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Each Tuesday, I send a short note on commercial real estate to help you be a better investor. Topics may include deal stories, how I'm thinking about risk, lessons I'm learning, and market observations as we oversee our $500MM+ CRE portfolio and serve our 1,100+ investors.
A few years ago, I didn't know that NOI audits (AKA net operating income verifications) existed for commercial real estate deals. I suspect most passive real estate investors haven't heard of them either.
Now we engage a consultant on almost every investment we make to verify one of the most important numbers in the deal: in-place NOI. The firm we primarily use has been doing this work since 1999, mostly for firms much larger than us.
It costs roughly $10,000 for a typical property, and more for larger ones. Here is what an NOI audit is and why we think it's worth the money.
Why Obsess Over Small NOI Adjustments?
At a 6% cap rate, $100,000 of recurring NOI equates to ~$1.66 million of property value.
Small discrepancies in NOI can create very large valuation issues. This is why paying $10,000 is a rounding error compared to the mistakes it is designed to catch.
NOI Is Easier to Overstate Than Most Investors Realize
NOI involves dozens of accounting details and underwriting judgments. In a sale process, many of those judgments can make the property's NOI appear stronger than it really is. For example:
A recurring repair or turnover expense classified as a capital improvement, which (incorrectly) does not show up in NOI
Property taxes based on the current assessment rather than the reassessment that follows a sale at a higher price
Payroll that reflects current staffing rather than what the property actually needs
One-time or non-recurring other income counted as if it repeats
In most cases, nobody is trying to deceive anyone. Sometimes it is inconsistent accounting. Sometimes a detail simply gets missed. Bottom line: small discrepancies can add up to a meaningful difference in NOI.
Why We Started Doing This in 2023
We first engaged a consultant for NOI verifications in 2023, when we started investing preferred equity for new acquisitions and recapitalizations (not rescue capital).
Our preferred equity typically earns a 7% to 10% current pay plus accrual. If today's property income is expected to fund some or all current pay, we need to know that the in-place NOI is real.
In-place NOI does not always cover current pay on day one. On stabilized recapitalizations, it usually does. On acquisitions, we have often structured a current pay reserve until the property can fully support it.
We also run the same verification for most of our JV Hybrid Equity investments, though the emphasis differs. In those deals, where NOI can go over the next several years matters more than where it is today.
Every pro forma starts with a baseline NOI. If the baseline is wrong, everything downstream is affected.
What the Verification Actually Checks
The firm we work with pulls operating statements, balance sheets, rent rolls, leases, tenant ledgers, bank and credit card statements, general ledgers, tax bills, insurance invoices, vendor invoice files, aged A/P and A/R schedules, and payroll schedules. Then they reconcile it all line by line. A few examples:
Bank reconciliation. Reported revenue for the last 12 months is tied to actual cash deposits, with a tolerance of 3%. This is the simplest and most powerful test in the process: did the tenants actually pay?
Lease testing. A sample of tenants is pulled from the rent roll, and their signed leases and ledgers are compared against what the rent roll claims.
Repairs versus capital. The operating statement is reviewed for repairs that should have been capitalized, and the balance sheet is reviewed for the reverse: repairs improperly capitalized to keep them out of NOI.
In one case, a verification reduced the NOI we were willing to underwrite by more than 30%.
There is a limit to what documents alone can prove. With AI and other technology, it is easier than ever to alter or fabricate documents that look legitimate. That is one reason an NOI verification is only one part of our diligence.
There is still no substitute for getting on-site, walking the units, inspecting the property's physical condition, sitting with the on-site manager, reviewing leases, and ensuring the operations we observe match the story told by the numbers.
Couldn't You Find This Yourself?
A fair question. Much of what an NOI verification uncovers is technically discoverable by our own team. We are not paying for access to secret information. We are paying for two other things:
The first is reconciliation labor from a seasoned pro. This looks like systematically testing whether the rent roll, leases, bank activity, general ledger, staffing, contracts, and other records all tell the same story. Often, the issue is not obvious in one document. It appears when two documents do not reconcile.
The second is independence. Our own team, six weeks into a deal, wants the deal to work. We fight hard against the sunk cost fallacy, but a third party with no economic interest in whether the deal closes is less exposed to that bias.
Why This Matters to You
Though you will probably not hire a consultant to complete one of these yourself, it is worth knowing that NOI is more subjective than you may think.
When evaluating a deal, it's worth taking time to understand the various assumptions that go into the NOI calculation. The list above is a reasonable place to start.
If you are an accredited investor and want to learn more about deals in our pipeline and how we underwrite, click here to schedule a call with us.
If you have feedback or if there's a commercial real estate topic you'd like me to cover in a future newsletter, reply to this email. I read every response!
All the best,
Ben Kahle
Managing Partner | Wellings Capital