California Real Estate Practice Exam

When is debt service deducted from potential gross income in calculating net operating income?

1. Always

2. When calculating annual income

3. Never

4. Only when specified by the lender

The correct answer is: Never

The correct reasoning for why debt service is never deducted from potential gross income when calculating net operating income (NOI) lies in the definitions and purposes of these financial metrics. Net Operating Income is intended to reflect the income generated by a property from its operations, excluding financing costs. Potential gross income is the total income that a property could generate if fully rented and operating at optimal efficiency, while operating expenses are costs associated with running the property, such as maintenance, property management, and taxes. Before financing is taken into account, NOI is calculated by subtracting these operating expenses from the potential gross income. Including debt service in this calculation would muddy the operational performance of the property and is more appropriate for determining cash flow after operating expenses and debt obligations are separated. Thus, debt service is considered a finance-related expense rather than an operating expense, and it is addressed at a different stage in financial analysis, typically when evaluating cash flow or return on investment. In brief, calculating NOI strictly focuses on operating performance without factoring in financing costs, cementing the rationale that debt service is never deducted from potential gross income in this context.