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Calculating Net Operating Income

Friday, January 13, 2006
So lets say you have been looking into getting into real estate now, but you just do not know how to value income properties from one to the other. You want to know what makes one a better investment than the other, etc. Well one way you will want to valuate real estate is to by finding the Net operating income.

Let me first start out by explaining the basics behind this type of real estate valuation. First off, it is only really useful for properties you intend on renting out. Second, it is not necessarily even close to the actual price of the property, or even how low the seller may go with the property, but more of a point you will use in order to determine whether the property will make a good investment. The basic net operating income equation is:

V (Valuation) =NOI (Net Operating Income) / R (Capitalization Rate)

NOI is Gross annual potential rent, minus vacancy and collection losses, operating expenses, maintenance, taxes, insurance, and other operating expenses. It is, the net income of the property assuming you bought it outright with cash. (Which does not make sense in real estate, because why buy 1 property at 100% down when you can buy 5 at 20% down.

R, or the Cap rate can be found from local real estate organizations such as universities and such. Another way that you can find a Cap rate to use is by taking the sales price of similar properties and estimated NOI, then working backwards to find their Cap rates. A generally used capitalization rate is .10 which is probably used because it allows for evaluation of profitability while you are inspecting the home.

Valuation is obvious, but let me just say that it is essentially the value in which you could justify the cost of purchasing it for. I usually figure up a property with the valuation of rents if they were in good condition. Then I go through the house and figure out how much it will cost to get the units in that condition and work backwards from there.

Now that I have gone through the basics of how everything works, lets go over a simple example for a 4 unit rental property. We will assume that you determined that each unit could rent for $400 if you put $7,000 of repairs into the building. Then the annual taxes were $2,400, insurance was $720, maintenance at $1000, and water at $900. We will build in 7% vacancy to account for any losses due to vacancy.

Income
Unit 1 $4,800
Unit 2 $4,800
Unit 3 $4,800
Unit 4 $4,800
Less: Vacancy 7% $1344
Gross Income $17856

Expenses
Taxes $2400
Insurance $720
Water $900
Maintenance $1000
Total Expenses $5020

NOI = Gross Income – Total Expenses
NOI = $17856 - $5020
NOI = $12836

V = NOI / R

V = $12,836/.1

V= $128,360

Then you subtract the $7000 from that to arrive at a valuation of $121,360. This means that financially, you can justify the cost of anything up to that point. If the building was for sale for $140,000 it would not really be a good deal. If it were for sale for $109,000 then it might become very profitable for you.