There are considerable expenses involved in property management—including insurance, maintenance, taxes, utilities, landscaping, cleaning, and security. When the owner tallies it up, they come up with a critical measure: their net operating income (NOI).
With NOI you can determine the worth of a property and the potential returns it may provide. But NOI can be a bit tricky to understand, especially if you’re new to the game. Here’s more about net operating income and how to calculate it.
What is net operating income?
Net operating income, or NOI, measures the profitability of an asset or an investment after subtracting operating expenses from income. It’s often used in the commercial real estate industry to determine the profitability of investment properties such as office buildings, apartment complexes, or warehouses.
To calculate NOI, you add all revenue and then subtract operating expenses—typically expenses directly tied to property management, including real estate taxes, insurance, utilities, and maintenance. This calculation leaves out many other costs, including income tax, interest on debt, capital spending, and depreciation, because these are not considered direct operating expenses.
NOI is similar to earnings before interest, taxes, depreciation, and amortization (EBITDA), a measure widely used in other industries to determine a business’s underlying operational profitability.Net operating income is typically calculated annually, rather than monthly or quarterly, to account for seasonal or irregular expenses, such as landscaping, snowplowing, or window washing.
NOI also measures the potential return on investment of a property based on its purchase price using what’s known as the capitalization rate or cap rate. For example, an apartment building purchased for $10 million that produces $1 million in annual net operating income has a cap rate of 10% (or $1 million divided by $10 million).
How to calculate net operating income
The net operating income formula is as follows:
However, obtaining both variables of this equation requires a few steps. Gross operating income is derived from gross potential income, or the maximum a property produces if all of its rental space is filled. Any lost income due to vacancies or unpaid rent is subtracted from gross potential income. Then subtract operating expenses.
To demonstrate an annual NOI calculation, imagine an office building with the following specs and statistics:Office space: 75,000 square feetRental rate: $30 per square foot, annuallyGross potential income: 75,000 × $30 = $2,250,000 Income from vending machines: $25,000Accounting for the building’s net operating income might look like this:
Gross operating income Rent, 75,000 sq. ft. at $30/sq. ft. $2,250,000 Vending machines $25,000 Gross potential income $2,275,000 Minus vacancies, 2,500 sq. ft. at $30/sq.ft. -$75,000 Gross operating income $2,200,000
You’d then subtract the following from gross operating income:
Property tax $300,000 Building on-site management $100,000 Utilities $50,000 Insurance $60,000 Maintenance $90,000 Total operating expenses $600,000
With both variables, you can tally the NOI using the equation:
You can then calculate the cap rate by dividing the NOI by the current market value of the property. Suppose the owner paid $20 million for the building. In this case, the cap rate calculation (NOI / market value of the property) looks like this:
Net operating income and debt costs
A property’s net operating income is often compared with its debt interest payments. This is called the debt-service coverage ratio (DSCR), a financial metric used to measure a property’s ability to repay its debt obligations, i.e, how much its NOI exceeds—or falls short of—its interest expense.
Owners and lenders evaluate DSCR to determine the terms for financing a property purchase—or whether a loan even makes sense. The higher this ratio, the better. A DSCR above 1 is essential for a profitable investment.
If a property owner paid half the $20 million purchase price in cash and financed the other $10 million with a 6% annual interest rate loan, then interest expense is $600,000 a year. The DSCR equation in this case is:
The building, therefore, generates $2.67 in net operating income for every dollar of loan interest expense, meaning the transaction is financially viable.
Factors that affect net operating income
Net operating income and the cap rate can fluctuate based on the following factors:
- Rent and vacancy rates. Rental property income can increase if an owner raises rental rates, fills vacancies, or collects delinquent rents. Conversely, lower rental rates and more vacancies and delinquencies cut rental income.
- Operating expenses. Property taxes may increase (or more rarely, decrease), and insurance, utilities, and maintenance costs can rise or fall.
- Market conditions. An economic boom or slowdown can cause vacancies and delinquencies to increase or decrease. The same applies in regions where housing or office space supplies are out of line with demand.
