True-ing Up Operating Expenses, for accurate NOI determination and Cap Rate application
Commercial real estate has a language and math of its own. In John’s article, he explains how the accuracy of the numbers can make a big difference to the bottom line.
Expense wise, a Triple Net (NNN) lease structure is not complex; a CAM/Expense Pass-Thru charge, plus a Reserve Factor for the replacement of long lived items such as HVAC systems, and an imputed Management Fee; pretty simple. But what about Full Service, Gross and Industrial/Modified Gross Lease terms? Are there “normal, typical and reasonable” property expenses (a/k/a: “Stabilized” expenses) for these other lease types, you ask? The answer, of course is yes.
Understanding what a property’s Stabilized/Normalized Operating Expense Ratio should be, is essential in determining a “Stabilized” or “trued-up” property expense calculation & ratio. Expenses provided by a 3rd party, such as a property owner, are not necessarily “trued-up”; meaning they are not accurate, realistic and therefore, cannot be relied on at face value. Often a property’s operating expenses are overstated by the owner to reduce income for tax purposes; or the expenses are understated to inflate a NOI figure and therefore, the value estimate.
This is a common finding when reviewing a property Income & Expense Statement provided by a “potential seller”. Real Estate taxes are often understated when, in fact, a huge leap up in a newly recorded sales price will mean a large increase in real estate taxes for the new buyer. Owners rarely include a Reserve Factor for the eventual replacement of the big stuff, like the roof and the HVAC system. The mentality is “I’ll pay for it if it breaks and I have the money”; this is not “Competent Management”. Additionally, many property owners believe that their time is “free” and therefore they don’t include a “Management Fee” as an ordinary expense. I’ll venture to say that during business hours, no one’s time is “free”. Therefore, prior to the application of a Cap Rate to a NOI (Net Operating Income) based on the owner’s expense statement, it is essential to “true up” or normalize estimates, whether they are misstated intentionally or otherwise. This is done via an analysis of “Expense Comparables” and the extracting of appropriate expense ratios, once a repeated and normalized pattern can be recognized.
Published Sources, such as Realty Rates.com, Korpacz and others, provide a secondary source as a cross-check to the market extracted expense conclusions. Arriving at the NOI line without a firm grasp of what expenses are appropriate and accepted as “Stabilized” for a given Property type, will surely result in an inaccurate value determination. The process for an accurate and reliable Cap Rate selection is similar to the Expense process and is essentially determined via the same two methods utilized for the Expense Ratios; 1) Market Extracted Cap Rates from the sale of properties that were leased at the time of closing; and 2) Published Sources such as Kopacz Investor Survey, etc., where you can familiarize yourself with Expense Ratios per Property Type and Capitalization Rates.
You’ll find that with accurate property expense estimates and the appropriate Cap Rate selection and application, your value estimates will be “trued up” and solid, thereby resulting in a “true” market value estimate.
PS. Competent Property Management is a condition inherent in the definition of the Market Value.