Effective Approaches and Methods

By Paul B. Finch, MBA and Susan Winters Finch, MS, MBA | 12/1/2025

While the practice of financial valuation encompasses all quantitative approaches and methods for the analysis and valuation of asset-based investments, most literature and commentary on the subject focuses on corporate and business financial analysis and valuation as opposed to specific approaches and methods for commercial real estate analysis and implied property valuation. In this article, we want to focus on best practices to improve the validity and reliability of commercial real estate analysis and valuation utilizing Income Approaches.

Our focus on Income Approaches exclusively is intentional. This is because Income Approaches provide a direct link to the cash flow of a commercial real estate investment and, thereby, provide a basis for understanding rate of return, growth rates, transactional risk, debt capacity, and implied valuation, all of which are important factors in analyzing and valuing commercial real estate transactions.

This article is targeted for the following audiences:

· Commercial Property Owners and Investors;

· Commercial Real Estate Brokers and Agents; and

· Bankers that Fund Commercial Real Estate Investments.

The Purpose of this article is to:

· Introduce Commercial Property Owners and Investors, Commercial Real Estate Brokers/Agents, as well as Bankers, to creditable financial approaches and methods to analyze and value Commercial Property Investments; and

· To assist these Commercial Property Owners and Investors, Commercial Real Estate Brokers/Agents and Bankers, in the proper use of these financial approaches and methods in order to improve the validity and reliability of commercial property analysis so as to bring financial decision making into better focus.

Net Operating Income – The Fundamental Measure for Comparing Commercial Property Investments

In its most commonly practiced form, Net Operating Income (“NOI”), in commercial real estate, is a key financial metric that measures the unlevered profitability of a commercial real estate investment resultant from the property’s core operations. Because NOI focuses on the unlevered core performance of a property’s operations it is, therefore, a valuable metric for comparing the performance of mutually exclusive property investments through the analysis of a commercial property’s rate of return, growth rates, transactional risk, debt capacity, and implied valuation. Accordingly, NOI is expressed by the following equation:

NOI = Annual Net Revenue generated by the commercial property minus Operating Expenses

In this equation, Annual Net Revenue includes all revenue sources associated with commercial property such as rental income, room rates, crop sales and other ancillary revenue sources such as parking fees, laundry, vending.

Operating Expenses include all costs paid toward the regular operation and upkeep of the commercial property including property management fees, repair and maintenance, property taxes, insurance, and utilities. However, non-cash charges such as depreciation and amortization are excluded as they are “add-backs” to operating cash flow. Additionally, all principal and interest payments (debt service) as well as income taxes are excluded from the NOI calculation because these costs are non-operational in nature and are a function of, and/or are directly affected by, leverage resultant from borrowing and will skew analytical methods accordingly.

In this context, NOI for commercial real estate is the equivalent of EBITDA in corporate and business financial analysis and valuation, both in terms of the method by which they are calculated and in the way both are used. NOI and EBITDA are both widely used measures for valuing assets, whether it's a business, real estate, or security, by comparing these metrics to similar assets that have recently been sold or are currently on the market.

Best Practices for Calculating Net Operating Income

When calculating NOI, the Valuation Analysis should have four (4) overarching objectives:

1. Measure multiple periods in order to quantify growth and assess risk.

2. Make adjustments to the available financial information that economically normalizes financial statements to reflect the true economic financial position of the commercial property.

3. Define and Estimate the Benefit Stream; and

4. Utilize the resultant data for analysis and financial decision making.

Periods to be Measured – Many, if not most, Valuation Analysts will rely solely on one year of activity (usually the most recent year) to calculate NOI and, subsequently, calculate the Capitalization Rate for a commercial property. However, doing so may generate unreliable results as well as deprive the Valuation Analyst of critical data needed to quantify growth and assess risk. As such, and as a best practice, the Valuation Analyst should consider calculating annual NOI from a five-year lookback period, as a five-year lookback period is considered by economists to represent a generalized business cycle because it reflects the average duration of economic expansions and contractions observed historically[1].

Economic Normalizing of Results (Adjusted NOI) – When calculating NOI for any given year, it is essential that the Valuation Analyst adjust the audited/reviewed financial statements, tax returns, or compiled financial statements of a given commercial property to more closely reflect the true economic financial position and results of operations on a historical and current basis. Accordingly, the Valuation Analyst should separate and adjust, when applicable, persistent from non-persistent items (items that are random, erratic, unusual and/or non-recurring), discretionary items, and, also when applicable, non-operating items from operating items. Adjustments should be categorized as “Controlling” when the nature of the entry is such that it is discretionary, in that the entry is subject to owner control in a manner that benefits the specific interests of the owner and/or a related party and affects earnings/economic income accordingly. Likewise, adjustments should be categorized as “Economic” when the nature of the entry is not discretionary but, none the less, directly affects earnings/economic income.

Defining and Estimating the Benefit Stream - In this context, the Benefit Stream represents the various annual, after adjustment, NOI returns referenced above. That said, the process of defining and estimating the benefit stream refers to assigning statistical weight to the various annual NOI returns calculated (presumptively for the five-year lookback period) as follows:

· Linear Benefit Stream Assumptions – When future NOI growth is expected to remain relatively constant and stable going forward, equal weighting is usually assigned to each year’s benefit stream. This would be more theoretically appropriate for the analysis of commercial property that is in a mature phase of growth where future benefits are expected to be reasonably linear.

· Non-Linear Benefit Stream Assumptions - When future NOI growth is expected to grow at a non-constant rate and more variable going forward, unequal weighting is usually assigned to each year’s benefit stream, such as a more recent year(s). This would be more theoretically appropriate for the analysis of commercial property that is in earlier phases of growth and/or existing commercial property adopting new competitive strategies (with redevelopment plans) where future benefits are reasonably expected to be non-linear.

Common Uses of Adjusted Net Operating Income in Commercial Property Analysis

· Capitalization Rate Analysis - In its most commonly practiced form, the Capitalization Rate Analysis, in commercial real estate, provides for a calculation of the unlevered annual operating rate of return that is expected to be generated from commercial property as expressed by the following equation:

Capitalization Rate = Adjusted Net Operating Income/Current Market Value

where,

Current Market Value = Appraised Commercial Property Value

As discussed above, because the Capitalization Rate calculation is unlevered, which is to say that debt services, specifically principal and interest payments, are not included in the Capitalization Rate calculation, Capitalization Rate analysis is ideal for investors for the purpose of making comparisons to other mutually exclusive property investments.

· Growth Rate Analysis – As alluded to above, measuring multiple periods is necessary in order to calculate the growth rate of annual Adjusted NOI from a five-year lookback period. The Compound Annual Growth Rate (or “CAGR”) for annual Adjusted NOI returns can tell a lot about the attributes of a prospective commercial property such as (i) the growth phase of the property (mature growth or early growth phase of the property); (ii) if the property is suffering from deferred maintenance as might be the case with office or residential property as indicated by declining growth; or (iii) if the property has declining crop yields as might be the case with farming property.

· Risk Analysis – Also as alluded to above, measuring multiple periods is necessary in order to calculate the relative risk of mutually exclusive commercial property investments. Some authors/commentators will tell you that the Capitalization Rate itself is an indication of risk with the assumption being that the higher the Capitalization Rate, the higher the investment risk. This is a misnomer because, factually, the Capitalization Rate measured in isolation is a very poor indication of risk.

In finance, risk typically refers to the uncertainty of returns from a benefit stream, in this case, annual Adjusted NOI returns. As such, measuring the variance (or its square root known as the standard deviation) of annual Adjusted NOI returns from a five-year look back period is a much better way of measuring the risk of a commercial property investment because the variance provides valuable information pertaining to the possibility that actual outcomes will differ from expected ones. The higher the variance the greater the risk. This is especially valuable when comparing the variance of one commercial property to that of another.

· Debt Service Coverage – Adjusted NOI can be particularly useful when assessing a commercial property’s ability to incur debt financing. This is accomplished by dividing Adjusted NOI returns by existing or proposed debt financing (principal plus interest) to derive a Debt Service Coverage Ratio where a ratio of 1.0 represents an Adjusted NOI value exactly equal to the Debt Service Coverage requirement[2].

Using Adjusted Net Operating Income for Commercial Property Implied Valuations

· Implied Market Valuation – The Implied Market Value of a commercial property can be very effectively derived through an Income Approach by utilizing the Income Capitalization Method whereby the Defined Benefit Stream referenced above, resultant from the Adjusted NOI returns, is capitalized by the unlevered Cost of Equity Capital which is typically derived from a Capital Asset Pricing Model (or “CAPM”) modified for company specific risk factors.

Implied Valuations of commercial property can be a very important tool because the valuation itself is resultant from the present value of the underlying operating cash flow of the specific commercial property. Implied Valuations can provide a sanity check when compared with commercial property Appraisals[3].

Free Cash Flow – The Fundamental Measure for Assessing Specific Commercial Property Investments

Free Cash Flow (“FCF”) is a key financial metric that measures a commercial property’s ability to generate cash from its operations after accounting for capital expenditures (“CapEx”), working capital, interest expense, and entity taxes. A property’s FCF reflects the cash that is “free” to be distributed to equity holders or to repay creditors as well as to provide funds available to reinvest in a property’s operation. FCF also is a key financial metric used to determine the rate of return on a specific investment for existing commercial property or for predictive modeling used to determine CapEx, working capital and financing required to sustain operations for prospective new projects, making FCF an ideal measure for assessing property specific investments. FCF can be calculated from NOI as follows:

FCF = Adjusted Net Operating Income plus Depreciation & Amortization Expense minus CapEx plus/minus Changes in Working Capital minus Interest Expense (Net of Any Benefits Resultant From Tax Deductibility) minus Entity Taxes

Common Uses of Free Cash Flow in Commercial Property Analysis

· Net Present Value (“NPV”) Analysis - NPV facilitates the determination of whether a commercial property investment meets a required rate of return by comparing the present value of a property’s actual or expected FCFs to the initial investment. A positive NPV indicates economic value creation whereas a negative NPV indicates a prospective investment that may destroy economic value.

Required Inputs:

o Initial Investment: Purchase price + acquisition costs.

o Annual Free Cash Flows: Either from a historic Lookback Period or a prospective forward looking Holding Period.

o Lookback or Holding Period: Usually 5–10 years.

o Terminal Value: Estimated sale price at exit, discounted to present.

o Discount Rate: Your required rate of return (usually based on Weighted Average Cost of Capital (“WACC”) which represents the opportunity cost of the investment).

NPV Analysis assumes that all NPV positive cash flows can be reinvested in a commercial property at the NPV Discount Rate which is a reasonable assumption because the Discount Rate represents the opportunity cost of the investment. For this reason, NPV Analysis is ideal for ranking or comparing mutually exclusive investment opportunities.

· Internal Rate of Return (“IRR”) Analysis – IRR facilitates the determination of a commercial property’s annualized rate of return in a way that equates the present value of actual or expected FCFs to the initial investment.

Required Inputs:

o Initial Investment: Purchase price + acquisition costs.

o Annual Free Cash Flows: Either from a historic Lookback period or a prospective forward looking Holding Period.

o Lookback or Holding Period: Usually 5–10 years.

o Terminal Value: Estimated sale price at exit, discounted to present.

IRR Analysis assumes that all IRR positive cash flows can be reinvested in a commercial property at the IRR rate which is often not a reasonable assumption. For this reason, IRR Analysis is not advisable for ranking or comparing mutually exclusive investment opportunities.

· Modified Internal Rate of Return (“MIRR”) Analysis - MIRR modifies the traditional Internal Rate of Return (IRR) by addressing its major flaw, that being the unrealistic assumption that reinvestment of all IRR positive cash flows can be reinvested in a commercial property at the IRR rate. To remedy this flaw, MIRR allows for the reinvestment of interim cash flows at the required rate of return, usually based on WACC, which is the opportunity cost of the investment.

Required Inputs:

o Initial Investment: Purchase price + acquisition costs.

o Annual Free Cash Flows: Either from a historic Lookback Period or a prospective forward looking Holding Period.

o Lookback or Holding Period: Usually 5–10 years.

o Terminal Value: Estimated sale price at exit, discounted to present.

o Reinvestment Rate: The required rate of return (usually based on WACC which represents the opportunity cost of the investment).

Because MIRR Analysis assumes that all MIRR positive cash flows can be reinvested in a commercial property at the opportunity cost of the investment, MIRR Analysis is a good alternative to IRR for ranking or comparing mutually exclusive investment opportunities.

Interested in Working with Us?

Benchmark Solutions, Inc. is an industry leader in Financial Valuation for business owners, investors, commercial real estate agents/brokers, and bankers. Our services are used to analyze and determine the economic value of businesses, business assets, and capital investments as well as the viability of commercial real estate investments.

Since 1996, Benchmark Solutions, Inc. has been advising clients, both domestically and internationally, as it pertains to buying and selling business interests, raising capital, analyzing commercial real estate investments, as well as developing new and existing businesses. Our Strategic Financial Advisors individually possess over twenty-five (25) years of experience as financial executives in industry. Our breadth of experience and depth of knowledge enables us to give our clients exceptional advisory services and work product that will provide them with the competitive advantage needed to achieve their financial goals and objectives.

If you would like to learn more about Benchmark Solutions, you can locate us online at www.benchmarksolutions.us.com or visit us on LinkedIn at Benchmark Solutions, Inc.: Overview | LinkedIn

About the Authors:

Paul B. Finch, MBA, is a founding Executive Director of Benchmark Solutions, Inc. and a Sr. Strategic Financial Advisor at the firm. Professionally, Paul is an industry leader in Financial Valuation specializing in business and commercial real estate analysis and valuation for business owners, investors, commercial real estate agents/brokers, and bankers. Paul has significant post graduate training and experience in financial valuation, specifically, the analysis and determination of the economic value of businesses, business assets, commercial real estate and associated capital investments. Paul is a recognized subject matter expert in financial valuation, capital structure and acquisition, expected and required rates of return, the recognition and measurement of systematic and company specific risk factors, and the financial aspects of merger and acquisition transactions. Paul has published many articles pertaining to these topics, some of which can be found on LinkedIn. You can contact Paul at paul.finch@benchmarksolutions.us.com or on LinkedIn at Paul Finch, MBA | LinkedIn

Susan Winters Finch, MS, MBA, is co-founder and Executive Director for Benchmark Solutions, Inc. and is an Economist. Susan specializes in areas of Managerial Economics including Market Structure and Competitive Analysis, Supply and Demand Analysis, Cost and Production Analysis, Risk Analysis as well as assessments of current and forecasted macroeconomic activity. You can contact Susan at susan.finch@benchmarksolutions.us.com or on LinkedIn at Susan Winters Finch, MBA | LinkedIn

[1] Reference: Quant RL at https://quantrl.com/what-is-a-lookback-period/

[2] Note that financing institutions have minimum Debt Service Coverage Ratios, typically in the 1.20X-1.30X range.

[3] An Implied Valuation is an estimate of the worth of an asset based on specific financial metrics, in this case the commercial property’s NOI divided by the unlevered Cost of Equity Capital. For commercial property, Implied Valuations may differ from an Appraisal based on other relevant factors including, but not limited to, the following: (i) specific location; (ii) earnings quality; and (iii) legal and zoning considerations.