Reconstructed Operating Statement: Income and Expense Analysis

Chapter: Reconstructed Operating Statement: Income and Expense Analysis

Introduction

The reconstructed operating statement is a cornerstone of real estate income analysis, providing a normalized view of a property’s income-generating capability. Unlike an owner’s operating statement, which reflects historical performance and may include non-recurring items or ownership-specific expenses, the reconstructed operating statement aims to represent the typical annual income and expenses that a potential investor can reasonably expect. This chapter delves into the detailed analysis of income and expense components within the reconstructed operating statement, emphasizing the scientific principles and practical considerations involved.

I. Purpose and Principles of Reconstructing an Operating Statement

• A. Definition and Goal: A reconstructed operating statement (sometimes referred to as a pro forma although the terms are not perfectly synonymous) is an appraiser’s opinion of the probable future net operating income (NOI) of a real estate investment, adjusted to reflect market conditions and typical management practices. The goal is to create a standardized, market-driven representation of a property’s earning potential.
• B. Normalization: Normalization involves removing distortions caused by atypical events, accounting methods, or ownership characteristics.
• C. Market Perspective: The reconstructed statement reflects the perspective of a hypothetical, well-informed investor operating under typical market conditions.
• D. Focus on Net Operating Income (NOI): The primary objective is to accurately estimate NOI, which is the foundation for many valuation techniques.

II. Income Analysis

• A. potential gross income❓❓ (PGI): This represents the maximum possible income a property could generate if fully occupied at market rental rates.
  • 1. Theoretical Maximum: PGI assumes 100% occupancy and collection of all rents.
  • 2. Market Rents: Determining appropriate market rental rates is crucial. This involves analyzing comparable properties, considering factors such as location, size, amenities, and lease terms.
  • 3. Mathematical Representation:
    4. PGI = (Number of Units) * (Market Rent per Unit) * (Occupancy Rate) where Occupancy Rate = 1 if fully occupied.
• B. Vacancy and Collection Loss: This accounts for the inevitable periods when units are vacant or when tenants fail to pay rent.
  • 1. Vacancy Rate Analysis: Market vacancy rates for similar properties are essential. Historical vacancy rates for the subject property should also be considered, but given less weight if they are not reflective of current market conditions.
  • 2. Collection Loss Estimation: This considers the likelihood of uncollectible rents.
  • 3. Effective Gross Income (EGI): Calculated as the Potential Gross Income less Vacancy and Collection Loss. EGI represents the actual income the property is anticipated to generate.
    4. EGI = PGI - Vacancy and Collection Loss
• C. Other Income: This includes revenue from sources other than base rent, such as parking fees, laundry facilities, vending machines, and application fees.
  • 1. Identification of Ancillary Revenue Streams: A thorough analysis involves identifying all potential sources of income beyond base rent.
  • 2. Sustainability Assessment: Assess the reliability and consistency of these income streams.

III. Expense Analysis

Operating expenses are categorized into several types:

• A. Fixed Expenses: These expenses do not vary significantly with occupancy levels.
  • 1. Real Estate Taxes: Based on assessed value and tax rates.
  • 2. Insurance: Coverage for property damage, liability, and other risks.
    3. Insurance Premium = (Coverage Amount) * (Risk Factor)
  • 3. Licenses and Permits: Costs associated with legally operating the property.
• B. Variable Expenses: These expenses fluctuate with occupancy and usage.
  • 1. Utilities: Costs for electricity, gas, water, and sewer. These should be normalized to account for weather patterns and tenant usage.
  • 2. Repairs and Maintenance: Ongoing costs to keep the property in good condition. It is important to note that 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.
  • 3. Management Fees: Compensation for property management services. Management fees are usually expressed as a percentage of Effective Gross Income (EGI).
       *Management Fee = (Management Fee Rate) * (EGI)
  • 4. Payroll: Wages and benefits for on-site staff.
  • 5. Advertising: Costs associated with attracting new tenants.
  • 6. Leasing Commissions: These can be calculated using blended rates that reflect tenant renewal ratios and commission rates for new and existing tenants.
    7. 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 can be developed as follows:
    8. 0.70 x 0.025 = 0.0175
    9. 0.30 x 0.060 = + 0.0180
    10. Blended rate = 0.0355 (3.55%)
• C. Replacement Allowance (or Reserve for Replacements): This is a crucial expense that reflects the accrual of funds for future capital expenditures.
  • 1. Purpose: To provide for the periodic replacement of building components (e.g., roof, HVAC systems, appliances) that have a limited useful life.
  • 2. Calculation Methods:
    3. Component-Based: Estimate the replacement cost and useful life of each major component, then calculate the annual allowance.
    4. Percentage of Revenue: Use a percentage of EGI based on market standards for similar properties.
  • 3. 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.
    4. Annual Replacement Allowance = (Replacement Cost) / (Useful Life)
• D. Total Operating Expenses (TOE): Sum of all fixed expenses, variable expenses, and the replacement allowance.
  • TOE = Fixed Expenses + Variable Expenses + Replacement Allowance

IV. Net Operating Income (NOI) Calculation and Significance

• A. Definition: NOI is the remaining income after deducting total operating expenses from effective gross income.
  • NOI = EGI - TOE
• B. Importance: NOI is a key indicator of a property’s profitability and is used in various valuation methods. It represents the income available to service debt and provide a return on equity.
• C. Relationship to Capitalization Rate (R): NOI is directly related to property value through the capitalization rate.
  • Value (V) = NOI / R
• D. Exclusion of Certain Items: Items that are excluded from reconstructed operating statements include book depreciation, depletion allowances or other special tax considerations, income tax, special corporation costs, additions to capital, and loan payments.

V. Expense and Income Ratios

• A. Operating Expense Ratio (OER): The ratio of total operating expenses to effective gross income.
  • OER = TOE / EGI
• B. Net Income Ratio (NIR): The ratio of net operating income to effective gross income. It is the complement of the operating expense ratio.
  • NIR = NOI / EGI
  • NIR = 1 - OER
• C. Significance: These ratios provide insights into the efficiency of property operations and can be compared to industry benchmarks.

VI. Application of Reconstructed Operating Statement in Direct Capitalization

• A. Direct Capitalization:
  • 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.
  • Direct capitalization is applied using one of two basic methods:
    • Applying an overall capitalization rate or multiplier to relate value to the entire property income (e.g., net operating income)
    • Using residual techniques that consider components of a property’s income and then applying market-derived capitalization rates to each income component analyzed (Re, Rm etc.)
  • The basic formulas for direct capitalization are
    • I=RxV
    • R=I/V
    • V=I/R
    • V = IXF
  • where I is income, R is capitalization rate, V is value, and F is factor.
• B. Derivation of Overall Capitalization Rates:
  • Overall capitalization rates can be estimated with various techniques, including:
    • Derivation from comparable sales
    • Band of investment—mortgage and equity components
    • Band of investment—land and building components
    • Debt coverage analysis
    • Analysis of yield capitalization rates (the property model)
    • Surveys
• C. Derivation of Overall Capitalization Rates from Comparable Sales:
  • Deriving capitalization rates from comparable sales is the preferred technique when sufficient information about sales of similar, competitive properties is available.
  • If differences between a comparable property and the subject property that could affect the selection of the overall capitalization rate are concluded, an appraiser must account for these differences. In that case, the appraiser must decide whether the rate selection for the subject property should be higher or lower than the rate indicated by a specific sale or group of sales.
• D. Example:
  • Sale A: Net operating income $35,100, Price $368,500, Indicated R0 0.0953
  • Sale B: Net operating income $40,000, Price $425,000, Indicated R0 0.0941
  • Sale C: Net operating income $30,500, Price $310,000, Indicated R0 0.0984
  • Sale D: Net operating income $48,400, Price $500,000, Indicated R0 0.0968
  • If all four transactions are equally comparable, the appraiser might con- clude that an overall rate of 0.0941 to 0.0984 should be applied to the subject prop- erty. The final rate concluded depends on the degree of similarity between each sale and the subject property. For example, if Sales A and D are the most comparable, the concluded rate might be approximately 0.0960, or 9.6%.

VII. Considerations and Cautions

• A. Data Sources: Accurate data is crucial. This includes reliable market surveys, comparable property data, and historical operating statements.
• B. Market Fluctuations: Economic conditions and market trends can significantly impact income and expenses.
• C. Property-Specific Factors: The unique characteristics of each property must be considered.
• D. Justification: All assumptions and estimates must be well-supported and clearly explained.
• E. Investor Surveys: Appraisers must exercise caution in applying capitalization and discount rates from surveys because the survey rates may or may not include deductions for replacement allowances.
• F. It is essential that the income statements of comparable properties be consistent. Otherwise, adjustments will be required. A capitalization rate derived from a comparable sale property is valid only if it is applied to the subject prop- erty on an equivalent basis.

VIII. Conclusion

The reconstructed operating statement is a vital tool for real estate income analysis. By carefully analyzing income and expense components, applying sound scientific principles, and considering market realities, appraisers can develop a reliable estimate of a property’s NOI and, ultimately, its value. Mastering the principles and techniques outlined in this chapter is essential for any real estate professional involved in valuation or investment decision-making.