Structural Shift or Mean Reversion: Exploring the NOI Profit Margin Cycle

Investing is a game, a game ruled by expectations. Future expectations are commonly shaped by the business and real estate cycles, but for the purpose of this piece, let’s investigate a less frequently discussed topic – the profit margin cycle. For real estate investors, net operating income or NOI, is the primary focal point because it drives valuation. Furthermore, the NOI profit margin ratio (NOI / Revenue) provides valuable insight in a number of ways:

• it acts as a gauge into the financial health of an asset
• it measures how well costs are being controlled
• it illustrates pricing power
• it provides a comparison between similar investment opportunities

The chart below utilizes NCREIF data to illustrate the historical NOI profit margin for the U.S. apartment sector. It is important to note where we are in the current cycle as well as the historical norm. Since 2000, the profit margin has ranged from 60.5% on the high side to 51.4% on the low side. Meanwhile, the NOI profit margin stood at 57.3% as of 3rd quarter 2014 nationally, which was above the long-term average of 55.4%.

A healthy profit margin is generally tied to revenue growth. Historically speaking, when the NOI profit margin is at 55.4% or higher, revenue growth at the national level has averaged 4.0%. However, when the NOI profit margin is less than 55.4% average, revenue growth slows to 0.9%. Logically, this makes sense since most operating expenses are fixed costs and revenue change tends to be more volatile.

Since most real estate investments are valued using a discounted cash flow analysis, it is important to remember both revenue change and profit margins are most likely mean reverting. This suggests a pro forma analysis cannot assume current growth rates will remain constant. This insight is aimed at answering two important questions:

1) Am I paying the right price on a relative basis?

2) Am I paying the right price given where the profit margin cycle is?

Since real estate is a local business, these questions can only be answered at the metro and submarket levels.  It is important to think in terms of both the real estate cycle and the profit margin cycle. In the next blog, we will combine profit margin with a valuation metric.