How to Calculate Net Operating Income (NOI)
As a real estate professional serving investment clients, you need to be very familiar with all the methods of valuation of income properties. One of these is the calculation of Net Operating Income, as it is used with cap rate to determine the value of a property.
Time Required: 5 minutes
- Determine the Gross Operating Income (GOI) of the property:
- Determine the operating expenses of the property. This would include expenses for management, legal and accounting, insurance, janitorial, maintenance, supplies, taxes, utilities, etc.
- Subtract the operating expenses from the Gross Operating Income to arrive at the Net Operating Income. Using the example of a property with a gross operating income of $52,000 and operating expenses of $37,000, our net operating income would be:
$52,000 - $37,000 = $15,000 Net Operating Income
Commercial lenders use different qualification criteria to determine if a mortgage is warranted and how much they will loan against a property. The investor owners usually aren't individually evaluated as to their credit history, as it's not as important to the lender as the income generation potential of the property to be mortgaged.
The fact is that a home buyer is going to live in the home they're buying, so the lender evaluates their ability to pay the mortgage and their history of paying debt obligations.
It's a very different situation from a commercial property, let's say an office complex. The buyers are buying this property for one single purpose; to generate positive cash flow from rental income.
The motivation for the purchase is income, so the lender wants to evaluate the property based mostly on the income it will generate.
Sure, property condition and other factors enter into the mortgage qualification, but income is the big factor. If the property can service the debt (pay the mortgage payments) and still have an acceptable monthly income cash flow, then a mortgage is likely to be initiated.
Of course, expenses are one half of the major considerations in the NOI calculation. It is critical to capture all of the operating expenses of the property. These can and often do include:
- Marketing and Advertising - Depending on the property type, this expense category can vary a lot. For an apartment property, most of this expense would be advertising to generate tenant applicants. For a retail or office property, the same would apply, but there may also be marketing expenses to present the property to consumers or clients for the tenants.
- Management - Professional management is the norm for larger commercial properties. This expense is significant, but it can be offset a lot by the savings professional management can generate in the operation and maintenance of the property.
- Utilities - Those not passed along to tenants would be in this category.
- Repairs and Maintenance - Everything from landscaping to fixing broken air conditioning units or painting of units is in this bucket.
- Insurance - This is a major expense as well.
Those are the main categories, and there are other expenses that are dependent on the use of the property and the tenants.
If the ratios wanted by the lender based on income are not pointing to approval, the borrowers can come up with more cash for a down payment to bring the ratios into line. Net Operating Income is very important in commercial lending.
- Be very careful to get all the operating expenses into the calculation. Missing expenses will increase net operating income and thus cause your client to overpay for the property based on valuation using cap rate.
- For the most used investor calculations explained and a spreadsheet to calculate them, take this lin, for the top 10 calculations.
What You Need:
- Comprehensive itemization of operating expenses.
None of these calculations are rocket science. You'll quickly get up to speed and be able to do them or discuss them intelligently with commercial investor clients.