The Role and Importance of Net Operating Income in Commercial Real Estate Valuation
Written By: Josh Pankin
Calculating Net Operating Income for Commercial Real Estate
Net Operating Income (NOI) is a driving factor in determining the value of commercial real estate. Before getting into the importance of NOI, the role it plays in both short-term and long-term valuation, and how to analyze NOI, let’s walk through a simple example of how to determine the net operating income of a property.
As we can see from the table above, the following formula determines the NOI of a property:
Net Operating Income = Revenue – Expenses
Why is Net Operating Income so Important?
The majority of this paper will discuss the two main components of NOI, revenue and expenses. Before we get there, however, it’s important to discuss one thing that often trips up those who are new to real estate analysis and valuation. In the table above, below NOI, there are line items for Capital Expenditures (CapEx) and Debt Service (DS). When these items are subtracted from NOI, you’re left with the Net Cash Flow (NCF) of a property. The NCF represents the actual cash flow to an investor after any large improvements are paid for and after the mortgage payment is made each month/year. So why don’t we use the NCF for the valuation of a property if that’s what represents the money an investor ultimately receives from the property?
The simple answer is that the NOI is an objective number that represents the “market-based” operation of the property, meaning the market largely determines the occupancy rate and lease rate that determines the revenue and the amount of expenses a property incurs. The capital expenditures and debt service, however, are more subjective and relative to individual owners of a property. For example, one owner may feel that low leverage (a lower loan amount) is better for their investment criteria than another, more risk-tolerant, investor. Thus, the debt service payments will likely be lower, and ultimately the NCF will be higher, for each investor even though the operation of the property results in the same NOI. The same holds with the capital expenditures. If one investor chooses to invest more into renovation and upkeep than another, the NCF would be lower and the valuation would be lower if we were to use NCF for valuation. This doesn’t seem fair to have a property that was better maintained valued lower than one that was not.
So the industry standard is to use the NOI for the valuation of a property. It removes much of the subjectivity and differences in investor profile in the valuation of a property. Another key method to value commercial real estate is through determining cap rates, read our latest guide to find out more.
Major Components of Net Operating Income
Now we’ll dive into the two main determinants of NOI, the revenue and expenses for a property.
Revenue is made up of all payments that tenants or customers make to the owner of the property. It often consists of lease payments, reimbursements for expenses, and other income. Each property type (office, retail, multifamily, etc.) each have their own distinct sources of “other income”, which we’ll discuss only briefly in this paper because this item usually represents a small portion of the revenue for most properties. Although there are many potential sources of revenue, we’ll only discuss a few of the major sources in this paper.
- Lease Payments
Lease payments are the major source of revenue for most properties. For office, retail, and industrial properties, leases are typically five to ten years in length and include a “base rent” amount that determines how much the tenant pays per square foot of space per year. For multifamily properties, tenants pay a specified amount in rent each month.
- Expense Reimbursements – Expense reimbursements are also typically seen only with office, retail, and industrial properties. Tenants will reimburse the owner for either all or some of the expenses incurred during the operation of the property. These expenses could include real estate taxes, electricity, water, and potentially other services as well.
- Other Income – Other income, as mentioned above, usually represents a very small portion of the revenue of a property. For multifamily properties, other income could include laundry, furniture rental, or a membership to the fitness center on the property. With office, retail, and industrial buildings, other income could include parking, rental of space on the roof of the building for communications equipment, or cleaning services.
- Vacancies – Although vacancy is not a source of revenue, any empty space not receiving lease payments will reduce the amount of revenue an owner could potentially receive for the property. We’re only mentioning it here because vacancies are sometimes represented in two different ways that you should be aware of in case you come across them. Some real estate professionals include something called “Gross Potential Rent” and then subtract lost revenue from vacant space to get to “Net Rental Revenue,” while other professionals simply use the amount of revenue that was actually received. The Gross Potential Rent and Vacancy approach is the more formal method, but you should always check to be sure which method was used.
Operating expenses for commercial real estate properties are a little more straightforward than revenue. Typical expense items for properties are listed below.
- Real estate Taxes
- Repairs and Maintenance
- Sales and Marketing
For larger properties, there could be many more types of expense and even subcategories of expenses within each main category. A detailed discussion of expenses is beyond the scope of this paper, but you should be aware that each property should be carefully analyzed for all expenses that might be incurred by an owner.
Analysis of Net Operating Income
Now that we’ve established a basic understanding of what NOI is, why it’s important, and the main components that are used to determine the NOI, we can look more deeply at analyzing each of these factors to help determine both short-term and long-term potential value of a property.
How Net Operating Income Impacts Valuation and Return
Earlier, we mentioned that Net Cash Flow (NCF) is the ultimate cash flow to the investor, whereas NOI is the income before capital expenditures and debt service is deducted. While this is the case, the return that an investor receives is much more dependent on the amount of revenue the property generates rather than the optimization of expenses and debt service. For example, if rental revenue drops by 50% because of the loss of a major tenant, it’s unlikely that NOI or NCF will be positive, despite some small reductions in expenses that can be achieved. Likewise, if one sees decreasing rental rates and/or occupancy rates in the market, an owner may experience a gradual drop in NOI and NCF over time, which will slowly erode both the cash flow and the long-term value of the property. Therefore, it’s important to analyze a few factors that will affect the performance of the property over the hold period.
- Lease Expirations – When analyzing the rent roll for a property, you should look for any lease expirations. Multifamily property leases are generally for a one-year term, so this isn’t a significant factor. However, almost every commercial property (office, retail, industrial) will have leases that expire over a five- or ten-year hold period, but an analyst should pay careful attention to any major tenant expiration or any concentrated rollover (meaning multiple tenants with lease expiration at roughly the same time). Losing a major tenant or multiple tenants at once could have a major negative impact on the NOI of the property, thus the owner’s ability to cover expenses and debt service.
- Market Trends – The other major factor an analyst should be aware of is the larger direction of the real estate market as it relates to the subject property. If an investor is targeting a ten-year hold period in a market where rental rates and/or occupancy rates are declining (and expected to continue to decline), revenue and NOI will likely be slowly eroded over the hold period and could significantly decrease the value of the property and the overall return the investor achieves.
In this paper we’ve discussed the components of the NOI of properties and looked at some factors that impact NOI. We’ve also looked at the way NOI affects both the value of a property and the long-term return an investor could achieve. Every property is different and will have a unique set of tenants, income, and expenses. Over time, real estate professionals gain a better intuition of what factors are important for each property and a better understanding of the long-term consequences of changes to the NOI.
About the Author
Josh Panknin is a Visiting Assistant Professor of Real Estate at New York University’s Schack Institute of Real Estate and an adjunct professor in the school of engineering at Columbia University. Prior to academics, Josh was Head of Credit Modeling and Analytics at Deutsche Bank’s secondary CMBS trading desk where he helped develop and implement automated models for valuing CMBS loans and bonds. He also spent time at the Ackman-Ziff Real Estate Group and in various other roles in research, acquisitions, and redevelopment. Josh has a master’s degree in finance from San Diego State University and a master’s degree in real estate finance from New York University’s Schack Institute of Real Estate.