Part 1: Identifying the Property’s Real Income:There are four financial components of income producing real estate that are crucial to successful investing. They are (1) income, (2) the costs of occupancy, (3) operating expenses, and (4) debt service.

Debt service cost is straightforward math and openly disclosed, as required by law. The costs of occupancy are real estate’s cyclical problem child. They are neither straightforward nor openly disclosed. Occupancy costs are defined as all those factors (whether expensed or capitalized) used to identify, attract, and persuade a prospect to become a lessee. The true cost of occupancy is especially relevant in today’s soft economy. It is in a soft economy that occupancy costs are born and grow.

When you consider the current state of business, unemployment trends, decreasing consumer confidence, and real estate’s current credit markets, you discover that you have all the seeds for increased leasing costs. Thus, you need an accurate accounting of the costs of occupancy if you want to have a clear understanding of the current real estate marketplace. When you understand these costs of occupancy, you can manage your assets using sound business principles. The results of using sound business practices are more accurate goals and philosophies. Managers can make better decisions concerning income, costs, reporting, training, and personnel.

In the 1980s we didn’t recognize, or we failed to accept, the way real estate evolved. Thus the real estate industry was forced to react to circumstances. Reaction tends to reduce value. During the 1990s, we received the benefits of the defense reduction dividend from the end of the cold war and the technological explosion. New and more jobs were created, and real estate benefited. After a slight blip in 2000, real estate prices continued their up trend. Unfortunately, the combinations of greed, inexperience and naivety resulted in people believing increasing prices were a perpetual event and lenders responded accordingly. Now we pay the piper. Our cyclical economy has changed direction and is heading down. It is in an economy such as this that occupancy costs are born and grow. Hopefully, the real estate industry of 2008 will anticipate these problems and adjust accordingly. Anticipation tends to increase value. Now let’s look at some examples of occupancy costs and their impact on income property.

Figure 1:1 shows the impact of the costs of occupancy. It illustrates a residential unit that is 100% physically occupied, but is only 71.9% economically occupied.

ASSUMPTIONS:

• Rent: $750 per month
• Lease term: One-year (total lease rent $9,000)
• Lessee requirements: new carpet ($750), paint ($200), and new refrigerator ($500)
• Concession: one month’s rent ($750)
• Leasing commission: one-half month’s rent ($387.50)
• No deduction for vacant days (no income)
• No adjustment for a declining market with lower rents
• No deduction for marketing costs (e.g. advertising, flyers, personnel, signage, etc.)

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