Net income (NI) refers to a company’s total revenue minus the costs associated with running the business including operating expenses, taxes, interest, depreciation, and several others. Analysts use this figure to measure a company’s financial health and/or profitability over a defined period of time (e.g. quarterly, semi-annually, or annually).
Net Income, Net Profit, and Net Earnings
Are all of these terms different names for the same thing? The short answer is: yes, they are. Net income, net profit, and their less popular cousin, net earnings, are one in the same. Although some people prefer one over the other, these can be used interchangeably…which brings us to the next point.
What’s the difference between Net Income and Gross Income?
Net income, as mentioned earlier, is a company’s earnings after all associated costs are deducted. Gross income (GI), on the other hand, refers to a company’s total revenue minus the cost of goods.
Each of these computations are useful but serve different purposes. NI is used to determine the profitability of a business–that is, whether the business model is viable given its current revenue and costs. Whereas GI is used to determine the amount of profit generated by goods during a sale.
Both of these terms are not to be confused with Gross Revenue (GR) or the total revenue earned before anything is deducted.
Quick aside: Why are there so many ways of computing earnings?
A very important part of business is determining which income streams generate the most money and which expenses cost the most money. Having various figures at stage of deduction helps us identify where revenue is coming from and where it is going.
Net Income In Real Estate
Net Income is particularly useful in real estate, especially commercial real estate. Through it we can determine a property’s value and/or profitability.
Using Net Income, we can tell whether a piece of property is generating income and whether any associated overhead costs are greater or less than that income; it also tells us which expenses incur the greatest amounts.
It is important to note, however, that NI is exclusive of any financing or tax costs associated with the owners or investors of a property, which means that any personal liabilities and assets do not affect its computation.
Net Income And Lease Analysis
Before we go any further, let’s take a quick look at lease analysis. Lease analysis refers to the overall assessment of an income-generating property. It tell us which parts of the property generate revenue and which parts pay for certain expenses. As you may have already picked up, it’s easy to see why lease analysis is so crucial to NI.
Furthermore, because there are so many different kinds of real estate leases (e.g. full service lease, triple net lease, modified gross lease, etc.), it is important to differentiate between each type in order to fully appreciate the value of a property.
Experts are easily able to distinguish between absolute gross leases, where the owner shoulders the majority or all of the operating expenses associated with the property, and absolute net leases, where the tenant pays for the operating expenses, as well as other variations called hybrid leases that fall between these two extremes.
Computing for Net Income
Here, we break down each individual component of NI. These include the following:
Potential Rental Income (PRI)
The full sum of all rents assuming the property is 100% occupied. If the property has vacancies, then PRI is computed using current market rates or rents of other similar properties.
Vacancy and Credit Losses
Income lost due to vacancies and non-payment of leases. When computing for NI, vacancy can be calculated using current lease expirations and market figures on other similar properties.
Effective Rental Income
The amount of income an owner can expect to collect. Simply, PRI minus Vacancy and Credit Losses.
Other Income
Any income not associated with rent. These include parking, advertising space, laundry, vending, and others.
Gross Operating Income
All income generated from a property less any vacancies and credit losses.
Operating Expenses
All cash expenditures associated with operating a property and commanding market rents, including real estate taxes, property insurance, repairs and maintenance, utilities, management fees, legal expenses, and others.
Adding and subtracting all these factors above, we end up with Net Income.
What Doesn’t Net Income Include?
There are certain expenses a property owner has to pay that are separate from net income. These include the following:
Capital Expenditures
Irregular expenses such as major repairs, renovations, roof replacements, and other expenses usually funded by a reserve for replacement. These do not include minor maintenance costs such as light bulb or door replacement.
Reserve for Replacement
Funds set aside for capital expenditures. While textbooks generally exclude reserves for replacement in NI, lenders may include these to determine debt service coverage and the maximum loan amount. Doing so allows them to determine a property’s capability to service debt as well as how much capital expenses are required to keep it competitive in the market.
Income Taxes
Taxes specific to the owner/investor of the property.
Commissions
Any commissions or bonuses paid to real estate agents and brokers.
Debt Service
Costs associated with the owner or investor and not the property.
Depreciation
Costs associated with the wear and tear of the property.
Tenant Renovations or Improvements
Any construction or additions made by the tenant.
Other Uses for Net Income
Business
When calculating the NI of a business, start with the total revenue. From the total revenue, you can subtract operating costs, product costs, salaries and wages, and other expenses. Afterwards, you can deduct all associated taxes and find the net income.
Personal
You can know your net income by subtracting income tax from your taxable income (either from your salary or business); your income tax will depend on your tax bracket and various deductibles. In simpler terms, your personal net income is equivalent to your take home pay.
Tax Returns
In the United States, taxpayers report their incomes in terms of gross income, adjusted gross income (AGI), and taxable income. However, these don’t account for how much money you actually bring home.
To get NI, you need to Subtract Social Security benefits and other qualify deductions from your gross income, which gives you AGI; then from your AGI, subtract standard and itemized tax deductions, which gives you your taxable income; and finally from your taxable income subtract your income tax.
Conclusion
Understanding net income is a good first step in making sounder investments. Using it allows you to know where money is coming from and where it is headed, which, we can’t emphasize enough, is extremely valuable, especially when you’re looking to bet your hard-earned earnings on real estate or a business.
Remember, every time you value a property or a business, you need to know how it earns money and how it spends it.
