Understanding the Primary Drivers of NOI in MFH

While there are many dimensions to running a multi-family housing operation, I have found that often the business is deceptively simple. Let’s take for instance the idea of how our businesses create value. There are really only three inputs to value creation:

• What price did you pay for the asset?
• What price did you sell it for?
• What was the NOI while operating the property?

Given that the sale price is a function of NOI can cap rates, NOI is doubly important—NOI drives total IRR by increasing cash flow in the years of ownership and by increasing the sale price. In today’s low cap rate environment, a dollar of NOI can easily be worth $16-25 of extra value at sale price.

So, understanding the drivers of increasing NOI are critical to maximizing our value. While it’s not easy to drive NOI, it’s deceptively simple to understand as the logic below shows:

1. Only two things drive NOI...revenues and expenses
   
   
2. Expenses: Well-run companies tend to have strong expense management processes in place. Therefore, most operators aren’t going to significantly increase their NOI by reducing expenses. If you do have some room to reduce expenses, by all means do so. However, once done, there’s not much more room to go down. So even if you can get short-term NOI growth through expense reduction, you’re unlikely to find sustained, multi-year NOI increases through expense reduction
   
   
3. Revenues: Looking at revenue, there are only three significant drivers of revenue:
   
   
   1. Occupancy. Similar to expenses, well-run companies tend to have strong occupancy (95ish%). Therefore, most operators aren’t going to significantly increase their NOI by increasing occupancy. If you do have any low occupancy communities, by all means work to increase occupancy. However, once done, there’s not much more room to go up. So even if you can get short-term NOI growth through occupancy, you’re unlikely to find sustained, multi-year NOI increases through occupancy growth.
      
      
   2. Rents. Rents can be broken down into three key components
      
      
      1. Rents from new leases. There's no hard limit to how high rents can go. There may be indirect limits (e.g. the debate about how much rent growth can exceed overall inflation in the long term), but that's very different than the limit on expense reduction. Given that typically 40-50% of a rent roll are residents on their first lease, new rent growth over time is a key to value creation- all the more so when one considers that new rents often have an effect on where renewal rents can go as well.
         
         
      2. Rents from renewals. Typically, 50% or more of a rent roll are residents on their second or later leases. However the time dedicated to renewals is much less as most operators spend 8-10 hours or more on new rents and new leases for each hour spent on renewals. And I've seen many a fearful operater cap renewal increases at rates well below the 10-12% increase level that the analysis shows is the lowest rent increase that materially affects how many people will renew.
         
         
      3. Month To Month (MTM) rents. MTM rents also provide an opportunity to boost the rent roll, especially since most of these residents aren't likely to stay much longer than another month or two. However, most of the time, MTM rents only represent 3-5% of the rent roll, so the effect on overall revenue growth tends to be low.
         
         
   3. Ancillary Income. Ancillary income is a nice "extra", but typically doesn't amount to more than 5-10% of total revenue. It's important to do the "blocking and tackling" here, but rarely would it be a driver of sustained, multi-year material growth.

So there you have it. A deceptively simple strategic imperative…if you want to create value, then focusing on rent growth (new and renewal) is by far the most impactful thing you can do. Everything else is secondary.