Determining Net Operating Income
If you have ever filed your taxes, you know that a lot of owners over-report their expenses and under-report their income. The net operating income number is used to determine profitability, value and overall strength of the real estate property.
What is net operating income?
You get your NOI or Net Operating Income by taking your annual gross income and subtracting the operating expenses. No income taxes and interest are deducted. When the number you get is negative it is called a net operating loss.
Your gross operating income includes your rental income as well as all other income like, laundry receipts, parking fees, vending receipts... Every income that your property has brought to you.
Operating expenses are the costs you've made to operate and maintain your property. This can include insurance, utilities, repairs, supplies, management fees, maintenance, property taxes...
Capital expenditures, income taxes, loan payments, principal and interest, depreciation and amortization of loan points are not operating expenses and can't be subtracted.
Here's an example:
Income
Gross Rents: 150,000
Other income: 5,000
Total Gross Income: 155,000
- Vacancy amount 3,000
Effective Gross Income: 152,000
- Operating Expenses: 32,000
Net Operating Income: 120,000
The net operating income is used to calculate the Capitalization rate. You can use this Cap Rate to calculate an estimated value of a property that produces income. The net operating rate of income properties that are similar to the one that is for sale will be used to calculate the estimated value. We take the net operating income divide by the cap rate percentage and get the estimate.
The net operating income is an important key to calculate the DCR or Debt Coverage Ratio. This DCR is used to calculate if the property will be able to provide enough income to pay for the mortgage and operating expenses. If you have a DCR of 1 you are breaking even. Lenders will use this ratio to decide to give or not give a commercial loan to someone. The large the DCR, the better. To calculate the Debt Coverage Ratio you take the Net Operating Income and you divided by the Debt Service. The Debt Service is the sum of the principal and all the interest paid in a year. You can calculate this by multiplying the mortgage payments by twelve.
You can see it is of great importance to understand how your net operating income is being calculated. It's a key factor to calculate other ratios like the debt service coverage ratio, the capitalization rate and the net income multiplier. It's of great importance of the Cash Flow Statement and the Income Statement of an income property.
The Net Operating Income is often being used as a measure to see if a company has a healthy performance. It's a figure that can't be easily manipulated. Investors will decide to buy a property by taking a looking at the income the property is producing. The NOI is an objective measure of the income of a property.