Understanding Net Operating Income
March 22, 2019
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With regards to commercial property investment, net operating income (NOI) is a critical concept for investors to comprehend. The formula includes several components that are often misread or misunderstood, however, understanding NOI is imperative to adequately gauge potential investment opportunities. Gain insight into the details of NOI to ensure a more thorough and accurate approach to your next commercial real estate investment endeavor.

What is NOI?

Net operating income is the total annual revenue produced by a commercial property after deducting operating expenses. A property’s NOI represents its ability to generate steady income and is utilized to determine the profitability and quality of potential investment. The NOI formula is comprised of several components but does not include income taxes and capital expenditures in addition to a few other minor expenses. Calculating NOI is performed using the following formula:

 Potential Rental Income

-Vacancy and Losses

     ———————————————

 Actual Rental Income

+Alternate Income

     ———————————————

 Gross Operating Income

-Operating Expenses

     ———————————————

Net Operating Income

Breaking down NOI

To calculate net operating income, it’s important for investors to understand the breakdown of each of the formula’s components. The potential rental income is the sum of the revenue that would be generated if the property was at capacity. Several different types of leases dictate rental income and subsequently affect this portion of the NOI formula, such as net leases, double net leases, triple net leases, gross leases, pass-through leases and percentage leases.

The vacancy and losses subtracted from the potential rental income include credit losses, missed payments and empty apartments or office spaces. This resulting number is called actual rental income.

The gross operating income is then comprised of the sum of the actual rental income and alternate income, which includes revenue obtained from parking, vending, laundry and other affiliated tenant services.

Once the gross operating income is determined, the final NOI number is generated by subtracting the property’s operating expenses. Operating expenses are any financial expenditures that are reasonably necessary to the function and operation of the commercial property. Commercial property operating expenses include fees, insurance, repairs, property taxes, utilities and other essential costs.

Excluded from NOI

NOI does not include capital expenditures, debt, depreciation, income taxes, leasing commissions and tenant improvements. However, some NOI calculations include different interpretations and versions of these additional expenses and, thus, thorough assessment is recommended.   

NOI Takeaway

Net operating income alone is a useful calculation of a commercial property’s current or potential profitability. NOI is used in several other commercial investment formulas, such as cap rate, which is a valuable tool to evaluate an investment opportunity and anticipate potential financial return rates. These formulas are crucial to investors looking into their next commercial real estate venture.

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