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Invaluable predictions

A deep dive into budget forecasting

By Salvatore Dragone, CPM, ARM, CCIM
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Each year, we as real estate managers spend countless hours perfecting our budgets for the coming year. We pour over contracts and leasing projections, trying to estimate material costs and staffing needs. For the most part, the results are straightforward and respectable, but then the inevitable happens: real life.

In 2020, real life became somewhat unreal, and most budgets weren’t worth the paper they were written on. But not every year is like 2020.

In other years, a bad winter or hot summer can wreak havoc on any budget. When you encounter such a year, as we all did in 2020, you quickly understand why forecasting—and reforecasting—your budget is an important aspect of any well-run property.

First, the basics

We’ll start with the terms.

A forecast is typically associated with the first attempt of predicting income and expenses based on historical or known data of a specific property or budget. A reforecast is typically associated with updating the forecast for the same specific property or budget. My experience has been that most managers use the term “forecast” when creating budgets and “reforecast” when projecting a budget’s changes over the course of a year or other time period.

Wendy Dutenhoeffer, CPM

The first time that a manager may be required to forecast is when they’re creating a budget for any future period. While the term “zero-based budgeting” can sound smart or clean, the reality is that almost nothing is zero-based. At a minimum, you’ll have pricing for services in place that you’d most surely rely upon. Still, when creating a budget, you’re forecasting income and expenses based on a variety of factors such as leases in place, future absorption, economic climate, inflation, general services, taxes, and financing.

“If I had to pick one line item that new managers struggle with when it comes to budget forecasting,” Wendy Dutenhoeffer, CPM, says, “it‘s understanding the revenue line items and how vacancies, concessions, escalations, other income, and lease renewal dates factor into the correct calculations for budgeted revenue.”

Jay Kacirk, CPM Emeritus, CCAM, with Eugene Burger Management Corporation, sees new managers struggle with expense considerations. “Areas related to budgeted maintenance are a challenge for many. This usually improves with time as you get to know a property, but a new manager doesn‘t always have that perspective.”

Assuming historical information is available, the first steps typically are to look back 12 to 24 months and begin the process of evaluating past expenses to forecast future expenses. This can be done by using methods such as percentage trending. With this method, you analyze the year-over-year or period-over-period increases and/or decreases in certain expenses. Having identified the “trend” in these changes, you can then apply it as either a percentage or whole number to future periods of the same corresponding length.

Jay Kacirk, CPM Emeritus, CCAM, Eugene Burger Management Corporation

Examples of line items where this method is effective include property taxes, landscaping, fire protection, and other non-occupancy-related expenses. If these expenses have increased by 2% on average over prior years, then it would be reasonable to assume that the trend would continue. You can inflate current-year expenses by 2% to create a future-year budget.

If these expenses are related to occupancy, there will be some variability, and extracting simple trend lines will not work. For example, suite cleaning, utilities, and even management fees involve other factors that will affect their future values. Simply applying a percentage increase could result in a significant under- or over-forecasting of expenses.

In this case, apply a percentage multiplier to base costs, and then calculate a variable amount related to occupancy. When taken together with leasing absorption assumptions, this method will result in a competent budget, or at least the beginning of one.

In either situation, I always perform the calculation and then step back to compare the entire forecast to prior periods. This is how we can see the big picture. Simply applying percentage increases or decreases may seem reasonable based on a trend at the account level, but sometimes when everything is added up, the results are skewed. “Budgeting requires both a view from 10,000 feet, or big picture, and one from ground level, in the weeds,” Dutenhoeffer says. “If new budget managers fail to look from both altitudes, they cannot clearly see where they are going.”

Many repairs and maintenance items are one-time projects or at least not completed annually. One example is electrical infrared testing, which is generally completed every three to five years. Your historical expenses may have one-time large projects, such as seal coating a parking lot or renovating a cooling tower. A very snowy winter may also create anomalous expenses. Applying a percentage to those expenses for future years isn’t recommended, as the expense likely won’t reoccur.

A better option is to look at historical data based on a grouping of projects instead of a particular line item. For example, I oversee the management of about 15 million square feet of office space. Over the years, I have estimated that projects run about $0.15/sf. I use this information to better gauge the number of projects that I can accomplish in any given year. I also know that it represents about 2% of my operating expense budget—a good metric to remember. If during the year my expenses begin to trend higher or lower, the number of projects can help me bring a budget back in line.

Now that your budget is done, and you have forecast the expenses for the coming year, your job is done, right? Of course not, you’re a property manager—the job is never done. Over the next few months (typically on a quarterly basis), you should perform a reforecast of your budget to ensure your management efforts are resulting in income and expenses representative of your original budget.

We can break this process down into four stages.

Stage 1: First-quarter reforecast

I call this the “soft” reforecast, as it’s early in the year and you have only limited information. “The first-quarter reforecast is always the most challenging since there is not a lot of history for the current year,” says Lynne Miller, CPM, RPA, LEED AP O+M, with Charles Dunn Real Estate Services. “In addition, unanticipated increases might occur, but notices of the increases might not be provided until later in the year.”

Lynne Miller, CPM, RPA,
LEED AP O+M, Charles Dunn Real Estate Services

The key to the first-quarter reforecast is to set yourself up for the remainder of the year, allowing you to easily update the actuals, while reforecasting the remaining months of the year. It’s probably been about six months since you created the budget. By now, although the picture isn’t entirely clear, you should have a better handle on leasing and other income generators.

While this exercise may not result in a reforecast greatly different from your original budget, it is a beginning, and any results should be communicated to the ownership as part of your regular updates. No matter what reforecast you’re creating, you’ll need to pay particular attention to leasing and occupancy, as they will greatly influence many of your expenses, particularly management fees and utilities, which can make up as much as 30% of your overall expenses.

Stage 2: Second-quarter reforecast

The next milestone, and a very important one, is the second- quarter reforecast. For many, this is the basis of next year’s budget. Unlike the first-quarter go-round, this reforecast should be considered a “hard“ reforecast.

I require my managers to not only reforecast income and all expenses, but to submit a full-blown report. Time is set aside with ownership to dive deep into the forecasted income and expenses to ensure we’re on track, make decisions that will get us back on track, or simply approve any large variances.

Those large variances can lead to difficult conversations with owners. “Be prepared, do your research, review the numbers, and consider the effect of alternatives,” Miller says. “The key is communication. When emergency situations or any unbudgeted expenses arise, notify your owner as soon as possible to avoid surprises.”

Particular attention is given to operating projects and capital projects. The second-quarter reforecast is critical in deciding whether remaining projects are still feasible or must be pushed to the next year. Doing an analysis of whether you can complete projects is frequently overlooked. Projects can take time to develop and, in many cases, are delayed due to outside forces, such as material costs or lack of labor.

Considering that projects typically require higher cash needs or capital, planning and executing them is critical to cash flow projections.

You may want to make a case with your owner for moving forward on some projects, “even when net operating income is significantly lower than budgeted,” says Kacirk. “Communicate regularly with your clients about these variances, and get them to understand the need to fund important projects. That may mean capital contributions in some cases, which property managers generally don‘t like to ask for, but it is an important aspect of the job when necessary for the preservation of the asset or for stabilizing an investment‘s performance over time.”

Other frequently overlooked items with great cash-flow consequences are tenant improvements and leasing commissions, specifically when the latter are scheduled to be paid out.

We use the current year budget and second-quarter reforecast as benchmarks for the future budget (for example, 2021 budget vs. 2021 reforecast vs. 2022 budget). Over the course of the next few months, the reforecast and the next period’s budget are updated simultaneously, ultimately resulting in a new budget and the third-quarter reforecast.

Stage 3: Third-quarter budget

The third-quarter reforecast and the months following it are critical for a few reasons. First, it’s your last chance to make changes before the end of the year. It’s also your last chance to communicate to ownership any anticipated variances that may greatly affect cash flow. Finally, it’s your last chance to communicate any large variances to your commercial tenants in preparation for the year-end reconciliation.

For me, the ability to communicate with my commercial tenants any anticipated year-end reconciliation is critical in ensuring strong landlord-tenant relationships. There are not many things worse than having to tell a tenant that they owe a substantial amount of year-end reconciliation payments when we’re already two or three months into the next year. Most tenants close their books on Dec. 31, and unless they anticipated a year-end reconciliation, they will not have accrued for it. When they get that big bill, they are not too happy. In most cases, they will have to find the money in their current year budget, taking away from some other planned expenses. Giving your tenants a heads-up may seem hard at first, but trust me when I tell you, it is a lot better than surprising them later.

Stage 4: Year-end reconciliation

The year-end reconciliation is no longer a forecast or reforecast, but rather the final stage in your forecasting or reforecasting exercise. It’s the scorecard for the work that was done throughout the year, both in operating and adjusting your income and expense projections. If you stayed on top of your income and expenses, your year-end actuals shouldn’t be a surprise for your ownership, your tenants, or yourself.

In the end, forecasting and reforecasting your budget is a critical part of managing your property, along with your stakeholders’ expectations. A diligent process builds confidence in your relationships with ownership and your tenants, allowing you to make proactive adjustments rather than reactive excuses.

the Journal of Property Management staff

Salvatore Dragone, CPM, ARM, CCIM, is the senior vice president and director of property management for Rubenstein Partners in Philadelphia. In addition to serving IREM as both a course instructor and webinar presenter, he is on the board of directors of BOMA Philadelphia and is an adjunct instructor at Drexel University, where he sits on the Real Estate and Development Advisory Board.

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