How Is NOI Calculated? Formula, Operating Expenses, and Exclusions

Net operating income is calculated by subtracting a property’s total operating expenses from its effective gross income. That one subtraction is the whole formula. The work sits in deciding what belongs on each side: which streams of income count, which costs qualify as operating expenses, and which large line items get deliberately left out. Get those classifications right and the number tells you what the property earns independent of who owns it or how they financed it. Get them wrong and a valuation built on that NOI can be off by hundreds of thousands of dollars.

The Formula, Step by Step

The calculation moves from the top of the income statement down. Each line feeds the next.

Gross potential rent: total rent the property would collect at full occupancy and market rates.
Plus other income: parking, laundry, vending, storage, pet fees, utility reimbursements, and any other recurring non-rent income.
Equals total potential income.
Minus vacancy and credit loss: stabilized properties typically assume around 5% to 10% for vacancy and another 0.5% to 2% for bad debt, with the exact figure depending on asset class and local market.
Equals effective gross income.
Minus operating expenses.
Equals net operating income.

A worked example makes it concrete. A 20-unit apartment building rents at $2,000 per unit per month, producing $480,000 in gross potential rent. Add $20,000 in parking and laundry and total potential income is $500,000. Subtract 7% ($35,000) for vacancy and credit loss and effective gross income is $465,000. If operating expenses total $185,000, NOI is $280,000.

Building the Income Side

Gross potential rent comes straight from the rent roll, which lists every unit, its tenant, and the lease amount. For vacant units, plug in the market rate they could command. The result represents full occupancy with everyone paying on time, which is why the vacancy and credit loss deduction exists.

Ancillary income gets missed if you aren’t methodical. Monthly parking, coin-operated laundry, vending commissions, pet fees, and storage rentals all belong here. Properties that use a Ratio Utility Billing System to pass utility costs through to tenants should record those reimbursements as income and keep the matching utility bill in expenses. Treating a reimbursement as pure profit while hiding the offsetting cost inflates NOI artificially.

Pull income data from detailed profit and loss statements and bank records. When you’re evaluating a property you don’t own, ask for a trailing 12-month operating statement rather than a summary or an annualized snapshot. Twelve months captures seasonal swings that a single quarter misses.

Operating Expenses That Belong in NOI

Operating expenses are the recurring costs required to keep the property functional and generating rent. The line between an operating expense and something else is where most calculation errors live, so be precise.

Property taxes, typically the single largest operating expense. These are public record, though a reassessment after a sale can shift the number significantly.
Insurance premiums for property damage, liability, and any supplemental coverage like flood or umbrella policies.
Maintenance and repairs: HVAC servicing, plumbing fixes, appliance repairs, landscaping, snow removal, pest control, and similar routine work.
Property management fees, typically 4% to 12% of collected rent depending on property type, size, and location. Larger properties command lower percentages because of economies of scale.
Owner-paid utilities: water, sewer, trash, common-area electricity, and anything else the landlord covers rather than passing through to tenants.
Administrative costs: legal fees for lease enforcement, accounting, advertising vacant units, and office supplies for on-site management.

Repairs vs. Capital Improvements

This classification decides whether a cost reduces NOI or sits outside it entirely. The IRS draws the line based on whether the work betters, restores, or adapts the property to a new use. If it does any of those three, it’s a capital improvement and stays out of operating expenses. If it simply keeps the property in its current condition, it’s a deductible repair that belongs in operating expenses.¹

Patching a leaky pipe is a repair. Replacing the entire plumbing system is an improvement. Painting a unit between tenants is a repair. Converting a storage room into a rentable office is an adaptation to a new use. When reviewing someone else’s numbers, check whether large maintenance entries should actually sit in capital expenditures. Misclassifying a $40,000 roof replacement as a repair inflates expenses and depresses NOI below reality.

Replacement Reserves

Replacement reserves are annual set-asides for big-ticket items that wear out predictably, like roofs, HVAC systems, and parking lot surfaces. Whether they appear above or below the NOI line depends on the asset. Multifamily lenders, including Fannie Mae and Freddie Mac, generally require reserves to be deducted above the NOI line because apartments turn over more often. Commercial properties with long-term leases, such as office, retail, and industrial, typically place reserves below NOI with other capital items.

If you’re comparing two properties and one includes reserves in operating expenses while the other doesn’t, the NOIs aren’t comparable. Confirm the treatment before drawing conclusions.

What NOI Leaves Out

NOI measures the property’s earning power independent of ownership and financing. Several significant line items are excluded on purpose, and sweeping any of them into expenses is the most common error.

Mortgage payments. Both principal and interest stay out. Two investors can buy the same building on completely different terms, so debt service reflects the buyer, not the property.
Capital expenditures. A new roof, a repaved parking lot, an elevator replacement. These extend the property’s useful life rather than keep it running day to day.
Depreciation. The IRS allows an allowance for wear and tear on income-producing property under federal tax law, but it is a non-cash accounting entry. No money leaves the bank account, so it doesn’t belong in a cash-based performance metric.²
Income taxes. Personal or entity-level tax liability varies by filing status, deductions, and structure. None of that reflects how the building itself performs.

Use this sanity check: if the cost would change depending on who owns the property, it probably doesn’t belong in NOI. Mortgage terms, tax brackets, and depreciation schedules all vary by owner. Property taxes, insurance, and maintenance don’t.

Actual Numbers vs. Pro-Forma Projections

A pro-forma NOI is a projection built on assumptions about future rents, occupancy, and expenses. An actual NOI comes from verified historical data, usually a trailing 12-month operating statement backed by a rent roll and bank deposits. The two can be far apart.

Pro-forma figures from a seller tend to assume aggressive rent increases, understate vacancy by projecting 3 to 6 months of downtime when the local market produces 9 to 12 for comparable spaces, understate tenant concessions like free rent, and treat expense reimbursements as pure income without the offsetting cost. Each of these inflates NOI, which inflates the apparent value.

Start with actual numbers. Request the trailing 12-month profit and loss statement, the current rent roll, and bank statements to verify deposits. A refusal to provide these tells you something. Projections are useful for modeling upside after you know what the property earns today; they aren’t a starting point for a purchase decision.

Why Precision Matters

NOI drives valuation and lending decisions. Property value under the income approach is NOI divided by the market capitalization rate for comparable properties. At a 7% cap rate, each dollar of NOI changes valuation by roughly $14, so a $280,000 NOI implies about $4 million in value. Lenders also measure debt service coverage by dividing NOI by annual principal and interest payments, and most commercial lenders look for a ratio between 1.20 and 1.25.³ Small classification errors in your NOI calculation move both numbers meaningfully.

Common Mistakes That Distort NOI

A handful of errors show up again and again in operating statements. Catching them early saves you from overpaying or misjudging a property’s health.

Including mortgage payments in operating expenses. Debt service belongs below the NOI line. If “mortgage” or “loan payment” appears in the expense section, pull it out.
Mixing capital expenditures with repairs. A $50,000 roof buried in the maintenance line depresses NOI; leaving legitimate recurring repairs out of expenses inflates it.¹
Using pro-forma income instead of actual rent collected. The result is a hypothetical NOI, not a real one.
Ignoring below-market leases. A tenant paying $1,200 in a $1,600 market will show up as lower current NOI. That reading is accurate, but model the upside separately when leases roll over.
Forgetting management fees on self-managed properties. An owner who runs the building personally may not record a management expense. If you plan to hire a manager, add the 4% to 12% fee back in to see what NOI looks like under professional management.

Verify every line against source documents. Tax bills confirm property taxes. Insurance declarations confirm premiums. Utility bills confirm owner-paid utilities. Bank deposits confirm rent actually collected. If a number can’t be traced to a document, treat it with skepticism.

1
Internal Revenue Service. Tangible Property Regulations – Frequently Asked Questions
2
Office of the Law Revision Counsel. 26 USC 167 – Depreciation
3
Fannie Mae. Debt Service Coverage Ratio (DSCR) Examples