Unit 5: Reconstructing the Operating History PDF

Investment Analysis for Real Estate Decisions, Ninth Edition Unit 5: Reconstructing the Operating History Unit Outline This unit gives an overview of the property operating statement and demonstrates how to estimate operating revenues and expenses. It shows...

Investment Analysis for Real Estate Decisions, Ninth Edition Unit 5: Reconstructing the Operating History Unit Outline This unit gives an overview of the property operating statement and demonstrates how to estimate operating revenues and expenses. It shows how to reconstruct a property's operating history and discusses factors affecting future operating cash flows. A. Introducing the Operating Statement 1. Whereas traditional income statements seek to show operating revenues "when earned" and operating expenses "when incurred," whether or not these represent actual cash receipts and disbursements, real estate investment analysts are concerned with actual cash flows into and out of the investor's coffers. 2. Operating statements therefore usually present cash inflows and outflows from operations and extend the presentation to include non-operating cash flows such as those from debt service, income taxes and capital expenditures. 3. Potential gross rent is the amount of rental revenue a property would generate with no vacancies. Adjusting potential gross rent to reflect losses from vacancies and uncollectible accounts, and to include income from sources other than rents, results in effective gross income. 4. Operating expenses include all cash expenditures required to maintain and operate the property so as to generate the gross rent. 5. Net operating income is simply the difference between effective gross income and operating expenses. 6. Debt service is a consequence of using borrowed money to acquire a property. The final item affecting cash flow, income tax, is determined in large measure by the investor's individual income tax position rather than specifically by operating results of property on which the report is based. 7. The bottom line, after-tax cash flow, is the amount of cash remaining at the end of the reporting period, after all operating expenses have been paid, all obligations to borrowers satisfied, and all income tax obligations met. B. Types of Leases 1. Leasehold Estates: Periodic, For Years, At Will 2. Leases: Service versus Gross; Flat versus Variable C. Estimation of the Ability to Command Rent ©2019 Kaplan, Inc. May be reproduced for educational uses only.  Investment Analysis for Real Estate Decisions, Ninth Edition 1. The usual starting point for estimating the results of current operations is the history of recent operations as reflected on the property's records. 2. Analysts seek to verify all records by referring to original source documents and by comparing reported operating results with known or determinable outcomes from comparable properties. 3. To estimate recent gross income, inspect the property's rent roll and leases to determine contract rental rates, vacancies, and concessions. Verify indicated rental rates, if possible, by conversation with the building manager and tenants. 4. Reference to the experience of comparable properties is frequently the most valuable source of data for estimating a property's recent operating history. The challenge is to find properties that are truly comparable. a. The first step is to define the market area. This is the geographic area from which tenants are likely to be drawn. Comparable properties should be chosen from within this area. b. Identification of comparable properties in the market area involves finding those that prospective tenants would consider close substitutes when looking for rental space. C. Estimation of Operating Expenses 1. The starting point is the subject property's operating history. 2. The recent expense history of comparable properties is usually a good indication of the experience of the subject if it were competently managed. 3. Published compendiums of average operating expenses for similar properties in the general market area often serve as valuable benchmarks for judging the reliability of data from the subject and from comparable properties. D. An Apartment Building Example: Going through the text's example of Maegen's Magic Manor is an excellent way to illustrate the issues discussed in this chapter. This example is carried forward and expanded to illustrate additional cash flow forecasting steps in future chapters. ©2019 Kaplan, Inc. May be reproduced for educational uses only.