Last issue I gave you the overview. This one is about the number that makes the whole strategy work: Net Operating Income, or NOI.
Understanding NOI is the single most important thing you can do before you look at your first deal. Once it clicks, the logic behind value-add investing becomes obvious.
The formula
Commercial real estate is valued based on income, not on what similar buildings sold for. The formula is:
Value = NOI / Cap Rate
NOI is just your income minus your operating expenses:
NOI = Gross Rent - Vacancy - Operating Expenses
The cap rate is the market's expected return for a given property type and location. If industrial buildings in your target market trade at a 7% cap rate, that means buyers are willing to pay roughly 14x annual NOI (1 / 0.07 = 14.3).
Why this matters for value-add
Here's the insight that changes how you look at these deals: when you raise rents or fill vacant space, you directly increase NOI. And when NOI goes up, the value of the property goes up proportionally.
A simple example. You buy a building with $50,000 in annual NOI. At a 7% cap rate, it's worth about $714,000. You do the work: fill vacancies, renovate, get tenants to market rents. Now the property generates $80,000 in NOI. At the same 7% cap rate, it's worth about $1,143,000.
You manufactured $429,000 in equity by improving operations rather than just waiting for it to appreciate over time.
This is the core mechanic. Everything else (the financing, the renovations, the leasing) is in service of this one thing: increasing NOI.
What I use to track it
When I look at a deal, the first thing I want to know is the gap between in-place NOI (what the property earns today) and pro-forma NOI (what it could earn once stabilized). The bigger that gap, and the more confident I am I can close it, the more interesting the deal.
I use two templates to run this analysis: a quick screening sheet for initial evaluation, and a fuller back-of-envelope model for deals that make the first cut. Both are included in the Concrete Returns Playbook if you want to work through a real deal
NOTE: You might be wondering about the other part of the equation (cap rate) and where it comes from. I’ll go over how to determine the market cap rate for a particular property in a separate issue.
— Javi