Net operating income is another key metric used to assess real estate property investments.
A relatively straightforward and easy figure to calculate, net operating income assesses the profitability of a commercial building. It can be used to quickly compare the potential income earned on a building and acts as a crucial precursor to other calculations like the capitalisation rate.
Net operating income, or NOI, is one of the most important commercial property metrics used to compare investment opportunities.
By calculating the NOI of a commercial property, you can discover how its rental income and other incomes compare to ongoing property management fees and other ongoing costs.
What is Net Operating Income?
NOI is a real estate investment metric that assesses the net income of a commercial building.
By deducting operating expenses from rental payments, NOI finds the potential income of a building after expenses have been taken into account.
Net operating income is calculated on what is theoretically an all-cash purchase – mortgage payments are not included when calculating net operating income.
Net operating income looks only at the potential income of the building itself. This is suitable when a mortgage has not yet been found or is not needed.
Once a mortgage has been found, other metrics like ROI become more useful. NOI is considered in the early stages of commercial property investment. A lender will likely want to see NOI information about a building to approve any sort of mortgage.
Needless to say, the net operating income of a building has to be a positive figure for the investment to be worth further consideration. An NOI figure in the minus would is known as a net operating loss, or NOL.
How to Calculate Net Operating Income
Net operating income is a simple figure to calculate, so long as you know what to include and what not to include in the calculation.
The calculation for net operating income is:
NOI = Total Property Revenue – Total Operating Expenses
The total property revenue is reasonably easy to calculate in the vast majority of cases and is typically comprised of the rent. There may be other income to factor in, such as ground rents or any additional revenue made from parking or equipment/services hire or rental.
The total operating expenses include all predictable and ongoing costs associated with the operation of the building.
Most of these are straightforward to calculate, e.g service charges and building maintenance.
Others are not so easy to calculate, such as the vacancy rate, where you’ll need to induct vacancy data from other similar properties in the area.
The net operating income does not include any mortgage payments – these are not relevant to the net operating income of the building itself. Net operating income essentially assumes an all-cash purchase, much the same as the capitalisation rate.
Mortgages are factored into other metrics, like ROI.
The debt yield and debt service coverage ratio are used to factor in mortgage rates. Net operating income is just a quick measure of building profitability.
NOI can be calculated for monthly, quarterly or annual periods, but is usually calculated annually. It could also be calculated for the entire duration of the lease.
Net Operating Income Examples
Building 1: Commercial Office Block
- Monthly rent = £2,500 monthly x 12 = £30,000 annually
- Car parking charges = £5,000
Total annual revenue = £35,000
- Service changes, insurance and maintenance = £500 monthly x 12 = £6,000 annually
- Vacancy rates = 5% (5% of £30,000 rental income) = £1,500
Total annual expenses = £7,500
NOI = £35,000 – £7,500 = £27,500
Note, the vacancy rate of 5% here is typical of office commercial real estate in London, which fluctuated between 4.3% and 6.5% between 2013 and 2019.
5% vacancy rates will result in an additional 5% loss on rental payments over a given period, which counts as an expense in the case of calculating NOI.
In reality, the building may not be vacant at all. The vacancy rate can also factor in the chance of tenants defaulting on their payments.
Once you have the NOI, calculating the cap rate is simple:
Cap rate = NOI/Present value of the building x 100
27,500/1,000,000 x 100 = 2.75
The above building, if valued at £1,000,000 would present a capitalisation rate of 2.75%.
This percentage can then be compared to other similar buildings on the market.
What is Included in an NOI Calculation?
Here is a breakdown of what to include in a net operating income calculation:
Rental Income – Rental income is the sum of all rents collected over the measurement period, usually 1 year. You could also measure rental income for the entire duration of the lease. Note that rental income usually does not take vacancy rates into account. You could deduct vacancy rates from the rental income to find the gross rental income, but don’t deduct it again as an expense if you do.
Insurance Costs – The costs of regularly insuring a building is a routine operating expense and should always be included in the NOI.
Other Incomes – You might be collecting other income from your tenants. This might relate to the renting of services such as machinery, car parking or other equipment that comes with the building. These will also have their own expenses.
Vacancy rates – Factoring in vacancy rates gives you an idea of how much rent you can expect to lose from vacancies. This is essentially calculated as an expense. Of course, vacancy rates are open to interpretation and it depends on your tenants and rent/lease terms.
However, to produce an NOI measure, it’s handy to factor in vacancy rates to give some indication of how much revenue you could lose on an average year due to vacancies.
Operating expenses and maintenance – Operating expenses pertain to the building itself. It includes everything that you’ll be paying to maintain the building.
Management fees, repairs, utilities and service charges are included here, as well as other miscellaneous costs. Any expenses that are regular, routine and predictable should be included when calculating the net operating income of a commercial building.
If there are any extra fees associated with acquiring the property, e.g. legal fees and surveys, then these could be included as expenses in the first year’s NOI, thus rendering the first year’s NOI lower than subsequent years.
What Not to Include in a Net Operating Income Calculation
It’s also crucial to understand what to leave out of an NOI calculation. NOI calculates all regular, predictable and routine revenues and expenses relevant to the property. It does not include:
Debt Service/Mortgages – Debt servicing, mortgages and other financing are not included in an NOI calculation. These figures are not related to the operating income of the building. Moreover, it’s unlikely that the investor will have looked into financing a building at the time of calculating NOI (though they may have some idea of what they can or can’t get.
Depreciation – Depreciation isn’t a cash flow and would not be factored into the NOI calculation.
Capital Expenditure/Reserves for Repair and Replacement – Cash reserves for more serious repairs and replacements aren’t a predictable or routine cash flow. Therefore, they’re not typically included in the NOI. This does depend, though, as some level of capital expenditure is inevitable, especially over a longer rental period.
Income Tax – Income tax is not an expense relevant to the operation of the building itself and is therefore not included in NOI.
Related Metrics that Use Net Operating Income
Capitalisation Rate – The capitalization rate, or cap rate, divides the NOI of a building by its current market value expressed as a percentage. Buildings with higher cap rates are more profitable at their current market value.
Debt Service Coverage Ratio – DSCR uses NOI to help lenders and investors decide on whether to finance a property. It looks at the cashflows of NOI and annual debt service.
Cash On Cash Returns – Cash on cash returns use NOI relative to the initial cash investment made on a property.
Pros and Cons of Calculating the Net Operating Income
Pro: Quickly Assess Property Cash Flows
NOI allows both the investor and lender to quickly assess a property’s cash flows. A positive NOI will have to be submitted to a lender for them to consider a mortgage.
Since NOI is simple to calculate from relatively easily gathered information and data, it’s one of the first metrics to analyse when considering a commercial property investment.
Pro: Visualise Operation Costs
Penning down a property’s operation costs will give you an idea of how much rent is required to turn a net profit. A borderline or low NOI might indicate that maintenance costs are too high, thus prompting the investor to readdress whether these costs are accurate, necessary or appropriate. Switching service providers, tariffs or utilities could lower operating costs.
Raising the rent may also be an option. Moreover, NOI can help investors visualise how vacancy rates affect their bottom line – if the damage posed by vacancy rates are great then the investor will have to offset them.
Pro: NOI is Required to Calculate Other Metrics
NOI is a fundamental property metric. NOI is required to calculate many other metrics including the capitalisation rate, cash on cash returns and debt service coverage ratio. It’s a prerequisite for securing a mortgage or other loan.
Con: NOI Fails to Account for Future Changes
NOI is only realistically correct over shorter periods of time. The metrics used to calculate NOI vary throughout time, especially operations costs and utility bills which are more likely to increase than decrease. Some metrics like net present value (NPV) factor in inflation and other future changes to cash flows, but NOI fails to do this.
Con: NOI Relies on Accurate Figures
Accurate rental and operating cost figures are crucial to finding an accurate NOI. Overestimated or underestimated figures may drastically influence the NOI of a building. Management costs may be particularly difficult to estimate without some knowledge of the potential tenants at least.
Con: Only a Simple Measure
Ultimately, NOI is limited when it comes to assessing the true ROI of a building. ROI factors in mortgages and lending, thus making it a more comprehensive measure of profitability. NOI should be viewed only as a rough guide to cash flows.
Summary
Net operating income describes the operating income and expenses of a commercial property investment. It’s a quick measure used to gauge how much income remains after property expenses are accounted for.
NOI is easy to calculate from a limited selection of information. You won’t need any information on mortgages or lending to calculate it.
So long as you have accurate figures pertaining to a property’s rent and other revenue (e.g. equipment rental) as well as standard routine maintenance and operation costs such as management fees and routine repairs, then you can calculate the NOI.
The NOI will be assessed by lenders – a higher NOI likely means a bigger mortgage will be afforded by the lender to the investor.