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Operating Expenses & Reserves in Property Valuation

Instructor: Eileen Cappelloni

Eileen worked for the Orange County Asssociation of Realtors for 31 years. She has written real estate courses and exams for other publishing companies

This lesson defines operating expenses and explains how they vary from property to property, depending on the type of occupancy, use type, and management quality. You'll learn how to use the income approach to estimate operating expenses and how to analyze and estimate reserves.

Investment Property

When Joseph approaches his appraiser friend, he lets him know he is determined to invest in an apartment building in his area that has just been renovated. This is not Joseph's first investment, but he needs an appraiser to help him determine what price he should be offering to purchase this property. Joseph's friend, Michael has been an appraiser for years and knows that in order to come up with a value for this property, he needs to be able to calculate what the approximate net operating income will be. In order to decide that, he will need to know the income of the property and, of course, the expenses.

Three Types of Operating Expenses

Michael explains to Joseph that estimating operating expenses is a major factor to help determine the value of the property that he's interested in. There are three types of operating expenses:

  • Fixed expenses, which do not vary regardless of the occupancy rate of the individual units in the building. These would include property taxes and property insurance.
  • Variable expenses depend on occupancy rates. Examples of variable expenses in an apartment building would be maintenance and utility costs, trash removal, janitorial expenses, advertising, and management fees.
  • Reserves for replacements. This is where monies are set aside each year to replace items that will not last throughout the entire useful life of the building. Even in an apartment building such as this one, where all the units have been recently renovated, many components will need to be repaired or replaced each year due to normal wear and tear and based on the quality of the replacements. Some examples include appliances, air-conditioning, carpeting, etc.

Other Costs Not Considered to be Operating Expenses

There are also ownership charges associated with the operation of a building. These charges are not considered operating expenses and include mortgage payments, tax depreciation, personal expenses not related to the operation of the property, capital improvements and personal expenses.

Operating Expenses for Other Types of Properties

Of course, if you owned a factory or other type of commercial building, for example, there would be different types of operating expenses. Some commercial investments, such as a factory, would also include the costs of goods sold (COGS) as an operating expense, and direct labor costs or rent for production facilities, as well as compensation and benefits for staffing .

Calculating Operating Expenses

In an apartment building, where there's, let's say, 20 apartments, and they each rent for $2000 monthly, you would have a potential annual gross income of $480,000, assuming all apartments were rented. In the real world, there would probably be a vacancy rate, which also would be calculated. In addition to estimating vacancy and loss collections, you would then add any other income to arrive at your effective gross income, and then subtract your operating expenses.

PGI - V&C + OI = EGI - OE

PGI Potential gross income
V&C Vacancy and loss collections
OI Other income
EGI Effective gross income
OE Operating expenses

Examples of Reserves

Here are just a few examples to demonstrate the different types of reserves that must be subtracted from the effective gross income.

For fixed expenses: The fixed expenses do not rely on occupancy rates; we already calculated that the potential annual gross income in this example would be $480,000; the annual fixed expenses would be property taxes of $45,000 and $25,000 annually and that total of $70,000 would be one part of the reserves that would be deducted from the effective gross income.

For variable expenses: (At 100% occupancy rate) $12,000 is the annual electric bill for the common areas , $25,000 annually for maintenance fees and $22,000 for trash removal; therefore the total variable expense annually would be $59,000. Remember, these figures will change depending upon the current vacancy rate. To simplify the example, we are using a 100% occupancy rate. If there was a 95% occupancy rate, the variable expenses would decrease by about 5%, as would the potential gross income.

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