How to Calculate NOI (Net Operating Income) for Real Estate Investing
Mastering the net operating income or NOI of a property is crucial to properly understanding underwriting and managing your real estate portfolio. But there is a big mistake some people make when calculating NOI. In this blog post, I’m going to walk you through what NOI is and how you can correctly calculate it for your property.
What Exactly is NOI?
NOI stands for net operating income. There is a formula that we use to calculate NOI — NOI = your gross income minus your operating expenses.
To understand NOI, we have to understand what gross income and operating expenses are — the two components in the formula.
What is Gross Income?
Let’s start with gross income. What is gross income? With a multi-family property, we have:
● Rents (all the rent money that comes in)
● Late Fees
● Laundry (if we charge for laundry)
● Application Fees
● Trash Pickup
● Yard Fees (if they get a private yard)
Basically, every single dollar of income produced by the property. It doesn’t matter how it’s produced — it’s going to fall under gross income. Gross means everything, so gross income means every single dollar of income, whether through rents, late fees, laundry, and all the examples we mentioned above. Those items — plus a whole lot more — are going to come under gross income. It’s your big dollar figure.
What Are Operating Expenses?
Then we have operating expenses. Operating expenses are expenses that the property incurs over the course of normal business. What are some operating expenses?
● Staff Cost — on-site leasing agent, on-site maintenance staff, etc.
● Repairs — Examples: If we have to repair an appliance, if we have to repair the parking lot (maybe we have potholes), or maybe we have to repair the roof.
● Utilities — If you have a RUBS (Ratio Utility Billing System) program where you’re putting the utilities back on the tenant, utilities will come under operating expenses and then with your gross income you will have your RUBS other income coming in for the utilities and that offsets itself.
● Management — You get the idea.
So basically, any expense that the property incurs over the course of doing normal business.
Capital Expenses Are Not Operating Expenses
A capital expense is an improvement to the property. For example, let’s say we are renovating the kitchen in a unit. We’re improving the property. We’re increasing the value of that property so that would not fall under an operating expense. That would be a capex or capital expenditure. But an operating expense is incurred in the normal course of doing business — repairs, maintenance costs, utilities, staffing, that sort of thing.
Let’s say we have a property with a gross income of $1 million. Our operating expenses are $500,000. We’ll use that 50% rule for expenses. That means the NOI of the property — the gross income — all the income we have coming in — minus all the operating expenses — is $500,000. That’s the leftover money — the free cash flow of the property. So the NOI is really just telling us what the gross income is but subtracting the normal operating expenses.
Debt Service Is Not Included in the NOI
There is a big mistake a lot of people make when calculating the NOI. They include debt service like mortgage payments. If you have a loan on the property, debt service is not included in the NOI. This is a huge mistake.
When we’re talking about free cash flow, we’re talking about debt service included. Debt service is not included in an operating expense because an operating expense has to do with the property itself — what is the property expending or spending to make sure the business runs smoothly. The owner of the property decides what sort of debt they’re going to place on the property. That’s going to vary from owner to owner. One owner may choose to acquire property all for cash. Another owner may choose to leverage the property up to 50% at one mortgage rate. Still another may choose to leverage the property at 75% at a different mortgage rate. That’s going to change the free cash flow after debt service which is not what we want to do. We are using the NOI to assess the actual business of the real estate property.
Bottom line, we need to exclude the debt service because that’s up to the owner’s discretion. The owner makes that choice. We do not include it in operating expenses. That’s a huge mistake I see people making all the time. So once again, remember, debt service is not included in operating expenses. So again, NOI is gross income minus operating expenses and that gives us our net operating income.