Reconstructing Operating Statements: Fundamentals of Income & Expense Analysis

Chapter 3: Reconstructing Operating Statements: Fundamentals of Income & Expense Analysis

Introduction

Real estate income analysis hinges on the accurate reconstruction of operating statements. This process involves transforming raw financial data into a standardized format that reflects the sustainable income-generating capacity of a property. Unlike accounting-focused pro forma statements, a reconstructed operating statement prioritizes the economic reality of the property’s operations, guiding valuation and investment decisions. This chapter delves into the theoretical underpinnings and practical techniques involved in creating such statements.

3.1. The Purpose of Reconstructing Operating Statements

The primary aim is to determine the Net Operating Income (NOI) which is a key input in various valuation models, especially the income capitalization approach. Reconstructed operating statements provide a stabilized, normalized view of a property’s financial performance, stripping away idiosyncratic owner-specific factors and non-recurring items.

• Stabilization: Eliminating short-term fluctuations to reveal long-term trends.
• Normalization: Adjusting for unusual expenses or revenues to reflect typical operations.
• Market Perspective: Focusing on income and expenses a typical market participant would experience.

3.2. Defining Net Operating Income (NOI)

NOI is defined as Effective Gross Income (EGI) less Total Operating Expenses (TOE). Understanding the components of EGI and TOE is crucial.

• Potential Gross Income (PGI): The maximum possible income assuming 100% occupancy and full rent collection. This is rarely achieved in practice.
• Vacancy and Collection Losses (V&C): Reductions from PGI due to unoccupied space and uncollectible rent. Vacancy rates are often market-driven and influenced by factors such as location, property type, and economic conditions. Collection losses are influenced by tenant screening processes and economic factors.
• Effective Gross Income (EGI): PGI - V&C. This represents the actual income generated by the property before operating expenses. EGI = PGI - V&C.
• Total Operating Expenses (TOE): All necessary expenses incurred to maintain the property and generate income. These are broadly classified into fixed and variable expenses, with the addition of a replacement allowance. TOE = Fixed Expenses + Variable Expenses + Replacement Allowance.
• Net Operating Income (NOI): EGI - TOE. This represents the property’s income after accounting for all operating expenses, but before debt service, income taxes, and depreciation. NOI = EGI - TOE.

3.3. Exclusions from Reconstructed Operating Statements

Certain items, while potentially appearing on an owner’s operating statement, are excluded from a reconstructed statement for appraisal purposes. These exclusions stem from the focus on the inherent income-generating ability of the property, independent of ownership structure or financing decisions.

1. Book Depreciation: Depreciation is a non-cash accounting expense reflecting the decline in value of an asset over time. In income capitalization, value is derived from income, inherently reflecting capital recovery. Including depreciation would be redundant.
2. Depletion Allowances or Other Special Tax Considerations: Similar to depreciation, these are accounting mechanisms specific to certain industries or tax situations. They are related to the owner, not the property’s inherent income-generating capacity.
3. Income Tax: Income tax liability varies significantly based on the owner’s legal structure (e.g., individual, corporation, REIT). It is an expense of ownership, not of property operation.
4. Special Corporation Costs: These are expenses tied to the operation of a corporate entity, not the property itself. Examples include corporate legal fees and administrative costs.
5. Additions to Capital (Capital Expenditures): These are investments that increase the value of the property or extend its useful life. While capital expenditures impact future income (and are considered in discounted cash flow analysis), they are not periodic operating expenses and should be included as a replacement reserve.
6. Loan Payments (Debt Service): NOI is calculated before debt service. Including debt service would conflate property performance with financing decisions. The level of debt and interest rates are influenced by market conditions, lender terms, and borrower risk.

3.4. Detailed Analysis of Operating Expenses

Operating expenses are classified into fixed, variable, and replacement allowance categories.

• 3.4.1 Fixed Expenses: Expenses that generally do not fluctuate with occupancy levels.

  1. Property Taxes: Based on the assessed value of the property and tax rates set by the local government.
  2. Insurance: Coverage against property damage, liability, and other risks.
  3. License Fees: Government related fees such as fire safety or occupancy.

  4. Example: A property tax of $10,000 per year is a fixed expense, regardless of whether the building is 90% or 100% occupied.
     * 3.4.2 Variable Expenses: Expenses that tend to fluctuate with occupancy levels or usage.

  5. Utilities: Electricity, gas, water, and sewer.

  6. Repairs and Maintenance: Routine repairs and upkeep to maintain the property’s condition.
  7. Management Fees: Compensation paid to a property manager for overseeing operations.
  8. Leasing Commissions: Fees paid to brokers for securing new tenants.
  9. Janitorial/Cleaning: Costs associated with cleaning and maintaining common areas and tenant spaces.

  10. Example: Electricity costs will generally be higher in a fully occupied building compared to one with significant vacancy.
      * 3.4.3 Replacement Allowance (Reserves for Replacement): An annual allocation to cover the cost of replacing short-lived components of the property as they wear out. This is a critical element for maintaining long-term property value.

  11. Theoretical Basis: The replacement allowance is based on the concept of capital recovery. While book depreciation is excluded, a replacement allowance ensures that funds are available to replace depreciating assets.

  12. Components Typically Included: Roof, HVAC systems, major appliances, carpeting, elevators, and parking lot resurfacing.

  13. Calculation Methods:

      • Straight-Line Method: (Replacement Cost - Salvage Value) / Useful Life. This provides a consistent annual allocation.
        • Example: A roof costs $50,000 to replace, has no salvage value, and a useful life of 20 years. The annual replacement allowance is $50,000 / 20 = $2,500.

      • Sinking Fund Method: Calculates the annual deposit required to accumulate the replacement cost at a specific interest rate. This acknowledges the time value of money. The formula for the sinking fund factor (SFF) is: SFF = i / ((1 + i)^n - 1) where i is the interest rate and n is the number of years. The sinking fund deposit is then Replacement Cost x SFF.
        Example: Using the same roof example and assuming a 3% interest rate, the sinking fund factor is 0.03 / ((1.03)^20 - 1) ≈ 0.0372. The annual deposit is $50,000 x 0.0372 = $1,860.

      • Percentage of Revenue Method: Allocates a percentage of gross revenue to the replacement reserve. This is simpler but less precise.

  14. Relationship to Repair and Maintenance: A robust replacement allowance can reduce the need for extensive (and potentially duplicated) repair and maintenance expenses.

  15. Tenant Improvements (TI): In some markets, landlords provide significant TI allowances to attract new tenants. These costs can be capitalized and amortized as part of the replacement allowance or treated as a separate capital expenditure category.

3.5 Leasing Commissions: Blended Rate Approach

Leasing commissions, paid to brokers for securing tenants, are a recurring expense. A blended rate can accurately reflect the cost of renewing existing leases and securing new ones.

The blended rate takes into account the tenant renewal ratio, the commission rate for existing tenants, and the commission rate for new tenants.

Formula

Blended rate = (Renewal Ratio * Renewal Commission Rate) + ((1 - Renewal Ratio) * New Tenant Commission Rate)

For example, if the tenant renewal ratio is 70%, the leasing commission for existing tenants is 2.5%, and the leasing commission for new tenants is 6%, the blended rate is calculated as follows:

Blended Rate = (0.70 * 0.025) + (0.30 * 0.060) = 0.0175 + 0.0180 = 0.0355 = 3.55%

3.6. Applying Capitalization Rates

Direct capitalization is a method used in the income capitalization approach to convert a single year’s income expectancy into a value indication. This conversion is accomplished in one step, either by dividing the net operating income estimate by an appropriate income rate or by multiplying the income estimate by an appropriate factor. The following are the basic formulas for direct capitalization:

I = R x V
R= I / V
V= I / R
Where:
I = Income
R = Capitalization Rate
V = Value

The overall interest in real estate that is capable of generating income can be valued using direct capitalization. The direct capitalization formula is:

Value = Net Operating Income / overall capitalization rate❓❓
V = NOI / Ro

3.7. Income and Expense Ratios

These ratios provide insights into a property’s operational efficiency and risk profile.

• Operating Expense Ratio (OER): Total Operating Expenses / Effective Gross Income. A lower OER indicates greater efficiency. OER = TOE / EGI.
• Net Income Ratio (NIR): Net Operating Income / Effective Gross Income. A higher NIR indicates greater profitability. NIR = NOI / EGI. Note: NIR = 1 - OER.

3.8. Example of Reconstructing an Operating Statement

Let’s consider a small apartment building with the following information (based on the owner’s statement):

• Potential Gross Income: $100,000
• Vacancy and Collection Losses: $5,000
• Property Taxes: $12,000
• Insurance: $3,000
• Utilities: $8,000
• Repairs and Maintenance: $7,000
• Management Fees: $5,000 (5% of EGI)
• Book Depreciation: $10,000 (ignored)
• Loan Payments: $15,000 (ignored)

Here’s the reconstructed operating statement:

• Potential Gross Income (PGI): $100,000
• Vacancy & Collection Losses: $5,000
• Effective Gross Income (EGI): $95,000
• Operating Expenses:
  • Fixed Expenses:
    • Property Taxes: $12,000
    • Insurance: $3,000
    • Total Fixed Expenses: $15,000
  • Variable Expenses:
    • Utilities: $8,000
    • Repairs & Maintenance: $7,000
    • Management Fees: $4,750 (5% of $95,000 EGI)
    • Total Variable Expenses: $19,750
  • Replacement Allowance (estimated based on component analysis): $3,000
• Total Operating Expenses (TOE): $15,000 + $19,750 + $3,000 = $37,750
• Net Operating Income (NOI): $95,000 - $37,750 = $57,250
• Operating Expense Ratio (OER): $37,750/$95,000 = 39.74%
• Net Income Ratio (NIR): $57,250/$95,000 = 60.26%

3.9. Conclusion

Reconstructing operating statements is fundamental to sound real estate income analysis. By adhering to established principles and utilizing appropriate techniques, analysts can develop a clear and reliable picture of a property’s income-generating potential, facilitating informed investment decisions and accurate valuations.