Your NOI Calculations Are Probably Not What You Ended Up With

Planning finances and cash management are often treated as givens in most industries, including commercial real estate. There’s some new evidence that often in real estate one of the basic calculations—expectations of net operating income—is frequently far off from eventual reality.

Any potential deal needs some degree of underwriting. Someone has to determine, even at the start, before any possibility of an offer, whether a property has the ability to generate enough income to make a purchase ultimately profitable. That often means a back-of-the-envelope calculation, according to real estate technology firm Archer.

Now, Archer sells software systems to help a company identify real estate deals that might make sense, based on historical likelihood of a party to sell and determine potential pricing from cash-flow forecasting models and market-specific companies. So, yes, the company has an ax to grind, but this is an attempt at persuasion at least worth a listen considering.

As Archer puts it, “One common approach is to take rents and the property size, get revenue from that, and then apply a margin (say 65%) to get net operating income (NOI). Divide that NOI by a target cap rate, and viola! You’re done.”

Fast and easy it is. Accurate? Perhaps not.

The firm took a “random sample of over 300 deals that came out over the two years” and then calculated the actual NOI margins. “The vast majority are below 60%, with a mean of 49%, a median of 51%, and as standard deviation of 13%,” the company noted.

Click the above link and look at the bar graph of the NOI margin distribution. It looks suspiciously like a statistical normal distribution—a bell curve. The mean and median hover right about each other at about 15 percentage points of NOI margin below the type of target figures many in the industry would have sought. Out of the 300 deals, only 17, or just under 6%, had an NOI margin above that 65% number.

Although the distributions weren’t quite as clear, when split out by property class, similar distributions appeared. 

Archer says the difference between an estimated NOI margin and ultimate reality is likely because the estimates missed information and variables that made the difference.

One class of missed information is operational line items that indicate how the property is being managed and offer insight into where conditions could be changed for the better.

Another category is rapidly changing environments. Maybe rents are increasing faster than expected and current owners might reach their target investment faster and be willing to sell. Or rising interest rates and complications in collections could mean poorer potential performance.

Whatever the case, using software to help speed underwriting, whether Archer’s or that of another firm, might make good sense.