Why Rising Operating Costs Are Eating Your Commercial Real Estate NOI

“You can make more revenue and technically make less money, because your expenses are increasing dramatically over time.” — Daniel Roccanti

In this episode of Your CPA’s Take on Real Estate, hosts Daniel Roccanti and Kyle Paxton break down the operating costs quietly eating into commercial real estate cash flow, including insurance, property taxes, and labor and vendor expenses, and what owners can do to get ahead of them.

What This Episode Covers

Rents went up 4%, but if operating expenses climbed 7%, that owner is losing ground. Daniel and Kyle walk through why insurance premiums keep rising even when a building hasn’t changed, how property tax reassessments blindside buyers right after closing, and why the smaller recurring cost increases in labor, maintenance, and vendor contracts add up to a material hit on net operating income.

They close with a practical framework for building a rolling operating forecast so owners catch these variances early instead of discovering them at year end.

Resources

1. James Moore Real Estate Industry
2. Your CPA’s Take on Real Estate Series
3. Watch the Full Episode: Rising CRE Costs Are Quietly Killing Your NOI

Full Transcript

[00:03] Daniel: Welcome to Your CPA’s Take on Real Estate. I’m your host, Daniel Roccanti, backed by Kyle Paxton, on another great video today. Today we’re going to talk about some of the hidden threats to commercial real estate cash flow, and we’re talking about operating costs and costs in general.

[00:21] Daniel: It seems like everything these days is just getting a little bit more expensive, Kyle.

[00:23] Kyle: Sure enough. Let’s open this up by talking about where we typically have CRE conversations. We talk about interest rates, cap rates, rent growth, occupancy, leasing activity, debt and refinance, but then we overlook the expenses sometimes. We focus a lot on occupancy and rent, but we can still miss our return targets on the expense side.

[00:58] Daniel: Yeah, the industry just naturally gravitates towards revenue, because revenue is exciting. Everyone wants to make more money. When people talk about their business, they’re always asking, “What’s your revenue?” Not, “What are your expenses? What’s your profit?” It’s always revenue.

[01:12] Daniel: But the reality nowadays is you can make more revenue and technically make less money, because your expenses, especially in today’s environment, are increasing dramatically over time. That increase in revenue gets eaten up. If you’re really looking at optimizing your commercial real estate, you still have to care about revenue, but you should be looking at the other side too.

[01:38] Daniel: You should be looking at your expenses and figuring out what’s really going on, because I’ll see a lot of owners say, “Rents are up 4%, we’re doing great.” Then you look at their P&Ls, their net operating income, their cash flow, and it’s telling a different story. Their expenses went up 7% even though rents only went up 4%.

[02:01] Kyle: Yeah, we don’t like those numbers. This conversation is interesting and loaded, because there are so many big expense drivers in the CRE space that we don’t have much control over. You’re talking about insurance markets, tax assessments, utility rates, labor costs. These are all inputs you’re factoring in when you enter a deal, looking at the local landscape and all these numbers, but then on an ongoing operating basis, they’re a lot harder to control.

[02:23] Kyle: Before we get into how inflation can erase a lot of this rent growth, if any of our listeners are finding this conversation helpful, please subscribe to our channel so you don’t miss out on future episodes.

[02:45] Daniel: We’re doing this twice a month, covering topics and strategies around real estate and tax strategy from two CPAs. We appreciate you joining us.

[03:05] Daniel: Our first topic is insurance. This has touched everyone, especially here in Florida.

[03:12] Kyle: People need to realize it’s more than just larger premiums these days. Insurance has dramatically gone up over time, but owners still aren’t getting this right and aren’t underwriting it correctly.

[03:30] Daniel: So why have premiums changed so dramatically, Kyle?

[03:33] Kyle: Looking at the major drivers, we talk about replacement cost. If the estimated cost to rebuild the property increases, the amount that needs to be insured increases too. That’s construction cost and construction labor. Contractors I talk to consistently point to the increase in inputs for construction, and that’s across the board, all asset classes and material types. Your building hasn’t changed, but the cost to replace it has changed significantly.

[04:11] Kyle: Then there’s geographic risk. We talked about Florida’s hurricane exposure. There’s wildfire exposure out west, flood exposure, hail, tornadoes, all of that factors into cost. The other big lever is property characteristics: building age, roof age, current electrical and plumbing systems.

[04:43] Kyle: Premium isn’t the whole story either. We have to factor in deductibles, coverage limits, and exclusions. There are a lot of hidden costs here, and being intentional about the insurance process goes a long way toward mitigating surprises and unexpected expenditures.

[05:07] Daniel: When you’re talking about insurance, Kyle already mentioned there are three main drivers. First, if an incident happens, what does it cost to replace your building, and that’s gotten more expensive since the pandemic. Second is your location. Depending on where you are, you’re at more risk for certain incidents. Here in Florida we deal with hurricanes, and when one hits, it can be devastating. If you’re in California, you deal with fires. And third, like Kyle mentioned, property characteristics: the older your building and roof, the more it factors in.

[06:05] Daniel: So premium isn’t the whole issue. We need to evaluate the property, because insurance is very property-specific. You need to look at your deductible. Can you cover a much higher deductible? What are your coverage limits? If it’s an older building, maybe there’s room to work with. Really, it’s about talking with your insurance broker early to see what can be done.

[06:34] Daniel: I’ve seen clients where their roof could last a bit longer, but insurers really don’t like old roofs. So you run the numbers: does it make more sense to replace the roof now and get a better premium, or hold off and pay a higher premium until the roof needs replacing anyway? Sometimes the numbers show it’s actually better financially to replace the roof now, pay the lower premium, and come out ahead over time.

[07:27] Kyle: Good conversation on insurance. Big insurance surprises typically come at renewal. Let’s talk about property taxes. This can surprise you after you’ve already closed on the deal, and it’s even harder to unwind at that point.

[07:54] Kyle: On the CRE side, which is our focus today, historical property taxes are totally misleading when underwriting an acquisition. This varies a lot by location, but owners need to understand what can happen to the assessed value after a sale: reassessment, new construction, renovation, change in use.

[08:17] Kyle: Walking through the common underwriting trap: you might receive a trailing operating statement showing property tax at $300,000 a year, and you assume 2 to 3% growth per year going forward. But there’s so much more to it. How long has the seller owned the property? Is the assessed value significantly below current market value? Will this transfer actually trigger a reassessment? If not, when is the next scheduled reassessment? Are there tax caps? Is there a current exemption in place? This can be a huge material impact on that 7% expense growth you mentioned, Daniel.

[09:19] Daniel: Property taxes are another one of those expenses significantly on the rise, especially depending on where you’re located in Florida. A lot of people underwrite using the current or previous owner’s historical property taxes, and that needs to change, because you’re almost always going to get reassessed when you sell.

[09:40] Daniel: Properties are typically reassessed every 5 to 10 years anyway, but every time a property is sold, it gets reassessed and it almost always increases, because the prior value was undervalued relative to the new sale price. I’m seeing large increases just because property values have already gone up dramatically, and then the sale price triggers a much higher reassessment.

[10:27] Daniel: Depending on your state, property tax can be one of the biggest tax revenues available. In Florida, we don’t have income tax, which is great, but the money still has to come from somewhere to fund essential services. Commercial property doesn’t have the same limitations that residential primary-residence property has, so you need to understand that if you’re being conservative, property taxes are always going to go up more than the standard 3% assumption, especially since the pandemic.

[10:49] Daniel: When I bought my own residential home, my property tax went up 15% in one year, and that was just residential. I’ve seen commercial go up even more than that.

[11:36] Kyle: Daniel, I think property tax management after acquisition is overlooked in a lot of jurisdictions where it could make a material impact. It starts with basic stuff: maintaining documentation supporting your value, actually reviewing assessments when they’re received, monitoring whether there’s an appeal process, and deciding if a formal appeal makes economic sense given the deadlines and any professional fees tied to managing the appeal.

[12:21] Daniel: We see owners all the time who just take the assessment and assume there’s nothing they can do. You absolutely need to review your assessments and see if that reflects your actual value, or you can challenge it. That doesn’t mean every assessment should automatically be challenged, but you should look at whether you have supporting documentation for a lower value. You can do a formal appeal, and the county will change it if you make a good argument that the value is lower than what they’re implying.

[13:18] Kyle: Good point, totally agree. Let’s pivot to death by a thousand cuts, everything else in the expense categories. I think the biggest input here is labor. It takes different forms in real estate, whether it’s a property manager, direct employees, back-office staff, and it creeps into contractor expenses for HVAC, plumbing, and electrical too.

[13:53] Kyle: Then you pull in general maintenance expenditures: repairs, utilities, turnover costs, administrative expenses. It’s death by a thousand cuts, where each item creeps a little over budget, say you budgeted 3% but the actual increase is 6 to 8%. Each individual line is only a little over, but in total it has a material impact. Take us a little deeper into that, Daniel.

[14:21] Daniel: This is kind of a catchall, but it’s just where the economy has been since the pandemic. It’s been a strange ride for business owners. With inflation, salaries are rising, which means everything costs more. Then there are tariffs, supply chain issues, and a lot of other pressures. What does this mean for you as an owner of commercial real estate? All your expenses have increased: payroll, maintenance, and any renovations see significant cost increases.

[15:20] Daniel: We often assume in our budgets that everything will increase by 3%, because that’s roughly what people assume inflation to be. But actual inflation on any given input is all over the place. Groceries going up 3% doesn’t mean renovating your apartment building only goes up 3% too. It could go up significantly more. We really need to look at what the actual increases are and where we can make changes, rather than underwriting new properties on historical expenses, because costs are changing significantly year to year.

[16:27] Kyle: I think now’s a good time to look at major contracts. When was the last time your major contracts, security, landscaping, cleaning, and other recurring expenditures, were competitively bid? Is there an opportunity to get competitive bids and drive that cost down?

[16:59] Kyle: I want to reemphasize why operating costs matter so much in underwriting. We’ve talked about the fixation on revenue, NOI, and debt service coverage, but the expense surprise is really what whittles that away. This expense creep can happen in an environment where nothing catastrophic occurred: no collapse in occupancy, good rental income, no major tenant leaving, interest rates unchanged, and you’re still seeing reduced NOI. Expense line items aren’t just back-office details, they’re a very important part of the investment thesis. Daniel, walk us through how underwriting should change to factor in and hedge against these surprises.

[18:36] Daniel: I think the important word you used is “surprise.” It’s about expectations. If you’re an owner with investors, surprises are not good, and very rarely is the surprise “I made more money than I thought.” It’s usually the other way around. We want to make sure we’re setting realistic expectations for properties, and that starts with understanding what our realistic operating costs actually are, and how much they’ve increased from historical data.

[19:19] Daniel: When we’re really going through it, are we coming close to our expectations? We see insurance and property tax get missed by a lot, but now we’re really looking at maintenance and other categories too, and finding what we projected is missing the target significantly. We need to change our underwriting instead of just assuming 3% increases across the board.

[19:46] Daniel: I see this all the time in budgets: last year was X, we’ll increase it by 3%, that’s the budget, and we move on without really checking whether that makes sense.

[20:04] Kyle: I’ll have to admit I’ve done that a time or two, Daniel.

[20:07] Daniel: The old 3% shortcut. We all do it. It’s a timesaver, but it doesn’t really reflect what today’s market is going to be.

[20:33] Daniel: When you’re budgeting, you really need to ask what’s a realistic expectation for the property. It’s better to be upfront and say you don’t think the property will make as much money, and then have it come in a little better than expected, rather than the reverse. You never want to overpromise and underdeliver. With investors, if you show a good projection with a good budget but the actual numbers come in dramatically different, you’re hurting your investors and your credibility, so it’s important to build this out realistically.

[20:53] Daniel: As an owner, there are things you can do beyond just being accurate at estimating. Let’s talk about strategies to actively fight these rising costs.

[21:21] Daniel: The first is building a rolling operating forecast. Don’t wait until the end of the year. I see so many people waiting until year-end. It should be updated every month or every quarter, whatever cadence works, so you’re catching differences before or right when they happen. You need to compare actual to budget, actual to prior year, actual versus what you underwrote at acquisition, and current forecast versus lender covenants. One of the simplest questions an owner can ask each month is: what changed, why did it change, and do we expect it to continue? Building this out puts you in front of the problem instead of accepting it after it’s already happened.

[22:28] Kyle: Daniel, I loved that four-pronged approach: actual versus budget, actual versus prior year, actual versus acquisition underwriting, and current forecast versus lender covenants. That’s gold. The natural tendency is to do just one of those, but laying them all out in an accessible way is huge, especially with access to real-time data for budget-to-actual tracking.

[23:04] Kyle: Where I want to pivot is focusing on the biggest expenses. It’s easy to get paralyzed when every line item is over budget and not know where to start. Grounding in the recurring contracts and focusing on the areas where you can make the most material difference is huge. And starting early on insurance renewals, getting ahead of everything that goes into that, same concept applies to refinancing on the lender side, making sure you’re doing due diligence to get the coverage you need at premiums that make sense.

[24:28] Daniel: Back to building that operating forecast: you want to look at the biggest variances first, because those have the most impact. Don’t spend hours analyzing a $500 line item when there’s a $100,000 increase elsewhere. Always take your biggest variances and ask why it went up, whether it’s a one-time charge or a broader cost increase, and what you can do about it. It’s the same as personal finances: you’re not going to save much by cutting out your morning coffee. You save money on your biggest items, your house payment, your car payment. It’s no different in commercial real estate. Find the biggest drivers, then figure out where you can make a change.

[25:19] Daniel: On insurance, if you wait for your renewal, you’re stuck accepting whatever the insurer gives you. Reach out to your insurance broker early and ask what can be done. Brokers want to help you get better insurance because it keeps you as a client, though their hands are somewhat tied by their underwriters. If you want to bring your premium down, you need to start early.

[26:01] Daniel: Same with property taxes. Understand your real property tax exposure before you even close on the property. Are you likely to get reassessed, and what would that look like? If you do get reassessed, do you have supporting documentation to fight it? There are companies that will assess your property tax value, provide supporting documentation if it’s lower, and even fight the assessment for you. I’ve seen significant savings on commercial properties this way. Property tax values very rarely go down on their own, so buying your own assessment and providing a more supportable value is sometimes the only real path to a meaningful reduction.

[27:24] Daniel: Next is vendors. Every vendor has increased its prices, that’s just how the world is right now. You need to look at your major vendors and ask what’s changed and what you can do. Are you just auto-renewing? Review the contract, get additional bids. That doesn’t mean chasing the cheapest vendor, you still want quality, but if you always accept whatever you’re given, you’re probably paying the most out there. Talk to your vendor directly: acknowledge that prices have gone up, but ask if there’s room to be more reasonable, especially if the relationship is a good one. People who like working together are usually willing to find a better agreement.

[28:32] Kyle: We’re a vendor ourselves, Daniel, and we see it too. Our own costs go up and we have to pass some of that along. These are normal conversations, and as a business owner you should be having them.

[28:52] Kyle: One more point before we close: I like the idea of using preventative maintenance as an NOI strategy. It’s not just an engineering issue, maintenance doesn’t have to be reactive. Taking a proactive approach helps mitigate emergency repairs, tenant disruption, equipment replacement, and insurance claims, and it helps relationships with vendors too. It also prevents unplanned capital expenditures that can come with a big price tag. That’s another area that’s sometimes overlooked and important not to lose in this conversation.

[30:20] Daniel: Great conversation, Kyle. Last thing: while revenue and revenue growth are important, they’re not the full story. Don’t let good rent growth distract you from expense assumptions that aren’t accurate. Look at your insurance, your taxes, your labor, and your vendor contracts, those are the three main categories. Start with the biggest items and work backward, and if you want real change, it takes action. Get out ahead of it early. If you’re doing nothing, you’re just accepting whatever the market gives you, which right now is high cost eating into your profits.

[30:53] Daniel: Hopefully this gives you a bit of a nudge: revenue is great, but look at the profits, look at your operating expenses, so you can optimize your property and run it as efficiently as possible. Thanks for hanging around, and we’ll see you next time.

Want the Full Breakdown?

Watch the complete episode above for the full conversation on insurance, property taxes, and labor and vendor costs, including the specific questions to ask your broker before renewal and how to know if a property tax appeal is worth pursuing.

 

All content provided in this article is for informational purposes only. Matters discussed in this article are subject to change. For up-to-date information on this subject please contact a James Moore professional. James Moore will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within these pages or any information accessed through this site.