Rental properties not only generate ongoing income, but you can predict that income before you buy a property. In order to do so, however, you need to know how to run the numbers.
Numbers such as net operating income or NOI.
While it may sound complicated, NOI in real estate investing is actually a simple calculation. As in, back-of-the-napkin simple.
Before investing in rental properties however, make sure you understand the role NOI plays in real estate cash flow.
What Is NOI in Real Estate?
First of all, a quick refresher on accounting terms: gross income means “total income before expenses,” while net income means “income left after expenses.”
So, net operating income refers to landlords’ take-home income after most expenses. I say “most” because NOI does not include every single expense — more on that shortly.
A property’s net income reveals what kind of profit and return you can expect to earn from it. Important information to know, especially before you shell out thousands of dollars on a down payment for a rental property.
As a final note, both gross and net operating income are calculated as annual numbers.
Formula for Net Operating Income
The formula for NOI in real estate isn’t exactly rocket science:
Net Operating Income = Gross Operating Income – Operating Expenses
Like I said, you can calculate the net operating income formula on the back of a cocktail napkin. After your third old fashioned.
The real meat of calculating NOI, however, lies in accurately estimating each expense.
Expenses Included in Real Estate NOI
To calculate NOI in real estate, you need to forecast all operating expenses. Including expenses that many novice real estate investors forget about entirely.
Make sure you include all of the following expenses when you calculate real estate NOI and cash flow profitability.
No property has a 100% occupancy rate. You’ll have turnovers and vacancies for every property you buy.
That said, some properties and neighborhoods boast much lower vacancy rates than others. In markets with plenty of demand, landlords receive dozens of rental applications within a few days of advertising vacant units. In areas with less demand for housing, rental applications may only trickle in over weeks of advertising.
As a general rule, plan on at least a 4% vacancy rate, which represents around one month vacancy every two years.
Maintenance & Repairs
Likewise, all properties need repairs and maintenance, and more often than new landlords guess.
From repainting units in between tenants (which usually costs several thousand dollars) to new carpets, from furnace repairs to new roofs, you will have plenty of these expenses. While some investors don’t count capital expenditures (CapEx) as repairs in NOI, I do. A $5,000 new roof certain impacts your bottom line, and you can predict these capital improvement costs as a long-term average.
I generally set aside 10-15% of the rent each month for these repairs.
Property Management Costs
Rental properties are not a completely passive source of income. They require work to manage, from screening tenants to fielding 3am phone calls about broken toilets and beyond.
You can do this work yourself of course, or you can hire a property manager and outsource it. Either way, you need to account for these costs. If you manage the property yourself at first, it’s still a labor cost, so make sure you compare apples to apples by including labor costs with rental properties when you compare them to other investments like ETFs or crowdfunded real estate investments.
Expect average property management fees to run 7-10% for collecting lease payments and ongoing management, plus one month’s rent for each new tenant placed. That comes to roughly 10-14% of the rent, depending on the fees you pay and the property’s turnover rate.
While property tax rates vary by county, there’s not a single county in the US that doesn’t charge property taxes.
And no, you can’t just use the current property tax bill at the time you buy a property. You need to calculate the increased property tax bill, based on the local tax rate and the purchase price for the property. Because the local tax assessment office will certainly bump up the assessed value based on what you pay.
Landlords must carry property insurance just like homeowners. The only real difference is that landlord insurance policies cover only the building, and don’t include the personal possessions inside. (Try Sure as a good landlord insurance provider.)
Some landlords also keep rent default insurance, which kicks in and pays the rent if the tenant stops paying. These policies aren’t expensive, and they provide great peace of mind.
Accounting, Legal, Marketing, and Miscellaneous
Rental property expenses don’t end with the bills above. Landlords periodically need to pay for legal services such as hiring an attorney for the eviction process, or buying a state-specific lease agreement, or asset protection measures.
Then there’s the travel to and from rental properties. The bookkeeping, the higher accounting bill for your more complicated tax return. The marketing expenses to fill vacant units quickly. And so on and so forth.
Budget for these expenses, setting aside 2-4% of the rent for them.
..What’s Not Included in NOI?
Not all expenses are included in NOI for real estate. When you run your numbers for net operating income, don’t include the following expenses.
Debt Service (Mortgage)
Net operating income — and its sister calculation cap rates — are intended to be specific to the property, not to the buyer. One buyer could pay in cash, the other could get a rental property loan for 80% of the purchase price, and that would affect each buyer’s cash flow. But your financing decisions don’t affect the property’s intrinsic NOI.
Don’t include your monthly mortgage payment when running the numbers for NOI.
Similarly, income taxes are unique to you, not the property. One landlord might be taxed at the 10% federal income tax rate, while another pays 24% in federal income taxes. Which says nothing of state and local income taxes, depending on where the landlord lives.
Note that landlords pay income taxes on net rental income at their normal income tax rate. They can, however, take rental property tax deductions without having to itemize their personal deductions. Rental property tax deductions are “above the line” expenses and deductions.
As a more unique deduction, landlords can deduct the cost of the building and any capital improvements to it. However, they must spread these deductions over 27.5 years, using depreciation.
It can get confusing, so read up on how rental property depreciation works if you’re not familiar with it.
If tenants improve your property, that doesn’t count toward expenses included in NOI.
But this is much more common in the commercial property space, and rarely affects residential landlords.
Example Calculation for Net Operating Income
Ready with that cocktail napkin?
You buy a property for $100,000, that rents for $1,200. Gross operating income is therefore $14,400 ($1,200 x 12 months).
The monthly expenses break down as follows:
Vacancy rate: $48 (4%)
Maintenance & repairs: $144 (12% of the rent)
Property management: $144 (12% of the rent)
Property taxes: $150
Accounting, legal, miscellaneous: $36 (3% of the rent)
Total Monthly Costs: $602
Total Annual Costs: $7,224
Net Operating Income: $7,176
Note that these numbers are in line with industry averages — non-mortgage expenses typically add up to around half the rent. This trend even has a not-so-original name: the 50% Rule.
In real life, you don’t even have to use a cocktail napkin to run these numbers. Use our free rental property calculator to run these and other related numbers!
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NOI & Cap Rates
Real estate investors frequently talk about capitalization rates (cap rates) when comparing rental properties. Cap rates use NOI in their calculation.
Investors use cap rates as one way to measure return on investment (ROI) for rental properties. The formula looks like this:
Capitalization Rate = NOI / Purchase Price
In the example above, the cap rate is 7.18: $7,176 / $100,000 = 7.18. Which means that if you bought the property in cash, you could expect an annual return of roughly 7.18%. Note that cap rates only measure income yield, not appreciation or capital gains.
Of course, if you took out a rental property loan, it would change your cash-on-cash return on the property. Imagine you put down 20% ($20,000), and after accounting for the mortgage payment, you were left with $2,000 in net rental income each year. You’d earn a 10% cash-on-cash return: $2,000 / $20,000.
How to Improve NOI in Real Estate
Landlords do have a degree of control over NOI for each investment property.
One way to improve your NOI and rate of return is by raising rents. With higher rental rates, you boost the property’s income and returns.
You can also look for ways to add income streams to your property, such as charging parking fees or installing vending machines or laundry machines in multifamily properties.
Also come at the problem from the other direction: reducing your operating costs. How can you reduce maintenance and repair costs? Reduce turnovers and vacancy losses? Can you negotiate lower property management fees?
Property owners can and should look for ways to optimize their income properties by maximizing monthly rents and other receipts, while minimizing expenses like property vacancies.
Net operating income is merely one of many measurements you should understand as a real estate investor. Cap rates represent another, and cash-on-cash return another.
Fortunately, they’re all interrelated, and none require a math degree.
Once you learn how to predict returns on real estate investments, you’ll never make a bad investment again.♦
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About the Author
G. Brian Davis is a landlord, real estate investor, and co-founder of SparkRental. His mission: to help 5,000 people reach financial independence by replacing their 9-5 jobs with rental income. If you want to be one of them, join Brian, Deni, and guest Scott Hoefler for a free masterclass on how Scott ditched his day job in under five years.