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Net Operating Income: A Guide to Boosting Property Value

invest

What is Net Operating Income?

Net operating income (NOI) is the most commonly used analysis tool for real estate investments. The net operating income is the total operating income for a property minus the total operating expenses for a property.

The net operating income is useful because it shows a property’s ability to generate income without considering its capital structure. Since different owners will have different capital structures and financing costs, the NOI allows the property to stand alone before taking any of these owner-specific factors into account.

The net operating income is often referred to as “the line” because operating expenses are calculated “above the line” while capital expenditures and leasing costs are “below the line” items.

Net Operating Income Formula

Net operating income (NOI) is the income generated by a property minus all expenses incurred from operations. The basic net operating income formula is as follows:

   Potential Gross Income
- Vacancy and Credit Loss
= Effective Gross Income
- Operating Expenses
=Net Operating Income
 

Net operating income is positive when effective gross income exceeds operating expenses, and negative when operating expenses exceed effective gross income.  For the purposes of real estate analysis, NOI can either be based on historical financial statement data or instead based on forward-looking estimates for future years, known as a proforma.

Net operating income measures the ability of a property to produce an income stream from operations. Unlike the cash flow before tax (CFBT) figure calculated on a real estate proforma, the net operating income figure excludes any financing or tax costs incurred by the owner/investor. In other words, the net operating income is unique to the property, rather than the investor.

How to Calculate Net Operating Income (NOI)

The major components of net operating income consist of potential rental income, vacancy, and credit losses, other income, and operating expenses.
 

Potential Rental Income

Potential Rental Income is the sum of all rents under the terms of each lease, assuming the property is 100% occupied. If the property is not 100% occupied, then a market-based rent is used based on lease rates and terms of comparable properties.
 

Vacancy and credit losses

Consist of income lost due to tenants vacating the property and/or tenants defaulting (not paying) their lease payments. For the purposes of calculating NOI, the vacancy factor can be calculated based on current lease expirations as well as market-driven figures using comparable property vacancies.
 

Effective Gross Income

Effective Gross Income (EGI) in the net operating income formula above is simply potential rental income less vacancy and credit losses. EGI is the amount of rental income that the owner can reasonably expect to collect from a property.
 

Operating Expenses

Operating expenses include all cash expenditures required to operate the property and command market rents. Common commercial real estate operating expenses include real estate and personal property taxes, property insurance, management fees, repairs and maintenance, utilities, and other miscellaneous expenses (accounting, legal, etc.).
 

Net Operating Income

As shown in the net operating income formula above, net operating income is the final result, which is simply effective gross income minus operating expenses.

What’s Not Included in Net Operating Income

It’s also important to note that there are some expenses that are typically excluded from the net operating income figure.
 

Debt Service

Financing costs are specific to the owner/investor and as such are not included in calculating NOI.
 

Depreciation

Depreciation is not an actual cash outflow, but rather an accounting entry, and therefore is not included in the NOI calculation.
 

Income Taxes

Since income taxes are specific to the owner/investor, they are also excluded from the net operating income calculation.
 

Tenant Improvements

Tenant improvements, often abbreviated as just “TI”, include construction within a tenant’s usable space to make the space viable for the tenant’s specific use.
 

Leasing Commissions

Commissions are the fees paid to real estate agents/brokers involved in leasing the space.
 

Reserves for Replacement

Reserves are funds set aside for major future maintenance items, such as a roof replacement, or air conditioning repair. While the textbook definitions of NOI usually exclude reserves from the NOI calculation, in practice many analysts actually do include reserves for replacement in NOI. For example, most lenders will include reserves for replacement in the NOI calculation for determining debt service coverage and the maximum loan amount.
 

Capital Expenditures

Capital expenditures are expenses that occur irregularly for major repairs and replacements, which are usually funded by a reserve for replacement. Note that capital expenditures are major repairs and replacements, such as replacing the HVAC system in a property. This does not include minor repairs and maintenance which are considered an operating expense, such as replacing doorknobs and lightbulbs.
 
While many of the above items are almost always excluded from net operating income, it’s important to remember that some are open to interpretation depending on the context. Keep this in mind when building your own proformas and when evaluating NOI calculations performed by others.

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Anna Gruenloh

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49 Calhoun Street
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