Property management involves many costs, including insurance, maintenance, taxes, utilities, landscaping, cleaning, and security. When the owner adds everything up, they get a key figure: net operating income (NOI).

NOI can help business owners understand how much a property is worth and what kind of returns it might offer. However, anyone new to this might find NOI a little confusing. Don’t worry. This article will explain what net operating income is, how to calculate it, and why it matters for your business’s growth.

Table of Contents
What is NOI?
Net operating income vs. operating income vs. net income
How to calculate net operating income
What resources can businesses use to calculate net operating income
3 Factors that influence net operating income
Final words

What is NOI?

Net operating income shows how profitable an investment is by subtracting operating expenses from the total revenue. It’s a common metric in commercial real estate for assessing properties like office buildings, apartment complexes, and warehouses.

To calculate NOI, business owners can add up all the revenue from the property and then subtract the operating expenses, including property taxes, insurance, utilities, and maintenance. However, NOI doesn’t include costs like income tax, interest on loans, depreciation, or capital expenses since businesses can’t consider them as part of daily operations.

NOI is like EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), which other industries use to measure a business’s core profitability. Usually, enterprises calculate their net operating income annually to account for seasonal expenses like landscaping, snow removal, or window cleaning.

It also helps measure a property’s return on investment (ROI) using the capitalization rate (or cap rate). For instance, if owners buy an apartment building for $20 million and it generates $2 million in annual NOI, the cap rate would be 10% ($2 million divided by $20 million)

Net operating income vs. operating income vs. net income

These terms may sound similar, but they’re different. Net income is what’s left after businesses subtract all operating and non-operating expenses from revenue. On the other hand, net operating income is just revenue minus operating expenses.

Likewise, operating income refers to how much a company makes after covering its operating costs, including selling, general, and administrative expenses (SG&A). The key difference is that NOI focuses purely on operating income, while OI can also include some non-operating expenses.

How to calculate net operating income

Here’s the formula businesses need when calculating net operating income:

Gross operating income – operating expenses = NOI

Businesses will need these key figures to calculate their NOI. A great place to start is with the gross operating income, which is based on the property’s maximum potential income if every rental space is filled. From that, subtract any lost revenue due to unpaid rent or vacancies and then subtract operating expenses.

Here’s a simple example to show how to calculate the annual NOI for an office building:

• Office space:55,000 square feet.

• Rental rate: US $50 per square foot per year

• Gross potential income: 55,000 x US $50 = US $2,750,000

• Additional income from vending machines: US $30,000

Here’s what accounting for the property’s net operating income will look like:

Gross operating income

Next is getting the total operating expenses. Here’s an example of calculating this variable:

Operating expenses

With both values in hand, businesses can now calculate the NOI with the equation provided above:

US $2,680,000 million – US $850,000 = US $1,830,000

After this, businesses must also determine the cap rate by dividing the NOI by the property’s current market value. Let’s say the owner bought the building for US $35 million. The cap rate calculation would look like this:

US $1,830,000➗ US $35,000,000 = 0.05 or 5%

Net operating income and debt costs

Net operating income (NOI) is often compared to a property’s debt interest payments, which gives owners the debt-service coverage ratio (DSCR). This ratio shows how well a property can cover its debt payments—in other words, how much its NOI is above or below the interest expense.

Both property owners and lenders consider DSCR when deciding the terms of financing or whether it’s worth pursuing a loan. A DSCR over 1 means the property can cover its debt, which is necessary for a profitable investment. For example, if an owner paid half of a US $35 million property in cash and financed US $17.5 million with a 4% loan, the yearly interest expense would be US $700,000. Here’s what the DSCR calculation will look like:

NOI (US $1,830,000)➗Interest (US $700,000) = 2.61 or US $2.61

Based on this calculation, the building in the example generates US $2.61 in net operating income for every dollar or loan interest cost. This means the investment is worth it financially.

What resources can businesses use to calculate net operating income?

Figuring out net operating income means businesses must pull together a few important documents. So, when owners are ready to calculate, they must have the following documents:

1. Income statement

A company’s income statement, which tracks its revenue and expenses over a set period, is a key tool for calculating net operating income. This document includes all the numbers businesses need, even for operating and net income. For this reason, an income statement is a go-to resource for getting a clear picture of a company’s financial performance.

2. Property management documents

Operating expenses are a core part of calculating NOI, but they can differ based on the property type and amenities. Businesses must check contracts and management documents to ensure that all expenses and revenue streams are accounted for accurately.

3. Tax documents

Depending on how the income statement is set up, businesses might need to check tax returns or other documents to get all the net operating income calculation numbers. For instance, when considering its total operating expenses, an investor may want exact numbers on how much the business paid in property taxes (instead of just a lump sum of all taxes).

3 Factors that influence net operating income

Net operating income and the cap rate can change due to three key factors:

1. Rent and vacancy rates: If property owners raise rent, collect overdue rent, or fill vacant units, their rental income will increase. On the flip side, rental income will drop if rents are lower or there are more vacancies and unpaid rents.

2. Market conditions: Economic changes can impact vacancies and rent collection. In a booming economy, vacancies may decrease, while in a downturn, they may increase. Areas with a mismatch between supply and demand for housing or office space can also see fluctuations.

3. Operating expenses: Property taxes, insurance, utilities, and maintenance can fluctuate. Property taxes may go up (or occasionally down), and other costs may rise or fall over time.

Final words

Net operating income is an important measure of profitability, especially in commercial real estate. However, it differs from net income because it doesn’t include debt interest, income taxes, capital expenses, or depreciation. While there’s no ideal NOI percentage, investors and lenders look closely at NOI and cap rates.

The cap rate helps compare the cost of financing a property against its net operating income. If the NOI is higher than the interest payments (a coverage ratio greater than 1), it’s a good sign the investment is likely profitable.