The reconstructed income and expense statement: NOI and cash flow

Reconstruct the property's earning capacity

A reconstructed income and expense statement adjusts reported results to estimate a property's supportable ongoing performance. Review leases, the rent roll, collection history, bills, and market evidence. Correct omissions, separate personal costs from property costs, and distinguish recurring operations from unusual expenditures. Do not simply accept an unusually good year or replace contract rents with hoped-for rents.

From potential income to NOI

Potential gross rental income assumes full occupancy and collection at the rents used in the analysis. Subtract an allowance for vacancy and collection loss, then add other property income, such as parking or laundry receipts, to obtain effective gross income. State what the vacancy percentage applies to so that other income is not unintentionally reduced twice.

Subtract operating expenses from effective gross income to obtain net operating income (NOI). Operating expenses include property taxes, insurance, management, utilities paid by the owner, and routine repairs and maintenance. Include a supportable management allowance even when an owner performs that work without a paycheck. Exclude mortgage principal and interest, income taxes, and noncash depreciation. A major capital improvement, such as replacing an entire roof, is not a routine repair.

From NOI to cash flow

NOI measures the property's operating performance before financing. Subtract debt service, including both principal and interest payments, to find before-tax cash flow when no other cash adjustments apply. If the analysis includes capital expenditures or reserve funding below NOI, subtract those amounts too. Reserve placement varies among statement conventions; follow the stated convention and never deduct the same amount twice.

For example, annual potential rent is $200,000. Vacancy and collection loss is 5% of potential rent: $200,000 × 0.05 = $10,000. Add $5,000 of other income: $200,000 − $10,000 + $5,000 = $195,000 effective gross income. Subtract $75,000 operating expenses: $195,000 − $75,000 = $120,000 NOI. Subtract $80,000 debt service: $120,000 − $80,000 = $40,000 before-tax cash flow, with no other adjustments.

Two buyers can obtain different cash flows from the same NOI because their financing differs. Positive NOI can coexist with negative cash flow if debt service and other cash requirements exceed it. Neither NOI nor before-tax cash flow is taxable income: tax deductions and their limitations require a separate analysis.