Understanding the financials is essential when analyzing investment property. Therefore, knowing the terminology and how it reflects any property you own or plan to own is relevant to your real estate success. One of the most commonly used terms is net operating income which directly influences the value of an investment property.
Net operating income is the gross income less the operating expenses.
The following items are often referred to as operating expenses.
-Real Estate Taxes
-Property Insurance
-Utilities
-Repairs and Maintenance
-Janitorial
-Interior/Exterior Decorating
-Management
The operating expenses determine how much is taken away from the gross income and what is left in your bottom line (which of course is taxed). Therefore, if two properties have the same gross income of say $100,000 a year and one has operating expenses of $20,000, while the other has operating expenses of $40,000, your net operating income will vary from $80,000 for the first property to $60,000 for the second! That's quite a chunk of change.
When looking at any investment property looking at operating expenses is just as important as looking at income streams. However, it's just less flashy and attractive than dealing with cash flow. Smart investors will find properties that have strong gross income, and have room for expense cutting. For example, if you can eliminate the standard 5% management company fees, you've saved yourself $5,000 a year if you used the same numbers as the example above. Therefore, if you can find ways to reduce the operating expenses of a property you could find a diamond in the rough.
Keep in mind that gross income (all cash inflows) is limited in terms of investment analysis. Net operating income is the most important number on the balance sheet and will affect how much you keep in your pocket and the value of the property.
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