Reconstructed Operating Statements and Direct Capitalization

Chapter: Reconstructed Operating Statements and Direct Capitalization

Introduction
This chapter delves into the process of reconstructing operating statements for real estate income analysis and introduces the direct capitalization method. It provides a scientific and practical understanding of these essential tools used in real estate valuation.

1. Reconstructed Operating Statements

A reconstructed operating statement aims to provide a clear and standardized representation of a property’s income and expenses, reflecting its stabilized earning capacity. This differs from an owner’s operating statement, which might include non-recurring items or costs specific to their ownership structure.

1.1. Purpose of Reconstruction

The primary goal of reconstructing an operating statement is to arrive at a reliable estimate of Net Operating Income (NOI) that accurately reflects the property’s potential under typical management and market conditions.

1.2. Exclusions from Reconstructed Operating Statements

Certain items found in owner’s operating statements should be excluded from a reconstructed operating statement due to their non-recurring nature, irrelevance to the property’s earning capacity, or reflection of ownership characteristics rather than property operations.

1. Book Depreciation❓❓: Depreciation is a non-cash accounting expense based on historical cost and tax regulations. Since capitalization already accounts for capital recovery, including book depreciation would be redundant.

2. Depletion Allowances: Similar to depreciation, depletion allowances are tax-related deductions for properties with natural resources.

3. Income Tax: Income tax liability depends on the owner’s specific circumstances (corporation, partnership, individual) and is not a property operating expense.

4. Special Corporation Costs: These costs are associated with the corporate ownership structure, not the property itself.

5. Additions to Capital: Capital improvements are non-recurring expenditures that enhance the property’s value or extend its economic life. These should not be treated as recurring operating expenses, unless accounted for in a replacement reserve.

6. Loan Payments: Mortgage debt service (principal and interest) is a financing cost and is excluded from NOI.

1.3. Components of a Reconstructed Operating Statement

A reconstructed operating statement typically includes the following components:

1. Potential Gross Income (PGI): The maximum possible income a property can generate if fully occupied.

2. Vacancy and Collection Loss: A deduction from PGI to account for periods of vacancy and uncollectible rent.

3. Effective Gross Income (EGI): The actual income expected after accounting for vacancy and collection loss. Formula: EGI = PGI – Vacancy & Collection Loss

4. Operating Expenses: The costs associated with operating and maintaining the property.

   • Fixed Expenses: Expenses that do not vary significantly with occupancy levels (e.g., property taxes, insurance).
   • Variable Expenses: Expenses that fluctuate with occupancy levels and usage (e.g., utilities, repairs, maintenance).
     *Historical operating statements prepared on a cash basis may include periodic replacement expenses under repair and maintenance. If comprehensive provisions for replacements are made in the reconstructed operating statement, these charges may be duplicated unless the annual maintenance expense estimate is reduced.
   • Replacement Allowance: An allowance for future capital expenditures necessary to maintain the property’s long-term income-generating capacity (e.g., roof replacement, HVAC upgrades, tenant improvements).
     In certain real estate markets, space is rented to a new tenant only after substantial interior improvements are made. If this work is performed at the landlord’s expense and is required to achieve the estimated rent, the expense of these improvements may be included in the reconstructed operating statement as part of the replacement allowance in a separate “tenant improvements” or “capital expenditure” category, depending on local practice.
     A total expense estimate that provides for all items of repair, maintenance, and replacement may exceed the actual expenditures shown in the owner’s operating statements for recent years. This is particularly common when the building being appraised is relatively new and the owner has not incurred many capital or repair expenses. In preparing a reconstructed operating statement for a typical year, an appraiser recognizes that replacements must be made eventually and that replacement costs affect operating expenses. These costs can be reflected in increased annual maintenance costs or, on an accrual basis, in an annual replacement allowance.*

5. Net Operating Income (NOI): The property’s income after deducting all operating expenses from effective gross income. Formula: NOI = EGI – Total Operating Expenses

1.4. Estimating Operating Expenses

Accurately estimating operating expenses is crucial for reliable income analysis. The following methods can be used:

1. Historical Data: Analyzing the property’s historical operating expenses, adjusted for any non-recurring items or unusual circumstances.

2. Comparable Properties: Researching the operating expenses of similar properties in the same market.

3. Industry Benchmarks: Consulting industry surveys and publications to obtain typical expense ratios for the property type.

4. Blended Rate for leasing commissions: A blended rate can be developed to reflect leasing commission costs for both existing leases and new leases. For example, if the tenant renewal ratio for a property is 70%, the leasing commission for existing ten- ants is 2.5%, and the leasing commission for new tenants is 6%, a blended rate can be developed as follows: 0.70 x 0.025 = 0.0175; 0.30 x 0.060 = + 0.0180; Blended rate = 0.0355 (3.55%). This blended rate is then applied to existing tenant leases as they expire.

1.5. Expense and Income Ratios

Analyzing expense and income ratios provides valuable insights into the property’s operating performance and risk profile.

1. Operating Expense Ratio (OER): The ratio of total operating expenses to effective gross income. Formula: OER = Total Operating Expenses / EGI

2. Net Income Ratio (NIR): The ratio of net operating income to effective gross income. Formula: NIR = NOI / EGI
   Properties with low NOI ratios, small changes in ef- fective gross income will have an inordinately large effect on net income.

2. Direct Capitalization

Direct capitalization is a method of converting a single year’s income expectancy into a value indication.

2.1. Basic Principles

Direct capitalization relies on the principle that a property’s value is directly related to its income-generating capacity. It simplifies the valuation process by using a single capitalization rate or income multiplier to convert income into value.

2.2. Direct Capitalization Formulas

The fundamental formulas for direct capitalization are:

1. Value (V) = Income (I) / Capitalization Rate (R)
2. Capitalization Rate (R) = Income (I) / Value (V)
3. Value (V) = Income (I) x Income Multiplier (F)

2.3. Application of Direct Capitalization

Direct capitalization is typically applied using one of two methods:

1. Overall Capitalization Rate (Ro): Applying a single capitalization rate to the property’s overall net operating income to derive its value.

2. Residual Techniques: Applying different capitalization rates to separate components of the property’s income.

2.4. Derivation of Overall Capitalization Rates

The overall capitalization rate (Ro) represents the relationship between a property’s net operating income and its value. Several methods can be used to derive Ro:

1. Derivation from Comparable Sales: This is the preferred method when sufficient data on comparable sales is available. The Ro is calculated by dividing the NOI of each comparable property by its sale price.

   Formula: Ro = NOI / Sale Price

   Example:

   Sale	NOI	Sale Price	Ro
   A	$50,000	$500,000	0.10
   B	$60,000	$650,000	0.0923
   C	$45,000	$475,000	0.0947

   Considerations:
   Data on each property’s sale price, income, expenses, financing terms, and market condi- tions at the time of sale is needed. In addition, appraisers must make certain that the net operating income of each comparable property is calculated and estimated in the same way that the net operating income of the subject property is estimated.
   Operating data available for comparable sale properties is from the year that ended just prior to the date of sale, so appraisers may have to account for chang- es that have occurred over time. Both income and expense data (in the 12 months after the date of valuation) and the structure of expenses in terms of replacement allowances and other components should be similar to those of the subject property.
   Non-market financing terms, different market conditions, nor dif- ferent property rights should have affected the prices of the comparable properties. If the objective of the appraisal is to value the fee simple estate, market rent and terms must be used or adjustments will be necessary. Capitalization rates from leased prop- erties provide capitalization rates for the leased fee, not the fee simple.
   Expecta- tions for changes in the income and value of the comparable properties should also match those of the subject property, or an adjustment to the rate will be necessary.
   Credit rating of the property’s tenants, market conditions for the particular property, the stability of the property’s income stream, the level of investment in the property by the tenant, the property’s net income ratio, and the property’s upside or downside potential. In some property types, bonded leases are provided when the full faith and credit of the tenant company guarantees the lease. This is common in sale leasebacks or build-to- suit leases and results in leases with significantly reduced risk to the purchasers, and therefore may affect rents and capitalization rates caused by the reduced risks.

2. Band of Investment:

   • Mortgage and Equity Components: The mortgage and equity components is weighted average of the mortgage constant and the equity dividend rate.

     Formula: Ro = (L/V * Rm) + (E/V * Re)

     Where:

     • L/V = Loan-to-value ratio
     • Rm = Mortgage constant (annual debt service / loan amount)
     • E/V = Equity-to-value ratio
     • Re = Equity dividend rate (equity income / equity investment)
       • Land and Building Components: The land and building components is weighted average of the land capitalization rate and the building capitalization rate.

     Formula: Ro = (VL/VT * RL) + (VB/VT * RB)

     Where:

     • VL/VT = Land-to-value ratio
     • VB/VT = Building-to-value ratio
     • RL = Land capitalization rate (land income / land value)
     • RB = Building capitalization rate (building income / building value)

3. Debt Coverage Ratio Analysis: Formula: Ro = Mortgage Constant * Debt Coverage Ratio

4. Analysis of Yield Capitalization Rates (The Property Model): Yield Capitalization requires more information but takes into account varying discount rates to determine property value.

5. Surveys: Consulting industry surveys can provide general guidance, but should be carefully evaluated for applicability to the specific property and market.

2.5. Selection of the Capitalization Rate
The process of capitalization rate selection is not a simple task. The appraiser must thoroughly analyze the data, apply sound judgment, and carefully consider market conditions.

2.6. Direct Capitalization Vs. Yield Capitalization
The fundamental difference between direct capitalization and yield capitalization is that direct capitalization uses a single year’s income whereas yield capitalization considers the future income pattern over the investment period.

Conclusion

Reconstructed operating statements and direct capitalization are fundamental tools in real estate income analysis. By understanding the principles and methods outlined in this chapter, analysts can develop reliable value estimates and make informed investment decisions.