Net Operating Income

What is net operating income?

Net operating income (NOI) is a crucial metric in commercial real estate for measuring the profitability of investment properties. This calculation considers all operating expenses and subtracts them from the property's income, providing an accurate view of its profitability. Whether you're looking to invest in office buildings, apartments, or warehouses, analysing NOI can help you make better-informed decisions about your real estate investments.

Net Operating Income = (Gross Operating Income + Other Income) − Operating Expenses

When calculating a business's net operating income (NOI), it's important to note that many other costs may not be taken into account. These can include income tax, debt interest payments, capital expenditures, and depreciation. Though these are not considered direct operating expenses, they still impact a company's overall profitability.

NOI is similar to Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA), another commonly used measure in various industries to determine a business's operational profitability.

Net operating income (NOI) is typically calculated annually and accounts for irregular or seasonal expenses like landscaping or snowploughing. The capitalisation rate, also known as the cap rate, uses a property's purchase price to determine its potential ROI. For instance, if an apartment building purchased for $15 million generates $1.2 million in NOI each year, its cap rate would be 8% ($1.2 million divided by $15 million).

Factors affecting net operating income

Various factors, such as rent and vacancy rates, operating expenses, and market conditions, can impact a property's rental income.

Raising rent rates, filling vacancies, and collecting delinquent rents can increase rental income. Conversely, lower rental rates and higher vacancies or delinquencies may decrease rental income.

Changes in operating expenses such as property taxes, insurance costs, utilities, and maintenance fees can also affect the overall rental income.

Market conditions such as economic booms, slowdowns, and imbalanced housing or office space supplies can impact vacancies within a given location.

Normalising expenses to calculate NOI

4 primary categories of expenses need to be recognised to compute a property's NOI. They are:

Non-controllable expenses

Non-controllable expenses are necessary for running a business, especially when it comes to properties. These expenses, such as property taxes, utilities, insurance, and maintenance services like snow removal or security, are called non-controllable because they must be paid to maintain the lease agreement between landlord and renter(s). Unlike other expenses that can be deducted from NIBT when calculating NOI, non-controllable expenses are always paid in cash.

Example: As a landlord, you must pay certain fixed costs regardless of the property's occupancy or income. These include annual expenses such as $5,000 for property taxes, $3,000 for utilities, $2,000 for insurance, and $1,000 for snow removal and security services.

Controllable expenses

Controllable Expenses: NOI and NIBT are impacted by three important categories of controllable expenses. These include interest, overhead expenses, and maintenance & repairs.

Landlords have the power to influence or adjust expenses that can impact Net Operating Income (NOI) and Net Income Before Tax (NIBT). For example, a landlord may choose to delay a $10,000 roof repair until next year to lower the current year's expenses. This decision could make the property appear more profitable in the short term but may have long-term consequences.

Non-cash expenses

One of the largest expenses for businesses is depreciation, which falls under the category of non-cash expenses. Similar to EBITDA in corporate finance, depreciation is removed from NIBT when calculating NOI. This helps provide a clearer picture of the business's financial performance without factoring in non-cash expenses.

Hypothetical expenses

Planning for potential vacancies is important to financial stability. This can be achieved by estimating future expenses, such as a 5% vacancy allowance for a fully leased commercial property. This means preparing for a hypothetical loss of $50,000 in rental income out of the total expected income of $1,000,000.

What is operating income?

Operating income is a key metric for determining a company's financial success. It reflects the income generated solely from its operations after deducting operating expenses. These expenses include various business activities such as rent, payroll, utilities, office supplies, benefits, and marketing and sales materials. Operating income helps businesses better understand their performance without being influenced by external factors like taxes or interest expenses on loans.

Operating income = Total revenue - Operating expenses

Operating income = Gross income − Operating expenses

Net income vs. net operating income

Net income and net operating income are often confused, but they have distinct meanings. Net income is a company's total revenue minus all expenses, both related and unrelated to its operations. On the other hand, net operating income only considers a company's revenue minus its operating expenses.

Also read: What you need to know about U.S. tax code

NOI vs. EBITDA: What is the difference?

Net Operating Income (NOI) and Earnings Before Interest, Taxes, Depreciation, and Amortisation (EBITDA) are commonly used non-GAAP financial measures in their respective industries.

NOI is specifically used in the real estate sector to measure a property's potential profitability. To calculate NOI, start by determining a property's Effective Gross Income (EGI) and subtracting direct operating expenses such as maintenance costs, repair fees, property management fees, utilities, and property taxes. It is important to note that NOI does not factor in debt service payments, interest expense, capital expenditures (Capex), depreciation or income taxes.

EBITDA, or earnings before interest, taxes, depreciation, and amortisation, is a common metric for evaluating a company's operational performance. This measure is calculated by adding operating income (EBIT) to depreciation and amortisation expenses or by adding net income to interest, taxes, and D&A. Unlike other financial metrics that may be impacted by factors such as capital structure decisions or tax jurisdiction, EBITDA provides a clear picture of how efficiently a company is operating and its overall profitability.

Is net operating income the same as profit?

No, net operating income is not the same as net income. While both are profitability measures, net operating income does not include debt interest, income taxes, capital spending, depreciation, and amortisation. It is primarily used in the commercial real estate industry to assess a property's potential for generating profit.

What Is a good NOI%?

Net operating income (NOI) is a key metric for evaluating the financial health of a property. It represents the difference between a property's revenues and expenses and can be compared to its value as if it were paid in full with cash. While NOI is not expressed as a percentage, it is often used to calculate a property's NOI-to-value ratio, which compares the NOI to the total value of the property. Generally, higher net operating income percentages indicate better financial performance and profitability for a property.

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