The Role of Net Operating Income in Property Valuation

Key Takeaways

• As a valuation method, net operating income will tell a property owner whether renting the real estate is worth the cost of owning and maintaining it.

• NOI helps investors fix the capitalization rate – a measure of an investment property’s profitability in relation to total cost — which consequently helps them determine a property’s value.

• NOI allows real estate investors to compare properties they may be mulling purchasing or selling.

Investors interested in determining whether income generated from owning and maintaining a property would do well to understand net operating income (NOI), a commonly used figure to gauge its value and profitability. To that end, here is net operating income: what it is and how to calculate it. 

What is Net Operating Income (NOI)?

NOI is a calculation employed by real estate professionals, investors, and lenders to assess the profitability of income-producing properties. 

A figure that appears on a property’s income and cash flow statement, NOI is equal to all property revenue, less all reasonably necessary operating expenses.

Operating expenses could include everything from insurance premiums, utilities not covered by tenants, and legal fees, to repair costs, property management fees, property taxes, and janitorial fees. 

In addition to rent, income could be from, for example, vending machines, laundry facilities, or parking structures.

How is NOI Helpful?

As a valuation method, NOI will tell a property owner whether renting the real estate is worth the cost of owning and maintaining it. It helps investors fix the capitalization rate – a measure of an investment property’s profitability in relation to total cost — which consequently helps to determine a property’s value. In turn, investors are able to compare the various properties they are considering buying or selling.

Lenders also commonly use NOI to determine the loan size they are willing to make — on a profitable property. Should the property reveal a net operating loss, lenders are more apt to turn down the application.

What is Excluded from NOIs?

While net operating income can help estimate the prospective income from an investment property, it does not account for potential costs such as mortgage amortization, income taxes, loan payments, or depreciation. NOI also excludes capital expenditures, such as for a new air conditioning system for the building.

Because debt loads can vary from investor to investor, debts are not included in a net operating income calculation. Excluding debt permits mortgage companies to compare properties equally: income versus outflow.

Also, net operating income is a pre-tax figure, meaning that it excludes all taxes. After all, investors have widely varying tax expenses, and NOI is specific to the property, not the individual.

Depreciation is not included in NOI because it is not as much an expense as it is an accounting concept. Net operating income exclusively considers actual expenses. One-time large expenses, such as the aforementioned new air conditioning system, are also excluded from the calculation since such an expense can vary broadly from year to year and property to property.   

Note that property owners commonly finesse their operating expenses by deferring some expenditures while speeding up others. Further, net operating income can be heightened by increasing rents and various fees, while at the same time slashing reasonably necessary operating expenses.

Net Operating Income: Example Calculation

The NOI formula is: Net operating income = RR – OE

where:

RR = real estate revenue

OE = operating expenses

To illustrate, say a condo building its owner was renting had revenue that included $20,000 in rental income, $5,000 from parking fees, and $1,000 from laundry machines, for total revenues of $26,000.

Next, say the building’s operating expenses were $1,000 in property management fees, $5,000 in property taxes, $3,000 in repair and maintenance, and $1,000 for insurance. Thus, operating expenses totaled $10,000.

In the above example, net operating income is $16,000: $26,000 – $10,000. 

In general, the higher the revenues are and the smaller the expenses, the more profitable a property is considered. NOI derives most of its power from the fact that it considers all a property’s necessary income and expenditures in a single calculation.

Significance of Net Operating Income in Real Estate

In addition to a good working knowledge of whatever real estate market they are in, any real estate investor must be able to approximate remodel expenses as well as have a solid understanding of fundamental financial concepts. They also must know how to accurately calculate net operating income, which allows them to make at-a-glance financial calls.

Using net operating income, a property owner can find out whether renting a given structure out is worth ownership and maintenance costs. Through establishment of the cap rate and calculation of a property’s value, NOI also allows real estate investors to compare properties they may be mulling purchasing or selling.

For property that is financed, NOI is also employed in the debt coverage ratio, which tells investors and lenders whether a property’s income covers its debt payments and operating expenses. In addition, NOI is utilized to calculate cash return on investment, net income multiplier, and total return on investment.

In essence, a key NOI role is to provide investors with a glimpse into a rental property’s true cash flow, how profitable the property is or is not, how much the property costs to maintain it, as well as the investment’s overall health. 

Net Operating Income and Property Valuation

Net operating income is vitally important to consider when performing property valuation and investing in real estate in general.

After all, alternatives in general, and real estate, in particular, are increasingly popular as investors seek assets that are not directly tied to public markets, and thus are less volatile. 

Consider Yieldstreet, which focuses on generating secondary income for investors. The alternative investment platform, on which more than $3.2 billion has been invested so far, boasts an array of private-market offerings, including a real estate investment trust (REIT), with low minimum buy-ins. Yieldstreet’s Growth & Income REIT is a fund that makes debt and equity investments in varied commercial real estate properties, and types, nationwide throughout key markets.     

Another primary reason to invest in alternatives – any securities other than stocks or bonds – is to diversify one’s investment holdings. After all, diversification can mitigate overall portfolio risk and protect against inflation — and is key to long-term successful investing. 

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

Summary

It is essential for investors to factor in net operating income when conducting valuations of income-producing properties and investing in real estate overall. After all, the figure can be used to assess a property’s profitability and value. It is also important to be aware of options when it comes to alternative investments, including in real estate.