NOI and Cash Flow Basics
Understanding Net Operating Income - the foundation of real estate analysis
What is NOI?
Net Operating Income (NOI) is the total income a property generates from operations minus all operating expenses, before considering financing, taxes, or capital improvements.
NOI Formula:
Why NOI Matters
1Property Performance Metric
Shows the true earning power of a property regardless of how it's financed. A property with high NOI is a good performer.
2Comparison Tool
Allows apples-to-apples comparison between properties since it excludes financing differences and focuses on operating performance.
3Valuation Foundation
Used to calculate property value using the formula: Property Value = NOI ÷ Cap Rate. Higher NOI means higher property value.
4Financing Decisions
Banks use NOI to determine how much they'll lend. They want to see that NOI can comfortably cover debt service payments.
The NOI Formula Explained
Breaking Down Each Component
Income Components
Total rent if 100% occupied
This is the total rent you'd collect if every unit was occupied and paying full rent.
Additional revenue streams
Extra money the property generates beyond base rent.
- • Parking fees ($25/month per spot)
- • Laundry machines (coin-operated)
- • Storage units
- • Late fees and pet deposits
Income lost from unoccupied units
Always budget for vacancy, even if currently 100% occupied. Properties need time between tenants for turnover, cleaning, and finding new renters.
Operating Expenses
These are the costs to operate and maintain the property day-to-day. They don't include financing costs or major renovations.
Property Taxes
Paid to local government based on assessed property value
Insurance
Protects the building against fire, storms, liability claims
Property Management
Company that handles day-to-day operations (typically 6-10% of income)
Utilities
Only if owner pays (common areas, master-metered properties)
Maintenance & Repairs
Keeping property functional: plumbing repairs, painting, cleaning
Professional Services
Accounting, legal fees, marketing costs
- ❌ Mortgage payments (debt service)
- ❌ Major renovations (capital improvements like new roof)
- ❌ Income taxes
- ❌ Depreciation (accounting concept)
Real-World Example
Let's take Tuna's Tower Apartments as an example. This 20-unit property was purchased for $3,200,000 and has 20 units renting for $1,500 per month each, with additional income from parking and laundry services. We'll assume a market vacancy rate of 5.0% and an annual income growth rate of 3% to demonstrate NOI calculations over a 3-year period.
🏢 Tuna's Tower Apartments - 3-Year Analysis
| Line Item | Year 1 | Year 2 | Year 3 |
|---|---|---|---|
| Gross Rental Income | $360,000 | $370,800 | $381,924 |
| Vacancy Loss (5.0%) | ($18,000) | ($18,540) | ($19,096) |
| Other Income (parking/laundry) | $12,000 | $12,360 | $12,731 |
| Effective Gross Income | $354,000 | $364,620 | $375,559 |
| Property Taxes | ($40,000) | ($41,200) | ($42,436) |
| Insurance | ($18,000) | ($18,540) | ($19,096) |
| Property Management (6.0%) | ($21,240) | ($21,877) | ($22,534) |
| Utilities | ($18,600) | ($19,158) | ($19,733) |
| Maintenance & Repairs | ($18,200) | ($18,746) | ($19,308) |
| Other Expenses | ($6,500) | ($6,695) | ($6,896) |
| Total Operating Expenses | ($122,540) | ($126,216) | ($130,003) |
| Net Operating Income (NOI) | $231,460 | $238,404 | $245,556 |
Assumptions: 3% annual income growth, 3% annual expense growth, 5% vacancy rate throughout. Property management calculated as 6% of effective gross income.
Interactive NOI Calculator
Now that you've seen how NOI is calculated in a real scenario, try inputting your own numbers in the interactive calculator below. Start with the example values or modify them to explore different scenarios.
Property Income & Expenses
NOI Analysis Tips
- • NOI excludes debt service, depreciation, and income taxes
- • Operating expense ratios typically range from 25-45%
- • Operating expenses include property taxes, insurance, maintenance, and management
- • Exclude capital improvements and one-time expenses
- • Use actual or market-based vacancy rates for accuracy
NOI vs Cash Flow
While NOI measures property performance, Cash Flow measures investment performance. Cash flow represents the actual money you receive as an investor after accounting for debt service and capital expenditures - it's what goes into your pocket.
Cash Flow Formula:
Property Performance
- • Independent of financing
- • Compares property-to-property
- • Used for cap rates
- • Before debt service
Investment Performance
- • Depends on financing
- • Investor-specific
- • After all major expenses
- • Shows actual returns
Real-World Example Continued: Cash Flow Analysis
Now let's continue with our Tuna's Tower Apartments and calculate the actual cash flow an investor would receive. We'll add financing assumptions and account for a major capital expenditure to show the complete investment picture.
Investment & Financing Assumptions:
- Property Value: $3,200,000
- Loan-to-Value (LTV): 50%
- Loan Amount: $1,600,000
- Interest Rate: 6.0%
- Loan Term: 10 years
- Amortization: 30 years
- Annual Debt Service: $115,086
- Roof Replacement (Year 1): $100,000
🏢 Tuna's Tower Apartments - Cash Flow Analysis
| Line Item | Year 1 | Year 2 | Year 3 |
|---|---|---|---|
| Net Operating Income (NOI) | $231,460 | $238,404 | $245,556 |
| Capital Expenditures (Roof) | ($100,000) | $0 | $0 |
| NOI After Capital Expenditures | $131,460 | $238,404 | $245,556 |
| Annual Debt Service | ($115,086) | ($115,086) | ($115,086) |
| Cash Flow Before Taxes | $16,374 | $123,318 | $130,470 |
Key Insights: Notice how Year 1 cash flow is significantly lower due to the $100,000 roof replacement. This shows why separating NOI from cash flow is important - the property's operating performance (NOI) remains strong, but the investor's return is impacted by necessary capital improvements and debt service.
Key Takeaways
Key Differences:
- • NOI = Property performance (before financing)
- • Cash Flow = Investor returns (after debt & capex)
- • NOI stays consistent regardless of financing
- • Cash flow varies with debt structure and capital needs
- • Use NOI for property comparisons and cap rates
- • Use cash flow for investment return analysis
Common Mistakes:
- • Confusing NOI with cash flow in analysis
- • Including debt service in operating expenses
- • Forgetting vacancy allowances in NOI
- • Mixing capital improvements with repairs
- • Using pro forma instead of actual expenses
- • Comparing properties using cash flow instead of NOI
Test your understanding with these 3 questions. You must get all answers correct to complete the lesson.