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Resources - Financial Terms

Net Operating Income

Net Operating Income (NOI) is equal to a property's yearly gross income less operating expenses. Gross income includes both rental income and other income such as parking fees, laundry and vending receipts, etc.

Operating expenses are costs incurred during the operation and maintenance of a property. They include repairs and maintenance, insurance, management fees, utilities, supplies, property taxes, etc. The following are not operating expenses: principal and interest, capital expenditures, depreciation, income taxes, and amortization of loan points.

Net operating income is calculated as follows.

Gross Rents Possible $100,000
Other Income $1,000
Potential Gross Income $101,000
Less Vacancy Amount $5,000
Effective Gross Income $96,000
Less Operating Expenses $70,000
Net Operating Income $26,000

Net operating income or NOI is used in two very important real estate ratios. It is an essential ingredient in the Capitalization Rate (Cap Rate) calculation that is used to estimate the value of income producing properties. A market cap rate is calculated by evaluating the financial data from current sales of similar income producing properties in a given market place. Assuming a market capitalization rate of 10 for a property. Evaluating a similar income property that is currently for sale with a net operating income of $50,000.

Net Operating Income $50,000
Capitalization Rate .10
Estimated Value= 50,000 x .10 = 500,000

Another important ratio that is used to evaluate income producing properties is the Debt Coverage Ratio or DCR. Lenders and investors use the debt coverage ratio to measure a property's ability to pay its operating expenses and mortgage payments. A debt coverage ratio of 1 is break even. Most lenders require a minimum of 1.1 to 1.3 to be considered for a commercial loan. From a bank's perspective and an investor's perspective, the larger the debt coverage ratio the better.

Debt coverage ratio is calculated like this.

Net Operating Income 50,000
: Debt Service 40,000
Debt Coverage Ratio = 40,000/50,000 = 1.25

Debt service is the total of all interest and principal paid in a given year. It is equal to the mortgage payment times 12 or the mortgage payments times 12 if you have multiple loans on a property.

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