Net Operating Income (NOI)

The definition comes from lending and appraisal practice, not from the tax code.

The Internal Revenue Code never uses the term. The working definition sits in the OCC's Comptroller's Handbook, Commercial Real Estate Lending (version 2.0, March 2022): annual gross income less operating expenses. Gross income covers rent plus other income such as parking, laundry and vending, and tenant reimbursements where the reimbursed costs are also counted as expenses.

Operating expenses are the costs of running and maintaining the property. The handbook says they do not include interest, principal or income taxes, and do not include depreciation or capital items, but they do include a replacement reserve, which is imputed for underwriting whether or not it is actually funded. Underwriters work from a stabilized NOI: income when fully leased, less a vacancy factor drawn from comparable properties.

Your tax return measures something else. Under IRS Publication 527 you deduct mortgage interest and depreciation against rent, while NOI ignores both. The handbook itself warns that tax returns can understate or overstate NOI, for example when capital spending is not expensed or when a cash-basis return skips unpaid property taxes.

A worked example shows how one NOI figure sets value, loan coverage and debt yield.

Hypothetical: a small retail building collects $260,000 of rent and $10,000 of reimbursements. A 5% vacancy factor takes $13,500, leaving effective gross income of $256,500. Taxes, insurance, maintenance, management and a $6,500 replacement reserve total $106,500, so NOI is $150,000.

At a 6% capitalization rate, the handbook's direct capitalization method gives a value of $150,000 divided by 0.06, or $2,500,000. A loan with $120,000 of annual debt service has a debt-service coverage ratio of 1.25, and a $1,500,000 loan has a debt yield of 10%. The $1,500,000 loan's interest and your depreciation never enter the NOI line. Illustration only, in round numbers; your own figures belong with your CPA.

It bites when a seller's NOI and a buyer's or sponsor's NOI are built on different assumptions.

A seller's trailing statement may omit management fees or reserves, which the handbook notes an NOI analysis may include even when they are not a cash expense. Every dollar of NOI is multiplied by the cap rate's inverse, so a $10,000 difference at a 6% cap rate moves value by about $166,700. Ask which version a price or appraisal uses.

Replacement offerings present projected NOI too. A DST's projected distributions start from NOI and then subtract debt service, fees and reserves, so compare the figures on the same basis; see DST yield versus an NNN cap rate and reading a DST memorandum and Form D. Under FINRA Rule 2210(d)(1)(F), member firm communications may not predict or project performance, so treat any NOI projection as an assumption to test, not a promise. The trustee limits in Rev. Rul. 2004-86 also restrict how a DST can raise NOI after closing.