By Josh Panknin | September 18, 2020

In a previous paper, we discussed the use of Net Operating Income (NOI) in the valuation of commercial real estate. We also explored the role that revenue plays in determining the NOI of a property. In this paper, we’ll briefly revisit the roles that NOI and revenue play in commercial real estate value and then analyze the second major half of the NOI equation: expenses.

Projecting and managing revenue through leasing activities often receives more attention than managing expenses, but optimizing expenses for efficiency and efficacy can play a key role in maximizing the value of a property.

The NOI Calculation and its Role in Valuation

NOI is calculated using the following formula:



NOI Calculation



The NOI is used in many approaches to property valuation, including the income capitalization and discounted cash flow methods. Thus, accurately estimating and projecting the NOI is a hugely important part of the valuation process.

What are Operating Expenses?

Owning and operating a commercial real estate property, or just about any property for that matter, costs money. Before we start, it’s important to make a distinction between operating expenses and other expenses a property incurs. In this article, the term “operating expenses” includes only those expenses that are incurred in the day-to-day operations of the property. Excluded from this definition are expenses such as capital expenditures (major renovations or repairs) and debt service (mortgage payment).

For those items that are included in the definition of operating expense, there are two general categories they fall within. The first is fixed expenses and the second is variable expenses. The reason for this distinction will become more clear as we discuss the major operating expenses in more detail in the next few sections, but the high-level explanation is that some expenses tend to vary with the occupancy of a property while others are not affected by changes to the operations of the property.

Examples of Common Property Operating Expenses

Below are some of the major categories of operating expenses for commercial properties with a brief description of each. There is absolutely no standardization for categorizing operating expenses for commercial properties, so an analyst should be vigilant in breaking down and understanding all off the current and all of the potential expenses a property might incur.

Fixed Expenses

Real Estate Taxes – Almost every jurisdiction has a unique tax structure that is applied to real property and is based on the “assessed value” of the property. While this expense is considered “fixed,” there are situations in which it could change. The next section discusses some of these situations in more detail. Entire books have been written on real estate taxation. The takeaway here for analysts should be that real estate taxes are often a major, if not the biggest, expense for commercial properties. Spending time understanding how that tax is calculated and how it could potentially change in the future is a crucial part of any valuation analysis.

Insurance – Properties must maintain various insurance coverage items such as liability, natural disaster, fire, etc.

Variable Expenses

Utilities – Includes items such as electricity and water.

Repairs and maintenance – Properties will need repairs from time to time as something breaks or needs updating. Major repairs are not included in this item.

Sales and marketing – Properties usually advertise their space for lease or use and sometimes pay commissions to brokers for any tenant that broker brings in that ends up becoming a tenant.

Management – Often property owners will hire a third party management firm to handle the day-to-day operations of the property. These fees can vary substantially.

Other – There will sometimes be line items for categories such as administrative, payroll, or any number of other things. Clarification should be obtained for any item that’s ambiguous.

The list above is introductory. It’s also important to note that within each of these major categories are numerous subcategories. Analysts should become familiar with expenses properties incur in order to get a feel for when an expense is being left out of a financial statement.

Fixed Versus Variable Operating Expenses

The distinction between fixed and variable operating expenses is related to how each expense is incurred by the property. While taxes and insurance are loosely based on the value of the physical structure of the property, variable operating expenses are largely based on the interaction with tenants. For example, if a property is fully occupied, then the amount of utilities (electricity, water) used to operate the property should be much higher than if the property was only half occupied. With fewer tenants, there should be less use of utilities.

Alternatively, a fully occupied property might incur very low sales and marketing expenses due to the fact that there is currently no space to lease. As tenants leave and space becomes available, the sales and marketing expenses could increase as advertisements and commissions are paid to attract new tenants.

Analysts should understand this variable relationship and which ones are likely to increase/decrease for different situations. Variable expenses should also be analyzed in context to the circumstances of the property when the expenses were incurred. An example of this is using expense amounts incurred during the lease-up of a property to project future operating expenses when the property reaches stability.

Variation of “Fixed” Operating Expenses

There are a few nuances to the rule that fixed expenses are assumed to not change based on the operations of the property. Often, the real estate tax expense for a property will change under certain circumstances, such as when the property sells, is refinanced, or major improvements or deterioration occur. This is because the taxes are defined as a percentage of the value of the property and when the value of the property changes, especially significantly, the taxes are likely to change as well. An unexpected increase in the real estate tax expense could cause a major negative impact to cash flow and has happened more than once to unsuspecting analysts and buyers.

Another nuance an analyst needs to be aware of is the structure of the lease. The Insights article on revenue and lease analysis discusses the different structures of leases and how those structures define the responsibility for expenses.  In short, some expenses could be passed on to tenants who pay a pro rata share of those expenses.


Each of the expenses above should be evaluated for their efficacy in operating the property. Sometimes a line item for an expense on a financial statement will be insufficient for long-term operation of the property. For example, if a previous owner spent very little on repairs and maintenance on the property, an analyst may need to increase the estimate for that expense item to an amount that is more reasonable for maintaining a good physical condition on the property. With experience (and lots of comparable properties), analysts should develop a better feel for what experiences are relevant for different property types and what those expenses should be.

Because operating expenses can significantly affect the NOI of a property, every effort should be made to maximize the efficacy of each expense the property incurs. This is not to say, however, that corners should be cut in order to reduce the expenses at all costs. This type of strategy usually leads to unhappy tenants and lots of deferred maintenance that will reduce the value of the property over the long-term.

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.


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