Greetings, and welcome to another installment of “Investing Defined.” If you’ve been keeping up, you already know about Cash Flow and Cash on Cash Returns. There are many definitions out there; some are downright confusing! In “Investing Defined”, we clear up the clutter and explain the terms so you can understand!
Enter “Net Operating Income”
Short and sweet definition: Net Operating Income (NOI) is the amount of rent income you have left after basic property expenses such as property management fees, repairs, insurance, and taxes on the property.
Meet Jim. Jim just closed on his first real estate investment property. He quickly found a tenant, got a lease signed, and now he’s getting $1000 of rent a month. Good for him, but by now we all know that all $1000 doesn’t go to Jim’s pocket. Good ol’ trusty expenses will take a little bit of that away from him. Where does Net Operating Income (NOI) come into play here?
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Net Operating Income – This is the amount of money Jim puts into his account before paying the mortgage payment. One little twist on this is that your insurance and taxes, included in your payment to the bank, should also be part of your expenses. Now, you are going to pay those as part of your escrow, so isn’t that part of the mortgage payment? It’s part of your payment to the bank, but it really has nothing to do with the payment of the mortgage itself. The bank is just doing you a “favor” by lumping taxes and insurance in with your total mortgage payment. Let’s just say it’s really more of a favor to the insurance company and tax collector since they are making sure they get their money!
Before getting too confusing with the wording, let’s lay this out so you can see how it all works. Here are Jim’s financials. We are going to assume there may be one month of vacancy for every year the rental is on the market.
= $1000 Potential Gross Income (the best you can do)
– $83 Vacancy (adding some risk)
= $917 Expected Gross Income (after vacancy, this is likely)
– $83 Repairs (adding some more risk)
– $100 Property Management (optional, but valuable)
– $120 Taxes (part of your escrow payment)
– $65 Insurance (part of your escrow payment)
= $549 Net Operating Income
Notice how I am not taking out the mortgage payment yet, although I did grab the escrow portion of Jim’s payment and toss it up in the expenses section (Hint: this is taxes and insurance). Once you remember that little trick, you will always do your Net Operating Income calculation correctly. Most people forget to add the taxes and insurance into the mix.
Net Operating Income vs. Cash Flow
After recently hearing about cash flow, you may be wondering how Net Operating Income and Cash Flow differ. Now that I’ve explained Net Operating Income, let’s review Cash Flow quick and see how it affects Jim’s available cash:
= $549 Net Operating Income (we just calculated this)
– $430 Mortgage Payment (Principal and Interest ONLY)
= $119 Cash Flow
By the way, this is the same example we used in Cash Flow – Investing Defined, Part 1 so you can see how this all works out.
After paying his mortgage payment, Jim ends up with $119 of cash flow. This is real money in his pocket after the month is over. I know it doesn’t “seem” like a lot, but remember I am assuming you have a month of vacancy every year and $83 of repairs every month. You are also getting the tenant to pay your mortgage and likely holding an appreciating asset, so that’s another plus. It’s good to be very conservative on your calculations to ensure you can keep your cash flow positive in good times and bad. It’s obviously critical to have your Net Operating Income positive and higher than your mortgage! One more thing to remember about your cash flow–because of depreciation, he probably won’t be paying any taxes on it this year either. For a 25% tax bracket, that’s about like getting a $150 check before taxes. Swing by our post on depreciation if you want to dig into that topic!