You’ll often hear the term NOI mentioned by real estate investors, which stands for “net operating income,” which is just a fancy term for an investment property’s operating profit after expenses, not including non-cash expenses like depreciation.
Similar to the accounting term EBITDA, NOI is also an income figure that excludes depreciation, amortization, interest or taxes. The reason for doing so is to get a true metric of a property’s profitability before individualized factors such as financing, taxes and depreciation are considered that is comparable across properties.
Figure out your top line revenue
To calculate NOI, first determine what top line revenue figure you will use. Look at recent comps in the building if the investment property is a condo unit, or comparable houses in the area if it’s a single or multi-family house. Once you’ve done your research and determined what the market value rent should be, multiply that monthly rent figure by 12 to get your gross annual income.
While optional, some investors in markets that aren’t quite as hot as Miami or NYC will incorporate a vacancy rate into their revenue numbers. For example, if you expect a 5% vacancy rate, you could use an adjusted gross income figure that is 95% of the gross income figure we previously discussed.
If you’re buying in a hot market like Miami in 2021 or 2022, we wouldn’t worry too much about factoring in a vacancy rate considering how little inventory there is.
Add up operating expenses
The next step is to add up all of the investment property’s expected cash operating expenses, assuming you purchased the property all cash and didn’t have to worry about a mortgage. Don’t factor in income taxes, if any, and don’t factor in non-cash “expenses” like depreciation.
Capital expenditures, meaning major one-off repairs or improvements like a new roof, should also not be included in your operating expenses. Capital expenditures get added to your cost basis, and are depreciated over time along with the rest of your cost basis.
Here are some examples of operating expenses to consider:
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Property taxes
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Common charges or HoA fees
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Home insurance
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Flood insurance, if applicable
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Repair costs
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Maintenance costs
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Legal fees
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Janitorial fees
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Property management fees
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Accounting fees
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Marketing fees
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Furniture and furnishings, if renting furnished
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Sewar, water, municipal garbage fees
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Any other utility fees not paid by the tenant
Subtract operating expenses from revenue
As you might expect, simply subtract your total operating expenses from your total revenue to get your net operating income, or NOI. NOI can be expressed as a monthly or yearly income figure, but the latter is more common to see.
Let’s do an example of a high floor, 05 line at the Biscayne Beach Condominium in the Miami neighborhood of Edgewater that should rent for at least $7,000 a month as of this writing. That’s $84,000 in annual revenue.
For expenses, the unit has common charges of $1,161.47 per month, or $13,937.64 per year. For property taxes, the TRIM notice states $11,785.74 if the new budget is adopted, or $11,326.03 if no budget change is adopted. Let’s use the higher and more conservative tax number.
The unit is a great condition, and also comes with furniture included so it’s ready to rent out, and at a higher rate because it’s furnished. There are no maintenance or repairs of substance to note, and we’ll assume a vacancy rate of 0% due to how hot the Miami real estate market is. Furthermore, let’s assume this property will be managed directly by the owner, hence no property management fee. Since the condo building pays for things like sewar, water and garbage pickup, there’s no need to factor any of these expenses in as a condo investor.
Even though buying condo H06 insurance is optional for an all cash buyer, let’s assume you get a wall-to-wall condo insurance policy for $1,000 a year. As a result, after subtracting for these expenses, you’re left with a net operating income of $57,277, or $4,773 per month of cash flow.
Pro Tip: Calculate net operating income and cap rates with our interactive Cap Rate Calculator. And if you’re looking to see what your levered returns would be with financing, then check out our Rental Property Calculator.
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Now that you’ve calculated the property’s NOI, you can easily calculate its cap rate, which is just your annual NOI divided by your cost basis.
What is a property’s cost basis?
For the purposes of our cap rate calculation, we’ll want to find out your potential investment’s initial cost basis. Your initial cost basis will be the property’s purchase price plus your closing costs and any renovations you do.
Continuing along with our prior example, we’ll use Hauseit’s Miami Buyer Closing Cost Calculator to figure out what the estimated closing costs will be. Let’s say the closing costs will be $5,910. Let’s also say that because the property is in great condition, no renovations are needed. Keep in mind that major renovations and repairs would be added to your cost basis, but regular maintenance such as minor painting would be part of your regular operating expenses.
Assuming that the purchase price is $940,000, the cost basis of our potential investment will be $945,910. Not bad with $84,000 in annual income which is ~8.9%!
However, we can just divide the annual revenue by the initial cost basis, as that would give you a gross yield vs the cap rate figure that we are after. This would be a disingenuous metric to use because different properties have very real costs that vary which often can’t be controlled such as property taxes or common charges.
So instead let’s use the NOI figure of $57,277 and divide that by the cost basis of $945,910 to get 6.06%, which is the cap rate.
In contrast, this NOI figure is pure in that it tells an investor how profitable an investment property is irrespective of whether the investor chooses to get financing, irrespective of the investor’s specific tax situation, and irrespective of how much depreciation the property can generate.
Pro Tip: NOI is just a way for real estate investors to say EBITDA, or Earnings Before Interest, Taxes, Depreciation and Amortization. Just like in corporate finance, NOI is a way to compare the core potential of different acquisition targets. After all, the current owner’s financing and tax profile won’t matter once you buy the property right?
