The content of this article is provided for informational purposes only. You should always obtain independent business, tax, financial, and legal advice before making any business decision.
If you own or are considering purchasing income-generating real estate assets — rental properties, apartment complexes, commercial office buildings or storage facilities — you may have heard or been asked about a core valuation metric: net operating income.
What is net operating income? It measures how much your real estate asset brings in after accounting for its operating costs. Essentially, your NOI will tell you how profitable an existing property is or what kind of return you could expect on a property investment you may be considering.
Read on to learn more about how to calculate net operating income.
Net operating income, or NOI, is equivalent to how much you stand to gain from an asset after subtracting what it takes to maintain that asset. It's a profitability measurement typically used in the context of valuing commercial real estate or other income-generating property assets that requires routine maintenance and upkeep, such as a large piece of machinery or equipment.
NOI is a pre-tax calculation that will not include non-operating expenses like income tax, principal or interest on any loans, depreciation, or amortization. Capital expenditures, or large one-time purchases for the building — such as a new HVAC system — are also excluded in calculating net operating income because they don't qualify as routine maintenance expenses.
Let’s say you have a 100,000 square foot office building. As you work to forecast revenue, what you would bring in if every last unit is rented is known as your gross potential income (GPI), or potential rental income. However, in any given month, there are likely to be vacant units or units where a pro-rated or discounted lease is in place. Account for that missing revenue in your overall income, you get what is referred to as your gross operating income or operating income — the more accurate number you'll use when calculating net operating income.
Next, you'll tally the operational costs of managing the property. These costs may include landscaping, maintenance, insurance, taxes, utilities and security, and any property management fees you pay. These are all operating expenses that contribute to the cost of maintaining this property, generally recorded on business financial statements.
Subtract your operating expenses from your operating income and that is your net operating income or NOI.
There will be many possible factors that affect net operating income for a given period.
Consider an apartment complex. Regarding revenue, vacancy rates and rental rates could fluctuate seasonally. They could even impact one another. What if rents go down and occupancy shoots to 100%? Or the opposite could hold true — what if you raise the rent and then are left with more open units?
You’ll also want to account for secondary sources of revenue from the property. Maybe you charge for parking, or have vending machines, or there’s an onsite kitchen? Collect all those numbers to be added together.
On the flip side, it's important to examine your operating expenses carefully as you work to maximize your profitability. Include all the costs you may incur to keep up your property:
See a more in-depth look into potential operating expenses here.
The net operating income formula is:
Operating Revenue – Operating Expenses = Net Operating Income (NOI)
Examine every bit of income you take in at the property and subtract all the costs it takes to keep the property up and running. Let’s look at a specific example in more detail.
Say you have a 100,000 square foot office building that rents for $25 per square foot. The building is normally at 90% capacity.
$100,000 x $25 = $2,500,000 gross potential income.
90% of $2,500,000 = $2,250,000 operating revenue.
The building also has an unmanned coffee and snack bar that sells $100,000 worth of concessions in a year and an unstaffed parking garage that brings in an additional $100,000 annually.
$2,250,000 (rental operating revenue) + $100,000 (concessions revenue) + $100,000 (parking revenue) = $2,450,00 total operating revenue.
Next, let’s calculate operating expenses in this example. This will include property taxes, utilities, maintenance, insurance, and salaries of those who work at or manage the property. There could also supplies (such as for the coffee and snack bar,) marketing costs, and more.
In this example, while the coffee bar and parking are both unmanned, let’s say the cafeteria spends $30,000 on goods and another $20,000 for someone to keep it stocked.
Adding all expenses to get the total operating expenses might look like this:
Since NOI = Operating Revenue – Operating Expenses, net operating income in this case is $1,850,000 (or $2,450,000 minus $600,000).
Because NOI is likely to change over time, you'll want to revisit your calculation regularly — such as an on annual basis, after expenses for a full year are available. For example, maybe the electric bill goes up when air conditioning is used more in the summer and then the gas spikes in the winter for heat.
NOI is a core signal about the health of your investment - and it can be used in a variety of ways. It can help you:
For example, after calculating net operating income, some investors will then divide it by the operating expense total. This calculates what is called a debt coverage ratio, or DCR. If your DCR is above 1, you can consider the property a profitable investment – and the higher the DCR number, the better. In the example above, the property’s DCR is 1,850,000 / 600,000, which equals 3.08 – meaning the property is returning $3.08 for every $1 spent.
You can also calculate debt-service coverage ratio (DSCR) by dividing net operating income by the total remaining debt for the property, which gives you a view into available cash flow to make necessary debt payments.
Another measure of the profitability of your business is referred to as the capitalization rate – sometimes shorthanded as “cap rate” – and it’s calculated by dividing net operating income by the initial cost of the building. For the office building example above, let’s say the building was purchased for $15 million dollars. You would calculate the capitalization rate as:
1,850,000 / 15,000,000 = .123 or a 12.3% cap rate.
The cap rate allows for comparison across different properties and will help you estimate the value of the building for resale in the future. It may also be considered by lenders when determining whether to approve a mortgage on a prospective property.
Keep in mind that identifying your net operating income isn't the sole metric for the health of an asset. There is also interest paid on debt, income tax, capital expenditures, and depreciation. Many publicly-traded companies report their earnings to reflect this — known as EBITDA, or earnings before interest, taxes, depreciation, and amortization.
Knowing your net operating income is an essential step in gauging the operational efficiency of your business and can provide insight into where you can optimize to increase your return.
For example, you may realize you have a need to increase lease amounts to keep pace with utility costs that have risen over time. Or you may identify ways to control routine but variable costs — by, for example, installing motion sensors for building lighting so they only run when someone is in the area.
You could also realize that expansion is advantageous in situations where potential revenue increases would scale disproportionately to increased costs.
Get more information about managing your business finances and accounting here.
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