Net operating income
Also called NOI.
Net operating income is a property's effective gross income less all operating expenses, before debt service, income taxes, depreciation and capital expenditure. It is the figure a cap rate is applied to, the numerator of debt yield and DSCR, and the number a purchase price is ultimately negotiated against.
How it works
NOI is deliberately capital-structure blind. Two buyers with different loans, different tax positions and different depreciation schedules should compute the same NOI on the same building, which is what makes it comparable across a market and usable as a valuation input. The moment something below the line creeps above it, that comparability is gone.
The recurring fight is over what counts as operating. Real estate taxes, insurance, utilities, repairs and maintenance, contract services, payroll, management fee, general and administrative and marketing are operating expenses and always belong above the line. Debt service, income tax, depreciation, amortisation, partnership fees, capital improvements and leasing costs are below it. The genuinely contested items are replacement reserves, tenant improvements and leasing commissions: appraisers and lenders normally deduct reserves above the line, and many seller pro formas do not.
Because value is NOI divided by a small number, an error in NOI is amplified enormously. At a 5.4 percent cap rate, one dollar of overstated NOI is $18.52 of overstated value. A $55,000 reserve line that was quietly left out moves the implied value by more than a million dollars.
Formula
NOI = effective gross income - operating expenses- Above the line: taxes, insurance, utilities, repairs and maintenance, contract services, payroll, management fee, general and administrative, marketing
- Below the line: debt service, income taxes, depreciation, capital expenditure, tenant improvements, leasing commissions, partnership fees
- Replacement reserves are treated inconsistently across the market and must be checked on every statement
Worked example
Same property, same expenses, one line moved. Cap rate held at 5.40 percent.
| Effective gross income | $4,727,800 |
|---|---|
| Operating expenses excluding reserves | ($1,708,000) |
| NOI as the seller presents it | $3,019,800 |
| Replacement reserves at $250 a unit | ($55,000) |
| NOI with reserves above the line | $2,964,800 |
| Value difference at a 5.40% cap | $1,018,519 |
A $55,000 annual line item is worth just over a million dollars of purchase price. Whether reserves sit above or below the line is not a presentation preference, it is a price negotiation.
Conventions worth knowing
- Lenders almost always underwrite reserves above the line, so a loan sized on the seller's NOI will come back smaller than expected.
- Trailing NOI, normalised NOI and pro forma NOI are three different numbers. Every conversation about a deal should specify which one is being quoted.
The common mistake
Buying on a pro forma NOI and financing on a trailing one
The purchase price gets negotiated against a forward NOI that assumes rents pushed, expenses fixed and vacancy tightened. The lender sizes the loan against trailing performance with normalised taxes and insurance and reserves deducted. The two numbers can differ by 15 percent or more, and the gap shows up as a funding shortfall at closing rather than as a modelling error, because nothing in the model was arithmetically wrong. Run both and size the equity against the lender's version.
Related terms
- Effective gross incomeEffective gross income is all the revenue a property is expected to collect in a year: gross potential rent, less vacancy, loss to lease, concessions and bad debt, plus other income. It is the revenue figure operating expenses are subtracted from to reach net operating income.
- Cap rateA cap rate is a property's net operating income divided by its value or price, expressed as a percentage. It is the unlevered first-year yield on the purchase price and the standard shorthand for what a market is paying for a stream of property income.
- Replacement reservesReplacement reserves are an annual allowance set aside for the periodic replacement of building components that wear out: roofs, HVAC, appliances, parking surfaces, elevators. They smooth lumpy capital spending into a level annual charge.
- Operating expense ratioThe operating expense ratio is total operating expenses divided by effective gross income. It is a fast sanity check on whether an expense budget is plausible for the asset type, the market and the way the property is run.
- Capital expenditure versus operating expenseAn operating expense keeps a property running in its current condition and is deducted above the net operating income line. A capital expenditure replaces or improves a component with a life beyond the current year and is deducted below it. Which side of the line an item lands on changes the property's value.
- T-12A T-12 is a trailing twelve month operating statement: every income and expense line a property actually produced over the last twelve months, normally shown as twelve monthly columns with an annual total. It reports what happened, as opposed to what a seller projects.
Keep reading
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.