Are you wondering what the difference is between Net Operating Income (NOI) and Cash Flow?
While these two financial formulas are similar, they have a few notable differences. Both formulas are important in evaluating the performance of your rental property. However, they measure different aspects of the performance.
Cash Flow is the difference between the income and expenses of a rental property. Cash Flow measures the distributable money after all expenses are paid, including the mortgage. Net Operating Income does not include the mortgage expense and can be used to determine the value of a rental property.
Let’s take a look at how each of these is calculated, what is included in each of the formulas, and what each of these formulas means for real estate investors.
Net Operating Income (NOI)
The first formula we will look at is the Net Operating Income or NOI for short. The formula for Net Operating Income is pretty straightforward.
NOI = Operating Income – Operating Expenses
Net Operating Income is a financial formula used to determine the profitability of a real estate investment. NOI considers all operating income and expenses, but discounts capital income and expenses, loans, and income taxes. Because NOI determines profitability, it can be used to determine the value of a rental property.
The value of a multifamily real estate investment can be determined by multiplying the Net Operating Income and the Cap Rate.
Property Value = Net Operating Income X Cap Rate
Cap Rate provides a fairly equal comparison when deciding between similar investment properties. Therefore, knowing the NOI of a potential investment is crucial in the decision to invest. It isn’t a perfect comparison but it is a good starting point.
Since Net Operating Income is directly correlated to the value of a rental property, increasing the NOI results in an increase in the property’s value. This is true for multifamily real estate, but not for single-family. The price of single-family real estate is dictated primarily by market conditions.
Next, let’s take a look at what income and expenses are included in Net Operating Income.
What’s Included In Net Operating Income
As we determined earlier, Net Operating Income is the difference between operating income and operating expenses.
So, what is considered operating income and expenses? The simple guideline is any income or expense incurred in the operation of the rental property. This includes any rent or other fees charged to your tenants, and any utilities, maintenance, or property management fees.
Income Included In NOI
- Rents Collected
- Income from parking, storage, etc
- Fees Collected
- Utility Buybacks
- Any other income generated by the operation of the rental property
Expenses Included In NOI
- Property Management
- Maintenance/repairs
- Utilities
- Turnover
- Insurance
- Property Tax
- Any other expense incurred in the operation of the rental property
What’s Not Included In NOI
Income and expenses that aren’t directly related to the operation of the rental property are not included in the NOI. These are primarily capital income and expenditures, and taxes. This is because NOI is used to determine the profitability of the rental property rather than make any assessment of the value of the business.
- Mortgage Payments
- Mortgage Interest
- Tax (State and Federal)
- Capital Expenditures
- Cash distributions made to the owners of the rental property
Cash Flow
So, how does cash flow differ from Net Operating Income?
Unlike Net Operating Income, Cash Flow shows how much free cash is available after accounting for all income and expenditures. Typically this is used to determine how much available cash can be distributed to the owner or owners of the rental property.
Maintaining a positive cash flow will ensure you can keep your rental property business running. A positive cash flow means you have money left over after accounting for all income, expenses, and debt service. Positive cash flow also means you can pay yourself. This is why it is said that cash flow is king.
Since cash flow includes debt repayment, it is possible to have a positive NOI but a negative cash flow. In this case, however, your rental property may be gaining value through a reduction of the principal loan balance.
What’s Included In Cash Flow
Cash flow includes all of the Net Operating Income items and includes debt servicing and capital expenditures. This is because cash flow is meant to show the change in capital of the business.
The items included in cash flow, but not Net Operating Income are bolded.
Income Included In Cash Flow
- Rents Collected
- Income from parking, storage, etc
- Fees Collected
- Utility Buybacks
- Any other income generated by the operation of the rental property
Expenses Included In Cash Flow
- Property Management
- Maintenance/repairs
- Utilities
- Turnover
- Insurance
- Property Tax
- Capital Expenditures
- Mortgage Payments (P&I)
- Any other expense incurred in the operation of the rental property
What’s Not Included In Cash Flow
The primary expense which is not included in the cash flow calculations is state and federal taxes. Most rental property businesses are set up as sole proprietors, LLCs, or LLPs. These provide a pass-through of the business income, so taxes are incurred by the individual or partners.
Summary
Net Operating Income and cash flow are both useful in evaluating the performance of a rental property.
Both formulas have unique purposes. Net Operating Income shows the profitability of the operation of the rental property. Cash flow determines the funds left over after accounting for all expenses.
When used together, these calculations can give you a good sense of the performance and value of your rental property.