What is the Difference Between Net Operating Income & Gross Operating Income
This couldn’t get simpler. Here’s how it is in a nutshell.
- Gross operating income represents the total earnings potential from rent and other revenue streams before factoring in vacancies or operating expenses.
- Net operating income takes the analysis a step further by subtracting operating expenses to reveal actual profit.
Gross income sets the ceiling for possible earnings, but NOI paints a more precise picture of funds available to service debt, cover taxes, and ultimately land in the investor’s pocket.
Comparing the two metrics highlights the impact vacancies and costs have on the bottom line. However, the real essence of calculating NOI is accurately estimating each expense.
Expenses Included in Real Estate NOI
To calculate NOI in real estate, you need to forecast all operating expenses. And when I say all, I mean all of them—even the ones that others tend to forget.
To help you out, here’s a great list of all the expenses to include when you calculate NOI and cash flow profitability.
Vacancy Rate
Rental vacancy rates in the US rose to 6.6% in the fourth quarter of 2023 from 5.8% year-over-year, while homeowner vacancy rates held steady at 0.9%.
So, no property has a 100% occupancy rate. You’ll have turnovers and vacancies for every property you buy.
That said, some properties and neighborhoods boast much lower vacancy rates than others. In markets with plenty of demand, landlords receive dozens of rental applications within a few days of advertising vacant units. In areas with less demand for housing, rental applications may only trickle in over weeks of advertising.
Maintenance & Repairs
Likewise, all properties need repairs and maintenance more often than new landlords guess.
From repainting units in between tenants (which usually costs several thousand dollars) to new carpets, from furnace repairs to new roofs, you will have plenty of these expenses. While some investors don’t count capital expenditures (CapEx) as repairs in NOI, I do. A $5,000 new roof certainly impacts your bottom line, and you can predict these capital improvement costs as a long-term average.
Expect to spend 1% to 4% of your home’s value on annual maintenance. A $250,000 home equates to $2,500-$10,000 per year.
Property Management Costs
Rental properties are not a completely passive source of income. They require work to manage, from screening tenants to fielding 3 am phone calls about broken toilets and beyond.
You can do this work yourself or hire a property manager and outsource it. Either way, you need to account for these costs. Suppose you manage the property yourself at first. In that case, it’s still a labor cost, so make sure you compare apples to apples by including labor costs with rental properties when you compare them to other investments like ETFs or crowdfunded real estate investments.
Expect average property management fees to run 7-10% for collecting lease payments and ongoing management, plus one month’s rent for each new tenant placed. That comes to roughly 10-14% of the rent, depending on the fees you pay and the property’s turnover rate.
Property Taxes
While property tax rates vary by county, every county in the US charges property taxes. And no, you can’t just use the current property tax bill when you buy a property. You need to calculate the increased property tax bill based on the local tax rate and the purchase price for the property, as the local tax assessment office will certainly bump up the assessed value based on what you pay.
Insurance
Landlords must carry property insurance just like homeowners. The only real difference is that landlord insurance policies cover only the building and don’t include personal possessions inside. (Try Sure as a good landlord insurance provider.)
Some landlords also keep rent default insurance, which kicks in and pays the rent if the tenant stops paying. These policies aren’t expensive, and they provide great peace of mind.
Expect to pay roughly $1,759 per year for a typical $250,000 homeowners insurance policy, though your actual rate will depend on several risk factors.
Accounting, Legal, Marketing, and Miscellaneous Fees:
Rental property expenses don’t end with the bills above. Landlords periodically need to pay for legal services such as hiring an attorney for the eviction process, buying a state-specific lease agreement, or taking asset protection measures.
Then there’s the travel to and from rental properties. The bookkeeping and the higher accounting bill for your more complicated tax return. The marketing expenses to fill vacant units quickly. And so on and so forth. Set aside 2-4% of your rental income for them.
What’s Not Included in NOI?
Not all expenses are included in NOI for real estate. When you run your numbers for net operating income, don’t include the following expenses.
Debt Service (Mortgage)
Don’t include your monthly mortgage payment when running the numbers for NOI.
Net operating income—and its sister calculation cap rates—are intended to be specific to the property, not the buyer. One buyer could pay in cash, the other could get a rental property loan for 80% of the purchase price, affecting each buyer’s cash flow. But your financing decisions don’t affect the property’s intrinsic NOI.
Income Taxes
Similarly, income taxes are unique to you, not the property. One landlord might be taxed at the 10% federal income tax rate, while another pays 24% in federal income taxes, which says nothing of state and local income taxes, depending on where the landlord lives.
Note that landlords pay income taxes on net rental income at their normal income tax rate. However, they can take rental property tax deductions without itemizing their personal deductions. Rental property tax deductions are “above the line” expenses and deductions.
Depreciation
As a unique deduction, landlords can deduct the cost of the building and any capital improvements to it. However, they must spread these deductions over 27.5 years using depreciation.
It can get confusing, so read up on how rental property depreciation works if you’re unfamiliar with it.
Tenant Improvements
If tenants improve your property, that doesn’t count toward expenses included in NOI. But this is much more common in the commercial property space and rarely affects residential landlords.