What is NOI and Why is it Important?
NOI stands for Net Operating Income, and it is a term that is widely used in the property investment and real estate sector. NOI is an indicator used to analyze what the yield of a particular asset will be. It is used to calculate an investment’s profitability and the revenue generated from a property after deducting all operating costs.
Some real estate investors even think of NOI as the most important metric when considering any investment since it directly affects the cash flow for various real estate properties, especially multifamily properties.
One major fact that must be remembered when dealing with NOI is that it comes before operational tax deductions. Some other finance sectors call it an “EBITDA” or “earnings before interest, taxes, depreciation, and amortization” which normally appears on your income and cash flow statement excluding all loans, amortization, capital expenditures, taxes, mortgage payments, interests, and depreciation.
NOI in the Multifamily Sector
Since NOI is a valuation tool, it is essential in the multifamily sector. It helps real estate professionals evaluate the exact income that is generated from their property. To do this, the property’s operating cost is deducted from the overall income generated by the property. The major source of income for the property is rental income. Other income sources for the property include revenue from parking lots, laundry facilities, vending machines, and other property owners’ amenities. On the other hand, operating costs include insurance fees, legal fees, utilities, property taxes, the cost for repairs, and cleaning or janitorial expenses.
In multifamily properties and real estate in general, NOI is used in calculating DSCR or debt service coverage ratio. This metric clearly shows if a property or investment can cover all of its debt payments and operational costs. Other metrics in which NOI is used in real estate include the NIM or net income multiplier, total return on investment, and cash return on investment.
How Net Operating Income is Calculated
To calculate the net operating income of any real estate property, we use the following formula:
Net Operating Income = Real Estate Revenue (or total income) – Operating Expenses
To understand the formula very well, let’s use an example. Consider the table below for a multifamily property.
|Description||Real estate Revenue||Operating Expenses|
|Property Management fees||$100,000|
|Repairs and maintenance||$300,000|
Total Revenue (RR) = $2,500,000
Total operating expenses (OE) = $1,000,000
NOI = RR – OE
NOI = $2,500,000 – $1,000,000 = $1,500,000
In the above example, the net operating income is $1,500,000. For instance, If the total income a property pulls in is around $500,000, and the total operating expenses are $800,000, the NOI is negative, by $300,000. This is referred to as Net Operating Loss or NOL. We must also realize that NOI is a key tool in measuring any property’s capitalization rate, as we see below. Other parameters that are dependent on the net operating income include:
- Lenders use debt service coverage ratios (DSCR) to determine if a property is worth financing. It calculates using both the NOI and the annual mortgage debt service.
- Cash on cash return – Investors usually use this to evaluate the annual returns on invested cash. It is generally calculated in relation to the initial cash investment put into a particular property.
- Return on investment (ROI) – This is usually calculated by dividing the NOI by purchasing the desired property and multiplying the result by 100 to get the ROI in percentage. Return on investment is a crucial tool for weighing the potentials a property has.
- Net cash flow (NCF) – The net cash flow is derived by subtracting both your Capital Expenditures (CapEx) and Debt Services (DS) from your NOI.
The Importance of NOI
Real estate investors and lenders are particularly interested in NOI because it represents the cash available to pay mortgages. This means that NOI is critical in many areas of real estate investing, including multifamily investing. NOI is mainly significant when it comes to:
- Property Market Value
- Financing Considerations
- Business Planning
- Investment Allocation
Property Market Value
A vital tool in NOI calculation and real estate investing is the cap rate. Capitalization rate goes a long way in determining the market value of any property. The capitalization rate is calculated by dividing the NOI of a property by the sales price or fair market value.
Capitalization rate = NOI / Sales Price
To calculate the market value, the NOI is divided by the capitalization rate of that property. i.e
Sales Price = NOI / Capitalization rate
When lenders offer debt services to property owners, the NOI becomes vital in determining if a property would have enough cash flow to offset the debt service. Lenders use the Debt Service Coverage Ratio (DSCR) to determine if a property can cover debt service after the operating expenses are paid.
The debt coverage ratio is calculated by dividing the NOI by the annual loan payment.
Debt Service Coverage Ratio = NOI / Annual Loan Payment
Real estate investors can make more informed decisions in evaluating properties by using NOI metrics. Assessing the viability and profitability of any property is paramount in succeeding in multifamily investing. The NOI metric is calculated by deducting all the operating expenses from the real estate income on a property. Higher revenues and lower expenses mean better NOI. Lower revenue and higher expenses represent lower NOI. Anyway is a great way to assess the financial health of an overall investment. It can also be a tool to evaluate if a property has the ability to perform better than it currently is performing.
Veena Jetti is the founding partner of Vive Funds, a unique commercial real estate firm that specializes in curating conservative opportunities for investors. Veena brings a dynamic perspective to targeting, acquiring, managing, and operating assets using best practices combined with cutting-edge technologies. Her professional expertise includes driving corporate strategy and business development opportunities.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.