Reconstructed Operating Statements: Income, Expenses, and Capitalization Rates

Chapter Title: Reconstructed Operating Statements: Income, Expenses, and Capitalization Rates

Introduction

Real estate income analysis involves projecting future benefits and converting them into an estimate of value. A crucial step in this process is the creation of a reconstructed operating statement. This statement differs significantly from the financial statements prepared by property owners or accountants. It aims to present a stabilized, normalized view of a property’s income and expenses, reflecting its potential under typical management and market conditions. This chapter delves into the components of a reconstructed operating statement and the principles underlying their calculation, with a particular focus on capitalization rates and their relationship to net operating income (NOI).

1. Reconstructed Operating Statement: Definition and Purpose

A reconstructed operating statement, also known as a “pro forma” by some practitioners, provides an estimate of a property’s potential income and expenses. It’s not a historical record but a forward-looking projection designed to reflect a typical, stabilized year of operation. The primary purpose is to arrive at a reliable estimate of Net Operating Income (NOI), a key input in many valuation methods.

• Purpose: To estimate stabilized Net Operating Income (NOI) for valuation purposes.
• Focus: Typical, stabilized year of operation under competent management.
• Distinction from Owner’s Statements: Omits non-recurring items, owner-specific expenses, and focuses on the property’s inherent earning capacity.

2. Income Component: Potential Gross Income (PGI)

Potential Gross Income (PGI) is the total income a property could generate if it were 100% occupied. It represents the theoretical maximum revenue.

• Definition: Total possible income, assuming full occupancy.
• Calculation: Sum of all potential rents from all units/spaces.
• Considerations: Market rent levels, lease terms, and historical occupancy data.
  • Market rent research is critical to ensuring that the potential gross income is realistic and reflective of current market conditions.

3. Vacancy and Collection Loss (V&C)

Vacancy and Collection Loss (V&C) accounts for the reality that properties will not always be fully occupied and that some tenants may not pay rent.

• Definition: Reduction in PGI due to vacant units and uncollectible rents.

• Calculation: Determined as a percentage of PGI, based on market data and property-specific factors.

  • Mathematically:

    V&C = PGI * Vacancy Rate

    Where:

    • V&C is the Vacancy and Collection Loss
    • PGI is the Potential Gross Income
    • Vacancy Rate is the expected percentage of vacancy.
    • Factors Influencing V&C:
      • Market conditions: High demand typically leads to lower vacancy.
      • Property type: Different property types have different typical vacancy rates.
      • Property quality and location: Higher quality properties in desirable locations tend to have lower vacancy.
      • Management effectiveness: Proactive management can reduce vacancy rates.

4. Effective Gross Income (EGI)

Effective Gross Income (EGI) is the actual income a property is expected to generate after accounting for vacancy and collection losses.

• Definition: Income remaining after deducting vacancy and collection losses from PGI.
• Calculation: EGI = PGI - V&C
• Significance: A more realistic indicator of a property’s revenue-generating capacity than PGI.

5. Operating Expenses: Fixed, Variable, and Replacement Allowance

Operating expenses are the costs associated with operating and maintaining a property. They are typically categorized as fixed, variable, and replacement allowance.

• Fixed Expenses: Expenses that remain relatively constant regardless of occupancy levels.
  • Examples: Property taxes, insurance.
• Variable Expenses: Expenses that fluctuate with occupancy levels and property usage.
  • Examples: Utilities, maintenance, repairs, management fees.

• Replacement Allowance: An annual provision for the periodic replacement of short-lived assets (e.g., roofing, HVAC systems, appliances).

  • An appraiser must know whether or not a replacement allowance is included in any operating statement used to derive a market capitalization rate for use in the income capitalization approach. 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.

  • 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.

  • Calculation: Can be estimated based on the asset’s replacement cost and useful life.

    • Mathematically:

      Replacement Allowance = (Replacement Cost) / (Useful Life)
      * leasing commission❓s: 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.

6. Items Excluded from Reconstructed Operating Statements

Certain items found in owner-prepared statements are not included in reconstructed operating statements because they are either non-operating expenses or relate to the owner’s specific financial situation. These items include:

• Book Depreciation: This is a non-cash expense based on historical cost and tax regulations. The capitalization process inherently accounts for capital recovery.
• Depletion Allowances: Similar to depreciation but for natural resources.
• Income Taxes: Dependent on the owner’s tax bracket and entity structure.
• Special Corporation Costs: Expenses specific to corporate operations.
• Additions to Capital (Capital Expenditures): These are one-time investments that increase value, not recurring operating expenses. Note: A replacement allowance provides for future capital expenditures on a recurring basis.
• Loan Payments (Mortgage Debt Service): NOI is calculated before debt service.
  • Net operating income is defined to exclude mortgage debt service.

7. Net Operating Income (NOI)

Net Operating Income (NOI) is the property’s income after deducting all operating expenses from Effective Gross Income (EGI). It represents the property’s core earning power.

• Definition: Revenue remaining after deducting operating expenses from EGI.
• Calculation: NOI = EGI - Total Operating Expenses

8. Capitalization Rates (Cap Rates): Definition and Calculation

A capitalization rate (cap rate) is a ratio that expresses the relationship between a property’s NOI and its value. It is a key metric used in the income capitalization approach to valuation.

• Definition: The rate of return an investor expects to receive on their investment in a property.

  • 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 accom- plished in one step, either by dividing the net operating income estimate by an appro- priate income rate or by multiplying the income estimate by an appropriate factor.

• Calculation: Cap Rate (R) = NOI / Value (V)

  • It implies V = NOI / R
  • Interpretation: A higher cap rate indicates a higher perceived risk or a lower purchase price relative to income.

9. Factors Influencing Capitalization Rates

Several factors influence capitalization rates, including:

• Risk: Higher risk properties (e.g., those with unstable income streams, high vacancy rates, or located in declining markets) typically have higher cap rates.

  • Investors often have minimum first-year capitalization rate requirements.

• Market conditions: Cap rates tend to be lower in strong, competitive markets and higher in weaker markets.

  • Investors often have minimum first-year capitalization rate requirements. In these cases, comparables with similar future expecta- tions may not be available and a yield capitalization technique may be more appropriate.

• Interest rates: Cap rates are often correlated with interest rates. Higher interest rates can lead to higher cap rates as investors demand a higher return to compensate for increased borrowing costs.

• Property type: Different property types have different typical cap rate ranges due to varying risk profiles.
• Location: Prime locations generally command lower cap rates due to higher demand and lower perceived risk.

10. Deriving Capitalization Rates from Market Data

The most reliable method for determining an appropriate cap rate is to extract it from comparable sales.

• Process: Analyze recent sales of similar properties to determine their NOI and sale price. Calculate the cap rate for each comparable sale.

  • Deriving capitalization rates from comparable sales is the preferred technique when sufficient information about sales of similar, competitive properties is available. 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.

• Comparable Sale Data Needed:

  • Sale Price
  • Date of Sale
  • Net Operating Income (NOI) - for the year prior to the sale date, if possible, or pro forma.
  • Verification of Expense Structure (is a replacement allowance included?)
  • Formula: Cap Rate = NOI (Comparable Sale) / Sale Price (Comparable Sale)

  • Considerations:

  • The definition of income and expense must be consistent between the comparable properties and the subject property. For example, if the subject property’s NOI includes a replacement allowance, the comparable properties’ NOIs should also include one (or an adjustment must be made).

  • The comparable properties should have similar property rights, income- expense ratios, land value-to-building value ratios, risk characteristics, occupancy or vacancy levels, and future expectations of income and value changes over a typical pro- jection period. The choice of capitalization method does not affect the indication of value.

• Example: If a comparable property sold for $1,000,000 and its NOI was $80,000, the indicated cap rate is 8.0% ($80,000 / $1,000,000 = 0.08).

11. Other Methods for Estimating Capitalization Rates

When sufficient comparable sales data is unavailable, other methods can be used:

• Band of Investment: A weighted average of the mortgage and equity components of financing.

  • Band of investment—mortgage and equity components
  • Band of investment—land and building components
  • Debt Coverage Ratio (DCR): Used to assess the ability of a property’s NOI to cover debt service.
  • Debt coverage analysis

  • Surveys: Published surveys of cap rates for different property types and markets can provide a general benchmark.

  • Investor survey rates may or may not include deductions for replacement allowances, and appraisers must exercise caution in apply- ing 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.

12. Expense and Income Ratios

Expense and income ratios provide a relative measure of a property’s operating efficiency and profitability.

• Operating Expense Ratio (OER): The percentage of EGI consumed by operating expenses.

  • Calculation: OER = Total Operating Expenses / EGI
  • Net Income Ratio (NIR): The percentage of EGI that remains as NOI.
  • The complement of this ratio is the net income ratio (NIR), which is the ratio of net operating income to effective gross income.
  • Calculation: NIR = NOI / EGI
  • Relationship: OER + NIR = 1 (or 100%)
  • Significance: These ratios can be compared to industry benchmarks and comparable properties to assess the reasonableness of the reconstructed operating statement.

13. Application: Reconstructing an Operating Statement and Deriving Value

Let’s illustrate the application of these concepts with an example:

Property: 50-unit apartment building

Step 1: Estimate Potential Gross Income (PGI)

• Average market rent per unit: $1,200/month
• PGI = 50 units * $1,200/unit * 12 months = $720,000

Step 2: Estimate Vacancy and Collection Loss (V&C)

• Market vacancy rate: 5%
• V&C = $720,000 * 0.05 = $36,000

Step 3: Calculate Effective Gross Income (EGI)

• EGI = $720,000 - $36,000 = $684,000

Step 4: Estimate Operating Expenses

• Property Taxes: $50,000
• Insurance: $10,000
• Utilities: $30,000
• Maintenance & Repairs: $40,000
• Management Fee: $34,200 (5% of EGI)
• Replacement Allowance: $10,000
• Total Operating Expenses: $174,200

Step 5: Calculate Net Operating Income (NOI)

• NOI = $684,000 - $174,200 = $509,800

Step 6: Determine Capitalization Rate

• Based on comparable sales, the appropriate cap rate is 7.5%.

Step 7: Estimate Value

• Value = NOI / Cap Rate
• Value = $509,800 / 0.075 = $6,797,333

Conclusion

The reconstructed operating statement is a crucial tool for real estate income analysis. By carefully estimating income and expenses and applying an appropriate capitalization rate, appraisers can arrive at a reliable estimate of value. Understanding the principles and techniques discussed in this chapter is essential for mastering real estate income analysis.