Reconstructed Operating Statement: Expense Analysis and Direct Capitalization

Chapter: Reconstructed Operating Statement: Expense Analysis and Direct Capitalization

Introduction
This chapter delves into the critical process of reconstructing an operating statement for real estate valuation, focusing on expense analysis and its application in direct capitalization. A reconstructed operating statement provides a standardized, market-oriented view of a property’s income and expenses, essential for accurate valuation. Direct capitalization then converts this income stream into a value estimate.

1. Reconstructed Operating Statement: Purpose and Principles
2. 1 Definition and Purpose:
   • A reconstructed operating statement is a financial statement adjusted to reflect the typical income and expenses a property is expected to generate under normal market conditions.
   • It differs from an owner’s operating statement, which may include non-recurring items, personal expenses, or accounting conventions irrelevant to market value.
   • The purpose is to arrive at a Net Operating Income (NOI) that is representative of the property’s earning potential and that can be used reliably in capitalization techniques.
3. 2 Exclusions from Reconstructed Operating Statements:
   • Certain items are systematically excluded to isolate the property’s true operating performance:
     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 depreciation would be redundant.
     2. Depletion Allowances: Similar to depreciation, depletion is relevant for properties extracting natural resources. It’s excluded for the same reasons as book depreciation.
     3. Income Tax: Income tax liability is specific to the owner’s situation (entity type, tax bracket) and not a property operating expense.
     4. Special Corporation Costs: Expenses related to corporate structure and overhead are excluded as they aren’t directly related to the property’s operation.
     5. Additions to Capital (Capital Expenditures): These are investments in the property that enhance its value or extend its life (e.g., roof replacement, major renovations). While they affect value, they aren’t recurring operating expenses, unless considered through a replacement allowance.
     6. Loan Payments (Debt Service): NOI is calculated before debt service. Including debt service would conflate the property’s operating performance with its financing structure.
   • The exclusion of capital expenditures applies specifically to reconstructed operating statements used to calculate NOI.
4. Expense Analysis: A Deep Dive
5. 1 Categories of Operating Expenses:
   • Operating expenses are broadly categorized into fixed, variable, and replacement allowance.
     1. Fixed Expenses: These expenses remain relatively constant regardless of occupancy levels. Examples include:
        • Property Taxes: Determined by the local government and assessed value of the property. Understanding assessment methods is crucial.
        • Insurance: Covers property damage, liability, and other risks. Premiums depend on coverage levels, property characteristics, and risk factors.
     2. Variable Expenses: These expenses fluctuate with occupancy or usage. Examples include:
        • Utilities (Electricity, Water, Gas): Consumption depends on occupancy rates, weather conditions, and energy efficiency. Benchmarking against similar properties is important.
        • Repairs and Maintenance: Covers routine upkeep of the property. Higher-quality properties may have lower maintenance costs.
        • Management Fees: Compensation for property management services, often expressed as a percentage of Effective Gross Income (EGI).
        • Leasing Commissions: Costs associated with securing new tenants or renewing leases.
     3. Replacement Allowance (Reserve for Replacement): This is a crucial expense that represents an annual allocation to cover future capital expenditures for items with limited lifespans (e.g., roof, HVAC systems, appliances).
6. 2 Analyzing and Estimating Expenses:
   • Data Sources: Accurate expense analysis relies on reliable data. Sources include:
     1. Historical Operating Statements: Reviewing past performance provides insights into expense patterns.
     2. Comparable Properties: Analyzing expenses of similar properties in the market helps establish benchmarks.
     3. Industry Surveys: Organizations like IREM, BOMA, and ULI publish expense data for various property types.
     4. Vendor Quotes: Obtaining quotes for insurance, maintenance contracts, and other services provides accurate cost estimates.
   • Expense Estimation Techniques:
     1. Percentage of Revenue Method: Some expenses (e.g., management fees) are often estimated as a percentage of EGI.
     2. Per Unit/Square Foot Method: Other expenses (e.g., utilities, repairs) can be estimated on a per-unit or per-square-foot basis.
     3. Detailed Component Analysis: For complex properties, a detailed analysis of each expense component may be necessary.
7. 3 Special Considerations:
   • Vacancy and Collection Losses: Vacancy represents unoccupied space, while collection losses represent uncollectible rent. These are deductions from potential gross income.
     Effective Gross Income (EGI) = Potential Gross Income (PGI) - Vacancy & Collection Losses.
   • Leasing Commissions: Leasing commissions are costs associated with securing new tenants or renewing leases.
     • A blended rate can be developed to reflect leasing commission costs for both existing leases and new leases.
       • Renewal Ratio = Tenant Renewals / Total Leases
       • Blended Rate = (Renewal Ratio * Renewal Commission) + ((1 - Renewal Ratio) * New Tenant Commission)
         *For 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 x 0.025 = 0.0175
     • 0.30 x 0.060 = + 0.0180
     • Blended rate = 0.0355 (3.55%)
   • Replacement Allowance Calculation: The replacement allowance should adequately fund future capital expenditures. Methods for calculating the allowance include:
     1. Straight-Line Method: Dividing the total cost of the item by its useful life.
        Annual Replacement Allowance = Total Cost / Useful Life.
     2. Sinking Fund Method: Using a present value of an annuity formula to determine the annual contribution needed to accumulate the replacement cost.
        Annual Replacement Allowance = (Total Cost * i) / ((1 + i)^n - 1), where i is the interest rate and n is the number of years until replacement.
8. Direct Capitalization: Converting Income to Value
9. 1 Principles of Direct Capitalization:
   • Direct capitalization converts a single year’s income expectancy (typically NOI) into a value indication.
   • It relies on the principle of substitution: an investor will pay no more for a property than the present value of its future income stream.
   • It’s most appropriate for properties with stable income streams and readily available market data.
   • The basic formula for direct capitalization is: Value = Net Operating Income / Overall Capitalization Rate (V = NOI / R)
10. 2 Deriving the Overall Capitalization Rate (R):
    • The overall capitalization rate (Ro) reflects the relationship between a property’s NOI and its value. Several methods can be used to derive Ro:
      1. Comparable Sales: This is the preferred method.
         • Ro = Net Operating Income (Comparable) / Sale Price (Comparable)
         • The appraiser analyzes sales of similar properties, calculates Ro for each, and reconciles the data to arrive at an appropriate rate for the subject property.
         • Adjustments may be needed to account for differences in property characteristics, market conditions, or financing terms.
      2. Band of Investment: This technique considers the weighted average cost of debt and equity financing.
         • Ro = (LTV * Mortgage Rate) + ((1 - LTV) * Equity Dividend Rate), where LTV is Loan-to-Value ratio.
      3. Market Extraction:
         • Extract Ro from comparable sales by dividing the Net Operating Income by the Sale Price.
         • Adjust as necessary.
         • Ro = NOI / Value
11. 3 Applying Direct Capitalization:
    • Once Ro is determined, it’s applied to the subject property’s reconstructed NOI to estimate value.
    • It’s crucial to ensure consistency: the NOI used in the formula must be calculated on the same basis as the NOI used to derive Ro.
      • This includes considering replacement allowances and other expense items.
    • Sensitivity Analysis:
      • Evaluate the impact of changes in Ro and NOI on the value estimate.
      • This helps understand the potential range of values and the impact of key assumptions.
    • Strengths and Weaknesses
      • Strengths
        • Easy to Use
        • Market Data if Available
      • Weaknesses
        • Best for Stabilized Properties
        • Single Year of Income

Conclusion
Reconstructing the operating statement and applying direct capitalization are fundamental skills for real estate valuation. Accurate expense analysis is crucial for determining a reliable NOI, and a well-supported capitalization rate is essential for converting that income stream into a credible value indication. Understanding the underlying principles and applying these techniques with careful judgment will lead to more accurate and defensible valuation conclusions.