Net Operating Income (NOI): Definition, Formula & Calculation (2024)

KEY TAKEAWAYS

• Net operating income is used to determine the profitability of a real estate property by subtracting total expenses from income.
• NOI leaves out several factors in its calculation. These include taxes, debt, depreciation, capital expenses, tenant improvements, and more..
• NOI helps real estate investors compare the potential profitability and return on investment of different properties when researching opportunities.

What Is Net Operating Income (NOI)?

Net operating income (NOI) is a calculation used to analyze the profitability of real estate investments. It considers the overall revenue after deducting necessary operating expenses.

NOI doesn’t include taxes, interest, depreciation, amortization, or capital expenditures. So it won’t provide all the information about an investment’s financial outlook. However, it does offer a quick, reliable way of understanding a property’s cash flow. By taking into account all necessary income and expenditures, NOI provides insight into whether an investment is worth the cost of ownership and maintenance.

In other industries, net operating income is often referred to as EBIT (earnings before interest and taxes).

Net Operating Income (NOI) Formula & Calculation

The formula for calculating net operating income is relatively straightforward. Simply subtract operating expenses from gross operating income to determine NOI. In other words:

• Other income includes money that a property makes outside of rental income. For example, extra parking lots, coin-operated laundry machines, vending machines, signage and billboards all count as additional income sources that should be included in the NOI calculation.
• Operating expenses are all the annual expenses incurred by the regular operation and upkeep of the property. These include insurance, property taxes, and ordinary repair and maintenance work. It also covers miscellaneous costs such as property management fees, marketing costs, and legal fees.
• Gross Operating Income can be defined by the following formula:

Here’s a breakdown of each term:

• Potential rental income refers to the amount a property would collect with a 100% occupancy rate. This is the ideal scenario, but realistic occupancy rates usually fall below 100%.
• Vacancy rates and credit losses reflect the difference between potential rental income and actual occupancy. Credit losses refer to losses due to tenants who did not pay the total rent owed or theft losses. When evaluating a property, use historical occupancy rates or compare it to similar properties to obtain a reasonable figure.

Once the gross operating income is determined, it can be used to calculate net operating income.

What’s Not Included in Net Operating Income

NOI does not include large one-off costs like significant repairs and other numbers that can be written off against future earnings and taxes. In other words, NOI aims to provide insight into the true cash flow of a property.

Here’s what the NOI calculation leaves out:

Income Taxes

NOI is calculated pre-taxes. Income taxes are excluded from the calculation because they depend on the investor and are not standardized across all properties. Property taxes, on the other hand, are included in the formula as they’re considered operating expenses.

Depreciation

Depreciation does not count as an operating expense. This is because it can’t be paid for like an out-of-pocket expense with a check or cash. Depreciation is only actualized when written off on taxes or once the property is sold. NOI calculations only include real, annual expenses, not accounting concepts like depreciation.

Debt

Debts, including mortgage payments, are not included in NOI calculations as the amount can vary widely from investor to investor. For example, one investor may be able to cover a 40% down payment, while another may only put down 20%. Removing debt from the equation places focus on the income and outflow of a specific property, regardless of an investor’s financials.

Tenant Improvements

Sometimes, tenants may make improvements to their individual living quarters. However, this does not indicate an improvement to the property as a whole. As a result, tenant improvements are not included in NOI calculations.

Capital Expenditures

Over the years, a property will require upgrades and maintenance. Daily maintenance costs are included in the NOI calculation under operating expenses. However, major repair jobs and replacement of long-term assets are classified as capital expenditures and are excluded from the calculation.

These costs are usually one-off expenses and can vary significantly depending on the region and nature of the purchase. In addition, most of these expenses are not covered by rental income. Instead, they are typically covered using cash reserves and other savings.

Example of Net Operating Income (NOI)

Generally, it’s best to calculate NOI on an annual basis. Here’s an example of how to find the net operating income for a property.

First, let’s look at the gross operating income, found by subtracting vacancy losses from the potential rental income.

GOI = (Potential rental income: $150,000) – (Vacancy losses estimated at 10%: $15,000)

So, the gross operating income would be $135,000.

Then, other income from vending machines, parking fees, laundry, and signage would be added together. For instance, this figure could be $10,000.

As for the operating expenses, let’s say they add up to $60,000.

These figures would be inserted into the NOI formula to generate a figure, as shown in the following calculation.

NOI = (Gross operating income $135,000 + Other Income $10,000) – (Operating Expenses $60,000)

In this example, the annual net operating income would be $85,000.

To determine if this is a good NOI, it would need to be compared to other financial metrics and similar properties.

Summary

Net operating income is one of the most useful metrics for understanding the potential profitability of a real estate investment.

While it doesn’t give a complete picture of a property’s financials, NOI is a relatively simple formula that offers real insight into cash flow. It’s a figure that is difficult to manipulate and gives clues about how well a property is managed. As a result, it can be useful for predicting potential return on investment.