What is the Net Operating Income Formula?
Net operating income (NOI) is a formula real estate investors use to determine the profitability of a potential real estate investment or other investment. The net operating income formula subtracts your annual gross operating income from your annual operating expenses to see how much cash flow a property or business generates.
NOI, also known as earnings before interest, taxes, depreciation, and amortization or EBITDA, is a popular metric for real estate development, rental property management, commercial property sales, and other real estate investments. Calculated correctly, net operating income tells you how much profit you can expect a property to generate every year.
What does net operating income mean?
Your net operating income is the money you have left over every year after the costs of running that property. As a real estate investor, you’d use this formula to see if a property would generate a positive return.
However, keep in mind that net operating income doesn’t account for several factors, including:
- Mortgage payments or debt
- Leasing commissions
- Income taxes
- Tenant improvements
- Capital expenditures
- Amortization and depreciation
- One-time costs for major repairs
While these expenses are important, they aren’t included in the net operating income formula. That’s because the purpose of NOI is to tell you how well you’re managing the property. It’s the best way to understand the actual cash flow of a rental.
Why net operating income matters
Net operating income is an important metric for real estate investors. If you want to buy a property that produces income, you need to calculate NOI to predict your expected returns.
NOI is also useful for:
- Understanding a property’s cash flow.
- Making data-driven decisions. NOI will tell you if you need to increase rent or decrease operating costs to remain profitable.
- Compare properties. Compare the NOI of properties you own against each other or against nearby competing properties.
- Spotting trends. It’s important to notice if a property is becoming less profitable over time. NOI will help you see if a property is historically performing better or worse. If it’s the latter, it might be a good time to sell!
How to calculate net operating income
The net operating income formula is very simple:
Net operating income = gross operating income - operating expenses
While the formula itself is easy to understand, it’s important to include all relevant income and expenses to calculate NOI correctly.
Gross operating income is the revenue you earn in exchange for operating the property. For most properties, this is how much you earn in rent, but it also includes income from sources like:
- Paid parking
- Vending machines
- Laundry facilities
However, remember that this isn’t an estimate of how much you could have earned from a property. You’ll have repairs and vacancies throughout the year, which means you can’t estimate gross operating income based on the number of units alone.
You’ll need to subtract your operating expenses from your gross operating income to see your true NOI. Operating expenses include all of the money you spent operating a property, including:
Once you know all of your income and expenses, it’s easy to calculate net operating income.
Let’s say you own a property that generated $100,000 last year (gross operating income) but it cost you $30,000 to operate the rental (operating expenses). Plug these numbers into the net operating income formula to find the NOI of this property:
$100,000 - $30,000 = $70,000 NOI
This means you earned $70,000 on that property after expenses.
You want your property to generate as much positive net operating income as possible; positive NOI usually means it’s a profitable, wise investment. However, it’s important to calculate historical NOI to ensure that the property is trending up, not down. While it’s most commonly used in real estate investing, the NOI formula can be used to determine any company’s revenue after subtracting direct and indirect operating costs from the business’s sales revenue.