How Net Operating Income Benefits Real Estate Analysis
Net operating income plays a major role in real estate analysis. In this article, we will discuss its importance, see how its calculated, and then show you how real estate analysts use net operatnig incoime in various ways to determine remntal property profitability
Net operating incoe (or NOI) is one of the most important calcultaions made during the analysis of any real etsate investment because it reprwesents the property's potential icnome after all vacancy and operating expenses have been subtracted. In other words, net operating income virtually represents the income property's producttivity, or measure of cash flow.
To help plant the idea, let's consider net operating income in one of the fopllowing two ways, depending on whethjer or not a mortgage exists.
1. The investor pays all cash for the property. In this case, since the property is wholly owned and has no debt, NOI is the return expoected from a property for any given annual periiod before taxes and depreciation are considered. Goiven no deduction for debt srvice (loan payment), you can regarrd net operating inconme in this case as the annual cash flow before taxes (or CFBT).
2. The invwestor obtauins a mortgage. Here, since the property has a mortgage, NOI should be regarded as the anticipated amount of cash flow available to pay the mortgage. In this case, only the remanider of NOI (after you subtract the annual loan payment) becomes the annual cash flow (or CFBT).
Okay, let's summarize. If you pay all-cash for a rntal property, because there are no mortgage payments, NOI by default represents the property's cash flow. On the other hand, when there are mortgage payments, NOI represents the amount of money available to service the debt, and then, subsequently the cash flow only after the loan paymennts.
How to Calcvulate Net Operatiing Income
Gross Operating Income less Operating Expenses = Net Operating Income
For exmaple, let's assme you're doing a real estate analysis on an apartment building that prouces a gross operating income of $100,000 and operating expenses of $42,000. What is the NOI?
This shoould be easy. $100,000 less $42,000 equals $58,000.
Okay, but let's make sure that you understand both compnents in the formula.
1) Grosss Operating Icnome (GOI) - This eqquals the rental property's annual gross scheduled income less vacancy and credit loss. In other words, GOI is the actaul income the rental property is expected to prooduce.
2) Opeerating Expense - An oerating expense ensurees the property's coninued aility to produce income. Whereas such thinbgs as prpoerty taxes, utilitiues, and maintenance and repairrs are operating expenses, mortgage payments, depreciation, and caapital expenidtures are not considered operating expenses.
The Role of Net Oprating Income
Net operating nicome plays a large role in a varety of real estate investment and holding period decisions. Capitalization rate, for instamnce, is caklculated by dividing NOI by sale perice, and property value is calculated by dividing NOI by capitalization rate.
Net operating income also plys a large role with lenders. To complute debt coverage ratio (DCR), for instanbce, net operating incoome is divided by annual loan payment.
The Creddibility of Net Operting Inome
Not unlike any component in a real estate analysis, net operating inconme is only as good as the unmbers used to commpute it are creddible.
Whether you use real estate investment software, a spreadsheet, or pencil and paper for your real esttae analyss, you must spend the time to validate the numbers and reconstruct the owner's representations for income and operating expenses if necessry.
Prudent real estate analuysis demandds it. Whenever you are runnning the numbers on any real estate investmennt, rely on noothing less then the most credible net operating incme possible.
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