What is net operating income (NOI) in commercial real estate?

Net operating income (NOI) is a driving factor in determining the value of commercial real estate. It measures what a property earns from its operations after operating expenses, but before debt service, capital expenditures, income taxes, and depreciation are taken out. Because those excluded costs vary by owner rather than by property, NOI gives buyers, lenders, and appraisers a common basis for comparing one commercial asset against another.

How to calculate net operating income

Net operating income is calculated by subtracting a property's annual operating expenses from its annual operating revenue. Operating revenue includes base rent, tenant expense reimbursements, and other income such as parking or storage. Operating expenses include property taxes, insurance, utilities, repairs, management, and payroll. Mortgage payments, capital expenditures, depreciation, and income taxes are excluded.

The following formula determines the NOI of a property: Net operating income = Revenue - Expenses

The example uses round figures for clarity. In practice each line is built from the rent roll and the trailing twelve months of operating statements, then normalized for any item that is unusual for the asset or the market.

What net operating income does not include

NOI excludes four categories of cost: debt service, capital expenditures, depreciation and amortization, and income taxes. Leasing commissions and tenant improvement allowances are usually held outside it as well. Each of these depends on how an individual owner finances, maintains, and structures the asset rather than on how the property itself performs in its market.

This is what separates NOI from profit. Two investors can buy the same building on the same day, and one may carry a 70 percent loan while the other pays cash. Their returns will look nothing alike, but the building produces one NOI. The exclusions are not an accounting technicality. They are what makes the figure portable between owners, and portable between a buyer, a lender, and an appraiser all looking at the same asset.

Why is net operating income so important?

NOI is the industry standard input for commercial property valuation because it isolates market driven performance from owner specific decisions. Occupancy and lease rates are largely set by the market, as is the cost of operating a building in a given submarket. Leverage and reinvestment are set by the owner. Valuing on NOI means two buildings with identical operations receive comparable valuations regardless of how their owners finance them.

The majority of this paper will discuss the two main components of NOI, revenue and expenses. Before we get there, however, it's important to discuss one thing that often trips up those who are new to real estate analysis and valuation. In the table above, below NOI, there are line items for capital Expenditures (CapEx) and Debt Service (DS).

When these items are subtracted from NOI, you're left with the Net Cash Flow (NCF) of a property. The NCF represents the actual cash flow to an investor after any large improvements are paid for and after the mortgage payment is made each month/year. So why don't we use the NCF for the valuation of a property if that's what represents the money an investor ultimately receives from the property?

The simple answer is that the NOI is an objective number that represents the “market-based” operation of the property, meaning the market largely determines the occupancy rate and lease rate that determines the revenue and the amount of expenses a property incurs.

The capital expenditures and debt service, however, are more subjective and relative to individual owners of a property. For example, one owner may feel that low leverage (a lower loan amount) is better for their investment criteria than another, more risk-tolerant, investor. Thus, the debt service payments will likely be lower, and ultimately the NCF will be higher, for each investor even though the operation of the property results in the same NOI.

The same holds with the capital expenditures. If one investor chooses to invest more into renovation and upkeep than another, the NCF would be lower and the valuation would be lower if we were to use NCF for valuation. This doesn't seem fair to have a property that was better maintained valued lower than one that was not.

So, the industry standard is to use the NOI for the valuation of a property. It removes much of the subjectivity and differences in investor profile in the valuation of a property.

What are the major components of net operating income

NOI has two determinants: operating revenue and operating expenses. Revenue for a commercial property comes mainly from base rent, expense reimbursements from tenants, and smaller other income lines. Expenses cover property taxes, insurance, utilities, administration, repairs and maintenance, marketing, management, and payroll. Vacancy reduces revenue and is presented two different ways depending on the format of the operating statement.

Now we’ll dive into the two main determinants of NOI, the revenue and expenses for a property

Revenue

Revenue is made up of all payments that tenants or customers make to the owner of the property. It often consists of lease payments, reimbursements for expenses, and other income. Each property type (office, retail, multifamily, etc.) each have their own distinct sources of “other income”, which we’ll discuss only briefly in this paper because this item usually represents a small portion of the revenue for most properties.

Although there are many potential sources of revenue, we’ll only discuss a few of the major sources in this paper.

Lease payments

Lease payments are the major source of revenue for most properties. For office, retail, and industrial properties, leases are typically five to ten years in length and include a “base rent” amount that determines how much the tenant pays per square foot of space per year. For multi-family properties, tenants pay a specified amount in rent each month.

Because rent is the largest single input to NOI, a detailed lease analysis of the rent roll is normally the first step in underwriting a commercial asset.

Expense reimbursements

Expense reimbursements are also typically seen only with office, retail, and industrial properties. Tenants will reimburse the owner for either all or some of the expenses incurred during the operation of the property.

These expenses could include real estate taxes, electricity, water, and potentially other services as well.

Other income

Other income as mentioned above, usually represents a very small portion of the revenue of a property. For multifamily properties, other income could include laundry, furniture rental, or a membership to the fitness center on the property.

With office, retail, and industrial buildings, other income could include parking, rental of space on the roof of the building for communications equipment, or cleaning services.

Retail properties can also carry percentage rent, where the tenant pays a share of sales above an agreed threshold. That portion of revenue moves with tenant performance rather than with the lease term, which makes it more volatile inside an NOI figure.

Vacancies

Although vacancy is not a source of revenue, any empty space not receiving lease payments will reduce the amount of revenue an owner could potentially receive for the property. We’re only mentioning it here because vacancies are sometimes represented in two different ways that you should be aware of in case you come across them.

Some real estate professionals include something called “Gross Potential Rent” and then subtract lost revenue from vacant space to get to “Net Rental Revenue,” while other professionals simply use the amount of revenue that was actually received. The Gross Potential Rent and Vacancy approach is the more formal method, but you should always check to be sure which method was used.

Method 1: Including vacancy loss

Method 2: Using revenue received

Operating expenses

Operating expenses for commercial real estate properties are a little more straightforward than revenue. Typical expense items for properties are listed below.

• Real estate taxes

• Insurance

• Utilities

• Administrative

• Repairs and maintenance

• Sales and marketing

• Management

• Payroll

For larger properties, there could be many more types of expense and even subcategories of expenses within each main category. A detailed discussion of expenses is beyond the scope of this paper, but you should be aware that each property should be carefully analyzed for all expenses that might be incurred by an owner.

Real estate taxes are often among the largest expense lines in a US commercial property, and an over assessment flows straight through to a lower NOI. It is worth confirming the assessment before an NOI figure is treated as settled.

Analysis of net operating income

Now that we’ve established a basic understanding of what NOI is, why it’s important, and the main components that are used to determine the NOI, we can look more deeply at analyzing each of these factors to help determine both short-term and long-term potential value of a property.

How net operating income impacts valuation and return

NOI converts to property value through capitalization. Dividing a property's stabilized NOI by a market capitalization rate produces an estimate of value, which means a change in NOI moves value by a multiple of that change. At a 6 percent cap rate, each additional dollar of annual NOI adds roughly $16.70 of value, and each dollar lost removes the same.

Now that we've established a basic understanding of what NOI is, why it's important, and the main components that are used to determine the NOI, we can look more deeply at analyzing each of these factors to help determine both short-term and long-term potential value of a property.

Earlier, we mentioned that Net Cash Flow (NCF) is the ultimate cash flow to the investor, whereas NOI is the income before capital expenditures and debt service is deducted. While this is the case, the return that an investor receives is much more dependent on the amount of revenue the property generates rather than the optimization of expenses and debt service.

For example, if rental revenue drops by 50% because of the loss of a major tenant, it’s unlikely that NOI or NCF will be positive, despite some small reductions in expenses that can be achieved.

Likewise, if one sees decreasing rental rates and/or occupancy rates in the market, an owner may experience a gradual drop in NOI and NCF over time, which will slowly erode both the cash flow and the long-term value of the property. Therefore, it’s important to analyze a few factors that will affect the performance of the property over the hold period.

How NOI converts to property value

The direct capitalization approach divides stabilized NOI by a market cap rate to arrive at value: Value = NOI ÷ Cap Rate. Using the figures above, a property producing $600,000 of NOI in a market trading at a 6 percent cap rate is worth roughly $10 million. The same property in a market that has repriced to 7.5 percent is worth $8 million on an unchanged NOI. That is a fifth of the value gone without a single tenant leaving, which is why cap rate movement matters as much as operating performance in any given year.

Direct capitalization is one of several commercial real estate valuation methods, and it works best for stabilized assets with predictable income. It becomes less dependable when cap rates diverge between otherwise similar properties, which has been the pattern in multifamily as rate expectations, insurance costs, and concessions moved independently of one another. Our breakdown of DCF versus direct capitalization sets out where the single year snapshot stops holding up.

Where income is uneven, where major leases roll inside the hold period, or where a repositioning is planned, a discounted cash flow analysis models each year separately instead of capitalizing a single figure.

Lease expirations

When analyzing the rent roll for a property, you should look for any lease expirations. Multifamily property leases are generally for a one-year term, so this isn’t a significant factor.

However, almost every commercial property (office, retail, industrial) will have leases that expire over a five- or ten-year hold period, but an analyst should pay careful attention to any major tenant expiration or any concentrated rollover (meaning multiple tenants with lease expiration at roughly the same time).

Losing a major tenant or multiple tenants at once could have a major negative impact on the NOI of the property, thus the owner’s ability to cover expenses and debt service. Commercial real estate asset management software such as ARGUS Asset Manager ties lease expirations and renewals directly to NOI, so asset managers can see how an upcoming expiry would change income before the lease rolls.

Market trends

The other major factor an analyst should be aware of is the larger direction of the real estate market as it relates to the subject property. If an investor is targeting a ten-year hold period in a market where rental rates and/or occupancy rates are declining (and expected to continue to decline), revenue and NOI will likely be slowly eroded over the hold period and could significantly decrease the value of the property and the overall return the investor achieves.

What NOI tells you about long-term property value

In this article we’ve discussed the components of the NOI of properties and looked at some factors that impact NOI. We’ve also looked at the way NOI affects both the value of a property and the long-term return an investor could achieve.

Every property is different and will have a unique set of tenants, income, and expenses. Over time, real estate professionals gain a better intuition of what factors are important for each property and a better understanding of the long-term consequences of changes to the NOI.

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