Net Operating Income

Do you remember your first paycheck? More than likely, the very 1st thing you noticed was the dollar figure at the top of your check stub that said “Gross pay” was significantly larger than the dollar figure at the bottom of your check stub that said “Net pay.”  

Regardless of how much (or little) your net pay was after deductions, it was the money you had to live on until your next check. Believe it or not, it’s much the same for owners of investment real estate. If you’ve ever rented an apartment, the 1st of the month was basically your landlord’s payday. 

And just like you don’t get to keep all your gross pay, landlords don’t get to keep all of the rent they collect either. Landlords have expenses. Think of the rent you and all your neighbors pay as the gross pay for your landlord. As you learned the hard way from your 1st paycheck, net pay is what really matters. The revenue your landlord keeps after basic expenses is known as net operating income.  

What is Net Operating Income

Net operating income, also known as NOI, is a measure of how much money a particular investment property is making after expenses on a yearly basis. Any investor who purchases a rental property or other commercial real estate does so with the intention of profiting from the rental income generated by the property. Being able to calculate a property’s NOI gives the investor a clue as to what kind of revenue to expect from a particular property. 

How to Calculate NOI

Before investors can use a net operating income formula to assess a property, they must have 2 important pieces of information (both of which can be found on the property’s income statement). 

First, they must have the total revenue from all the income streams generated by the property. These income streams are not limited to rent and can include ancillary revenue such as parking fees, income from on-site laundry machines or rebates from local utilities for providing energy-efficient fixtures.

Second, they must have the property’s annual operating expenses.  After getting the income and operating expenses, the NOI is calculated as follows:

1. Calculate total annual gross revenue.
2. Calculate total operating expenses, then subtract the operating expenses from the total gross revenue.
3. The remaining funds are the property’s NOI.

NOI Formula

For example, a property with $100,000 total gross revenue and $35,000 in operating expenses has a net operating income of $65,000.

$100,000 total gross revenue

-   35,000 operating expenses

$  65,000 net operating income

NOI Calculator

Common Real Estate Operating Expenses

All property owners have nonnegotiable expenses taken out of their property’s gross revenue. In real estate parlance, these expenses are known as operating expenses. Every property has them and the name “operating expenses” comes from the fact that these expenses are associated with owning and operating investment real estate. They are paid regardless of whether or not there is a mortgage or other encumbrances on the property. Examples of common real estate operating expenses include, but are not limited to, the following:

• Maintenance
• Property taxes
• Management fees
• Insurance
• Other professional fees (e.g. accounting, legal representation)

Factoring Vacancy Rates

In a perfect world, investors could just multiply the monthly rent due for each unit by the number of months in a year and add up the totals to get a building’s annual rent revenue. However, very few, if any buildings remain 100% occupied for an entire year, which means every investor loses a percentage of income to vacancy.

What this means is that before an accurate NOI calculation can be made, the property’s average annual vacancy rate must be figured into the equation. For example, if a property’s total potential rent revenue was $100,000, but the property had an average annual vacancy rate of 5%, the total gross revenue (and NOI calculation) would be based on the $95,000 projected rents.

Expenses not Included in Net Operating Income

Every property has operating expenses (as discussed above). However, operating expenses are not the only costs associated with the property. Think of your net pay after taxes. It’s still not all your money. You’ve got other expenses like rent, gas and car insurance. Likewise, landlords have additional expenses they must pay out of their NOI. Examples of these expenses include, but are not limited to, the following:

• Debt service
• Depreciation
• Income taxes 

Using Net Operating Income to Determine Property Value

NOI can also be used to determine the value of a particular property. In addition to NOI, every property has a capitalization rate or cap rate. Cap rates are a percentage measure of how much revenue a property returns to its owner in relation to the cost of the property. 

If you divide a property’s NOI by its cap rate, you will be able to come up with a valuation for the property.

So, for example a property with an NOI of $65,000 and a cap rate of 6.5% is worth $1 million:

$65,000 NOI ÷ 6.5% cap rate = $1 million.

How a Change in Net Operating Income Affects Property Value

A property’s NOI can change based on good (or bad) decisions by the property owner and/or market conditions beyond the owner’s control. In either case, a change in NOI can have a huge effect on a property’s value.

Imagine being able to increase the NOI on the property in the example above from $65,000 to $80,000. This would result in a nearly 25% increase in property value.

$80,000 NOI ÷ 6.5% (old cap rate) =  $1,230,769  

The Bottom Line on NOI

NOI is an incredibly important data point in assessing the viability of a particular investment. It gives investors an idea of how much cash they have to work with after the basic expenses of running investment property are subtracted. However, it’s important to remember NOI is not always static and there is other information hiding beneath the balance sheet.

A low NOI can be indicative of a poorly managed building that’s actually a great investment. On the other hand, a high NOI can be reflective of a lack of competition in a market that’s about to be flooded with inventory, which could lower the NOI significantly. That’s why smart investors look at NOI as a big part of the picture — but not the entire picture — when purchasing income property.