What is Net Operating Income (NOI)?
Updated: Jan 6
As we talk with current and potential investors, we come across a wide variety of professional backgrounds. Some folks are very well versed in aspects of finance as they have had very successful careers in the corporate world on the finance/accounting side, own their own business and therefore have had to do the books in the past, or have had a chance to work in a finance related field in the past. Others however, haven’t been exposed much to corporate finance and the different acronyms we throw around can be confusing.
Wherever you fall on that spectrum, it’s important to know the different metrics associated with valuing commercial real estate. One of the most important metrics is Net Operating Income (NOI) and we want to discuss what it is, how we get there, and why you as a passive investor should care.
NOI – what is it and how is it calculated?
Net Operating Income is your revenues minus operating expenses, excluding capital expenditures and debt service. Debt service is the principal and interest payments on your loan.
The biggest revenue source is rental income, however there are numerous other ways for a large multi-family property to generate income such as pet fees, covered/reserved parking, utility reimbursements, etc.
Expenses will include payroll, vacancy, maintenance, property management fees, insurance, property taxes, etc.
Take all the revenue, subtract all the expenses, and that gets you to NOI.
Why should you care?
The answer is two-fold:
1) If you’re going to invest with us, we want to make sure you’re educated and understand how real estate investing works. It’s our favorite part about this business.
2) NOI is one of the two main components in determining value
As we’ve written about before, commercial real estate’s value equation is:
Value = NOI / Cap Rate
Therefore, if we can increase NOI, our value goes up. This should be every real estate operator's main goal, finding ways to increase NOI which will ultimately increase the value.
It’s worth noting that if cap rates increase in the market, then the value of our asset will go down if we don’t find ways to increase NOI. We always underwrite to a higher cap rate on the projected exit, as we’re assuming the economy and sub-market will be worse in say 5 years than it is today. It’s another conservative approach we take on the underwriting side.
On the flip side, if cap rates compress in a market, you can literally do nothing to improve the property and you’ll make money.
We can’t control cap rates, but we can control NOI. If we continue to buy in good areas with job and population growth, job diversification, projected rental growth, and implement a value add strategy, then we feel confident about how our investments will perform as we have a proven model for increasing the asset’s value.