Originally published on March 29, 2024
Quick Take: What is NOI in real estate? Net operating income is the key metric showing how much income a property generates after operating expenses. NOI helps investors measure performance, compare opportunities and estimate value—without the noise of debt or taxes. Understanding NOI allows investors to evaluate assets objectively and make smarter investment decisions.
Net operating income (NOI) measures a property’s profitability and ability to generate cash flow. It’s a key factor in valuing a real estate investment and assessing both performance and potential return. Market cycles, interest rates and investor sentiment shift over time. But NOI remains a consistent benchmark for how effectively an asset generates income relative to its costs. In today’s environment, operating expenses, insurance and financing costs continue to rise. So understanding how to interpret and improve NOI helps investors identify durable opportunities and managers who can create lasting value. Skilled real estate managers execute business plans designed to grow NOI and, in turn, increase property value.
How is NOI Calculated?
Simply put, a property’s net operating income is its revenue minus its operating expenses. NOI does not factor in capital expenditures, interest or taxes. So, it is less subject to manipulation than other metrics: It allows an investor to consider a property solely from the perspective of income and profitability. NOI offers a clear, comparable measure of how efficiently a property generates cash flow across different markets and investment types.
Increasing both NOI and value generates a high equity multiple, which reflects the amount of money an investor gets back by the end of a deal. Increasing NOI over time typically leads to higher property value, since value in commercial real estate is often determined by dividing NOI by the capitalization rate (cap rate). As NOI rises, so does the property’s estimated worth. In its simplest form, the NOI equation looks like this:
Why is NOI Important?
NOI drives value. It directly influences property value and investment returns. NOI is a crucial component in calculating the capitalization (cap) rate, which is the ratio of a property’s NOI divided by its purchase price or estimated market value.
If NOI drives value in a property, that value in turn drives returns, helping investors assess a project’s overall feasibility. This value can be shown through two other metrics: cash-on-cash return and total return. Cash-on-cash return, expressed as a percentage, measures the cash income earned relative to the cash invested and accounts for cash flow after mortgage costs are paid. In general, a higher percentage signals a stronger investment. While the cap rate and cash-on-cash calculations are income-focused, the total return considers both income and appreciation.
Across all three metrics, NOI remains the key input for evaluating property performance and long-term value. A property’s NOI is an important input no matter which metric is being considered.
What are the Biggest Drivers of NOI?
NOI is determined by two primary inputs: revenue and operating expenses. Aside from rent, revenue can include items such as parking, storage, pet fees, utilities, and late-fee income. From this total, adjustments are made for vacancies, concessions, or revenue lost from non-paying tenants. Together, these variables form effective gross revenue (EGR). This could be considered a more realistic measure of how much income a property actually produces. Calculating EGR helps investors compare NOI and operating expenses to market norms and uncover opportunities to improve efficiency.
To calculate EGR, take revenue, subtract any adjustments, and add other income sources. EGR is important because only considering revenue can overstate value. And it comes in handy when comparing both NOI and operating expenses to typical standards or the overall market.
The second half of the equation, operating expenses, captures all costs required to run the property. These are typically categorized as controllable or non-controllable expenses. Controllable expenses include payroll, marketing, administrative costs, repairs and maintenance, and management fees—items that can often be managed, shopped for and optimized. Non-controllable expenses, such as utilities, property taxes and insurance, fluctuate with external market forces and can change independently.
Understanding how each component affects NOI allows investors and property managers to identify where operational adjustments can increase cash flow and, ultimately, enhance property value.
What is the Operating Expense Ratio?
With accurate revenue and expense assumptions, the operating expense ratio (OER), a key metric for evaluating efficiency, can be determined. Calculate the OER by dividing the property’s operating expenses by EGR. It can help determine if operating expenses are in line with other local properties and if there could be potential increases, cost savings or efficiency improvements down the line. It also helps indicate how the current manager is running the property.
A lower operating expense ratio typically indicates stronger management and greater potential for higher NOI. A higher ratio, on the other hand, may suggest rising costs or operational inefficiencies that could erode future returns.
It is not enough to simply estimate one year’s worth of rental rates or expenses, however. The NOI analysis also involves estimating future expectations, as well as forecasting revenue and expense growth. Origin typically limits these estimates to five years, but standards can range from three to 10 years. Forecasting relies on many factors that require experience and resources. Having the market knowledge and experience to forecast appropriately, and recognize if a set of assumptions is achievable, is crucial when evaluating an investment opportunity.
NOI: Detailed Calculation
What Are the Different Types of NOI in Real Estate?
In addition to ensuring that inputs and assumptions are correct, it is important to review NOI across multiple time periods to gain a clearer picture of a property’s performance and potential. Reviewing NOI over time helps validate assumptions and shows whether income and expenses are trending as expected. A trailing 12-month NOI, commonly referred to as a T-12 or TTM, summarizes a property’s income and expenses over the past year of operations. This metric provides insight into historical performance, which you can compare to actual NOI, and verify the accuracy of current projections. This can validate certain assumptions that might not be reflected in historical numbers. And it can show how the property is performing in real time.
Projected or stabilized NOI is utilized mostly for value-add or development opportunities. This version estimates what a property’s NOI will be once renovations, lease-ups or other improvements are complete. It is important to remember that projected NOI is based on a set of assumptions rather than proven results. Investors should carefully test the defensibility of those assumptions before relying on them for valuation.
Adding value to an existing property has the potential to increase NOI. The chart below compares the in-place, or as-is, value of a value-add deal versus the stabilized value of an improved property. The decision to improve a value-add project depends on the defensibility of the assumptions used. Analyzing in-place, trailing and stabilized NOI side by side gives investors a full picture of operational performance, risk and upside potential. These are key insights when comparing opportunities or tracking portfolio results over time.
Change in NOI: Value-Add Deal
How Does NOI Affect Cap Rates in Real Estate?
A property’s cap rate (the ratio of a property’s NOI to its purchase price or estimated market value) is one of the most widely used measures of real estate valuation. It provides a simple way to compare different investment opportunities and to understand the relationship between a property’s income, risk and value. Higher NOI generally increases value. But cap rates vary by market, asset type and perceived risk. A higher cap rate usually indicates greater risk but may also suggest stronger potential returns.
Say you are evaluating two properties: Option A, valued at $5 million, and Option B, valued at $3 million. Keeping NOI constant at $200,000, Option A would have a cap rate of 4% while Option B’s would be 7%. Is Option B a better opportunity? Not necessarily. You must also consider the properties’ locations, ages and need for improvements. If Option B was an older building needing $1 million in improvements, Option A might be more favorable in the long run.
Does a higher cap rate result from strong NOI or a lower property value? If a property appreciates but revenue lags the appreciation, the cap rate compresses, signaling lower yield. Conversely, reducing expenses or growing rent can raise NOI, lower the cap rate, and increase market value.
Conclusion
Ultimately, NOI anchors how investors and appraisers determine a property’s worth and compare it to similar assets. Understanding how NOI and cap rates interact helps investors assess risk-adjusted returns and identify where value creation is achievable.
Origin’s investment management team tests the acquisition team’s assumptions about future rents, expenditures, exit capitalization rates and many other inputs that drive value. The investment management team implements these model business plans after acquisition. They constantly monitor and adjust the plan as the asset’s competitive landscape and the broader economy change. Being able to appropriately calculate NOI is crucial in the success of our projects.
Key Takeaways
- Net operating income (NOI) is one of the most important measures of a property’s profitability and efficiency.
- Understanding how to calculate NOI helps investors evaluate performance, compare opportunities, and estimate value.
- Cap rates, cash-on-cash returns, and total returns all rely on NOI as a core input.
- Increasing NOI through revenue growth or expense control can directly enhance a property’s market value and investor returns.
- Strong management and disciplined forecasting are key to maintaining healthy NOI and identifying long-term, durable investments.
FAQs About Net Operating Income (NOI)
1. What is NOI in real estate?
Net operating income (NOI) measures how much income a property generates after deducting operating expenses from total revenue. It excludes financing costs, capital expenditures, and taxes, giving investors a clear view of property performance and profitability.
2. How do you calculate NOI?
Calculate NOI by subtracting a property’s operating expenses from its total revenue. The formula is simple: NOI = Revenue – Operating Expenses. It helps investors evaluate efficiency, compare assets, and estimate value without the influence of debt or tax factors.
3. Why is NOI important to investors?
NOI drives property value, cash flow, and return potential. It’s central to calculating cap rates, cash-on-cash return, and total return—key measures investors use to assess risk and performance in real estate investments.
4. What affects a property’s NOI?
NOI changes based on revenue (rents, parking, fees) and expenses (taxes, insurance, maintenance). Strong management that controls costs and grows income can increase NOI, leading to higher property value and improved investor returns.
