What Is Net Operating Income – NOI?

Net operating income (NOI) is a calculation used to analyze the profitability of income-generating real estate investments. NOI equals all revenue from the property, minus all reasonably necessary operating expenses. NOI is a before-tax figure, appearing on a property’s income and cash flow statement, that excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization. When this metric is used in other industries, it is referred to as “EBIT”, which stands for “earnings before interest and taxes”.

Key Takeaways

  • Net operating income measures an income-producing property's profitability before adding in any costs from financing or taxes.
  • The operating expenses used in the NOI metric can be manipulated if a property owner defers or accelerates certain income or expense items.
  • The NOI metric does not include capital expenditures.

The Formula for NOI Is:

Net operating income=RROEwhere:RR=real estate revenueOE=operating expenses\begin{aligned} &\text{Net operating income} = RR - OE \\ &\textbf{where:}\\ &RR=\text{real estate revenue}\\ &OE=\text{operating expenses}\\ \end{aligned}Net operating income=RROEwhere:RR=real estate revenueOE=operating expenses

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Net Operating Income

What Does NOI Tell You?

Net operating income is a valuation method used by real estate professionals to determine the precise value of their income-producing properties. To calculate NOI, the property's operating expenses must be subtracted from the income a property produces.

In addition to rental income, a property might also generate revenue from amenities such as parking structures, vending machines, and laundry facilities. Operating expenses include the costs of running and maintaining the building, including insurance premiums, legal fees, utilities, property taxes, repair costs, and janitorial fees. Capital expenditures, such as costs for a new air-conditioning system for the entire building, are not included in the calculation.

NOI helps real estate investors determine the capitalization rate, which in turn helps them calculate a property’s value, thus allowing them to compare different properties they may be considering buying or selling.

For financed properties, NOI is also used in the debt coverage ratio (DCR), which tells lenders and investors whether a property’s income covers its operating expenses and debt payments. NOI is also used to calculate the net income multiplier, cash return on investment, and total return on investment.

Example of How to Use Net Operating Income

Let us assume that you own a property which annually pulls in $120,000 in revenues, and incurs $80,000 in operating expenses. In this circumstance, it will have a resulting NOI of $40,000 ($120,000 - $80,000). If the total is negative, where operating expenses are higher than revenues, the result is called a net operating loss (NOL).

Creditors and commercial lenders heavily rely on NOI to determine the income generation potential of the property to be mortgaged, even more than they factor an investor's credit history into their decisions. Simply put: this metric helps lenders fundamentally assess the initial value of the property, by forecasting its cash flows. If a property is deemed profitable, the lenders also use this figure to determine the size of the loan they’re willing to make. On the other hand, if the property shows a net operating loss, lenders are likely to reject the borrower's mortgage application, outright.

Property owners can manipulate their operating expenses by deferring certain expenses while accelerating others. NOI can also be increased by raising rents and other fees, while simultaneously decreasing reasonably necessary operating expenses. As an example of the latter, consider a scenario where an apartment owner waives a tenant’s yearly $12,000 rent, in exchange for that renter acting as a property manager. If the apartment owner would normally pay a building manager a $30,000 salary, he may consequently subtract the “reasonably necessary” cost of $30,000 from revenue, rather than the actual cost of $12,000. (For related reading, see "NOI vs. EBIT: Comparing the Differences")