Every commercial real estate metric—cap rate, cash-on-cash return, debt coverage ratio—starts with NOI. Net Operating Income is the foundation of real estate analysis. Get it wrong, and every other calculation is wrong too.

What is NOI?

Net Operating Income is the annual income a property generates after operating expenses but before debt service and taxes.

NOI = Gross Operating Income - Operating Expenses

It measures the property's profitability from operations alone, independent of how it's financed.

The NOI Formula in Detail

Step 1: Calculate Gross Potential Income (GPI)

Gross Potential Income is what you'd earn if every unit was rented at full market rate with 100% occupancy.

GPI = Number of Units × Monthly Rent × 12

For a 10-unit building where each unit rents for $1,500/month:

GPI = 10 × $1,500 × 12 = $180,000

Step 2: Subtract Vacancy and Credit Loss

No property runs at 100% occupancy forever. Account for:

• Vacancy: Empty units between tenants
• Credit loss: Tenants who don't pay

Typical assumption: 5-10% of GPI

Effective Gross Income = GPI - Vacancy/Credit Loss

Using 5% vacancy: $180,000 - $9,000 = $171,000 EGI

Step 3: Add Other Income

Properties often generate income beyond rent:

• Parking fees
• Laundry
• Storage
• Pet fees
• Application fees
• Late fees

If other income is $6,000/year:

Gross Operating Income = $171,000 + $6,000 = $177,000

Step 4: Subtract Operating Expenses

Operating expenses include everything required to run the property:

Let's say total operating expenses are $62,000 (35% of GOI).

Step 5: Calculate NOI

NOI = $177,000 - $62,000 = $115,000

This property generates $115,000 in net operating income annually.

What's Included in Operating Expenses

Always Included:

• Property taxes
• Property insurance
• Utilities (owner-paid portion)
• Repairs and maintenance
• Property management fees
• Landscaping/groundskeeping
• Pest control
• Snow removal
• Advertising and marketing
• Professional fees (legal, accounting)
• Licenses and permits

Sometimes Included:

• Capital expenditure reserves: A percentage set aside for major repairs (roof, HVAC, parking lot). Some investors include this; others don't.
• Management fees: If self-managed, impute a fee anyway—you could pay someone else to do it.

Never Included:

• Mortgage payments (principal or interest)
• Income taxes
• Depreciation
• Capital expenditures (actual)

NOI specifically excludes debt service because it measures property performance regardless of financing.

Why NOI Matters

1. Determines Property Value

Commercial properties are valued based on NOI using cap rates:

Property Value = NOI / Cap Rate

At a 6% cap rate:

$115,000 / 0.06 = $1,916,667

Every $1,000 increase in NOI adds $16,667 to property value at a 6% cap rate.

2. Calculates Cap Rate

Cap Rate = NOI / Property Value

$115,000 / $1,800,000 = 6.4% cap rate

3. Determines Debt Capacity

Lenders use the Debt Service Coverage Ratio (DSCR):

DSCR = NOI / Annual Debt Service

Most lenders require 1.20-1.25x DSCR. With $115,000 NOI:

Maximum annual debt service = $115,000 / 1.25 = $92,000

4. Calculates Cash-on-Cash Return

Cash Flow = NOI - Debt Service

Cash-on-Cash = Cash Flow / Total Cash Invested

Common NOI Calculation Mistakes

1. Using Pro Forma Instead of Actual

Sellers present "pro forma" NOI based on optimistic assumptions—market rents, full occupancy, minimal expenses. Always analyze actual historical performance.

2. Ignoring Management Costs

Self-managed properties often show no management expense. Add 6-10% anyway—you'd pay this if you hired help.

3. Underestimating Repairs

Older properties require more maintenance. Don't use the seller's "good year" as your benchmark.

4. Missing Expense Categories

Common overlooked expenses:

• Snow removal (seasonal markets)
• Elevator maintenance
• Fire safety inspections
• Common area utilities
• Turnover costs

5. Including Debt Service

NOI excludes mortgage payments. If you see "NOI" that subtracts debt service, it's actually cash flow, not NOI.

6. Not Adjusting for Vacancy

Even with current 100% occupancy, underwrite realistic vacancy. Tenants leave.

NOI Quick Sanity Checks

Expense Ratio by Property Type

If someone shows you a multifamily with 25% expense ratio, something's missing or understated.

Per-Unit Operating Costs

Compare operating expenses per unit to market norms. If similar properties run $3,500/unit in expenses and yours shows $2,000, investigate.

Year-Over-Year Trends

NOI should grow roughly with inflation in stable properties. Sudden jumps suggest one-time items or manipulation.

Increasing NOI

Revenue Side:

• Raise rents to market rate
• Reduce vacancy through better marketing
• Add income sources (parking, storage, laundry)
• Implement RUBS (ratio utility billing system)
• Add pet fees or premium amenities

Expense Side:

• Contest property tax assessments
• Shop insurance annually
• Improve energy efficiency
• Negotiate vendor contracts
• Consider professional management (counterintuitive—sometimes pros are more efficient)

The 1% Rule

For every $100 you add to monthly rent across the property:

• Annual revenue increase: $1,200
• NOI increase (assuming 60% flows through): ~$720
• Value increase (at 6% cap): ~$12,000

Small rent increases compound into significant value creation.

Key Takeaways

• NOI = Gross Operating Income - Operating Expenses
• NOI excludes debt service, income taxes, depreciation, and capital expenditures
• Property value = NOI / Cap Rate—every NOI dollar is multiplied
• Always verify NOI with actual financials, not pro forma assumptions
• Include management fees even if self-managed
• Expense ratios vary by property type—know the benchmarks
• Small NOI improvements create large value increases

NOI is where real estate analysis starts. Master it, and cap rates, valuations, and cash flows all become clear. Get it wrong, and you're building analysis on a faulty foundation.