Real estate investors define net operating income as annual gross potential rental income from a property less vacancy and collection losses, operating expenses, replacement reserves, property taxes, and property and liability insurance.
Here’s how a typical net income statement might look for any-size rental income property.
Income Statement (Annual)
1. Gross scheduled income
2. Vacancy and credit losses
3. Effective gross income
4. Other income, e.g., laundry, parking and storage areas
5. Gross operating income
Less operating and fixed expenses
6. Property taxes
7. Property and liability insurance
8. Water and sewer
9. Trash pickup
10. Property management fees
11. Electric
12. Repairs and maintenance
13. Advertising and promotion
14. Landscaping
15. Miscellaneous, e.g. application fees, key fees, late fees
16. Replacement reserves
17. Net Operating Income
The following list explains each of the lines in the net income statement:
1. Gross scheduled income - This amount is the largest possible sum of rents that you could theoretically bring in at current market rent levels and 100 percent occupancy.
2. Vacancy and collection losses – Even the best-managed apartments experience some vacancies when apartments turn over. As a practical matter, therefore, also add in some losses even when all units in the building are rented.
3. Effective gross income – This term refers to the actual amount of cash that an owner receives net of vacancy and collection but before any other income.
4. Other income – This represents the income a landlord collects from such things as a coin-operated laundry facility, parking garages, and storage areas.
5. Gross operating income – This term refers to the actual amount of cash that an owner receives before operating and fixed expenses.
6. Property taxes – This item includes city, county, and state taxes annually assessed against the property.
7. Property and liability insurance – This insurance reimburses for property damage caused by fire, hail, windstorms, sinkholes, hurricanes, and other perils. It also pays to defend against, and compensate for, lawsuits alleging owner negligence, e.g., slip and-fall cases.
8. Water and sewer – This is self-explanatory.
9. Trash pickup – This is self-explanatory.
10. Management fees – What the owner of the apartments pays to manage the property. Always show an amount for management, even when the landlord self-manages the apartment. After all, he should pay himself the same amount he would otherwise have to pay a property management firm.
11. Electric – Tenants pay their unit utilities, but the property owner pays for lighting in the hallways, basement, laundry room, grounds, and parking area.
12. Repairs and maintenance – This reflects costs associated with cleaning, painting, and making small repairs around the property. Always show some amount, even when the owner does the work.
13. Advertising and promotion – The costs associated with a For Rent sign that’s posted on the property, newspaper ads, referral fees, and the Yellow Pages.
14. Landscaping – Yard care costs. In some cases, the owner might pay this amount to one of the tenants to keep the grass cut, rake leaves, and shovel snow off the walks.
15. Miscellaneous – This expense covers legal fees, supplies, snow removal from the parking lot, municipal assessments, auto mileage to and from the property, and other items not accounted for elsewhere in the income statement.
16. Replacement reserves – Building components subject to wear and tear such as the roof, plumbing, appliances, and carpeting must be replaced periodically. For the purposes of the income statement, these replacement costs should be averaged out annually.
17. Net operating income (NOl) – After you itemize and total all operating expenses, subtract this amount from the gross operating income to compute the net operating income (NOI).
Okay, let’s consider some final thoughts.
When you calculate NOI, make sure you include all expenses for the coming year, and never accept a seller’s income statement as accurate; ask to see the seller’s tax return IRS Schedule E for the subject property. Even if the seller is perfectly truthful in reporting last year’s income and expenses, always estimate how each of those figures might move up or down in the coming years; you’re buying the future, not the past.
Here’s more. Are property tax assessments headed up? Are vacancy rates (or rent concessions) increasing? Have utility companies scheduled any rate hikes? Has the seller deferred maintenance on the property? Has the owner allocated enough maintenance expenses to cover replacement reserves? Has the seller self-managed or self-maintained the property and therefore omitted these items as cash expenses?
Just bear in mind, that when it comes to calculating NOI, accept nothing on faith; prudent real estate investors thoughtfully reconstruct seller-prepared net income statements without hesitation. So should you.
