The definition and formula
Net operating income is effective gross income minus operating expenses. Effective gross income is everything the property collects — rent plus other income such as laundry, parking, storage and fees — after allowing for vacancy and unpaid rent. Operating expenses are the ordinary costs of running the property.
In formula form: gross potential rent, minus vacancy and credit loss, plus other income, equals effective gross income. Effective gross income minus operating expenses equals NOI.
What counts as an operating expense
Operating expenses are the recurring costs of keeping the building running and leased:
- Property taxes and insurance.
- Utilities the owner pays, such as water, sewer, trash and common-area electricity.
- Repairs and maintenance, turnover costs and landscaping.
- On-site payroll and property management fees, including a market-rate fee even if the owner self-manages.
- Administrative costs: leasing, marketing, software, legal and accounting for the property.
- Many underwriters also deduct a per-unit replacement reserve, so check whether a quoted NOI includes one.
What NOI leaves out
NOI deliberately excludes costs that depend on the owner rather than the property. Mortgage principal and interest are left out, because two owners with different loans should still see the same NOI. Capital expenditures such as roofs, boilers and unit renovations are left out, because they are long-term investments rather than annual operating costs. Depreciation and income taxes are left out because they depend on the owner’s tax situation.
That is what makes NOI comparable across buildings. It describes how the property performs, not how it is financed or who owns it.
A worked example
A 20-unit building has gross potential rent of $360,000 a year. A 6% vacancy and credit loss allowance removes $21,600. Laundry and parking add $9,000, so effective gross income is $347,400. Operating expenses — taxes, insurance, utilities, repairs, payroll and management — total $150,000. NOI is $197,400.
At a 6.5% cap rate, that NOI supports a value of about $3,037,000. If the owner trims $10,000 of expenses, NOI rises to $207,400 and the value at the same cap rate rises by roughly $154,000. That multiplier is why owners focus so hard on NOI before selling.
Why NOI matters to buyers, sellers and lenders
Buyers divide NOI by a market cap rate to estimate value. Lenders divide NOI by annual debt service to calculate the debt service coverage ratio and size the loan. Investors compare NOI growth over time to judge how well a building is managed.
Because so much depends on it, buyers verify NOI carefully. They compare the trailing twelve-month operating statement with the rent roll, bank deposits and tax bills, and they adjust for expenses an owner may have left out, such as a property tax reassessment after the sale. A seller who presents a clean, documented NOI tends to get stronger, faster offers.
