NOI 101: The Basics of Net Operating Income
Both novice and seasoned real estate investors know that accurate facts and figures are key to buying real estate in Hawaii. Sloppy math and the taint of optimism can easily mask the poor earning potential of a property. If you don’t calculate your figures carefully, you stand to suffer from preventable and regrettable losses. Perhaps the most critical figure to assess when buying real estate in Hawaii is a property’s Net Operating Income, an indicator of a property’s profitability. A solid NOI promises ample income and portfolio growth, which, of course, is every real estate investor’s objective.
What is Net Operating Income?
A property’s Net Operating Income, or NOI, is the net profit it generates from rental income. In other words, it is the income left over after accounting for the expenditures necessary to maintain the property. To determine the NOI of a property, you must subtract the operating expenses, or OPEX, from the gross operating income, or GOI.
The NOI itself expresses the degree to which a property will generate profit. Thus, the higher the NOI, the more profitable the property. If you are buying real estate in Hawaii, the NOI of a property should be the first thing you look for.
Of the two critical figures necessary for calculating NOI, the GOI is the simplest to ascertain. GOI, or total revenue, includes both rental income and income from services like parking, vending and laundry machines, and other facilities. If operating expenses exceed GOI, you are looking at a Net Operating Loss.
What are Operating Expenses?
Operating expenses can be a little more difficult than GOI to determine, especially if you are attempting to project future NOI instead of calculating existing expenditures. The difficulty of determining operating expenses lies in the definition. Not all necessary expenses for buying real estate in Hawaii are considered operating expenses.
Operating expenses are expenses made for maintaining the property and its value. OPEX includes home insurance, utilities, property taxes, repairs, and property management expenses. If you own a large apartment complex, the money you spend on landscaping, janitorial staff, and doormen are considered OPEX as well. OPEX does not include your mortgage, nor does it account for taxes, depreciation, loan payments, or amortization.
It is also important to discuss how renovations and repairs influence your OPEX. Any repairs necessary for maintaining the functionality and current value of your property are considered operating expenses. For example, fixing a leaking roof or a plumbing problem will increase your operating expenses. Capital expenditures, or expenses that increase the value of a property, are not operating expenses. Renovating a functional kitchen or bathroom for the sake of increasing the value of the property would not count as an operating expense.
The distinction is important. Necessary repairs increase OPEX, thereby decreasing NOI and, by extension, the value of the home. Value-adding renovations, on the other hand, do not increase OPEX. Further, if they allow you to increase rental rates, they actually drive up GOI, increasing your NOI.
How To Calculate Operating Expenses
Calculating operating expenses is difficult, especially if you are attempting to predict NOI instead of using records of past expenses.
Operating expenses are represented in a figure called an expense ratio. The expense ratio expresses the relationship between operating expenses and gross operating income. For example: if operating expenses amount to $50,000 on a property with a GOI of $100,000 , the operating expense ratio is 1:2, or 50%. Broadly speaking , operating expenses typically amount to 35-80% of a property’s GOI. The ratio tends to be far higher for apartment complexes and other larger, nicer properties, as they require more maintenance and staff. If your calculations fall below 35%, recalculate, as you have likely made an error.
Maintenance costs can be unpredictable, making it difficult to calculate OPEX. Typically, it is safe to assume that maintenance costs will amount to 1% of the property’s value. Investors typically pay property managers 6-8% of the value of rent per month. Utilities like water, electricity, and gas are highly contingent upon the behavior of your tenants. To increase and stabilize your NOI, it is wise to require tenants to cover these bills themselves.
The Significance of NOI
NOI is, primarily, an indicator of profitability. But it is important for several other reasons as well. The NOI is the primary determinant of the value of an income-generating property, and it appears on property income statements. Because NOI indicates the earning potential of a property, banks will look at the NOI in determining loan amounts. Banks are more likely to issue loans on properties with high earning potential, i.e. high NOI’s. Thus, if you are buying real estate in Hawaii, you are more likely to obtain a good loan on a property with a high NOI.
The NOI also helps determine the capitalization rate, or the rate of return on your investment when buying real estate in Hawaii. The capitalization rate is expressed as a ratio of the NOI to the current market value of a property. The capitalization rate is another key indicator of earning potential and a selling point for investors.
By increasing a property’s NOI, you increase the value of the asset, as well as the capitalization rate. In turn, you increase your net worth and expand your future earning potential. Though NOI is difficult to manipulate, there are a few things you can do to increase your NOI and, in turn, your net worth.
Increasing NOI
In order to increase your NOI, you must either increase GOI or decrease OPEX. Generally, it is more difficult to accomplish the former. In order to increase GOI, you can complete renovations that allow you to raise rental rates. You can also provide extra services, like common areas for rent and other amenities. Typically, though, it is easier to decrease OPEX than it is to increase GOI.
As previously mentioned, it is a good idea to require tenants to pay for water, electricity, and gas. If you are paying these utilities yourself, you are driving up your OPEX unnecessarily. Plus, tenants typically use way more water and energy when they aren’t covering the bills themselves. Requiring them to do so thus increases your bottom line and encourages conservation for the betterment of the planet.
Another way to decrease OPEX is to manage the property yourself instead of outsourcing. Though property management can be difficult and time consuming, it would greatly increase your net worth.
Finally, decreasing your OPEX requires you to be financially savvy in your repairs. Doing so might mean learning some simple repairs yourself, or developing a good relationship with a repairperson. The more inexpensive your maintenance services are, the higher your NOI and, by extension, your earning potential.