What Is Net Operating Income – NOI?

Net operating income (NOI) is a calculation used to analyze the profitability of real estate investments that generate income. Net operating income equals all revenue from the property minus all reasonably necessary operating expenses.

NOI is a before-tax figure that excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization. The metric is also used in other industries but is called EBIT, or 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 how much income-producing properties are worth. To calculate net operating income generated, the property's operating expenses must be subtracted from the income produced by the property.

Other than rent, a property might also generate revenue from parking and service fees, such as vending and laundry machines. Operating expenses include the costs of running and maintaining the building and its grounds, such as insurance, property management fees, legal fees, utilities, property taxes, repairs, and janitorial fees. Capital expenditures, such as the cost for a new air-conditioning system for the entire building, are not included in the calculation.

Net operating income helps owners and potential owners of retail buildings, office buildings and residential single- and multi-family properties to calculate several helpful ratios. NOI is used in determining the capitalization rate, which helps determine the property’s value and helps real estate investors compare different properties they might 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

NOI appears on a property’s income and cash flow statements. Assume you own a property that takes in $120,000 annually in revenues and incurs $80,000 in operating expenses. It will have a resulting net operating income of ($120,000 - $80,000) = $40,000. If the total is negative, with operating expenses higher than revenues, the result is called a net operating loss (NOL).

Creditors and commercial lenders, rather than evaluating a property owner or investor's credit history, use net operating income to determine the income generation potential of the property to be mortgaged. This fundamental metric is used to assess the initial value of the property by forecasting its cash flows. If the property is deemed to be profitable, the lender decides how much to loan the investor. However, if the property has a net operating loss, the lender may reject the borrower's mortgage application.

Property owners can manipulate their operating expenses by deferring certain expenses and accelerating others. Net operating income can also be increased by raising rents and associated fees or by decreasing reasonably necessary operating expenses. NOI is not the same as taxable income or cash flow. The difference between NOI and earnings before interest and taxes (EBIT) is non-operating income.

The “reasonably necessary” criterion for operating expenses in the NOI calculation means property owners might adjust some of their actual expenses up or down. If the owner provides one tenant with free rent, valued at $12,000 a year, in exchange for acting as property manager, but it would cost $24,000 to hire a professional manager on the open market, the owner can subtract the “reasonably necessary” cost of $24,000 from revenue rather than the actual cost of $12,000.