Expense Analysis: Reconstruction, Reserves, and Capitalization

Chapter: Expense Analysis: Reconstruction, Reserves, and Capitalization

This chapter delves into the critical aspects of expense analysis within real estate income analysis, focusing on expense reconstruction, the establishment and utilization of reserves, and the proper capitalization of expenses. Understanding these concepts is crucial for accurately estimating Net Operating Income (NOI) and, consequently, determining a property’s value.

1. Expense Reconstruction: Establishing a Realistic Operating Expense Profile

Real estate operating statements prepared for owners may not accurately reflect the typical annual expenses required for a property’s optimal operation and long-term value. The appraiser’s role is to reconstruct the expense profile to reflect a stabilized, “typical” year.

• 1.1. Purpose of Expense Reconstruction:

  The primary goal is to create a reliable estimate of future operating expenses, allowing for a consistent and objective basis for income capitalization. This involves:

  • Eliminating non-recurring items
  • Adjusting for owner-specific circumstances
  • Considering deferred maintenance or under-management
  • Accounting for market-typical expenses

• 1.2. Exclusions from Reconstructed Operating Statements:

  Certain items, while legitimate expenses for the property owner, are irrelevant for determining NOI within the context of income capitalization. These include:

  1. Book Depreciation: This is a non-cash accounting entry based on historical cost and tax regulations. Capitalization inherently accounts for capital recovery, rendering depreciation redundant.

  2. Depletion Allowances: Similar to depreciation but specific to natural resource extraction. Irrelevant for real estate valuation focusing on income-producing potential.

  3. Income Tax: Tax liabilities are dependent on the owner’s specific circumstances (entity type, tax bracket). NOI focuses on the property’s inherent income-generating ability.

  4. Special Corporation Costs: Expenses related to corporate operations (e.g., executive salaries, shareholder meetings) are not property-specific operating expenses.

  5. Additions to Capital: Capital expenditures are not recurring annual expenses. While they may enhance value by increasing income or extending the property’s economic life, they are not operating expenses.

     • Exception: Replacement reserves, discussed later, account for the annualized cost of future capital replacements.
     • Discounted Cash Flow (DCF) Analysis: Capital expenditures are explicitly deducted from NOI in the year they occur in DCF models, rather than being averaged annually.

  6. Loan Payments (Debt Service): NOI excludes mortgage debt service. The definition of market value is based on financing terms compatible with those found in the market. The mortgage debt service to be deducted from the net operating income must be based on market terms.

     • Equity Income (Ie) = NOI - Debt Service.
     • Used in certain capitalization procedures.

• 1.3. Examples of Expense Reconstruction Adjustments:

  • Below-Market Management Fees: An owner managing their own property may charge a fee lower than the market rate. The reconstructed statement should reflect a market-typical management fee.
  • Deferred Maintenance: If a property has been under-maintained, the reconstructed statement should include increased expenses to address these issues.
  • Vacancy Rate Normalization: A property with unusually high vacancy may require an adjustment to reflect a stabilized occupancy rate and associated expenses.

2. Replacement Reserves: Accounting for Future Capital Expenditures

Replacement reserves are crucial for maintaining a property’s long-term income-generating capacity. These reserves account for the periodic replacement of short-lived components that wear out or become obsolete.

• 2.1. Definition and Purpose:

  A replacement reserve is an annual allocation of funds to cover the cost of replacing capital items, such as:

  • Roof
  • HVAC systems (Heating, Ventilation, and Air Conditioning)
  • Appliances
  • Carpeting
  • Elevators
  • Tenant Improvements (TI)

  The purpose is to avoid large, unexpected capital outlays that could negatively impact NOI and property value.

• 2.2. Methods for Estimating Replacement Reserves:

  Several methods can be used to estimate the appropriate reserve amount:

  1. Straight-Line Allocation: This involves dividing the total replacement cost by the component’s useful life.

     • Formula: Annual Reserve = (Replacement Cost - Salvage Value) / Useful Life
     • Example: A roof costs $50,000 to replace and has a useful life of 20 years. The annual reserve would be $2,500 (assuming no salvage value).

  2. Sinking Fund Method: This method accounts for the time value of money by calculating the annual deposit needed to accumulate the replacement cost at a specific interest rate.

     • Formula: Annual Reserve = Replacement Cost * (i / ((1 + i)^n - 1)) where i is the interest rate and n is the number of years.
     • This requires a financial calculator or spreadsheet software.

  3. Percentage of Revenue: A percentage of Effective Gross Income (EGI) is allocated to the reserve. This method is simple but less accurate than other methods. Percentages may be determined from comparable properties in the area.

  4. Component Breakdown Method: This is the most detailed and accurate method. It involves:

     • Identifying all replaceable components.
     • Estimating the replacement cost of each component.
     • Estimating the remaining useful life of each component.
     • Calculating the annual reserve for each component using the straight-line or sinking fund method.
     • Summing the individual reserves to arrive at the total annual reserve.

• 2.3. Interaction with Repair and Maintenance Expenses:

  A crucial consideration is the relationship between the replacement reserve and annual repair and maintenance (R&M) expenses. If a comprehensive replacement reserve is established, the R&M expense estimate may need to be reduced to avoid duplication.

  • Historical operating statements prepared on a cash basis may include periodic replacement expenses under R&M.
  • When tenant improvements (TI) are substantial and required to achieve estimated rents, their expense may be included in the replacement allowance as a separate “tenant improvements” or “capital expenditure” category, depending on local practice.

• 2.4. Application in Income Capitalization:

  It is crucial to understand whether a replacement allowance is included in operating statements of comparable properties used to derive a market capitalization rate. The income statements of comparable properties need to be consistent.

  • A capitalization rate derived from a comparable sale without a replacement allowance cannot be applied to a subject property with such an allowance without an adjustment.
  • Investor surveys may or may not include deductions for replacement allowances. Appraisers must exercise caution when applying rates from surveys and should contact the survey author for clarification if necessary.

3. Capitalization of Expenses: Integrating Expense Analysis into Valuation

Capitalization of expenses involves understanding how expenses affect the value of a property, and the techniques used to convert income streams into a value indication.

• 3.1. Operating Expense Ratio (OER) and Net Income Ratio (NIR):

  • OER = Total Operating Expenses / Effective Gross Income (EGI).
  • NIR = Net Operating Income (NOI) / Effective Gross Income (EGI).
  • NIR = 1 - OER
  • These ratios provide insights into a property’s efficiency and profitability and allow for comparisons with similar properties. They tend to fall within certain ranges for specific categories of property. Risk varies inversely with the NIR because small changes in EGI will have a large effect on NOI for low NOI ratios.

• 3.2. Direct Capitalization:

  Direct capitalization is a method to convert a single year’s income expectancy into a value indication, by dividing the NOI by an appropriate income rate (capitalization rate or “cap rate”). It is most suitable for stabilized properties with relatively predictable income streams.

  • Formula: Value = NOI / Cap Rate where Cap Rate is an overall capitalization rate❓ (Ro)
  • Or Value = NOI * F (Factor)
  • Where F = 1/R

• 3.3. Deriving Overall Capitalization Rates (Ro):

  • Comparable Sales: Ro = NOI / Sale Price (for comparable properties).
  • Band of Investment: A weighted average of the mortgage and equity return requirements.
  • Debt Coverage Ratio (DCR): Analyzing the relationship between NOI and debt service to determine an acceptable capitalization rate.

• 3.4. Using Reconstructed Expenses in Direct Capitalization:

  The reconstructed expense profile is used to calculate the stabilized NOI, which is then capitalized to arrive at a value indication. It’s imperative that capitalization rates derived from comparable sales are based on NOI calculated in the same manner as the subject property’s NOI (e.g., including or excluding replacement reserves).

4. Practical Applications and Examples:

• Scenario: An older apartment building has consistently low maintenance expenses due to deferred repairs. The appraiser identifies several major repairs needed immediately.

  • Analysis: The appraiser must reconstruct the expense profile to include these deferred maintenance costs, either as an immediate expense or as a replacement reserve to address the issues over time. This will lower the NOI and the value indication compared to a simple capitalization of historical income.

• Scenario: A retail property’s anchor tenant is on a below-market rent.

  • Analysis: While the current expense profile may seem favorable, the appraiser must project the expenses and income based on market rents when the lease expires. Leasing commissions and tenant improvements associated with the new tenant must be considered and potentially capitalized or amortized.
  • Example formula for a blended rate: Blended Rate = (% Renewal * Renewal Commission Rate) + (% New * New Commission Rate). This rate is then applied to existing tenant leases as they expire.

• Experiment: Analyze operating statements from several comparable properties in a specific market segment. Calculate the OER and NIR for each property. Identify outliers and investigate the reasons for the discrepancies. This helps develop a strong understanding of typical expense ranges for that market segment.

By mastering expense analysis, including reconstruction, reserves, and capitalization techniques, appraisers can develop reliable NOI estimates and credible value opinions, ensuring sound decision-making in real estate investment and valuation.