Net Operating Income (NOI) evaluates a real estate investment’s ability to produce operating income from its operations. It measures the amount of cash flow generated by an investment property after operating expenses have been paid. NOI analysis is typically used by real estate investors determine the value and profitability of a commercial property.
Net Operating Income Formula
It is relatively simple to calculate the net operating income (NOI) of a property. We will show you the formula and then discuss each of the components below.
The net operating income (NOI) formula is:
NOI = (Potential Rental Income) – (Vacancy and Credit Losses) + (Other Income) – (Total Operating Expenses)
Potential Rental Income
Potential rental income (PRI) is the combined total rent under the terms of each individual commercial lease, with the assumption that the property is 100% occupied. If the property is not fully occupied, then the amount of PRI is based on market analysis, according to the leases and terms of comparable properties.
Vacancy and Credit Losses
Vacancy and credit losses represent the lost of income due to tenants vacating the property and/or tenants defaulting on their lease payments. The vacancy factor can be calculated based on current lease expirations. Market-driven figures using comparable property vacancies can also be used for the purpose of calculating a property’s NOI.
Because there are many different ways a property can generate income, real estate investors need to include all possible revenues in their calculation, in addition to monthly rent. These other revenues include, but are not limited to, facility rental proceeds, proceeds from vending machines, proceeds from laundry services, income generated from parking fees, billboard/signage fees, and other relevant service charges.
Total Operating Expenses
Total operating expenses include all necessary expenditures associated with revenue-generating activities. These expenses are usually required to maintain the property and run a commercial real estate business. Operating expenses can include property management fees, marketing and advertising, utilities, property taxes, repairs and maintenance, insurance, and janitorial expenses.
Expenses Not Included In NOI
It is important to note that debt service, depreciation, capital expenditures, leasing commissions, tenant improvements, income taxes, and mortgage interest expenses are not included in the calculation of net operating income. This is because NOI is unique to the property itself and does not include other expenses that are specific to the owner/investor.
Why is Net Operating Income Important?
Net operating income (NOI) is important because it helps real estate investors evaluate whether a potential rental property is worth investing in. Before a purchase, an investor can use NOI to assess a property’s value, helping them to make an investment decision. After the purchase, NOI can be used as a measure of operating cash flows.
In some cases, lenders who finance an investment property are also interested in knowing the net operating income of the property. This is because NOI is sometimes used as one of the deciding factors in approving a commercial loan for real estate investors.
Pros and Cons of Using Net Operating Income
The calculation of a property’s net operating income is an important way to determine its value as well as evaluate its profitability. Still, the use of NOI in making decisions about a real estate investment has both its advantages and its downsides. Let’s take a look at the potential pros and cons of NOI below.
Pros of Using NOI
- NOI determines an investment property’s initial value, helping real estate investors identify whether it will make a good investment.
- The use of NOI provides an overview of a property’s ongoing operating revenue.
- NOI also helps lenders and creditors determine whether a property generates sufficient cash flow to cover any potential debt service.
Cons of Using NOI
- NOI analysis can be manipulated since a property owner can choose to accelerate or defer certain expenses.
- The NOI of a property is not always constant – it can change depending on how the property is managed.
- Because other expenses are not considered in NOI (e.g. interest expense, debt service, income taxes, capital expenditures), the actual cash flow that a property can generate may differ after all these other expenses are paid.
How to Improve Net Operating Income
A property with high net operating income is typically a good thing. A positive NOI means a property’s operating revenues are higher than its operating expenses. A negative NOI indicates that the operating expenses of a rental property exceeds its revenues. To help, there are different methods to improve the NOI of a real estate investment.
Here are 3 ways to improve an investment property’s NOI:
1. Improve Rental Income
The main source of revenue from an investment property is its rental income. One way to improve your rental income is to make sure that you have a high occupancy rate at 90% or above. Another method is to review your rental rates to make sure that the rent is properly priced according to its comps and its target tenant demographic.
2. Find Additional Income Sources
Review other possible sources of revenue that your property can generate. For example, does it have laundry and vending services? Do you charge parking fees for tenants and/or guests? Do you offer other premium services? Perhaps there are other ways to make the property generate more revenues in addition to what it already does.
3. Minimize Operating Expenses
A property’s operating expenses have a big impact on its net operating income. Therefore it is a good idea to cut or trim operating costs when you can. For instance, you can reduce costs on utilities by ensuring that unused lights are turned off. Or maybe you can pass through janitorial expenses to the tenants as maintenance fees instead of absorbing it as an amenity.
Net operating income is essential in evaluating and valuing an investment property. This helps investors and creditors decide whether the property is worth investing. Although NOI has its drawbacks, it gives good insight into a property’s ability to generate cash flow as well as its overall value.