Net Operating Income, or NOI, is a calculation that analyzes the profitability of income-generating real estate.
Understanding the Net Operating Income of a property helps real estate investors understand more than the profitability of an investment property, though. It is also a key number for investors to calculate the Capitalization Rate (Cap Rate), Debt Coverage Ration (DCR), Cash Return on Investment, and Total Return on Investment.
Because it exposes such an important element of investment properties (its profitability) and serves as a key number in other necessary real estate calculations, the Net Operating Income formula is fundamental to understand.
What is the Net Operating Income Formula for Real Estate?
The Net Operating Income formula is:
(Gross Operating Income + Other Income) – Operating Expenses = Net Operating Income
Now that you know the Net Operating Income formula let’s discuss all of the numbers involved in the formula and how to calculate NOI.
How To Calculate Net Operating Income (NOI)
The first thing many people notice is that there are two types of income referenced within the NOI formula.
“Gross operating income” is the amount of money you make. “Net operating income” is what you have remaining after all of your operating expenses are taken out of what you made.
Operating expenses, on the other hand, include all funds used to maintain a property in order to generate income. Operating expenses include property taxes (but exclude income taxes), vendor and supplier fees, upkeep and repair costs, insurance, utilities, permits, supplies, and overhead expenditures, including costs for accounting, legal counsel, and advertising.
Operating Expenses exclude income taxes, principal and interest payments on loans, tenant leasehold improvements, leasing commissions, amortization and depreciation, and capital expenditures.
To calculate NOI, start by adding all operating income. For example, an office building may earn money from tenant rents, which is one income stream. However, you may also have vending machines in the common area and meters in the parking lot, which generate additional income. Therefore, add the total amount of all three income streams on the property. The sum of all three income streams in this example equals your gross operating income.
Next, add all the operating expenses. The sum of all these expenses equals the operating expenses.
When you have the gross operating income and operating expense numbers, you simply take the operating income and subtract the operating expenses from it.
The difference is your Net Operating Income.
Does NOI Include the Mortgage?
No, the NOI figure does not include the mortgage. Mortgage payments are not considered when calculating net operating income for a straightforward reason: they aren’t regarded as operating expenses or ongoing costs associated with maintaining the property.
What Expenses Are Excluded From Net Operating Income?
It’s critical to distinguish between expenses specific to the investor and those specific to the property when calculating net operating income. For instance, mortgage interest costs won’t be considered when calculating NOI. Other expenses not factored into the calculation of net operating income include the following:
- Mortgage Interest
- Income Taxes
- Leasing Commissions
- Debt Service
- Property Depreciation
- Tenant Improvements
- Capital Expenditures
- Repair For Wear And Tear
Calculating Net Operating Income Example
Practice always helps improve understanding, so let’s calculate a Net Operating Income example.
Let’s say that an investor purchases a multifamily building for $10M.
- Rental income: $1,245,000
- Premium parking fees: $20,000
- Vending machine: $5,000
- Gross Income = $1,270,000
Now that we have our gross income, let’s look at the operating expenses:
- Repair & maintenance: $60,000
- Payroll (includes property management in this example): $125,000
- General & Administrative: $37,000
- Utilities: $40,000
- Property taxes: $200,000
- Insurance: $30,000
- Total Operating Expenses = $492,000
The NOI in this example would be $1,270,000 – $492,000 = $778,000.
One important note is that the Net Operating Income is a before-tax number. It often appears on a property’s income and cash flow statement, which excludes capital expenditures, depreciation, amortization, principle and interest payments on loans, and other expenses. Earnings Before Interest and Taxes (EBIT) is the name given to this measure when it is applied to other industries.
How is Net Operating Income Used?
Net Operating Income is used in various ways for commercial real estate investing.
One of the primary ways NOI is used is to determine a property’s Capitalization Rate (Cap Rate), also known as the return on investment (ROI) in real estate. To calculate the cap rate, you divide the NOI by the purchase price.
For financed properties, Net Operating Income is used as a key number to calculate the debt coverage ratio (DCR), which tells lenders and investors whether a property’s income covers its operating expenses and debt payments. The loan amount that lenders offer primarily depends on whether or not a property is regarded as profitable when evaluating the NOI. On the other hand, lenders will likely reject the borrower’s mortgage application if the property shows a net operating loss.
Net Operating Income is also used to help calculate other vital real estate investing metrics such as the Net Income Multiplier, Cash Return on Investment, and Total Return on Investment.
What to Watch Out For With Net Operating Income?
It’s always important to do your due diligence, and it’s no different with NOI.
It’s common for investors and accountants to understate a property’s NOI to lower tax liabilities and inflate it when trying to sell the property because it increases the property’s value. This is not ethical, and you should scrutinize all numbers when evaluating a property to ensure you don’t overpay.
Investors can manipulate their NOI by delaying some costs while accelerating others. For example, an investor may increase rent and other fees to boost revenue while pausing or holding off on critical operational costs to raise their NOI before listing it for sale.
What is the Difference Between Net Income and Net Operating Income (NOI)?
Net operating income is revenue less all operating expenses. Net income is revenue less all expenses, including operating expenses and non-operating expenses such as mortgage interest.
Net operating income (NOI) is a frequently used metric to evaluate a property’s profitability. The formula requires you to subtract all property-related operational costs from any income the property has produced. The investor can then use this number to decide whether the money from owning and maintaining the property is worthwhile.