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Profitability is a crucial metric most investors use to determine if an opportunity is worthwhile. The profitability of a real estate investment can be summarized using a metric known as net operating income (NOI). This is also known as the bottom line. Knowing what is above the line (included in the expenses) versus what is below the line (not included for this subtraction) is also vital and can change the profitability of an asset. Let’s get to the bottom line and discover why NOI is the lifeblood of a real estate property.
What Is NOI?
Before we can calculate NOI, we must define the following terms:
• Net operating income shows the total annual income minus expenses.
• Total income is equal to gross potential income minus vacancy, loss to lease, bad debt and concessions.
• Gross potential income is the income if all units are receiving full market rent.
• Vacancy is the percentage of units that are unoccupied and, therefore, not earning rent payments.
• Loss to lease is when a tenant is paying below the full market rent. This unit is occupied but not earning its full potential rent.
• Bad debt is when a tenant doesn’t pay even though they are occupying the unit. This must be subtracted from the gross potential rent since money is not being collected on this unit.
• Concessions are credits given to offset rent, application fees, pet fees, move-in/move-out fees, etc. They can also be used to waive extraneous fees to entice a new tenant to move in, or as customer service for an existing tenant to keep them from moving out.
Gross potential income = gross potential rent – vacancy – loss to lease – bad debt – concessions.
Once we have determined our gross potential income, next we must determine our expenses. Expenses include all reasonable and nonvariable annual costs, such as:
• Contract services such as grounds, security, lawn care, pest control, etc.
• Turnover expenses to clean up and rehab the unit to make it move-in ready between tenants.
• Utilities such as electricity, gas, water, sewer, trash, telephone, cable, etc.
• Management fees, which are usually a percentage taken out of the monthly income. Make sure to annualize all numbers for consistency.
• Repairs and maintenance for the property during the year.
• General and administrative (G&A) expenses, including travel, office supplies, printers, subscriptions, consultant fees, office furniture, etc.
• Payroll (plus benefits and bonuses) for all employees on the property.
• Marketing expenses, including marketing the property for a potential tenant to see in order to move in.
All these expenses are added to form the total annual expenses and then subtracted from the gross potential income. A key point to consider here is expenses that are not included in this calculation: interest, taxes and capital expenditures (one-time expenses such as a new roof or major renovations).
Annual expenses = contract services + turnover expenses + utilities + management fees + repairs and maintenance + G&A + payroll + marketing.
How To Calculate NOI
The next step is understanding how to calculate the net operating income.
Net operating income = annual gross potential income – annual expenses.
The total income minus expenses is also known as the bottom line. This determines the total cash left over to pay the bank (if financed) and investors and to make a profit. The ability to increase income (by lowering vacancy or increasing rents) while at the same time lowering expenses forces the NOI to increase.
NOI Is The Lifeblood Of A Deal
Net operating income is the lifeblood of a deal because of the cash flow it provides. This cash left over after paying annual expenses usually first goes to the mortgage on the property, interest and property taxes. Assets that deliver great results also have enough “meat left on the bone” at this point to pay out investors and sponsors. How profitable this is to the investor is largely governed by the NOI of the property. The ability to increase annual income and decrease annual expenses makes it more profitable for the investor.
Other Related Metrics
There are a few other key metrics to mention when discussing NOI. These are usually used when determining the NOI, and others are calculated using the NOI. Some examples would be cap rate, property value and, if financed, DSCR:
• Capitalization rate is the ratio of NOI to purchase price. Cap rate = NOI / purchase price.
• Property value is determined using the NOI and the cap rate of the property. This means that the property value is largely influenced by both the NOI and the cap rate. Purchase price = NOI / cap rate.
• Lastly, if the property is financed, then the ability for the NOI to cover the payment to the bank is known as the debt service coverage ratio (DSCR). DSCR = NOI / mortgage payment X 100.
Lenders typically want to see a DSCR of 1.25, or 125%, for a property in order to lend money for the asset. This means that the net operating income can cover the mortgage payment by 125%. The higher the NOI, the higher the DSCR, and therefore the more likely a lender will finance the property.
The Bottom Line
The profitability of a property determines the ability to get financing, how much the investor will get paid and the ability to cover all expenses. The profitability of an apartment is its net operating income, the vital lifeblood of the investment. Increasing rental income while lowering expenses will boost the NOI and influence the purchase price of the property as a ratio of the capitalization rate as well as the percentage an investor is paid as a return. Comparing the NOI of multiple properties can also show which property produces enough cash flow to substantiate all expenses, debt payment, interest and taxes to create an overall more attractive investment opportunity.
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