How to Analyze Expenses When Valuing Distress

The adage that real estate investors make the most money on the buy is even more germane with the purchase of distressed real estate. To this extent, I am amazed at the lack of understanding about how to analyze expenses on distressed properties. Often the expense estimate is the second most important figure in an appraisal, with value obviously the most important. Consequently, the inability to appropriately analyze expenses is a critical concern for both investors and appraisers.

Potential buyers of distressed real estate have to be cognizant of a property's historical operation. Historical expenses associated with repairs and maintenance on distressed assets are often understated due to cost controls exercised to minimize cash outlays. However, for a new owner much higher repairs and maintenance expenses are appropriate and should be reflected going forward.

Before starting on the individual expense discussions, a primer is needed. It's important to focus on how to analyze three key expenses: property taxes, management and repairs and maintenance. Property taxes are often the largest expense component and vary tremendously based on assessment practices in a market as well as the ability to seek tax relief in times of property distress.

Prudent management is critical to turning a property around. Management should always be analyzed on a dollar basis first and then on a percentage basis. Repairs and maintenance will vary greatly based on the property's past operation, to this avail, this expense category requires understanding the motivation of the existing owner. For example, an owner trying to save a property will typically reduce this expense at the risk of having to incur capital repairs/expenditures in the future. In contrast, an owner that is trying to seek debt relief often will have enormous repairs and expenses that may be overstated.

With property taxes, the constraints of the local Value Adjustment Board, or equivalent, have to be scrutinized. Some municipalities are able to make adjustments to current property valuation, while others have very little flexibility. When valuing an acquisition, it is unsafe to assume that just because an asset's market value has been reduced, its assessed value has been reduced. Until the VAB adjusts the assessed value, the current property taxes will be due.

Insurance also requires careful analysis. Insurance costs can vary dramatically based on market risk. When a property loses tenants, insurance costs can rise due to the associated risks with vacancy. Even if the vacated tenant is still paying rent, the increased insurance expense may become the owner's responsibility.

Management expenses may decrease with the loss of revenue, however, if the owner is trying to replace management on a distressed property, it may be necessary to entice a management company with a fixed minimum fee, netted against a certain percentage. As such, management fees should be first analyzed on a dollar basis and then compared and contrasted to a percentage of revenue.

Another expense commonly associated with the management fee is advertising, which will likely rise with distressed properties in order to attract new tenants and customers.

Variable costs associated with utilities and janitorial expenses should decrease as vacant space no longer requires constant attention or electricity. However, it is important to note that these expenses do not correlate directly to occupancy levels. Another variable cost, leasing commissions, may actually increase. As with the management fee, higher rates may be needed to entice leasing agents to spend time on a distressed property.

Reserves are often overlooked in expense forecasting. Most who disregard reserves risk incurring massive expenses in overdue repairs. It is imperative to be very knowledgeable about the current state of a property's maintenance requirements as well as historical expenses.There are many minute details associated with analyzing the operating expenses on a distressed property. Expense analysis may seem insignificant, but the task is critical for a prudent purchase decision.

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