Understanding Net Operating Income (NOI) is essential in commercial real estate. Without a firm grasp of net operating income, commonly referred to as just “NOI”, it’s impossible to fully understand investment real estate transactions. In this article, we’ll take a closer look at net operating income, discuss the components of NOI, and also clear up some common misconceptions.
What is Net Operating Income (NOI)
Net operating income (NOI) is the most widely used performance metric in commercial real estate. What is NOI in real estate? The net operating income is defined as the total operating income for a property minus the total operating expenses for a property.
The net operating income is useful because it describes a property’s ability to generate income without considering its capital structure. Since different owners will have different capital structures and financing costs, the NOI enables the evaluation of property performance before taking any of these owner-specific factors into account.
The net operating income is often referred to as “the line” because operating expenses are calculated “above the line” while capital expenditures and leasing costs are “below the line” items.
Depending on the property type or the parties involved, there is often some nuance in how the net operating income is calculated. For example, a multifamily property will have property-specific line items such as the loss to lease, while an office building will have line items for tenant reimbursements. In any case, at a high level, the net operating income formula is the same and measures operating income minus operating expenses.
How to Calculate Net Operating Income (NOI)
Calculating net operating income is relatively straightforward once you break out each of the individual components. The major components of net operating income consist of potential rental income, vacancy and credit losses, other income, and operating expenses.
Potential Rental Income – Potential Rental Income is the sum of all rents under the terms of each lease, assuming the property is 100% occupied. If the property is not 100% occupied, then a market-based rent is used based on lease rates and terms of comparable properties.
Vacancy and Credit Losses – Vacancy and credit losses consist of income lost due to tenants vacating the property and/or tenants defaulting (not paying) their lease payments. To calculate NOI, the vacancy factor can be calculated based on current lease expirations as well as market-driven figures using comparable property vacancies.
Effective Gross Income – Effective Gross Income (EGI) in the net operating income formula above is simply potential rental income less vacancy and credit losses. EGI is the amount of rental income that the owner can reasonably expect to collect from a property.
Operating Expenses – Operating expenses include all cash expenditures required to operate the property and command market rents. Common commercial real estate operating expenses include real estate and personal property taxes, property insurance, management fees (on or off-site), repairs and maintenance, utilities, and other miscellaneous expenses (accounting, legal, etc.).
Net Operating Income – As shown in the net operating income formula above, net operating income is the final result, which is simply effective gross income minus operating expenses.
Although these are the high-level line items used to calculate NOI, the format of a real estate proforma can vary widely depending on the property type, intended use, sophistication of the parties involved, and more. For more complicated net operating income calculations, you might consider using our commercial real estate analysis software.
What’s Not Included in Net Operating Income
It’s also important to note that some expenses are typically excluded from the net operating income figure.
Debt Service – Financing costs are specific to the owner/investor and as such are not included in calculating NOI.
Depreciation – Depreciation is not an actual cash outflow, but rather an accounting entry, and therefore is not included in the NOI calculation.
Income Taxes – Since income taxes are specific to the owner/investor, they are also excluded from the net operating income calculation.
Tenant Improvements – Tenant improvements, often abbreviated as just “TI”, include construction within a tenant’s usable space to make the space viable for the tenant’s specific use.
Leasing Commissions – Commissions are the fees paid to real estate agents/brokers involved in leasing the space.
Reserves for Replacement – Reserves are funds set aside for major future maintenance items, such as a roof replacement, or air conditioning repair. While the textbook definitions of NOI usually exclude reserves from the NOI calculation, in practice many analysts do include reserves for replacement in NOI. For example, most lenders will include reserves for replacement in the NOI calculation for determining debt service coverage and the maximum loan amount. This makes sense because lenders need to understand the ability of a property to service debt, which of course has to consider required capital expenses to keep the property competitive in the marketplace. To see how much confusion and disagreement there is on this, just take a look at all the various answers you see here on this Reddit thread.
Capital Expenditures – Capital expenditures are expenses that occur irregularly for major repairs and replacements, which are usually funded by a reserve for replacement. Note that capital expenditures are major repairs and replacements, such as replacing the HVAC system in a property. This does not include minor repairs and maintenance which are considered an operating expense, such as replacing doorknobs and lightbulbs.
While many of the above items are almost always excluded from net operating income, it’s important to remember that some are open to interpretation depending on the context. Keep this in mind when building your proformas and when evaluating NOI calculations performed by others.
If you have any questions regarding NOI or simply want more information, reach out to Think Real Estate Benefits today.
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Source: “Net Operating Income (NOI): A Beginner’s Guide.” PropertyMetrics, 7 Jan. 2023, propertymetrics.com/blog/net-operating-income/.
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