How Net Operating Income is Used in Real Estate Analysis

In this article, we want to discuss the role of net operating income to real estate analysis. How it's calculated and then how real estate analysts use net operating income to determine the profitability of investment real estate.

Net operating income (or NOI) is one of the most important calculations made during the analysis of any real estate investment because it represents the property's potential income after all vacancy and operating expenses have been subtracted. In other words, net operating income virtually represents the income property's productivity, or measure of cash flow.

To help plant the idea, let's consider net operating income in one of the following two ways, depending on whether or not a mortgage exists.

1. The investor pays all cash for the property. Since the property is wholly owned and has no debt, in this case, NOI is the annual return the investor would expect from the property before consideration for taxes and depreciation. Given no deduction for debt service (loan payment), you can regard net operating income in this case as the annual cash flow before taxes (or CFBT).

2. The investor obtains 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 remainder 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 rental 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 payments.

How to Calculate Net Operating Income

Gross Operating Income less Operating Expenses = Net Operating Income

For example, let's assume you're doing a real estate analysis on an apartment building that produces a gross operating income of $100,000 and operating expenses of $42,000. What is the NOI?

This should be easy. $100,000 less $42,000 equals $58,000.

Okay, but let's make sure that you understand both components in the formula.

1) Gross Operating Income (GOI) - This equals the rental property's annual gross scheduled income less vacancy and credit loss. In other words, GOI is the actual income the rental property is expected to produce.

2) Operating Expense - An operating expense ensures the property's continued ability to produce income. Whereas such things as property taxes, utilities, and maintenance and repairs are operating expenses, mortgage payments, depreciation, and capital expenditures are not considered operating expenses.

The Role of Net Operating Income

Net operating income plays a large role in a variety of real estate investment and holding period decisions. Capitalization rate, for instance, is calculated by dividing NOI by sale price, and property value is calculated by dividing NOI by capitalization rate.

Likewise, net operating income is significant to lenders. To compute debt coverage ratio (DCR), for instance, net operating income is divided by annual loan payment.

The Credibility of Net Operating Income

Not unlike any component in a real estate analysis, net operating income is only as good as the numbers used to compute it are credible.

Whether you use real estate investment software, a spreadsheet, or pencil and paper for your real estate analysis, you must spend the time to validate the numbers and reconstruct the owner's representations for income and operating expenses if necessary.

Prudent real estate analysis demands it. Whenever you are running the numbers on any real estate investment, rely on nothing less then the most credible net operating income possible.