Net Operating Income

Net Operating Income or NOI is equal to a property’s yearly gross income less operating expenses. Gross income includes both rental income and other income such as parking fees, laundry and vending receipts, etc. All income associated with a property. Operating expenses are costs incurred during the operation and maintenance of a property. They include repairs and maintenance, insurance, management fees, utilities, supplies, property taxes, etc. The following are not operating expenses: principal and interest, capital expenditures, depreciation, income taxes, and amortization of loan points. Net operating income is calculated like this.

Income
Potential Gross Rents	$100,000
Other Income	$3,000
Potential Gross Income	$103,000
Less vacancy Amount	$2,000
Effective Gross Income	$101,000
Less Operating Expenses	$31,000
Net Operating Income	$70,000

Net operating income or NOI is used in two very important real estate ratios. It is an essential ingredient in the Capitalization Rate (Cap Rate) calculation that is used to estimate the value of income producing properties. Lets assume we have a market capitalization rate of 10 for the type of property we are considering purchasing. A market cap rate is calculated by evaluating the financial data from current sales of similar income producing properties in a given market place. We are evaluating a similar income property that is currently for sale with a net operating income of $50,000. We would estimate the value of this property like this.

		Net Operating Income
Estimated Value	=	————————-
		Capitalization Rate

$50,000
—————–	=	$500,000
.10

Another important ratio that is used to evaluate income producing properties is the Debt Coverage Ratio or DCR. The NOI is a key ingredient in this important ratio also. Lenders and investors use the debt coverage ratio to measure a property’s ability to pay it’s operating expenses and mortgage payments. A debt coverage ratio of 1 is breakeven. Most lenders require a minimum of 1.1 to 1.3 to be considered for a commercial loan. From a bank’s perspective and an investor’s perspective, the larger the debt coverage ratio, the better. Debt coverage ratio is calculated like this.

		Net Operating Income
Debt Coverage Ratio	=	————————-
		Debt Service

$50,000
—————–	=	1.25
$40,000

Debt service is the total of all interest and principal paid in a given year. It is equal to the mortgage payment times 12 or the mortgage payments times 12 if you have multiple loans on a property.

The Net Operating Income is an important ingredient in several real estate ratios which include the Capitalization Rate, Net Income Multiplier and the Debt Service Coverage Ratio. It is also an essential part of an income property’s Income Statement and Cash Flow Statement. It is therefore important to understand how the Net Operating Income is calculated.


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