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Cash Flow projection question

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Vin Piazza

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Jan 16, 2003
I came across AI's "The Appaisal of Real EState" 12th edition and decided to spend some time learning about commercial building valuation. (I am an equity analyst, not an appraiser.) I have a general question on the theory used in the book. On page 590, the book presents a projected income statement that excludes interest expense, depreciation, and amortization. I am somewhat puzzled by this. Interest, depreciation and amortization are really tax shields and are a part of the ongoing operations of the building-interest for the debt, depreciation for capital expenses, etc. So why remove these from a typical income statement. When I project cash flows as an equity analyst I do add back certain items to get pure free cash flow to the firm. Can someone explain/reconcile this for me please ? Thanks, Vin.
 
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Jan 13, 2002
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Retired Appraiser
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Vin,

I'm moving this post to the Commercial Forum and hope that you'll receive more exposure and answers there.

Pamela Crowley
 

Bill_FL

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Aug 23, 2002
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Try to think of it as two areas of expenses. Property expenses and owner expenses. The interest, depreciation, etc is considered an owner expense and are typically not related to the performance of an income producing property, in terms of its net operating income. Only income and expensese directly attributable to the property, before debt service, taxes, etc are considered.

There are cases where some of these expenses are considered, but it is in a different methodology in the income approach. I assume you were reading about direct capitalization.
 

Vin Piazza

Freshman Member
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Jan 16, 2003
If I repair the roof, the heating system, the floors, etc am I not improving the building and hence its performance/value as an income producing property ? Those improvements enhance my potential income stream. Why does the asset receive the benefit but does not incur the cost of the enhancements; it's the asset (building) that is throwing off the income. In accounting don't we match expenses w/ the income ? The owner is not generating the income; he/she gives up the tax shield when the property is sold. Why is the expense the owner's expense and why does the benefit accrue to the underlying asset ?? This is an interesting topic; when valuing fixed income investments we look at depreciation/amortization as an expense of the operating company not as an expense of the owner of the asset. Any other thoughts ?? I would like to learn more about this.
 

Paul Ness MAI

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You jumped from interest, depreciation and amortization, to maintenance and capital improvements. The latter two are always reflected in a real estate valuation as "maintenance/repairs" and a "replacement reserve".

To build on Bill's comments, interest, depreciation and amortization vary obviously depending on financing terms, which depend on the individual investor. Expenses in the typical "market value" appraisal are "stabilized operating expenses", those expenses necessary for the income generation of the building.

I have the 11th edition, but there is a section in my Chapter 21 (Income and Expense Estimates) entitled "Exclusions from Reconstructed Operating Statements" and there is probably a similar section in your 12th edition. This section explains in greater detail why business expenses, financial costs associated with the specific circumstances of ownership, as well as non-recurring extraordinary expenses are all excluded.
 

Vin Piazza

Freshman Member
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Jan 16, 2003
Let's say I buy a boiler for $100,000 and it has a 10 year useful life. I depreciate that asset over 10 years at $10,000 a year. Where does the accountant stick the "depreciation expense"? It has to go somewhere ? Why do appraisers not consider this in their valuation when other analysts of fixed income assets take depreciation and other similar items into account. That's my question. Let's say I owned a company and purchased a new machine for $100,000 with a 10 year useful life. I stick $10,000 every year in "depreciation expense" on my income statement; this is my tax shield since less taxable income is reported. When I model cash flow, I add back depreciation to get my true cash flow.

If I looked at an income statement (financial statements) for a building would it be vastly different than income/expense statements modelled by an appraiser ? Is the income/expense statement really a cash flow statement ?
 

Curtis West

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Jun 7, 2002
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Certified General Appraiser
State
North Carolina
When estimating the market value of an income producing property appraisers consider only those income and expenses that are directly related to that property. The income is that which is produced through operation of the property and the expenses are those that are necessary in order for the property to produce that income. The income may be categorized or may be summarized and, even when categorized, usually falls within broad category of gross income (and within the sub-categories of potential gross and effective gross). Operating expenses are typically considered as being within one of three categories: Fixed Expenses (those that do not vary with changes in occupancy levels), Variable Expenses (including management, repairs and maintenance, and so forth – that do tend to vary with changes in occupancy levels), and Replacement Reserves (annualized allowance for periodic replacement of short lived property components – not already considered under repairs and maintenance). When operating expenses are deducted from effective gross income, the result is net operating income (attributable to the property).

Since income tax is not directly to the market value of property, it is not an appropriate deduction in a market value analysis. Likewise, depreciation related to income tax issues is not an appropriate deduction.

If, on the other hand, the purpose of the analysis is to estimate Investment Value rather than market value, consideration of income tax and depreciation related to income tax would be appropriate. The result of this analysis would be an indicated value of the property to that particular that considers that investors potential tax consequences along their other particular investment criteria.
 

Paul Ness MAI

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Pennsylvania
Yes, it is really a cash flow statement rather than an income statement in accountant's jargon. I thought you were originally refering to building depreciation taken on taxes. The depreciation you just described is accounted for in the estimate of a replacement reserve. Such short-lived items are listed and their cost and life are estimated to calculate a reserve that represents a hypothetical sinking fund for replacement of such items. I say hypothetical because most investors have no such reserve.
 

Vin Piazza

Freshman Member
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Jan 16, 2003
Curtis, thank you-that's exactly what I was thinking about in this case-Investment Value !! Paul, thank you for the clarification !! Have a great weekend !!
 

Paul Ness MAI

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Jan 14, 2002
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Certified General Appraiser
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Pennsylvania
Remember what is ultimately done with the appraiser's net operating income. In direct capitalization, it is capitalized into value using an overall cap rate. It reflects one year of income and therefore must be "stabilized". Use of the overall cap rate provides a snapshot view of the property but still indirectly reflects the dynamics of changes in income (cash flow) and value over time.
 
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