Best Ways to Increase the NOI of Commercial Properties

After completing thousands of commercial real estate appraisals, I have found there are a number of ways to grow the net operating income (NOI) of nearly any type of commercial property. Some of these things are easy to implement, some take a little more time, but ultimately, for any investor seeking to maximize their NOI, here's what has to happen.

Pass-Through Expenses

Industrial and retail landlords have been doing this for eternity. It's called the triple net lease (NNN). Real estate taxes, insurance, common area maintenance (CAM) and utilities are directly paid or reimbursed to the landlord by the tenant. At some office or retail properties, where suites are not separately metered for utilities, or there is effort on management's part to determine the pro-rated share of expenses, an admin fee of 3% to 5% can be tacked onto the gross reimbursement amount. Yes, a triple net lease is likely going to have a lower rent per SF than a gross lease, but passing through these expenses means the landlord is exposed to less risk in changing operating expenses year-over-year. For multifamily properties, utility costs can be passed-through to tenants via a ratio utility Bulling System (RUBS).

Base-Year Increases

Sometimes it may be not be possible to implement a triple net lease structure on a property if it would be too prohibitive for management or the landlord to oversee on a monthly basis. Another option to capture back operating expenses are base-year increases. Here's a simple explanation. As operating expenses increase, that increase over the base year amount (usually the first year of a lease term) is passed through to the tenants. So let's say expenses at a property are running at $7.00 per SF the first year of a tenant's lease. The next year, expenses are $7.50 per SF. The tenant is responsible for reimbursing the landlord an additional $0.50 per SF. Base years can be applied to any expense including real estate taxes, insurance, CAM and even general/administrative. Shrewd tenants are going to negotiate a cap on base year increases, but even with a cap, NOI can really be bolstered with the help of tenants covering increases on expenses year-over-year.

Annual Escalations

This is a gimme. Contract rental rates should escalate annually during a typical lease term by 1.00% to 3.00% per year. Alternatively, escalations can be at a set dollar amount like $0.50/SF/year. Fixed rental rates with no escalations limit NOI potential during the lease term. Also, annual escalations help offset operating expenses which can increase 1.00% to 5.00% per year.

Analyze Expenses

Always shop around to ensure operating expenses are not skyrocketing. How many times have you signed up for an internet/cable package for your home or office only to find out three years later the monthly cost is double from where you started? The same thing can happen with a commercial property. Shop around insurance every two or three years, get multiple quotes before signing a contract for trash collection, cleaning services, HVAC maintenance, etc. Something to keep in mind is even if operating expenses appear very high or very low, as an appraiser, I will try to normalize those expenses by looking at the reported expenses of similar properties.

Use a Commercial Broker to Lease

What does a real estate broker or agent have to with the NOI? A lot, actually. Unless an investor or landlord has tenants in their back pocket, using a good commercial broker when trying to lease a vacant industrial building, or an office or retail suite, can result in a faster lease-up period, effectively reducing carrying costs and increasing the NOI. Sure, it is going to cost some money, but wouldn't you rather pay a broker to help you market the space and possibly find you a tenant in three to six months versus doing it yourself and waiting 12 to 18 months? A good broker with a strong network is more likely to outperform the owner trying to lease the space themselves.

Appeal Property Taxes

This one is a bit more challenging, but appealing property taxes can reduce tax liability if a property is over-assessed. In Michigan, the assessed value, or state equalized value, is half of the true cash value, in theory. Even though a property owner pays taxes based on the taxable value, in determining market value, an appraiser relies on the assessed value. In other words, the NOI can take a big hit if there is a significant spread between the assessed value and taxable value, especially if that expense is not being passed through to the tenant. Take a look at the table below.

The current owner of this property is paying approximately $18,000 in taxes (capped). However, the buyer of the property will have to pay over $30,000 in taxes (uncapped) based on the assessed value. That's a 64% swing! I know a lot of property owners may not care about the assessed value on their commercial property since they are not paying taxes based on that amount, but an over-assessed property can really ding the NOI and in turn, the market value.

If you're not sure if your commercial property is over-assessed, consider consulting with an attorney or hiring an appraiser (like me!) to determine the true cash value.

Other Thoughts and Considerations

The following considerations could be blog posts on their own, but here are some other quick thoughts:

Occupancy: 100% occupancy does not necessarily need to be the goal. An appraiser is going to apply a vacancy and collection percentage to the potential gross income (PGI) anyways. Unless we are talking about a net lease property leased on absolute net terms to say a dialysis center, there will almost always be some deduction applied to the PGI for market vacancy. This vacancy and collection loss percentage can depend on so many factors, but safe to say it will likely range from 3% to 20%, or possibly more. Also, having some vacant space gives the landlord flexibility. If market rent is increasing dramatically, a landlord will be able to fill vacant space at market rental rates. Alternatively, available/vacant space gives the landlord flexibility to rearrange space should a tenant require more/less space.

Amenities: Consider converting vacant suites or an under-utilized lower-level area into an amenity like a fitness center, conference room or café space. Perhaps add storage lockers into a windowless space or lower-level and charge a fee. Does offering amenities at a property increase market rent potential? Possibly. The easiest way to quickly check this is compare the asking rents of a property with amenities to a similar property without amenities.

Mechanicals: As lightbulbs, condensers, HVAC equipment or other types of mechanicals require replacement, look into energy-efficient options that could reduce utility expenses. Also look into HVAC control systems on large multi-tenanted buildings to regulate and optimize heating/cooling.

Renewal Options: Writing renewal options into a lease can be good. It can also be bad. On one hand, renewal options would indicate there is a possibility a property could have a long term tenant if options are triggered which creates cash flow stability. But, in a market where rental rates are changing rapidly, the pre-set renewal rental rate in a lease could be below or above-market when it comes time to renew. If the renewal rate is below market, the tenant is more likely to renew and the landlord is stuck with a lease at a rate below market . If the renewal rate is above-market, the tenant may be more likely to vacate and the landlord will be stuck trying to re-lease that space.

Coworking Space: I believe coworking remains a viable product type, however, management of these short term leases is very time intensive. Also, because users of coworking spaces usually sign short term leases on month-to-month terms, it can be harder for an appraiser to project future cash flows. If a building has space that could be suited for coworking or salon suites, lease it out to a specialized operator. Simply collect their rent check and let them handle all the month-to-month leases, cash receivables, etc.

Final Thoughts

These suggestions are all ways to improve income "above the line." I'm sure there are plenty of ways an accountant, lawyer or savvy financial professional can help identify other beneficial strategies to improve cash flows. From an appraiser's perspective, however, the higher the NOI of a property, the higher the overall property value.