What NOI measures
NOI is the income a property produces from operations alone. It ignores how the building is financed and who owns it, which is what makes it useful: two buyers with very different loans can look at the same building and agree on its NOI. Cap rate, value, debt coverage and cash-on-cash return all start from this number.
The formula
NOI equals effective gross income minus operating expenses. Effective gross income is gross potential rent, minus vacancy and credit loss, plus other income from the property.
Operating expenses are the recurring costs of running the building. Three items are deliberately left out: debt service (mortgage principal and interest), capital expenditures such as a new roof or boiler, and depreciation. Debt service reflects financing, capital expenditures are periodic investments rather than annual running costs, and depreciation is a tax deduction, not a cash outlay.
- Include: property taxes, insurance, owner-paid utilities, repairs and maintenance, property management, payroll, landscaping and snow removal, trash, pest control, legal and accounting, advertising.
- Exclude: mortgage payments, capital improvements, depreciation, income taxes, owner personal expenses.
A worked example
A 12-unit building has gross potential rent of $180,000 a year. A 5% vacancy allowance removes $9,000, and laundry and parking bring in $6,000, for effective gross income of $177,000.
Operating expenses: property taxes $24,000, insurance $9,000, owner-paid utilities $12,000, repairs and maintenance $10,000 and management $14,000, a total of $69,000. NOI is $177,000 − $69,000 = $108,000. At a 7% cap rate, that income would support a value of about $1,543,000.
How to read the result
Compare NOI with effective gross income to get the operating expense ratio; in the example it is about 39%. An unusually low ratio often means an expense is missing, and an unusually high one may point to utilities the owner pays, deferred maintenance being handled as repairs, or management that is not working.
When you are evaluating a purchase, calculate NOI twice: once from the seller’s trailing twelve months, and once from your own budget with market-rate management, current insurance quotes and property taxes reassessed at your purchase price. The gap between the two is where most underwriting surprises live.
Common mistakes
These errors show up regularly in offering memos and owner statements.
- Subtracting mortgage payments, which understates NOI and double-counts financing later.
- Counting a one-time capital project as an operating expense, or the reverse.
- Leaving out management because the owner self-manages.
- Using scheduled rent with no allowance for vacancy or unpaid rent.
- Mixing time periods, such as annual rent with a single month of expenses.