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August 15, 2022

The Ultimate Guide to Calculating NOI (Net Operating Income)

NOI is one of the most commonly discussed metrics in commercial real estate. It’s indisputably essential for understanding the performance of commercial real estate investments and portfolios, but it’s also often difficult to fully grasp. Many people discuss NOI as authoritative experts, leaving others to wonder: What is it? How does it work? Let’s discuss.
TECHNOLOGY & TRENDS

NOI is one of the most commonly discussed metrics in commercial real estate. It’s indisputably essential for understanding the performance of commercial real estate investments and portfolios, but it’s also often difficult to fully grasp.

Many people discuss NOI as authoritative experts, leaving others to wonder: What is it? How does it work? Let’s discuss.

What is NOI?

NOI stands for Net Operating Income. It’s a relatively simple calculation that requires comprehensive and accurate accounting in order for it to maintain relevance as a relevant metric for your business.  

Critically, NOI as a metric allows you to evaluate the performance of a property without having to factor in specific capital structures and other owner-specific details. 

It’s agnostic towards such factors because it’s a straightforward calculation of money in and money out.  

Additionally, NOI is best used as a comparative metric. It’s not necessarily accurate to actual profitability or net profits. While it is used in the calculation of fair market value, it doesn’t need to be precise—to-the-penny—in real life. It is, typically, a proxy figure.

NOI vs. NIBT

NIBT is another metric similar to NOI, which is often used for similar purposes.  

NIBT is Net Income Before Taxes. Like NOI, it’s a simple calculation of income minus expenses. Unlike NOI, NIBT is a metric that can be calculated at a per-property level, for a geographic area and all owned properties within it, or a total portfolio level.

Some people use NOI to calculate NIBT. Others use NIBT as a starting point and add/remove income and expenses to adjust to create NOI.

NOI vs. EBITDA

EBITDA, or Earnings Before Interest, Taxes, Depreciation, and Amortization, is very similar to NOI. 

However, despite the similar equation used to calculate them, the inputs are different—as is the purpose of the metric. 

NOI is used to calculate and compare the profitability of a piece of commercial real estate. EBITDA is used in a similar way for businesses rather than real estate. Due to their similarities, the two metrics are often compared, but unless your portfolio includes both commercial real estate and businesses, you aren’t likely to be using both.

How to Calculate NOI

A simple description of a NOI calculation is this:

(Total income of a revenue-generating property) – (Total operating expenses for the property)

You must calculate both income and expenses accurately in order to produce a relevant, accurate NOI figure.  

NOI can be calculated manually, but in reality, the vast majority of commercial real estate owners will use accounting software to handle it for them. Gross estimates are only so helpful, so the more accurate the data and the more various factors can be included, the better it will be for forecasting and investment analysis.

Examining Income

Income for a revenue-generating property can cover many different income streams.

For a rental property, this is mainly made up of rent from tenants, but other income streams may include parking fees, vending machines, paid services, and more.  

  • Potential Rental Income. General NOI calculations make the assumption that each unit in a property is 100% occupied under a known lease term. If the property is not fully occupied, calculations pick a market-based rent and lease period chosen from comparable properties as an estimate.
  • Other Income Sources. Some properties generate income above and beyond rentalfees. Many ave other associated fees and income streams, from parking to laundry rvice to concierge services. These are property-specific.

Income for a property varies depending on the use of the property and the surrounding assets.

Examining Expenses

Operating expenses are the class of expenses necessary to keep the property functioning but expressly do not include capital expenses. Capital expenses are typically improvements to the property, like replacing an air conditioner.

Operating expenses are expenses related to maintaining the property, such as janitorial fees, property insurance, and general maintenance costs.

  • General Operating Expenses. These can include things such as an average cost of maintenance, property insurance, utilities, accounting fees, legal fees, and so on.
  • Vacancy Losses. Vacancies, broken leases, non-payment of rent, and other such factors can be calculated based on expected and actual figures, as well as market-based comparable statistics.

These expenses are considered to evaluate the value of a property. Operating expenses therefore, doesn’t include expenses such as financing to pay for the property.As an owner-agnostic metric, it can thus be used to examine the property and determine its potential profitability before making an investment in the property itself. 

Operating expenses can be calculated using historical data or using forecast data.

Expenses are often examined by breaking them down into three specific categories.

  • Non-controllable expenses. These are expenses that typically must be paid by the owner of the property, and while they may be adjustable by changing suppliers or hiring different contractors, they must exist, lest they cause a breach of contract between landlord and tenant. For example, snow removal, trash service for commercial or multi-unit residential, security services, and so on.
  • Controllable expenses. These expenses can be shuffled, minimized, or inflated to make NOI-derived metrics look better for various purposes. A typical example is property maintenance. A property owner can defer maintenance to make the ongoing expenses of a property appear lower before selling it, or they can inflate it by conducting "manufactured" maintenance to maximize the costs and minimize the tax burden. Management fees are also a controllable expense.
  • Hypothetical expenses. These are expenses that may or may not occur, primarily vacancy expenses, as described above.

NOI also has a time dimension. It is most often an annual calculation but can be applied to any duration for which data can be calculated.

What is Excluded from NOI?

As mentioned above, NOI excludes many owner-specific costs.

What should be excluded for an accurate NOI?

  • Capital expenditures. As significant, irregular expenses that are often funded by a reserve budget, these are not valuable to include in an NOI calculation. NOI is meant to serve as a picture of ongoing, regular income and expenses, not irregular spikes in either.
  • Debt service. Debt as an owner-specific factor (as it is not attached to the property but instead to the owning entity) is not calculated as part of NOI.
  • Depreciation. Depreciation is an accounting factor but not an actual expense. So, while the value of a property can fall without upkeep, that inherent depreciation is not an expense and thus not calculated.
  • Income taxes. While property taxes are specific to the property (as they are calculated based on where the property is, not who owns it), income taxes are an owner-specific factor. Income taxes vary depending on the filing location of the owning entity, after all. Taxes as a whole are one of the most complex parts of commercial real estate ownership, but they don’t have to be.
  • Reserves. As a pooled budget for capital expenditures, reserve funds are also not calculated as part of NOI. Note that some NOI systems will include reserves, as they can be an essential factor for an owner’s ability to handle debt and maintain a property in alignment with market values.
  • Tenant improvements. Construction costs associated with making a space usable by a specific tenant are not part of NOI. Again, they are not regular, recurring expenses; they’re irregular expenses associated with a particular tenant, who may or may not be there when you purchase the property.

Any other irregular or owner-specific cost or income is also excluded.

How to Make Use of NOI

NOI is a good metric for use in analyzing and comparing properties, precisely because it’s difficult to manipulate. While some expenses can be embellished or manipulated, they’re a relatively minor part of the overall NOI calculation. The overall picture of a commercial property’s NOI is an excellent way to estimate how well it may perform when put into your portfolio under your usual financing and capitalization rates.

NOI can be used to benchmark a property you own against comparable properties in the area. It can also be used to compare multiple properties you’re considering purchasing to see which ones may be the best options for investment. It can additionally be used to compare properties in your portfolio and determine which ones are the best and which are the worst from their own merits.

NOI is also used to derive a number of different metrics.

  • Capitalization Rate, or Cap Rate, is the NOI of a property divided by its total value. A property worth $500,000, with an NOI of $50,000, has a cap rate of 10%. A higher cap rate means a property with a higher potential return on investment but also typically a higher risk.
  • Property Value. If you don’t know the value of a property, but you do know the cap rate, you can reverse the equation to calculate property value using NOI.
  • DSCR. The DSCR is the Debt Service Coverage Ratio. It’s calculated as NOI divided by annual debt service and allows you to determine how much leeway you have in repaying financing and debt using the income provided by the property.

It’s calculated as NOI divided by annual debt service and allows you to determine how much leeway you have in repaying financing and debt using the income provided by the property.

All of this makes NOI a fairly helpful metric to use.

The Drawbacks of NOI

There are two significant drawbacks to using and relying on NOI.

  1. The first is that NOI is, generally, nothing more than an estimate. Many of the income and expense factors used to calculate NOI are either estimates, averages, or hypotheticals. The actual reality of a situation – lower-than-comparable rents, under 100% occupation, manipulation of expenses, and other factors can all make the reality of a property much different than the on-paper NOI. Worse, this is almost universally in a negative way—NOI will paint a rosy picture.
  2. Another drawback is that management style and capability have a significant yet invisible impact on NOI. Two different property owners, faced with the same set of maintenance tasks, may have vastly different actual costs. On a small scale, a property owner may have personal skills that enables them to perform handyman tasks without incurring labor costs, while another owner may not and will need to pay a skilled trade to come in to solve various problems. Response times, sources of materials, and other factors can all significantly impact maintenance costs.

Another issue is that there’s no objective standard for what constitutes a “good” NOI. NOI is heavily dependent on context. How does this property compare to other properties in the area? How does it compare to other properties in your portfolio? A “good” NOI for one region will be different from the same NOI in a different area. Moreover, depending on your various owner-specific factors, a property with an NOI that appears bad to many investors may actually be a prime opportunity for your specific portfolio.

Relying too much on NOI can lead to situations where the reality is very different – and often worse – for the property owner.  

Calculating NOI and Other Property Metrics

When handling the finances of a commercial property portfolio, dozens – if not hundreds– of different factors influence the outcomes. Knowing what goes into which metric, how accurate your sources of data are, and how to use and calculate each metric is an immense task. Commercial real estate accounting is, after all, a full-time profession.

Luckily, there are many ways to help streamline this process and other financial tasks relevant to commercial real estate. For example, property taxes alone can be vastly complicated. When you’re examining a property’s NOI, knowing how it fits into your portfolio and how it may affect your tax burden is crucial to determining whether or not it would be a good investment. One of the best ways to do that is by using an excellent commercial property tax program.  

Success in commercial real estate is entirely possible, but there are many pitfalls that need to be avoided. Fully understanding the metrics and data used to estimate expenses and income streams is just one part of the picture. So, if you have any questions about specific elements of commercial real estate, feel free to leave them in the comments below.

NOI is one of the most commonly discussed metrics in commercial real estate. It’s indisputably essential for understanding the performance of commercial real estate investments and portfolios, but it’s also often difficult to fully grasp. Many people discuss NOI as authoritative experts, leaving others to wonder: What is it? How does it work? Let’s discuss.

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