We could debate all day on the most important figures to factor when evaluating a commercial property in Los Angeles. Most would still agree that few numbers matter more than the net operating income (NOI). Of course, before we tackle the best net operating income formula for your needs, we need to understand what NOI is and why it fuels the investment decisions that can spell the difference between smart acquisitions and costly mistakes. Fortunately, this blog will supply you with everything you need to know about NOI.
What is NOI?
If your first question is “What is NOI?”, start here. Net operating income, often abbreviated simply to “NOI”, is a figure used to measure the profitability of a commercial property prior to accounting for financing costs and taxes. It’s one of the most popularly used metrics for property comparisons, underwriting loans, and estimation of value. This is because NOI takes into account the actual income that a commercial property generates from its core operations.
Of course, there are other metrics to consider, such as how a commercial investment is financed. But NOI keeps the focus firmly on a property’s operating performance. And that’s why it’s such a vital metric. A property’s NOI remains consistent regardless of whether an owner took out a loan or purchased their investment with cash. This means investors can compare deals more easily and directly.
The Best Net Operating Income Formula for Property Investors
Fortunately for investors, the universal net operating income formula is also fairly simple:
NOI = Gross Operating Income – Operating Expenses
Let’s break it down so you can calculate your investment’s net operating income step by step.
(1.) Begin with your property’s gross potential income. You can determine this amount by taking the total rental income your property would generate if fully leased at the current market rates.
(2.) Subtract any vacancy and credit losses. This is to account for an undeniable fact: Most properties don’t maintain a year-round lease rate of 100%. Tenants also sometimes fall behind on rent payments. By subtracting realistic vacancy/collection losses, you can develop a more accurate figure representative of your investment’s effective gross income.
(3.) Don’t forget to include any additional income. Add in parking fees, laundry, storage rental, and other income sources.
(4.) Subtract operating expenses. Don’t forget about property management fees, insurance, property taxes, utilities, repair and maintenance costs, and common area maintenance (CAM) costs like landscaping (if your tenants don’t cover this).
However, it’s worth noting that not every expense makes its way into the standard net operating income formula. You should not factor in mortgage payments, capital expenditures, or income taxes. Why? Because these costs fall under ownership and financing and thus should have no bearing on your cost of operation.
Why is NOI So Important for Investors to Understand?
There’s not just a single clear reason why net operating income is such a vital consideration for commercial investors. Rather, the figure holds multiple benefits.
(1.) It’s crucial for accurate property valuation. You’ll need the NOI formula to determine one of the essential components for the universal capitalization rate formula: Cap Rate = NOI/Property Value. And, if you’re unfamiliar with the cap rate formula, it’s one of the most popularly used methods of valuing income-producing real estate.
(2.) Lenders pay close attention to NOI. In fact, commercial lenders specifically use net operating income to calculate the debt service coverage ratio (DSCR), a figure that helps them gauge how much they’re willing to lend against a property. The stronger the NOI, the more likely a property can effectively cover its debt.
(3.) NOI sets up a more direct comparison. By excluding financing structure, investors can use the NOI formula to compare two disparate properties on equal ground. Need to know how that Culver City multi-use property stacks up against a San Fernando Valley industrial site? Knowing how to calculate net operating income helps!
(4.) NOI clarifies your operational efficiency. By tracking NOI over a period of time, you get a clearer picture of whether your investment’s income is building, whether expenses are on the horizon, and whether management is most efficiently running your operations.
Get to Know the NOI Formula Today
It doesn’t matter whether you’re purchasing your flagship commercial property or building onto a robust portfolio. Mastering the net operating income formula is essential. By developing a firm understanding of NOI, you gain access to a clearer, more objective means of asset evaluation. By diligently running the NOI formula before committing to an offer, you give yourself a clear advantage. And, as always, don’t hesitate to reach out to a trusted commercial real estate professional if you need help verifying the numbers behind your next deal.
