A business could have sales for 10 million dollars a year and be in poor shape financially. We need to know the revenue and cost of running the business to figure out a net profit before taxes.
Gross operating income
Operating expenses (negative)
Potential rental income
Vacancy and credit losses
Effective rental income
Net operating income
Simple NOI Calculation
All is so simple….. well you still have to know that NOI ( Net Operating Income) only includes operating expenses. It does not include NOI principal and interest payments on loans, loan amortization, capital expenditures and depreciation.
Operating expenses are the day-to-day expenses necessary to maintain the property. Operating expenses are deducted at the time when they occur.
Capital expenses are improvements or expenses that will extend the useful life of the property. Capital expenses are for example improvement deducted over the expected life of the improvement. Operating expenses have a direct impact on the NOI, Capital expenses or Capex will have an indirect impact. You will have to save money or get a loan to face capital expenses.
Example of Capital Expenses:
A new roof, new AC and Heat system, parking lot paving
Major plumbing or electrical work
Capital Expenses are not considered when computing NOI but you have to keep them in the accounting anyway. If you are buying a commercial property and you are happy because you are expecting an 8% Cap Rate you will not be too happy to know that the property needs a new roof, new AC unit, or needs total remodeling because it is outdated. These expenses will wipe out your earnings for a while. so you can go from a theoretical 8% to a negative return.
Another use of NOI is ( mostly used in commercial ) trend analysis. Did the property NOI go up or down in recent years? A decreasing NOI usually is not a good sign.
If you run a real estate business and are looking to buy a new investment property, you will normally carefully examine the properties’ due diligence documents including all financials, including the income statements, for items such as NOI. In this way, you have a way of evaluating the property and formulating a bid.