What Is Net Operating Income (NOI)?
Net operating income (NOI) is a core profitability metric for income-producing real estate. It measures the cash flow generated by a property from operations before financing costs and income taxes. In simplest terms, NOI equals all property-related revenue minus all ordinary operating expenses. It does not include mortgage principal or interest, capital expenditures (CapEx), depreciation, amortization, or income taxes.
Key Takeaways
– NOI = Total property revenue − Operating expenses (excluding financing and tax items).
– NOI is used to value properties (via the capitalization rate), to evaluate lender risk (debt coverage ratio), and to compare investment opportunities.
– Capital expenditures, debt service, depreciation, and income taxes are excluded from NOI.
– NOI itself is a dollar amount; when expressed relative to property price it becomes a cap rate (a percentage used for valuation/ comparison).
(Source: Investopedia)
What NOI Tells Real Estate Investors
– Operating profitability: NOI isolates performance of property operations (rent, fees, services) and the costs needed to run and maintain the asset.
– Market comparability: Because NOI excludes financing and tax treatments, it enables apples-to-apples comparisons between properties with different capital structures.
– Valuation and underwriting input: NOI is used to calculate cap rates and debt service coverage, which lenders and buyers rely on when setting prices and loan terms.
– Leverage implications: NOI does not show cash available to equity after debt payments; you must subtract debt service to understand cash-on-cash returns.
Important — What Is and Is Not Included
Included in NOI:
– Rental income (scheduled rent)
– Other property income (parking, laundry, vending, storage, signage)
– Vacancy and credit loss (typically modeled as an allowance against gross income)
– Operating expenses: property management, repairs & maintenance, utilities (if owner-paid), insurance, property taxes, janitorial, supplies
Excluded from NOI:
– Mortgage principal and interest (debt service)
– Capital expenditures (roof replacement, major HVAC systems)
– Depreciation and amortization (accounting non-cash charges)
– Income taxes (on property or owner level)
Note: Owners sometimes manipulate NOI through timing of expenses or by treating recurring maintenance as CapEx—be alert for aggressive accounting.
Formula and Simple Examples
NOI formula:
NOI = Real estate revenue (effective gross income) − Operating expenses
Examples:
– Small condo: Total revenues $26,000 − Operating expenses $10,000 = NOI $16,000.
– Larger example: Revenues $120,000 − Operating expenses $80,000 = NOI $40,000.
If revenue < operating expenses, the result is a net operating loss (NOL).
How to Calculate NOI — Practical Step-by-Step
1. Gather revenue data
– Start with potential gross scheduled rent (all units fully rented at market).
– Subtract a realistic vacancy & credit loss allowance to get effective gross income.
– Add non-rental income (parking, laundry, vending, etc.).
2. Compile operating expenses
– List recurring, ordinary expenses: property taxes, insurance, utilities (owner-paid), repairs & maintenance, landscaping, security, management fees, advertising, supplies, and administrative costs.
– Separate recurring operating expenses from nonrecurring CapEx.
3. Exclude financing, taxes, and CapEx
– Do not include mortgage principal/interest, depreciation, amortization, or major capital replacement costs.
4. Calculate NOI
– NOI = Effective gross income − Total operating expenses.
5. Validate and stress-test
– Reconcile with historical P&L and tax returns; run sensitivity scenarios (rental growth, vacancy changes, expense inflation).
Using NOI: Key Ratios and Valuation
– Capitalization Rate (Cap Rate): cap rate = NOI / Property value (or Property value = NOI / cap rate). Cap rate is a market measure of return and risk—higher cap rates imply higher perceived risk.
Example: NOI $40,000; market cap rate 6% → estimated value = $40,000 / 0.06 = $666,667.
– Debt Coverage Ratio (DCR; also DSC): DCR = NOI / Annual debt service. Lenders typically require a DCR above a minimum threshold (common minimums are 1.20 to 1.35 depending on lender and property type).
Example: NOI $40,000; annual mortgage payments $30,000 → DCR = 40,000 / 30,000 = 1.33.
Profit and Loss vs. NOI
– A property’s profit-and-loss (P&L) statement may include non-operating items (depreciation, interest) and owner-level taxes. NOI is an operating-line metric on the P&L that precedes those non-operating items.
– For overall return to equity investors, subtract debt service and taxes from NOI to estimate cash flow to equity.
How Does NOI Differ From Gross Operating Income?
– Gross operating income (or potential gross income) refers to total possible revenue before allowances. Effective gross income (EGI) is gross income after vacancy/collection loss and including other income.
– NOI is EGI minus operating expenses. So NOI = Gross operating income (less vacancy adjustments) − Operating expenses. NOI reflects the net performance after operating costs, not merely top-line revenue.
Is NOI Used in Other Industries or Sectors?
– NOI is primarily a real estate metric, but the concept of earnings before interest and taxes (EBIT) is similar in other industries. EBIT measures operating profit before financing costs and taxes and is used to compare operating performance across companies.
What Is a Good Net Operating Income Percentage?
– NOI itself is a dollar amount, not a percentage. When you express NOI relative to property price you get the cap rate (NOI / Price), which is the commonly used percentage to compare investments.
– “Good” cap rates vary by property type, location, and market cycle. Core, low-risk assets in prime locations often have lower cap rates (e.g., 3–6% in many major markets), while higher-risk or value-add assets show higher cap rates (7–12%+). Always compare a property’s cap rate and NOI margin to local market comps and historical ranges.
Practical Ways to Improve NOI
– Increase revenue: raise rents to market levels, add ancillary income streams (parking, storage, laundry), reduce concessions.
– Reduce operating costs: renegotiate service contracts, improve energy efficiency to lower utilities, implement preventive maintenance to avoid costly repairs.
– Reposition or renovate selectively to raise rents—ensure upgrades are treated as CapEx appropriately for accounting and tax purposes.
– Beware: cutting maintenance may boost NOI short-term but harm long-term value and tenant retention.
Cautions and Common Pitfalls
– Be careful with one-time or nonrecurring items—don’t let them mask underlying performance.
– Distinguish between maintenance (operating expense) and capital improvements (CapEx). Misclassifying can artificially inflate NOI.
– Sellers and buyers may calculate vacancy and expense allowances differently—standardize assumptions when comparing properties.
– Lenders will scrutinize NOI when underwriting loans (see Northern California National Bank on lender analysis).
The Bottom Line
NOI is an essential, straightforward metric that isolates a property’s operating profitability before financing and tax effects. It underpins valuations (cap rates), lender underwriting (DCR), and investor comparisons. Calculate NOI carefully—using consistent, market-appropriate assumptions for vacancy and expenses—and combine it with debt-service analysis and market cap-rate data to make informed investment decisions.
Sources
– Investopedia, “Net Operating Income (NOI)” (https://www.investopedia.com/terms/n/noi.asp)
– Northern California National Bank, “How Do Lenders Analyze Real Estate Investment Properties?”
If you’d like, I can:
– Walk through a customized NOI calculation for a property you provide; or
– Build a simple NOI/valuation worksheet (Excel-style) you can use to run scenarios.