When evaluating properties, the income approach is one of the best ways to gauge how to proceed with the deal and what details need to be collected. One of the most critical metrics of income in real estate is the “net operating income” or the NOI. The NOI is used to calculate a variety of values, measurements, and rates, including property value and capitalization rates. It helps you to find the potential long-term upsides to a property.
But what exactly is NOI, and how does one calculate it? Also, how can one use this approach to evaluate different properties? Well, you can get all the details you need by reading below.
NOI: The Formula
At its core, the NOI is a mathematical formula. It’s merely the real estate revenue subtracted from the operating expenses. The NOI is an essential tool for all real estate investors since it helps show them how valuable property is and whether it is a good investment. Investors can also use the NOI to help calculate the rent rates for properties they already own and to work out potential upsides. The NOI is typically calculated annually and is considered a before-tax figure, meaning the figure represents a total before income tax, and other interest rates are deducted. The formula for NOI is the following:
Gross Operating Income(GOI) – Operating Expenses(OE) = Net Operating Income(NOI)
This formula seems simple enough, right? There’s a little more to it, however, as there is some nuance to the definition of the terms used in the formula itself. First, one has to understand what “gross operating income” entails. This is a little more complexed, however, to find the total value of real estate revenue, you’ll have to find the potential rental income, or the combined total of rent paid out by residents. That number is to then be added to other income streams created by the property, such as additional services like laundromats, or parking garages. That total is then subtracted from the losses incurred by vacant leases, not turning a profit. That’s how you find the total real estate revenue. The formula looks a little like the following:
Gross Operating Income (GOI) = Projected Gross Opportunity Income(PGOI) + other income sources – vacancy losses.
Calculating The Operating Expenses
The next component to figuring out the NOI is calculating your total operating expenses. Operating expenses usually entail property taxes, regular maintenance, rental property insurance, property management fees, and various other expenses like legal fees. However, not all expenses are necessarily operating expenses. Take, for instance, capital expenditures on major, irregular repairs. This might seem similar to normal maintenance, but there’s an important distinction.
Regular maintenance, like cleaning and the replacement of simple components, is a consistent expense that can be calculated into a normal expense report cycle. But major repairs, like replacing an HVAC system, might occur only once every decade or so. They are far from being regular expenses and shouldn’t be calculated as such. Other expenses that aren’t calculated into the total operating expenses are tenant improvements, debt services, income tax, etc. Generally, anything that isn’t exclusive to the property itself and involves the investor/borrower.
Evaluating a Property Based on the Income Approach
Now that you have a clearer idea of the NOI, you can use this figure to start evaluating properties. Whether you have an industrial property, multi-family complex, office building, or mixed-use property, it is always vital to figure out the rental income being generated, and the potential income that could be generated. Regardless of what the type of property or asset class is, you can use the income approach to measure the viability.
The income approach is based on finding the upsides and opportunities of your investment. Essentially, these are the opportunities to make more money, and any investor should be looking into these. The real value of a property is not limited to the current ROI, but rather to the potential upsides that may be present. Down the line, you may be able to extract more value and make more money as a result.
Upside comes from increasing the rent or decreasing your expenses. These methods will allow you to get added value from a property. Therefore, you can use the NOI to start playing with these figures and see where the potential upside will come from. This income approach is a way to move forward with your deals and to extract long-term value from prospective properties. Having these figures in hand will allow you to calculate these potential upsides with ease.
Finally, An NOI That Makes Sense!
Now that you understand the terms behind the NOI, you can finally calculate it. However, you might be asking yourself when you would need to calculate the NOI in the first place. There are certain instances when an NOI calculation is incredibly useful. We already mentioned that the NOI can be used to calculate property value or the rate of rent. However, the NOI is also vital to calculating more specific measurements, like return on investment, that are useful for figuring out how much you’re making. You should keep this figure handy whenever you need to consider an approach for a property since it will let you know whether it is financially viable.
All in all, NOI is a nifty tool that helps investors and landowners navigate the complexity of real estate finance and determine whether or not a property is worth investing in. It also brings up a lot of vital information for analysis, and the income approach is one that you should definitely follow.
