Property Operating Statement

property operating statement

Accurately recording all cash flows of a property and assessing its income-earning capacity is key to evaluating it from an investment point of view. This can be done by constructing the property operating statement, which typically includes not only the cash inflows and cash outflows from the operations of the property but also cash flows that are not strictly operational, such as debt service, capital expenditures, and income tax payments. According to Greer and Farrell (1993), a typical property operating statement should include the following:

Potential Gross Income
Vacancy and rent loss allowance
+ Other Income
= Effective Gross Income
– Operating Expenses (see note below)
= Net Operating Income
Debt Service
= Before-Tax Cash Flow
– Income Tax Liability
= After-Tax Cash Flow

 Note that the following with respect to the above items:

(1) Potential Gross Rental Income is the income that the property can produce assuming that it is fully occupied
(2) Vacancy and rent loss allowance represents the potential loss of income due to vacancies or non-paying tenants
(3) Other income includes income other than rent, such as income from laundry machines,  parking, etc.
(4) The Debt Service refers to the annual payments required to repay any mortgage loans for which the property serves as security. Such loans are usually taken by the owner for acquiring or for renovating the property.
(5) The Operating Expenses are entered into the statement analytically as below:

Maintenance and repair
Insurance
Utility expenses
Management fees
Property taxes
Payroll
Security
Supplies
Advertising
Replacement allowance (for any required periodic replacements of equipment or other items)

The operating statement will provide the detailed current cash flows of the property that will provide the basis for the formulation of the property’s cash flows over the planned holding period of the investment. These cash flows are a required input for analyziing a property from an investment point of view using the discounted cash flow (DCF) model.

Constructing the Property Operating Statement

According to Greer and Farrell (1993) constructing a reliable current operating statement for a particular property requires verification of all records pertaining to the income and operating expenses of the property by inspecting original source documents and by comparing the reported operating results of the property with available results for comparable properties in the vicinity or neighbourhood of the property under consideration. This exercise can help also evaluate whether the property has unjustifiably considerably higher operating expenses or lower rental rates compared to similar properties in the area, and assess whether there is potential for improving the property’s income-earning capacity. In the latter case the property would be suitable for a value-added strategy if bought at the right price.

In terms of determining the gross potential income of the property the investor or his/her consultants need to examine the property’s rent roll and leases in order to record the contract rate for each lease, the yearly review date, any escalation clauses, and any concessions that may result to reductions in payable rent compared to the contract rate.  Analysis of all rental contracts pertaining to the property will also help identify existing vacancies.

The rents quoted in the lease contracts pertaining to the property need to be compared against the market rent levels prevailing in the neighborhood. The rationale of this comparison is to evaluate whether they are significantly above or below such levels and assess the feasibility or necessity to adjust the current rental levels charged in the property upwards on downwards (when these leases expire) in order to be in line prevailing rent levels in the neighborhood.

In order to estimate the operating expenses of the property, the investor needs to look at the immediate and past experience of the particular property and compare it against the experience of other comparable properties in the local market.

References

Kolbe, P. T., & Greer, G. E. (Author), Gaylon E. Greer.  (2012). Investment Analysis for Real Estate Decisions, 8th  Edition. Dearborn Real Estate Education.

Geltner, M., Miller, N. G., Clayton, J., & Eichholtz, P.  (2013). Commercial Real Estate Analysis and Investments (with CD-ROM). Oncourse Learning.

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Property Investment Basics: Equity Capitalization Rate
Going-in Cap RateThe Cap Rate Cycle
Property Investment Basics: Gross Income Multiplier
Property Investment Basics: Return on Equity
Property Investment Basics: Capital Return

Author: Petros Sivitanides, Ph.D.

Dr. Sivitanides is a seasoned expert in real estate investment strategy and analysis, property portfolio modeling and strategic analysis, and real estate market research and econometric forecasting with over 16 years of experience with leading global real estate investment managers and real estate consultants (CBRE Global Investors, AXA Real Estate, Torto Wheaton Research, DTZ, etc.). He is the editor of the textbook titled “Market Analysis for Real Estate”, which has been used as the main textbook for a graduate course at Harvard University. He is also the author of the book "Real Estate Investing for Double-Digit Returns" and many widely quoted articles that have been published in popular real estate journals. Currently, he is the Head of the Real Estate Department at Neapolis University in Cyprus, and an international real estate consultant.

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