Net Operating Income in Real Estate: What is it and Why Does it Matter?

If you’re new to real estate investing, you’ve probably heard the term “net operating income” (NOI) thrown around a lot but may not be entirely sure what it means.

NOI is a key metric that all investors should understand, as it’s a good indicator of a property’s profitability.

In this article, we’ll explain what NOI is and why it’s so important.

Key Takeaways – Net Operating Income in Real Estate

• NOI Core Definition – Net Operating Income (NOI) equals gross revenue minus operating expenses (e.g., taxes, maintenance, insurance). It excludes mortgage interest, capital expenditures, and depreciation.
• Valuation & Cap Rates – Divide NOI by purchase price to find the Capitalization Rate (Cap Rate). Higher cap rates signal higher relative cash yield, while lower cap rates reflect higher property valuations or lower perceived risk.
• Tax Impact on Price – Higher ongoing holding costs increase the discount rate. In a worked example we have below, a 3.1% effective property tax rate in Texas suppresses market values by ~21%-28% relative to a low-tax market like Las Vegas (~0.8%). This assumes equal baseline housing utility.
• Return Metrics – Investors evaluate efficiency by comparing portfolio NOI to actual out-of-pocket equity invested to determine cash-on-cash return.
• NOI Drivers – Maximizing NOI requires raising gross income (higher rents, lower vacancy) or cutting operating overhead (energy efficiency, vendor negotiations).

What is Net Operating Income?

Net operating income is a measure of a property’s profitability that takes into account all revenue and reasonably important operating expenses.

In some industries, NOI is the same as EBIT.

How to Calculate Net Operating Income

To calculate NOI, you simply take a property’s total revenue and subtract all operating expenses (e.g. property taxes, insurance, repairs and maintenance, etc.).

Non-operating expenses, such as interest on loans or depreciation, are not included in the calculation.

Why is Net Operating Income Important?

Investors use NOI to assess a property’s potential profitability and to compare properties against one another.

For example, if two properties have identical purchase prices but one has an NOI of $50,000 while the other has an NOI of $100,000, the latter property will be more profitable and therefore more attractive to investors.

It’s also important to keep in mind that a property’s NOI can change over time based on changes in revenue or expenses.

For example, if a property owner raises rents or decreases operating expenses, the property’s NOI will increase.

Conversely, if a property owner incurs significant repair costs or sees a drop in rental income, the property’s NOI will decrease.

How Do Real Estate Investors Find Their Return?

It varies, but many do this by comparing the NOI of their portfolio to the overall amount of cash invested.

This gives them their cash-on-cash return, which is a good way to measure the performance of an investment property.

For example, if an investor has a portfolio of rental properties with a combined NOI of $100,000 and they have invested $1 million of their own cash into the properties, their cash-on-cash return would be 10%.

While NOI is a helpful metric, it’s important to remember that it’s just one piece of the puzzle when it comes to assessing a property’s profitability.

Investors should also consider the property’s capitalization rate (cap rate) and its potential for appreciation.

What Is a Cap Rate?

The cap rate is a measure of a property’s potential return on investment (ROI).

It takes into account both the property’s NOI and its purchase price.

To calculate the cap rate, you simply divide the property’s NOI by its purchase price.

For example, if a property has an NOI of $50,000 and it was purchased for $500,000, the property’s cap rate would be 10%.

How to Use Cap Rates

Cap rates can be used to compare properties against one another and to assess a property’s ROI potential.

Higher cap rates generally indicate higher ROI potential, as they indicate that a property is relatively inexpensive compared to its NOI.

Conversely, lower cap rates may indicate that a property is overpriced and may not be a wise investment.

It’s important to keep in mind, however, that cap rates can vary widely depending on the location and type of property.

For example, properties in high-growth markets tend to have lower cap rates than properties in slower-growing markets.

This is because investors are willing to pay more for properties in high-growth markets that have the potential to appreciate quickly.

NOI Example

Let’s do a worked example using property tax rate differentials between US states to calculate how much the tax rate directly affects property valuations.

In this case, Nevada and Texas.

All else equal, a 3.1% effective property tax rate depresses home valuations by approximately 21% to 28% relative to Las Vegas.

Let’s look at the calculations.

Under classical asset pricing theory, a buyer evaluates the total annual cost of housing services. Because property taxes represent a perpetual annual liability, higher property tax rates directly increase the required discount rate (capitalization rate) of the property.

The Capitalization Formula

The price of a property relative to its annual gross housing value / net operating income (NOI) is calculated as:

P = NOI / (r + t)

Where:

• r = Required rate of return / discount rate (mortgage interest rate + equity yield expectation)
• t = Effective property tax rate

In Las Vegas (Clark County), the effective property tax rate for a newly purchased property typically ranges between 0.70% and 1.00% (around 0.80% on average across tax districts), protected long-term by Nevada’s 3% annual tax increase cap on primary residences. In Texas, the scenario rate is 3.10%.

Price Depression Across Discount Rates

Because the tax rate sits in the denominator of the capitalization equation, the exact price suppression depends on the prevailing discount rate (r).

Assuming a base Las Vegas effective tax rate of 0.80% versus Texas at 3.10% (a 2.30% tax rate spread):

Cash Flow Perspective

Looking at cash outlay for a home generating $60,000/year in gross imputed housing value:

• Las Vegas ($1M asset baseline at 0.8% tax): Annual tax bill = $8,000/year
• Texas ($1M asset baseline at 3.1% tax): Annual tax bill = $31,000/year
• Annual Tax Delta: Texas carries an additional $23,000/year in holding costs per $1,000,000 of initial benchmark value.

Capitalizing that $23,000 annual drag at a 6.5% discount rate yields a lump-sum present value loss of ~$353,846.

Consequently, a buyer with a fixed monthly budget can afford a much higher purchase price in Las Vegas than in Texas for the exact same monthly outlay.

Important Practical Caveats to This

1. State Income Tax Offset – Neither Texas nor Nevada levies a state personal income tax, meaning property taxes in both states shoulder a heavy portion of local municipal revenue.
2. Assessment Caps – Nevada caps annual property tax bill growth at 3% per year for primary residences regardless of market appreciation. Texas homestead exemptions offer ceiling caps for seniors, but statutory growth caps for standard primary residences are generally looser (up to 10% annual assessment growth limit), causing the long-term tax differential to often widen over time.
3. SALT Cap Limitations – Federal deduction limits for State and Local Taxes ($10,000 cap) mean higher Texas property tax bills are largely paid with post-tax dollars. In turn, this reinforces the price suppression effect for high-value properties.

NOI, CAP RATE, & VALUATION in Real Estate EXPLAINED with a SIMPLE ANALOGY

FAQs – Net Operating Income

What is Net Operating Income?

Net operating income (NOI) is a measure of a property’s potential profitability.

It is calculated by taking the property’s gross revenue and subtracting all reasonably necessary operating expenses.

Why is Net Operating Income Important?

Net operating income is important because it provides a snapshot of a property’s profitability.

By understanding a property’s NOI, investors can make informed decisions about whether or not to purchase or finance it.

What are Some Factors that Affect Net Operating Income?

There are several factors that can affect a property’s NOI, including its location, age, and condition.

Additionally, the type of tenant occupying the property can also have an impact on NOI.

For example, a property with high-paying tenants is likely to have a higher NOI than one with lower-paying tenants.

What are the Benefits of Using Net Operating Income?

The benefits of using net operating income can include:

• A steadier income stream – Because NOI takes into account all expenses related to the property, it can provide a more accurate picture of a property’s potential profitability. This can be helpful for investors who are looking for a steadier income stream.
• Greater insight into profitability – By understanding a property’s NOI, investors can get a better sense of its potential profitability and make more informed investment decisions.
• Reduced risk – Net operating income can help investors assess a property’s risk and make decisions accordingly. For example, a property with a higher NOI is generally considered to be less risky than one with a lower NOI.

What are the Risks of Relying on Net Operating Income as a Metric?

The risks of using net operating income can include:

• Volatility – Because NOI is heavily based on a property’s gross income – or imputed value (i.e., for owner-occupiers) – it can be subject to volatility. This means that properties with high NOIs today may not have as high of an NOI in the future depending on how things transpire.
• Difficulty predicting – It can be difficult to predict a property’s future NOI.
• Tenant turnover – Tenant turnover can have a big impact on NOI. If a property’s tenants move out, the property may suffer a decrease in NOI.

What are Some Tips for Investing in Properties with High Net Operating Incomes?

Some tips for investing in properties with high net operating incomes can include:

• Consider the location – When assessing a property’s NOI, it is important to consider its location. Properties in prime locations may be more likely to generate higher NOIs than those in less desirable areas.
• Look for well-maintained properties – Another factor to consider when assessing a property’s NOI is its condition. Well-maintained properties are more likely to generate higher NOIs than those that are in need of repair.
• Review the lease agreement – When considering a property for investment, it’s important to review the lease agreement. Some leases may contain provisions that could impact the NOI, such as rent increases.
• Consider the type of tenant – The type of tenant occupying a property can also affect its NOI. Properties with high-paying tenants (e.g., closer to a business district) are more likely to generate higher NOIs than those with lower-paying tenants.

What Is the Difference Between Net Income and Net Operating Income?

NOI is revenue minus operating expenses while net income is revenue minus all expenses.

What Is a Good NOI?

A “good” NOI varies depending on the property type, location, and other factors.

However, a general rule of thumb for many landlords is that an NOI of 10% or more is considered to be good.

Generally the higher the better, but it will depend.

What Are Some Ways to Increase a Property’s Net Operating Income?

There are several ways to increase a property’s NOI, including:

• Increasing rent – One way to increase a property’s NOI is by increasing rent. By charging higher rents, investors can potentially generate greater profits.
• Reducing expenses – Another way to increase a property’s NOI is by reducing its operating expenses. This can be done by negotiating lower prices with vendors or improving the property’s energy efficiency.
• Adding amenities – Adding amenities to a property can also potentially increase its NOI. By adding amenities that appeal to tenants, landlords may be able to charge higher rents.
• Increasing occupancy – Increasing the occupancy rate of a property can also lead to a higher NOI. This can be done by marketing the property to a wider range of potential tenants or offering incentives to current tenants.

Conclusion – Net Operating Income

Net operating income is a key metric that all real estate investors should understand.

It’s a good indicator of a property’s profitability and can be used to compare properties against one another.

Investors should also be familiar with the concept of a property’s capitalization rate (cap rate), as it can be used to assess a property’s ROI potential.

When evaluating investment properties, be sure to calculate the NOI and compare it against similar properties in order to make the most informed investment decision possible.