Investing in a new property for your vacation rental business is a gamble. If you make a solid investment that pays off, it could take your business to the next level. However, if your investment flops, you could be left with loads of debt and bills from an empty house.
How do you know if your investment will be worth the risk? There’s no way to know for sure, but there are several real estate investment formulas that can help you construct an idea of how risky your investment is. One of these formulas is NOI, or net operating income.
NOI is used to determine whether a property is a good investment by analyzing the ongoing costs of a property. With this formula, you can get an informed idea of how much profit you can make from the investment. From there, you can decide if the income made from running your vacation rental property will be worth the purchase and operating costs.
This formula allows you to analyze the real estate market and the individual property to see how much income can be generated after expenses.
NOI is a powerful estimation tool for making financial decisions at a glance, but it’s important to note that NOI does not account for capital expenditures, taxes or interest payments. Due to this exclusion, NOI is less subject to manipulation in comparison to other investment property calculations.
How to calculate NOI
The formula for calculating NOI is:
Net Operating Income = Gross Operating Income – Operating Expenses
The equation subtracts the operating expenses from the gross operating income. NOI is typically calculated on an annual basis; however, the formula can be adapted to a monthly basis by dividing the expenses by 12.
Gross operating income
Gross operating income is the total rental income generated from renting out the property for your vacation rental business.
One challenge in predicting gross operating income when calculating NOI is that it depends entirely on how the property is being run. Roadbumps always appear and a vacation rental property will not always be operating at its full potential, so it’s important to take market factors into consideration and use them as a reference when estimating rental income.
The formula for finding gross operating income is:
Gross Operating Income = Potential Rental Income – Vacancy Rate
Potential rental income is how much you would make if your short term rental property is filled with guests every day of the year. Vacancy rates are the vacancy percentage of the property, so the percentage of days the short term rental is empty. This can be found using historical data or by using the vacancy rate of comparable properties.
Make sure to add any additional income from the property to your gross operating income when calculating NOI. This can be income from parking lots, vending machines, coin laundry machines, or any other income generated from the rental property.
Operating expenses are how much it costs to own and operate the vacation rental investment property. Think about day-to-day costs to keep the property running, for example:
Property management fees
There may be more operating expenses than the ones mentioned above, so make sure you factor in every expense for your individual investment property.
What isn’t included in NOI?
Some costs are excluded from your NOI calculations because they don’t align with the purpose of net operating income, which is to get a look into the cash flow of a rental property. It’s important to differentiate between property costs, which are included, and investor-specific costs, which are excluded.
Costs you should exclude from your NOI calculations:
Mortgage payments and interest
One-time repairs for wear and tear
NOI and Cap Rate
NOI and Cap Rate are interrelated investing terms in the real estate business because you use NOI to find the Cap Rate of an investment.
The formula for Cap Rate is:
Capitalization Rate = Net Operating Income/Purchase Price
While NOI examines cash flows to see if a property will be a good investment or not, Cap Rate is used to determine the potential profitability of a specific investment or estimate the return on investment for a given property. They are used together to make a more informed decision.
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