Net operating income (NOI): Definition and formula

If you plan to invest in real estate, one concept you’ll need to be familiar with is your net operating income. You can think of NOI as how much you’re making after deducting the expenses of operating your investment. In other words, it tells you how profitable your investment is.

What is net operating income and why is it important in real estate?

Net operating income is a formula used to calculate the profitability of an investment property. To calculate your NOI, you need to determine your effective gross income. This sounds like a confusing figure, but it just means the money that’s being generated after you subtract any vacancy or credit losses, like unpaid rent. Once you have your effective gross income, you subtract all of your operating costs. That gives you your net operating income and tells you how much you’re really making.

For example, a property may earn money from rental payments and a laundry machine. Operating expenses might include maintenance fees, homeowners insurance, and property taxes. NOI takes into consideration all of the income and expenditures for the property in one calculation.

Investors and lenders use NOI to evaluate a property’s potential cash flow, estimate profitability, and determine the capitalization rate, which tells you the relationship between the net operating income and the property’s market value.

Net operating income formula

Here’s the formula to calculate NOI:

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

Now, let’s go through what each of those figures represents and how to calculate each.

Gross income vs. net income

When calculating NOI, you’ll first need to know the difference between your gross income and your net income. Your gross income is how much money the real estate investment generates, while your net income is the amount of money you take home after expenses are deducted. You may also hear net income referred to as your bottom line. Unlike net income, NOI does not include capital expenditures, principal and income payments, income taxes, depreciation, or amortization.

Gross operating income

The difference between gross operating income and gross income is that GOI accounts for the possibility of any fluctuations in a property’s income due to vacancies. GOI considers factors like tenant rents and vacancy rates to give a more accurate representation of how much income the property generates. Here’s the formula to calculate GOI:

Gross Operating Income = Potential Rental Income − Vacancy Rates

Potential rental income

Potential rental income is how much you’d make if the property were 100% leased 100% of the time. This number is easy to stumble on because investors often think about the best-case scenario. Making upgrades and providing additional amenities can boost the desirability of a property, increase rental rates, and boost gross operating income. 

Vacancy and credit losses

In an ideal world, every unit of your property would be leased at all times. However, that’s not a realistic expectation. That’s why the gross operating income formula factors in vacancy and credit losses due to unpaid rent against rental income.

When evaluating a potential investment, consider using vacancy rates from comparable properties in the area or request the property’s historical accounting records from the current owner. This can give you a better idea of the vacancy percentage to use in your calculations. Having long-term tenants will provide you with more stable income, minimize vacancy losses, and enhance gross operating income over time.

How to calculate net operating income

Now that you understand how to calculate your gross operating income, let’s review some of the other factors included in the NOI formula: your additional income and operating expenses.

Other income

Remember, NOI considers all income, which is your gross operating income plus any additional income a property makes. A property can make money outside of rental income. For instance, maybe the property has vending machines, a parking lot that requires an additional monthly fee, or laundry machines.

If your rental property doesn’t make other income, you don’t have to add another value to your GOI in the net operating income formula.

Operating expenses

After you figure out your gross income, you’ll need to consider what it actually costs to own the property. Operating expenses you’ll want to include in your calculations are:

• Property taxes
• Homeowners insurance
• Maintenance and repair costs
• Paying utilities such as water, trash, or internet 
• Property management fees
• Accounting and attorney fees
• Marketing costs

Conducting regular property inspections and maintenance can prevent costly repairs in the future and reduce overall operating expenses. 

Example NOI calculation

NOI is typically calculated on an annual basis. Let’s take a look at an example of how to calculate your NOI.

Say you’re evaluating a potential four-unit apartment complex as an investment property. Each unit rents for $1,500 per month, making the potential rental income $72,000 per year. The laundry machine on the property makes about $1,000 annually.

Historical accounting records show that the property’s vacancy losses are around 10%. If you multiply that by the potential rental income, it comes out to $7,200 per year. If you subtract the vacancy losses from the potential rental income, it looks like this:

$72,000 – $7,200 = $64,800

Gross operating income = $64,800

Based on the current owner’s accounting, operating expenses are $15,000 annually. So let’s calculate net operating income:

NOI = ($64,800 + $1,000) − $15,000

NOI = $50,800 annually

How NOI is used to determine the cap rate

The capitalization rate, or cap rate, is another method that investors use to assess the potential profitability of a real estate investment. NOI is used to help determine the cap rate of an investment property.

The formula for the cap rate is:

Capitalization Rate = Net Operating Income ∕ Purchase Price

Let’s use an example. Suppose the four-unit property in the example above is listed with an asking price of $360,000. The NOI is $50,800. Using the cap rate formula, you can determine that the property has a cap rate of 14%:

($50,800 ∕ $360,000 = 0.1411, or about 14%)

Depending on how much someone wants to earn on their real estate investment, they can use the cap rate metric to vet potential investments.

What’s not included in the NOI formula?

Certain numbers are excluded from NOI calculations because they do not directly affect how profitable a rental property is, how much it costs to maintain the property, and the overall health of the investment.

Because we’re looking at actual cash flow with NOI, here are a few factors you might want to exclude from your NOI calculation.

• Total debt service: Mortgage payments and debt amortization are excluded because they vary by investor. Instead, investors can use the debt-service coverage ratio to assess loan obligations.
• Income taxes: NOI is a pretax calculation, so taxes are not included as they differ among investors.
• Depreciation: Since depreciation is an accounting concept rather than an actual cash expense, it is not factored into NOI.
• Tenant improvements: Costs specific to individual tenants rather than the property itself are excluded.
• Capital expenditures: Large, one-time costs for major repairs and maintenance are not included, as they fluctuate from year to year.

The bottom line: How investors can use NOI calculations

Net operating income is one metric that real estate investors can use to determine whether a property will be profitable. You’ll need to first determine the gross operating income and additional income the property will generate, then subtract your total operating expenses. Investors use NOI calculators to compare property incomes, ensure that earnings will cover mortgage payments, determine the capitalization rate, and assess a property’s value to make informed purchase offers.

Are you ready to finance a real estate investment? Start your application with Rocket Mortgage® today, and we’ll guide you through the process.