Net operating income
Net operating income is what a property earns after operating costs and before financing. It is the foundation of cap rate, of the income approach, and of almost every valuation of income property.
It is also the most commonly overstated number in real estate.
The build-up#
Start with gross scheduled rent — what the property would collect fully occupied.
Subtract vacancy and credit loss. On $36,000 of gross rent at 7 percent, that is $2,520, giving effective gross income of $33,480.
Subtract operating expenses:
| Property taxes | 4,200 |
| Insurance | 1,400 |
| Maintenance | 2,400 |
| Management at 8% of EGI | 2,678 |
| Utilities paid by owner | 900 |
| Capital reserves | 1,800 |
| Total | 13,378 |
NOI = $33,480 − $13,378 = $20,102.
Note where that lands against the $36,000 gross. Roughly 44 percent of gross rent went to vacancy and expenses, and nothing has been paid to a lender yet.
What does not belong in it#
Debt service. NOI is pre-financing by definition.
Depreciation, which is a tax concept rather than a cash cost.
Income taxes.
Capital improvements, which sit outside operating expenses — though the reserve that funds them belongs in.
The four omissions that inflate it#
Every one of these appears routinely in seller pro formas.
Vacancy at zero. No property is fully occupied indefinitely.
No management allowance, because the owner does it themselves. The work has a cost whether or not it is invoiced, and it will have a cost to whoever buys next.
No capital reserve. Roofs, furnaces and water heaters fail on schedules that do not respect a single year's accounts. Excluding the reserve makes a property look profitable right up until the roof.
Current property taxes. A sale can trigger reassessment. Using the seller's tax figure on a property that has not been reassessed in years understates the buyer's actual expense.
Why the errors compound#
NOI is divided by a cap rate to produce value, so an error in NOI is multiplied.
At an 8 percent cap, every $1,000 of overstated NOI overstates the property by $12,500. The four omissions above easily total several thousand dollars a year on a modest rental, which is tens of thousands of dollars of imaginary value.
Rebuild NOI from actual collections and actual expenses, not from the schedule. Our cap rate calculator works from an NOI you supply, which puts the burden exactly where it belongs.