gross Income to get Net Operating Income (NOI).

What is a good NOI?

The basic rule for a good NOI is that it’s positive and higher than mortgage payments. NOI minus mortgage payments should equal your cash flow. So, the higher the NOI, the better the probability of a larger operating cash flow.

NOI is also an essential figure in the calculation for the capitalization rate (cap rate) for commercial properties. The calculation for capitalization rate is the NOI divided by the sales price, or value of the property. A good capitalization rate is relative to the investor and the location and market of the investment.

A high capitalization rate could indicate a high-risk property that has a lower value rather than a property of high value with a high NOI. A lower capitalization rate could mean a high-value property with a steady NOI. As NOI increases, capitalization rate increases, but the capitalization rate can also increase if a property’s value decreases.

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New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

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© 2022 Robinhood. All rights reserved.