A property’s net operating income (NOI) is the amount of income it generates after operating expenses. The value of a commercial real estate property is determined, to a large extent, by its NOI. It’s an essential number in CRE.
The net operating income formula is a simple calculation: operating income minus operating expenses. What’s more complicated is to determine what exactly counts as an operating expense.
To understand net operating income in real estate, it’s important to understand not only the formula but what gets factored into each part of the equation. This article outlines the NOI formula and discusses which expenses are included when you’re coming up with a property’s net operating income.
What Is Net Operating Income in Real Estate?
The net operating income is the revenue of an investment property minus operating expenses. It is necessary when completing your income taxes and you’ll find it on your income statement.
Many people confuse net operating income with cash flow because the term sounds like it describes the profitability of an investment property. But unlike cash flow or gross operating income, net operating income refers to the operating income after operating expenses.
“The keyword in net operating income is operating,” said Desmond Holzman-Hansen, a former Capital Markets Analyst at Lev. You can think of these expenses as those tied to the building operations like payroll, repairs and maintenance, or any tangible expense related to the building. The less tangible expenses, like debt service, are not included in the property’s net operating income.
Net operating income calculates how much money you’re making at the property level. Holzman-Hansen provided an example: For a property with tenants, your operating income would be the total rent you receive, and your expenses would be the amount you’re spending on your property, such as paying people to keep the building maintained and utilities.
The Net Operating Income Formula
Here’s the simple formula you can use to determine a property’s NOI:
NOI = gross operating income – operating expenses
Of course, to ensure the net operating income is accurate, you need to factor in the right expenses and income.
Expenses Included in Net Operating Income
A crucial part of the NOI formula is your operating expenses. Here’s what’s included in this calculation:
When you’re considering investing in a piece of real estate, you’ll need to calculate how much money you’ll pay for property taxes on a yearly basis. This number is a fixed expense and will be the same year-to-year (unless there is a tax reassessment).
Like property taxes, insurance is another line item that will be the same year-to-year. This amount varies greatly depending on the type of real estate.
Repairs and Maintenance
Repairs and maintenance can be a little trickier to calculate, as it’s not strictly a fixed expense. When it comes to calculating an estimate for repairs and maintenance, it’s important to distinguish what expenses are recurring and nonrecurring, Holzman-Hansen said. However, when you look at the historical records of the property’s expenses, you should be able to come up with a number that accurately reflects your future operating expenses.
While utilities do have some variation over the year or month, again, this number is pretty consistent on an annual basis. For example, if your building is 90% occupied, tenants will typically use about the same amount of electricity across the whole building, month-to-month, and year-by-year.
If your building requires management, you’ll add this fee to the operating expenses. Management fees are usually somewhere between 3% and 5%, taken from gross income, according to Miguel Jauregui, Director of Capital Markets at SAB Capital.
Other: Administrative Costs, Leasing Commissions and Tenant Improvements
These expenses vary according to the specific property. A multifamily building with a leasing office will have ongoing administrative costs. Apartment complexes and residential buildings will also need to factor in leasing commissions and tenant improvements.
Expenses Not Included
NOI does not factor in property expenses that are not ongoing or expenses that are not tangible to the property.
Depreciation and Amortization
These changes are not included in the NOI, as they are not operating expenses but rather part of the overall value of the property.
The interest that’s being paid for in a loan is not included in the NOI calculation. Again this isn’t a tangible operating expense.
Replacing a roof, building a new facade, or doing a huge repair on all your tenant units would not be included in the NOI, as it’s a one-time expense. As a general rule, if you’re looking at a stable property, you won’t be seeing a lot of capital expenditures, Holzen-Hansen said.
The Role of NOI in Real Estate Calculations
A property’s NOI plays a huge role in determining its value. In general, there are three ways you can appraise a property:
- Replacement cost — What would it cost to build this building if you were to build a new one next door?
- The sales comparison — If I buy a similar building, what would it cost?
- The income approach — Where you’re taking the building’s NOI and capitalization rate (NOI divided by purchase price)
Here’s an example: In New York, people say buildings trade out at a 4.5 capitalization rate. So if you wanted to do a loose calculation for how much a building should cost, and it’s returned $200,000 in NOI yearly, you can use the formula to divide $200,000 by 4.5, and determine how much you should pay for the building, Holzen-Hansen explained.
Of course, it also factors into how property values are determined.
“Some investors want to be really honest and will factor a lot of expenses into the NOI,” Jauregui explained. “But if you see an investor who’s looking to sell a property, their ultimate value is going to be driven by the NOI. The higher the NOI, the more money they’re going to get for the property, which is why they may play with it.”
How to Improve Your NOI
Based on the formula, there are really only two ways to improve NOI: improve operating income or decrease operating expenses. Here are a few ways property owners go about this.
Decrease Operating Expenses
One of the most common ways people decrease operating expenses is by replacing management with one that’s more efficient and cost-effective.
Another way to decrease expenses is by decreasing utilities. That change may mean putting in more efficient water systems to manage the utilities better. Separately, an owner might appeal the real estate taxes with the county or the state to decrease taxes based on a new value.
Increase Operating Income
Of course, as you increase your income and decrease your expenses, your NOI increases. If rents are under market, or if the property is largely vacant, a property owner might work on increasing the income as a way to improve operating income, and therefore NOI.
It’s an Important Tool in Real Estate Evaluation
If your NOI goes up or down, your valuation will change as well. Even though the NOI is a simple formula, the ultimate number can change based on what investors include (or leave off) for operating expenses or income. Some investors want to be really honest about their expenses, and others will be more conservative, in an effort to increase their NOI. Ultimately, the higher the NOI, the more money an investor will receive for the property.