Definition

In real estate, the net operating income, or NOI, represents the annual revenue (or income) generated by an investment property after annual operating expenses. The NOI is used by real estate investors to calculate a property’s capitalization (cap) rate, which helps determine its annual yield (or rate of return) and provides a simple basis for comparing the relative value of similar properties in a given market.

NOI Calculation:

Gross Potential Income

To finish the calculation, simply subtract operating expenses from gross operating income, arriving at net operating income (NOI)

Gross Potential Income

What do you need to calculate NOI?

Gross Potential Income

This is the sum of the annual rent paid by tenants in any commercial property. A multifamily property with 4 apartments, each renting for $1,000 per month would generate an annual gross potential income of $48,000. This assumes 100% occupancy, which is not always the case. Accounting for vacancy and missed rent payments comes next.

Vacancy and Credit Loss

Regardless of the type of commercial real estate, there is always the potential for vacancies and missed rent payments. This is slightly trickier to calculate, because it depends on demand, tenants’ credit, and unforeseen reasons to keep a unit vacant such as a need for renovations. Anticipated vacancy and credit loss is estimated as a percentage of net operating income.

Comparable properties in the area are the best resource for determining vacancy and credit loss. Property managers go to great lengths to minimize these losses, which is why rental applications often include a credit report, and regular updates are made to properties to keep occupancy high.

Other Income

Properties earn the majority of their income through rental payments. Other income can be earned from sources related to the operations of the property, such as parking spaces, vending machines, and laundry services. Typically, this income will only represent a small fraction of the rental income earned by the property.

Operating Expenses

These include all of the expenses incurred by “operating” the property. Expenses typical of many commercial real estate assets include:

  • Maintenance and repairs
  • Leasing and management costs
  • Utilities not paid by tenants
  • Security
  • Property taxes
  • Insurance

Note that net operating income does not include any costs associated with principal and interest payments on any debt, as these are considered financing costs, not operating costs. Operating expenses can change from year to year, especially when it comes to maintenance and repairs. Property managers differentiate themselves on the basis of their active management strategy for reducing expenses and increasing rental income.

An Example of Net Operating Income

Consider a real estate company is going to make an investment in a large mixed-use development which includes apartments and event space. The property generates annual rental income of $500,000 from the apartments. Similar properties in the area have experienced vacancy and credit loss of 5% annually, which amounts to $25,000. Other income is generated by a parking garage that charges hourly, and event space that can be rented. These generate an annual income of $30,000. Major expenses include maintenance of the buildings, property taxes, and management costs, amounting to $100,000. This means that the NOI for the property is $405,000 (see footnote for calculation).

1. (500,000 - 25,000 + 30,000 - 100,000) = $405,000

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