Net Operating Income
The most important piece of the puzzle in commercial and investment real estate lending.
Net operating income, or NOI for short, is a measurement used to determine the profitability of a property in commercial, multifamily, and investment real estate. NOI determines the revenue of a property by subtracting gross operating expenses from gross income.
By measuring NOI, investors can get a quick picture of the cash flow of a property. NOI also helps investors better understand the potential risks and profit in real estate. Read more to learn about how to calculate NOI and how to use it.
Net operating income (NOI) definition
Net operating income (NOI) measures a property’s ability to generate a positive cash flow from operations. The NOI formula is:
Net operating income = Gross operating income - Operating expenses
Gross operating income: For income-producing real estate, which is a long-term asset, gross operating income results from rents and fees, while operating expenses stem from all the reasonably necessary costs of owning and managing a property.
Operating expenses: These operating expenses include property taxes — but not income taxes — vendor and supplier costs, maintenance and repair, insurance, utilities, licenses, supplies, and overhead costs, such as expenses for accounting, attorneys and advertising. Commercial properties often have a NNN lease (Triple-Net) where the property taxes, insurance, and maintenance are paid by the tenant. In this case, those expenses do not affect the NOI, as they are paid by the tenant, not the property owner.
NOI does not include the effects of income taxes, loan interest and principal payments, tenant leasehold improvements, leasing commissions, amortization and depreciation — that is, the gradual write-off of the capital costs of long-term assets — or capital expenditures, which is money spent on purchases, improvements, major repairs and replacement of long-term assets.
The following table breaks down the components of revenue and operating expenses:
|
Term
|
Type
|
Description
|
|---|---|---|
| Potential rental income | Revenue | The amount of rent you would collect if the property was 100% leased. If less than full occupancy, a total rent is estimated based on market conditions at comparable properties. |
| Vacancy and credit losses | Revenue | Rent not collected because tenants moved out or did not pay the rent owed. Can be estimated using comparable properties. |
| Effective rental income | Revenue | Rental income minus vacancy and credit losses, which is the actual income the landlord will collect. |
| Other income | Revenue | Other property related income from items like parking, vending, laundry and signage/billboards. |
| Gross operating income | Revenue | Total of all revenues. |
| Operating expenses | Expense | All money spent on operating a property in order to collect revenues, such as property taxes, vendor and supplier costs, maintenance and repair expenses, insurance, etc. |
| Net operating income | Revenue | Gross operating income minus operating expenses. |
Based on the information in the table, we can define NOI as follows:
Net operating income = (Potential rental income - Vacancy and credit losses + other income) - Operating expenses
How to calculate net operating income (NOI)
The following example illustrates the calculation of NOI. A small office building had the potential for generating $185,690 in annual rent if the property had been 100% occupied. However, $12,563 was lost on vacancies, leaving the effective rental income at $173,127. The building owner specified five categories of operating expenses totaling $70,378 in the table below. When these expenses are subtracted from the effective rental income, we see that NOI is $102,749, which is 55.3% of potential rental income—a figure known as the operating margin.
|
Gross operating income
|
Operating expenses
|
|
|---|---|---|
| Potential rental income | $185,690 | |
| Vacancy and credit losses | $(12,563) | |
| Effective rental income | $173,127 | |
| Property taxes | $(20,775) | |
| Insurance | $(8,750) | |
| Maintenance | $(15,682) | |
| Other direct costs | $(19,326) | |
| Overhead | $(5,845) | |
| Total expenses | $(70,378) | |
| Net operating income | $102,749 |
How to interpret net operating income (NOI)
The owner of income-producing real estate uses NOI to get an unembellished understanding of the cash flows generated by properties. That’s because NOI is difficult to manipulate. You can change NOI only by increasing rental or fee income, reducing vacancies or by cutting operating costs. Financing and income tax considerations are divorced from NOI, which makes it a good measure for assessing how well a property is being managed. For example, operating margin, which is the potential rental income divided by NOI, can be directly compared across similar properties. It’s important to compare a property’s NOI components with those of competing properties in the same neighborhood. It can also help business owners compare multiple properties they own.
Another important use of NOI is trend analysis — how a property’s NOI has changed over the last several years. A deteriorating NOI should be a red flag that remedial action is required, or that the property might be a good candidate for sale.
If you run a real estate business and are looking to buy new income-producing properties, you will normally carefully examine the properties’ financials, including the income statements, for items such as NOI. In this way, you have a way of evaluating the property and formulating a bid.
NOI is also used in other important equations used extensively in the real estate sector, including:
- Capitalization rate: Known as "cap rate," it is equal to NOI divided by the property’s value. This can be viewed as the rate of return on a property you purchase in all cash. For example, if you pay $1 million for a property with an NOI of $100,000, then the cap rate is 10%. The higher the cap rate, the larger the return on your investment, but also the higher potential risk. The cap rate is also used in more involved calculations that help determine the cost of debt and the cost of equity capital for the purchase of an income-producing property.
- Property value: The cap rate equation can be arranged to determine property value, which is NOI divided by cap rate. This is handy for making a rough calculation on the fair value of a property given the NOI and cap rates of similar properties in the same neighborhood.
- Debt service coverage ratio (DSCR): DSCR is equal to NOI divided by annual debt service, which is how much principal and interest you must pay each year to repay a loan. It is an indication of whether you have sufficient income cash flow to meet your debt service obligations. The larger the DSCR, the more cash cushion you have as a safety margin.
Naturally, lenders prefer properties with high NOIs, since they will interpret this as evidence of a low probability of default on the loan. From the lender’s point of view, NOI is important not only in determining the DSCR to help evaluate a borrower’s creditworthiness, but it also helps to determine the maximum size of the loan via the loan-to-value (LTV) equation. By solving the cap rate equation for property value, a lender can apply the LTV ratio. For example, on a property with a cap rate of 10% and NOI of $100,000, the estimated property value would be $1 million. A lender with a 70% LTV policy will set the maximum loan amount at $700,000 for this property, with the borrower putting up $300,000 in equity.
Net operating income (NOI) formula FAQs
What is the formula for NOI?
The formula for calculating net operating income is:
NOI = Gross operating Income - Operating expenses
Another way to determine NOI is:
NOI = Potential rental income - Vacancy and credit losses + Other income - Operating expenses
What is the difference between net operating income and net income in real estate?
In real estate, net operating income is the revenue generated from a property’s daily operations, less its operating expenses. It doesn’t include earnings from other investments, taxes, loan interest and other capital expenditures.
Net income, on the other hand, includes all income and expenses, including investment income and expenses, debt service payments, taxes, etc.
Are NOI and EBITDA the same?
Net operating income is similar to earnings before interest, taxes, depreciation and amortization (EBITDA) because they both measure the profitability of an entity before deducting interest, taxes, depreciation and amortization. However, there are some crucial differences.
NOI is primarily used to evaluate the profitability of an investment in a commercial or residential real estate property, whereas EBITDA is used to evaluate the profitability of a company. As a result, NOI takes into account lost revenues from vacancies whereas EBITDA does not.
What document shows NOI?
Income properties, including commercial, multifamily, and investment properties are financed based upon the NOI of the asset. In most cases, long-term financing requires a DSCR of 1.2x or more. This means the NOI must be at or above 1.2x the monthly mortgage payment. Properly managed properties will keep records consistently throughout the year. The NOI is shown on the property Operating Statement (also called the Profit & Loss) or T12 for multifamily properties. It is very important to always gather the year-to-date property P&L and previous year's P&L to properly evaluate the past, current, and projected net operating income of a property.
In the world of finance, the abbreviation TTM tends to come up a lot. TTM, or sometimes T12, stands for “trailing twelve months” and often refers to a financial statement that represents the entity’s performance over the past year. This type of operating statement is specific to multifamily properties, as leases are typically one year or less, unlike commercial office, retail, and industrial properties that have long-term leases up to 10-years or more.
TTM Meaning:
A trailing twelve months, T12, or TTM, is a financial statement that shows a multifamily property’s previous twelve months of operations. A T12 is generally used for apartment buildings and other types of multifamily properties, but not for other types of commercial real estate, such as retail or office properties, as tenants for these types of properties typically have leases that extend beyond twelve months. A property’s T12, along with its rent roll and T3 (trailing 3-month financial statement) are some of the most important forms of documentation that a borrower will need to show a lender. In regards to their personal finances, a borrower will also generally need to show a PFS (personal financial statement), and an SREO (schedule of real estate owned).
TTM Uses:
A TTM report can be utilized in many different ways. Additionally, since the purpose of the trailing twelve month statement varies between situations, the TTM can be calculated using a multitude of different data. The figures that make up a TTM can come from balance sheets, income statements, cash flow statements, and various other financial statements. It is important to ascertain what kind of data needs to be scrutinized when compiling a Trailing Twelve month report for this reason.
How Do Investors and Lenders Calculate A Property’s T12?
A T12 can generally be calculated by looking at a property’s financial statements, such as balance sheets and income statements. The process of calculating a property’s trailing twelve months may via its income statements may vary slightly, depending on whether the property records its income semi-annually, quarterly, or monthly. As balance sheets are more commonly updated on a monthly basis, one can generally just use the previous twelve months of information to calculate a property’s T12.
