Real Estate Investing Terms: Net Operating Income

OK, ok, full disclosure, this one is really for me. When recently analyzing a real estate investment opportunity, I added an expense that is not considered an operating expense and it totally through off my evaluation of the #s and almost resulted in a very offensive offer. Sometimes offensive offers are required, but always take a 2nd look or obtain a fresh set of eyes to review your analysis.

Back to the basics, I started this blog as a way to create a knowledge base for myself, a repository I can reference over and over. As I combed through my own articles I discovered I had not approached the topic of how to define nor calculate Net Operating Income, also known as NOI. Future self, you’re welcome. (I know I’ll have to reference this again soon).

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As we walk through this post, let’s work through an example. We’ll keep it simple and easy and analyze a duplex that receives a total of $1,000 month for rent ($500/each side). Also, when I talk about analyzing I’m talking about what historically the rental property has produced, not a pro forma. Pro forma = lies and any add you seeing “rents could be XXX of dollars more than they are now”is almost always a lie. If it was that easy the current owner would have done it by now, something is fishy. Always question this lingo, and always buy on the historic run rate of the property, not how it can potentially perform. Make sense?

First, let’s start with a definition. Net Operating Income is defined as the annual income generated by an income-producing property after taking into account all income collected from operations and deducting all expenses incurred for operations (thank you Google).  More simply put:

Net Operating Income = Operational Income – Operational Expenses

Operational Income is fairly straightforward. Any income being produced by your rental property is operational income. Rent is the most obvious. Laundry facility income is a second source if you have one on your property and/or storage facilities located on the same property are all considered part of your operational income.

Pro Tip: for a more advanced way to compute Operational Income, compute Gross Operational Income which is calculated by subtracting Vacancy & Credits from Gross Potential Income. More on this subject later, want to keep this post introductory. 

Operating Expenses are a little more involved. By that I mean, what is an operating expense and what is not an operating expense. Property management, utilities, insurance, property taxes, lawn maintenance/care, home maintenance or repairs are the main operating expense categories. Mortgage payments are not considered an operating expense, which is the incorrect expense I spoke about earlier – practice makes perfect.

Working through our example, looking at the #s from an annual, historical view where both tenants have always paid rent, $1,000/month, on time:

  • Operational Income = $12,000
  • Operational Expenses= $7,593
    • Property Management = $1200 -> 10% of income
    • Utilities: $0 -> tenants are responsible for all
    • Insurance: $1,164 -> annual premium price
    • Property Taxes: $978 -> they are what they are
    • Lawn Maintenance: $600 -> you take care of this for your duplex tenants, you’re a nice guy!
    • Maintenance / Repairs (total for both units): $3,651

Net Operating Income = $12,000 (Operational Income) – $7,593 (Operational Expenses)

NOI of $4,407, but is this good? And don’t confuse NOI with cash flow. And no, this is not good.

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Why is Net Operating Income (NOI) important? 

For starters, NOI is important so that you can ensure you have enough monies to cover additional, non-operational expenses and still cash flow as desired. For example, we now know mortgage expenses are not included in calculating the NOI, but it is a very important expense we need to ensure is paid monthly. With an NOI of $4,407 ($367.25/month) and desires to cash-flow according to our criteria, this doesn’t leave much room to pay a mortgage.

In this scenario, the expenses seem to be a little high (target operational expenses @ 50% of rental income), so one of a few things is the issue. Either (a) ran into some capital expenses during the past year, which you should always plan for, separate post, (b) rent is not high enough (c) this is just a bad deal! Further digging will give you the answer.

Pro Tip: With Property Taxes, be cautious with your future projections. Even though we are analyzing here based on historical property run rates, increase in property value thus property taxes may increase with a higher sell price than current property appraised value. This can eat into your cash flow quickly. Any concerns, give your county property appraiser a call to discuss. I’ve always found mine to be helpful.

 

How I use NOI in Analyzing Potential Rental Properties

Most commonly I use NOI for two scenarios: (1) to quickly analyze deals like we did through this post to ensure it will cash flow like I want and (2) to derive at an offer price for a potential rental property, especially for commercial properties (office buildings, 5+ unit multi-family, & apartment complexes). To derive at a fair offer price for a commercial property you divide the NOI by the current market CAP Rate. A separate, more advanced posts.

Questions or comments? Leave them below!

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Real Estate Investing Terms: Cash Flow [example]

Because we focus on buy & hold rental properties in Pensacola, Cash Flow is the most important metric we look at when considering an acquisition.
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real estate investing pensacola fl

Caution: This post goes technical real quick and my geeky side does come out 🙂

Most people, even some experienced Realtors, think cash flow is the gross revenue generated from a rental property. Unfortunately, that is not true.  Cash Flow is similar to Net Operating Income, but also includes some calculations for future expenses. Let me explain…

Cash Flow, as I calculate it, is the Monthly Revenue minus ERMVITC.

Monthly Revenue – ERMVITC = Cash Flow

What is ERMVITC?  Glad you asked.
Expenses (General): these include utilities, garbage, mortgage, property management fees, etc. You should be able to obtain exact #s for these variables.

Repairs & Maintenance: I typically estimate these between 5-10%. The range is based on the amount of repair work done prior to placing a tenant. The work performed up front, the lower the percentage and vice versa.

Vacancy: Also estimated between 5-10% based on the property, current tenant situation, and neighborhood.

Insurance: Insurance carriers always vary, so I encourage you to shop around. While underwriting a potential acquisition I stay conservative an estimate $100-125/unit.

Taxes: usually a known quantity by visiting your county’s Property Appraisers site.

Capital Expenses: I typically estimate these between 5-10% also. The range is based on the amount of repair work done prior to placing a tenant in the property and covers such things as a new roof, bath room remodel, appliances, etc. And just like RM,  the more work performed up front, the lower the percentage I use in my underwriting and vice versa. 

 

Here is a real life example of how I evaluated a Pensacola property for acquisition. This property is fairly old and needs some repairs so I’ll be using 10% for Repairs & Maintenance as well as 10% for Capital Expenses. This property should stay rented fairly easy so I’ll use 7% for vacancy. I’ll also be using 10% for Property Management Fees, the tenant is responsible for all utilities, there is no HOA and I’m purchasing this Pensacola property with cash, so no mortgage payment. Let’s do some math!

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Monthly Rent: $750

Expenses: 10% of $750 = $75 (for Property Management)
Repairs & Maintenance: 10% of $750 = $75
Vacancy: 7% of $750 = $52.50
Insurance: $125/month
Taxes: $840/yr or $70/month
Capital:  10% of $750 = $75

Add up all of our estimated expenses:
$75 (E) + $75 (RM) + $52.50 (V) + $125 (I) + $70 (T) + $75 (C) = $472.50

$750 (Monthly Rent) – $472.50 (ERMVITC) = $277.50 (Cash Flow)
 
 

Based on these calculations, this meets one of our investing strategy criteria. Now to further evaluate this property with our other criteria before making an offer.

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Real Estate Investing Terms: Capitalization Rate

Cap Rate…it’s not science rockets!? Wait, did I say that wrong?
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real estate investing pensacola fl

Capitalization Rate (Cap Rate for short) is the measurement used to reveal how well a real estate investment will perform or is performing. I look at 3-5 investments in Pensacola a day and Cap Rate is one of the factors I consider when investing or deciding to hold onto or let a property go. There are many ways to calculate Cap Rate but I do it by dividing the annual net operating income by the original capital costs (or its current market value). I explain why the potential to use different denominators below.

The example we’ll use for this post is a SFR with a purchase price of $50,000 and after all monthly expenses are paid, I expect $350/month in positive net cash flow (or $4,200/yr.), So, the net operating income for this property is $4,200/yr. Cap Rate is calculated as follows:

  • $4,200 / $50,000 = 8.4% Cap Rate
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A couple of resources we use, put Pensacola property appreciation between 1.2-1.8% annually, on average, for the last 30 years. For this calculation we’ll land in the middle using 1.5% appreciation. 

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Using our same example, let’s fast forward 10 years down the road. Now that I’ve owned the property for ten years, I want to see how this piece of property is performing against other properties in my portfolio. To recap, I purchased the property, made some improvements and some natural appreciation has occurred. Forcing appreciation by improving the property has allowed me to increase rents over the last 10 years. By doing so, this property’s annual net operating income is now $6,000 and with 1.5% appreciation for the last 10 years, the property is now worth approx. $58,000. After owning the property for 10 years, my Cap Rate calculates as follows:

  • $6,000 / $58,000 = 10.34% Cap Rate
At the 10 year mark, if I use my original purchase costs to calculate Cap Rate, my cap rate would look like this:
  • $6,000 / $50,000 = 12% Cap Rate (higher, but not an accurate insight on how this asset is performing today)

Cap Rates are used to compare one investment to another. If I’ve owned the Pensacola property for years, I use the present market value as my denominator. If I’m underwriting a property for potential purchase, then my denominator is my expected initial costs.

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