cash flow and 36 other financial metrics:chapter 2
Assessing the Viability of a Real Estate Investment
Uncovering Financial Mysteries Prior to Purchase: Revealing the Reality Behind the Seller’s Discourse
Whether you’re the owner of a suburban shopping mall or a duplex tucked around the corner, the fundamental principle of income-generating properties remains consistent. The core idea is to generate revenue, primarily through rent, while also covering operating expenses and property-related loans. By the end of the year, the aim is to have a surplus and to retain as much of it as possible, minimizing tax liabilities. There’s also the prospect of selling the property down the line for a substantial profit. In essence, the key objectives revolve around cash flow, appreciation, amortization, and tax benefits – the four fundamental returns.
To attain these objectives, as an investor, it’s imperative to meticulously analyze the income and expense data of any potential property acquisition. Similarly, when the time comes to sell, prospective buyers will scrutinize your financial figures to gain a realistic understanding of the property’s potential value.
Within this chapter, we delve into a comprehensive examination of the financial statement for real estate – commonly referred to as the Annual Property Operating Data (APOD). We explore how this data can function as a guide for evaluating a property’s performance and how it can help identify potential problematic areas.
Foundational Definitions: Let’s embark on an exploration of income and expenses by revisiting some crucial concepts:
- Gross scheduled income represents the cumulative annual rental value of all units within the property. This encompasses both the actual rent collected from occupied units and the potential rent from vacant ones.
- Vacancy allowance is typically expressed as a percentage of the gross scheduled income. As the name suggests, it estimates the income loss due to vacancies. Some investors prefer to term this category as “vacancy and credit loss” to also encompass uncollectible rent.
- Gross operating income (GOI) equates to the gross scheduled income minus the vacancy allowance. It’s also referred to as effective gross income – essentially, the amount you tangibly receive.
- Operating expenses encompass elements like property insurance, taxes, repairs, utilities, and management fees. These expenses are necessary to sustain the income stream. Notably, mortgage payments and depreciation aren’t considered operating expenses, nor are capital improvements.
- Net operating income (NOI) is calculated as the gross operating income minus the operating expenses. In simpler terms, it’s what remains of your total potential income after deducting all vacancy and expense items. Mortgage payments and capital expenses don’t impact NOI.
- Annual Property Operating Data serves as the real estate equivalent of an income and expense statement. The terms APOD and income and expense are used interchangeably.
Utilizing these definitions, let’s apply them to a practical property analysis. Imagine you’re contemplating the acquisition of Property A, a four-unit apartment building. The current owner informs you that each apartment commands a monthly rent of $400, and their operating expenses for the previous year amounted to $5,200. You could structure this information in the following manner
Gross Scheduled Income R19200
Less Vacancy Allowance(3%) R576
GrossOperating Income R18624
Less Operating Expenses R5200
Net Operating Income R13424
The gross scheduled income amounting to R19,200 corresponds to 4 units rented at R400 per month for 12 months. The estimation of the vacancy allowance is a practical necessity, which you should ideally base on your understanding of prevailing market conditions and comparable properties in the locality.
Guideline: When reliable market data is unavailable, many investors find it helpful to employ a vacancy allowance within the range of 3 to 6%. A notable exception to this guideline often arises in the context of newly constructed projects being leased for the first time. During the initial lease-up phase, vacancies can be notably higher.
Conventional wisdom also suggests that a property with minimal historical vacancy likely implies that it has been rented below market rates. Essentially, if you’re not encountering some level of vacancy, you might be undercharging.
By subtracting a 3% vacancy allowance from the gross scheduled income, the resulting gross operating income (GOI) stands at R18,624. Deducting the operating expenses of R5,200 yields a net operating income (NOI) of R13,424.
While these fundamental figures offer valuable insights, it’s prudent to delve deeper into the property’s operational aspects. Naturally, your next question would be, ‘How exactly was that R5,200 allocated?’
In response, the seller provides an itemized breakdown: R2,550 for fuel oil, R130 for electricity, R200 for water, R250 for repairs, R1,270 for property taxes, and R800 for fire and liability insurance.
With this information, your Annual Property Operating Data (APOD) takes shape as follows:
Gross Scheduled Income R19200
Less Vacancy Allowance(3%) R576
Gross Operating Income R18624
Less Operating Expenses
Insurance R800
Repairs R250
Taxes R1270
Utilities
Electricity R130
Fuel oil R2550
Water R200
Total Operating Expenses R5200
Net Operating Income R13424
You can enhance your comprehension of this property by taking an additional step. Recognize that the rent you actually gather, known as the Gross Operating Income (GOI), is somewhat diminished by your operational costs. To gauge the extent of impact from each expense on your earnings, you can calculate the proportion of GOI that corresponds to each individual expense. This calculation is achieved by dividing each expense by the GOI and then multiplying the outcome by 100.
Gross Scheduled Income R19200
Less Vacancy Allowance(3%) R576
Gross Operating Income R18624
Less Operating Expenses
Insurance R800 4.3%
Repairs R250 1.34%
Taxes R1270 6.82%
Utilities
Electricity R130 0.7%
Fuel oil R2550 13.69%
Water R200 1.07%
Total Operating Expenses R5200 27.92%
Net Operating Income R13424
Examining Comparable Properties
It would be convenient if there were concrete and fixed guidelines to gauge this property against—for instance, a rule like “Heating costs should not exceed 11% of GOI; otherwise, the building might require a new furnace.” However, the absence of such neat and rigid rules doesn’t imply a complete lack of guidelines. The real estate in this scenario isn’t isolated; as a potential buyer, you’ll inevitably inquire about how the operating statement of this property stacks up against that of other potential investments. This should indeed be one of your primary concerns.
What you truly seek is the capability to compare your data against some sort of benchmarks. While your expense percentages might not offer significant insights in an individual instance, they could provide valuable insights when juxtaposed with reasonable expectations.
Where can you source these benchmarks? We explored several options in the preceding chapter. You could consult the real estate broker who is facilitating the sale of this property. They might have amassed data on comparable buildings in the vicinity and should be willing to provide you with the necessary information to make an educated purchasing decision. Another avenue is to engage with a property manager in the area, someone with firsthand familiarity with the operational costs of such properties. If you’re fortunate, you might own other properties whose historical performance can guide you. At the very least, you can delve back into the market, inspect other currently available properties, and analyze the operating statements of these competing properties vying for your investment.
Let’s consider Properties B, C, and D—each small, multiunit apartment buildings—along with Property E, a compact commercial parcel featuring two stores and an office. Utilizing the same structure as previously mentioned, you can create income and expense statements for each property:
Property B:
Gross Scheduled Income 29000
Less Vacancy Allowance(3%) R870
Gross Operating Income R28130
Less Operating Expenses
Insurance R2650 4.3%
Repairs R800 1.34%
Taxes R1575 6.82%
Utilities
Electricity R0 0.0%
Fuel oil R5680 13.69%
Water R330 1.07%
Total Operating Expenses R11035 39.29%
Net Operating Income R17095
Property C:
Gross Scheduled Income R16800
Less Vacancy Allowance(3%) R504
Gross Operating Income R16296
Less Operating Expenses
Insurance R800 4.91%
lawn R250 1.53%
Repairs R1000 6.14%
Taxes R1150 7.06%
Utilities
Electricity R150 0.92%
Fuel oil R2600 15.95%
Water R180 1.10%
Total Operating Expenses R6130 37.62%
Net Operating Income R10166
Property D:
Gross Scheduled Income R26500
Less Vacancy Allowance(3%) R795
Gross Operating Income R25705
Less Operating Expenses
advertising R95 0.37%
Insurance R1340 5.21%
grass R360 1.4%
Repairs R1875 7.29%
Taxes R1735 6.75%
trash removal R150 0.58%
Utilities
Electricity R360 1.4%
Fuel oil R3875 15.07%
gas R300 1.17%
Water R720 2.8%
Total Operating Expenses R10810 27.92%
Net Operating Income R14895
Property E:
Gross Scheduled Income R16800
Less Vacancy Allowance(3%) R1008
Gross Operating Income R15792
Less Operating Expenses
Insurance R1100 6.97%
Repairs R300 1.90%
Taxes R1250 7.92%
Utilities
Electricity R0 0%
Fuel oil R0 0%
Water R0 0%
Total Operating Expenses R2650 16.78%
Net Operating Income R13142
The most apparent distinction among these statements lies in the fact that the commercial parcel, Property E, demonstrates the fewest expense categories and the lowest total expense ratio. This outcome isn’t surprising, given that it’s quite common for a commercial tenant to bear the responsibility for their utilities, interior repairs, and sometimes even property tax increases. While advantageous for the landlord, it’s essential to take note and thoroughly examine the leases associated with this property to ensure these costs are genuinely shouldered by the tenant, rather than being obscured from visibility. (“Well, you know, I could have passed those expenses through, but my dog ate the leases. You can handle it after purchasing the property, no problem.”)
It might be wise to allow for a larger vacancy allowance compared to residential properties since an empty commercial space often takes longer to rent than an empty apartment.
However, the critical point here is that the nature of this property significantly differs from the others being considered. Drawing inferences from a non-comparable property might lead to an erroneous “apples-to-oranges” comparison, risking misleading assumptions about Property A. While this commercial investment might be valuable, it isn’t an appropriate benchmark for evaluating Property A.
Shifting focus to the residential investments, it’s essential to compare them with each other and with your initial proposition. Upon analyzing the operating statements for Properties A through D, several similarities and differences emerge in expense ratios:
Similarities include:
- Insurance expenses range from 4 to 5% of Gross Operating Income (GOI) in three of the four properties.
- Lawn/snow expenses are about 1.5% in two of the four properties.
- Repairs account for approximately 6 to 7% in two of the properties.
- All four properties indicate property taxes ranging from 5.5 to 7% of GOI.
- Electricity costs are below 1.5% in three properties.
- Heating fuel expenses make up 13.5 to 16% of GOI in three properties.
- Water costs fall between 1 and 1.5% in three properties.
- Total operating expenses range from about 37 to 42% in three properties.
Differences are apparent as each property exhibits inconsistent expense ratios in various categories. Additionally, certain expenses like lawn/snow, advertising, trash removal, and gas appear in limited instances across the operating statements.
How can this information be useful? The APOD form serves not just as a source of answers about an investment property, but as the origin of crucial questions. By carefully examining it, you can unveil the most insightful inquiries about how a property currently operates and its potential future functioning.
Taking Property B, which shows the highest Gross Operating Income, as an example, you notice unusual expense percentages. Insurance and heating costs consume a larger portion of income, while repair costs represent a lower percentage. The absence of electricity costs is due to tenants having separate meters and paying for their usage. However, why are there entries of $130, $150, and $360 on the other statements?
Upon inquiring with each building owner, it’s revealed that the electricity expense is for a separate meter governing common area lighting, such as hallways and entryways. This raises questions about why such an expense isn’t listed for Property B. Is it an oversight or does it lack a separate meter? If the latter is true, could this absence violate local codes or ordinances, necessitating correction at the new owner’s expense?
The higher insurance costs at Property B might indicate potential building code violations, prompting the necessity for an independent insurance quote to assess insurability. An inspection by your insurance company could highlight violations affecting insurance coverage.
Considering the condition of the heating system, verifying utility costs directly with suppliers is crucial. Higher costs, as seen here, warrant investigation into potential system issues or inefficiencies. A comprehensive inspection is vital to answer these inquiries.
Lastly, the lower spending on repairs at Property B requires understanding. Exploring possible explanations is essential, demanding thorough investigation to ascertain the true cause or combination of factors.
In summary, scrutinizing each property’s unique expense ratios provides invaluable insight into their operational functionality. It prompts a series of vital inquiries and considerations necessary for making informed investment decisions.
- The property didn’t necessitate much maintenance this year. If this trend persists this year, it’s unlikely to continue next year.
- The owner spent a significant sum maintaining the property this year. His expenses were so extraordinary that he feels it would be misleading not to provide the “typical” annual repair costs. This raises questions about potential hidden surprises.
- Although the owner spent the specified amount, it wasn’t sufficient for proper building care. Investors term this “deferred maintenance,” signifying neglect and impending repair costs. Delaying repairs escalates costs and heightens the risk of management issues and income loss. Unusually low repair costs warrant scrutiny as much as excessively high ones. Noting atypical expenditures leads to numerous investigative questions for further property consideration.
An additional note: Property B’s total operating expenses amount to 39.29% of the Gross Operating Income (GOI), seemingly within the typical range. However, delving into the breakdown of these expenses alerted to potential problem areas.
Shifting to Property C, no glaring red flags in expense percentages catch your attention. Yet, a new expense category, lawn/snow, surfaces. This emphasizes the importance of not only evaluating provided expense figures but also considering missing information. Essential questions revolve around future potential expenses beyond those reported.
Property D introduces advertising and trash removal expenses, prompting consideration of further expense categories beyond the previously analyzed ones. Additional scrutiny will occur when reconstructing Property A’s income statement.
Property D is unique in reporting gas expenses and significantly higher water bills. While deviations from the norm require explanation, not all deviations signal trouble. In this case, the increased water usage is due to appliances provided by the owner for tenant use.
Returning to Property A, the focus will involve reconstructing the original operating statement to reflect realistic expectations over the next 12 months.
The Annual Property Operating Data Form: Understanding and working with an APOD form similar to what experienced investors utilize is crucial. Utilize the provided form or a downloadable spreadsheet for detailed analysis, focusing on necessary rows for calculation.
Review the property’s operating statement with the same critical perspective applied to Properties B through D.
Gross Scheduled Income R19200 100%
Total Gross Income R19200 100%
Less Vacancy Allowance() R576 3%
Gross Operating Income R18624 97.00%
Expenses
Insurance R800 4.3%
Repairs R1117 6.00%
Taxes R1270 6.82%
Utilities
Electricity R280 1.5%
Fuel oil R2900 15.57%
Water R200 1.07%
Total Operating Expenses R6567 35.26%
Net Operating Income R12057 64.74
Upon scrutinizing the expenses, the insurance cost seems consistent with other properties, but it’s still advisable to obtain a quote from your own agent. Taxes also appear typical, and a quick call to the assessor’s office can determine if any changes are anticipated soon. It’s crucial to remember that a revaluation or tax rate change can impact the next year, even if last year’s figures are accurate. Fuel oil costs align with the lower end of the typical range, confirmed by the seller’s oil dealer based on delivered gallons and prevailing oil rates.
However, the electricity cost at this property is notably lower than in most other buildings, without a clear explanation from the owner. For the reconstructed analysis, an estimate adjustment to align with the expected 1.5% of gross income, or R280, is suggested.
The most significant deviation from the norm is evident in the repair category. Although the property appears well-maintained, the 1.34% expense is considerably lower than the 6 to 7% spent at other buildings. Inquiring the owner about this discrepancy is essential. The owner explains that recent remodeling classified as capital improvements led to lower repair costs, as the apartments were extensively renovated within the last 18 months, resulting in minor repairs during the year.
While answering this query, the owner raises additional considerations. Anticipating realistic repair and maintenance costs for the following year, possibly around 6%, is advised. Furthermore, the vacancy during renovations suggests reduced heating use, warranting an estimated increase in heating costs. Additionally, the accountant’s advice implies potential added expenses to your tax preparation costs.
Considering the remaining expense categories on the APOD form, your management approach indicates no need for a resident superintendent, professional property manager, janitorial service, or legal costs due to a standard lease. If a vacancy occurs, self-showing negates rental commissions, but a nominal amount, around R75, should be allotted for advertising. For lawn/snow and trash removal, hiring services consistent with other properties, approximately R250 for lawn/snow and R5 per week (R260 in total) for trash, is recommended.
With these adjustments, the reconstructed APOD form provides a realistic operating budget for Property A, reflecting the known facts and industry trends. This offers reasonable confidence in income and expense projections.
Gross Scheduled Income R19200 100%
Total Gross Income R19200 100%
Less Vacancy Allowance() R576 3%
Gross Operating Income R18624 97.00%
Expenses
Insurance R800 4.3%
Repairs R1117 6.00%
Taxes R1270 6.82%
Utilities
Electricity R280 1.5%
Fuel oil R2900 15.57%
Water R200 1.07%
Total Operating Expenses R6567 35.26%
Net Operating Income R12057 64.74
In determining the property’s worthiness as an investment, further analysis on cash flows, value, and rates of return is necessary, which will be explored in upcoming chapters. However, no alarming issues have been uncovered through your examination. Having distilled raw data into a realistic operating budget, you’re poised to evaluate at what price and terms this property could be a viable investment.