Building wealth through real estate involves more than renting out a property, flipping and selling a house, or buying into a Real Estate Investment Trust (REIT) and tallying every cashed check as income. Managing a real estate portfolio requires a number of hard and soft investments that cut into your bottom line, impacting your overall income.
When calculating your annual earnings and making decisions about your real estate investment portfolio, it’s essential to look at net operating income (NOI). But what is NOI, and how does it apply to your short- and long-term investment goals?
Here’s a quick guide to better understand what net operating income is and how it applies to your real estate investments.
What Is Net Operating Income (NOI)?
In short, net operating income (NOI) is the total amount of money earned and reported every year after factoring in all operating expenses. This differs slightly from net income, which is all revenue minus all expenses, such as paying taxes, and not just those required for operating. A simple way to look at it is that NOI is your before-tax income.
NOI is important for real estate investors because it is a valuation metric that helps you to understand and calculate the profitability of income-producing properties over time. Armed with this information, you can make informed decisions about your properties, such as how much to charge for rent in the new year.
How Do You Calculate Net Operating Income?
To determine your net operating income, you need to subtract all operating expenses from all revenue earned by your properties. It’s a simple calculation — real estate revenue minus operating expenses equals NOI.
For example, say you recently sold a home for $300,000, purchased by cash with $200,000, making your revenue on the property $100,000. However, you also spent $25,000 on improvements and $20,000 on real estate commissions and closing costs. To determine your NOI, you would subtract all those expenses – which come in at $45,000 – from your revenue of $100,000, meaning your NOI for this property was $55,000.
Calculating your NOI requires a few additional steps if you have a more extensive real estate portfolio, including rental properties that earn monthly or annual profits. You’ll start with your gross operating income, meaning the amount of money you would earn from all of your properties when fully leased, plus any additional income, such as that earned from parking spaces. Then, you’ll subtract operating expenses as well as vacancy and credit losses sustained when your property sits without a tenant.
What Expenses Should You Include in Calculating Your Net Operating Income?
Operating expenses include the amount of money you pay every year to keep your real estate investment business functioning. If you work with rental properties, your expenses might include maintenance, service fees, and permits. You can also include utilities paid by the landlord, such as sewer and water, and what you pay every year in property taxes.
Capital expenses, such as what you would spend to install a new HVAC system or build a new roof, are not calculated in your NOI. You also do not count any potential income tax.
How Does NOI Inform Your Decision-Making?
When you know how much money you are actually earning compared to how much money you could be earning every year with your real estate investments, you’re not only a more informed investor — you can also make more informed decisions to increase your profit margin.
Say you typically buy and flip three properties yearly and work with a real estate agent to help you set the prices and find sellers. If you look at your NOI and see it continue to decline year after year, it might be time to find a new agent to work with to help you find properties that will improve your profit margin. You can also explore working with other contractors or using less expensive building materials in future updates and renovations.
Let’s say you have ten properties that each earn $12,000 a year, making your gross income $120,000. You had three units sit empty for five months, costing you $15,000 in profits. You earned $5,000 total this year from leasing parking spaces near your building and spent $12,000 on repairs and paying a leasing company. That means you would subtract $27,000 from $120,000 and add $5,000, making your NOI $98,000.
With a $120,000 potential income, a $98,000 NOI may seem like a large deficit, coming in at $22,000 below your projected income. While you can expect periods of vacancy with most rental properties, you can also look at this number and consider ways to narrow that gap more. Perhaps it involves hiring a new management company that reduces the length of vacancy between tenants. You could also decrease your annual operating costs by finding more efficient means for maintaining and repairing your investment property.
You can also use your NOI to decide if it’s time to sell a rental property that isn’t earning its full potential, by either take the money you earn from the sale and count it toward that year’s income, or reinvest it in another rental property with more income potential.
Depending on where you are in your investment journey, reinvesting in a new property can not only increase your future earning potential, it can also provide you with immediate tax breaks, such as those available with a 1031 exchange.