Investment & Income Property

Net Operating Income (NOI) equals effective gross income minus operating expenses before debt service and income taxes. Cash flow to the investor is NOI minus debt service. NOI is before financing; cash flow is after.

Net operating income is effective gross income less operating expenses attributable to operating the property. In a standard valuation calculation, NOI is before mortgage principal and interest, income taxes, depreciation, and owner-specific financing costs. Depending on the problem or lender convention, reserves or management costs may be classified differently, so follow the stated definition.

Cash flow is a later step: subtract debt service from NOI, and account for capital expenditures, income taxes, and other owner-level items only when the question asks for them. NOI helps compare properties without financing differences; cash flow reflects a particular capital structure. Do not use one measure as a substitute for the other.

Potential Gross Income (PGI) is the income at full occupancy. Effective Gross Income (EGI) = PGI − Vacancy and Collection Loss (+ Other Income). Operating expenses are deducted from EGI to arrive at NOI.

Potential gross income (PGI) is scheduled income at full occupancy under the assumptions used, before vacancy and collection loss. Effective gross income (EGI) adjusts PGI for expected lost rent and adds other property income, such as parking or laundry, if the problem includes it. Do not count an expense reimbursement twice if already incorporated into rent or other income.

Operating expenses are deducted from EGI to derive NOI. Typical operating costs can include property taxes, insurance, utilities paid by owner, routine maintenance, and management, but debt service, income taxes, and depreciation are not operating expenses in the standard NOI formula. Distinguish operating costs from capital improvements that extend useful life or add value.

Leverage uses borrowed money to control an asset with less investor equity. Positive leverage occurs when the return on investment exceeds the cost of debt. Leverage magnifies both gains and losses.

Leverage is the use of borrowed funds to acquire or control an investment with less investor equity than an all-cash purchase would require. It can improve the equity return when the property's return exceeds the effective borrowing cost, after accounting for expenses and risk. But the comparison must use compatible definitions and periods.

Debt is a fixed contractual obligation even when rent or value declines. Leverage magnifies gains when performance is favorable and magnifies losses when income falls or financing costs rise. A property's cap rate alone does not establish a positive leveraged return: amortization, loan terms, transaction costs, taxes, and appreciation assumptions can change the result.

Direct capitalization converts one stabilized year's NOI into value using an appropriate capitalization rate. Value = NOI ÷ Cap Rate. This is the core income approach formula for the real estate exam.

Direct capitalization converts one stabilized period of expected NOI into a value indication: value = NOI ÷ capitalization rate. Use the same time basis for both—typically annual NOI with an annual market cap rate—and express the rate as a decimal. The method assumes the income is stabilized and the rate appropriately reflects market risk and expectations.

Direct capitalization is not a discounted-cash-flow forecast of every future year and is not a mortgage calculation. Select a rate supported by relevant market evidence; changing the rate can materially change indicated value. If income is atypical or expected to change significantly, a single stabilized year may not represent the investment, so the method's assumption should be stated.