What to Watch for in Net Operating Income

How is the Net Operating Income or NOI calculated? Why is this income so important in rental property analysis? What to watch for when interpreting the NOI? In this brief article I plan to answer these questions for real estate agents, landlords and investors.

Rental property analysis is made up of various ratios, margins and value comparisons. One of the most important is the annual income from the operation of the property. The income we are discussing is the property's income after subtracting out annually all vacancy and credit loss minus all operating expenses.

NOI = Gross Potential Income (maximum income) - Vacancy & Credit Loss - Operating Expenses

Let us stop our discussion for a little side note. Vacancy and credit loss, why are they usually lumped together? A vacancy is an apartment unit that does not have a tenant. However, a credit loss is an apartment unit with a tenant who does not pay the rent. A credit loss is uncollected rent. Vacancy and credit loss both refer to loss income, one loss from a potential income and the other loss from actual income.

In the operation, maintenance and repair of a rental property, you will have operating expenses. These expenses do not include; capital improvements or additions, principal and interest, amortization loan points, income taxes and depreciation.

We left our discussion on the importance of the Net Operating Income in rental property analysis. The annual resulting income is used in the calculation of other ratios and values. NOI is part of the calculation of; Capitalization Rate, Net Income Multiplier, Debt Coverage Ratio and Cash Flow Before Taxes.

Cap Rate = NOI / Market Value or Purchase Price

NIM = 1 / Cap Rate

DCR = Net Operating Income / Debt Service

CFBT = NOI - DS - Capital Additions + Loan Proceeds + Interest Earned

This special operating income affects the estimated value of a rental property. It also affects the financing from a lender who is concern with the property's ability to pay its operating expenses plus loan payments. In the end, this income is the foundation of property value plus the ability to obtain financing for the property.

Given the importance of the NOI, the values used to calculate this income must be accurate, complete and verifiable. Never take this operating income at face value without first compiling all the incomes and expenses that it represents. What is missing or added in the value? Who has given you the value? Can this value be manufactured or fabricated to affect the Cap Rate or other ratios? The only way to answer these questions is to verify everything that makes up the Net Operating Income. Run the numbers yourself.