What Is NOI in Real Estate and Why Does It Matter?
Net Operating Income (NOI) is one of the most influential metrics for determining the value of commercial real estate. Indeed, for commercial and multi-family real estate, you will need to know the NOI before considering a valuation (this differs from single-family homes, which derive their value from their area (comps), condition, and physical features). What is NOI in real estate, and why does this metric matter? Let’s find out!
What Is NOI in Real Estate (Net Operating Income)?
The NOI in real estate has a straightforward formula:
Net Operating Income (NOI) = Revenue – Expenses
To better understand this number, let’s first look at these terms.
Revenue encompasses all the money that your commercial real estate building makes. For most commercial buildings, their primary source of income comes from tenants – companies that rent or lease office space, apartment units, store space, restaurant space, etc. Some facilities have other revenue sources, like advertising or parking income. If it’s money coming into the building through the day-to-day operations, it counts as revenue!
While revenue has a straightforward definition, the “expenses” term is slightly trickier. As the “net operating income” name implies, this is the net income from operating the building. Therefore, the expenses term does not encompass all expenses but rather the ones necessary to run the structure.
Expenses like electricity, water, routine building maintenance, salaries, advertising, etc., all count as operating expenses. However, costs that fall under capital expenditures or debt servicing do not count. The interest your company pays on its line of credit is not an operating expense.
Therefore, you’ll want to discard all non-operating expenses from the equation above.
Why Is This Simple Equation So Essential?
When determining how much a commercial building should be worth, one question comes to an investor’s mind: how much money will it make for me?
Commercial real estate’s value is the amount of money it can bring both active and passive real estate investors. Intuitively, a property that can only bring in $1 million annually is less valuable than a property that brings in $10 million.
Net Operating Income is the only metric that can objectively compare earning potential and thus provide a baseline for valuation.
Recall that debt servicing costs and capital expenditures are not part of the expense side of the equation. These are intentionally left out because they are subjective. In our example above, an investor group that could buy the commercial property with no debt would prefer the $10 million yearly income property to the $1 million a year one. However, another group might choose the $1 million property because the debt costs on the $10 million one would eat up all the income.
Therefore, net operating income is the only accurate way to measure profit potential. How much someone will have to pay in capital expenditure costs and interest on debt varies from group to group.
What Are Some Major Sources of Revenue and Expenses?
When looking at net operating income, it’s essential to look at the complete income statement and not just the final NOI number. How a commercial real estate entity earns and spends its money will help your syndication determine potential improvement areas.
There are typically four sources for revenue that you will find on income statements: lease payments, expense reimbursements, vacancies, and a catch-all bucket called “other income.”
Lease payments will be the bulk of the revenue. For commercial real estate, leases are typically a few years long. A “base rent” amount determines how much the tenant will pay per square foot of space annually.
Tenants will also reimburse building expenses for commercial properties. These expenses usually include taxes, water, and electricity, at least. However, some buildings have other reimbursements in place.
Vacancies are not a source of revenue, but some buildings will explicitly call out the lost revenue as a line item on the income statement. For example, consider a building with 100,000 square feet that rents at $10 per square foot. The “Gross Potential Rent” is $1,000,000 (100,000 sq. feet x $10 per square foot = $1,000,000). However, if only 70,000 square feet have a lease, the vacancy rate is 30%. Therefore, the “Net Rental Revenue” is the Gross Potential Rent ($1 million) minus the vacancy amount ($300,000) for the total amount of $700,000. You may see revenue calculated either way, so please double-check their method.
Lastly, there will always be a catch-all bucket for other revenue. Buildings lease parking space, billboards, space on the roof, and more to help increase profits. That all goes into the other income bucket.
Since we are discussing what is NOI and not what is net profit, only operating expenses will show up for this equation.
Operating expenses include but are not limited to:
- Repairs and Maintenance (Routine)
- Sales, Marketing, and other Promotional Materials
- Real Estate Taxes (Property Taxes)
- Business Licensing Fees
- Internet, Electricity, and other Utilities
Anything that you have to pay during the normal operations of the building counts as an operating expense. The above ones are examples, but there are other categories.
What Is NOI in Real Estate: A Simple but Powerful Gauge for Valuation
When looking at a commercial building’s potential value, you’ll want to know its NOI. That will give you a good feeling for what the profit potential of the acquisition would be. It is worth noting that you should not stop at that single number, though. Look into the income and expenses, and, in particular, potential lease expirations and market trends. For example, if one lessor rents out 80% of the building, and that lease is due in a year, that could be a considerable post-acquisition complication.
Like most metrics in real estate, there’s no silver bullet that will tell you with 100% certainty if a deal is worthwhile or not, and NOI is no exception. However, it is an excellent barometer of what a commercial property currently earns (and its earning trends, both in the past and the future). That makes it a wonderful place to start when analyzing a deal’s potential!