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Commercial Mortgage 101: Net Operating Income

Overview

Investors don’t usually decide to buy properties based on “curb appeal” or aesthetics—more likely, they buy the income stream from the property. Commercial real estate value is based on numbers and ratios, and the most important number to know is the net operating income for a property. The net operating income (NOI) is the single most important number used to determine value and financing options.

Definition

Net operating income is the gross income minus vacancy loss and operating expenses. It is not to be confused with cash flow (unless there is no debt on a property), since debt service is not considered part of operating expenses. In the same way, capital improvements are not considered an operating expense, nor is depreciation considered an operating expense (depreciation is considered a non-cash deductible expense and plays a role in determining taxable income—more on that later).

  • A simple way to calculate NOI is to use the following formula:

    Scheduled Gross Income + Other Income (Laundry, Garage, etc.)

    Less: Vacancy Factor = Effective Gross Income

    Less: Operating Expenses = Net Operating Income

    A quick rule-of-thumb that lenders and appraisers use to determine NOI for apartment properties in Southern California is to use a 5% vacancy factor and 35% operating expense ratio. The operating expense ratio is derived from the Effective Gross Income.

  • For example, let’s say an apartment property has an annual scheduled gross income of $100,000 andno other income. Using the rule-of-thumb outlined above:

    Schedule Gross Income $100,000
    Less: Vacancy @ 5% -5,000
    = Effective Gross income (EGI) $95,000
    Less: Operating Expenses @ 35% of EGI -$33,250
    = Net Operating Income (NOI) $61,750