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.”
- Net operating income measures an income-producing property's profitability before adding in any costs from financing or taxes.
- To calculate NOI, subtract all operating expenses incurred on a property from all revenue generated on the property.
- 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.
- NOI will indicate to a property owner if renting a property is worth the expense of owning and maintaining it.
Net Operating Income
Understanding Net Operating Income (NOI)
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.
How to Calculate Net Operating Income (NOI)
To calculate net operating income, subtract operating expenses from the revenue generated by a property. Revenue from real estate includes rental income, parking fees, service changes, vending machines, laundry machines, and so on.
Operating expenses include all of the costs associated with operating the property. These include property management fees, insurance, utilities, property taxes, repairs, and maintenance.
Net operating income=RR−OEwhere:RR=real estate revenueOE=operating expenses
As an example, let's assume the below information was the profile of a particular condo building that an owner was renting out.
- Rental income: $20,000
- Parking fees: $5,000
- Laundry machines: $1,000
Total Revenues = $26,000
Now, let's assume the operating expenses of the condo building are as follows:
- Property management fees: $1,000
- Property taxes: $5,000
- Repair and maintenance: $3,000
- Insurance: $1,000
Total Operating Expenses = $10,000
The net operating income (NOI) in this example would be $26,000 - $10,000 = $16,000.
Components of NOI
Based on the formula above, the primary components of NOI are total revenues and total operating expenses. The total revenue includes all of the income from a real estate property, not just the rent. In some buildings, that may include the additional income from renting out parking or storage spaces, or the revenue from on-site vending machines or laundry services.
The operating expenses represent the total costs associated with the rental property. In addition to maintenance and repairs, it also includes the costs of taxes and insurance, property management fees, and any utilities that are not covered by the tenants.
Net Operating Income vs. Gross Operating Income
NOI is different from the gross operating income. In real estate, this represents the total potential income from a property, minus any lost income due to vacancies. The net operating income is the gross operating income, minus operating expenses.
Net operating income is useful in estimating the potential income from an investment property. However, it does not account for some potential costs, such as income taxes or mortgage amortization.
NOI and Cap Rate
Net operating income is used to calculate the capitalization rate, a measure of the profitability of an investment property in relation to the total cost. The cap rate is calculated by dividing the NOI by the total cost of a property.
Expressed as a percentage, the capitalization rate represents the investment returns from different properties. Investors use cap rates to compare the returns of different properties.
Example of NOI
Let us assume that you own a property that 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 rely heavily 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.
NOI is used to determine the capitalization rate of a property, also known as the return on investment (ROI) in real estate. It divides NOI by the purchase price.
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, they may consequently subtract the “reasonably necessary” cost of $30,000 from revenue, rather than the actual cost of $12,000.
What Is the Formula for Calculating NOI?
The formula for calculating NOI is as follows:
NOI = real estate revenue - operating expenses
What Is the Difference Between Net Income and Net Operating Income?
Net operating income is revenue less all operating expenses while net income is revenue less all expenses, including operating expenses and non-operating expenses, such as taxes.
What Is a Good Net Operating Income Percentage?
NOI is not a percentage but rather a number that takes into consideration the revenues and expenses of a property. It can be compared to the entire value of the property if that property had been paid fully in cash. In this case, the higher the net operating income to property price percentage, the better.
The Bottom Line
Net operating income (NOI) is a commonly used figure to assess the profitability of a property. The calculation involves subtracting all operating expenses on the property from all the revenue generated from the property. The higher the revenues and the smaller the expenses, the more profitable a property is. This tells the owner if the income generated from owning and maintaining the property is worth the cost.