What is Net Operating Income (NOI) in Real Estate?


What is Net Operating Income (NOI) in Real Estate? 

If you own a real estate property or are considering investing in one, the one thing that you certainly want to know is what the Net Operating Income that it offers is, as that is a measure of the return on your investments. Simply, NOI in real estate is a measure of the income you earn from the property through the year less the operating expenses that you need to incur to keep it operational. 

What is Net Operating Income (NOI)? 

Net Operating Income (NOI) serves as a metric for assessing the profitability of income-generating real estate ventures. It is determined by subtracting all essential operating expenses from the property’s total revenue. NOI, a pre-tax indicator featured on a property’s income and cash flow statement, doesn’t include loan payments, capital expenses, depreciation, or amortization. In industries beyond real estate, this metric aligns with “EBIT,” representing “earnings before interest and taxes.” 

Net Operating Income Formula 

Net Operating Income = Gross Operating Income – Operating Expenses 

In calculating The Gross Operating Income for the year, it is important that you account for potential vacancies during the year. Calculations of Gross Operating Income that are made assuming full capacity can leave you wanting at the end of the year. If you go by the full capacity numbers what you are looking at is Gross Potential Income & not Gross Operating Income. Seen this way: 

Gross Operating Income = Potential Rental Income – Vacancy Rates 

Here’s a breakdown of the elements encompassed within the gross operating income formula: 

  1. Potential Rental Income: Potential rental income represents the hypothetical earnings if the property were fully leased all the time. It’s a figure that investors commonly focus on, often envisioning the best-case scenario. 
  2. Vacancy And Credit Losses: While achieving full occupancy would be ideal for a property, it’s rarely guaranteed annually. Hence, the gross operating income formula considers vacancy and credit losses against potential rental earnings. 

When you are considering whether to invest in a property, it is important to look at vacancy rates of similar properties in the area or ask the current owner for historical records. This helps you get a more accurate picture of how much you might lose due to vacancies. 

If you are calculating this for a property that you are considering investing in, it will be helpful to research the following: 

  • Average Vacancy Rates 
  • Average Rate of Rent Default

Operating Expenses 

When it comes to the operating expenses, you need to take into account the following: 

  • Insurance 
  • Property Management Fee 
  • Repairs 
  • Fee for accountants, lawyers & more 

What’s Not Included in the NOI Formula? 

NOI doesn’t account for future tax deductions or one-time expenses like significant repairs. It focuses on revealing the actual cash flow of a rental property to investors, reflecting its profitability, maintenance costs, and investment viability. To ensure an accurate cash flow assessment, certain elements are excluded from NOI calculations. 

1. Income Tax 

NOI, or Net Operating Income, is calculated before taxes, meaning taxes aren’t part of the formula. Tax expenses can differ greatly from one investor to another. Since NOI focuses on the property itself rather than the individual, tax expenses aren’t factored into the NOI formula. 

2. Total Debt Service 

You might observe that the NOI formula doesn’t include mortgage payments and amortization. This exclusion is because debts vary among investors. For instance, one investor might afford a 50% down payment, while another can only manage 20%. Including debt would significantly influence NOI, but since the goal is to assess the property’s overall health rather than an individual’s finances, mortgage payments are left out of NOI calculations. 

By excluding debt, property comparisons focus solely on income versus expenses. 

If you are financing an investment property, you might consider the debt-service coverage ratio (DSCR). This ratio measures a property’s cash flow against its mortgage obligations. DSCR incorporates NOI and can be quickly calculated using the formula: 

DSCR = Net Operating Income/Total Debt Obligations 

3. Depreciation 

Depreciation isn’t a direct expense because it doesn’t involve actual cash outflows like paying with cash or a check. It is more of an accounting concept, and it only translates into real money when deducted from taxes or when selling a property. 

As Net Operating Income (NOI) focuses solely on tangible, yearly expenses that affect your annual earnings, depreciation of property isn’t factored into the NOI calculation. 

4. Capital Expenditure 

Managing an investment property can incur significant costs, especially in years requiring extra capital for maintenance. However, as these expenses can fluctuate greatly from year to year and property to property, it is not necessary to factor in large, one-time expenses when calculating NOI. 

5. Tenant Improvements 

Tenant improvements are unique to the tenant rather than the entire property, so they are not included in NOI calculations. 

An Example of How to Calculate NOI 

Hypothetically, if you are evaluating a potential investment property, that has 5 apartments where the average rental is $2000, your potential income amounts to $120,000 annually. If vacancy losses are estimated at 10%, it amounts to $12,000. The Gross Operating Income therefore amounts to $ 108,000. If operating expenses are estimated to be $15,000 annually,  

Net Operating Income = Gross Operating Income – Operating Expenses 

NOI in this case equals $108,000- $15,000 =$93000 

How Investors Can Use NOI Calculations 

Using this NOI figure, the investor can proceed to: 

  1. Compare this investment’s income with that of other properties. 
  2. Assess whether the income from the investment property is sufficient to cover any mortgage payments. 
  3. Determine the property’s capitalization rate (cap rate), representing the overall potential return on investment (ROI). 
  4. Estimate the property’s value and decide on an appropriate purchase offer amount. 

The Importance of NOI 

NOI is extremely useful when it comes to real estate investing since it offers you a good estimate of what kind of income you could stand to make from your property. You will therefore make an informed decision whether or not you should invest in the said property. 

Besides being an important metric in ascertaining the potential return on investment of a property, NOI also comes in handy in helping you measure several other aspects of the investment. Some of these include: 

Cap Rate 

If you are entering the real estate investment, you have likely come across the term “cap rate” quite often. Interestingly, NOI plays a crucial role in calculating the cap rate of an investment property. The capitalization rate, or cap rate, serves as a quick measure for investors to assess the profitability potential of a real estate investment. 

The cap rate formula is: 

Capitalization Rate = Net Operating Income/Purchase Price 

For instance, let’s take a four-unit property priced at $360,000 with an NOI of $50,800. Applying the cap rate formula reveals a cap rate of 14% ($50,800/$360,000 = 0.1411, approximately 14%). 

Investors can leverage the cap rate to evaluate potential investments based on their desired return on investment. 

Debt-Service Coverage Ratio 

 When you divide the Net Operating Income for the year by the debt owed for the year including both mortgage & interest, what you get is the Debt-Service Coverage Ratio (DSCR). This helps to assess whether or not the net operating income is enough to cover debt obligations. 

Net income Multiplier 

When you divide the purchase price of the property by the net operating income, what you arrive at is the Net Income MultiplierThis is a reciprocal of the Capitalization rate. The lower this ratio, the better placed you are since it would mean that the net operating income earned by the property represents a higher percentage of the price paid by you in order to acquire the property.  

Manage Your Real Estate Portfolio With BFPM 

Net operating income (NOI) measures how profitable a property is before considering financing or tax expenses. To figure out NOI, you subtract all operating costs from the revenue generated by the property. However, it’s important to note that operating expenses in NOI can be adjusted if a property owner delays or speeds up certain income or expense items. Additionally, capital expenditures are not factored into NOI. By relying on NOI, property owners can assess whether renting out a property justifies the costs associated with owning and upkeeping it. 

With over 2 decades of property management experience, Beach Front Property Management can help you identify and purchase the right property that offers you a high Net Operating Income with RUBS and therefore is a valuable addition to your portfolio. To know more, get on a quick 15-minute consultation call with us. We’d be happy to guide you. 

Trevor Henson

Trevor Henson is an experienced entrepreneur (10+ highly-successful start-ups) and property investor with a demonstrated history of building and leading teams in investment property management environments, maximizing returns for property owners, and optimizing properties through construction management and re-positioning. He…
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Frequently Asked Questions(FAQs)

NOI is short for net operating income and is a financial metric that is used to calculate the profitability of a real estate investment. It is arrived at, by subtracting operating expenses from Gross Operating Income.

Net Operating Income = Gross Operating Income – Operating Expenses

Net Operating Income isn’t the same as Net Profit in terms of accounting. To give a parallel example, Net Operating Income is to real estate what EBITDA is to corporate finance.

NOI is typically calculated annually, reflecting the property's income and expenses over a year.

A high NOI is generally considered favorable in real estate because it indicates strong profitability and financial performance for the property. It signifies that the property is generating substantial revenue relative to its operating expenses, which is a key metric for investors and property owners.