Understanding the Importance of Net Operating Income (NOI)

net operating income tutorialNet operating income (NOI) is one of the most important calculations you will ever make for a real estate investment. Therefore it makes sense that it should be understood by real estate investors and agents engaged in real estate investing.

Nonetheless, NOI is seldom understood by either investors or agents, though it routinely appears in every real estate analysis conducted for any rental income property and always impacts the bottom line.

In this article we’ll take a look at net operating income. Hopefully you’ll get an idea what it is and perhaps understand why it plays such a significant role in the evaluation of real estate investment property.

What is NOI?

NOI is a measure of a rental property’s net income from all sources before allocations for debt service or tax (payments or savings) are calculated.

In other words, it’s sum of money remaining after the operating expenses have been deducted from all the property’s rental income. Or, simply put, all income less all expenses required to ensure the property’s continued ability to produce income (i.e., not loan payments, depreciation, and capital expenditures).

Mathematically, it is a property’s gross operating income less the sum of all operating expenses.

Gross Scheduled Income
– Vacancy and Credit Loss
= Gross Operating Income
– Operating Expenses
= Net Operating Income

Significance of NOI

Real estate investors and lenders are primarily interested in a rental property’s NOI because it represents the amount of cash flow (or funds available) to pay the mortgage.

As a result, NOI impacts rental property market values, financing considerations, and a variety of real estate investment and holding period decisions.

Let’s break it down.

Market Value

One of the most popular methods for establishing rental property market value is capitalization rate – which in turn is computed with net operating income.

NOI / Sale Price = Capitalization Rate

Conversely, by using cap rate, an investor or appraiser establishes a fair market value for any specific rental property by applying the average cap rate other similar rental properties have recently sold in the local market area to the property’s NOI.

NOI / Capitalization Rate = Market Value

For example, if a particular rental property generates a NOI of $62,000 and similar other properties have been selling for an average cap rate of 10% you would be presume that the subject property is worth about $620,000 (62,000 / 0.10).

Financing Consideration

Lenders, of course, are interested in the net operating income produced by a property because they want to know whether the property generates sufficient cash flow to cover the debt service. As a result, they use it to compute what is called Debt Coverage Ratio (or DCR) to base their financing consideration.

NOI / Annual Loan Payment = Debt Coverage Ratio

For example, if a real estate investor is attempting to finance a rental property that generates an NOI of $60,000 with a loan resulting in an annual loan payment of $60,000, than the debt coverage ratio would be 1.0 (60,000 / 60,000); thereby telling the lender that the NOI is exactly equal to the loan payment with no room to spare.

Normally lenders would require nothing less then 1.00, but typically require a more aggressive DCR in the range of about 1.20 because this would reveal that the net operating income exceeds the loan payment ratio by 20%. In other words, that the rental property produces enough cash flow to service the loan payment with money to spare.

Naturally, this requirement may vary between lenders, but you get the idea. Lenders always want a rental property to produce sufficient net operating income to amply reduce the risk that it may not cover the mortgage payment.

Where NOI Appears

Any number of reports in a real estate analysis simplify the computation of NOI depending on the which real estate investing software solution you are using. But it is quite common to use an annual property operating data (APOD) because it includes the rental income data and most common line-item expenses.