OARs and Reserves for replacement

[Michigan CG]

Appraised a property where I included a reserves for replacement line item expense. I have multiple sale comparables some of which I have the broker listings. The broker listings have actual (mostly) expenses. These expenses do not include a Reserve for Replacement.

On one property without the reserves the OAR is 7.68%. Adding in similar Reserves for Replacement results in a 7.19% OAR. I say that the 7.19% should be used since it compares red apples to red apples. Not adding in the reserves, in my opinion, is comparing green apples to my red apple that has reserves in the operating proforma.

Taking into account all of the sales the subject property was estimated at 7.5%.

Any opinions?

 

[George Hatch]

It's not uncommon for brokers and some property owners to omit certain expense items from their calculations, particularly in their forecasts. You're going to have to decide whether to base your forecast on the same basis as your comps or whether you're going to adjust all your comps to the same basis as your subject. You obviously want to avoid mixing the two up.

For instance, here in Calif. with Prop.13 (which pegs assessed values at their most recent purchase price regardless of market conditions), most properties with a low current assessment will be reported by the brokers as having expense loads based on the current assessments; and for the current ownership those are the correct expenses. The problem is that a new buyer is subject to the new (and higher) property tax assessment. That means in order to figure out what those prices really meant to their respective buyers you have to adjust the income/expense to reflect the new expense, which will be much higher than the old one.

You are trying to figure out what the income stream means to a well informed/advised buyer as well as the seller. I routinely adjust expense loads upward on comps if/when I spot one that's been grossly underestimated. Actually, I usually report it both ways so my readers can see how/why I did it.

 

[Boonders]

I'm all for including reserves in extracted cap rates if you are including them in your operating expenses.

 

[Caligirl]

I view reserves as a management issue and include them. Included in my intro/blurb to the operating statement is something about assuming 'professional and competent management' and performing a market survey for property management fees and practices.

I'm interested to hear what others think.

 

[Stephen J. Vertin MAI]

Tim:

You are correct. If they are not in the comps they need to be extracted or dont count they within the subject. Either way is comparing apples with apples.

 

[Calvin the Airedale]

It's not uncommon for brokers and some property owners to omit certain expense items from their calculations, particularly in their forecasts. You're going to have to decide whether to base your forecast on the same basis as your comps or whether you're going to adjust all your comps to the same basis as your subject. You obviously want to avoid mixing the two up.

The most reliable cap rates are those generated by transactions with institutional investor appeal. Because they compete on a national basis, are generally professionally managed to standard accounting practices, and thus, their net income numbers are more reliable.

Aside from such deals, the rates are always suspect. As GH notes, it is normal for owner managed apartment projects to offer properties for sale with scrubbed up pro formas. All capital expenditures are left out, no reserves are included, and very little if any management expense. It is often difficult to determine, even with face to face verification with the broker or seller, what exactly is in the pro forma.

The historicals of such deals are also suspect because, and this may come as a shock to some, these same owners sometimes pad their expenses on IRS form 8825.

Remember what reserves are for: to even out the cash flows to account for those short lived items that need replacement on only an occasional basis. Depending on the property, I will include reserves for such short lived things like mechanicals, roofs, etc, but am careful to make sure similar capital replacment expenses have not already been included in the repairs & maintenance category.

Tim, your treatment of the comps without such reserves is exactly as it should be providing their expenses do not include a margin for actual dollars spent on capital replacements. In other words, if they include actual capital expenditures, their rates should not be adjusted. OTOH, if the actual expenses for such items is slight, perhaps the rates will need adjustment.

One thing is for certain, and assuming the data does not come out of your files, between the typical broker, agent, accountant, buyer, and seller, only God knows the truth of those comp NOIs!

 

[andy ruffner]

Just my opinion, but contact the broker (listing) and/or the seller to confirm the allocation or non-allocation of expenses. Non-institutional grade is about all I do and I've gotten reasonably good at figuring out the jumbled mess of numbers I get sometimes. I find in the northern virginia/dc metro area, that small stuff like 8-10 unit apartments, small offices, etc. don't specifically make a "budget" for RFR. I'd call though. I work specific markets, so sometimes when I see something goes up for sale, I call the broker and ask for the brochure and the financials (i keep a real estate license too.) Then when it sells in about 3-4 months, I've already got the data. I know that's hard to do a small scale, but it takes very little time and you can build up quite a database. Just my one cent.

 

[PropertyEconomics]

The reserves for replacement discussion is one that can be long and heated among any set of appraisers. I dont know about other markets, however, within my market I have never seen a property which has a reserves for replacement account set up but rather owners treat these expense items as capital expenditures in the years they are realized.
I have always thought that inclusion of reserves for replacement was more of an accounting issue, and while some of my clients have required their inclusion, many more dont. I have always done my best to reflect what actual market participants in my market were doing and as such reserves typically are not an expense item.
I agree with all others however you measure the overall rates they must be consistent with the manner in which you treat your subject. If your subject has reserves expenses then calculation of the comparable OARs should also include reserves. If your subject doesnt then your comparable sales shouldnt either. I believe as long as you are consistent in your analysis you should be fine .... with that said Id be curious what happens to value when you measure it both ways (with and without reserves). It may well be interesting to compare the two just to see the value differences.

Also, for what its worth, I understand in the late 80s and early 90s when Trump suffered through the commercial crisis, one of the things that was discussed was that he had such large reserves for replacement accounts on the real estate he owned, it essentially kept him from the need to file bankruptcy. An interesting factor in current economic times.

 

[PL1957]

with that said Id be curious what happens to value when you measure it both ways (with and without reserves). It may well be interesting to compare the two just to see the value differences.

If you are doing it properly, there shouldn't be any value difference.

 

[PropertyEconomics]

If you are doing it properly, there shouldn't be any value difference.

I agree with you PL ... to me it was just a test of reasonableness for both methods. I was hoping Mr Evans would come back and say the exercise proved the numbers were the same, or at least very close, there will be slight differences.