Net Operating Income (NOI): Definition, Calculation, Components, and Example
What is Net Operating Income?
Net Operating is a method used to calculate or measure the income a property produces or generates. It is the income before tax; therefore, all the operating costs are subtracted from the income generated by the property to get the precise value of Net Operating Income (NOI).
Property can generate income in many ways, such as rent and amenities like parking structures, vending machines, and laundry facilities.
Real estate investors often use NOI to calculate the precise value of any property before buying, as it helps them compare the properties' worth from one property to another.
Now, the question arises, "what are the operating costs and what costs will be included while calculating the NOI?" Operating costs are the costs that the property owner incurs to run and maintain the building or the property. It also includes property taxes, insurance premiums, legal fees, repair costs, and utilities. But, it will not cover any kind of capital expenditure.
For example, if the owner has installed AC for the whole building, then the cost incurred in the installation will not be included in the calculation of NOI.
Lenders or investors also use this method before investing in any property. They do this to check whether the property they are investing in or the money they are lending in the name of the property is generating enough income to cover operating costs and loan payments.
In particular, NOI is calculated by subtracting all the operating costs which are reasonable and necessary to maintain the property from the net revenue that the property is producing. This is how you may get the NOI for any property.
Net operating income is also sometimes referred to as "Earnings Before Interest and Taxes" or EBIT.
NOI gives an idea to the owner of whether it is worth it or not to rent the property and incur/ bear all the operating costs to maintain it.
Calculation of Net Operating Income
Net Operating Income is equal to the value which comes after subtracting all the operational costs incurred to maintain the property, for which the NOI needs to be calculated from the total income the property produces.
The revenue the property generates could be in the form of rent, fees for parking, laundry machines, or any other kind of income.
And the operating cost is the total cost which is incurred by the owner of the property in the maintenance of the property.
In mathematical terms, the formula for the calculation of Net Operating Income is defined as below:
NOI = RR - OE
Where RR stands for Real estate Revenue, and OE stands for Operating Expenses.
Let's understand this through an example. Suppose there is a property that has been put on rent by the owner. And the following figures are given for such property:
Income from Rent= Rs. 200000
Fees for Parking = Rs. 1500
Laundry Machines= Rs. 500
Total Revenue = Income from Rent + Fees for Parking + Laundry Machines = Rs. 202,000
Suppose the following operating expenses:-
Property management fees= Rs. 100000
Property Taxes = Rs. 15000
Repair and Maintenance= Rs. 10000
Insurance = Rs. 5000
Total Operating Expenses = Property management fees + Property Taxes + Repair and Maintenance + Insurance = Rs. 1,30,000
Therefore, to calculate the property's Net Operating Income (NOI), we need to put the above data in the formula of NOI, i.e.:
NOI= RR- OE
NOI = 202,000 - 1,30,000 = 72000
Therefore the Net Operating Income for this property will be Rs. 72000.
Suppose a property generates revenue of Rs. 1200000 annually. The operating costs which are incurred on that property totals Rs. 800000.
Therefore, in such a case, the Net Operating Income will be -
NOI= 1200000 - 800000 = 400000
In the case where the total operating cost incurred on any property is more than the total revenue generated, then the result which will be received by putting the data in the formula of the NOI will be negative, and therefore, it will be called Net Operating Loss (NOL).
Lenders and creditors consider NOI a great deal to determine the ability of an asset to generate income.
If the lenders are satisfied with the calculated NOI of the property, then only they invest in such properties. The value of the NOI also affects the decision of the lenders on how much loan they should give to such property. If the NOI is negative in value, then in such a case, the lenders do not usually accept the application of the borrower for a mortgage.
Also, many property owners manipulate the operating expenses by postponing such expenses, which are not that necessary and may increase NOI. For instance, suppose the property owner needs to increase the net operating income. In that case, he may increase the rent and other fees and reduce the expenses incurred in maintaining the property.
Let us understand this concept practically. Suppose the owner of a property plans to waive off Rs. 12000 from the rent of the tenant. However, in return, he asks the tenant to act as the manager of the property. If the owner hires any property manager, then he needs to pay or expend around Rs. 30,000 more. But, here, he saves that money by appointing the tenant as a property manager, and he only needs to expend Rs. 12000 instead of Rs. 30,000. In this way, he appropriately reduces the operating expenses by deducting the reasonably necessary cost, and hence the NOI will increase.
Components of NOI
The two main components of the Net Operating Income are revenue and total operating expenses. It should be noted that capital structure does not matter in determining the value of the firm.
The total revenue in such cases includes all the earnings made by any real estate and, in some cases, a firm or a business conducted on a property. It not only includes the rent, which is coming from the property, but also includes earnings from any other services being provided, like fees for parking, earnings from any vending machines on the property, or laundry services.
All the costs which the tenants do not cover if the property is rented are included under the operating expenses. Simply put, the operating expenses are the cost that is required for maintenance and repair and cannot be avoided. It also includes the cost incurred for insurance or taxes, which must be paid, and property management fees, if any.
Difference between Net Operating Income and Gross Operating Income
To calculate the Gross Operating Income for any property, all the losses which are incurred because of vacancies of any type are subtracted from the total potential income from that property.
Conversely, while computing net operating income, the total operating expenses are subtracted from the Gross Operating Income. The Net Operating Income method can be used to calculate the potential income from a property in which the investment has been made.
Net Operating Income and Capitalization Rate
If you have the value of NOI, then that can also be used to calculate the Capitalization Rate as the formula for the calculation of Cap. Rate is defined as-
Cap. Rate= NOI/ Total Cost of the Property
It is expressed as a percentage and shows investment returns from various assets. The investors use the Cap. Rate to compare the returns from different properties.
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