NOI Meaning in Real Estate: Unpacking Net Operating Income

Financial metrics are vital for your development team to track, helping you demonstrate a project is financially viable and will deliver high returns. From the Internal Rate of Returns (IRR), cap rates, and Return on Investment (ROI), your team is likely to use key data metrics to show a project’s profitability to potential investors. Net operating income (NOI), which offers a standardized measure of a real estate asset’s profitability, is one of the most important metrics your team will use.

Net operating income (NOI) is the calculation used to analyze a real estate project’s potential to generate cash flow. It’s found by calculating all the revenue generated from a property, minus all necessary operating expenses. 

Here we’ll dive deeper into what net operating income is, what it means to your investors, and practical applications in the development process.

Breaking Down NOI Meaning in Real Estate

Net operating income (NOI) is a key financial metric used to measure the profitability of a property. NOI is found by subtracting the property’s operating expenses from all the revenue generated by the property. Revenue can be generated from a variety of sources including rent, pet rent, late fees, and amenities such as parking structures, laundry, or vending machines. Operating expenses include all the costs associated with running and maintaining a building, including utilities, insurance premiums, legal fees, property taxes, repair costs, or sanitation.

NOI is a before-tax figure, and in other industries is called Earnings Before Interest and Taxes or EBIT. As a pre-tax figure, NOI excludes principal and interest payments on loans, capital expenditures, depreciation, and amortization. In general capital expenditures, such as renovations for an entire building, are not included in an NOI calculation because it’s a large, one-time expense and investors often use cash reserves or savings to fund these improvements. 

How NOI Differs From Other Real Estate Metrics 

As a financial metric, NOI’s meaning in real estate is unique in its focus on the operational performance of an income-producing property. Return on Investment (ROI)  is different from NOI because it is looking at the total return on an investment, including income and capital appreciation. ROI takes into account the initial investment and changes over time, and unlike net operating income, does not isolate the property's operational income. Capitalization Rates (Cap Rates) are also different from net operating income and are found by dividing a property’s NOI by its asset value. The cap rate is used to assess a property’s yield over time. 

Investors and realtors should consider NOI’s meaning in real estate because it offers insight into the core operational income and expenses on the property level. That means investors can use the calculations to compare different development opportunities and objectively evaluate which opportunities will deliver strong returns and meet their goals. NOI is also an important component of other critical financial calculations, such as a property’s cap rate, or its debt coverage ratio (DCR) which measures a firm’s available cash flow to pay current debt obligations. 

What Does NOI Mean For Property Investors? 

So, what does NOI mean for investors? Net operating income is used to help determine how risky an investment is by comparing the NOI  to the annual debt service. NOI’s exclusion of expenses that vary from investor to investor, such as mortgage interest payments and capital expenditures, allows investors to get a clear idea of a property’s current and projected cash flow. The metric is especially useful for comparing different investment options with each other because the NOI is difficult to manipulate compared to other financial calculations. 

Calculation of NOI 

The simple formula for calculating net operating income is to subtract the operating expenses from gross operating income. The formula looks like this: 

NOI = Gross Operating Income - Operating Expenses 

Investors will sometimes recalculate NOI to adjust for other factors, such as ancillary income (such as pet rent, appliance rentals, parking fees) made on the property or losses from vacancies. When adjusted for other income sources besides revenue generated from rentals, the formula can look like: 

NOI = (Gross Operating Income + Other Income) - Operating Expenses 

In order to calculate NOI, it’s essential to first define gross operating income (GOI). Gross Operating Income is a property’s total revenue before expenses. GOI revenue does not include potential revenue from vacancies but does include revenue generated by the property, such as parking or storage units. Here’s what you need to consider to get to true GOI. 

Potential Rental Income. Potential rental income is how much a property would yield if leasing was at 100%. This statistic should be readily available because investments are often considered in terms of a best-case scenario. 

Vacancy Losses. As above, Gross Operating Income cannot include potential revenue from vacancies, so GOI has to factor in vacancy and credit losses against the Potential Rental Income. In order to get an accurate idea about vacancy rates, you can look into a building's historical data or compare it with similar properties in a given market. 

Other Income. NOI has to take into account all income, including everything from vending machines to coin laundry. 

Operating expenses, or what it actually costs to own and maintain the property, can include everything from property taxes, insurance, maintenance or repair costs, and any fees, such as accounting, marketing costs, or property management. 

What Is Not Included in NOI? 

Specific metrics are excluded from net operating income calculations, such as numbers that can be written off against future earnings or large one-time costs or repairs considered capital investments. Here are a few things to exclude from your NOI calculations: 

Capital Expenditures: Large investments in maintenance for a property, such as a new roof or updating appliances, are likely to occur over a property’s lifecycle. However, these expenses are not recurring year-of-year and can vary in costs, so they are not included in an NOI calculation. 

Tenant improvements: Since tenant improvements are specific to the tenant and not the property as a whole, this cost is excluded from the NOI calculations. 

Income Taxes: NOI is a pre-tax calculation, so all taxes are excluded from calculations. 

Debt Service: Debt service, or the regular payments made by a borrower to repay the principal amount and interest on a debt such as a loan or mortgage, is also excluded from NOI. Debt is considered a variable factor because they vary from investor to investor and would dramatically influence NOI if included. The point of NOI is to evaluate the financial health of an individual property, not the finances of a specific investor, so these are excluded as well. 

Practical Applications of Understanding NOI Meaning in Real Estate

Once you understand NOI’s meaning in real estate, the metric has several practical applications to ensure a project’s financial viability. 

Cap Rate and NOI 

Capitalization rate (cap rate) is used to determine the current and future potential rate of return on investment. The higher the cap rate, the larger the returns on investment will be considered to be. The cap rate is calculated by dividing the net operating income by the total cost of a property, so the formula will look like 

Cap Rate = NOI ÷ Property Value 

NOI and Loan Consideration 

High NOI can lead to better loan terms, indicating to investors the strong potential for financial performance and reduced risk for the lender. Lenders use NOI as a key indicator of the property’s ability to generate income and cover debt service payments. Loan-to-value ratios, which represent the ratio of the loan to the value of the property, should be low to appeal to lenders. Higher NOI contributes to lower loan-to-value ratios and can increase the property's value. 

NOI and Portfolio Management 

You can use net operating income to evaluate the performance of multiple properties. NOI offers a standardized method for comparing properties of different asset classes, sizes, and locations. It also allows you to identify high-performing properties, as higher NOI relative to expenses is generally a key performance indicator for investors. Looking at NOI metrics across different properties in a given market can also help you gain insight into demand, trends, and pricing. 

Modern real estate development software can be a valuable tool for evaluating potential returns on a given property or market. Northspyre’s DeepLook functionality offers key insights into what your project should cost based on asset class, location, or other factors by leveraging data gathered from $125 billion dollars of successful projects. You can use the platform to get access to data gathered from over 2,000 projects, create accurate budget forecasts and start your next project with confidence. 

Download our whitepaper Commercial Real Estate Needs to Rethink Its Relationship With Excel for additional insight on how technology can help you create reliable budget forecasts.