Reconstructed Operating Statements & Direct Capitalization

Chapter: Reconstructed operating statements❓ & Direct Capitalization

Introduction

This chapter delves into the crucial aspects of real estate income analysis, specifically focusing on reconstructed operating statements and direct capitalization techniques. We will explore how to accurately estimate net operating income (NOI) and subsequently convert it into a reliable indication of property value using direct capitalization methods. This process is fundamental to sound real estate valuation and investment decisions.

1. Reconstructed Operating Statements

A reconstructed operating statement provides an opinion of the probable future net operating income (NOI) of an investment, representing a “typical” year of operation. It differs significantly from an owner’s operating statement, which may include non-recurring items, business expenses, or costs related to the specific ownership structure.

1.1 Purpose and Principles

The primary goal of a reconstructed operating statement is to project a stabilized NOI that reflects the property’s earning potential under typical management and market conditions. This involves scrutinizing historical income and expense data, making necessary adjustments, and applying sound judgment based on market research.

1.2 Exclusions from Reconstructed Operating Statements

Certain items found in owners’ operating statements must be excluded from reconstructed statements due to their non-recurring nature, irrelevance to property operations, or potential for double-counting. These exclusions ensure that the reconstructed statement focuses solely on the property’s core earning capacity. Key exclusions include:

• Book Depreciation: Depreciation is a non-cash accounting concept designed for tax purposes and historical cost reporting. Capital recapture is provided for in the capitalization method. Including depreciation in the operating expense statement is redundant.

• Depletion Allowances or Other Special Tax Considerations: These are accounting processes that allow for lower taxation of revenue generated by extracting natural resources from a property, similar to the depreciation of assets. Including the depletion allowance in the operating expenses would be redundant for similar reasons given for book depreciation.

• Income Tax: Income tax liability depends on the owner’s specific tax situation (e.g., corporate structure, individual circumstances). It is an expense of ownership, not of the property’s operation.

• Special Corporation Costs: Corporate expenses are not part of a reconstructed operating statement developed for appraisal purposes.

• Additions to Capital: Capital expenditures (CAPEX) are typically non-recurring and add value to the asset. They should not be included in estimating typical annual expenses, but instead, average annual capital expenditures may be included in the replacement reserve.

• Loan Payments: Debt service (principal and interest) is a financing expense, not an operating expense. NOI is calculated before considering debt service.

1.3 Components of a Reconstructed Operating Statement

The basic structure of a reconstructed operating statement follows a hierarchical format:

Potential Gross Income (PGI)
- Vacancy and Collection Losses
= Effective Gross Income (EGI)
- Operating Expenses
= Net Operating Income (NOI)

• Potential Gross Income (PGI): The total income a property could generate if fully occupied, and all rents are collected. It is based on market rent levels and lease terms.

• Vacancy and Collection Losses: An allowance for vacant space and uncollectible rents, reflecting the property’s historical performance and market conditions. Vacancy rates can be estimated based on market averages and comparable properties. Collection losses are estimated based on historical data and tenant quality.

• Effective Gross Income (EGI): The actual income a property is expected to generate after accounting for vacancy and collection losses. EGI = PGI – Vacancy & Collection Losses

• Operating Expenses: The costs associated with operating and maintaining the property. These are divided into fixed expenses (relatively constant regardless of occupancy) and variable expenses (fluctuate with occupancy).

• Net Operating Income (NOI): The property’s profitability before debt service, income taxes, depreciation, and capital expenditures. NOI = EGI – Operating Expenses

1.4 Treatment of Replacement Allowances (Capital Expenditures)

• Annualization of Capital Expenditures: While capital expenditures are not included as periodic operating expenses, an appraiser will include an annual replacement allowance to account for costs that do not recur annually but are necessary over the long term.

• Blended Rates: A blended rate can be developed to reflect leasing commission costs for both existing leases and new leases.

  • Formula: Blended Rate = (Renewal Ratio * Renewal Commission Rate) + ((1 – Renewal Ratio) * New Tenant Commission Rate)

  • Example: If the tenant renewal ratio for a property is 70%, the leasing commission for existing tenants is 2.5%, and the leasing commission for new tenants is 6%, a blended rate can be developed as follows:

    • 0. 70 * 0.025 = 0.0175
    • 8. 30 * 0.060 = + 0.0180
    • Blended rate = 0.0355 (3.55%)
    • 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.

1.5 Repair and Maintenance Considerations

• Duplication of Expenses: The portion of the replacement allowance is related to the annual repair and maintenance expenses of the property for the specific components considered in the allowance. 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.

1.6 Practical Applications

• Comparable Data: 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 property❓ on an equivalent basis. Consequently, a rate derived from a sale with an expense estimate that does not provide for a replacement allowance should not be applied to an income estimate for a subject property that includes such an allowance without an adjustment that reflects the difference.
• Investor Surveys: Investor survey rates may or may not include deductions for replacement allowances, and appraisers must exercise caution in applying capitalization and discount rates from surveys. Most surveys explain the basis for their rates. If they do not, an appraiser may contact the survey’s author for clarification.

2. Direct Capitalization

Direct capitalization is a valuation technique that converts a single year’s stabilized NOI into an estimate of value. It is predicated on the principle that a property’s value is directly related to its income-generating ability. This method is most applicable to properties with stable income streams and predictable future performance.

2.1 Basic Principles

Direct capitalization relies on the fundamental relationship between value, income, and a capitalization rate.

• Formula: V = I / R

  Where:

  • V = Value
  • I = Net Operating Income (NOI)
  • R = Capitalization Rate

This formula highlights that value is determined by dividing the NOI by an appropriate capitalization rate. Conversely, the capitalization rate can be derived by dividing the NOI by the property’s value (R = I / V). Finally, V = I x F where F is a factor.

2.2 Deriving Capitalization Rates

Obtaining an accurate capitalization rate is critical to the direct capitalization process. Several methods are employed:

• Comparable Sales: The preferred approach is to extract capitalization rates from comparable sales transactions. This involves analyzing recent sales of similar properties, determining their NOI, and dividing the NOI by the sale price to derive the capitalization rate.

  • R = NOI / Sale Price

  For instance, if a comparable property sold for $1,000,000 and had an NOI of $80,000, the indicated capitalization rate would be 8% (0.08).

• Band of Investment: This technique constructs a capitalization rate based on the weighted average of the required returns of debt and equity investors. It recognizes that property financing typically involves both mortgage debt and equity investment.

  • R = (LTV x Mortgage Rate) + (Equity Ratio x Equity Yield Rate)

    Where:

    • LTV = Loan-to-Value Ratio
    • Mortgage Rate = Interest rate on mortgage debt
    • Equity Ratio = Percentage of property value funded by equity (1 - LTV)
    • Equity Yield Rate = Required rate of return for equity investors

    Example: Assume a property is financed with a 70% LTV mortgage at 5% interest and requires a 12% equity yield rate.

    • R = (0.70 x 0.05) + (0.30 x 0.12) = 0.035 + 0.036 = 0.071 or 7.1%

• Band of Investment - Land and Building Components: This technique is used to develop a capitalization rate when the land and building components are analyzed separately.

  • R = (Land Value/Total Value * Land Rate) + (Building Value/Total Value * Building Rate)

• Debt Coverage Ratio (DCR) Method: This method derives the capitalization rate based on the relationship between NOI, debt service, and the debt coverage ratio (DCR).

  • R = (Mortgage Rate x LTV) / DCR

    Where:
    * DCR = Net Operating Income / Debt Service

    Example: if the mortgage rate is 5%, LTV is 70%, and DCR is 1.25, the capitalization rate is: R = (.05 * .70) / 1.25 = 0.028 or 2.8%

• Yield Capitalization Rates: Yield capitalization rates can be extracted by using property models.

• Market Surveys: Published surveys of capitalization rates can provide general benchmarks. However, these rates should be carefully scrutinized and adjusted to reflect the specific characteristics of the subject property and local market conditions.

2.3 Direct Capitalization Process

The direct capitalization process involves these steps:

1. Estimate Stabilized NOI: Develop a reconstructed operating statement to project the property’s stabilized NOI.
2. Derive Capitalization Rate: Select an appropriate capitalization rate using one or more of the methods discussed above.
3. Apply the Formula: Divide the stabilized NOI by the capitalization rate to arrive at an indication of value.

2.4 Limitations and Considerations

• Stable Income Assumption: Direct capitalization assumes a relatively stable income stream. It may not be suitable for properties with fluctuating income or significant expected changes.
• Market Data Reliance: The accuracy of direct capitalization depends heavily on the availability and reliability of market data for comparable properties.
• Oversimplification: Direct capitalization does not explicitly consider future income growth, changes in operating expenses, or the impact of capital improvements.

2.5 Total Operating Expenses

Total operating expenses are the sum of fixed and variable expenses and the replacement allowance in the reconstructed expense estimate.

2.6 Additional Calculations

After an appraiser calculates net operating income, further calculations may be needed to determine:

• Mortgage debt service
• Equity income
• Expense and income ratios

2.7 Expense and Income Ratios

The ratio of total operating expenses to effective gross income is the operating expense ratio (OER). The complement of this ratio is the net income ratio (NIR), which is the ratio of net operating income to effective gross income.
* Formula: NIR + OER = 1.0
* NIR = NOI / EGI

These ratios tend to fall within certain ranges for specific categories of property. Experienced appraisers recognize appropriate ratios, so they can identify statements that deviate from typical patterns and require further analysis.

3. Conclusion

Reconstructed operating statements and direct capitalization are essential tools in real estate income analysis and valuation. By accurately projecting stabilized NOI and applying appropriate capitalization rates, appraisers and investors can arrive at reliable indications of property value. However, it is crucial to understand the underlying assumptions and limitations of these techniques and to use sound judgment based on market research and comparable data.