There are many tools real estate investors use to help calculate risk before diving into a new project. Within this toolbox is net operating income (NOI), which takes a holistic look at cashflow and project profits. Real estate investors use this calculation to help guide their decisions to invest based on what type of success NOI predicts.
What is an investment property?
An investment property is a property purchased by one or more people to generate profit long-term. This could be a piece of property with multiple units (like an office building or apartment complex) or a property with a single unit that someone buys and rents out.
Investment properties are positioned differently than, say, house-flipping or owning a second home because the investment strategy is oriented around the long-term goal of generating profit. In addition to the long-term nature of the investment, the property isn’t where the investor will reside part- or full-time (like they would in a primary or secondary home.)
What does net operating income (NOI) mean?
NOI is the formula real estate investors use to quickly calculate the profitability of an investment after considering overhead and other operating costs:
- Net: Profits that are left over after considering operating and income
- Operating: How much it costs to operate their business
- Income: Revenue generated from the property
By considering all income and all expenses in this one calculation, investors get relatively dependable insights into their projected profit.
The NOI formula
The NOI formula is a quick, effective and holistic way of calculating projected profit by considering all streams of income, subtracted by every possible expense in one calculation. For example, if you invest in a rental property, you’d typically generate income from rental payments. From an operations perspective, you might be looking at property upkeep, insurance and employment costs (like a management company or groundskeeper.)
The formula for NOI is as follows:
(Gross Operating Income + Other Income) - Operating Expenses = Net Operating Income
Gross operating income (GOI)
Your GOI is the rental income your property would generate if it was filled to 100% capacity minus vacancy rates. GOI is key to NOI, because you don’t want to make a calculation based on the assumption that your property will be performing to the best of its ability at all times.
You might be wondering how people project vacancy rates — some investors do market research by investigating the historic rental rates of their property before they owned it and by looking at similar properties on the market and their historic vacancy rates.
There are ways real estate investors generate income outside of rent payments. Vending machines, laundry units or parking are just a few examples. Taking other income into consideration, outside of GOI, when calculating your NOI contributes to more accuracy.
Your operating expenses consider everything it costs to maintain your property. For example:
- Regular maintenance
- Insurance costs
- Legal fees
What does NOI not consider?
The point of NOI is to get real insight on cash flow with the goal of determining the risk of the investment. Anything that doesn’t serve this goal — like technicalities or expenses that aren’t permanently relevant to the business model — are excluded from the calculation. For example:
- Tax write-offs
- Large one-time expenses, like replacing a cesspool
- Mortgage payments
If you’re interested in becoming a real estate investor, it’s helpful to project the risk of your investment before making a big financial commitment. There are many ways to research and help form your decision. Consider seeking advice from a financial advisor and using NOI to help protect the health of your real estate investment.