Net operating income, or NOI, is a critical metric used by commercial real estate (CRE) investors. It is calculated by deducting a property’s operating expenses from its potential rental income.
These expenses include utilities not passed on to tenants, property management fees, and property taxes. However, mortgage payments of principal and interest are not considered an operating expense.
In this blog, we’ll delve into the intricacies of NOI, exploring its calculation, components, and its significance in evaluating a property’s financial performance. We’ll also touch upon unique income sources in commercial real estate, the importance of understanding operating expenses, and how financing decisions are influenced by NOI.
Understanding Net Operating Income (NOI)
Calculation of NOI
At its core, NOI is determined by subtracting a property’s operating expenses from its potential rental income. The formula is straightforward:
NOI=Potential Rental Income−Operating ExpensesNOI=Potential Rental Income−Operating Expenses
Operating expenses encompass various costs, such as utilities not billed to tenants, property management fees, and property taxes. Notably, mortgage payments (both principal and interest) are excluded from operating expenses.
Components of Operating Expenses
To gain a comprehensive understanding of NOI, it’s essential to recognize the components of operating expenses. These include:
- Building and Grounds Maintenance: Costs associated with the upkeep of the property’s physical structure and surrounding areas.
- Janitorial Services: Expenses related to cleaning and maintenance services.
- Insurance: The cost of insuring the property against various risks.
- Utilities: Expenditure on essential services like water, electricity, and gas.
- Property Management: Fees for professional management services.
- Legal Fees: Costs incurred for legal services, if required.
Importantly, certain items are excluded from the NOI calculation, such as debt service, mortgage amortization, and depreciation. This exclusion enables a more accurate evaluation of a property’s performance independent of capital structure and financing costs.
The Role of Rental Income
Rental income serves as the primary revenue stream for commercial properties. It includes not only the actual rent paid by tenants but also additional sources like parking fees, security deposits, and service charges. The calculation of NOI involves subtracting operating costs from this revenue.
Other Income Sources
Commercial real estate has unique income sources that distinguish it from residential properties. Professionals at Caliber, for instance, believe in the potential of these non-rental income sources to boost overall revenue. Beyond traditional rental income, commercial real estate offers unique revenue streams. These sources, collectively known as other income, contribute to the property’s overall financial picture. Examples of other income include:
- Parking Fees: Charges for parking spaces.
- Laundry Revenues: Income generated from on-site laundry facilities.
- Vending Machine Profits: Revenue from vending machines on the property.
- Pet Rent: Additional rent charged for tenants with pets.
- Storage Unit Charges: Fees for rented storage units.
These non-rental income sources are integral to the calculation of Gross Potential Income (GPI), representing the total potential cash flow if all units are occupied at market rates. GPI, in turn, influences the determination of NOI.
Operating Expenses: The Heart of NOI
Operating expenses, often abbreviated as OpEx, form the backbone of NOI calculations. These expenses encapsulate the costs associated with running a commercial property. It’s crucial for property owners and investors to understand these expenses thoroughly.
Awareness for Tenants
Tenants should be vigilant about their landlord’s operating expense calculations. Lease agreements should ideally include an operating expense clause that limits expenses to normal out-of-pocket costs. This ensures that tenants aren’t burdened with unjustified increases in maintenance expenses or other costs. For instance, landlords should not recalibrate space measurements to justify higher maintenance expenses.
The Financing Connection
NOI plays a pivotal role in financing decisions related to commercial real estate. Investors and lenders rely on several key metrics, including capitalization rates, debt coverage ratios, and, notably, net operating income.
Evaluating Property Viability
Investors and lenders assess NOI to determine if a property’s income is sufficient to cover its debt and operational expenses. This evaluation is crucial for comparing properties in the market and making informed decisions about acquisitions or leases. Additionally, it helps in determining the appropriate loan amount for a property.
Strategies for Improving NOI
Owners seeking to enhance a property’s NOI have several strategies at their disposal. They can consider raising rental rates, exploring additional revenue streams such as vending machines or laundry facilities, or implementing cost-cutting measures. Hiring a professional management company to handle certain property functions and services can also contribute to improved NOI.
Real-Life Impact: The Numbers
Let’s substantiate the importance of NOI with real-life numbers and examples. Consider a commercial property with a potential rental income of $500,000 annually and operating expenses totaling $150,000. Using the NOI formula:
NOI=$500,000−$150,000=$350,000
In this scenario, the property’s net operating income is $350,000. This figure provides a clear understanding of the property’s financial performance, enabling investors and lenders to make informed decisions.
Conclusion
In the complex landscape of commercial real estate, Net Operating Income emerges as a beacon, guiding investors and lenders through the financial intricacies of properties. Understanding NOI involves grasping its calculation, the significance of rental and other income sources, and the critical role of operating expenses. By demystifying NOI, stakeholders can make informed decisions, ensuring the profitability and sustainability of their commercial real estate investments.