If you’re involved with commercial real estate, you’ve probably heard the term net operating income (NOI). NOI is a metric used by real estate professionals to determine and analyze the potential worth of income-generating real estate investments, such as apartment buildings. As such, it is central to any discussion involving commercial real estate and real estate investing.
Today’s blog post is all about NOI: what it is, how to calculate it, why it matters, and how to build it the right (and wrong!) way.
Growing net operating income with apartment buildings: key takeaways
- NOI represents the difference between any revenue produced by a property and all day-to-day operating expenses, such as insurance, property taxes, utilities, maintenance, and repairs. NOI does not include income taxes, capital expenditures, and expenses related to financing.
- NOI is used in combination with the cap rate to determine the current market value of the asset. NOI is also used to decipher loan eligibility and debt servicing.
- Outdated and inefficient physical systems can be a NOI killer. For instance, outdated boilers, furnaces, and non-separated hydro services.
- The right way to build your NOI is to maximize and actualize your revenue potential and minimize your operating expenses.
- Another way to build NOI is by making strategic capital improvements that will improve the functionality and efficiency of the asset to decrease overall operating expenses.
What is net operating income and why does it matter for apartment buildings
Net operating income is considered to be one of the most important metrics to a real estate investor because it is a measure of an income property’s potential worth. NOI is calculated by subtracting all day-to-day operating expenses—for instance, insurance, property taxes, utilities, maintenance, and an estimated percentage for repairs—from any revenue produced by the property. That said, it intentionally excludes any capital expenditures and expenses related to financing, because things like mortgage payments, loan costs, depreciation, and leasing commissions do not factor into the investment’s future worth. NOI also ignores income taxes.
Here’s why NOI is so important. Given that NOI is an expression of an investment property’s potential worth, it is used to (a) determine the current market value of an asset (b) determine the cap rate of an asset, and (c) determine the loan eligibility for an asset.
- Determining current market value. In the buying and selling process, NOI is important because it correlates with the market value. In general, the higher the NOI, the higher the market value of the property, and vice versa. As such, NOI is used to determine the maximum price a buyer would pay for a property. NOI is also used to calculate cap rate.
- Determining loan eligibility and debt servicing. Finally, NOI affects how the bank will view the property. In general, a higher NOI will qualify for a higher loan, and vice versa.
NOI versus EBITDA
EBITDA is an abbreviation for earnings before interest, taxes, depreciation, and amortization. As its name suggests, EBITDA can be calculated by adding your net income, interest, taxes, depreciation, amortization together. Like NOI, EBITDA is a metric used by investors to measure profitability.
Though both NOI and EBITDA are a measure of profitability, they are not the same. The biggest difference between the two is that NOI doesn’t take interest, income taxes, capital expenditures, depreciation, or amortization expenses into account. Meanwhile, EBITDA excludes taxes and interest, but it includes depreciation and amortization expenses.
NOI versus cash flow
NOI is often confused with cash flow. In reality, NOI and cash flow are distinctive metrics. As we’ve discussed, NOI represents an investment property’s potential worth, so it ignores any investor-specific expenses, such as income taxes and financing. Cash flow, on the other hand, represents an investment property’s literal worth. As such, cash flow considers some of the expenses that are discluded from the NOI calculation, such as income taxes.
The components of net operating income
Potential rental income (PRI)
Monthly rent collection is the main way income properties generate revenue. PRI assumes that the property is 100 percent occupied, so if the property is not at full occupancy, PRI can be ascertained based on a rental market analysis.
Secondary income sources are also factored into NOI. For instance, parking fees, laundry services, storage fees, billboard/signage fees, and vending machines.
Operating expenses include any day-to-day expenditures associated with running a commercial property. For example, property taxes, rental property insurance, as well as costs associated with utilities, repairs, maintenance, and management.
Vacancy and credit loss
Vacancy and credit loss is an estimation of the amount of rental income that could be lost due to property vacancies and tenants defaulting on their rent payments. It is often expressed as a percentage of the net operating income.
(The hidden NOI killers)
Since NOI is contingent on operating expenses, it’s important to consider the expenses that won’t benefit the property’s bottom line and could end up needlessly harming your NOI.
Building insurance is a must when operating a commercial property, but not all policies are created equal. Moreover, insurance companies have the tricky tendency to raise premiums when it comes time to renew. This is why it’s important to shop around well ahead of your policy renewal and compare premiums to make sure you are getting the most competitive rate possible. Keeping your insurance premium low will positively impact your NOI. Meanwhile, the higher your building insurance is, the higher your operating expenses will climb, and the lower your NOI will be.
Outdated physical and mechanical systems
At first blush, it may seem financially smart to hold on to existing physical and mechanical systems, but there are some upgrades that stand to benefit your bottom line in the long haul. For instance, an outdated furnace system may seem like a big expenditure, but your NOI will reflect heat loss from an inefficient furnace. By upgrading to a more energy-efficient model, you will save on energy costs, which will reduce your operating costs and positively impact your NOI.
(Building your NOI the right way)
Strategic capital improvements
Upgrading an inefficient furnace is a great example of a capital upgrade that will help to build net operating income for your apartment building. A similar example would be replacing an old roof. If you’re planning on holding onto your property for an extended period of time, it’s in your best interest to not only maintain but to improve the functionality and efficiency of the asset to decrease your overall operating expenses.
The same goes for updating old/inefficient boilers, water heaters, and insulation. Upgrading with energy efficiency in mind could end up decreasing your energy bill—and subsequently your operating expenses—in the long run. Moreover, there are some utility companies, such as Enbridge, that offer government-backed grants and rebates to incentivize energy-efficient upgrades. Such companies also offer rebates for energy audits, so that you can pinpoint exactly where your property is losing energy, and how to better achieve cost- and energy-efficiency.
Finally, slow leaks, such as leaky taps and toilets, can wreak havoc on your operating expenses and negatively impact your NOI. As such, water consumption should be closely monitored and your water systems should be routinely improved so that you’re not caught off-guard by a sky-high water bill, which could have repercussions on your building’s value and your options for financing.
Maximizing and actualizing revenue
In conjunction with minimizing your operating expenses, you want to maximize your revenue to push that NOI even higher. This can be done a few different ways: (a) increasing your primary source of revenue (A.K.A. rent) and (b) tapping into secondary sources of revenue.
For multi-family dwellings, you can justify increasing your monthly rents by offering additional value to your tenants. For example, you could incorporate free internet into your monthly rent prices. This is a very manageable expense to absorb as a property owner—plus it’s a value addition that your tenants will likely need and appreciate and would be willing to pay for.
You can also tap into those secondary revenue sources that we mentioned earlier. Think parking fees, laundry services, storage fees, billboard/signage fees, and vending machines. Mixed-used properties can also gain revenue through a retail component. Actualizing these additional sources of revenue will not only mean a higher net operating income for your apartment, but more capital in your pocket to maintain and improve your asset.