Net Operating Income

By Robert Prouty and Darrell Roberts

Net Operating Income (NOI) is not only one of the most common terms in real estate but, arguably, the most important. Consider that NOI is the foundation for the following calculations:

• Cap Rate
• Debt Service Coverage Ratio
• Loan Amount

Net Operating Income refers to the cash flow that remains after subtracting the operating expenses incurred at a property from the net income collected. Income is not limited to rent but can also include other items such as parking fees, laundry income, cable fees, late fees, etc. Specifically, any income that is attributable from the operation of the property.

Operating expenses include such items as insurance, real estate taxes, utilities, maintenance, management fees, payroll, and admin expenses. Similar to income, any expense attributable to the property’s operation is included in the NOI calculation.

Income – Expenses = NOI

Notice that loan payments, depreciation and amortization are not components in the net operating income. While many borrowers will report these items for tax reasons, loan payments, depreciation and amortization – both of which are non-cash items – do not have any bearing on a property’s operational performance. Likewise, some owners will run non-property related items through a property’s operating statements (boats, cars, etc.). Those items would also not be attributable to the property.

When looking at historical operating statements at a property everyone should come to the same conclusion. However, when trying to estimate how a property will run into the future (i.e. the pro forma or budget) there could be disagreements among the borrower, lender and appraiser. Although NOI is a simple calculation, it is subject to interpretation.

As an investor, it is important to support your underlying assumptions. For example, if the historical real estate taxes at a property have been $45,000 per year and the pro forma shows $30,000, you will need to demonstrate why that lower number is accurate.

• Does the sale trigger an automatic reassessment (such as California)?
• Is there an appeal in process at the county assessor’s office?
• Has an appeal been granted?
• Or, is the buyer assuming a new assessment based upon a lower purchase price? Assuming a new assessment is not the same as being granted a new assessment!

Due to the importance of the NOI calculation, it is in the investor’s best interests to keep detailed records of the property’s operations. Likewise, when purchasing a property, careful thought should be used in developing a realistic and sustainable NOI.

Misjudging a property’s actual NOI can lead to a financial disaster.