Net operating income (NOI) in real estate, explained
Net operating income (NOI) is a rental property's gross operating income — effective rent plus other income — minus operating expenses like property taxes, insurance, management, maintenance, and a vacancy allowance. It excludes the mortgage, capital expenditures, depreciation, and income tax. NOI is the numerator that cap rate and DSCR are both built from.
The NOI formula
NOI = Gross operating income − Operating expenses
Gross operating income starts with gross potential rent (all units at full occupancy at market rates), then subtracts a vacancy and credit-loss allowance to reach effective gross income (EGI). Any other income — parking, laundry, storage fees — gets added here too. Operating expenses come out next.
A worked example
| Line item | Annual figure |
|---|---|
| Gross potential rent | $42,000 |
| Vacancy allowance (7%) | −$2,940 |
| Effective gross income | $39,060 |
| Property taxes | −$4,200 |
| Insurance | −$1,800 |
| Property management (9% of EGI) | −$3,515 |
| Maintenance and repairs | −$2,500 |
| HOA dues | −$600 |
| Total operating expenses | −$12,615 |
| Net operating income | $26,445 |
The cap rate on a $370,000 purchase is $26,445 ÷ $370,000 = 7.15%.
All the arithmetic foots: $42,000 − $2,940 = $39,060; $39,060 × 0.09 = $3,514.40, rounded to $3,515; operating expenses total $4,200 + $1,800 + $3,515 + $2,500 + $600 = $12,615; NOI = $39,060 − $12,615 = $26,445.
What counts as an operating expense
Included:
- Property taxes
- Landlord insurance
- Property management fees
- Routine maintenance and repairs
- Vacancy and credit-loss allowance
- HOA fees (where applicable)
- Utilities the owner pays (common in multifamily with master-metered water or heat)
Excluded:
- Mortgage principal and interest
- Capital expenditures (roof replacement, HVAC, major structural work)
- Depreciation
- Income taxes
Capital expenditures are excluded because they are infrequent and their cost is recovered over time through depreciation. But they do come due. A building that hasn’t replaced a roof in 25 years may show a clean NOI while hiding a $20,000 obligation just over the horizon. Treat capex as a separate reserve analysis alongside NOI, not as a reason to ignore it.
Why the vacancy allowance matters
Modeling 0% vacancy produces a phantom NOI. Even a well-managed property in a tight market has turnover, and a month vacant between tenants on a $3,500/month unit costs $3,500, about an 8% vacancy rate on that unit for the year. Using actual local market vacancy data is more accurate than a fixed assumption; 5% is common in strong urban markets, 8–10% in areas with more supply or slower lease-up.
How NOI connects to the other numbers
Two ratios use NOI as their numerator:
- Cap rate: NOI ÷ market value. A property with $26,445 NOI bought for $370,000 has a 7.15% cap rate. That same NOI at a 6% market cap rate implies a value of $440,750, useful when you’re underwriting a sale or estimating an appraisal value for a refi.
- DSCR: NOI ÷ annual debt service. If that $370,000 property carries $18,000 per year in principal and interest payments, DSCR is $26,445 ÷ $18,000 = 1.47, comfortably above the 1.20–1.25 most lenders require.
Inflate the rent or drop an expense line and the error shows up twice — once in the cap rate you quote and again in the DSCR your lender runs.
Frequently asked questions
Why does NOI exclude the mortgage payment?
The mortgage is a financing decision, not a property characteristic. Excluding debt service lets you compare two properties on the same footing regardless of who is buying them or how they are financing the deal. Cap rate, which divides NOI by market value, would be meaningless as a cross-property benchmark if it varied with each buyer's loan terms.
Does property management come out before or after NOI?
Before. Management fees are an operating expense, so they reduce NOI. The standard convention is to calculate management as a percentage of effective gross income (rent collected after vacancy), typically 8–10%. Applying the fee to gross rent before the vacancy deduction overstates the expense slightly.
Is vacancy already in NOI, or do I add it separately?
A realistic vacancy allowance is deducted from gross potential rent to get effective gross income, which is then the starting point for NOI. If you skip the vacancy adjustment and use gross potential rent, your NOI and your cap rate will be flattering and wrong.
How does NOI connect to cap rate and DSCR?
Cap rate is NOI divided by the property's market value; DSCR is NOI divided by annual debt service. NOI is the shared numerator in both ratios, so any error in it — overstated rent, understated expenses, missing vacancy — flows directly into the metrics a lender or buyer uses to price and underwrite the deal.
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