The Little Geeni

The income statement of a firm indicates the flow of sales, expenses and earnings during a period of time, typically on a monthly, quarterly or yearly basis. 

Net Operating Income (NOI) is the product of subtracting operating expenses from gross income, excluding depreciation and amortization. In particular: 

Gross income: it includes any type of income associated with a property such as plant and equipment, parking fees, vending receipts etc. 

Operating expenses: they are costs incurred during the operation and maintenance of a property.  They include repairs and maintenance, insurance, management fees, utilities, supplies, property taxes, etc.   

Depreciation: it is an annual charge that reflects the estimated costs of the assets used during a specific period, typically a year. Depreciation refers typically to the plant and equipment, i.e. the tangible assets of the firm and it is subtracted after Net Operating Income is calculated in order to calculate the Net Income of the firm. 

Amortization: it is an annual charge that reflects the estimated costs of the assets used during a specific period, typically a year. Amortization refers typically to the intangible asses of the firm such as loans, patents, goodwill etc. and it is subtracted after Net Operating Income is calculated in order to calculate the Net Income of the firm. 

Example

We assume the following income statement in order to calculate the Net Operating Income (NOI) of firm X: 

1/ Calculating Gross Income

Net Sales = 38,000$

Cost of Sales = 23,700$

Gross Income = Net Sales – Cost of Sales = 38,000$ – 23,700$ = 14,300$

2/ Calculating Operating Expenses

Rent = 1,000$

Salaries = 3,500$

Utilities = 400$

Supplies = 1,500$

Equipment Repair and Maintenance = 150$

Advertising & Promotion = 1,600$

Loan Interest = 250$

Operating Expenses = 1,000$ + 3,500$ + 400$ + 1,500$ + 150$ + 1,600$ + 250$ = 8,400$

3/ Calculating Net Operating Income (NOI)

Net Operating Income = Gross Income – Operating Expenses = 14,300$ – 8,400$ = 5,900$

Net Operating Income (NOI) is used when calculating the Operating Profit Margin ratio of a firm. Operating Profit Margin ratio measures the operating efficiency of a firm indicating if the relationship of the fixed costs to the production volume. The higher the ratio, the better a company is because this indicates that the firm’s fixed costs are lower than the firms’ gross income.

The ratio is calculated as follows: 

Operating Profit Margin = Net Operating Income (NOI) / Net Sales.  

Assuming above example and plugging in our data in the formula we derive that:

Operating Profit Margin = Net Operating Income (NOI) / Net Sales = 5,900$ / 38,000$ = 15.5%

This means that firm X makes $0.15 before interest and taxes for every dollar of sales.

Operating Systems Income, Operating, Understanding

Net operating income (i.e., NOI) is one of the most important calculations made in regard to any real estate investment because it represents the property’s potential income after all vacancy and operating expenses have been subtracted. In other words, net operating income represents the investment property’s productivity, or measure of cash flow.

To help plant the idea, consider net operating income in one of the following two ways, depending on whether or not a mortgage exists.

The investor pays all cash for the property. In this case, since the investment property has no debt, NOI virtually becomes the rate of return expected from a property for any given annual period before taxes and depreciation are considered. In other words, given no deduction for debt service (loan payment), you can regard net operating income as the annual cash flow (cash flow before taxes, or CFBT).

The investor finances the property. Here, since the property has a mortgage, NOI should be regarded as the anticipated amount of cash flow available to pay the mortgage. In this case, only the remainder of NOI (net operating income less annual loan payment) becomes the annual cash flow before taxes (or CFBT).

How to Calculate Gross Scheduled Income Less Vacancy and Credit Loss = Gross Operating Income Less Operating Expenses* = Net Operating Income

Example: Assume that you want to do an analysis on an income property that generates a GOI of $100,000 with Operating Expenses of $42,000. What is the NOI?

$100,000 Less $42,000 = $58,000

*Mortgage payments, depreciation, and capital expenditures are not considered operating expenses and therefore have no impact on net operating income.

It’s Role in Real Estate Investing

Net operating income plays a large role in a variety of real estate investment and holding period decisions. For instance, capitalization rate (cap rate) is calculated by dividing NOI by sale price. Likewise, property value (or the property’s sale price) is calculated by dividing NOI by the cap rate.

Example: Let’s continue to assume a net operating income of $58,000 (as in our example above) and a sale price of $580,000. What is the property’s capitalization rate?

Net Operating Income Divided by Sale Price = Cap Rate

$58,000 Divided by $580,000 = 10.0%

Okay, now let’s assume an NOI of $58,000 of and a cap rate of 8.0%. What is the property value?

Net Operating Income Divided by Cap Rate = Property Value

$58,000 Divided by 10.0% = $580,000

Net operating income also plays a large role with lenders. For example, Debt Coverage Ratio (DCR) is calculated by dividing the net operating income by loan payment.

Net Operating Income Divided by Annual Loan Payment = Debt Coverage Ratio

$58,000 Divided by $46,000 = 1.26

How Credible Is It?

Conceptually, NOI is important because of its use in numerous calculations surrounding property performance. Because it’s used to estimate property value and cap rate, as well as useful to lenders, NOI has become an essential component of real estate investment analysis. As a real estate investor, therefore, you should understand net operating income, and recognize what it means to your potential investment valuation.

But be careful.

Remember, NOI is not unlike other calculations typically used for real estate investing purposes. The result is only as good as the numbers are credible, and numbers can be manipulated. Sellers have sometimes been known to become very creative in order to make the relationship between the price and NOI to come out right.

So here’s a tip. Whether or not a property appears to have a favorable NOI with positive rates of return, don’t just accept the numbers. Spend the time to validate the numbers. Reconstruct the owner’s representations for income and operating expenses if necessary, and compute your own NOI. Whatever you do, rely on nothing less then the most credible net operating income possible. You can’t afford not to.

Operating Systems Analysis, Estate, Income, Operating, Real

In this article, we want to discuss the role of net operating income to real estate analysis. How it’s calculated and then how real estate analysts use net operating income to determine the profitability of investment real estate.

Net operating income (or NOI) is one of the most important calculations made during the analysis of any real estate investment because it represents the property’s potential income after all vacancy and operating expenses have been subtracted. In other words, net operating income virtually represents the income property’s productivity, or measure of cash flow.

To help plant the idea, let’s consider net operating income in one of the following two ways, depending on whether or not a mortgage exists.

1. The investor pays all cash for the property. Since the property is wholly owned and has no debt, in this case, NOI is the annual return the investor would expect from the property before consideration for taxes and depreciation. Given no deduction for debt service (loan payment), you can regard net operating income in this case as the annual cash flow before taxes (or CFBT).

2. The investor obtains a mortgage. Here, since the property has a mortgage, NOI should be regarded as the anticipated amount of cash flow available to pay the mortgage. In this case, only the remainder of NOI (after you subtract the annual loan payment) becomes the annual cash flow (or CFBT).

Okay, let’s summarize. If you pay all-cash for a rental property, because there are no mortgage payments, NOI by default represents the property’s cash flow. On the other hand, when there are mortgage payments, NOI represents the amount of money available to service the debt, and then, subsequently the cash flow only after the loan payments.

How to Calculate Net Operating Income

Gross Operating Income less Operating Expenses = Net Operating Income

For example, let’s assume you’re doing a real estate analysis on an apartment building that produces a gross operating income of $100,000 and operating expenses of $42,000. What is the NOI?

This should be easy. $100,000 less $42,000 equals $58,000.

Okay, but let’s make sure that you understand both components in the formula.

1) Gross Operating Income (GOI) – This equals the rental property’s annual gross scheduled income less vacancy and credit loss. In other words, GOI is the actual income the rental property is expected to produce.

2) Operating Expense – An operating expense ensures the property’s continued ability to produce income. Whereas such things as property taxes, utilities, and maintenance and repairs are operating expenses, mortgage payments, depreciation, and capital expenditures are not considered operating expenses.

The Role of Net Operating Income

Net operating income plays a large role in a variety of real estate investment and holding period decisions. Capitalization rate, for instance, is calculated by dividing NOI by sale price, and property value is calculated by dividing NOI by capitalization rate.

Likewise, net operating income is significant to lenders. To compute debt coverage ratio (DCR), for instance, net operating income is divided by annual loan payment.

The Credibility of Net Operating Income

Not unlike any component in a real estate analysis, net operating income is only as good as the numbers used to compute it are credible.

Whether you use real estate investment software, a spreadsheet, or pencil and paper for your real estate analysis, you must spend the time to validate the numbers and reconstruct the owner’s representations for income and operating expenses if necessary.

Prudent real estate analysis demands it. Whenever you are running the numbers on any real estate investment, rely on nothing less then the most credible net operating income possible.

Operating Systems Analysis, Estate, Income, Operating, Real, Used