Net Operating Income (NOI) is the driving number behind the valuation of commercial real estate. It's important to understand where that number comes from, how it's used, and the significance that it has over our investments.
Net Operating Income is exactly that -- the net income from operations after all of the operating expenses have been paid.
NOI can be used for a lot of things.
If we take our NOI and we divide it by our purchase price (or value), that gives us our Cap Rate.
NOI can also be used to calculate our Debt Service Coverage Ratio. If we take our NOI divided by our annual debt service, that gives us our Debt Service Coverage Ratio.
Since NOI is what we use to pay our debt service, if we take the NOI minus the debt service, that gives us our Net Cash Flow, which we can use to calculate our Cash-on-Cash Return.
Here are the steps to calculating the NOI on a property:
We need to know what our Scheduled Rents are. Scheduled rents are the rents that would be collected on the property if all spaces or units were completely full 100% of the year. Effectively, it's the rent roll or the lease schedule x 12 months, for the total annual rents.
From there, most of the time, we have an Assumed Vacancy. Vacancy can be variable depending on the market, however, most of the time we must assume that some vacancy is going to happen. The industry standard, for multifamily vacancy or most investment properties, is 5%.
From there, we also get Other Income. Other Income can be laundry income, application fees or credit check fees, late fees, non-sufficient funds, anything that isn't part of the rent roll but it's still income to the property.
And if we tally these, we get our Effective Gross Income. Effective Gross Income, or EGI, is basically our net revenue number.
Next, we need to take out Operating Expenses. Important to note is that operating expenses do not include debt service or payments to the owner. They are expenses that are related strictly to the operation of the property. Operating expenses would include things like real estate taxes, hazard insurance, property management, utilities, repairs and maintenance. Anything that is necessary to operate the property (along with collecting the rents) are considered operating expenses. Those would be our total expenses.
If we take our Effective Gross Income minus our total Operating Expenses, we get our NOI.