NOI Growth: Drivers and Performance by Property Type

NOI growth

NOI is the abbreviation for net operating income, one of key metrics of the income earning capacity of a property. NOI growth is a key factor for achieving high returns when investing in real estate assets. The reason for this is that when a property’s NOI increases after it is acquired by the investor the return on investment gets double boost.

Firstly, the increase in NOI translates immediately to an increase of the property’s income return. This is the case because the income return is calculated as the ratio of the NOI over the property purchase price. Since the increase occurs after the purchase of the property, then the income return generated by the property should rise as well.

Secondly, all else being equal, NOI growth should result also in an increase in the value of the property.  This is the case, because according to the direct income capitalization approach the value of an income-producing property is equal to the ratio of its NOI over the market cap rate appropriately adjusted to take into account the idiosyncratic characteristics of the property and its location. Thus, assuming that as the NOI of a property increases the cap rate remains constant, its value should be increasing.

What Drives NOI Growth

NOI is calculated as the gross rental income produced by the property minus operating expenses and any rent losses due to non-paying tenants.  As such, the NOI produced by a property can grow for any of the following reasons:

(1) Increases in market rents that can be passed on the rent paid by the existing tenants

(2) Reduction of the property’s vacancy rate and increase of its occupancy rate, if it is not fully occupied

(3) Reduction of the operating expenses of the property

 

How Fast Can NOI Grow?

The growth rate of the NOI of a specific property will depend on a number of factors. For example, it will depend on how fast rental rates for comparable properties in the local market are growing and the extent to which those increases can be passed on to existing tenants of the particular property. In the case of residential properties with short-term contracts, let’s say six months to one year, investors will have greater flexibility in passing the full increases in market rents to the rent paid by the tenants. However, in the case of commercial properties where lease duration typically ranges from 3 to 10 years, it is not possible to pass on any large increases in market rents. Usually, these leases have escalation clauses that allow the investor to raise rents annually but at rates that are closely linked to the registered inflation rate in the previous 12 months.

Increases in the occupancy rate of a property can occur because of two reasons. The first reason is effective marketing and management of the property that results in attracting new tenants. The second factor that can contribute to decreasing vacancy rates is market conditions. In a market in which demand for the particular property type is outstripping supply, investors would be able to increase occupancy rates, unless the property is poorly managed and fails to attract its fair market share of new demand.

Although NOI growth varies from property to property and from market to market, we can get an idea of how fast NOI can grow in the case of investment-grade real estate assets that are professionally managed from data provided by the National Council of Real Estate Investment Fiduciaries (NCREIF).

According to this data, over the last 20 years (from the first quarter of 2000 until the second quarter of 2019) the highest average annual NOI growth rate of 18% and was registered by office properties in the first quarter of 2001. The largest NOI drop in percentage terms was registered by apartment properties. Looking at each property type separately, apartment annual NOI growth over that period ranged from -7.9% to 12%, while office NOI growth ranged from -7.2% to 18%. Industrial NOI growth ranged from -7.7% to 7.9% and retail NOI growth ranged from -3.7% to 9.8% (Fisher and Ludgin, 2019).

In terms of average annual NOI growth over the last twenty years, apartments appear to have registered the highest rate of 3.6% followed by retail with a rate of 3.1%. Office and industrial properties registered the lowest average annual NOI growth rates (2.4% and 2.3%, respectively) over the two decades.

References

Fisher, J and M.  Ludgin. 2019. Second Quarter 2019 NCREIF Indices Review. NCREIF

Kolbe, P. T., & Greer, G. E. (Author), Gaylon E. Greer.  (2012). Investment Analysis for Real Estate Decisions, 8th  Edition. Dearborn Real Estate Education.

Sivitanides, P.  2008. Real Estate Investing for Double-Digit Returns. BookSurge Publishing.

Geltner, M., Miller, N. G., Clayton, J., & Eichholtz, P.  (2013). Commercial Real Estate Analysis and Investments (with CD-ROM). Oncourse Learning

Author: Petros Sivitanides, Ph.D.

Dr. Sivitanides is a seasoned expert in real estate investment strategy and analysis, property portfolio modeling and strategic analysis, and real estate market research and econometric forecasting with over 16 years of experience with leading global real estate investment managers and real estate consultants (CBRE Global Investors, AXA Real Estate, Torto Wheaton Research, DTZ, etc.). He is the editor of the textbook titled “Market Analysis for Real Estate”, which has been used as the main textbook for a graduate course at Harvard University. He is also the author of the book "Real Estate Investing for Double-Digit Returns" and many widely quoted articles that have been published in popular real estate journals. Currently, he is the Head of the Real Estate Department at Neapolis University in Cyprus, and an international real estate consultant.

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