What Is Net Operating Income?

The OCC’s handbook for bank examiners defines net operating income as annual gross income less operating expenses. The arithmetic is simple. Most of the arguments are about what goes on each line.

• Gross income: rent, plus other income from the property such as parking fees and vending. Tenant reimbursements may be included if the reimbursed expenses appear in operating expenses.
• Operating expenses: the costs of operating and normally maintaining the property, such as property taxes, insurance, repairs, utilities and management.
• Not operating expenses: interest, principal and income taxes, according to the handbook. Depreciation and capital items are also excluded.
• Replacement reserve: the handbook says operating expenses do include a reserve for replacing capital items, imputed for underwriting whether or not it is actually funded.

That last point catches people out. A seller’s summary may show NOI with no reserve, while a lender’s calculation includes one. Two people can honestly quote different NOI figures for the same building, so ask which definition is being used.

Here is a hypothetical, for illustration. These figures are invented and are not market data. A small multi-tenant building has the following year:

• Scheduled rent: $300,000
• Parking income: $10,000
• Gross income before vacancy: $310,000
• Less a vacancy allowance: $15,000
• Effective gross income: $295,000
• Property taxes: $60,000
• Insurance: $12,000
• Repairs and maintenance: $28,000
• Management: $15,000
• Utilities: $20,000
• Operating expenses before a reserve: $135,000
• Replacement reserve: $15,000
• Total operating expenses: $150,000

NOI is $295,000 minus $150,000, or $145,000. Without the reserve, it would be $295,000 minus $135,000, or $160,000.

Look at what that one line does to value. At a hypothetical 8 percent capitalization rate, $160,000 implies $2,000,000 and $145,000 implies $1,812,500. A $15,000 definitional difference has moved the implied value by $187,500. This is why the definition matters when a seller is using NOI to justify a price.

A high NOI does not mean the building puts that much money in your bank account. Several real costs sit below it or outside it.

• Your loan payments, which may take up much of the NOI.
• Capital projects such as a roof or chiller, beyond whatever a reserve set aside for them.
• Income taxes, which depend on your structure and on deductions your CPA can explain.
• Commissions and tenant improvements on leased space, which may or may not appear depending on how the figure was prepared.
• Your own staff time, if the company manages the building and no management fee is charged.

NOI also looks at one year. The handbook describes the goal of underwriting as developing an NOI that represents a stabilized estimate of income and expenses, and it asks that expenses be compared with those of similar properties. A single unusually good year, or a year with deferred repairs, can flatter the figure. So can a year when a large tenant was still paying rent but has since given notice. Ask for several years of statements and read the trend, not just the latest total.

If you will occupy the whole building, it may have no third-party rent after you move in, so NOI as a seller reports it may mean little to you. It is still a useful tool in four ways.

1. Use the expense lines as your budget. Taxes, insurance, repairs, utilities and any management cost are what you will be paying, regardless of who occupies the space. Check whether the taxes could change after the sale.
2. Estimate a market NOI. Assume a stranger leased the building at a supportable rent, subtract realistic expenses, and you have a measure an appraiser or investor might recognize.
3. Convert it to a value cross-check. Divide your estimated NOI by a capitalization rate your advisor or appraiser can support, and compare that value with the asking price.
4. Compare with your current occupancy cost. Your rent and pass-throughs today, set against your projected operating expenses and debt service, give you a first view of the lease-or-buy math.

Be careful if you buy through a separate company and lease to your own business. In that case, your NOI depends on rent you set yourself. The OCC handbook warns that rents used for valuation should be consistent with the market, and not established outside an arm’s-length transaction. IRS guidance adds that rent to a related person should be what you would pay a stranger. Your CPA should set this up.

• ✓Is this figure from actual results, a budget or a projection, and for which period?
• ✓Are several recent years of operating statements available, and do they tie to tax bills and insurance invoices?
• ✓Is a vacancy allowance included, or does it assume full occupancy forever?
• ✓Is a management fee included, even if the owner manages the building personally?
• ✓Is a replacement reserve included, and at what amount?
• ✓Are any repairs being deferred, or any one-time items being excluded?
• ✓Which rents depend on leases that end soon, or tenants we intend to replace?
• ✓Is any rent paid by a party related to the seller?

Maynard Nexsen’s overview of the purchase process recommends obtaining the history of operating income and expenses during due diligence, along with a maintenance plan, and reviewing them with your accountant. Tenant Advisory Group works with buyers to put those numbers next to the real alternative, which for an occupier is usually the cost of leasing comparable space.