Analyzing Income Property: Real Estate
Part 1 – The Income Statement
The basic analytic tool for evaluating the Investment Quality of any given income producing real estate investment property is the Income Statement. The Income Statement is a summary of all the critical information concerning the property:
- Purchase Price
- Costs of Acquisition, or Purchase
Assumptions. The Income Statement presumes a long term commitment to ownership and prudent management. An example of “long term commitment to ownership” is the inclusion of Maintenance and Replacement Reserves, two items often neglected and dealt with ‘as needed,’–another word for Crisis Management by unsophisticated investors.
“Prudent management” is reflected in recognizing the Cost of Management Services, even if the owner/landlord plans to manage his/her own properties. Another example is budgeting for Vacancy and Credit Losses. No one is ever disappointed by better than anticipated investment performance. But such vacancies and credit losses do occur – with the best of management. Lenders and other creditors may be sympathetic with losses due to vacancy, but they seldom forgive or suspend the investor’s obligation to pay while these problems are ‘worked out.’
Net Operating Income. The first objective is to determine Net Operating Income (“NOI”) of the property. This is the foundation, or primary building block, upon which you will build your Income Statement. Net Operating Income is the income remaining after all property related expenses and budgeted Reserves and Vacancy have been deducted. NOI does not take into account mortgage payments (“Debt Service”) or tax consequences; nor will it tell you whether, at the end of the year, you will have any cash left over for other purposes. These matters will be dealt with below.
Assembling the Information. In evaluating or purchasing a specific property, much of the needed information should be available from the present owner. A conscientious real estate agent will have collected the property’s operating information from the owner at the time the property is listed or offered for sale.
A word of caution is in order here: This is a classic example of the old adage “let the buyer beware!” While lease information should be readily available and verifiable (it’s not unusual to request copies of the actual leases), expense information is frequently understated or omitted entirely. In many cases, the sales agent him/herself may or may not be experienced in selling investment real estate, may not know enough to ‘ask the right questions,’ or may accept misrepresented information as fact. It is extraordinary that maintenance expenses or vacancy reserves are offered up voluntarily by sellers or their brokers. In every instance, the astute investor will take the information provided and test it against his own experience and judgment, collecting vender quotes or ‘comparables’ as needed.
Operating Income. Where there are leases in place, the seller should provide a schedule of leases in effect and, at the appropriate time (certainly prior to closing), reference copies of all leases. Special note should be taken of expiration dates, security deposits held by the landlord, provision for utility payments (who pays for heat and electricity), and any special clauses relating to lease extensions, options to buy, or any other matters that may effect the value or enforceability of the lease.
With regard to vacant properties, rent comparables must be collected from the marketplace. Rents currently being asked by landlords may be available from the real estate rental classified section of the community’s newspapers. Where properties are characteristically offered subject to government subsidy programs, such as Section 8, then prevailing rents information should be available from the appropriate agency. State and county-wide information is available from the HUD website: http://www.huduser.org/portal/datasets/fmr/fmr_il_history/select_Geography.odn
It should be noted the “payment standards” shown generally represent the maximum amounts allowable in each category; housing agency staff may then “adjust" the allowable rents (on Chicago's South Side, invariably downward) for specific neighborhood, condition of the property, etc. Where tenants are to pay their own utilities, a formula amount based on room count, etc., will be deducted to provide for utility payment. To enhance accuracy of pro forma operating statements based on Section 8 rental income, prospective landlords should secure current information concerning the voucher program from the appropriate housing agency.
Income lost due to vacancy or, for example, vacancy due to fire damage and the time needed to repair the damage, is just that: lost income. Lost or uncollected rents are not tax deductible.
Other Income. Security Deposits deposited with the landlord are generally not considered income unless and until such security deposits are seized by the landlord in satisfaction of unpaid rent or damage to the premises. Additional income may be derived from late payment fees collected, parking or garage rental fees, coin operated laundry facilities, utility reimbursements, etc. These “other income” sources may prove difficult to project without operating experience with the particular property but will, nevertheless, be taken into account in preparing year end financial reports for tax purposes.
NEXT TIME: Operating Expenses