True-ing Up Operating Expenses, for accurate NOI determination and Cap Rate application
Commercial real estate has a language and math of its own; the accuracy of the numbers can make a big difference to the bottom line.
Let’s go into a little detail on the calculations and the process used to figure commercial real estate profitability.
How to Determine Commercial Real Estate Profitability
First let’s look at expenses. There are several ways to structure the leases on commercial real estate which determines who pays the expenses.
Expense-wise, a Triple Net (NNN) lease structure is not complicated; a CAM (Expense Pass-Thru) plus a reserve factor for the replacement of long-lived items such as HVAC systems, and an imputed management fee make up a pretty straightforward Triple Net lease.
At the next level is a Full-Service Gross lease and Industrial/Modified Gross Lease. These kinds of leases incorporate normal, typical and reasonable expenses, for example, utilities and property insurance – these are referred to as stabilized expenses.
Understanding a property’s stabilized/normalized operating expenses is essential in determining a stabilized or trued-up property expense calculation & ratio. One of the main things to consider is, where is the information regarding the expenses coming from? 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 an NOI figure and, therefore, the value of the property.
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 significant 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 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 can be done via an analysis of Expense Comparables and the extracting of appropriate expense, once a repeated and normalized pattern can be recognized.
Published Sources, such as RealtyRates.com, Korpacz and others provide a secondary source as a cross-check to the market. Arriving at NOI without a firm grasp of the appropriate and accepted expenses for a given property will inevitably result in an inaccurate value determination.
On the Income side, 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.
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 reliable, thereby resulting in a true market value estimate.