The net operating income definition is the total profit generated by a business or real estate development after the necessary operating expenses are taken out. In order to determine the net operating income, an investor needs to subtract the operating expenses for the business from the gross operating income.
This valuation is used by real estate investors to determine the actual income of their properties to figure out the actual profit of a property. NOI is the figure without taxes or operating expenses that are listed on a real estate property’s cash flow and income statements. It excludes capital expenditures, amortization, depreciation, and principal and interest payments on loans. Other industries refer to this measurement as Earnings Before Interest and Taxes (EBIT), but in real estate investments, only NOI is used.
Net operating income = Real Estate Revenue (Gross operating income) - Operating expenses
So if a property could generate a potential rental income of $200,000 but wasn’t filled to capacity and only generated $150,000 (Gross operating income). The property also spent $50,000 in operating expenses that we subtract from the gross operating income of $150,000. This leaves us with $100,000 in net operating income.
As mentioned above, NOI is a way to measure the exact value generated by an income-producing property. It is an evaluation method used by real estate professionals for rental properties, residential or commercial, to determine the profit of those properties. To get to this evaluation method the real estate professional must know the gross operating income and the operating expenses of the property, otherwise, the value will not be correct. It is also important not to miscalculate and add capital expenditures to operating expenses.
NOI is also a way for real estate investors to establish the capitalization rate so that they can evaluate the value of the property. The capitalization rate also provides real estate professionals the means to compare their property or potential investment with other properties, either to see who is the better investor or look for other investments.
In case an investor considers taking out a loan to purchase a property, the NOI will help them calculate the Debt Coverage Ratio (DCR). The DCR will tell them if the income of a certain property will cover not only the operating expenses but also the debt payments.
Other evaluations that NOI can help with are Cash Return on Investment, Net Income Multiplier, and Total Return on Investment.