The Rent Growth Narrative Is Out and NOI Is In

Karlin Conklin

Aggressive rent hikes have dominated our news feeds for years. And what a story it’s been. Average national rents in 2021 posted a new record at 15 percent year-over-year, with 2022 coming in second at over 6 percent, according to Yardi Matrix.

With rents projected to trend flat-to-slightly-increasing this year, investors and operators need to shift to a new paradigm. We’ve left the “double-digit rent growth” chapter and entered the era of expense management.

Operating expenses have steadily increased in recent years. For many multifamily owners, that has tempered what would have been tremendous growth in NOI. Additionally, interest rates escalated rapidly during 2022 as the Fed aimed to curb inflation. This forced cap rates to rise from all-time lows. It also had an immediate impact on asset values, in some areas resulting in value loss of 12-18 percent. A sharp focus on increasing NOI is critical to recapturing asset values.

The Other Side of the Story

As economic drags from the pandemic eased in 2021, rent growth trends that were already in place accelerated. Rents moved up quickly in nearly every market, especially across the Sunbelt. Many firms—mine included—expanded their portfolios in these markets that were increasingly attractive to residents seeking affordable housing, lower taxes and a higher quality lifestyle. But for firms with little-to-no asset management oversight, higher income masked problems with rapidly rising expenses that weren’t being monitored well. A few operators were simply raising rents instead of creating renter-focused business plans.

Fundamental to understanding real estate operations is knowing that NOI is a function of income and expenses. Focusing exclusively on income, or solely on expenses, misses the mark. While income ran up over the past two years, expenses—many of which are difficult for an operator to control—started taking big bites out of NOI.

Insurance costs, property taxes, construction materials, and onsite wages have climbed at a pace even greater than inflation. If operators weren’t paying attention, record property revenues didn’t make it to the bottom line. Their NOI may have increased positively but not impressively. This pattern wouldn’t have been an issue in a normal market. But interest rate increases have shaken market values, underscoring the importance of NOI with new emphasis.

Preserving Value by Driving NOI

Multifamily assets are valued as operating businesses, with pricing based on the NOI the property produces. Ultimately, property value is determined by the cap rate, taking into consideration the quality of the physical asset, location, and strength of cash flow.

As an example, in 2022, when cap rates hovered in the 4 percent range, an NOI of $1.4 million resulted in a $35 million valuation. A cap rate shift of 100 basis points higher to 5 percent would require that same property to operate at a $1.75 million NOI to achieve the same $35 million valuation. This would require an increase of 25 percent in NOI just to hold the value steady in a rising cap rate environment.

Where deals traded at mid-to-high 3 caps a year ago in top markets, pricing on those same deals today is starting at a 5 cap. Managing expenses to maximize NOI is one of the few levers that operators can control through a market that is hanging on every move of the debt markets.  Even small changes in NOI have a multiplier effect on overall property value.

Don’t Fear the Correction

The market correction that hit in 2022 was unsurprising, although a bit painful. The NOI narrative is a familiar conversation to those of us who have been multifamily operators through multiple cycles. Perhaps it’s why we’re not fearing the current correction or rise in cap rates. We know that commercial real estate will always be cyclical. We know that in times of market volatility, a hypersensitive focus on expense management allows us to creatively save where we can in order to drive NOI. By adopting this proactive and strategic approach, operators can succeed through up and down cycles in the years to come.

Karlin Conklin is principal, co-president & COO of Investors Management Group.