You’ve identified a potential property that appears to tick all the boxes, but how can you quickly tell whether it’s a worthy investment?
Many properties on the market may seem like they’re a good deal, but considering the expenses required to maintain them, or their vacancy rates, they are in fact, the opposite.
One of the most useful calculations to have in your toolbox is for ‘net operating income’. It’s arguably one of the most foundational indicators of real estate value, and what’s more, its relatively quick and easy to calculate.
What is Net Operating Income?
Net operating income is essentially a measure of profitability.
It measures the net income, or potential net income, generated by the property. It’s usually calculated using annual figures.
Like other net income calculations, it’s fundamentally about gross income less expenses. Net operating income is calculated by subtracting the property’s operational expenses (for example management fees, basic repairs, and insurances) from the revenue generated (for example rental income).
A high net operating income means higher profitability. And you can expect a property’s valuation to increase with a higher net operating income.
How is Net Operating Income Calculated?
Net operating income is calculated using the following formula:
The higher the revenue and the lower the expenses, the more profitable a property is likely to be.
Real Estate Revenue
‘Real estate revenue’ includes all the income the property produces, which would usually be made up of rental income and additional forms of income such as those from parking facilities or vending machines.
Don’t forget to take vacancies into account. If you are planning revenue projections for a new property, be sure to check the historical vacancy data. This will give you an idea of the trends so that you can more accurately plan your projected real estate revenue calculations.
Real estate revenue can include:
- Rental income
- Income from facilities on site such as parking and storage facilities
- Income from additional sources such as vending machines and coin-operated laundry
- Advertising income (for example billboards on the property)
‘Operating expenses’ include all expenses incurred in the ongoing operations of the property.
Maintenance, insurance, and janitors’ fees are all obvious inclusions here. These are all specific to that individual property.
Expenses not to include in your operating expenses include those specific to the investor, such as taxes or interest payments on loans. These can vary widely per investor, so will only cloud your results.
We also don’t include capital expenditures in the operating expenses. Major repairs like a new roof, or a new air conditioning system for the building, can vary widely year to year, and as such do not support an accurate reflection of the ongoing profitability.
Such expenditures are often paid for using cash reserves (savings). Remember, with net operating income you’re wanting to get a view of the true cash flow of the property.
Operating expenses can include:
- Basic repairs and maintenance
- Insurance premiums
- Property taxes
- Janitorial fees
- Miscellaneous fees – property management fees, accounting and legal fees, marketing costs
Operating Expenses do not include:
- Capital expenditures – for example the cost of a new aircon system for the entire building or a new roof
- Tenant improvements
- Income taxes
- Principal and interest payments on loans
Example: Working Out the Net Operating Income on an Apartment Complex
Let’s say you’re looking to buy a small investment property: an apartment complex with five units, fully tenanted. Each unit earns you a monthly rental of $1 000, so your annual potential rental income is $60 000.
Additional revenue from the coin operated laundry is $100 per month, and therefore $1 200 annually. So, your annual real estate revenue is $61 200.
The current owner has shared their expense records, showing annual operating expenses of $15,000 per year. In this instance, these are made up of:
- Repairs and maintenance
- Property taxes
- Management fees
Using the above figures, your calculation is $61,200 less $15,000, which leaves $46,200 as your net operating income.
Bear in mind though, that there are things the seller may not tell you.
It’s important to be aware that sellers are likely to understate their operating expenses and overstate their revenue to make the property appear as profitable as possible. Make sure you have a good grasp of what operating expenses to expect when reviewing the figures supplied so that you can spot any ‘optimistic’ figures.
By the same token, try to get a sense of the vacancy rate by using observation and asking the right questions of the seller. It might be wise to build vacancy rates into your calculations too. Reduce your real estate revenue figure if so.
Benefits of Measuring Net Operating Income for Commercial Real Estate
What makes net operating income really convenient, is that it simply and quickly shows a snapshot of operational cash flow. This is valuable when sizing up properties in a portfolio, or considering new commercial real estate investments. Some typical examples of when it’s useful include:
As an Indicator of a Property’s Earning Potential
As an investor, your foremost question is going to be around the earning potential of this property. How profitable could this property be? Net operating income is a great indicator to start with.
To Compare Multiple Properties for Investment
How does this property’s ROI compare to others? You can use the net operating income on this and other properties to quickly compare and simply to identify which property will likely yield the greatest returns.
To Help Plan Cash Flow and Financing for a Property
Does the investment have enough cash flow to cover debt expenses on it? If you’re considering financing the property, you’ll want to know whether the investment will cover itself, or how best to structure the finance.
The net operating income will give you a clear starting point showing you what cash you’ll have available to pay off debt.
It is also used in the debt coverage ratio, which is another helpful tool you can use to assess whether the property’s income covers its operating expenses and debt payments.
To Help Determine a Fair Selling Price
Is this property being accurately valued by the seller?
Since the net operating income is an indicator of profitability, it can assist you in determining what a reasonable asking price might be.
Use it to accurately work out how much to offer the seller.
Limitations of Net Operating Income
Net operating income is incredibly helpful in the examples shown above, however when making investment decisions, it must be used with the wider picture in mind. It tells the story at property level and makes comparing properties an ‘apples with apples’ exercise.
What net operating income does not tell you is the investor-level view, which would include the financing of the property as well as the investors’ personal tax deductions, and other factors that inform investment decisions.
As an investor you might also have plans to upgrade the property. For instance, you may plan to add a solar array on the roof or invest in extensive remodeling. These items would count as capital expenditure, and therefore not play a part in net operating income calculations.
They would, however, need to be taken into account when working out your actual return on investment.
Final Thoughts on Net Operating Income
Net operating income is arguably one of the most important and useful calculations for commercial real estate investors. Knowing how to calculate it correctly can empower you with a quick overview of a property’s profitability, so that you can make informed investment decisions.
The great thing is that it’s simple, relatively quick, and applicable to so many different types of investments. But do remember to go in with open eyes and use common sense to check for inconsistencies in the balance sheet details.
If it looks too good to be true, it probably isn’t. With experience you’ll develop a keen sense for these figures.
Understanding net operating income will no doubt streamline and support your real estate investment process, whether you’re deciding on a new property, or evaluating your existing portfolio. It’s one of the many tools at your disposal to ultimately help you make smart choices and maximize profitability.