How To Calculate Net Operating Income (NOI) for Your Business

Image to represent article about net operating income

There are considerable expenses involved in property management—including insurance, maintenance, taxes, utilities, landscaping, cleaning, and security. When the owner tallies it up, they come up with a critical measure: their net operating income (NOI).

With NOI you can determine the worth of a property and the potential returns it may provide. But NOI can be a bit tricky to understand, especially if you’re new to the game. Here’s more about net operating income and how to calculate it.

What is net operating income?

Net operating income, or NOI, measures the profitability of an asset or an investment after subtracting operating expenses from income. It’s often used in the commercial real estate industry to determine the profitability of investment properties such as office buildings, apartment complexes, or warehouses. 

To calculate NOI, you add all revenue and then subtract operating expenses—typically expenses directly tied to property management, including real estate taxes, insurance, utilities, and maintenance. This calculation leaves out many other costs, including income tax, interest on debt, capital spending, and depreciation, because these are not considered direct operating expenses. 

NOI is similar to earnings before interest, taxes, depreciation, and amortization (EBITDA), a measure widely used in other industries to determine a business’s underlying operational profitability.

Net operating income is typically calculated annually, rather than monthly or quarterly, to account for seasonal or irregular expenses, such as landscaping, snowplowing, or window washing.

NOI also measures the potential return on investment of a property based on its purchase price using what’s known as the capitalization rate or cap rate. For example, an apartment building purchased for $10 million that produces $1 million in annual net operating income has a cap rate of 10% (or $1 million divided by $10 million).

How to calculate net operating income

The net operating income formula is as follows:

Gross operating income − operating expenses = NOI

However, obtaining both variables of this equation requires a few steps. Gross operating income is derived from gross potential income, or the maximum a property produces if all of its rental space is filled. Any lost income due to vacancies or unpaid rent is subtracted from gross potential income. Then subtract operating expenses.

To demonstrate an annual NOI calculation, imagine an office building with the following specs and statistics:

Office space: 75,000 square feet
Rental rate: $30 per square foot, annually
Gross potential income: 75,000 × $30 = $2,250,000
Income from vending machines: $25,000

Accounting for the building’s net operating income might look like this:

 Gross operating income
Rent, 75,000 sq. ft. at $30/sq. ft.  
Vending machines
Gross potential income
Minus vacancies, 2,500 sq. ft. at $30/sq.ft.
Gross operating income

You’d then subtract the following from gross operating income:

 Operating expenses
Property tax $300,000
Building on-site management $100,000
Utilities $50,000
Insurance $60,000
Maintenance $90,000
Total operating expenses $600,000

With both variables, you can tally the NOI using the equation:

$2.2 million − $600,000 = $1.6 million

You can then calculate the cap rate by dividing the NOI by the current market value of the property. Suppose the owner paid $20 million for the building. In this case, the cap rate calculation (NOI / market value of the property) looks like this:

$1.6 million / $20 million = 0.08 or 8%

Net operating income and debt costs

A property’s net operating income is often compared with its debt interest payments. This is called the debt-service coverage ratio (DSCR), ​​a financial metric used to measure a property’s ability to repay its debt obligations, i.e, how much its NOI exceeds—or falls short of—its interest expense. 

Owners and lenders evaluate DSCR to determine the terms for financing a property purchase—or whether a loan even makes sense. The higher this ratio, the better. A DSCR above 1 is essential for a profitable investment.

If a property owner paid half the $20 million purchase price in cash and financed the other $10 million with a 6% annual interest rate loan, then interest expense is $600,000 a year. The DSCR equation in this case is:

NOI ($1.6 million) / Interest ($600,000) = 2.67 or $2.67

The building, therefore, generates $2.67 in net operating income for every dollar of loan interest expense, meaning the transaction is financially viable.

Factors that affect net operating income

Net operating income and the cap rate can fluctuate based on the following factors:

  • Rent and vacancy rates. Rental property income can increase if an owner raises rental rates, fills vacancies, or collects delinquent rents. Conversely, lower rental rates and more vacancies and delinquencies cut rental income.
  • Operating expenses. Property taxes may increase (or more rarely, decrease), and insurance, utilities, and maintenance costs can rise or fall.
  • Market conditions. An economic boom or slowdown can cause vacancies and delinquencies to increase or decrease. The same applies in regions where housing or office space supplies are out of line with demand.

Net operating income FAQ

Is net operating income the same as profit?

Net operating income is a key measure of profitability, primarily in the commercial real estate industry. Still, it’s not the same as net income because it doesn’t account for debt interest, income taxes, capital spending, or depreciation and amortization.

How is net operating income calculated?

Net operating income is gross operating income minus operating expenses. Gross operating income is total rent plus any other related income, such as fees for parking and vending machines. Operating expenses include property taxes and insurance, building management, maintenance, and utilities. It excludes income tax, interest paid on debt, and capital expenditures.

What is a good net operating income percentage?

There is no good net operating income percentage per se. Investors and lenders do, however, evaluate NOI and cap rates, a measure comparing the cost of financing a purchase against net operating income. If net operating income exceeds interest expense—meaning the so-called coverage ratio is more than 1—then the purchase probably is profitable.