When evaluating the potential purchase of a commercial real estate asset, one of the most important tools is the financial model that is constructed to estimate potential returns. Broadly, these models have three main components: Income, Expenses, and Debt Service. For the purposes of this article, the focus is on income and expenses.
A property’s income derives from rents paid by tenants for the privilege of occupying space. As a starting point, the property’s income is reasonably easy to project by looking at the details of existing lease and by applying assumptions about rental growth and lease renewal rates. In addition, some properties may produce ancillary income from non-rental sources like parking, pet, or application fee revenue. This is particularly common with multifamily assets.
Once the income projections are complete, the next step is to estimate future operating expenses. This can be slightly more difficult because there are two types—fixed and variable.
Fixed vs. Variable Expenses in Commercial Real Estate
Fixed expenses—sometimes called fixed costs—are those that must be paid, regardless of the property’s occupancy level. The two most prevalent examples of fixed operating expenses are property taxes and insurance. In both cases, these expenses are the same whether the property is completely empty or completely full. When creating the financial model, property taxes can be found by looking at the most recent tax bill and/or the local county assessor’s website. Insurance expenses can be found by looking at the property’s most recent financial statements or by looking at the most recent bill.
As you may have guessed, variable expenses are those that fluctuate with the level of a property’s occupancy. For example, one of the most common variable expenses is for property management. In many cases, a property manager charges a fee based on the amount of income the property produces. As such, the more tenants a property has, the higher the income that it produces; and the more income it produces, the higher the property management bill will be. Other examples of variable costs are: sales commissions, maintenance (including HVAC), repairs, landscaping, parking, trash removal, utilities, and security.
Variable expenses are harder to model because they require an accurate estimate about the property’s occupancy levels. For example, if an analyst models a property’s management fees based on 70% occupancy, but the actual occupancy turns out to be 90%, this is a big miss, and one that will have material implications.
Why Getting Expenses Right is Important
Commercial properties are valued based on the amount of Net Operating Income (NOI) that they produce. This metric is calculated by subtracting the property’s operating costs from its income. Missing on a major expense line item like property management can cause the property’s Net Operating Income to be higher or lower than it actually is. Thus, the estimated value may be higher or lower than it actually is, and this can have an impact on potential investment returns.
Operating Expense Best Practices
Creating a pro forma financial projection is part art and part science. Fundamentally, these projections are just estimates, but there are common methodologies and strategies that can be used to make them as accurate as possible. To that end, there are a number of best practices that should be followed for estimating fixed and variable expenses:
- Use Data. In many cases, the best source of information for operating expenses is what happened in previous years. Analysts should use a property’s income statement and actual bills to validate each and every major expense line. For example, the property management line item could be estimated by reviewing the three most recent years of bills, in addition to speaking with the manager about estimated future bills.
- Make Conservative Assumptions: The difficulty in projecting a property’s expenses is compounded by the fact that it has to be done over a multi-year holding period. Historical operating data may be useful for estimating the first year of the holding period, but certain assumptions must be made for the additional years. These assumptions should be conservative and supported by market data.
- Use Comparables: In the absence of historical operating data, sometimes the best source of total cost information is to look at comparable properties. This task can be difficult without access to the right databases, but it is often completed by the appraiser as part of the valuation assignment.
- Use a Modeling Tool: Pro forma can be complicated, but the construction of these projections can be simplified by using modeling tools. The sophistication of these tools can range from Microsoft Excel to Argus, which is used by many professional investors.
The bottom line is this: Although they are both expense types, fixed and variable expense estimates must be approached very differently. This differentiated approach is important for the accuracy of the pro forma, property value, and potential investment returns.
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