What is net operating income (NOI)?

Net operating income is the standard measure of a commercial property's earning power. It starts with potential gross income, subtracts vacancy and credit loss to reach effective gross income, then subtracts operating expenses such as property taxes, insurance, utilities, repairs and management fees. Debt service, depreciation, capital improvements and the owner's income taxes are excluded.

Lenders use NOI as the numerator in debt service coverage and debt yield calculations and as the basis for income-approach valuations, where value equals NOI divided by a capitalization rate. Underwriters usually build their own underwritten NOI rather than accepting the borrower's figure, applying market vacancy, a management fee and replacement reserves even when the owner does not incur them.

Common NOI errors include using in-place rents from leases about to expire, ignoring concessions and free rent, omitting a management fee for owner-managed properties, and leaving out replacement reserves. Expense ratios that look unusually low compared with similar properties deserve scrutiny. Pro forma NOI for properties in lease-up should be clearly separated from historical performance in the credit memo.