Looking at the net operating income of your real estate investment helps you compare your regular, recurring costs with the income you’re receiving. In general, your operating expenses should be much less than the revenue you’re bringing in.
In many ways, your net operating income acts as an important valuation of your business. It provides several key indications such as:
- How much you can pay yourself initially or in the long run as an owner
- Whether you can make mortgage payments using the excess from your operating income or if you’ll need other funds to pay the principal and interest
- Whether your net operating income provides ability to save for larger repairs, like a new roof or an update to the kitchen
- If you should make adjustments to your business operating model. For example, do you need to lower your operating costs or increase the price of your monthly rent?
So, whether you’re new to real estate or a seasoned veteran, this guide will help you understand net operating income, what it means, and how to calculate it. Being knowledgeable about your net operating income and the health of your business directly impacts your personal finances. With the right knowledge, you’ll be a more savvy and prosperous investor.
What Is Net Operating Income for Real Estate Investing?
Net operating income is a valuation method utilized by real estate owners to evaluate their operating income against their operating expenses. This number is often reported on a business’s income and cash flow statements.
Your net operating income is an important indicator of the profitability of a real estate investment — whether it’s a rental or commercial property. The higher the net operating income, the more valuable the real estate investment is.
By evaluating net operating income, you can better determine if you’d like to purchase a property, sell a property, or adjust the business’s income and expenses. A net operating income may even dictate whether or not a lender will approve a loan. Your bank or financial institution will likely consider this number among other valuation methods.
How to Calculate Net Operating Income for Real Estate Investing
To determine your own net operating income, look at the remaining dollar amount after subtracting your operating expenses from the operating income in a given accounting period.
When it comes to operating costs, here are common expenses to include:
- Repairs to the building and grounds
- Property insurance
- Maintenance (such as snow removal, lawn care, and janitorial services)
- Property taxes
- Staff salaries
- Property management costs
- Utilities not covered by tenants such as trash, recycling service, or heat
For income, be sure to include the following revenue streams:
- Rent from tenants (business or residential)
- Laundry income (such as from coin-operated machines)
- Vending machine income
- Parking fees or permits
- Revenue from cell phone tower if it’s stationed on your property
- Billboard advertisements if located on property
A net operating income equation doesn’t include principal payments, interest payments, or interest revenue.
Net Operating Income Formula
The simplest way to calculate your net operating income is to utilize the following formula. By entering in the values for each component, you’ll have a clear number to consider in your business decision making.
Formula: Net Operating Income = Gross Operating Income – Operating Expenses
To see this formula in action, we’ll use a concrete example. If Sarah owns a rental property, she’ll need to consider her operating expenses and her gross operating income.
In this example, Sarah’s net operating income is substantially positive. It demonstrates that her real estate property, in one year’s time frame, has an operating income that exceeds her operating expenditures by $22,164. With this excess, Sarah can put the funds toward her mortgage and interest payments. She can also save part of her net operating income for future upgrades and capital investments if desired.
Operating Income vs. Net Income
While net income and operating income both show revenue, the two represent distinct financial indicators. By looking at both numbers, business owners can better understand where exactly a company earned a profit or where they suffered a loss.
Operating income refers to the profit that’s remaining after subtracting operating expenses such as property management fees and depreciation and amortization. Operating income includes income like rent and laundry fees but excludes taxes and interest expenses.
Net income, on the other hand, is a company’s earnings or profits. The income remaining after factoring in all expenses, including taxes and interest, is considered the net income or the bottom line. Once all expenses have been subtracted from all revenues, the net income is found.
Again, net income and operating income carry valuable information for the business owner. They should both be considered when evaluating a real estate investment or business opportunity.
Overall, understanding your net operating income allows you to evaluate a real estate property. By looking at your operating expenses compared to your gross operating income, you can gauge the overall health of your business. From there, you can determine if you want to reduce your operating expenses, raise your rent, or add additional streams of income such as having tenants pay for parking space.
As a more informed business owner, you’re able to make decisions that will help improve your financial standing. You can design a business that increases the value of your investments — as you continue to live a life of prosperity.