What is net operating income (NOI) in real estate?
Real estate professionals use net operating income (NOI) to determine a property’s profitability. A property’s NOI is its revenue minus operating expenses. A higher NOI indicates a greater level of profitability. On the other hand, a low or negative net operating income is a red flag for real estate investors.
Net operating income vs gross operating income
| Net Operating Income | Gross Operating Income |
| Calculated by subtracting operating expenses from gross operating income | Calculated by adding rent revenue to ancillary income |
| An indicator of the profitability of the property investment | Not an indicator of the profitability of the property investment as operating costs are not considered |
It is essential to differentiate between net operating income and gross operating income. The gross operating income figure is arrived at by adding the property’s revenue from rent to the other income it makes. For example, a commercial property can have ancillary income streams from parking fees and other services provided to tenants.
A commercial real estate property’s net operating income is its gross operating income minus its operating cost. The following are generally classified as an operating cost:
- Management and administration fees for the property
- Property taxes
- Insurance
- Common area maintenance fees
- Repair costs (excluding capital improvements)
The relationship between net operating income and gross operating income is as follows:
Net operating income = Gross operating income – operating expenses
The importance of NOI
The net operating income a property is expected to generate conveys crucial information to real estate investors. It tells them the property’s expected profitability and provides vital input for calculating the capitalization rate or cap rate.
The cap rate is expressed as a percentage and helps investors assess the potential return on commercial real estate investments. The numerator in the cap rate formula is the property’s net operating income.
Estimating a property’s profitability and calculating its cap rate are not the only reasons for the importance of NOI. A commercial property with a high net operating income is more likely to be accepted by a bank or financial institution as security for a loan. Lenders would be willing to extend finance to real estate investors for such properties.
What the NOI formula doesn’t include
Real estate investors should use the net operating income formula carefully. It is a metric that seeks to provide a measure of the actual cash flow from a rental property. Remember that NOI is a pre-tax figure, and it does not consider one-off expenses like capital costs. The NOI formula does not consider the following:
Income tax
The income tax payable on a property’s income is based on the investor’s level of income. Consequently, it could vary from investor to investor for the same property. As NOI pertains to a particular property and is a pre-tax metric, taxes are not built into the formula. However, real estate taxes pertaining to the property in question are considered when calculating NOI because these taxes are specific to the property.
Total debt service
Principal and interest payments on the loan taken to purchase a real estate investment property are not considered in the NOI calculation. The reason for this is straightforward – the same property can be purchased using different levels of debt.
For example, a $1 million office block can be bought with a $800,000 loan or a $600,0000 loan. If the debt service payment is considered in the NOI calculation, you would have two disparate net operating income figures for the same real estate investment. Bear in mind the NOI is a property-specific metric, not an investor-specific one.
Depreciation
Depreciation is a non-cash expense that records an asset’s value reduction over time. It is an accounting entry that does not involve any actual cash outgo. As the NOI of a property is based on actual cash inflows in the form of rentals and ancillary income and outflows for operating costs, depreciation is not considered when you calculate net operating income.
Capital expenditure
A significant sum can be spent on capital improvements to a rental property in one year, but there may be minimal capex for the next few years. If capex is considered, it will skew the NOI calculation, resulting in a wildly spiraling number that shoots up in a year when there is no capex and sinks when a substantial amount is spent on capital improvements.
It is important to remember that minor sums spent on property repair and maintenance every year are not viewed as capital expenditures. These are classified as an operating cost for maintaining the property and are considered when calculating net operating income.
Tenant improvements
A tenant improvement is a customized change made to an existing building by the property owner at the tenant’s request. As the costs pertain to a specific tenant and not to the whole property, they are not considered when calculating net operating income. Additionally, tenant improvement costs are usually one-off expenses that do not form part of an investment property’s regular cash outflow.
NOI formula: How to calculate net operating income
This is the NOI real estate formula:
Gross operating income includes the rent paid by tenants as well as income from sources like parking fees and concierge services. Operating expenses include property management fees, property taxes, insurance, and sums spent on regular repairs and maintenance.
NOI example
Here is how the NOI calculation works:
Consider a multifamily investment property with the following income and costs:
Gross operating income
- Annual rental income: $480,000
- Ancillary income: $35,000
- Total revenue: $515,000
Operating cost
- Property management fees: $20,000
- Property taxes: $50,000
- Insurance, repairs and maintenance costs: $28,000
- Total operating cost: $98,000
You can calculate net operating income by using this formula:
Net operating income = Gross operating income or total income – total operating expenses
Net operating income = $515,000 – $98,000 = $417,000
NOI and the profit and loss statement
There is a critical distinction between a property’s net operating income and the profit it provides the investor. NOI is calculated by subtracting direct operating expenses from the property’s gross revenue. Net operating income represents the actual cash flow of a rental property.
NOI does not consider debt service payments, depreciation, and income tax, which appear in the profit and loss statement. When we talk about the profit a rental property provides an investor, we refer to its NOI minus debt service payments, depreciation, and income tax.
What is a good net operating income?
A property’s net operating income is calculated by subtracting operating expenses from gross revenue. Additionally, NOI is a dollar amount, not a percentage, and a higher NOI indicates increased income and improved cash flow for the investor.
Having made the point that a greater NOI is a positive factor, let us consider a property with a negative net operating income. A negative NOI implies that operating expenses exceed revenues, a loss-making proposition that every investor would like to avoid.
How NOI helps determine cap rates
NOI is a critical component of the cap rate formula, a fundamental metric that is relied upon by real estate industry professionals. The cap rate is expressed as a percentage and calculated by dividing the property’s net operating income by its purchase price. For example, a property with an NOI of $100,000 and a price of $1 million would have a cap rate of 10%.
Cap rate = NOI / purchase price
The cap rate provides an essential input to property investors. It tells them how long it will take for them to get their initial investment back. This point can be explained with the following example:
NOI of the property: $100,000
Purchase price: $1,000,000
Cap rate: NOI / purchase price = 10%
Number of years to get back the initial investment: 10 years. ($100,000 X 10 years = $1 million)
Investors can also calculate a property’s value by repositioning the components of the cap rate formula:
Property value = NOI / cap rate percentage
Continuing with the example that we considered in this section, the property value can be calculated as follows:
Property value = $100,000 / cap rate percentage
Property value = $100,000 / 10% = $1 million.
How to maximize your real estate NOI
Net operating income for a property is computed by subtracting its operating expenses from gross revenue. Therefore, maximizing NOI can be achieved in two ways – minimizing operating expenses or boosting rental and other income. The best approach for an investor trying to maximize NOI is to do both.
1. Minimize operating expenses
There are many ways in which property investors can lower costs. However, remember that in your enthusiasm to improve NOI, you should continue to meet your contractual obligations to your tenants. Additionally, you should not give them any cause for complaint.
Recklessly reducing operating expenses may temporarily increase NOI, but it can have far-reaching negative consequences in the medium to long term. The last thing a property investor wants is dissatisfied tenants who will move out at the first opportunity. Keeping this in mind, here are some of the ways property owners can lower costs:
- Negotiate lower rates with vendors and suppliers.
- Explore ways to reduce energy costs.
- Ask the property manager to focus on cost reduction.
- Lower water consumption.
- Use the services of an insurance agent to reduce insurance costs.
- Look at outsourcing some tasks.
- Think of ways to reduce repairs and maintenance costs.
- Focus on preventative maintenance.
- Make an operating expenses budget and review it periodically.
2. Increase rental income
The simplest way to increase your property’s income is to charge your tenants more rent. However, that is easier said than done. Rents are subject to market forces, and arbitrarily increasing rents can lead to tenants leaving the property. Having said that, property owners must keep track of market trends and take the necessary steps to increase rents when possible.
Another way to raise NOI is to keep vacancy rates to a minimum. Remember, a well-maintained property is more likely to attract tenants than one in a state of disrepair. Another step that property owners can take to reduce vacancy rates is to use rental listing sites like Zillow or Apartments.com to find new tenants.
3. Charge fees for amenities and services
When negotiating the commercial lease terms with the prospective tenant, ensure that the agreement includes clauses in your favor. For example, how will the common maintenance fees be divided between tenants in the event of vacancies? From the property owner’s viewpoint, the tenants should share the total operating expenses. The property owner should not have to bear CAM charges attributable to the vacancies.
The bottom line
Net operating income is a fundamental metric used by real estate professionals. It helps determine the profitability of real estate investments. Additionally, NOI is a critical component of the cap rate formula, another basic real estate investment metric.
Property owners should remain consistently focused on maximizing NOI. This will enable them to earn a higher return on their investment in addition to increasing the value of their property.
