Why Net Operating Income Matters

It's common for many would-be investors to lump both single-family and commercial real estate into the broader category of 'real estate investing.' But grouping them together misses a key factor that separates the long-term value of commercial real estate investments from the buying and renting a single-family home'“net operating income.

As you can see in the chart above, the value of a single-family residence is driven by three primary factors: land value, the value of the physical structure (often referred to as 'improvements'), and market demand. Imagine if were you to build the exact same house in the Bay Area versus rural Oklahoma. When the housing supply is low, average incomes are high, and buyer demand is stratospheric (as it is in the Bay Area), property values skyrocket (even for older buildings that require significant improvements). In contrast, in less-competitive markets where there is enough housing and average incomes are lower, the overall property values are lower.

For some would-be investors, buying a second house as a rental property (and ultimately selling it) is part of their retirement plan. While the monthly rent may cover operating costs (taxes, maintenance, insurance, etc.), the real value of a single-family rental comes when you ultimately sell it. Net cash flow (or what's left after paying down the mortgage and operating costs) is low to non-existent for a single-family rental. And even if you can earn decent cash flow from a single-family rental for a year or more, all it takes is one major expense, like a new roof or a foundation issue, and your cash flow is wiped out. In order to really profit from a single-family rental, you're banking on an appreciation of the land on which the house sits, an increase in demand for your location, or a combination of the two.

Commercial real estate also relies on land, improvements and market dynamics as value drivers. But what sets it apart from single-family properties is net operating income (NOI).

NOI is defined simply as all revenue from a property (rent) minus all operating expenses. Since most commercial real estate properties have multiple tenants, you're likely to have better rent to operating cost ratios. While land, improvements, and market dynamics all factor into the total value of the commercial real estate, NOI is the largest single value driver. It provides a business model for commercial real estate, meaning that you can make (or lose) money on a property regardless of the greater market dynamics. Even if nothing else changes, if you can improve NOI you increase the value of a commercial real estate property.

This is not the case with single-family residences. It's not that those single-family rentals never have NOI (to the contrary, a leased single-family residence with no debt on it will almost certainly have NOI) but rather, the overall value of the property is not related to its occupancy status. In most cases, the maximum value of a single-family residence is its vacant value. After all, it's not often that a bid on a single-family residence comes in over the asking price by a buyer who just intends to lease it.

If a commercial real estate operator is able to acquire a property, particularly one that is undervalued, and increase its NOI (either by raising rents, decreasing operating costs, or a combination of the two), then, all else being equal, the value of that property increases, regardless if the property is in the Bay Area or Oklahoma. This partially explains why there is always an active market for commercial real estate. An owner may have recently increased NOI (and therefore, the value of a given property), and sees an opportunity to harvest better profits by selling. At the same time, a buyer values the newly improved NOI and wants to earn a yield on a property that is already fully-leased up and delivering a strong monthly cash flow. Those differing perspectives can lead to a transaction.

NOI may seem like a relatively small thing, especially when compared to larger conversations around supply/demand at the macro level. But NOI is the largest single value driver for commercial real estate and can have a dramatic effect on your asset's value.