How do you calculate NOI?
Net operating income, or NOI, is the revenue a property produces minus operating expenses.
Revenue – expenses = NOI
For instance, a property brings in $100,000 per year and expenses are $70,000. The property has an NOI of $30,000.
The greatest thing about multifamily investing is that NOI has a direct effect on the property’s value. For commercial properties, it’s feasible to increase value by $500,000 just by raising rents $100 per unit on a 20-unit building. (See the math here.) By leveraging NOI, you can produce windfall profits when you sell.
The NOI calculation sounds simple, but you’ll probably discover that finding true revenue and expenses is harder than it appears. Let’s look at them separately to see how we get those numbers.
For a multifamily apartment building, revenue mainly consists of rent, but can also come from amenities like laundry facilities and vending machines.
Keep in mind that lenders will use actual revenue over the previous 12 months, not an estimate of future revenue.
You should also use actuals when buying a property. The seller’s commercial broker may try to base the price off of future or potential rents. Don’t buy based on future income — use the actual income.
For example, say 20-unit property with rents at $800. For simplicity, we will say that there is no income from amenities. That’s $192,000 revenue per year. But that’s a theoretical number. Almost no property runs at 100% occupancy. When you dig into the financials, you realize that the property only brought in $180,000 due to vacancies. Now let’s look at expenses.
Expenses include taxes, insurance, management, regular repairs, and other regular ongoing expenses. Not included are capital expenditures — one-time costs like replacing the roof. For example, yearly expenses may look like this:
- $40,000 for 3rd party management
- $5,000 for landscaping
- $25,000 for repairs
- $20,000 for taxes
- $10,000 for utilities
- $12,000 for insurance
- $50,000 for a new roof — note that this does not affect NOI since it’s a one-time capital expenditure
$112,000 in yearly expenses
Now let’s plug the numbers into our formula.
$180,000 (revenue) – $112,000 (expenses) = $68,000 NOI. (Remember this number for the next section)
Why NOI is Important
NOI is important in two ways: 1) it helps determine the value of your property, and 2) it shows you if you can get approved for a loan.
An apartment building’s value is determined by this formula: NOI / Cap Rate = Value
We’ll use our NOI from from the above example of $68,000. Cap rate, or capitalization rate, is determined by the market and property type. For simplicity, let’s say cap rate is 5% (0.05). We can now calculate the value of the property:
$68,000 (NOI) / 0.05 (cap rate) = $1.36 million
Manipulating your NOI can increase value (by they way, this is the coolest thing about multifamily investing). Say you increased rents and decreased expenses. Now your NOI is $80,000 and the property is worth $1.6 million. You just increased your net worth by $240,000. Not bad.
NOI is also a component of debt service coverage ratio, or DSCR. DSCR is a comparison between net income and loan payments. The goal is to have higher income than payments on the loan.
Lenders analyze DSCR when deciding whether to approve an apartment building loan. Typically you need a 1.25x DSCR. That means NOI has to be 25% higher than the proposed loan payments, per year.
NOI (Net Operating Income) / Debt Service (Loan Payments) = DSCR
Let’s again look at our example from above. You have a $68,000 NOI. Your loan payments need to be under $54,400 to qualify.
$68,000 (NOI) / $54,400 (loan payments per year) = 1.25x
If your NOI is too low, you won’t qualify for the loan. But if it’s high, you’ll have a much easier time with lenders.
The Bottom Line
NOI is one of the most important numbers you need to know whether you’re buying, holding, or selling an apartment building. Get good at calculating this number, even on the fly and in your head. It will serve you well in your multifamily investment endeavors.