Under the Radar: Managing NOI Erosion Amid Rising CRE Expenses

The New Reality: Expenses Outpacing Rent Growth

 

Historically, property values have been supported by increasing rents, under the assumption that higher income would drive growth in net operating income (NOI). However, this dynamic is shifting as operating expense inflation — including taxes, utilities, insurance, and maintenance — often outpaces rental rate growth. When rents fail to keep up with and offset rising expenses, NOI stagnates or declines, leading to downward pressure on property values.

Even worse, in markets where rents remain flat while operating expenses continue to climb, the erosion of NOI becomes more severe.

 

In multifamily properties, for instance, landlords are increasingly employing promotional leasing strategies, such as offering tenants a free month of rent on a 13-month lease. These incentives reduce effective income, which, combined with escalating expenses, accelerates NOI erosion and diminishes property value.

 

This challenge highlights the broader pressures across asset classes, where rising operating costs are reshaping the relationship between rents and property performance.​​

 

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The Shift Toward Expense Pass-Throughs

 

To mitigate the erosion of net operating income (NOI), landlords are increasingly adopting expense pass-through strategies, shifting a larger share of operating expense responsibility to tenants. This transition toward triple-net (NNN) or similar lease structures is becoming a critical tool for landlords aiming to stabilize NOI in an environment of rising expenses.

In multifamily properties, tenants have traditionally paid for electricity, but owners are now increasingly passing through water, sewer, and trash expenses. In retail and industrial properties, while Class A assets have long operated under NNN lease structures, there is a noticeable trend among Class B and C assets transitioning from Modified Gross leases (where tenants typically pay utilities and partial reimbursements for taxes or insurance) to full NNN leases.

In the office sector, changes are subtler, with some properties shifting from Gross leases to light Modified Gross structures, where tenants contribute to utility costs.

While tenants may initially balk at these added costs, there is a psychological advantage for landlords: tenants may experience less "sticker shock" with lower base rents, even if their total cost of occupancy rises when accounting for

pass-through reimbursements as a separate expense.

The adoption of expense pass-through strategies is particularly critical in markets where landlords face substantial pressure from escalating expenses. By transferring these costs, landlords can better navigate inflationary pressures and preserve NOI, safeguarding long-term value.

 

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Challenges of Tenant Retention and Market Trends

 

While expense pass-throughs can help landlords stabilize NOI, they also introduce new risks, particularly with tenant retention. Tenants faced with higher total occupancy costs may seek alternatives, leaving landlords vulnerable to vacancies.

 

These challenges are pronounced in office markets like Harrisburg, where state agencies, the anchor tenants in many properties, are actively downsizing. This downsizing trend reflects broader shifts in the commercial real estate landscape, driven by reduced demand for urban office space as hybrid and remote work models reshape tenant preferences and space utilization.

Replacing tenants in this environment presents additional hurdles, particularly for properties with above-market rents that have not been adjusted to reflect current market conditions.

Prospective tenants are increasingly likely to demand substantial tenant improvement (TI) allowances or require landlords to reconfigure large spaces into smaller, more adaptable units to meet evolving needs.

 

Both scenarios result in significant additional costs, further compressing NOI and diminishing overall property value. These dynamics underscore the complexity of balancing expense recovery strategies with tenant retention.

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Expense Categories Under Pressure

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Real Estate Taxes

Real estate taxes remain one of the largest and most unpredictable expense categories for landlords. Property tax assessments often lag market changes, meaning landlords may see increased taxes even as market values decline. This misalignment can further compress NOI, particularly in high-tax states like Pennsylvania.

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Insurance

Insurance premiums have risen sharply in recent years, driven by global climate change, increased catastrophic events, and pooled risk across regions. Even properties in low-risk areas like Pennsylvania are affected, as premiums subsidize higher-risk areas. This trend is likely to persist, putting additional pressure on landlords' operating margins.

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Utilities

Energy costs, particularly electricity and natural gas, have been highly volatile. Rising utility costs are often passed through to tenants, but landlords must navigate tenant resistance, especially as energy efficiency expectations rise.

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Maintenance and Repairs

Material costs and labor shortages continue to drive up maintenance and repair expenses. The construction industry faces an aging workforce and limited capacity, leading to higher costs for even routine repairs. These increases are difficult to absorb, particularly for landlords with fixed rental income streams.

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The Long-Term Implications for Property Values

The relationship between rent growth and operating expenses is critical for determining property value. If operating expenses continue to rise faster than rents, property values will decline, all else being equal. This is because the capitalization of NOI into value relies on a stable or increasing NOI. When NOI declines, values are compressed, sometimes significantly.

Even more concerning, in scenarios where rent growth is stagnant and operating expenses rise, property values can decline sharply. Landlords must recognize this reality and take proactive measures to mitigate the risk of NOI erosion.

 

 

Strategies for Landlords

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1. Adopt Expense Caps or Stops
Landlords should incorporate expense caps or stops into leases to limit their exposure to rapidly rising costs. These provisions can help protect NOI and make pass-throughs more palatable to tenants.

2. Focus on Energy Efficiency
Investing in energy-efficient systems can reduce utility expenses over time, benefiting both landlords and tenants. Solar installations, smart meters, and efficient HVAC systems are examples of cost-saving measures.

3. Optimize Leasing Strategies
Landlords may consider offering flexible lease terms to attract tenants, such as shorter lease durations or options for expansion. These strategies can mitigate vacancies, while maintaining NOI.

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4. Tax Appeals

With property tax assessments often misaligned with market realities, landlords should proactively pursue tax appeals to reduce their tax burden. This strategy can significantly impact NOI, particularly in high-tax jurisdictions.

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5. Prepare for Tenant Retention Challenges
Landlords should anticipate tenant resistance to pass-through expenses and have plans in place to retain key tenants.

Offering incentives like phased expense increases or limited TI allowances can help retain tenants while maintaining financial stability.

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Strategies for Users

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1. Total Cost of Occupancy Modeling
Analyze all associated costs, including rent, utilities, maintenance, taxes, and pass- through expenses, for a complete financial picture. Our team can provide tailored models to support data-driven decisions.

2. Leverage CCIM Resources
The CCIM Institute’s CI 103: User Decision Analysis for Commercial Investment Real Estate course offers invaluable tools for understanding lease structures, effective rent, and occupancy costs.

3. Negotiate with Transparency
Use insights from cost models to clarify financial obligations and negotiate terms that mitigate future expense risks.

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Conclusion

 

The increasing shift toward triple-net-style lease structures reflects the challenges landlords face in managing operating expense inflation. While these structures can stabilize NOI in the short term, they also introduce risks around tenant retention, competitive positioning, and lease negotiations. In an environment where operating expense growth often outpaces rent appreciation, landlords must take proactive steps to preserve NOI just to maintain value for investment properties, let alone increase it.

Strategies such as renegotiating lease terms, implementing cost-saving initiatives, and carefully considering the total cost of occupancy for tenants will be essential for navigating the volatility of today’s commercial real estate market. Without these actions, the widening gap between rent growth and escalating operating expenses will continue to erode property values, posing significant challenges to the long-term sustainability of commercial real estate investments.

A forward-looking approach is critical for landlords to adapt to these evolving market dynamics and maintain the financial health of their assets.