It’s important to note that the NOI will remain the same whether you pay for a property with cash or a commercial real estate loan.
Don’t be intimidated - The calculation is not a science. Slow down - take your time - Mistakes are made by people in a hurry. Being meticulous in record keeping will go a long way.
Before you dive in:
- Don’t be intimidated - The calculation is not a science
- Slow down - take your time - Mistakes are made by people in a hurry
- Being meticulous in record keeping will go a long way
Why is NOI so Important to Commercial Real Estate Owners?
If you’re a commercial real estate owner, NOI is invaluable. Since it measures a property’s ability to generate a positive cash flow, it can help you understand its potential benefits and risks.
You can use NOI to compare different properties you might be interested in buying or selling. It’s a great way to make smart investment decisions, decide how to invest in commercial real estate, and thrive in the world of commercial real estate.
Even though NOI can change over time as the revenue and expenses of an investment property fluctuate, it will still provide crucial information about whether a certain property will earn enough rental income to support its debt payments.
How to Calculate Net Operating Income (NOI)
Fortunately, you don’t have to be a math genius to calculate NOI.
Here’s how you can do so:
The Net Operating Income Formula
NOI = Gross operating income - Operating expenses
Gross Operating Income
Gross operating income refers to your revenue when you operate a property. In most cases, this is how much you earn in rent. However, it can also include income from other sources like paid parking, laundry facilities, vending machines, and other additional services. Remember that since you’ll likely have vacancies and repairs throughout the year, you can’t base gross operating income solely on the number of units.
To understand your true NOI, you’ll need to subtract your operating expenses from your gross operating income. Operating expenses include all of the costs you spend to operate a property. If the tenants do not pay them, these may be repairs and maintenance, taxes, insurance, attorney and accountant fees, marketing expenses, and utilities.
Generally speaking, a positive NOI means that a commercial property is a wise, profitable investment. On the flip side, a negative NOI indicates that it’s likely risky and may not offer the ROI (Return On Investment) you’re looking for.
How to Interpret Net Operating Income (NOI)
The NOI of an income-producing property can give you, the owner or investor, a clear picture of a property’s potential cash flow because NOI is very difficult to manipulate. In this way it can help you determine how to value commercial real estate. You can only change the NOI if you increase the rental income, reduce vacancies, or cut operating expenses.
Therefore, the NOI will tell you how well a property is managed compared to similar properties in the area or other properties you may already own. You’ll be able to quickly find out whether your operating expenses are too high or rent or is too low.
Also known as “cap rate,” the capitalization rate is the NOI divided by the property’s value. The cap rate, which is expressed as a percentage, can show you the rate of return on a property you purchase on cash, rather than on loan. While a higher cap rate signifies a larger return on your investment, it also comes with a higher potential risk.
To determine the property value, divide the NOI by the cap rate. Suppose you’d like a rough estimate of the fair value of a property given the NOI and cap rates of comparable properties in the same neighborhood. In that case, this calculation can be very useful.
Debt Service Coverage Ratio (DSCR)
DSCR reveals whether you have enough income and cash flow to meet your debt service obligations. To calculate the DSCR, divide the NOI by annual debt service or how much principal and interest you owe each year to pay back a loan. A larger DSCR means you have a greater cushion or safety net and a rate over 1 means you are solvent and can pay debts.
Net Operating Income vs. Net Income
Net operating income is the revenue you generate from a property’s day-to-day operations minus operating expenses. It excludes earnings from other investments, loan interest, taxes, and additional capital expenditures.
Net income, however, takes all income and expenses, including non-operating expenses, into account. Non-operating expenses might be interest payments, taxes, inventory costs, lawsuit settlements, and derivatives.
You can think of net income as a property’s profits after every source of income and expense has been considered. It’s often the bottom line since it’s typically the last item on an income statement.
Capitalization Rate vs. Net Operating Income
Capitalization rate and NOI are two metrics real estate investors may use to make wise investment decisions. When paired with the NOI, the cap rate can assess the value of a property with great accuracy.
Both cap rates and NOIs serve as historical benchmarks to estimate what a property is worth and might be particularly useful in the early stages of the investing process. They’ll make it easier for you to compare investments and choose the properties that set you up for success.
How to Maximize NOI
To maximize NOI, you’ll need to take certain steps that increases a property’s profitability. Profits will increase if you increase rental rates, reduce vacancies, lower expenses, and consider investing in various types of real estate investment. While cutting expenses is easier said than done, it is possible.
Here are some ideas to explore:
- Outsource Labor: You may find it less expensive to outsource labor than pay for everything in-house. While it may be beneficial to have a small in-house team, you might be better off with contractors that you only hire on an as-needed basis.
- Reduce Water Usage: Water can be a great expense for your property, so it only makes sense to reduce it. You can install low-flow toilets and showerheads and/or convert some landscaping to xeriscape (a landscape design that requires little or no irrigation and requires little maintenance).
- Look for New Bids on Services: Chances are you’re overpaying for at least one service. It may be worthwhile to rebid services you receive, including trash, HVAC, plumbing, and electrical.
- Incorporate Recycling: It’s usually free or very inexpensive to implement a recycling program, and doing so can reduce the waste your residents generate. It means smaller dumpsters or fewer pickups, saving you a lot of money.
Use NOI to Make Smart Investment Decisions
NOI is a metric to calculate how profitable a potential investment property may be. It can help you make informed decisions when exploring types of real estate investment and deciding how to buy commercial real estate.
However, it’s just one way to help you choose the best properties as an investor. It’s a good idea to also look into the cap rate, internal rate of return, cash on cash return, gross rent multiplier, and other measurements.
Whether you’re new to commercial real estate or have been in it for quite some time, Lendio offers the commercial real estate loans you might need to help you meet your goals. You can register for free, apply within 15 minutes, and browse various offers. There’s no faster or easier way to find the perfect loan.