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What is 'Net Operating Income - NOI'

Net operating income (NOI) is a calculation used to analyze 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 which excludes principal and interest payments on loans, capital expenditures, depreciation and amortization.

BREAKING DOWN 'Net Operating Income - NOI'

Net operating income is a valuation method used by real estate professionals to valuate income properties. To calculate net operating income generated, operating expenses incurred 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.

NOI appears on the property’s income and cash flow statements. A property that rakes in $120,000 annually in revenues and $80,000 in operating expenses will have net operating income of $120,000 - $80,000 = $40,000. If the total is negative, that is, operating expenses is higher than revenues, it is called a net operating loss (NOL).

Creditors and commercial lenders, rather than evaluating a property owner or investor's credit history, use the net operating income to determine the income generation potential of the property to be mortgaged. The fundamental metric is used to assess the initial value of the property by forecasting its cash flows. If the property is deemed to be valuable, 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.

Net operating income is considered less vulnerable to manipulation than some other figures because it can only 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 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.

The 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.

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