Understanding net operating income (NOI) is extremely important when it comes to real estate investing. In fact, without this metric, it’s almost impossible to fully understand real estate investments. In this article, we’ll talk about the definition of net operating income, how to calculate NOI, the importance of it, and one of the most common pitfalls you should avoid. Let’s dive in.
How to Calculate Net Operating Income (NOI)
How to calculate NOI table of contents
What is net operating income (NOI)?
In real estate, net operating income (NOI) is the total income of a revenue-generating property, minus the total operating expenses. Investors use the net operating income formula figure to determine the profitability of a property and to help make investment decisions.
The total income includes all possible streams of revenue associated with the property. For example, a rental property’s main source of revenue is rental income. However, other sources of revenue can also include laundry service, parking fees, concierge service, vending machines, paid fitness classes, and other services offered on premises.
The total operating expenses include costs from regular maintenance and property operations, but exclude capital expenditures. Capital expenditures are improvements that the property owner decided to make, wholly or partially, in the premises—such as replacing an air conditioner, or carpeting. Typical operating costs include management fees, utilities, janitorial fees, insurance, legal services fees, and general maintenance repair fees.
How to calculate net operating income (NOI)
Now that we know what net operating income is, let’s figure out how to quickly calculate the amount. To calculate net operating income, subtract the total operating expenses from the total gross operating income. Here’s a quick formula below:
(Gross Operating Income + Other Income) - Operating Expenses = Net Operating Income
Now, let’s break it down and learn about the numbers to include in the calculations.
It can be easy to confuse the terms “gross” and “net” since they are pretty similar. However, it’s important that you understand the difference because it may affect your financial decision-making.
- “Gross” is the total revenue amount (without subtracting any costs).
- “Net” is the total profit (after subtracting the costs of business operations and non-operations). The net profit amount generally gives a more realistic representation of your company's profits.
Ultimately, the decision to use a gross or net amount will depend on your situation. However, a net amount is typically a more definitive profitability metric and is commonly used by investors and analysts.
Why is net operating income (NOI) important?
Now that we understand the definition of NOI and how to calculate net operating income, let’s find out why it’s important.
NOI is one of the most important metrics used in real estate investing, because when investors think about buying an income-producing property, they want to know how profitable the property will be after operational expenses.
Typically, a property is more profitable when it has higher revenues and smaller expenses. This indicates to the owner or investor that the income generated from owning and maintaining that property will be worth the cost.
In other words, NOI helps investors determine the property’s value, which helps them to compare various properties they may be interested in buying or selling.
Expenses to exclude
One of the most common mistakes people make when calculating net operating income is including expenses that should be excluded. When you calculate NOI, make sure you exclude the following expenses:
Capital expenditures. Capital expenditures are irregular expenses associated with major replacements or repairs (which are usually funded by a reserve). A common example of capital expenditure is replacing the HVAC system in a property. On the other hand, minor repairs or maintenance such as replacing a lightbulb or doorknob would not be considered a capital expense.
Depreciation. Depreciation isn’t included in the NOI calculation because it’s not an actual cash outflow, but rather an accounting entry.
Debt service. Debt service is a financing cost that’s specific to the investor or owner and should not be included in NOI. It’s the total cash required by the investor or owner to pay back debt obligations.
Income taxes. Income tax is another figure that is specific to the investor or owner and should not be included when calculating NOI.
Leasing commissions. Fees paid to real estate agents or brokers are known as leasing commissions.
Reserves. Reserves are special funds set aside for future major repairs or maintenance. Common examples include air conditioning repair, or a roof replacement.
Tenant improvements. Common examples of tenant improvements include construction costs within a tenant’s usable space (the actual space they occupy) used to make the space functional for the tenant’s specific use.
In general, the items listed above should almost always be excluded from net operating income. There may be some special circumstances and exceptions to the rule, so you’ll want to keep that in mind when making investment financial decisions.
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How to calculate net operating income FAQ
What is the NOI formula?
NOI, or net operating income, is a math formula used in real estate to determine the profitability of an investment property. The formula to calculate NOI is: (Gross Operating Income + Other Income) - Operating Expenses = Net Operating Income
How is annual NOI calculated?
NOI is calculated by determining the profitability and revenue of a real estate property, after subtracting the necessary operating expenses.
How do you calculate NOI cash flow?
To calculate NOI cash flow, use the following formula: Total Rental Revenue - Total Rental Property Expenses = NOI Cash Flow
How do you find the value of NOI?
To find the value of NOI, use the following formula: Property Value = NOI ÷ Cap Rate
Cap rate or capitalization rate is used to estimate the return on investment for a cash flow property. To calculate the cap rate, divide the NOI by the market value (or selling price) of a property.
NOI is a math formula used to calculate the profitability of a potential real estate investment property, and it’s something you should definitely be familiar with. (To calculate NOI, simply subtract total operating expenses from total income). Remember, NOI is just one tool that can help business owners and investors make better financial decisions. Make sure you consider your specific needs before making real estate investment decisions.
Want more helpful accounting tips for your small business? View our Ultimate Guide to Small-Business Accounting.
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