What is net operating income?

Net operating income is a foundational metric for a commercial real estate investor–or any investor. Because it compares income and expenses related to a particular investment, NOI provides a means to determine how viable an investment opportunity is for you, given your investment goals and constraints. The definition and formula for net operating income (NOI) address only expenses and income; the calculation is easy as long as you understand and carefully account for everything in those categories. 

NOI is defined as operating income minus the expenses incurred in order to generate it. The net operating income formula is simple: 

Net Operating Income = Gross operating income – Total operating expenses

Nuances of calculating total operating income on a commercial investment property 

If you’re estimating operating income as a means to evaluate the viability of an investment property, you’ll need to adjust your potential earnings in order to reflect what you’ll actually collect from the property rather than what you could earn if the property was always full and all the tenants paid on time. To determine the effective gross income, you’ll need to estimate:

• Vacancy losses–rent lost when the building sits empty
• Credit losses – rent lost because a tenant doesn’t pay the full amount owed or moves out early.
• Additional income – extra cash flow directly related to the property from vending, parking fees, late fees, storage and any other sources. 

Expenses typically incurred on commercial property 

Property taxes, insurance, and professional management fees typically comprise major expense categories you’ll need to account for. If you opt not to use a property management firm, you will need to track expenses related to rent collection, tenant interviews, groundskeeping, building maintenance and property upkeep. Any utilities

fees not paid by the tenants also need to be subtracted from operating income. 

Why is such a simple metric so critical? 

Correctly calculating a property’s net operating income is the vital first step to making a wise investment. NOI is an integral part of the formula used to calculate other metrics such as cash on cash return, debt service coverage ratio, and cap rate. Understate income or overstate expenses, and you understate your estimated cap rate, your debt service coverage ratio, and your cash on cash return. Overstate income or understate expenses, and you inflate the estimates for those 3 metrics. 

Investors look carefully at cash on cash return and cap rate when evaluating the viability of a property. Lenders use the debt service coverage ratio as a key metric to determine whether to finance an investment. Calculating metrics on a skewed estimate of net operating has far-reaching consequences.

Which would you choose?

You are evaluating 2 investment properties in Jackson, MS. Both are small apartment complexes that could use a few repairs. Their financial statements for last year reveal the following information.

Property 1 Property 2

Rental income: $50,000 $40,000

Additional income from vending, parking, etc.   ——- $  3,000    

Property management fees $10,000 $  6,000

Insurance $  8,000 $  8,000

Repairs $  8,000 $10,000

Property taxes $  3,500 $  2,000

Total Income $50,000 $43,000

Total expenses $29,500 $26,000

Net Operating Income $20,500 $17,000

You learn, too, that Property 2’s neighborhood is being revitalized. Rental rates have started to climb and the neighborhood vandalism rate has dropped significantly. Your insurance agent hints that the insurance rate on the property may actually drop if vandalism rates continue to drop.

If you based your decision only on net operating income, you would choose Property 1, even though the non-financial information seems to favor Property 2. 

Net operating income provides a critical starting point for commercial real estate investors when they evaluate a property.  Other metrics help clarify the decision, as long as the estimate of NOI is accurate. Incorrectly estimating net income affects the results of several other key metrics, and can be the catalyst for a poor investment decision.