Net operating income (i.e., NOI) is one of the most important calculations made in regard to any real estate investment because it represents the property's potential income after all vacancy and operating expenses have been subtracted. In other words, net operating income represents the investment property's productivity, or measure of cash flow.

To help plant the idea, consider net operating income in one of the following two ways, depending on whether or not a mortgage exists.

The investor pays all cash for the property. In this case, since the investment property has no debt, NOI virtually becomes the rate of return expected from a property for any given annual period before taxes and depreciation are considered. In other words, given no deduction for debt service (loan payment), you can regard net operating income as the annual cash flow (cash flow before taxes, or CFBT).

The investor finances the property. Here, since the property has a mortgage, NOI should be regarded as the anticipated amount of cash flow available to pay the mortgage. In this case, only the remainder of NOI (net operating income less annual loan payment) becomes the annual cash flow before taxes (or CFBT).

How to Calculate Gross Scheduled Income Less Vacancy and Credit Loss = Gross Operating Income Less Operating Expenses* = Net Operating Income

Example: Assume that you want to do an analysis on an income property that generates a GOI of $100,000 with Operating Expenses of $42,000. What is the NOI?

$100,000 Less $42,000 = $58,000

*Mortgage payments, depreciation, and capital expenditures are not considered operating expenses and therefore have no impact on net operating income.

It's Role in Real Estate Investing

Net operating income plays a large role in a variety of real estate investment and holding period decisions. For instance, capitalization rate (cap rate) is calculated by dividing NOI by sale price. Likewise, property value (or the property's sale price) is calculated by dividing NOI by the cap rate.

Example: Let's continue to assume a net operating income of $58,000 (as in our example above) and a sale price of $580,000. What is the property's capitalization rate?

Net Operating Income Divided by Sale Price = Cap Rate

$58,000 Divided by $580,000 = 10.0%

Okay, now let's assume an NOI of $58,000 of and a cap rate of 8.0%. What is the property value?

Net Operating Income Divided by Cap Rate = Property Value

$58,000 Divided by 10.0% = $580,000

Net operating income also plays a large role with lenders. For example, Debt Coverage Ratio (DCR) is calculated by dividing the net operating income by loan payment.

Net Operating Income Divided by Annual Loan Payment = Debt Coverage Ratio

$58,000 Divided by $46,000 = 1.26

How Credible Is It?

Conceptually, NOI is important because of its use in numerous calculations surrounding property performance. Because it's used to estimate property value and cap rate, as well as useful to lenders, NOI has become an essential component of real estate investment analysis. As a real estate investor, therefore, you should understand net operating income, and recognize what it means to your potential investment valuation.

But be careful.

Remember, NOI is not unlike other calculations typically used for real estate investing purposes. The result is only as good as the numbers are credible, and numbers can be manipulated. Sellers have sometimes been known to become very creative in order to make the relationship between the price and NOI to come out right.

So here's a tip. Whether or not a property appears to have a favorable NOI with positive rates of return, don't just accept the numbers. Spend the time to validate the numbers. Reconstruct the owner's representations for income and operating expenses if necessary, and compute your own NOI. Whatever you do, rely on nothing less then the most credible net operating income possible. You can't afford not to.