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Businesses that deal in the development, purchase, rental or sale of commercial properties must consider dozens of factors before committing their money, and that of their investors, to their next deals. Naturally, the profit on the investment, and the amount of risk associated with earning that profit, are important factors in the decision-making process, and net operating income is one of the numbers used to calculate expected profit and underlying risk. Thus, the term net operating income (NOI) is central to any discussion of commercial real estate.
Net Operating Income Definition
Net operating income measures a property’s ability to generate a positive cash flow from operations, and it is defined as follows:
Net Operating Income = Gross Operating Income - Operating Expenses
Gross Operating Income: For income-producing real estate, which is a long-term asset, gross operating income results from rents and fees, while operating expenses stem from all the reasonably necessary costs of owning and managing a property.
Operating Expenses: These operating expenses include salaries and wages, property taxes—but not income taxes—vendor and supplier costs, maintenance and repair, insurance, utilities, licenses, supplies, and overhead costs, such as expenses for accounting, attorneys and advertising.
NOI does not include the effects of income taxes, loan interest and principal payments, tenant leasehold improvements, leasing commissions, amortization and depreciation—that is, the gradual write-off of the capital costs of long-term assets—or capital expenditures, which is money spent on purchases, improvements, major repairs and replacement of long-term assets.
The following table breaks down the components of revenue and operating expenses:
|Potential Rental Income||Revenue||The amount of rent you would collect if the property was 100% leased. If less than full occupancy, a total rent is estimated based on market conditions at comparable properties.|
|Vacancy and Credit Losses||Revenue||Rent not collected because tenants moved out or did not pay the rent owed. Can be estimated using comparable properties.|
|Effective Rental Income||Revenue||Rental income minus vacancy and credit losses, which is the actual income the landlord will collect.|
|Other Income||Revenue||Other property related income from items like parking, vending, laundry and signage/billboards.|
|Gross Operating Income||Revenue||Total of all revenues.|
|Operating Expenses||Expense||All money spent on operating a property in order to collect revenues, such as property taxes, vendor and supplier costs, salaries, maintenance and repair expenses, insurance, etc.|
|Net Operating Income||Revenue||Gross operating income minus operating expenses.|
Based on the information in the table, we can redefine NOI as follows:
Net Operating Income = (Potential Rental Income - Vacancy and Credit Losses + Other Income) - Operating Expenses
How to Calculate Net Operating Income
The following example illustrates the calculation of NOI. A small office building had the potential for generating $185,690 in annual rent if the property had been 100% occupied. However, $12,563 was lost on vacancies, leaving the effective rental income at $173,127. The building owner specified five categories of operating expense totaling $70,378 in the table below. When these expenses are subtracted from the effective rental income, we see that NOI is $102,749, which is 55.3% of potential rental income—a figure known as the operating margin.
Gross Operating Income
|Potential Rental Income||$185,690|
|Vacancy and Credit Losses||$(12,563)|
|Effective Rental Income||$173,127|
|Other Direct Costs||$(19,326)|
|Net Operating Income||$102,749|
How to Interpret Net Operating Income
The owner of income-producing real estate uses NOI to get an unvarnished understanding of the cash flows generated by properties. That’s because NOI is difficult to manipulate. You can change NOI only by increasing rental or fee income or by cutting operating costs. Financing and income tax considerations are divorced from NOI, which makes it a good measure for assessing how well a property is being managed. For example, operating margin, which is the potential rental income divided by NOI, can be directly compared across similar properties. It’s important to compare a property’s NOI components with those of competing properties in the same neighborhood. It can also help business owners compare multiple properties they own.
Another important use of NOI is trend analysis—how a property’s NOI has changed over the last several years. A deteriorating NOI should is a red flag that remedial action is required, or that the property might be a good candidate for sale.
If you run a real estate business and are looking to buy new income-producing properties, you will normally carefully examine the properties’ financials, including the income statements, for items such as NOI. In this way, you have a way of evaluating the property and formulating a bid.
NOI is also used in other important equations used extensively in the real estate sector, including:
- Capitalization rate: Known as "cap rate," it is equal to NOI divided by the property’s value. This can be viewed as the rate of return on a property you purchase in all cash. For example, if you pay $1 million for a property with an NOI of $100,000, then the cap rate is 10%. The higher the cap rate, the larger the return on your investment. The cap rate is also used in more involved calculations that help determine the cost of debt and the cost of equity capital for the purchase of an income-producing property.
- Property value: The cap rate equation can be arranged to determine property value, which is NOI divided by cap rate. This is handy for making a rough calculation on the fair value of a property given the NOI and cap rates of similar properties in the same neighborhood.
- Debt service coverage ratio (DSCR): DSCR is equal to NOI divided by annual debt service, which is how much principal and interest you must pay each year to repay a loan. It is an indication of whether you have sufficient income cash flow to meet your debt service obligations. The larger the DSCR, the more cash cushion you have as a safety margin.
Naturally, lenders prefer properties with high NOIs, since they will interpret this as evidence of a low probability of default on the loan. From the lender’s point of view, NOI is important not only in determining the DSCR to help evaluate a borrower’s creditworthiness, but it also helps to determine the maximum size of the loan via the loan-to-value (LTV) equation. By solving the cap rate equation for property value, a lender can apply the LTV ratio. For example, on a property with a cap rate of 10% and NOI of $100,000, the estimated property value would be $1 million. A lender with a 70% LTV policy will set the maximum loan amount at $700,000 for this property, with the borrower putting up $300,000 in equity.