Net operating income is gross potential rent taken down through five deductions and seven expense lines, and the lines it leaves out matter as much as the ones it keeps.
Net operating income is effective gross income less operating expenses: rent at full occupancy, less loss to lease, vacancy, concessions and bad debt, plus recoveries and other income, less the costs of running the building. Capital expenditure, leasing costs and debt service are not deducted. On an illustrative 120,000 square foot multi-tenant property, $5,244,000 of effective gross income less $1,797,320 of operating expenses gives NOI of $3,446,680, worth $55,146,880 at a 6.25 per cent cap rate.
Worked in full in Real Estate Fund Management by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
NOI is the number every other number in real estate is built on: value through the cap rate, loan size through the debt yield and DSCR, and the asset manager's budget. The definition is simple; the discipline is in which lines go above it and which below, because each dollar in the wrong place is worth sixteen dollars of value at a 6.25 per cent cap.
| Line | Assumption | $ |
|---|---|---|
| Gross potential rent (GPR), all space at market | 4,800,000 | |
| Loss to lease (in-place rents below market) | 3% of GPR | −144,000 |
| Vacancy | 7% of GPR | −336,000 |
| Concessions and free rent | 1% of GPR | −48,000 |
| Credit loss | 1% of GPR | −48,000 |
| Net rental income | 4,224,000 | |
| Expense recoveries from tenants | 900,000 | |
| Parking and other income | 120,000 | |
| Effective gross income (EGI) | 5,244,000 |
EGI = GPR − loss to lease − vacancy − concessions − credit loss + recoveries + other income
NOI = EGI − operating expenses
Value = NOI ÷ cap rate
In Excel, with the management fee as a percentage of EGI: =EGI-SUM(Fixed_Opex)-Mgmt_Pct*EGI.
| Line | $ |
|---|---|
| Effective gross income | 5,244,000 |
| Real estate taxes | −620,000 |
| Insurance | −140,000 |
| Utilities (common areas and vacant space) | −310,000 |
| Repairs and maintenance | −260,000 |
| On-site payroll | −220,000 |
| General and administrative | −90,000 |
| Management fee, 3% of EGI | −157,320 |
| Total operating expenses | −1,797,320 |
| Net operating income | 3,446,680 |
NOI is 65.7 per cent of EGI, an operating expense ratio of 34.3 per cent, and $28.72 per square foot. At a 6.25 per cent cap rate it supports a value of 3,446,680 ÷ 6.25% = $55,146,880.
| Line | $ |
|---|---|
| Net operating income | 3,446,680 |
| Replacement reserves ($0.25 per sq ft) | −30,000 |
| Tenant improvements and leasing commissions | −280,000 |
| Capital expenditure | −150,000 |
| Cash flow before debt service | 2,986,680 |
| Debt service | −1,900,000 |
| Cash flow after debt service | 1,086,680 |
These are real costs, and a cap rate quoted on NOI already assumes the buyer will pay them out of the yield. That is why DSCR on NOI here is 1.81x but only 1.57x on cash flow after the $460,000 of capital items. Depreciation and the owner's income taxes never appear at all: they belong to the owner, not the building.
Recoveries are income, not a reduction of expenses. On net or partly net leases, tenants reimburse a share of taxes, insurance and common-area costs. Show the full expense and the recovery separately. Netting them hides the fact that recoveries fall with occupancy while most of the costs do not.
| Vacancy | EGI | NOI | Value | Change in NOI |
|---|---|---|---|---|
| 5% | 5,359,355 | 3,558,574 | 56,937,187 | +3.2% |
| 7% | 5,244,000 | 3,446,680 | 55,146,880 | 0.0% |
| 10% | 5,070,968 | 3,278,839 | 52,461,419 | −4.9% |
| 15% | 4,782,581 | 2,999,103 | 47,985,652 | −13.0% |
Because most expenses are fixed, NOI moves faster than income: eight extra points of vacancy, from 7 to 15 per cent, take 8.8 per cent off EGI and 13.0 per cent off NOI. With that much operating leverage, the vacancy line should be read as income lost, not space empty: the four deductions above add up to the gap between physical and economic occupancy, and it is the economic figure that drives NOI.
The same discipline applies to the vacancy line. Underwrite it from the market's long-run vacancy and the rollover schedule, not from today's rent roll: a building that is full today still loses income when leases expire and space sits empty between tenants. A stabilised NOI that assumes no vacancy at all is not stabilised, it is a best case, and capitalising it at a market cap rate overstates value by the full amount of the missing deduction. Credit loss deserves the same treatment for a tenant base of smaller occupiers.
A seller's trailing NOI also needs testing line by line before it is capitalised; going from T-12 to underwritten NOI shows how far that can move it.
Start at gross potential rent, take off loss to lease, vacancy, concessions and credit loss, add recoveries and other income, and deduct every cost of operating the building, management included, but nothing capital and nothing financial. Here that is $3,446,680 of NOI and $55,146,880 of value at 6.25 per cent. The free workbooks for this book build the budget from the rent roll up and take a trailing statement through the underwriting tests.
No. NOI stops at operating expenses. Capex, tenant improvements, leasing commissions, reserves and debt service are deducted below it. In the illustrative case NOI is $3,446,680; after $460,000 of below-the-line items, cash flow before debt service is $2,986,680, and after $1,900,000 of debt service $1,086,680 is left for equity.
Yes, even if the owner manages the building itself, because a buyer would have to pay for management. Leaving out a 3 per cent fee here adds $157,320 to NOI, which at a 6.25 per cent cap rate overstates value by $2,517,120, or 4.6 per cent.
It varies widely with the lease structure: net leases pass most costs to tenants and run high margins, gross leases and hotels much lower. The illustrative multi-tenant building converts 65.7 per cent of effective gross income into NOI, an operating expense ratio of 34.3 per cent. Compare margins only between buildings with the same recovery terms.
This article is one calculation from Real Estate Fund Management. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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