Budgets

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I have several acquaintances who operate many millions of dollars worth of rental property without using any budgets. When challenged about this

practice, they respond, “What if the boiler rusts out and needs to be re placed, but isn’t budgeted?” or, “What if we get twice the normal amount of snowfall—what would you do, consult a budget?” These same people insist that they do not waste money, but rather they spend what is necessary to properly operate their properties.

Many managers who are called upon during the busy last months of the year and asked to prepare a budget for the coming year would champion a “no budget” approach. These managers wish to be left alone to operate their properties—increasing revenues and curtailing expenses—while owners trust them to produce the best possible results.

Developing and using a budget is time-consuming and potentially re straining, but a budget is a valuable tool that demands forethought, goal- planning, and control. Budgets also provide a means to monitor progress. Unfortunately, too many budgets are prepared in haste, and their relation ship to reality is weak from the very beginning. Other budgets are developed only to be pared by an overly optimistic owner or superior in an effort to force unrealistic results. Such a budget will lose its value as a working tool shortly after the new budget year begins. Some budgets are created at a “higher level,” while the person who is responsible for in creasing rent levels or holding back on expenses makes no contribution to the budget’s development. This practice leads to frustration because neither party has a realistic impression of where the other is headed. An other example of budgets causing problems is the result of the short tenure of some managers; it is not unusual to find a manager trying to live within the bounds of a poorly prepared budget made by his or her predecessor. Any combination of these difficulties can contribute to the appeal of operating without the burden and restraint of a budget. Actually a bud get is like a road map—it helps you get where you want to go efficiently and within your means.

TYPES OF BUDGETS

October and November are typically referred to as budget time in the apartment management business. In areas of the country with four distinct seasons, the high point of rental occupancy usually occurs in mid-October. At this time, rent increases have been put to the test and most discretionary expenditures have been made for the year. Utility, seasonal, and make- ready costs are at their lowest. Armed with year-to-date operating data, a manager may use every spare moment in the months of October and November to prepare a budget for the upcoming year. A variety of budget types are commonly used in the management of rental apartments. These include: net operating income (NOI), cash flow, annual, quarterly, rent- up, major expenditure, and replacement reserve budgets. More than one type of budget may be needed to effectively plan for your specific property.

Net Operating Income (NOI) Budget

This type of budget reflects the gross possible income, vacancy and collection losses, sundry income projections, resulting collection expectations, and a listing of proposed operating expenses. The final budget line, the NOI, is broken out by month and totaled for the year. In a budget of this type, the monthly debt service is omitted or dealt with in a separate accounting. All inclusions up to and including the calculation of the NOI are matters of concern to the manager, a potential buyer, an appraiser, or others interested in the earning capability of the investment. Including the mortgage with its associated debt-service payments adds a personal variable to the budget and does not, or at least should not, affect the proper operation of the property.

Basic Budget Format (Stable / Upgrade)

  1. Gross Possible Income
  2. Laundry Receipts
  3. Other Income
  4. Vacancy Loss Effective Income
  5. Total Payroll
  6. Staff Apartments
  7. Painting and Decorating
  8. Maintenance and Repairs
  9. Supplies
  10. Trash Removal
  11. Exterminating
  12. Grounds and Pool Maintenance
  13. Cleaning and Janitorial
  14. Utilities
  15. Management fee _____%
  16. Miscellaneous
  17. Legal and Accounting
  18. Telephone and Office Supplies
  19. Advertising and Promotion
  20. Taxes and Insurance
  21. Total Expenses
  22. Net Operating Income

Cash Flow Budget

Most budgets for rental properties fall into this category. They follow the same pattern as the NOI budget except the cash flow budget does track the payment of principal and interest each month. The final budget line is referred to as cash flow. This is the spendable cash that constitutes the re turn on investment or the periodic income that is so critical in attracting investors. It is important that managers see this monthly expenditure requirement, but adding the debt-service payments to a basic operating budget presents some problems.

An owner who has been aggressive, or even unrealistic, in acquiring one or more levels of debt can effectively destroy the proper operation of the investment. The ability of an owner to acquire debt is not an automatic indicator that a property’s income can support the accompanying payments. This problem may eventually influence the budget because most managers adhere to an unwritten rule of payment priority that goes some thing like this: Pay the mortgage first, or there won’t be any property to manage; pay the employees next, or they won’t return to work; then pay the utilities—so it won’t be dark and cold; and finally, pay the insurance and real estate taxes so the lender won’t make a move to change the property’s ownership status. Most of these expenditures or ‘outflows” are very predictable in addition to representing a substantial percentage of the whole budget. Income remains a variable as well as maintenance, upkeep, and repair—which are more difficult to predict.

Having a budget with a negative cash flow is unsatisfactory to the owner, who will in turn pressure the manager to increase the income and cut back on upkeep expenses in order to balance accounts. This some times results in less care being taken in checking prospects’ references and eliminating many needed and scheduled repairs. Properties suffer when burdened with an unreasonable debt service. In my opinion, the reason most budgets do not work well is the influence of an unrealistic debt-service load.

Annual Budget

Most budgets detail income and expense projections for each of the months in the upcoming year. Nevertheless, there are situations when a total of annual income and expense items is sufficient. Usually an annual budget is prepared for submission to lenders, appraisers, investment partners, tax assessors, or others who do not need or should not be concerned with the monthly details of income or expenses. An annual budget is far less revealing and more difficult to track than a monthly budget schedule. For that same reason, an annual budget is not very valuable to either the manager or someone closely monitoring ongoing property performance.

Quarterly Budget

This budget, prepared in advance for each of the four business quarters, has become quite popular. There are several reasons for this: (1) budget numbers correlate to both the weather cycles and the changing rental activity during each of the four quarters; (2) managers can forecast income and expenses much more accurately using the smaller blocks of time; and (3) the owner’s optimism is more likely to be kept in check.

People who develop a quarterly budget are often more accountable for their predictions than are those whose budgets culminate a year from now. Shorter budget periods are also more effective in stimulating achievement. When quarterly budgets are used, there is usually an annual companion budget that includes far less detail. The conservative annual bud get is used for long-range planning while the shorter, quarterly budgets function more as goal-setting targets and learning tools. Utilizing this combination is the budgeting method I favor.

Rent-Up Budget

Some situations call for “special purpose” budgets. During a rent-up campaign, even a month is too long an interval between budget reports. Most rent-up budgets are prepared on a weekly schedule for periods of thirteen weeks. These budgets typically break out all of the various unit types and track week-to-week rental progress. Tracking begins the month that each unit becomes a revenue producer, not when the lease is signed or residents begin occupancy on a concession or rent holiday.

The expenses during a rent-up campaign are entirely different from those after the property has stabilized. Major costs will be advertising, public relations, collateral materials, rental personnel, incentives, and promotions. Real estate taxes, repairs, make-ready costs, and even mort gage payments will not become an issue for some months. The primary purpose of the rent-up budget is to monitor rental progress with the sea son and to regulate the use of advertising and promotional funds.

Major Expenditure Budget

This is a budget that is used to consolidate the major expenditures planned in a given period. For example, major expenditures might include new siding, a complete exterior paint job, redesigned courtyard landscaping, or the replacement of ten sets of appliances. By maintaining a separate budget for these items, they can be separated from the budget items that recur every year, making budget planning and analysis easier. This budget is frequently made before the actual operating budget is prepared be cause the decision to do certain work should be influenced by the need for the work rather than the availability of funds. The major expenditure

projects can be assigned priorities and later re-evaluated after the opera ting budget is prepared to determine which items can be accommodated with the projected availability of cash.

Major expenditures are often kept in a separate expense category to make year-to-year budget comparisons easier. Consider the repainting of all exterior wood surfaces, expected to cost $25,000. This expenditure should not be combined with the ongoing painting and decorating that must be done each year. In this way, the manager can follow the spending pattern for each category and recognize the difference between recurring annual maintenance items and special projects.

I prefer to draw a distinction between major and capital expenditures and treat them separately during the budgeting process. Because the two are often confused, it is important to distinguish between them: A capital expenditure represents a true improvement to the property; major expenditures are replacements and repairs. Hence, the $15,000 bill you incur by repainting the complex constitutes a major expenditure; the $75,000 you spend installing a new swimming pool is a capital expenditure.

Replacement Reserves

This is different from the major expenditure budget. Think of replacement reserves as something like a lay-away plan. Major expense items such as the roof, boiler, appliances, and carpeting are assigned a life expectancy. Money is set aside and it often earns interest, delivering the funds to pay for replacements when necessary. The money put away each month or year for this purpose is called a sinking fund. Many developments, insured under either federal or state programs, require periodic deposits into a sinking fund or, as it is more commonly called, a replacement re serve. The payments are allocated to different component categories and tracked on a reserve schedule. When a replacement becomes necessary, funds are deducted from that category and used to pay for the required item. Occasionally, permission is granted to shift money between categories to cover an unexpected replacement expense. While replacement re serves are carefully structured and regulated in government housing, they are far less formal in the case of conventional rental properties. Owners frequently set aside funds over a period of time to meet a planned major expenditure. The owner may choose to set aside $1,000 per month for a year and one-half to pay for a new roof or to replace leaky hot water lines. The money is budgeted on its own reserve schedule and is not included with the listing of other operating expenses. This takes place after the NOI line, hut before the line detailing cash flow. Unless the owner has a change of heart, this money will not be available as spendable cash because it is being held for the upcoming replacement. The money paid into this fund by the owner must be treated as part of the property’s earned income and as such is subject to income taxes. In the year that the major expenditure occurs, a transfer entry is shown on the income side of the budget inserting the replacement funds into the operating income and a line item is added in the operating budget for the cost of that improvement. At that point, the money spent is recognized and may be treated either as an expense or a depreciable asset depending on the accounting method chosen.

Contingency

In any upgrading or remodeling budget, the final expense line item to discuss is called contingency. All budgets—most particularly budgets such as rent-up or major improvement budgets—should provide an allowance for unknown items. This figure is often a percentage of the total budget and may range from as little as 2 percent to as much as 8 percent. The answer to the question, ‘What is it for?” is simply, “I don’t know.” That is why a contingency allowance exists in an estimation of upgrading expenses—to cover the unknown. If a manager can specify one or more possible expenditures such as higher labor costs, additional drywall patching, or the like, he or she would be better advised to increase the amount budgeted for those particular expense categories or add more line items to include these specific anticipated expenses. The contingency category is for items that cannot be foreseen; these things have a way of popping up as the year gets under way.

PREPARING A BUDGET

There are a series of important considerations in the process of preparing an operating budget for a rental apartment property. Obviously, the more experience a manager has operating a particular property or type of property, the more accurate and useful the budget will be. Without the benefit of past records, the budget preparation process will require much more time and reveal greater variances and outright distortions. Some useful guidelines follow.

Use Realistic Figures

Starting with income, there is a tendency to make calculations using current rent levels and to ignore the aging of the leases. It is also very easy to project rentals and fail to account for free rent allowances. Experienced managers have learned to be conservative with their income projections. Owners are never upset when their managers report more income than was anticipated in the budget; the problems arise when the situation is reversed. Being conservative is even more important regarding projections of unscheduled income.

When budgeting expenses, don’t skimp or ignore the price increases that will surely occur. This doesn’t mean that you cannot find ways to operate a property more efficiently or investigate trends to learn about departures from “the norm.” Utilities, services, insurance, and real estate taxes follow a pattern and can be tracked fairly easily, but make some telephone calls and do some investigation to avoid surprises. Payroll and related expenses often create a major problem. It is easy to account for existing salaries, but there is a tendency to forget to allow for overtime, salary in creases, seasonal workers, vacation replacements, incentives, and benefits. My experience indicates that this category is typically the most under- budgeted and overspent. Supplies, repairs, and maintenance are the other expense categories that are most frequently misjudged during budget preparation. They do not always show up as budgeting errors because as the manager sees a budget problem developing, expenditures are some times reclassified to other categories or eliminated entirely—thus depriving the property of repairs or improvements. This can harm the property in many other ways.

Again, the best advice is to develop a workable budget with realistic projections. Don’t be pressured into committing to an unrealistic budget in November, only to be forced to apologize each month in the following year.

Acceptable Variances

Just how far off can you be and still be within an acceptable variance? There are some established industry rules to help answer that question. Normally, a sense of limited variance acceptability is created by the use of spec rather than rounded figures. In other words, by estimating the water bill to be $3,434, one is effectively expressing a high degree of confidence in the projection. Anyone reading the budget might assume that the water bill will reflect that 6gure, plus or minus a few dollars. Had the projection been $3,400, that same person might assume an acceptable variance range from $3,300 to $3,500.

Remember, budgets are estimates and a lot can happen in one year; leave a little room for the unknown. A pro’s budget is filled with lots of triple zeros and double zeros. Don’t try to predict income or expenses to the exact dollar.

Budget Categories

There isn’t much to be gained by establishing a great number of income or expense categories. The more categories you have, the more likely things are to be misclassified; analysis is also made more difficult. This problem is exacerbated when overspending occurs in certain budget categories, and the manager begins changing expense classifications to minimize budget forecast miscalculations. Let’s take a look at the basic income categories:

• Apartment income

• Other scheduled income (parking, commercial, etc.)

• Concession income (laundry, vending, etc.)

• Non-scheduled income (clubroom rentals, late charges, NSF charges, forfeited security deposits, etc.)

The list of operating expenses can be considerably longer, but many major investors choose to limit the display of expenses to five major categories:

• Utilities and services

• Payroll and related expenses

• Management, administrative and promotion

• Real estate taxes and insurance

• Repairs and maintenance

Grouping expenses in these broad categories eliminates most of the confusion concerning category identification and provides the budget reader with a quick method of monitoring expense performance. Unfortunately, when too few categories are listed, the budget isn’t as great a help to a property manager. The typical breakdown for tracking and comparison are contained in these categories:

• Utilities

• Services

• Supplies

• Payroll and related expenses

• Advertising and promotion

• Management and administrative

• Legal and audit

• Insurance

• Real estate taxes

• Repairs and maintenance

• Miscellaneous

Seasonality

For each category of expense, it must be decided whether projections should reflect the trends exhibited in the previous months or in the same period during the preceding year. The latter focus is called seasonality. For example, when preparing a budget for heating expense, one should be more interested in what happened a year ago January than in the “lead up” months of November and December (months that are typically warmer than January). Lease-up expenditures, yard maintenance, exterior repairs, and utilities are a few examples of expenses that correlate more to a sea son than to the previous month’s pattern. Even expenses such as insurance and real estate taxes have seasonality because these charges do not accrue monthly. Laundry income is something else that follows a definite seasonal pattern. In locations with weather patterns that change with the seasons, January usually shows the smallest laundry collections because heavier winter clothing tends to be less washable, and many people receive new clothing over the holidays. July is one of the most lucrative laundry months because people change their washable summer clothing much more frequently. These patterns are well established and can and should be accounted for in monthly budget projections.

On the other hand, services, supplies, and many maintenance expenditures follow a monthly pattern. Income items follow their own patterns as well. Renewals and inflation often have a way of increasing rent each month; this makes month-to-month progression much more indicative of current trends than the amount collected at this time last year.

In most areas of the United States, the fuel consumed to heat a property during the first ninety days of the year is about one-half of the annual total, with January’s fuel expense being the highest. In order to be a useful planning and tracking tool, the budget must reflect consumption expectations rather than the annual heating costs divided by six to reflect the heating season, or even worse, by twelve for the entire year. The same is true of air-conditioning expenses during the warm months. Generally, property managers estimate monthly heating expenses with the help of “heating degree day” statistics that are recorded by several government agencies, most notably the United States Weather Bureau and the National Oceanic and Atmospheric Administration (NOAA). These records have been collected for over 100 years for most communities.

Heating degree days are calculated for the heating season in this way:

Starting with the base temperature of 65 degrees Fahrenheit, subtract the average temperature for a given day to produce that particular day’s heating degree days. For example, assume the average temperature in your city on February 28 is 45 degrees Fahrenheit. Subtracting 45 from 65, there are twenty heating degree days for your city on February 28th.

Daily temperatures and heating degree days are recorded and re ported at airports and many other locations. Many major newspapers re port degree days every day and often print temperature variances from a normal or average year. Subscription services are also available to provide wind and moisture information as well as very specific degree day data for each hour of the day. While this is interesting, it is much more than anyone needs for budgeting purposes. Knowing the average heating degree days for each month makes it easier to estimate heating costs. We can also determine how much fuel will cost or how many Btu’s (British thermal units) it takes to satisfy one heating degree day. For example, if you know that the total gas heating cost is $22,000 (i.e., the total bill, exclusive of the gas consumed for cooking, heating water, and drying clothes) and the average number of heating degree days in your location is 4,900, you can ascertain that about $4.50 is required to satisfy a single degree day. Knowing this, one is in a much better position to estimate the variable expense of heat and to enter an accurate budget forecast in each month’s column. You can do a similar analysis by carefully examining the monthly fuel bills for one or more years. It is important that you use the total fuel bill, including any charges, fuel adjustments, taxes, meter charges, etc. These extras often add up considerably; omitting them would significantly distort your projections.

Cooling degree days are calculated in much the same way, except that the base temperature of 65 degrees is subtracted from the average daily summer temperature to calculate that day’s number of degree day units (e.g., a day with an average temperature of 85 degrees would have twenty cooling degree days).

11-299.jpg Inefficiency of Scale 6 Expense Categories: Average Number of Units in Grouping, 1989 Operating Expenses 36,000 Unit Study

Development Size

You might expect this section to address the issue of economy of size, and to some extent it does. Nevertheless, there are limits to the advantage of size; the per-apartment costs of operating a large development tend to be higher than those of a smaller development. A very definite pattern emerged when I studied and monitored the expense ledgers for 36,000 units in several hundred apartment properties ranging in size from six apartments to as many as one thousand. Small properties, those under fifty units, enjoyed very little savings due to size. Those developments with more than fifty units showed an increasing efficiency of operation up through approximately the 110-unit point. After that high point, the opera ting efficiency—in per-unit operational costs—began a slow but consistent downturn that accelerated after passing the 130-unit point. This pat tern, or at least the high point on the chart, showed some movement during the years 1983 to 1988. The high point moved from 88 units to 110.

The very large developments, those with 300 units and more, spent many hundreds of dollars more per unit per year than did their smaller, correlative apartment communities. The differences in spending occurred in six distinct areas: vacancies, payroll, repairs, supplies, advertising, and legal expenses. There was also a disparity between the rent amounts collected for similar unit types. Differences became very pronounced as the size of the properties being compared increased.

Let’s take a closer look at my study. Starting with base figures from the communities with about 125 units, the cost increases experienced by properties larger than that were examined. The results strongly indicate that the apartment management industry has not increased management skills as fast as the building industry has increased its ability to build bigger developments. I will clarify this by providing some data from the study and pointing out the ways these figures relate to the expense categories affected most by the size of the development.

Vacancies. The average number of rent loss days between the departure of an old resident and arrival of a new one ranged from twenty-two days in the 125-unit properties to fifty-one days in the 750-unit group. The time required to get a vacant unit into market-ready condition was twelve days for the smaller properties and thirty-five days for the larger ones.

Managers of the smaller apartment communities reported impending move-outs considerably sooner than their counterparts managing larger properties. After interviewing managers, it was concluded that the manager of a smaller rental community was likely to have a more personal relationship with his or her residents than was the manager of a large community. Consequently, the manager of the smaller property is alerted to potential move-outs sooner, giving that manager a head start in a situation that is already favorable because he or she has fewer units to prepare each month. This difference in preparation time means money lost for the larger property.

Payroll. You might expect the number of apartments per staff member to increase in the case of larger properties, but in fact the opposite trend was observed. Staff members with highly specialized responsibilities were basically nonexistent in the smaller properties but became increasingly more commonplace as the size of the community increased. In the large properties there were staff members who handled only a single task. There is often little job flexibility within these developments, even when certain jobs such as bookkeeping or leasing demonstrated clear patterns of slow and busy times.

Repairs. It was concluded that smaller properties tend to repair things while larger properties are more likely to replace components. Perhaps the maintenance staff of smaller properties learn to fix things in place because they have little or no room to store replacements. Also, larger properties spend considerably more in hiring outside mechanics and trades people than do the smaller 125-unit properties.

Supplies. You might expect the manager of a large apartment complex to attract the attention of a wholesale supplier offering considerable discounts from the prices charged at the local hardware store. Though savings may exist in terms of price per item purchased, the study found that larger properties purchased larger quantities on an apartment per year basis. Waste, over-ordering, and subsequent pilferage were far more prevalent in the large developments.

Advertising. During the comparative examination of advertising, it was discovered that the larger 750-unit developments purchased more than three times the number of lines of print space per vacant apartment than the smaller 125-unit complexes. Ads for the smaller properties typically highlighted a particular unit and usually ran in weekend newspaper editions only. These ads were small—rarely over ten lines in length. It would seem that the size of the community dictated the size of the advertisement. Ad size did appear to have a relationship to the number of prospects who responded—more prospects responded to the larger ads—but the prospect-to-resident conversion ratio was clearly better in the smaller properties.

Legal Expense. Although legal fees make up a very small percentage of an apartment community’s overall expenditures, the pattern of higher legal costs followed the increase in the size of the developments being studied. It is interesting to note that in the five years of the study there were very few evictions in the smaller apartment communities. During the same five years, there was an almost monthly procession of court cases and evictions in the larger properties. This is attributable to the more personal relationship that exists between residents and managers in the smaller properties.

Rent Revenue. An additional observation from this study is worth sharing. The smaller apartment communities were consistently successful in achieving greater amounts of rent per apartment, probably because smaller developments offer more identity than do large ones.

Time and training will diminish the expense imbalance between smaller and larger properties, but the person putting together an opera ting budget must take size-related patterns into account. The budgeting method cannot be as simple as developing a set of per-unit expense figures for each category and multiplying them by the number of units in the development. I believe more owners and managers should begin to divide their larger properties into smaller, more economical sections. This can be done most easily when there is some geographical boundary such as a corner lot with entrances on two major streets, or if architecture varies from one section of the development to another.

Building Age and the Budget

There is a tendency to budget for all apartment communities basically the same way once buildings are built and completed. Nevertheless, when it comes to repairs and maintenance, there are significant differences among apartment properties that are the result of differences in their ages. Budgeting for repairs and maintenance for years two through four is fairly simple. Most equipment and components still function almost like new, and those items that do malfunction are often under warranty. Parts are readily available and repairs usually involve only a part or two rather than complete systems. Ceiling and closet painting can often be skipped; car pets need shampooing rather than replacement. After the first four years, however, the repair and maintenance pace picks up considerably in continuing four-year cycles. Assuming constant dollars (in other words, ignoring any inflationary effect), these two expense categories, considered together, increase about 7 percent per year. That means in five years, repairs and maintenance costs will have risen 35 percent—before any cost of living increases are taken into account. Over ten years, plan on a 70 per cent increase in the costs of repair and general maintenance. Older buildings simply cost more to maintain, and an accurate budget will reflect that fact. Unfortunately, just about the time this becomes obvious, another trend becomes clear: Achieving rent increases also becomes correspondingly more difficult as a building ages.

BUDGET ANALYSIS

Once a budget is prepared, there is still the job of comparing it to actual results and learning ways to analyze budget variances. Some variances occur because the budget does not account for the natural lag between the month in which an expense is expected and the month when the bill for that expense is actually received and paid. The utility bill paid this month usually covers the preceding month’s charges. This is true of many bills—with the exception of payroll, management fees, real estate taxes, and debt-service payments. This effect levels out when analyzing an entire year because one has accounted for all twelve months. Variances arise when the budget is examined a month at a time. It is usually better to ad just the budget to reflect the month when a charge or invoice will be received or paid rather than the time the commodity or service is delivered or performed. If the estimate of income and expenses does not reflect reality, the budget loses much of its month-to-month usefulness as a tracking tool.

Same Period Last Year

In addition to the item-by-item tracking of budget to actual, the most widely watched variable is a comparison of this year’s figures to the figures in a corresponding category the previous year. This practice reveals the beginnings of patterns that can lead to potential problems. If certain categories start to “slip” as the actual expenses begin to accumulate each month, it may be necessary to revise the budget. The budget is not etched in stone and should not be used to demonstrate just how far actual figures can vary from budget estimates. A budget is a tool that isn’t worth much when it fails to project what is actually occurring. Sticking to a budget that isn’t working is a waste of time.

Percentage of Income

The percentage of gross possible income is useful because it indicates trends in the larger and more important categories (e.g., real estate taxes equal 15 percent of gross possible income). This method is best used when comparing the year-to-year changes that occur for a single property or for properties with very similar rental ranges. However, such an analysis will cause problems when applied to properties that have a wide disparity in their rent levels. Most computer programs for financial analysis provide a column to express both income and expense as a percentage of the gross possible income. Some software, however, indicates the percentage of collections; this can be very misleading and may cause considerable confusion.

My studies of garden apartment complexes indicate that the total operating expenses expressed as a percentage of the gross possible in come can vary by as much as 18 percent, depending on the average rent level. Properties for the limited-income group tend to be older, need more repair and, more importantly, have a lower rent schedule than do some of the newer, more up-to-date complexes. While the rent in a limited-income complex maybe half that of the more-expensive and more- luxurious developments, certain expenses remain virtually the same. The charges for services such as rubbish removal or pest control are probably the same throughout a municipality, and the utility companies charge standard rates for heat, light, and water. The difference lies in expressing the expenses as a percentage of each property’s gross income. Owners who have several properties with a wide range of rent levels often have trouble understanding why one property requires 42 percent of its income for operating expenses while another property in the same town requires 56 percent. The truth of the matter is, the percentage of gross possible in come that is required to cover expenses goes down only as the average rent level goes up.

This changes when analyzing urban properties with major rent differentials, however, High-rise buildings are not only much more expensive to build, they also frequently add expensive amenities such as door attendants, parking garages, and a host of specialized services. These added expenses neutralize some of the variance I just described.

Dollars per Room

One of the standby indicators for comparing the operating results of one property to those of another is dollars per room per year. This is not nearly as popular a method as percentage of gross possible income. Though less affected by differences in rent levels, this method does not take size of rooms into consideration, nor does it consider bathrooms (a meaningful source of problems and expense). It requires uniformity in preparing the count of rooms, or much of its analytical value is lost. (The reader is re minded of the discussion in section 1 recommending a room-counting method.)

Cents (or Dollars) per Square Foot

Appraisers commonly use cents—or dollars—per square foot as another method of comparing operating expenses. It should be emphasized that square foot references in real estate are made on a yearly basis with one major exception, apartment rents, which are expressed monthly. Apartment rents, when displayed in a square foot format, are detailed in cents (or dollars) per rentable square foot. In other words, the rent is calculated using only the space that is contained in the occupied unit, and no allowance is made for the areas that feed and support the living space—often referred to as common area or non yield space.

While the residential manager receives rent for only the rentable square feet, he or she must operate and maintain the entire complex. Hence, operating expenses are expressed on a gross square foot basis—it is probably one of the most popular methods of examining operating expenses and is especially useful when comparing properties. Breaking expenses down to rentable square feet will lead to problems because of the constant adjustments necessary to compensate for differences in architectural styles and varying proportions of non-yield space. I am not aware of any data base collecting apartment expense information on a rentable square foot basis.

Cost per Apartment

Analyzing an apartment’s operating expenses based on the cost per apartment per year might appear simplistic, but it does produce surprisingly accurate results. The key to this method is expressing all of the property’s expenses as one total. Within a single apartment community, the cost to operate a smaller apartment is about the same as the cost to operate a larger one. Because turnover rates are higher in smaller units, make-ready expenses are incurred more frequently. This offsets the higher per-unit preparation cost for a larger unit. Repairs to mechanical systems and appliances do not vary much between apartments of different size—making these costs fairly similar. Significant differences in operating expenses will be revealed if comparisons are made by line item, but these expenses have a tendency to equalize when treated as a total.

Cost per Plumbing Fixture

In my opinion, analyzing operating expenses on a cost-per-plumbing- fixture basis produces some very reliable results for a number of reasons. This method involves looking at the number of plumbing fixtures per unit, a figure that will be closely related to both the size of an apartment and the rent level. In addition to adjusting for the extra damage and break down exposure of added plumbing connections, the relationship of plumbing fixtures to costs is a real one.

A count of plumbing connections would include the obvious, such as the kitchen sink, bathroom vanity, tub, and water closet as well as those connections necessary for disposals, dishwashers, hot water dispensers, ice makers, washers, bar sink, bidet, hot tub, fountains, etc. Larger bath rooms often have multiple sinks or bathing facilities, and each one should be counted as a plumbing connection. Most of these items require additional apartment area and this signals increased operating costs. As the number of these devices increases, your residents are likely to be more affluent, and your rent level—the prime indicator of a property’s quality of operation—is apt to be higher. I believe that this method of budget analysis will become more and more popular.

As you can see from this example, budgets and budget analysis can take many forms. The point to be made is that budgets are necessary to plan the financial operation of any complex. Learning to use them as management tools is a necessary lesson for every property manager.

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