If you work for a real estate agency, you may have heard about net operating income. This is a profitability formula that is used to determine the financial health and profit of a commercial property by deducting the operating expenses from the net income. In short, you can measure the profit of a property after all the expenses have been dealt with by calculating this metric.
Real estate investors need this formula to see whether a certain building is creditworthy. In other words, if they calculate the net operating income, they can determine if the building can bring a profit after paying all the expenses. One thing to note is that the building by itself is not the only part of a property that can generate cash flow. The parking fees, vending machines, and laundry machines can also produce free cash flow. So, these should be included in the calculation as well.
The Formula for the Net Operating Income
The formula is quite simple:
Keep in mind that almost all services that provide some profit must be included in this calculation, or else the result will not be accurate. However, though the expenses listed above are included income taxes and interest expenses are not. Some creditors and commercial lenders use the net income formula to determine the income generated by the property rather than to evaluate the property in regard to the credit history.
Net operating income is considered less vulnerable than other metrics. If the building or property is generating low income, the trick is to either raise the rents or lower the operating expenses. For example, some expenses like vending machines and laundry equipment may be removed to generate more income per property.
However, for a real estate agency, the above formula is really helpful. It can also be used for the owners and potential owners of the building to see if they made the payments correctly. The price could fluctuate as marginal revenue. This will determine the real value of the building and it will help the real estate agencies to put a correct price on those assets and properties.
This formula can also be used to determine if the property’s income could cover the operating expenses and net debt payments. So, if the property is considered valuable, the lender will decide how much to loan the investor. However, if the property records losses, then the lender may reject the borrower’s mortgage application.
So, the net operating income formula is widely used by real estate agencies. However, the formula can also be used by lenders. If the property is recording losses, then the deal might be doomed to fail. Keep in mind that all the services and equipment inside the building– such as vending machines or parking fees- could generate income. This income should be included in the formula. Otherwise, the calculation will be inexact.