Net Operating Income

In real estate, Net Operating Income (NOI) is considered one of the most important variables. NOI is a company’s operating revenues after deducting operating expenses. Operating expenses consists of real estate taxes, maintenance, repairs, insurance, and general maintenance. However, NOI is before deducting interest expense, depreciation and income taxes.

Similarly in manufacturing, another important variable is Gross Profit or Gross Profit Margin. Gross Profit Margin would consist of gross sales less variable manufacturing costs or cost of goods sold. Gross Profit Margin i s an important variable in determining the risk associated with a company’s ability to achieve breakeven and to meet other important obligations such as fixed overhead and debt service. Though gross profit margin is not as important a variable in real estate investment as it is in manufacturing, it is important to mention gross profit margin since it comes before NOI on the income statement and may provide a better understanding of income statement layout and hence further enhance our understanding of the usefulness of NOI.

Both NOI and Gross Profit Margin are important variables in evaluating the viability and determining value of a business and are key variables used to determine a businesses ability to service debt. They are also used among many of the methods in determining a businesses valuation. In real estate the purchase price of a real estate investment divided by the NOI is often used as a general way to compare the valuation of two similar properties. For example, by dividing a $5,000,000 real estate investment by its NOI of $500,000 and determining a 10% return on the property before depreciation, debt service and taxes, an investor can compare this return by performing the same calculation on a similar property. This return is referred to as the capitalization rate or Cap Rate. The Cap Rate is often used as a quick and rough method in comparing the value of two real estate investments. The Cap Rate represents what the asset is worth to the investor based on the investors desired Cap Rate or desired rate of return before depreciation, debt service and taxes.

In lending money or extending credit banks are particularly interested in a businesses ability to service debt. This makes gross profit margin and NOI both extremely important variables. One of the ratios used to measure the ability of a business to service debt is referred to as the Debt Coverage Ratio (DCR). This is calculated by dividing the NOI by the debt service. The greater the NOI to debt service, the greater the DCR. The lower the NOI to debt service, the lower the DCR. In manufacturing the gross profit margin reflects what is available after cost of goods sold to service such things as interest on debt. The narrower the gross profit margin or the lower the DCR the greater the risk to the lender. The stability of DCR, NOI and gross profit margin are also of concern. Revenues that are subject to seasonality or are highly sensitive to competition, require a higher DCR in order to compensate for the greater variability in revenues.