Commercial Real Estate Finance Archives

NOI is one of the most common requests by institutional and family office investors. What does NOI mean? It means “net operating income”.

Most real estate firms use NOI to value properties. NOI gives a true sense of the cash flow at the property by using operating revenues and operating expenses. Anything below the line, meaning below NOI, is not in the normal course of operating the property and therefore, not used in the property’s valuation.

Let’s take a hypothetical situation to better understand what NOI means.

New Investor Requests NOI Details from Real Estate Firm

Perhaps you landed a job at CALPERs. You go, Glen Coco! That’s a huge win.

As part of your job, you need to assess GPs, aka real estate firms, to understand potential investment opportunities in their funds or other vehicles. You will want to understand the investment vehicle’s overall returns as well as individual real estate investments’ performance. That’s because different funds or vehicles will have unique waterfall structures that impact how much you, the investor, get paid.

These waterfall structures are up for renegotiation anytime you invest in a new vehicle. As such, it’s important to understand how well the actual real estate performs, as that could potentially result in higher returns for you. It’s also easier to compare across other real estate firms’ vehicles, as the waterfall structures will vary.

Most new institutional investors (such as yourself in this scenario) make a HUGE mistake here. They know that NOI is important, but they fail to specify what kind of NOI they want. Instead, they send an Excel table with column headers for “Property Name” and “NOI”.

As a GP, I’m freaking out! Here’s what runs through my head:

12 Questions to Understand NOI

Did you mean NOI at acquisition?
Or NOI at exit?
Maybe you meant current NOI?
Or maybe base case underwritten?
Current projected?
What about the time frame? Did you mean trailing 12-months?
Current month (T1) annualized?
T6 annualized?
Or projected 12-months?
If trailing or projected, do I include the current month or start with the month prior or after?
What GL accounts should be included per their definition of NOI?
Is that consistent across all of my property types?

Trust me, these questions could go on and on. Most new institutional investors don’t know what they’re looking for, and many a real estate firm throws darts at a dive-bar decades-old dartboard blindfolded and milk-drunk from the fact that they finally landed an institutional investor.

How Real Estate Firms Should Present NOI

As a GP, I recommend presenting the version of each metric that shines your firm in the best light, as long as you’re consistent across all investments or properties. Then, leave your investor with a list of footnotes explaining what you did. You’ll want this anyway to document and train someone else to help you someday.

How Investors Should Request NOI

As an investor, you’ll want to clarify at least some of the 12 questions above. Otherwise, the data that you receive back won’t be comparable across GPs. And if that’s the case, what’s the point of requesting that data anyway?

What Actually Happens...

Now, let me let you in on a dirty little secret… most institutional investors rarely scrutinize these reports in detail. They will check to make sure that GPs filled them out at least partially. And that’s about it. That said, an investor will – perhaps a new one who read this article – review these reports line by line. They will ask detailed questions and send the report back to the GP, redlined and asking for explanations.

As a GP, you should complete these reports in the same way you do for your regular performance updates; provide just enough information that doesn’t beg additional questions. That may mean filling out all required information, or that may mean filling out what you feel most confident in. I’ll leave that up to you.

Now you know the 12 questions to ask about NOI as a GP and as an institutional investor. I hope you use this knowledge to make improved investment decisions and sharpen your portfolio’s performance. Let me know if you have any questions or edits. I always love hearing from you.

If you think it’s easy being a CFO, think again. You have internal pressures from the acquisitions and investments team to fund cash quickly, manage liquidity so everyone gets paid, quickly and correctly prepare your real estate valuations, and keep your investors (and auditors) happy. That’s a tall order.

Let’s say that you’re the CFO of a commercial real estate firm. It’s year-end, and you have to review your real estate valuations. You may be overwhelmed by the sheer volume of work. You may be tempted to cut corners. To avoid making mistakes in your haste, here are the 5 things that I’d never do as a CFO: real estate valuations edition.

1) Fail to review valuations

You may think this is an unnecessary mention, but I’ve seen enough CRE firms to know that this is worth mentioning. Depending on the size of your firm, you may not need to perform a detailed review of each valuation model (and roll-up, if a fund). That said, someone at your firm needs to perform a detailed, line-by-line review of each valuation.

They should sanity-check totals. Confirm the accuracy of formulas. Review reasonableness of variables. Determine whether quarterly or yearly changes in valuation make sense.

Ideally, you have at least one person performing an extremely detailed review, and another person performing a more high level “does this all make sense together?” type of review. If you’re the only reviewer, then do a detailed review, sleep on that, and then do a cursory second check.

2) Not support the cap rates used in the income approach

Real estate firms typically use one of the following three methods for valuing their properties:

The most common approach is the income approach. This is also commonly referred to as the DCF, or discounted cash flow, approach.

With the income approach, you predict the next 12 months’ net operating income for each investment. Then, you determine the market cap rate for your investment. Since you have the market cap rate and forward 12 months’ NOI, you can presume to know what the property/portfolio would trade at if it sold today. Calculate the investment’s value by dividing the forward 12 months’ NOI by the cap rate. You’ll need to account for the capital stack, which I’ll address next. For purposes of determining the overall property or portfolio valuation, the two key ingredients are forward 12 months’ NOI and the market cap rate. The market cap rate sounds pretty important, eh?

It is. And that’s why you need to support it. No self-respecting auditor is going to let you sneak by with a host of cap rates for various markets without justifying *why* you chose those cap rates. You can support it with research data services, BOVs or recent transactions from other properties that you’ve recently sold nearby, or other data sources. Regardless, you need to support where you got your market cap rate from and justify why that’s appropriate for your investment.

3) Forget to account for highly liquid assets in your real estate valuations

This one may surprise some of you! If you think about it, the income approach, BOV, and sales comps methods work to determine the current value of the real estate, not taking into account the current cash held by the real estate’s legal entity (or entities). If you have a material amount of cash sitting on your investments’ books, then you better include it in your total valuation of the investment.

4) Apply incorrect or incomplete prepayment penalties

If you have debt on your investment, then you must take into account the debt when valuing your equity. In other words, if you sold the investment today – or whenever you’re valuing it – then you would need to pay off the debt in full. Many commercial real estate loans come with prepayment penalties. Be sure that you account for those by reducing the amount of equity you’d receive by the prepayment penalty you would have to pay.

5) Fail to verify and document the waterfall structure and debt agreements

Now, this one is the most common of all. We often get in a rhythm of checking the box on valuations. Quarter after quarter or year after year, not much often changes for a single investment. The seemingly routine tasks involved in valuation may lead you to become lethargic. I strongly advise you to avoid this with the plague.

The easiest way to improperly value your real estate investment is not to make a mathematical error; it’s to fail to update your waterfall structure or debt information when a change has occurred. Not all changes involve capital transactions; for example, you may have added a GP to the investment who did not put in any cash, but they will receive payment for their “sweat equity” in the waterfall structure.

You also need to ensure that you have documentation of each of these agreements handy. In the likely event that an auditor requests them, you’ll be prepared. Or god forbid, the SEC makes a surprise visit… well, you’d be prepared for that too.

That’s a wrap, folks! I hope that you enjoyed the 5 things that I’d never do as CFO: real estate valuations edition. Let me know if you have any that you’d avoid too. I always love hearing from you.