Fixed and Variable Expenses in the Income Approach

The appraisal process includes the income approach to estimate the value of a property that an investor would ideally purchase for its annual income. The income approach assumes a relationship between a property’s average net income and the price an average investor would pay for the property. The first step to defining that relationship is estimating the amount of net income that would accrue to a property in a typical operating year after all expenses to produce that income are deducted. The resulting estimate is shown in a stabilized or reconstructed operating statement for the subject property.

How Typical Expenses Are Identified

Expenses are normally described as ‘fixed’ or ‘variable.’ An appraiser’s first and most important source of expense data is the property’s most recent operating history; almost as important are past operating statements for the property. The appraiser asks the owner/property manager about any unusual expenses or expense variations from year to year. They then compare the subject property’s actual expenses with those for other properties. Since most market value definitions assume an everyday, well-informed buyer, the appraiser confirms that those characteristic expenses reflect the norm for similar properties and not just the seller’s management.

Comparable expense data can be difficult to find. In a competitive market, owners hesitate to declare the details of their properties’ operation publicly. An appraiser who has appraised many properties will have the actual expenses for those other subject properties; he or she can then use those properties as comparables as long as he or she doesn’t break his or her confidentiality obligations to other clients. Also, belonging to a professional appraisal organization, such as the Appraisal Institute, can give an appraiser access to comparable operating data from professional colleagues or member-only publications.

Professional management organizations, such as the Institute of Real Estate Management (IREM) and the Building Owners and Managers Association, publish surveys of typical operating expenses by property type. These published valuations usually aggregate data from properties in specific regions. Surveys are useful as a practical evaluation for a specific property, but actual expense data are always an appraiser’s first choice.

Fixed Expenses

Fixed expenses are those that accrue to a property regardless of its occupancy. These usually include real estate taxes and property insurance. Tax data are often available from the local treasurer or assessor, who can also let an appraiser know if major changes in assessment or tax rates are imminent. The appraiser must confirm that only real estate taxes are used in net income analysis: personal property and income taxes don’t apply to real property. Similarly, property insurance costs should involve just the real estate, not any personal property.

Variable Expenses

Variable expenses typically fluctuate with a property’s level of occupancy. Higher occupancy results in higher expenses incurred (or incurrable) by an owner/a property manager. Some kinds of occupancy will also result in greater accumulation of expenditures; examples include electricity for a server farm or security for a medical building. Standard variable expenses include management charges, maintenance and repair, cleaning, parking and site maintenance, security, rubbish removal, and pest exterminating. Actual operating history is again the best source for estimating these costs, though the appraiser will verify that the subject property’s expenses aren’t outside the conventional rates for similar properties.

Appraisers usually include a reserve for replacement, or replacement allowance, as an additional expense in a stabilized income statement. A reserve for replacement is a calculated charge that accounts for periodic replacement of property elements that wear out faster than the building itself. These might include carpet, roofing, HVAC systems, tenant improvements, exterior painting, and landscaping.

Property owners mostly don’t include a reserve in their operating statements. Actual repair and capital improvement costs can provide the appraiser with a basis for developing a replacement reserve. In that case, an appraiser would be careful not to overestimate the reserve. Appraisers also use subscription services, such as the SwiftEstimator, to identify the usual lives and replacements of building components.

Putting it Together

Investors generally focus on properties’ income multipliers, direct capitalization rates, and yield rates. But an appraiser can apply these factors only after developing accurate and well-reasoned estimates of net income. Net income estimates are only valid if the appraiser carefully analyzes past, current, and typical expenses for a property. A property owner can help the appraiser by providing a complete operating history and by explaining any expense anomalies.