NOI (Net Operating Income)

What is NOI (Net Operating Income)?

NOI is, arguably, the most foundational component of real estate valuation.

Dividing a property’s NOI by the prevailing CAP rate (Capitalization Rate) for a certain property class in a given geography will provide an estimate of that property’s fair market value, sometimes referred to as FMV., e.g.

$500,000 (NOI) / 5% (CAP rate) = $10,000,000 (property value)

NOI is an important comparable figure and profitability metric used exclusively for income-producing commercial real estate assets. NOI is not the same as net profit or actual profitability by accounting standards. In that sense, think of NOI as being (to commercial real estate finance) very similar to what EBITDA is to corporate finance.

NOI vs. NIBT (Net Income Before Taxes)

It’s critical to understand just how different these two figures can be, even for the exact same property.

NIBT (Net Income Before Taxes)

NIBT is an accounting figure, whether we’re talking about an operating business or an investment property. It’s the total revenue minus the total expenses. For real estate, revenue is (largely) rental income:

Total Rental Income – Total Expenses = NIBT

Because passive income tax rates tend to be high in many jurisdictions, it’s a common strategy for real estate investors to try and actively inflate expenses in order to drive down their income tax bills.

Further, where an investor owns multiple properties, net income (or NIBT) may be calculated or presented at the portfolio level. This also makes understanding each individual property’s profitability (or ability to generate cash flow) difficult to understand.

(NOI) Net Operating Income

NOI is a metric used to measure the operating profitability of a specific property. NOI, like EBITDA, is often used as a proxy for operating cash flow when calculating debt service coverage ratios or when comparing properties to calculate estimated market values (since it ignores tax rates and capital structure decisions).

The best way to think about NOI is that a number of add-backs and normalizations are required to understand the property’s potential return for an investor.

Consider the following scenarios to help illustrate:

2. An individual investor owns a commercial property and this person generates most of their retirement income from the property. Because of this, they may take a very high management fee – which would overstate the property’s expenses (and understate its NIBT). Were an institutional investor to purchase this property, they may charge a much smaller management fee. Is one management fee “correct”? (not necessarily).
3. Real estate investor ‘A’ likes to employ maximum leverage, while real estate investor ‘B’ never uses debt at all (they pay cash for their properties). Assume these two investors each owned a property that was exactly identical in all material respects – B’s income statement would have no “interest expense” (and therefore a higher NIBT) than investor A, whose income statement has a high interest expense (and therefore a lower NIBT). Is one interest expense “correct”? (again, not necessarily).

As a general rule, analysts will often see investors and accountants look to understate income for accounting purposes (since it means a lower tax bill), but they will often seek to overstate NOI (since it implies a higher property valuation).

Normalizing Expenses to Calculate NOI

When looking to calculate a property’s NOI, there are four main categories of expenses that must be understood. These are:

1. Non Controllable Expenses

Examples include property taxes, utilities, insurance, maybe snow removal, security, or concierge services (where applicable). These are considered “non-controllable” since, if they aren’t paid, it’s likely a breach of contract between the landlord and the tenant(s).

Non-controllable expenses are cash expenses and are never added back to NIBT when calculating NOI.

2. Controllable Expenses

NOI and NIBT are impacted by three important controllable expense categories. These are repairs & maintenance, management fees, and interest.

They’re controllable in the sense that landlords can “defer” maintenance to overstate NIBT (if looking to sell, for example); they can also complete spurious repairs or maintenance to overstate expenses and pay less tax. Additionally, property owners can pay themselves as much or as little as they want in management fees. And finally, using debt as a funding source is optional, so interest (while an actual cash expense) is one that may or may not appear on all income statements depending on the owner’s preference for high- or low-debt capital structures.

Some controllable expenses are either added back to NIBT (or normalized) to arrive at NOI – we’ll look at an example shortly.

3. Non-Cash Expenses

The big one is depreciation expense. Like with EBITDA (for corporate finance), depreciation is a non-cash expense and is therefore added back to NIBT when calculating NOI.

4. “Hypothetical” Expenses

An important example is what’s called a “vacancy allowance.” While many commercial properties may be fully tenanted at the time of financing or acquisition, most commercial real estate professionals and lenders will assign a vacancy allowance to the property.

Vacancy allowances are expressed as a percentage of rental income, and they simulate hypothetical “downtime” where the property may sit vacant for a period of time without any rental income. Vacancy allowances are a function of the geography and the property type, with smaller communities and higher risk property classes usually commanding a higher “hypothetical” vacancy rate.

NOI Calculation

The simplest way to calculate NOI is to start with NIBT, add back non-cash and controllable expenses, then deduct normalized controllable expenses and “hypothetical” expenses.

Below is our earlier example, but adjusted accordingly:

You’ll notice in this example that the NOI figure of $119,000 is quite different from the NIBT figure of $60,000; it’s fairly common to see some discrepancy, even large ones like this, depending on the various circumstances we covered earlier.

But you can see that the NOI calculation is much more standardized and, therefore, comparable across property classes and geographies (like EBITDA).

More Resources

Thank you for reading CFI’s guide to NOI (Net Operating Income). To keep advancing your career, the additional resources below will be useful:

• Real Estate Fundamentals Course
• Commercial Mortgages Course
• Net Income After Tax (NIAT)
• Real Estate Appraiser
• See all accounting resources