Net operating income (NOI): Definition and formula

There are a handful of tools any real estate investor may need in their tool belt: solid knowledge of their preferred real estate market, the ability to estimate remodel costs and a firm grasp on basic financial concepts. One of the most important calculations for real estate investors is knowing how to correctly calculate net operating income (NOI).

This powerful calculation enables real estate investors to make financial decisions at-a-glance. Let’s take a look at what NOI means in real estate and how to calculate it.

What is net operating income in real estate?

Net operating income (NOI) is a formula that real estate professionals often use to quickly calculate the profitability of a particular investment. NOI determines the revenue and profitability of investment properties after subtracting necessary operating costs.

The formula works by succinctly considering all income a property makes minus all of the general expenses. For example, a property may earn money from tenant rental payments and a coin laundry machine. Operating expenses include home maintenance fees, homeowners insurance and property taxes.

NOI takes into consideration all of the necessary income and expenditures for every rental property into one calculation.

Net operating income formula

The formula for NOI is as follows:

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

Below, we’ll walk through all the numbers to include in your formula and how to calculate NOI.

Gross income vs. net income

When calculating NOI, you’ll need to be able to tell the difference between your gross profit and net profit, especially as we break down the formulas below. Here are two things to remember: Your gross income is the money you make from the real estate investment(s), while your net income is the money you take home.

Gross operating income (GOI)

To accurately calculate NOI, first you need to calculate your gross operating income (GOI). The formula for GOI is as follows:

Gross Operating Income = Potential Rental Income − Vacancy Rates

It’s easy to fall into the trap of assuming that your gross income is simply what the property is worth. This isn’t necessarily true. Gross operating income mathematically accounts for possibilities and fluctuations in a property’s income.

Here’s a breakdown of the factors that are included in the gross operating income formula.

Potential rental income

Potential rental income is how much you’d make if the property was 100% leased, 100% of the time. This is the number that’s easy to stumble on because investors often think in terms of the “best case scenario.”

Vacancy and credit losses

It would be great if a property was 100% leased, but this isn’t likely each year. This is why the gross operating income formula factors in vacancy and credit losses against potential rental income.

When evaluating a potential investment, use vacancy rates from comparable properties in the area or ask the current owner for the property’s historical accounting record. This can give you a better idea of the vacancy percentage you should use to come up with your calculations.

How to calculate NOI

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

Other income

Remember, NOI takes into account all income, which is your gross operating income plus any additional income a property makes. A property can make money outside of rental income in a variety of ways. For instance, maybe the property has vending machines, a parking lot that requires an additional monthly fee or a coin-operated laundry machine.

A property may make additional income, but not always. 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 know the amount of your gross income, you’ll need to consider all your operating expenses – or 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
• Property management fees
• Accounting and attorney fees
• Marketing costs

Example NOI calculation

NOI is often 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 investment property. It’s a small, four-unit apartment complex. Each unit rents for $1,500 per month, making the potential rental income $72,000 per year. The coin laundry in the basement of the property makes about $1,000 annually.

Historical accounting records show that the property’s vacancy losses are around 10% ($72,000 × .10), or $7,200 per year. This brings the gross operating income to $64,800 ($72,000 − $7,200). Based on the current owner’s accounting, operating expenses are $15,000 each year.

As a refresher, the formula for NOI is:

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

The formula for this example is:

NOI = ($64,800 + $1,000) − $15,000

NOI = $50,800 annually

How investors can use NOI calculations

The investor in the above example will make a net operating income of about $50,800 a year. Based on this NOI calculation, an investor can then:

• Use this number to compare the income of this investment to other properties.
• Determine if the investment property earns enough to cover any mortgage loans.
• Figure out the cap rate, which is the total rate of your potential return on investment (ROI).
• Calculate a property’s worth and determine how much to offer for the purchase.

How NOI is used to determine cap rate

If you’re journeying down the road of real estate investing, you’ve probably heard the term “cap rate” used frequently. NOI is actually used to help determine the cap rate of an investment property. The capitalization rate (cap rate) is another way that investors quickly assess the potential for profitability in a real estate investment.

The formula for cap rate is:

Capitalization Rate = Net Operating Income ? Purchase Price

Let’s consider an example. Let’s assume 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 the property has a cap rate of 14% ($50,800 ? $360,000 = 0.1411, or about 14%).

Depending on how much an investor wants to earn on their investment, they can use the cap rate metric to vet for potential investments.

What’s not included in the NOI formula?

NOI does not include numbers that can be written off against future earnings and taxes. It also does not include large one-time costs such as major repairs.

Certain numbers are excluded from NOI calculations because they do not support the purpose of net operating income. The purpose of NOI is to give real estate investors a look into the true cash flow of a rental property. This means considering how profitable a rental property is (or isn’t), how much it costs to maintain the property and the overall health of the investment.

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

Total debt service

You may notice that mortgage payments and mortgage amortization are missing from the NOI formula. Debts are not included in NOI calculations because the amount of debt can vary from investor to investor.

For example, one investor may be able to make a 50% down payment, while another can only put 20% down. This number would substantially influence NOI if it was included, but because you’ll want to see the overall health of the property (and not the financials of a specific investor), you can exclude mortgage payments from your NOI calculations.

Excluding debt lets you compare properties on the same merit: income vs. outflow.

If you’re financing an investment property, you might use the debt-service coverage ratio (DSCR). A debt service is the amount of money you’ll need to cover the principal and interest payments on a loan, like a mortgage. The DSCR is the measure of a property’s cash flow against what it needs to cover any mortgage loans. DSCR does take into account NOI, and you can get a quick accounting of DSCR by using the following formula:

DSCR = Net Operating Income ? Total Debt Obligations   

Income taxes

NOI is a pre-tax calculation, which means all taxes are excluded from the formula. Tax expenses also vary widely by investor, and since NOI is specific to the property and not the person, you don’t need to include it in the NOI formula.

Depreciation

Depreciation isn’t an actual expense because you never “pay” for depreciation out of pocket like with a cash or check. Depreciation is an accounting concept and only becomes “real money” when writing it off on your taxes or during the sale of a property.

Since NOI only looks at real, annual expenses that come out of the money you earn each year, property depreciation is also not included in the NOI calculation.

Tenant improvements

Because tenant improvements are specific to the tenant, and not the property as a whole, this cost also gets excluded from any NOI calculations.

Capital expenditures

Operating an investment property can be expensive, and there will be years where more capital is required for maintenance. However, because this expense can vary widely year-to-year and property-to-property, you don’t have to include large, one-time expenses in an NOI calculation.

The bottom lLine

Net operating income (NOI) is one metric that real estate investors can use to determine whether a property will be a profitable investment. You’ll need to determine the gross operating income and additional income the property will generate, then subtract your total operating expenses.

Understanding NOI and other investment terms can be helpful if you’re interested in property investing.

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