OK, ok, full disclosure, this one is really for me. When recently analyzing a real estate investment opportunity, I added an expense that is not considered and operating expense and it totally through off my evaluation of the #s and almost resulted in a very offensive offer. Sometimes offensive offers are required, but always take a 2nd look or obtain a fresh set of eyes to review your analysis.
Back to the basics, I started this blog as a way to create a knowledge base for myself, a repository I can reference over and over. As I combed through my own articles I discovered I had not approached the topic of how to define nor calculate Net Operating Income, also known as NOI. Future self, you’re welcome. (I know I’ll have to reference this again soon).
As we walk through this post, let’s work through an example. We’ll keep it simple and easy and analyze a duplex that receives a total of $1,000 month for rent ($500/each side). Also, when I talk about analyzing I’m talking about what historically the rental property has produced, not a pro forma. Pro forma = lies and any add you seeing “rents could be XXX of dollars more than they are now”is almost always a lie. If it was that easy the current owner would have done it by now, something is fishy. Always question this lingo, and always buy on the historic run rate of the property, not how it can potentially perform. Make sense?
First, let’s start with a definition. Net Operating Income is defined as the annual income generated by an income-producing property after taking into account all income collected from operations and deducting all expenses incurred for operations (thank you Google). More simply put:
Net Operating Income = Operational Income – Operational Expenses
Operational Income is fairly straightforward. Any income being produced by your rental property is operational income. Rent is the most obvious. Laundry facility income is a second source if you have one on your property and/or storage facilities located on the same property are all considered part of your operational income.
Pro Tip: for a more advanced way to compute Operational Income, compute Gross Operational Income which is calculated by subtracting Vacancy & Credits from Gross Potential Income. More on this subject later, want to keep this post introductory.
Operating Expenses are a little more involved. By that I mean, what is an operating expense and what is not an operating expense. Property management, utilities, insurance, property taxes, lawn maintenance/care, home maintenance or repairs are the main operating expense categories. Mortgage payments are not considered an operating expense, which is the incorrect expense I spoke about earlier – practice makes perfect.
Working through our example, looking at the #s from an annual, historical view where both tenants have always paid rent, $1,000/month, on time:
- Operational Income = $12,000
- Operational Expenses= $7,593
- Property Management = $1200 -> 10% of income
- Utilities: $0 -> tenants are responsible for all
- Insurance: $1,164 -> annual premium price
- Property Taxes: $978 -> they are what they are
- Lawn Maintenance: $600 -> you take care of this for your duplex tenants, you’re a nice guy!
- Maintenance / Repairs (total for both units): $3,651
Net Operating Income = $12,000 (Operational Income) – $7,593 (Operational Expenses)
NOI of $4,407, but is this good? And don’t confuse NOI with cash flow. And no, this is not good.
Why is Net Operating Income (NOI) important?
For starters, NOI is important so that you can ensure you have enough monies to cover additional, non-operational expenses and still cash flow as desired. For example, we now know mortgage expenses are not included in calculating the NOI, but it is a very important expense we need to ensure is paid monthly. With an NOI of $4,407 ($367.25/month) and desires to cash-flow according to our criteria, this doesn’t leave much room to pay a mortgage.
In this scenario, the expenses seem to be a little high (target operational expenses @ 50% of rental income), so one of a few things is the issue. Either (a) ran into some capital expenses during the past year, which you should always plan for, separate post, (b) rent is not high enough (c) this is just a bad deal! Further digging will give you the answer.
Pro Tip: With Property Taxes, be cautious with your future projections. Even though we are analyzing here based on historical property run rates, increase in property value thus property taxes may increase with a higher sell price than current property appraised value. This can eat into your cash flow quickly. Any concerns, give your county property appraiser a call to discuss. I’ve always found mine to be helpful.
How I use NOI in Analyzing Potential Rental Properties
Most commonly I use NOI for two scenarios: (1) to quickly analyze deals like we did through this post to ensure it will cash flow like I want and (2) to derive at an offer price for a potential rental property, especially for commercial properties (office buildings, 5+ unit multi-family, & apartment complexes). To derive at a fair offer price for a commercial property you divide the NOI by the current market CAP Rate. A separate, more advanced posts.
Questions or comments? Leave them below!