We love metrics in hospitality and real estate. From RevPAR to ADR, tracking key metrics are what allows us to understand our performance, improve operations and ultimately drive profitability for management and owners.
But what's the point of working so hard operating a hotel if you are not making money once all expenses are paid? Cash flow is king! That’s where net operating income comes in: it shows you how well you’re doing at managing expenses and turning top-line revenue into bottom-line profit.
In this article, you’ll see the value of NOI by learning both how to calculate it and how to translate it into operational improvements at your hotel.
What is NOI (Net Operating Income)?
NOI, which stands for net operating income, is the amount of money left after you have paid out all of your expenses. It's a profitability metric that shows you how well a hotel operates, from both a total revenue standpoint and total expenses standpoint. NOI is less prone to manipulation than other metrics, as you can’t really perform too many tricks to inflate income or reduce expenses. You may also see this metric as net operating profit, or NOP.
Understanding the NOI Formula (NOI Calculations)
NOI = Gross Operating Income - Operating Expenses and can be found at the very bottom of your income statement. Property owners focus on this metric because it tells them a lot about property value, potential rate of return on investment and even impacts financing costs like mortgage payments since banks and lenders want to know that there's enough income to cover interest payments.
NOI can also be expressed as a percentage of total revenue, which is how hotel management can easily identify upward and downward trends in profitability. In that case, the formula is: NOI = (Gross Income - Operating Expenses/Gross Income)*100.
Gross income would include all potential rental income a property generates, from both rooms and non-room lines of business. Operating costs are all expenses necessary to maintain and operate the business. Among these expenses are insurance, brand fees, property management fees, utilities, property taxes, repair cost and maintenance (even preventive maintenance), payroll, commissions and anything else related to day-to-day operations. Not included here are any expenses related to debt payments, income taxes, capital expenditures, depreciation and amortization.
Given the relationships in the formula, you can increase net operating income in two ways: increase revenue or reduce expenses. Ideally, you'd like to do both! If you successfully increase income and reduce expenses, you'll see a much more powerful impact on NOI than doing one over the other. Other factors that influence NOI include a property’s ADR, the market segment it serves and the property’s characteristics, such as age, amenities and location -- all things that affect a property’s income potential and overall cost structure.
Why is NOI so Important to Commercial Real Estate Owners?
Every facet of real estate investment is based around NOI since investment properties are valued and compared by a metric called capitalization rate (cap rate). We'll get deeper into cap rate in a future article but the value of a hotel can generally be measured by dividing NOI by cap rate. Let's say a hotel does $1M in NOI and it's located in downtown San Francisco with a cap rate of 6%. That hotel's value would likely hover around 1,000,000/.06 or $16.7M. See why NOI is so important to hotel owners?
But wait, there's more. It's not only real estate investors care about NOI - lenders typically base their willingness to lend on the amount of earnings before interest (EBIT) that a property can generate. EBIT is equal to NOI + interest expense + taxes. Whether you own a hotel, rental property or own any other kind of commercial property, understanding the net operating income formula (and how to grow NOI) is critical to your success.
Ultimately we use a lot of terms and acronyms in real estate investing but ultimately we want to know how we're doing relative to comparable properties. Understanding NOI informs our investment decisions and are more important now than ever before.
How to Influence Your Hotel’s NOI
Since NOI is a fundamental metric for calculating a hotel's ability to generate profit, it correlates directly to hotel valuation -- and thus a focus for owners and management: Hotels with healthy/growing NOI will be valued more highly than those with low/diminishing NOI. And those with negative numbers? That would be Net Operating Loss, or NOL. Not a place ownership wants to be!
Here are three tactics to influence your hotel’s net operating income and make your boss happy!
Expense Reduction's Impact on NOI
NOI benchmarks operational efficiency and helps you identify areas for improvement in your hotel operations. A simple way to turn NOI into a powerful tool for expense management is to track variable costs as percentages of revenue. You won't do this with your fixed costs, as those don’t fluctuate with occupancy. It’s your variable costs, which go up or down alongside occupancy, that you have direct control over each day.
For instance, rent, management payroll and other overhead expenses are fixed; they don’t change each month and you have little control over them. But, for expenses that you can influence, such as front-line labor, linen usage, third-party commissions and cleaning supplies, you can control these on a daily basis.
By tracking these variable costs as a percentage of revenue, you can easily see trends and catch runaway costs before they become problematic and depress NOI. For the most precise control over expenses, monitor your NOI on a daily basis so that you can adjust operations on the fly and keep your finger on the pulse of profitability.
RevPAR's Impact on NOI Growth
Of course, increasing revenue also has a positive impact on NOI. After all, you can only cut expenses so far because each property has fixed overhead costs. And aggressively slashing costs can negatively impact the guest experience -- a short sighted move that ends up making it more difficult to maintain desired occupancy levels.
Work closely with revenue management and marketing to create compelling campaigns that are targeted to the right people. That means that you aren’t just discounting rates in pursuit of occupancy. You are carefully marketing your hotel in a way that attracts the best guests who are paying rates that don’t jeopardize your pricing power.
Marketing to your most loyal guests is a great way to both boost occupancy and preserve ADR. These guests are already familiar with your hotel, so there’s less education needed. And, even better, these guests are often less price-sensitive than transient guests booking via a third-party. So you have an easier path to booking, one that doesn’t require “race to the bottom” discounting.
NOI Can Benefit Greatly From Upsells and Ancillary Add-ons
The third tactic to influence net operating income is to increase income from other areas of the property beyond just putting more heads in beds. This can include a variety of initiatives, such as focusing on upselling guests after booking and offering incentives to book packages that include ancillary services.
You should also do what you can to maximize revenue from guests once they have arrived on property. You've got a relatively captive audience; thoughtfully optimize the on-property experience to entice guests to spend more during their stay. This could include things like a generous happy hour at the bar, merchandising efforts to highlight your property’s culinary delights or a welcome drink that gets guests ready to grab a bite.
NOI During A Pandemic or Downturn
Major asterisk: the pandemic has dramatically restricted the ability of hotels to increase revenue. There's not just lower demands but there's also limited capacity. In this environment, NOI is even more valuable. To stay afloat with revenue harder to come by, you must assiduously track expenses. Those that carefully manage expenses will be more likely to survive than those without a strong focus on NOI.