Net Operating Income (NOI)

Net operating income (NOI) is a critical metric in financial analysis of real estate investment. It is a measure of a property's profitability before debt service and taxes are taken into account. In this article, we will explore the concept of net operating income and why it's an important mentric for real estate investors.

Introduction to Net Operating Income

Net operating income is calculated in a similar way to cash flow, but it will typically excludes non-operating expenses such as debt service (i.e. principal payments), interest and taxes. There are good reasons for excluding particular non-operating expenses from the calculation of NOI. Not including variables that may change from investor to investor helps to compare properties on a more even playing field.

Why is Net Operating Income Important When Analyzing Real Estate Investments?

Here's an example of why it's important to exclude non-operating expenses from the calculation of NOI: If two investors own similar properties, one investor has a much better credit history and rating than the other, the higher risk investor will likely have a higher interest rate on their debt. Even with identical properties initial down payents, the investor with the higher interest rate will have a higher debt service payment, and thus a lower NOI.

So, the formula for the calculation of Net Operating Income (NOI) is:

NOI = Gross Operating Income - Operating Expenses

In the example above, the two different properties would have the same NOI, but different cash flows. Here's a theoretical breakdown of the numbers to illustrate how NOI isolates the variable interest rate between two investors in order to compare the properties more equally:

Property A (Lower Interest Rate and Bigger Down-Payment)

Property A (Lower Interest Rate)
Operating Expenses: $10,000
Gross Operating Income: $100,000
NOI: $90,000
Debt Service: $60,000
Cash Flow = NOI of $90,000 - Debt Service of $60,000 = Cash Flow of $30,000

Property B (Higher Interest Rate and Smaller Down-Payment)

Property B (Higher Interest Rate)
Operating Expenses: $10,000
Gross Operating Income: $100,000
NOI: $90,000
Debt Service: $70,000
Cash Flow = NOI of $90,000 - Debt Service of $70,000 = Cash Flow of $20,000

As you can see from the numbers above, property A and property B have the same NOI, but property B with its higher interest rate has a lower cash flow because its debt service is $10,000 higher per year.

Why Taxes are Excluded from NOI

Taxes are excluded from NOI because they are not considered an operating expense. Taxes are a function of the property's value and are not directly related to the property's operations. Additionaly, taxes may vary from one location to another, making it difficult to compare properties across different locations. By excluding taxes from NOI, investors can focus on the property's operating performance and compare properties on a more even playing field. Granted, taxes are a significant expense for real estate investors, but they are not directly related to the property's operations.

Why Might You Want to Exclude Prinicipal Payments from NOI?

Principal payments are not included in NOI because they are not considered an operating expense. Principal payments are a function of the loan amount and are not directly related to the property's operations. Additionally, principal payments may vary from one loan to another, making it difficult to compare properties across different loans due to amortization schedules (where more interest is charged up-front and less interest is charged as the loan gets closer to being paid off - some people refer to this as "front loading" the interest on a loan). Another consideration is that given the same property value, one property may have been purchased with loan leverage, but with a much bigger down-payment, thus making the principal and interest on the loan substantially different between two equally valued properties. By excluding principal payments from NOI, investors can focus on the property's operating performance and compare properties equally.

Conclusion

Although cash flow is an important figure to consider when analyzing a real estate investment, it's important to understand that NOI is a more accurate measure of a property's profitability. By excluding non-operating expenses, NOI allows investors to compare properties on a more even playing field, making it a critical metric for real estate investors. The bottom line is that among three different investors, any given property might have different cash flows, but the NOI should be virtually the same.