The Case for Replacing NOI in Times of Economic Uncertainty

In the movie Smoke Signals, screenplay by Sherman Alexie and based on his short story collection The Lone Ranger and Tonto Fistfight in Heaven, a pair of young women are always driving a car backwards. There are extensive symbolic explanations of why this happens. According to Alexie, such commentary misses what really happens. They do because it’s an old car on a reservation and the transmission is shot, so it only runs in reverse.

The duo is stuck with one mechanism when they need another. A new paper by Danny Ismail and Harsh Hemnani of Green Street suggests that many CRE investors and owners are doing the same thing. They focus on net operating income, but the authors say that is looking in the past because the metric “is akin to a big ship that turns very slowly.” What it tells you might have been accurate a year ago but doesn’t say where things are going.

As the paper notes, the main approach to valuation involves dividing a yield into a cash flow metric. “The conversation of the last year has been focused on the interplay between inflation, interest rates, and cap rates,” they said. “In other words, ‘denominator risk’ dominated.”

But numerator risk is a big issue now. Interest rates have kept rising and may very well again in June after the Fed’s meeting. Even if not, the sudden bond auctions by the Treasury, given that it had to pause issuances with the debt ceiling limit crisis, will pull liquidity out of the investment markets and out of many bank deposits.

“Assessing ‘numerator risk’ takes the form of analyzing how economically sensitive a property sector is to GDP growth, the operational leverage embedded in the sector, and then what benefit might be gained by the protection of long-term leases,” they wrote. “Property sectors can vary dramatically across these metrics, which means numerator risk and thus valuation changes will differ when the economy takes a sudden, unexpected turn.”

The authors suggest using other cash flow metrics, like Market Revenue per Available Foot (M-RevPAF), which Green Street introduced in 2010, combining market rent and occupancy. They noted that, post pandemic onslaught, “NOI was still squarely in the recovery stage in ’21, while M-RevPAF growth was rapidly accelerating,” which means the latter was more better correlated with markets.

In 2016, Green Street added an additional metric, called Market NOI (M-NOI), which “takes changes in real estate fundamentals (M-RevPAF) and adjusts for operating leverage (NOI margins) and lease length.”