Building a Defensible NOI for U.S. Multifamily, Retail, and Office Assets

3 Star Low-Rise Apartments

Introduction

Net Operating Income (NOI) is the linchpin of commercial real estate finance – it measures a property's profitability and directly influences its value and financing potential. In simple terms, NOI equals a property’s income from operations minus its operating expenses. While the formula is straightforward, building a defensible NOI means ensuring that this number is unassailable under scrutiny. Lenders, investors, and appraisers rely on NOI for underwriting loans, valuing assets, and making investment decisions. Therefore, an accurate and defensible NOI is essential for multifamily apartment buildings, retail centers, and office properties in the U.S. market. A defensible NOI gives all parties confidence that the property’s financial performance is realistic and sustainable, preventing surprises during due diligence or negotiations. As one analyst notes, you don't want a buyer to “play games” by arguing that certain income or expense assumptions should be different, thus lowering your NOI and price. By thoroughly reviewing leases, financial records, and market norms, a seller or owner can enter negotiations knowing the true NOI of the property – eliminating wildcards that could undermine value.

In this educational guide, we discuss why a defensible NOI is so important in underwriting, valuation, and financing decisions. We will distinguish recurring vs. one-time income and expenses with practical examples, clarify how capital and replacement reserves should be treated (and how they impact NOI), and describe techniques to determine true operating margins while avoiding inflated figures. We also incorporate lender perspectives on NOI – what banks and other financiers look for during due diligence – and provide a practical checklist to verify and validate each component of NOI. The focus is on U.S. commercial real estate practices for multifamily, retail, and office assets. By the end, readers such as lenders, borrowers, and developers will understand how to construct a rock-solid NOI that stands up to scrutiny in any deal.

Why a Defensible NOI Matters in Underwriting, Valuation, and Financing

NOI as the Foundation of Value: In commercial real estate, property value is often derived by capitalizing the NOI (i.e. dividing NOI by a market cap rate). Thus, a small change in NOI can swing property value significantly. A defensible NOI underpins a credible valuation. If an NOI is overstated and cannot be justified, an appraiser or buyer will adjust it down, directly reducing the property's appraised value or purchase price. Offers are frequently based on a target cap rate applied to NOI, so any variable a buyer can argue down – such as overstated income or understated expenses – gives them grounds to lower their offer. By contrast, when an owner presents an NOI that’s been thoroughly vetted (with all assumptions backed by evidence), they can defend the asking price more effectively. In essence, a defensible NOI is an “unassailable” figure grounded in facts, removing ambiguity in negotiations. Sellers feel more confident, and buyers have less leverage to demand price reductions once they see the rigor behind the NOI calculation.

Underwriting and Risk Assessment: From a lender’s perspective, NOI is central to underwriting a loan. Banks and commercial mortgage lenders use NOI to calculate the debt service coverage ratio (DSCR), which measures how comfortably the property’s income covers loan payments. They also compare NOI against debt and equity to ensure the investment’s risk is acceptable. A high, stable NOI generally indicates strong cash flow and can lead to better loan terms, whereas a flimsy or inflated NOI raises red flags. Lenders and investors view NOI as a pure measure of property performance, since it excludes financing costs and taxes that depend on the owner’s situation. In underwriting, they will stress-test NOI by applying conservative assumptions – for example, using market vacancy rates or higher expense forecasts – to be sure the property can withstand adversity. If an owner provides an overly optimistic NOI (perhaps assuming full occupancy or unrealistically low expenses), underwriters will often haircut the income or add expense cushions. Such adjustments reduce the underwritten NOI to a level the lender deems defensible. If the adjusted NOI is much lower than initially presented, the loan amount might be cut or the deal could even fall through. Therefore, presenting a realistic NOI upfront can streamline the financing process and avoid unpleasant surprises. As one source notes, NOI drives both value and the allowable mortgage: NOI / cap rate = value, and meeting a lender’s DSCR threshold depends on accurate NOI projections. In short, getting the NOI right is in everyone’s interest – it informs prudent lending, fair valuation, and sound investment decisions.

Finance and Return Metrics: NOI also feeds into many other analyses. Investors use NOI to compare opportunities and calculate return measures like cap rates and cash-on-cash returns. An accurate NOI helps determine if an asset meets their criteria. For owners, NOI is a key input in cash flow projections and investor reporting. Because NOI excludes debt service, it reflects the property’s ability to generate income regardless of how the deal is financed. This makes it easier to compare properties and judge performance objectively. A strong, defensible NOI suggests the property can cover its operating costs comfortably and is likely to produce reliable cash flow for the owner (and to service any debt). Conversely, a declining or weak NOI might signal operational issues that need addressing (like rising expenses or softening rents). Overall, a defensible NOI is foundational for trust and transparency – it gives lenders confidence that the collateral can support the loan, and it gives investors confidence that the asset’s value and returns are based on reality, not rosy projections.

Recurring vs. One-Time Income and Expenses

A critical aspect of constructing a defensible NOI is distinguishing recurring operational income/expenses from one-time or non-recurring items. NOI should reflect the normal, ongoing performance of the property. By definition, it must exclude any extraordinary or one-time gains or losses that are not part of regular operations. Including a non-recurring windfall in income, or failing to remove a one-off expense spike, can distort NOI and mislead stakeholders about the asset’s true earning power.

Recurring Income includes rents and other income streams that the property consistently generates. For a multifamily property, this is primarily monthly apartment rents (less vacancies) plus regular ancillary income like parking fees, laundry machine income, pet fees, or storage rentals. For retail and office assets, recurring income comes from lease rents paid by tenants, and may also include things like common area maintenance (CAM) reimbursements, percentage rent (if any), parking revenue, etc. These are steady sources tied to occupancy and lease terms. When forecasting NOI, we count only income that is common in the market and likely to continue, supported by leases or historical trend. Any income that is unusual or not reliably repeatable should be scrutinized. For instance, if an office landlord received a lease termination fee from a tenant that broke a lease early, that is a one-time payment – it should not be blended into recurring rent projections since it won’t happen every year. In fact, underwriting guidelines explicitly state that income must be stable, market-driven, and exclude one-time extraordinary non-recurring items. Similarly, if a retail center had a one-time revenue from say, an insurance claim or the sale of an easement, those are not operational earnings and would be excluded from NOI.

Recurring Operating Expenses are the typical costs incurred to run the property on a day-to-day basis: property taxes, insurance, utilities, routine maintenance and repairs, management fees, administrative costs, janitorial services, etc. These expenses happen year after year to keep the property functioning and occupied. For example, a multifamily building will regularly incur expenses for things like cleaning common areas, fixing leaky faucets, paying property management, and so on – these are normal operating expenses and must be deducted from income to calculate NOI.

Non-Recurring Expenses are unusual or extraordinary charges that are not expected to recur annually. These often take the form of capital expenditures or major repairs. A classic example is a roof replacement or installing a new HVAC system – these are large costs that occur infrequently (perhaps once every 20 years for a roof). Because they are not regular annual costs, they are not included in NOI calculations. Instead, they are considered capital improvements and are usually accounted for separately (often “below the line” in financial statements). Another example: if in one year a property had an abnormally high repair expense due to an isolated event (say a major pipe burst causing water damage), that cost might be deemed non-recurring. In presenting a stabilized NOI, the owner would adjust that expense down to a normal level (or exclude the portion that was one-time). Appraisers and lenders remove non-recurring expenses from the historical financials to estimate the stabilized annual expense load. In fact, agency lenders like Fannie Mae explicitly instruct that non-recurring, extraordinary operating expenses must not be included in the underwritten expense estimate. This ensures that the NOI isn’t unduly depressed by a rare event that won’t affect future performance.

On the flip side, one must be careful that owners don’t misclassify expenses to artificially boost NOI. For instance, consistently high repairs and maintenance costs might indicate that something is effectively functioning as a capital expense in disguise (as in an old HVAC system that constantly needs expensive fixes). A buyer could argue those costs are part of true operations if they are recurring every year. Sellers might claim such costs are “capital” to exclude them from NOI, but a diligent analysis will reveal if the expense is really recurring. The rule of thumb is: If an expense is regularly needed to keep the property running, it belongs in the operating expenses. Only truly one-time or very infrequent major costs should be excluded (or capitalized).

Practical Examples:

• One-Time Income: A tenant in a shopping center pays a $100,000 fee to terminate their lease early. This boosts the current year’s revenue but is not a normal ongoing income source. A defensible NOI will exclude that $100K when projecting the stabilized income, since it won’t recur. Similarly, if a multifamily property received a one-off government grant or a legal settlement, those should be stripped out of NOI. Underwriters will only count other income that is stable and supported by historical evidence, excluding anomalies.

• One-Time Expense: An office building’s chiller fails and the owner spends $250,000 on an emergency replacement in one year. This is a capital repair; going forward, the new chiller will last many years with just routine maintenance. In calculating a normalized NOI, that $250K should be removed from the annual operating expenses (perhaps replaced with a smaller reserve amount for future wear and tear). If that large expense were left in a single year’s NOI, it would understate the property’s typical income. By excluding it, we reflect the true ongoing cost of operations. Another scenario is when prior ownership didn’t repair something and then did a big one-time overhaul – that catch-up expense shouldn’t burden future NOI repeatedly.

In summary, a defensible NOI only counts recurring revenues and expenses that represent the property's regular operation. All irregular, non-recurring gains or losses must be identified and adjusted out. This often requires examining several years of financial statements to spot anomalies. For example, if an apartment building’s other income spiked one year due to a one-off event, the underwriter will normalize it to the usual level. By carefully distinguishing these items, you avoid inflating NOI with ephemeral income or deflating it with one-time costs. The end result is a more reliable picture of cash flow that can be confidently used for valuation and lending.

Treatment of Reserves and their Impact on NOI

One nuanced area in NOI calculations is the treatment of capital reserves (replacement reserves). These reserves are funds set aside from operating cash flow each year to pay for the eventual replacement of major building components – things like roofs, mechanical systems, parking lot resurfacing, etc. They are not day-to-day operating expenses, but they represent a real ongoing cost of owning a property if you plan for long-term maintenance. The question is: should you deduct a reserve allowance as an expense when computing NOI?

In U.S. practice, many property owners and brokers do not include replacement reserves in NOI presentations, because excluding them makes the NOI (and thus appraised value) higher. By leaving out reserves, the property’s current income looks larger, which can “boost” the valuation and give an appearance of lower risk. However, most commercial lenders and appraisers do include a replacement reserve allowance when analyzing NOI. Why? Because they recognize that capital items will eventually require cash outlays. Ignoring reserves entirely can paint an overly rosy picture. At some point, a building will need those major expenditures; if the cash isn’t reserved annually, an owner might face a big bill or a loan default in the future. Including a modest reserve in the NOI calculation effectively smooths out those irregular costs by budgeting for them every year.

For example, a multifamily lender like Fannie Mae or Freddie Mac typically requires underwriting a replacement reserve of, say, $250 per unit per year (or more for older assets) as part of the expense load. Similarly, for office or retail properties, underwriters might use a reserve allowance based on square footage (e.g. $0.20 per square foot annually). These figures come from industry experience of typical long-term capital maintenance needs. According to one financing guide, reserve assumptions often range around $175–$250 per unit for multifamily and $0.15–$0.25 per square foot for office/retail/industrial properties, with higher amounts for older buildings. By factoring this in, lenders and investors are recognizing that a portion of the income really ought to be set aside for capital repairs if the property is to continue performing well.

The impact of including reserves is that NOI will be slightly lower in the short term, but this is a more conservative and arguably more accurate reflection of true free cash flow. For instance, imagine an apartment complex with NOI of $500,000 before reserves. If we include a reserve of $200/unit for 100 units ($20,000), the “net” NOI becomes $480,000. While an owner might prefer quoting $500K as NOI (to get a higher value on paper), the $480K is more defensible because it acknowledges the ongoing capital costs of property ownership. An appraiser or lender using $480K will apply the cap rate to that, yielding a slightly lower but more realistic value. It prevents overvaluation that ignores future capital needs.

Some investors intentionally exclude reserves in marketing an investment, effectively saying “capital improvements will be handled separately.” But sophisticated parties will often add it back in. In fact, not accounting for reserves “feigns” a lower risk profile of the asset than reality, which could mislead lenders. A building with no reserve budget might suffer deferred maintenance, leading to higher risk of failure or cash calls later. Lenders do not want that surprise, so they insist on reserves in underwriting. Many loan structures also require escrowing reserves monthly as part of the mortgage payment, ensuring the money is actually set aside.

From an ownership perspective, including a reserve in your pro forma NOI is a best practice for long-term asset management. One industry article notes that many landlords budget a monthly replacement reserve expense to reflect money set aside for future capex, which makes the reported NOI more accurate in economic terms. On financial statements for tax purposes, these reserve contributions might be added back (since they’re not immediately spent), but for internal analysis and underwriting it’s wise to treat them as an expense. Essentially, accounting for replacement reserves on a recurring basis gives a truer picture of a building’s cash flow after all necessary costs.

To illustrate, consider a retail strip center with an aging parking lot. Rather than waiting for a $100,000 repaving every 10 years, the owner sets aside $10,000 per year in a reserve. If that $10k is included in the NOI calculation each year, the NOI is lower, but when the repaving is due, the funds are available and it doesn’t suddenly crush the cash flow or require new financing. A buyer evaluating the deal will appreciate that foresight and might be more confident in the NOI figure knowing that major capital items are covered.

In summary, the treatment of reserves often differentiates an aggressive pro forma from a conservative one. For a defensible NOI, it's advisable to include a reasonable reserve allowance as part of operating expenses (or at least disclose it separately) so that all parties acknowledge those future costs. Most lenders will insist on it, and appraisers will factor it in, so failing to include reserves could lead to your NOI being adjusted downward in due diligence anyway. As a rule, exclude routine capital expenditures from NOI (as they are not regular operating expenses), but include a reserve line to capture the essence of those costs over time. By doing so, you align with industry norms and demonstrate a thorough, realistic approach to property financials.

Determining True Operating Margins (and Avoiding Inflated Figures)

A healthy operating margin – the percentage of income left as NOI after operating expenses – varies by property type, but it can serve as a check on whether your NOI assumptions are realistic or potentially inflated. Computing the operating expense ratio (OpEx ratio = operating expenses / effective gross income) or conversely the NOI margin (NOI / income) allows you to benchmark against typical ranges. If a property’s projected margin is far outside the normal range, it warrants investigation.

Typical NOI Margins by Asset Type: Every sector has different expense characteristics:

• Multifamily: Apartment properties usually have operating expense ratios in the range of roughly 35%–45% of effective gross income. This implies an NOI margin (the complement) of about 55%–65%. In other words, for each dollar of rent, $0.35–$0.45 goes to expenses and $0.55–$0.65 is NOI. Well-run multifamily assets often fall in this range, though older properties or those with lots of amenities might run higher expenses. If you see a multifamily pro forma claiming only 20% expenses (80% margin), that would be a huge red flag – it likely means some expenses are omitted or understated. Indeed, industry data suggests 35–45% is common for apartments, so anything drastically lower should be scrutinized for missing costs (like maybe no management fee assumed, or unrealistically low maintenance).

• Office: Operating expense ratios for office buildings tend to range from about 35% up to 55%, depending on lease structures. If an office is leased on a triple-net (NNN) basis, tenants pay most expenses directly or reimburse the landlord, so the owner’s expense ratio might be at the low end (35% or even less) and NOI margin high (~65% or more). On the other hand, in a full-service gross lease office (where the landlord covers all expenses in the rent), expense ratios can be higher, 50%+, meaning NOI margin around 40–50%. The presence of expense reimbursements, expense stops, and lease terms greatly influence margins. A defensible NOI for an office property will reflect the lease realities: for instance, if the pro forma assumes all tenants are paying their share of increases in expenses, verify that each lease actually has a mechanism like an expense stop or CAM charges. If an office NOI appears too good to be true (very high margin), check if perhaps the underwriter assumed NNN recovery of costs, whereas some leases might exclude certain expenses. As CREModels experts pointed out, a broker’s valuation might assume 100% expense recovery on a NNN asset, but if some leases have exclusions that leave the landlord with unreimbursed costs, the actual NOI could be much lower (e.g. $150k instead of $200k in their example). Thus, verifying the leases is crucial to determine the true margin.

• Retail: Retail property margins can vary widely by lease type as well. Multi-tenant shopping centers often use triple-net leases where tenants pay base rent plus their share of taxes, insurance, and CAM. In such cases, the property’s expense ratio could be very low – perhaps only 20%–30% of income – meaning an NOI margin of 70%–80%. This makes sense because the tenants are directly covering most operating costs. However, if a retail property has some gross leases or has vacancies (landlord pays expenses for vacant units), the effective expense ratio rises. A defensible NOI for a retail asset will incorporate a vacancy and credit loss factor (for lost reimbursements on empty space) and any non-reimbursable expenses. If a pro forma shows near 80% NOI margin, it likely assumes full occupancy with tenants covering almost everything – ensure that is aligned with reality (i.e., confirm that all current tenants are indeed paying their CAM/tax shares and that you have a reasonable vacancy allowance for downtime). On the higher end, if a retail property’s expense ratio is, say, 50% or more, it might mean either it’s a smaller property where economies of scale are lower, or some leases are gross. The typical range for well-run retail centers is around 20%–30% expense ratio under NNN leases, so any deviation from that should be explained by lease structure or unusual costs.

The key point is that by comparing your NOI margin to industry benchmarks, you can detect possible inflation or underestimation of expenses:

• If the margin is too high relative to norms, you may have overlooked costs (common culprits: property management, adequate maintenance, realistic insurance or taxes, or reserves). It could also be that you assumed 0% vacancy perpetually, which is not realistic – prudent underwriting will include a vacancy factor (often ~5% for stabilized multi-tenant properties).

• If the margin is too low compared to typical, it might mean the property is currently operating inefficiently or has unusual costs. That could signal upside potential (if expenses can be cut) or simply reflect issues like an old building requiring lots of repairs. Regardless, it’s important to understand why.

Avoiding Inflated NOI Figures: Inflated NOI often results from overly optimistic assumptions. Here are common pitfalls and how to avoid them:

• Ignoring Vacancy and Credit Loss: Even if a property is 100% occupied today, a smart analysis will include a vacancy allowance (for commercial, also credit loss for default risk). Standard underwriting assumes something like 5% to 10% vacancy depending on market and property type. If one presents an NOI assuming absolutely no vacancy forever, that is not defensible – vacancies are a regular occurrence in real estate. Including a vacancy factor makes the NOI more conservative and credible.

• No Management Fee (Self-Management): Owners who self-manage sometimes leave out a management fee in the expense list, claiming they won’t pay a third-party. However, lenders will impute a management fee (typically 3%–7% of income) anyway, because if the owner had to be replaced or if the property goes into default/receivership, a manager would need to be paid. Also, even for self-management, there is a cost of time and resources. Therefore, to build a defensible NOI, always include a reasonable management fee expense at market rate (e.g. 4% of effective gross income is a common minimum). This avoids overstating NOI. If you don’t, an underwriter certainly will add it, reducing your NOI in their analysis.

• Underestimating Operating Expenses: It’s crucial to do a line-by-line expense audit and also compare against norms (such as expense per unit or per square foot, and the OpEx ratio). Make sure you haven’t assumed, say, unrealistically low repair costs or property insurance. Double-check volatile items like utilities – are you using actual usage and current rates? Underwriting should also trend expenses upward for inflation where appropriate (e.g., property taxes and insurance costs tend to rise over time). If the submitted NOI ignores known upcoming expense increases (for example, an expiring tax abatement or an insurance premium hike), it’s not defensible. Buyers and lenders will catch that and adjust.

• Not Accounting for Property Taxes Properly: This is a big one in the U.S. If a sale will trigger a reassessment of property value for tax purposes (common in states like California), the future property taxes could be much higher than the historical number. An honest NOI projection for a buyer should adjust property taxes to the expected level post-sale. If one simply uses the seller’s current tax expense (which might be based on an old, lower assessment), the NOI is effectively overstated relative to what the new owner will experience. Lenders and appraisers often recalculate property taxes based on the purchase price or current market value to get an accurate expense figure.

• Excluding Necessary Reserves or CapEx: As discussed, ignoring replacement reserves can inflate NOI. Also, if major capital costs are imminent (like elevators at end-of-life, or a needed roof replacement), a fully defensible cash flow analysis would acknowledge those by either planning for them in a reserve or adjusting the price. While capital expenditures are below NOI, savvy investors may deduct recurring capital needs in their own cash flow models. It’s better to be transparent about them.

• Pro Forma Rent Increases Without Basis: Sometimes sellers project NOI growth by assuming rents can be raised significantly or vacancies will immediately lease at top-dollar rents. If you are using forward-looking NOI (e.g., for a development or a repositioning), those assumptions must be grounded in market data and leasing evidence. An aggressive pro forma NOI (future stabilized NOI) should be presented alongside the current NOI, with clear justifications (market rent comps, documented tenant interest, etc.). Otherwise, a lender will likely lend on the in-place NOI or require seasoning to see those pro forma incomes realized before giving full credit. In an existing property underwriting, use in-place or market-supported rents, not speculative high numbers, to be defensible. If a property has under-market rents that you plan to raise, you can note that, but expect underwriters to take a cautious view (maybe only partially crediting that upside until leases are actually signed).

In essence, to avoid inflating NOI, err on the side of conservatism and verify everything. Cross-check the expense ratio against known standards – for example, if your analysis says a suburban office building will operate at a 30% expense ratio, but it’s a multi-tenant building where the owner pays expenses (gross leases), that would contradict typical experience (office gross leases usually have much higher expenses). Such a discrepancy would prompt deeper investigation. By doing that homework yourself, you can correct unrealistic inputs before an external party does it for you. The end goal is an NOI figure that no one can poke holes in – all income and expense components are backed by support and align with real-world performance of that asset type.

Lender Considerations and Due Diligence Perspectives

When evaluating NOI, lenders bring a particularly critical eye. Their chief concern is ensuring the property’s cash flow is sufficient and stable enough to repay the debt with a comfortable cushion. From application through closing, lenders (and the appraisers and underwriters they work with) will dissect the NOI and often make their own adjustments. Here’s what they focus on:

• Income Stability and Quality: Lenders will scrutinize the rent roll and leases to assess how secure the income is. They prefer properties with diversified, seasoned income streams. For multifamily, this might mean looking at occupancy history and current rent collections; for retail/office, it involves reviewing each major lease’s terms, tenant creditworthiness, and lease expirations. They typically request historical operating statements (often 2–3 years) to see if income has been consistent. Any large fluctuations or one-time income items will be noted. As Fannie Mae’s guide emphasizes, they only count other income that is stable, market-standard, and supported by prior years – excluding unusual one-time items. So if a property’s trailing 12 months income includes an anomaly, the lender will strip it out in their underwriting. Lease audits are common: the lender may require estoppel certificates or other verification from major tenants confirming lease terms and rent, ensuring the reported income is real and ongoing.

• Occupancy and Lease-up: If the asset is not fully leased or is in lease-up, lenders often underwrite to a stabilized occupancy level (which might be slightly lower than 100% to reflect natural vacancy). They may hold back some loan proceeds until occupancy improves. For example, if an office building is only 85% leased, a lender might underwrite income at 85% plus maybe a modest upside if leases are in pipeline, but they will not give credit for hypothetical full occupancy unless there’s strong evidence. They will also consider lease rollover risk: if a big tenant’s lease expires next year, the underwritten NOI might assume a downtime and re-leasing cost for that space, effectively reducing income in the pro forma.

• Standard Expense Assumptions: As discussed earlier, lenders apply certain standard expenses in underwriting regardless of the owner’s current operations. They will include a property management fee (even if one isn’t currently paid) – typically at least 3–5% of effective income. They will include replacement reserves in the cash flow (for many loan types this is non-negotiable). And they will ensure that major expense line items are in line with market norms (if anything looks too low, they might increase it in the underwritten case). For instance, a lender might compare the expense per unit of a multifamily deal to industry averages or use underwriting guidelines that say, e.g., property insurance must be at least $X per unit and repairs at least $Y per unit, etc., to prevent underestimation. If an expense seems underrepresented, they’ll likely use a higher number from either historical highs or comparables. The goal is to leave no necessary expense unaccounted for in the NOI that supports the loan.

• Reserves and Escrows: Beyond including replacement reserves in the NOI calculation, lenders often require funding certain reserves at closing or monthly – such as a capital expenditure reserve, a tax and insurance escrow, and possibly a lease-up or TI/LC reserve for commercial properties. While these escrows don’t directly change NOI, they affect the net cash flow available to the borrower. From the lender’s viewpoint, money set aside for future costs is part of prudent operation. If a property has known upcoming expenses (like a large tenant improvement for a new lease or a roof that will need replacement), the lender might create a reserve account and withhold some loan funds for it. This is part of due diligence: identifying deferred maintenance or future costs and ensuring they’re covered.

• Property Condition and Deferred Maintenance: Lenders typically order a Property Condition Assessment (PCA) report as part of due diligence. If the PCA finds significant deferred maintenance, the lender may require those repairs to be done (or money escrowed for them). While this is outside the direct NOI calculation, it circles back to NOI because a building in disrepair might face higher operating costs or interruptions. Lenders want to see that the property can operate without major disruptions. If the PCA identifies, say, an elevator is at end of life, the underwriter might not allow NOI to be counted as stable unless there’s a plan (and reserve) to replace that elevator. Thus, property condition ties into how “defensible” the NOI is – the physical due diligence can validate whether the maintenance expenses are adequate or likely to spike.

• Appraisal and Market Rents: The lender’s appraiser will do an independent income approach to value, often constructing their own stabilized NOI for the property. They’ll look at market rent levels, vacancy rates, and expense ratios for similar properties. If the borrower’s provided NOI is off from market indicators, the appraiser might use different figures. For instance, if a borrower assumed rents higher than market or a vacancy lower than typical, the appraiser will cap the income to what’s supportable. Likewise, appraisers (especially for agency loans) have guidelines like capping how much commercial income can contribute for a multifamily property (Fannie Mae, for example, limits counting commercial income to 20% of effective gross income in many cases). They also might use a minimum management fee of 4% of income by appraisal standards, even if actual is lower. All these conservative touches mean that lenders often see a “net operating income” smaller than the seller’s pro forma. As a GlobeSt article noted, a buyer’s or lender’s NOI is usually lower than the seller’s because of more conservative assumptions – higher vacancy, ensuring sufficient expenses, etc. (the article referenced four different NOIs: seller’s, buyer’s, lender’s, and appraiser’s, each progressively more conservative). The best or most realistic one is typically the one that accounts for all these prudent adjustments.

• Due Diligence Verification: During underwriting, lenders will typically require a due diligence checklist of documents to verify NOI components. This can include:

  • Rent Roll (dated within 30-60 days) – to verify current rents, lease terms, deposits, etc. For multifamily, they may want a certified rent roll to ensure accuracy. In retail/office, they might ask for copies of major leases or lease abstracts to verify rents, escalations, renewal options, and expense responsibilities.

  • Operating Statements and GL – usually trailing 12-month and year-end financial statements. Lenders compare the year-to-date figures with annualized numbers, watch for seasonality (e.g., higher utility costs in summer/winter), and see if any line item looks off. They may even request bank statements or tax returns to cross-verify that the income reported was actually received (especially for smaller borrowers or if something seems fishy).

  • CAM Reconciliation Statements (for NNN properties) – to see how expenses vs recoveries matched up in prior years. This can reveal if the owner was unable to recover certain expenses from tenants (perhaps due to lease caps or exclusions). It helps the lender judge if the assumed recovery rate in NOI is valid.

  • Lease Documents and Estoppels: For larger tenants, lenders often require estoppel certificates, where the tenant confirms key facts of their lease (rent, term, any defaults, etc.). This protects against situations where, say, a seller might not disclose a tenant is on month-to-month or has a co-tenancy clause that got triggered. If a tenant is crucial to NOI, the lender will want to be sure that tenant is secure and paying.

  • Insurance and Tax Bills: Lenders will get the latest insurance quote or policy to confirm the premium (and they might require specific coverage increases, affecting cost). They also verify property taxes – checking with the county or using the mill rate on the latest assessed value – to ensure the tax expense used in NOI is correct. As mentioned, if a sale will reset the assessment, the lender will account for that higher tax bill.

  • Environmental Report: Though not directly related to NOI, if an environmental issue is found, it could lead to additional costs or escrows (for remediation) which indirectly affect the financials or the loan approval.

From a due diligence perspective of a lender (or a cautious buyer), the process is about verifying and validating every component of NOI. They assume nothing and confirm everything. Any income that isn’t backed by a lease or historical trend is tossed out or heavily discounted. Any expense that looks under-budgeted is increased to a realistic figure. The result is an underwritten NOI (sometimes called Underwritten Net Cash Flow) that the lender uses for loan sizing. For example, Fannie Mae calls this Underwritten NCF, and it requires that the lender’s underwritten income exclude non-recurring items and that stabilized expenses be used, with a minimum management fee, etc. All lenders, even private ones, follow similar logic: they want a cushion such that even if things go slightly worse than expected, the property will still generate enough NOI to pay the mortgage with room to spare.

For borrowers and developers, understanding the lender’s viewpoint is critical. You might be aiming to maximize NOI for valuation, but the lender will trim it to what’s defensible. To avoid surprises, it’s wise to pre-underwrite your deal like a lender would – include vacancy, management fees, reserves, realistic expenses – and see what loan amount that NOI supports. That way, you can gauge if the project is financeable and at what leverage. It also means that when you present financials to the lender, you’re speaking their language, which boosts your credibility. A fully documented, defensible NOI can expedite credit approval because the lender finds fewer issues to correct. And if you’re a developer projecting an NOI on a future stabilized basis, providing third-party evidence (market studies, pre-leases, expense comparables) for your assumptions will make the lender more comfortable.

In summary, lenders conduct thorough due diligence on NOI because their capital is at risk based on the property’s cash flow. They will recalculate and verify each line. A borrower’s job, in building a defensible NOI, is essentially to do this homework in advance. By wearing the lender’s hat and being rigorous, you not only get a realistic picture for yourself, but you also smooth the financing process, as there will be fewer discrepancies for the bank to iron out.

Practical Checklist for Verifying and Validating NOI Components

To ensure every element of your NOI is defensible, use a systematic approach. Below is a practical checklist that owners, buyers, and lenders alike can follow during underwriting and due diligence. This checklist covers the key components to verify, questions to ask, and common pitfalls to avoid:

1. Rent Roll and Lease Audit: Obtain the latest rent roll and verify that it matches the rental income used in NOI. Check each unit or tenant for:

   • Lease Terms: Verify rent amounts, lease start/end dates, options, and escalations. Are all tenants paying the expected rent? If any leases have free rent periods or upcoming step-ups, account for those in income.

   • Occupancy Status: Ensure the rent roll occupancy (occupied vs vacant units) aligns with the vacancy rate used. If the pro forma assumes 95% occupancy but only 90% is currently occupied, is there a plan or leases signed to justify 95%? Don’t assume higher occupancy without evidence.

   • Tenant Quality (Commercial): For retail/office, consider the credit and stability of major tenants. A small local business versus a national chain might imply different risk. If a major tenant is on month-to-month or has a termination right, be cautious in counting that income fully.

   • One-Time Tenant Payments: Check if any income in the statements was from one-off sources like a termination fee, reimbursement for improvements, or legal settlement with a tenant. Flag those to exclude from recurring NOI.

   • Rent Concessions: If tenants got concessions (like one month free on move-in), ensure the NOI reflects the effective rent, not just the face rent. Lenders will typically net out concessions over the lease term.

2. Other Income Validation: Break out all other income (parking, laundry, storage, signage, vending, etc.). For each category:

   • Recurring vs Non-recurring: Was this income collected consistently each month? For example, if parking income was $10,000 last year, is that from monthly parking fees (likely recurring) or was there a one-time event like renting the lot for a fair (non-recurring)? Only include the sustainable portion.

   • Market Commonality: Is the income type common for this property type and market? If you are counting income from something unusual (e.g., cell tower lease on an office building roof), make sure it’s a valid long-term contract and note if it expires.

   • Historical Support: Compare other income across previous years. Lenders prefer to see stable or increasing other income; if it jumped around, they may take a lower average. Make sure your NOI isn’t assuming the highest number without justification.

   • Bad Debt Adjustments: Review if any portion of other income or rent was uncollectible (bad debt). Typically, financials net out bad debt. If there were significant write-offs, underwriters might incorporate a bad debt reserve going forward, effectively reducing income.

3. Effective Gross Income Calculation: Ensure you have properly calculated effective gross income (EGI = gross potential rent + other income – vacancy – credit loss – concessions). This is the income side of NOI. Checkpoints:

   • Gross Potential Rent: If the property were fully leased at market/contract rents, what is the total? Compare that to actual collected rent + vacancy loss to see if the vacancy deduction applied is reasonable.

   • Vacancy Rate: Is the vacancy rate used for NOI consistent with either current vacancy or market stabilized vacancy (whichever is higher)? Lenders will often take the greater of actual or a market minimum (e.g., use at least 5%). Make sure you included a vacancy allowance even if currently fully occupied.

   • Concessions: Deduct any free rent given. If the current occupancy was achieved by offering concessions, reflect that cost. Lenders might amortize large concessions over the lease term as an effective rent reduction.

   • Prepaid Rents or Deposits: If any tenants paid rent in advance (beyond one month) or have significant deposits that were applied, ensure the timing is handled correctly and not double-counted in income.

4. Operating Expenses Audit: Perform a thorough review of each expense line item on the profit and loss (P&L) statements:

   • Property Taxes: Verify the current property tax bill and assess if it will change. If you are buying the property, calculate taxes based on purchase price (some jurisdictions reassess at sale). Use that number in the pro forma NOI to be safe. Check for any tax abatements or phased increases.

   • Insurance: Get an insurance quote for the coverage required (often lenders need certain liability and replacement coverage). Ensure the expense in NOI matches a realistic insurance premium. Sometimes sellers underinsure to cut costs – don’t carry over an unrealistically low insurance expense.

   • Utilities: Obtain actual utility bills (at least a summary). Verify usage and rates. If tenants reimburse utilities, see if owners pay anything (common area electric, water for residential unless submetered, etc.). Also, consider if any recent rate changes or additional charges (e.g., a new stormwater fee) apply.

   • Repairs and Maintenance: This can be a large, and often mis-estimated, category. Look at the general ledger for maintenance expenses. Were there any big ticket repairs classified here? If yes, consider if they were one-time (and perhaps move them out to one-time adjustments). Conversely, check if maintenance seems too low – perhaps the owner deferred things. An older property typically has higher R&M costs; compare the per unit or per square foot maintenance cost to industry benchmarks.

   • Contracted Services: Expenses like landscaping, trash removal, security, pest control, etc. – review service contracts and ensure those costs are included and correctly reflected. If the seller self-performs something (landscaping by their staff), and you will have to contract it out, adjust the expense accordingly.

   • Property Management Fee: As noted, include a reasonable management fee if one is not already in the statements. If the owner paid themselves a token $500/month but market rate is 4% of income, use the higher figure. A common minimum is around 3–4% of EGI for larger assets (and can be higher for small properties). Lenders often use at least 4%.

   • Administrative & Payroll: If applicable (e.g., on-site staff for large multifamily or office building engineers), include those costs. Ensure that any employee salaries, benefits, and related costs are captured.

   • General & Administrative: This might include legal, accounting, advertising, etc. Check if prior financials had any one-time legal fees (e.g., a lawsuit) – if yes, adjust that out as non-recurring unless such litigation is likely to recur.

   • Replacement Reserve: Add a reserve if not already in the P&L. As discussed, a typical amount might be ~$250/unit for apartments or ~$0.20/sf for commercial, but tailor it to the property’s needs. At minimum, lenders or appraisers will impose this, so better to include it upfront in your NOI.

   • Verify Expense Consistency: Compare the latest year expenses to prior years (and possibly to budget, if available). Significant deviations should be explained. For example, if utilities spiked 20%, maybe a rate increase occurred. If repairs dropped to near zero, maybe the owner did a renovation (or maybe they deferred everything – which means future expenses could jump).

   • Non-recurring Expenses: Identify any extraordinary expenses in the historical P&L and exclude them from the stabilized projection. If last year includes a $50,000 one-time repair (flood damage fix, etc.), that should be removed. Conversely, if an expense is abnormally low one year due to a one-time saving (e.g., a tax refund or an expense paid by insurance), normalize it back up.

5. Capital Expenditures (CapEx) vs Operating Expenses: Review the seller’s records for capital expenditures. Sometimes owners expense items that should be capitalized or vice versa. Ensure proper classification: true CapEx (roof replacements, new HVAC units, tenant improvements, etc.) should not be counted in NOI (other than via the reserve). If you find CapEx items buried in the operating expenses, you may remove them – but be careful. Verify that those were indeed one-time and that excluding them doesn’t ignore an ongoing issue. For example, if the owner expensed a new boiler (capital item), you can take it out of NOI calculation; but then note that a new boiler is installed (a positive for future operations). On the other hand, if the owner has been repeatedly patching a leaky roof under repairs each year, that expense might actually be recurring until the roof is replaced. Either capitalize the whole roof replacement in your budget (and remove the recurring patches going forward, with a reserve for roof), or account for continued high repairs. The bottom line is to prevent double counting or omission – CapEx should be out of NOI, but all necessary ongoing repairs must be in NOI. Document any adjustments clearly for transparency.

6. Operating Expense Ratio Sanity Check: After assembling the adjusted income and expense, calculate the operating expense ratio and NOI margin. Compare these to the typical ranges:

   • Does the expense ratio fall in the expected range for that property type and class? (E.g., ~40% for a stabilized multifamily, or ~25% for a NNN retail center, etc. ). If not, re-examine. Maybe you missed something or the property has a special situation. Be ready to justify why it’s outside the norm (e.g., “Property is new construction with very low maintenance needs, hence a lower expense ratio” or “Property has a union labor contract, hence higher payroll expense causing higher ratio”).

   • If you’re underwriting improvements (like you plan to do energy efficiency upgrades to reduce utilities), don’t assume the savings without evidence. Perhaps run an alternate scenario with and without to show impact, but maintain a conservative base case.

7. Lender Underwriting Assumptions: Before finalizing your “defensible NOI,” apply typical lender guidelines as a test:

   • Include the vacancy, management fee, and reserve assumptions a bank would use (often 5% vacancy, ~4% management, and appropriate reserves – which we have done in prior steps).

   • Compute the DSCR using the NOI and a plausible loan interest rate & amortization. Is the DSCR above the lender’s minimum (often 1.20x–1.30x)? If the NOI is truly solid and not inflated, you should meet the coverage. If not, either the NOI is too low (property might be over-leveraged or deal doesn’t work unless price comes down) or you’ve been extremely conservative. Double-check if any adjustments are overly pessimistic or if the property legitimately struggles to cover debt.

   • Check LTV: Using the NOI and a market cap rate, get a value and see loan-to-value. If you assumed a high NOI that gave a high value and the lender’s appraisal comes lower, you could have an issue. By validating your NOI against the market cap and sale comps, you ensure the value implied is reasonable.

8. Documentation and Support: For every element of NOI, maintain a backup document or explanation:

   • Rent roll highlights, lease abstracts for big tenants, market rent comps if you used them.

   • For other income, maybe copies of contracts (e.g., laundry machine lease, parking agreements).

   • For expenses, copies of tax bills, insurance quotes, utility bills, maintenance contracts, recent invoices, etc. Many lenders actually require these documents. For instance, they often ask for the last 12 months of utility bills, the insurance accord, and a tax statement.

   • If you removed or adjusted any item as non-recurring, write a short note explaining what it was and why it’s excluded (e.g., “Removed $15,000 expense from 2024 for one-time mold remediation after pipe burst – issue resolved and not expected to recur.”). This helps an investor or lender reviewing your NOI package to agree with your logic.

9. Third-Party Reviews: If possible, get a third-party or partner to review your NOI assumptions. Fresh eyes might catch something you missed. Sometimes hiring a professional real estate consultant or accountant to do a financial audit of the rent roll and P&L can be worth it, especially for larger assets. They might perform procedures similar to a due diligence team: verifying rent payments, ensuring expenses tie to invoices, etc. The end result can be a Defensible NOI™ report (to borrow the CREModels term), which sellers use to give buyers confidence in the numbers.

10. Ongoing Monitoring: Once you have a defensible NOI and the deal moves forward (whether a financing or sale), continue to monitor actual performance against that underwritten NOI. If something changes (a tenant leaves, a new expense emerges), update the NOI and inform relevant parties if material. Transparency builds trust – for instance, a lender will appreciate proactive updates if a surprise arises during closing (perhaps an insurance quote came in higher than expected, altering NOI slightly). It’s better to adjust and show the resiliency of cash flow than to hide it.

By following this checklist, you effectively reverse-engineer the due diligence process that sophisticated investors and lenders will conduct. The result is an NOI figure that has been verified and validated from all angles – lease-by-lease, bill-by-bill, and benchmarked by market data. Such an NOI is truly defensible: every line can be justified with documentation or reasoning, leaving little room for a counterparty to argue it down.

Conclusion

Building a defensible NOI for a commercial real estate asset is both an art and a science. It requires an analytical deep dive into the property’s financials and leases, a solid understanding of market norms, and a conservative mindset that prioritizes accuracy over optimism. The reward for this diligence is substantial. With a well-substantiated NOI, lenders are more likely to offer favorable financing since they trust the cash flow projections. Investors and buyers are more willing to transact (and at better pricing) when they see that the income has been vetted – it reduces the perceived risk of unpleasant surprises later. And for owners and developers, operating with a defensible NOI means better decision-making: you’re managing the property based on real numbers, which helps in setting rents, controlling expenses, and planning reserves for the long haul.

In U.S. commercial real estate, especially in multifamily, retail, and office sectors, the practice of distinguishing recurring vs. one-time items, including appropriate reserves, and benchmarking performance is now standard for serious professionals. It is what separates a quick-and-dirty pro forma from a robust financial analysis. As we’ve discussed, ignoring these principles can lead to inflated NOI figures that crumble under scrutiny, potentially derailing deals or financing late in the game. On the other hand, embracing a defensible NOI approach upfront instills confidence. It turns negotiation into a discussion of facts rather than guesswork – for example, when a buyer sees that the seller has already accounted for that one troublesome lease exclusion reducing recovery, or the upcoming roof replacement via reserves, there is less to haggle over. The focus can shift to the real opportunities of the asset, not squabbles about what the “real” NOI is.

In practical terms, always remember the fundamentals: exclude the extraordinary, budget for the necessary, and verify everything. Whether you are underwriting a new acquisition, preparing an asset for sale, or seeking a refinance, putting in the effort to build a defensible NOI is time well spent. It not only smooths the immediate transaction but also encourages a disciplined management culture that will benefit the property’s performance in the long run. Financial decision-makers in real estate – be they lenders, borrowers, or developers – all speak the language of NOI. By presenting them with a thoroughly defensible number, backed by clear data and reasoning, you are telling a story about the asset that is credible and compelling. And that can make all the difference in achieving a successful outcome in underwriting, valuation, and financing decisions.

October 03, 2025, by a collective authors of MMCG Invest, multi family study consultants.

Sources:

• CREModels – Disposition Services and Defensible NOI™

• Fannie Mae Multifamily Guide – Stable Income and Expense Underwriting

• Northspyre Real Estate Blog – What is (and isn’t) included in NOI

• CommercialRealEstate.loans – Understanding Replacement Reserves

• High Peaks Capital – Multifamily Operating Expenses and Reserve Practices

• Bullpen Real Estate Insights – Operating Expense Ratios by Property Type

• Progress Capital – Underwriting Assumptions (Vacancy, Management Fee, Reserves)