Impact of Depreciation as An Operating Expense (Guest Commentary)

The focus of this article is somewhat different than what Streetsmart NWA has presented in past issues of the Northwest Arkansas Business Journal.

As a result of our continual research of the real estate market in Benton and Washington counties, we have typically provided data pertaining to the single-family residential, multi-family residential, or commercial sectors of the market. In this article, real estate is still the focus. However, the intent is to address a current issue with respect to net operating income statements for income-producing properties.

Standard accounting procedure deducts depreciation as an operating expense when calculating the net operating income for real property. NOI divided by the indicated overall capitalization rate (RO) for the property in question results in the estimated market value of the property by the Income Capitalization Approach.

Therefore, if depreciation is deducted as an operating expense, the resulting value estimate is lowered. Standard procedure utilized by the real estate profession does not deduct depreciation as an operating expense, but rather as a deduction in arriving at taxable income from the property.

With this procedure, the annual depreciation deduction does not impact NOI. By not impacting NOI, the final value estimate is unaffected.

Utilizing depreciation as an operating expense is obviously taught in the fields of accounting and finance. This affects people in the real estate profession in two areas.

First, there is the estimate of value due to the lower net operating income; second is the estimate of the overall capitalization rate.

One of the most commonly used financial ratios is RO = NOI/Value. This ratio can be utilized as an indication of whether a property is profitable, as well as an indication of buy/sell opportunities. Deducting depreciation as an operating expense could result in the real estate professional being incorrect in the analysis of a property due to the overall capitalization rate being understated.

In support of a value or overall capitalization rate, it is important for the real estate professional to review the financial analysis pertaining to the property. The following is an example of a NOI statement utilizing the typical procedure by the real estate profession, as well as the methodology used by the accounting profession:

If the real estate professional, in attempting to arrive at a value or marketing price for a subject property, relied upon an overall capitalization rate from a similar property which was derived from the accounting NOI statement, the result would be an overstatement of value or marketing price.

Depreciation is not a cash expense. The use of this non-cash deduction as an operating expense will result in lower NOI income for the real property in question, as well as a lower market value. Also, using NOI derived from accounting methodology results in a lower overall capitalization rate for the property. 

Tom Reed is a partner in Streetsmart NWA of Fayetteville, which produces reports pertaining to the residential, multi-family and commercial sectors of the market. He may be reached at 479-575-9100.