Net operating income is at the heart of many calculations vital to determining investment profitability.
In previous articles, I have discussed how to estimate effective gross income and operating expenses. With those figures at hand, we can now estimate our property’s net operating income (NOI). NOI is calculated as follows:
Gross Scheduled Rents
(+) Other Income
(-) Vacancy Allowance
= Effective Gross Rent
(-) Operating Expenses
= Net Operating Income
NOI represents the amount of funds the property is expected to produce after the payment of normal operating expenses. Mortgage payments, capital improvements and depreciation are not part of the calculation of NOI.
WHY IS NOI IMPORTANT?
We have spent the last several articles explaining the steps required to estimate a property’s NOI. Why, you may ask, is the estimation of a property’s NOI so important?
For starters, real estate investors are not purchasing an asset. They are purchasing an income stream, and the NOI is the main component of that income stream. If you think this is a crazy idea, when was the last time you purchased a stock for the look of the stock certificate? The answer is “never.” You purchased the stock for the anticipated economic benefits that the company stock would provide over time. The same is true for real estate investing.
NOI represents the return that the investor will receive on his or her investment if purchasing the property utilizing a 100 percent cash purchase. For instance, if a property’s NOI is $10,000 and the investor purchased the property for $100,000 cash, the investor’s cash-on-cash return (before taxes) is 10 percent ($10,000 divided by $100,000).
NOI represents the maximum amount of funds available to service debt on the property should you desire to finance the property with a mortgage. For instance, the NOI of $10,000 could pay the mortgage on a $124,000 mortgage assuming a 30-year amortization period and a 7 percent interest rate, or it could fund a $150,000 note over a 15-year period at a 0 percent interest rate. Do you see how important this figure can be in the negotiation of the terms related to the purchase of real estate? We will be exploring this concept in more detail in future articles.
A traditional lending institution will utilize a property’s NOI to estimate the property’s debt service coverage ratio (DSC). The debt service coverage ratio is the ratio between a property’s annual NOI and the property’s annual debt service. A DSC of 1 means that there is exactly enough NOI to support your annual debt service and not a penny more. A DSC of less than 1 indicates that the NOI is not sufficient to cover your debt service, while a DSC of more than 1 indicates the NOI is sufficient to cover your debt service with additional funds remaining.
DETERMINING PROPERTY VALUE
NOI determines the value of the property in question when applying a capitalization rate, or cap rate. A cap rate is defined as the anticipated rate of return produced by a real estate investment.
The formula for calculating cap rate is:
Cap Rate = NOI / Purchase Price
Thus, if the NOI is $10,000 and the purchase price is $120,000, then the cap rate is 8.33 percent ($10,000/$120,000). In short, NOI is an objective measure of a property’s income stream, while the cap rate is a subjective measurement of how an investor’s capital must perform at a point in time. We will explore the concept of cap rates in detail in a future article.
NOI represents the starting point for the question, “How much did I make this year?” This begins to get us into the discussion of taxable income, which is calculated as follows:
(-) Interest on mortgage debt paid
(-) Amortization of points and other costs
= Taxable Income (Loss)
NOI is one of the most important calculations a real estate investor can make, as it is at the heart of so many other calculations that provide the investor with an indication of the expected performance of the property. These calculations can then be compared to other real estate investments in order to select the investment that best meets the return requirements of the individual investor.