Net operating income (NOI) is an essential measure of real estate profitability to help you calculate potential income from an investment property. The NOI provides valuable data for determining whether to buy a property, predict potential rental income, or raise rents to increase cash flow.

The NOI formula is simple. You deduct the operating expenses from the gross operating profit (RBE) to calculate the potential profitability of a property. In other words, net operating income is the difference between the cost of operating the property and the amount of revenue it generates.

Net operating income does not use expenses such as debt repayments, mortgage payments, depreciation, or capital expenditures in the calculation. However, it helps you compare properties when buying or selling real estate. As a result, some investors consider it to be the most critical metric in real estate investing.

This article explains why the NOI is important when making real estate investment decisions.

## What is net operating profit (NOI)?

Net Operating Income is a simple formula for calculating the potential rental income of an income-generating property. The formula uses two measures – projected rental income and all expenses. The net operating income figure is a property’s total income less operating expenses.

## How Net Operating Income (NOI) Relates to Real Estate

The beauty of using the NOI formula is that it is a simple calculation to determine a property’s operating performance. Here’s what that means in real estate terms:

**NOI and real estate investment:**Calculating the difference between gross operating income and operating expenses is essential when evaluating different properties. You can easily estimate the income potential of single-family homes, condos, and multi-family properties. Putting the numbers side by side helps to assess the best investment.**NOI and your rental portfolio:**The net operating income formula is also useful for evaluating the profitability of your current investments. For example, a simple scan might show that the NOI has changed since you purchased the property. This could mean you need to start looking for ways to find additional income. Or you may decide to sell the rental unit due to lost income.

## NOI Formula

The formula for net operating income is as follows:

*Net operating income = Gross operating income – Operating expenses*

Here are some useful explanations to help break down the formula:

**Raw:**The total amount of income before deducting any fees, expenses, taxes or commissions.**Net:**Your “net” amount after paying all related expenses.

Assume the annual operating revenue of a single family rental unit is $21,600. It is *Gross operating income*. However, suppose current expenses are $4,800 per year. This means that your net income after operating expenses is $16,800.

## How to Calculate Net Operating Income (NOI)

Although the NOI formula is simple, there are several variables you need to consider to get an accurate picture of a property’s potential profitability. For example, you need to consider vacancy rates, all operating expenses, and additional sources of income to calculate the NOI. The calculation also includes potential fluctuations in income.

Here are some of the variables to consider regarding expenses and income.

### Gross operating income (GOP)

Ideally, you could calculate GOI as monthly rent multiplied by 12 to determine gross annual income. However, it is essential to remember that income can fluctuate depending on vacancy rate and potential sources of additional income. Plus, you face the real possibility of a tenant not paying rent.

Here are the factors to consider when calculating gross operating income:

**Vacancy rate:**An empty rental unit affects your potential cash flow. Therefore, consider vacancy rates using metrics from comparable properties or information from the current owner of the rental property.**Credit loss:**It is wise to consider the occasions when a tenant does not pay their rent. Just like financial loss due to vacancies, credit loss impacts your bottom line.**Additional income:**Does the condo or multi-family property have additional sources of income? Here are some examples:- ATMs
- Laundry services like a coin-operated washing machine
- Parking fees

** Related: **How to increase rental income.

### Functionnary costs

It is important not to confuse income and cash. Therefore, it is essential to know which expenses to include and which to omit in the net operating income formula.

Here are the operating and non-operating expenses included in the calculation of the NOI:

- Property maintenance and repair costs
- Owner’s insurance
- Property management fees
- Other owner-related expenses, such as accounting and attorney fees
- Property taxes

Since the NOI is used to assess the current income of a property, capital expenditures are not included. Therefore, you do not have the following capital expenditures:

- Income taxes
- Depreciation of assets
- Capital expenditures like installing a new roof
- Depreciation of assets
- Mortgage payments

Why are mortgage payments excluded from operating expenses? After all, paying a mortgage may be your biggest monthly expense. This is because mortgage payments depend on individual investors, not the overall health of the property.

## Net operating income vs gross operating income

The difference between net operating income (NOI) and gross operating income (GOI) is how expenses affect the result.

**Gross operating income** is the total potential income of a property, taking into account vacancy and credit losses. It is also essential to include additional sources of income not included in the rent.

**Net operating income** is the income when daily expenses and costs are taken into account. The NOI is the amount of money you have left after deducting the cost of owning the rental property.

## Net profit vs operating profit?

The main difference between net operating income and net income is the type of expenses included. Operating profit refers only to revenue less the day-to-day running costs of owning a rental property. Net income is your bottom line. It takes into account all debts, mortgage payments, operating costs and additional income streams.

In short, operating income is the profitability of the rental property and is the most important measure when comparing individual investment properties.

## Examples of Net Operating Income

Net operating income measures the potential income stream from real estate investments. Typically, you calculate the figure every year due to variations in income and expenses from month to month.

Here is an example of calculating the NOI using the formula “*GOI – Operating Expenses = NOI*.”

Let’s say you are considering an investment property – a small multi-family property with five rental units. Here are some numbers:

- Monthly rent for each unit — $1,600
- Potential annual rental income — $96,000 ($1,600 x 5 x 12)
- Annual revenue from the coin-operated washing machine — $1,200

We also need to consider vacancy losses to determine a realistic GOI. The average is 10% for the area. The calculation is $96,000 x 10% = $9,600. Thus, our Gross Operating Income is:

*$87,600 ($96,000 + $1,200 – $9,600)*

The current owner’s accounts show the property’s annual expenses for the previous year were $16,500.

Here is our calculation of net operating income:

*$87,600 – $16,500 = $71,100*

This real estate metric can compare the property with other potential investments. Plus, you can determine if you can cover your mortgage payments and calculate the value of the property.

Calculating the NOI also helps you determine the total return on investment – the cap rate.

## NOI and capitalization rate

The calculation of the net operating profit makes it possible to determine other parameters such as the capitalization rate. Also called cap rate, lets you decide your potential return on investment (ROI).

Here’s how to use the NOI and Cap Rate formula:

*Capitalization rate = net operating income ÷ purchase price*

For example, let’s say the five-unit property in our example has a listing price of $460,000. Then we can use the cap rate formula to calculate the rate of return on investment.

*$71,100 ÷ $460,000 = 15%*

Therefore, you can use the NOI and cap rate to determine your annual return and whether the investment is sound.

** Related: **How to calculate the capitalization rate.

## What is an ideal net operating income percentage?

A common question in real estate investing is what is the best NOI percentage? Net operating income is not expressed as a percentage. Instead, it’s a number you get by deducting operating expenses from gross operating income.

Most investors use loans or financing to invest in real estate. Therefore, it is necessary to consider the cost of finance when valuing properties, calculating capitalization rate and working out your business cash flow.

Generally, it would be better to look for properties with higher net operating income figures relative to the price of the property. Most real estate investors agree that margins and operating income should be more than 15% of the investment cost.

## In summary

Calculating net operating income is invaluable when comparing real estate investments. And the good news is that the NOI is easy to calculate and helps you quickly identify potentially profitable investments. A higher NOI generally indicates a better investment opportunity.

**Note by BiggerPockets:** These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.