What Is Net Operating Income (NOI)?

Key Takeaways

• NOI equals gross operating income, including tenant reimbursements, minus operating expenses. Debt service, income taxes, depreciation and capital improvements are excluded.
• Because value equals NOI divided by the cap rate, $1 of NOI supports roughly $15 of value at a 6.5% cap rate, so small expense errors become large pricing errors.
• Under a true absolute NNN lease, NOI is close to base rent. Under a gross lease, the landlord absorbs expense growth, so NOI can shrink while rent stays flat.
• Many leases marketed as NNN leave roof, structure, management or capped expenses with the landlord. Those costs reduce NOI even when the offering memorandum ignores them.
• Bank underwriting guidance treats a replacement reserve and a management fee as operating expenses, so a lender's NOI is usually lower than a broker's.

NOIReimbursed taxes, insurance, CAMUnreimbursed landlord costs

Where a hypothetical $229,000 of income goes before NOI

	NOI	Reimbursed taxes, insurance, CAM	Unreimbursed landlord costs
As marketed	$180K	$49K	$0
As underwritten	$171K	$49K	$9.0K

Illustrative arithmetic to show the mechanism, not market data.

What goes into NOI and what stays out

NOI is the income a property produces from operations after paying the costs of running it, measured as if the owner had no loan and paid no income tax. It isolates the property's own earning power, which is why buyers, appraisers and lenders all start from it and why it is the numerator of the cap rate.

What NOI includes and excludes

Included in NOI	Excluded from NOI
Base rent actually due under the lease	Mortgage principal and interest
Tenant reimbursements of taxes, insurance and common area maintenance	Income taxes of the owner
Other property income such as percentage rent, parking or signage fees	Depreciation and amortization
Less a vacancy and credit loss allowance	Capital improvements such as a roof replacement
Less property taxes, insurance, repairs, utilities and management the landlord pays	Owner entity costs such as partnership accounting and asset management fees

Replacement reserves are the one line where conventions differ. Many investors report NOI before reserves and deduct them to reach net cash flow. The OCC's Comptroller's Handbook on commercial real estate lending (Version 2.0) instead treats a replacement reserve as an operating expense for underwriting, imputed whether or not it is funded. Know which convention a number uses before comparing it to anything.

How NOI works under NNN and gross leases

The lease decides who pays each expense, and therefore how much of the rent survives to NOI. Under a triple-net lease the tenant pays taxes, insurance and maintenance, so NOI tracks base rent. Under a gross lease the landlord pays them out of a higher rent, so NOI depends on how fast expenses grow.

Consider a hypothetical building where taxes, insurance and common area maintenance cost $49,000 a year. Under an absolute NNN lease at $180,000 of base rent, the tenant reimburses the $49,000 and NOI is $180,000. Under a gross lease at $235,000, the landlord pays the $49,000 plus a $7,050 management cost, and year-one NOI is $178,950, nearly the same. If those expenses then rise 5% a year while the gross rent stays flat, they reach about $59,560 by year five and hypothetical NOI falls to about $168,390. The NNN landlord's NOI does not move with expenses at all.

That difference in who carries expense inflation is a large part of why single-tenant net lease trades like a fixed-income investment. The comparison is covered in more detail in NNN vs gross lease: who pays what.

Landlord leakage: costs hiding in NNN leases

Leakage is any cost a landlord bears under a lease marketed as NNN. The label has no fixed legal meaning; the OCC handbook warns that net, NN, NNN and absolute net lack universally agreed definitions and that the lease itself must be read. Each leaked dollar lowers NOI and, at a 6.5% cap rate, about $15 of value.

The items that most often leak:

• Roof and structure. Many NN leases, and some leases called NNN, leave the roof, foundation, exterior walls or parking lot with the landlord. See absolute NNN vs triple-net and roof and structure obligations.
• Management and administration. Someone collects rent, pays reimbursable bills and reconciles them. If the lease does not allow a management or administrative fee, that cost is the landlord's. The OCC handbook notes that lenders typically underwrite management at 3% to 5% of effective gross income, excluding reimbursements, even for self-managed properties.
• Caps and exclusions. Leases often cap annual increases in reimbursable CAM or insurance, or exclude capital repairs. Anything above the cap stays with the landlord. See CAM reconciliation.
• Non-reimbursed items. Coverage the landlord or its lender requires beyond what the tenant must reimburse, legal costs in a tenant dispute, and the time and accounting cost of reconciling pass-throughs each year.

Worked example: marketed NOI vs underwritten NOI

The gap between the NOI in an offering memorandum and the NOI a buyer will actually receive can be several percent of income, which becomes a much larger dollar amount once capitalized. This hypothetical 10,000 square foot building has a lease marketed as NNN, but the landlord keeps the roof and structure, and the lease permits no management fee.

Hypothetical: the same lease, as marketed and as underwritten

Line item	As marketed	As underwritten
Base rent	$180,000	$180,000
Tenant reimbursements (taxes, insurance, CAM)	$49,000	$49,000
Reimbursable taxes, insurance, CAM	($49,000)	($49,000)
Management, 3% of base rent, not reimbursable	$0	($5,400)
Roof and structure repairs, annual average	$0	($2,500)
Insurance increase above the tenant's cap	$0	($1,100)
NOI	$180,000	$171,000
Replacement reserve, $0.15 per square foot	$0	($1,500)
Lender-style NOI with reserve	$180,000	$169,500
Value at a 6.5% cap rate	$2,769,231	$2,630,769 to $2,607,692

In this hypothetical, $9,000 of leakage, 5% of rent, is worth $138,462 of price at a 6.5% cap rate, and about $161,538 once the reserve is included. A buyer who pays the marketed price has effectively bought at a 6.2% cap rate on real NOI, not 6.5%.

How NOI connects to other metrics

NOI feeds almost every other measure used to price and finance a property, so an error in NOI carries into all of them at once. Value, loan size, debt coverage and cash yield to equity each start from the same figure, which is why buyers and lenders spend so much diligence time on it. The relationships are mechanical:

• Value: NOI divided by the cap rate.
• Debt service coverage: NOI divided by annual loan payments. See DSCR.
• Debt yield: NOI divided by the loan amount. See debt yield.
• Cash flow to equity: NOI minus debt service minus capital spending, the basis of cash-on-cash return.
• Tenant health: store sales or earnings relative to rent, the rent coverage ratio, tells you whether the NOI is sustainable at all.

A lender that underwrites a lower NOI than the seller's will size a smaller loan, which is often the first place a buyer discovers leakage.

Common NOI mistakes

Most NOI errors come from treating a marketing number as an accounting number, or a scheduled number as a collected one. The following mistakes show up repeatedly in net lease underwriting, and each one overstates NOI and therefore value, often by more than the buyer's entire negotiating margin on price.

• Using next year's rent. Some offering memoranda quote NOI on a scheduled increase that has not taken effect yet.
• Straight-line rent. Accounting statements may average scheduled increases over the lease term; the cash rent due today is lower in early years.
• Treating percentage rent as permanent. Rent tied to store sales can disappear in a weak year.
• No vacancy allowance on a short lease. A single-tenant building has zero vacancy until it has 100%. When the term is short, NOI should reflect re-leasing risk.
• Ignoring the tenant's actual payments. Compare the lease with the trailing twelve months of actual income and expenses and with the tenant's estoppel.

Frequently Asked Questions

Q: Does NOI include mortgage payments?

A: No. NOI is calculated before debt service so it measures the property itself, not the owner's financing. Loan payments are subtracted from NOI to arrive at cash flow to equity.

Q: Is NOI the same as cash flow?

A: No. Cash flow to the owner is NOI minus debt service, capital improvements and reserves. A property can have strong NOI and weak cash flow if it carries a large loan or needs a new roof.

Q: Is NOI the same as rent in a triple-net lease?

A: Only when the lease passes every property cost to the tenant, as an absolute NNN lease typically does. If the landlord keeps the roof, structure, management or costs above a cap, NOI is lower than rent.

Q: Does NOI include capital expenditures?

A: Capital improvements are excluded from NOI. Practice differs on replacement reserves: many investors deduct them below NOI, while bank underwriting guidance from the OCC treats a replacement reserve as an operating expense in underwritten NOI.

Q: Why does a small change in NOI matter so much?

A: Because value equals NOI divided by the cap rate. At a 6.5% cap rate, every $1 of annual NOI supports about $15.38 of value, so a $5,000 overstatement of NOI inflates price by about $77,000 in that hypothetical.

Sources

1. OCC, Comptroller's Handbook: Commercial Real Estate Lending, Version 2.0 (March 2022)
2. OCC, Commercial Real Estate Lending booklet index page

This page is for informational purposes only and is not an offer to sell or a solicitation of an offer to buy any security, nor investment, tax, or legal advice. Examples are hypothetical unless a source is cited. Consult your own advisors about your situation.