Analysts should use a property’s income statement and actual bills to validate each and every major expense line. In many cases, the best source of information for operating expenses is what happened in previous years. To that end, there are a number of best practices that should be followed for estimating fixed and variable expenses: 1. Fundamentally, these projections are just estimates, but there are common methodologies and strategies that can be used to make them as accurate as possible. Best Practices for Estimating Fixed & Variable ExpensesĬreating a pro forma financial projection is part art and part science. Thus, the estimated value may be higher or lower than it actually is, and this can have an impact on potential investment returns. 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. NOI is calculated by subtracting the property’s operating costs from its income. Why Getting Expenses Right is ImportantĬommercial properties are valued based on the amount of Net Operating Income (NOI) that they produce. 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. Variable expenses are harder to model because they require an accurate estimate about the property’s occupancy levels. As such, the more tenants a property has, the higher the income that it produces and the more income the property produces, the higher the property management bill will be. In many cases, a property manager charges a fee based on the amount of income the property produces. For example, one of the most common variable expenses is for property management. Variable expenses are expenses that fluctuate with the level of a property’s occupancy. Insurance expenses can be found by looking at the property’s most recent financial statements or by looking at the most recent bill. 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. In both cases, these expenses are the same whether the property is completely empty or completely full. Property taxes is an example of a fixed cost. What are Fixed Expenses?įixed expenses-sometimes called fixed costs-are expenses that must be paid, regardless of the property’s occupancy level. In this article, FNRP explains the difference between fixed and variable expenses in commercial real estate, the importance of getting expenses right, and best practices for estimating fixed and variable expenses. This estimate can be slightly more difficult because there are two types of operating expenses: fixed and variable. Once the income projections are complete, the next step is to estimate future operating expenses. This is particularly common with multifamily assets. In addition, some properties may produce ancillary income from non-rental sources, like parking, pet, or application fee revenue. As a starting point, the property’s income is reasonably easy to project by looking at the details of existing leases and by applying assumptions about rental growth and lease renewal rates. For the purposes of this article, the focus is on income and expenses.Ī property’s income derives from rents paid by tenants for the privilege of occupying space. Broadly, these financial models have three main components: income, expenses, and debt service. 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.
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