Here is the first post in many to come on analyzing residential income properties. This is directly from my course on property valuation and analysis which I will be discussing more of in my upcoming class on Buying and Selling  Apartment buildings.

Learning Objectives of this Post on Analyzing Apartment Buildings and Residential Income Properties: Data Collection and Income & Expense Analysis

  1. Identify sources of data
  2. Describe the components of an income & expense sheet
  3. Understand how to arrive at Net Operating Income from Gross Scheduled Income

The first step to accurately determine the market value of a real estate investment is a solid program of data collection and analysis. Each property will have its own unique considerations

All should at least begin with

• Property type
• Overall condition of the improvements
• Type of construction
• Neighborhood analysis
• Overall market conditions
• Income and expense analysis
• Legal requirements, zoning etc
• Comparable property data

This list is broad in scope, but it’s a good foundation for the data collection plan. The data collected from the market on comparable type property will be used to determine the appropriate capitalization (CAP)  rate and make market comparisons in a later step. The next step is the actual collection of the data.

Data Sources

The data required for the analysis is obtained from many of the same sources as the information used in residential sales:

• Owners records
• Multiple listing service (MLS), Costar, Loopnet, Commercial Agents & Property Owners
• Public records
• Census data
• Chamber of Commerce
• Local Housing Authority
• Appraisers
• Trade associations
• Local Council of Governments
• Tax assessment records

This should give you an idea of a few of the possible sources of data and the steps to begin the data collection process. Once the data has been collected the next step is the analysis of the data.

The Operating Report (Profit and Loss Statement)

When analyzing a real estate investment, we begin with an existing operating statement, also known as a profit and loss statement. The operating report will consist of both income and expense items attributable to the property. In the first step of the analysis we will only be concerned with the cash income and expense of the property. We will consider depreciation and other non-cash benefits in a subsequent calculation.

Gross Scheduled Income

The gross scheduled income is the amount of money that the property would produce on an annual basis if it were fully occupied. Included in gross scheduled income would be any income attributable to the property from non rent sources.

What types of sources can be included for determining gross scheduled income?

These sources could include income from laundry and vending machines, parking and storage fees, as well as other owner operated concessions.

When analyzing the gross income, consideration is given not only to the existing rents being charged, called contract or current rent, but also economic or market rent, which is the rent the property would command if it were available for rent in the current market. An adjustment can be made to the gross income if the market indicates that market rent differs from the actual rent. If such an adjustment is made, that should be plainly noted on the operating statement (see loss to lease).


Vacancy & Collection Losses and Effective Gross Income

The chief component in the calculation of effective gross income is the vacancy and collection loss rate. Most properties are not expected to remain fully rented for the entire period of ownership. When a tenant vacates, often there is at least some rental income lost during the turn over period due to repair or remodeling time. In addition to this consideration, one must face the reality that there may be a situation where a tenant becomes unable or unwilling to pay rent as agreed. In this circumstance there will be some rental income lost.

The vacancy and collection loss is usually expressed as a percentage of the gross annual rental income. There are several generally accepted methods for determining the amount of the vacancy and collection loss

• Historical data on the subject property
• Published figures for the community
• Market analysis

Other places to get historical operating data is

None of these things by themselves will probably give you a 100% complete picture but combining different resources the picture will become much clearer.

Historical data and market analysis are perhaps the most accurate, because typically published figures for the community are an average, and may not be representative of the property you are analyzing. Once the appropriate rate has been developed, the loss is subtracted from Gross Scheduled Income to derive at Effective Gross Income.

Example:
Gross Scheduled Income                     $12,000
Vacancy and Collection Loss (5%)      (600)
Effective Gross Income                 $11,400

Gross Operating Income

To figure the gross operating income you go through the following steps:

Gross Scheduled Income
- Vacancy & Credit Loss
= Effective Gross Income
+ All Other Income (garage rent, laundry income, vending, etc)
= Gross Operating Income

The figure derived from this process is what we will call rental income. This is the actual income received after taking into account vacancy and credit loss against potential income.

Other income can come from a variety of sources. In apartments, it is quite often laundry, but it could be rental on furniture for furnished apartments, garages, etc.

The resulting figure of gross operating income is all the income left over after subtracting out the above mentioned items. It is your actual income in hand before expenses. Therefore it is a very important number.

Operating Expenses

The next step in the analysis process is to determine the total operating expenses for the property. Like income, expenses will be analyzed on an annual basis. The investor will do a detailed analysis of the expenses of a given property, so it benefits the practitioner to have done a thorough analysis in the beginning.

It is important to carefully analyze all categories of expenses to accurately portray the financial condition of the property. There are different categories of expenses, depending upon the type of property you will be analyzing, however all expenses are segregated into two basic categories, fixed expenses and variable expenses.

What are three fixed expenses and 10 variable expenses?

Fixed Expenses

A list of typical fixed expense categories will include

• Property taxes
• Insurance
• Landscaping and service contracts
• Any expense that does not change from month to month

What determines a “fixed” expense is the fact that the expense will not vary in response to changing levels of occupancy.

Do not include mortgages as part of operating expenses!Mortgages are not part of operating expenses and are categorized elsewhere.

This group of expenses is not difficult to document for your analysis, but be careful to consider the fact that these expenses may not be the same for a new owner; i.e., the building insurance may go up and most likely the real estate property tax may be reassessed upon transfer.

Real Estate taxes can be one of the largest expenses so make sure to calculate any new tax increase or decrease in your analysis.

Variable Expenses

This category of expenses is much longer, and categories to consider will vary depending on the type and size of the property under analysis. This category will include all of the expenses necessary to maintain the income stream of the property and to provide agreed upon services to the tenant. To attempt a comprehensive list of all expense categories for all types of properties might be impossible and, certainly, is beyond the scope of our study. We will discuss the more common types of expenses in some detail, remembering that each property has unique characteristics and may include its own unique expense categories.

• Off-Site Management

Many properties will be managed completely by off-site personnel. The cost of off-site management is determined and subtracted as an expense of operation. It should be noted that a management expense is a valid deduction from income even if the owner is managing the property. There are many firms specializing in this field; they usually charge between 4% and 10% of the rental amount.

• Payroll On-Site Personnel

Resident management is used when the day to day activities of the property require constant supervision. A resident manager is sometimes given free or reduced rent. If that is the case, you must include the managers unit rent in gross scheduled income, then enter the amount of free rent as an expense. In California, if a property has 16 or more units it is the law to have a resident manager on site.

• Expenses/Benefits

This would be for other management costs. For instance, office and administrative expense, performance bonuses paid to an on-site manager, and any health insurance or retirement plan contributions would be listed here.

• Taxes – Workers’ Compensation

Whenever there is an employee, there are various taxes the employer is responsible for. Among these are: Social security tax, unemployment tax, as well as local, state and federal income taxes. These taxes are payable by the employer, and in addition, the employer is required to withhold some amount from the employee’s pay and forward it to the IRS.

• Repairs and Maintenance

This is the total amount of repairs and maintenance necessary for the year. This would not include any money spent on capital improvements. A capital improvement is any improvement which substantially increases the useful life of the property. If you find a property which has not had any maintenance expense in the recent past, you will probably find a trade off in the overall condition of the property.

• Utilities

This is probably the most difficult portion of the operating statement to complete accurately. This information is most easily obtained from the owner. NOTE: If the owner is paying the utility bills and is then reimbursed by the tenant, the full utility cost will be listed here and the amount reimbursed to the owner would be listed as other income (this is referred to as R.U.B.).

• Accounting and Legal

This is the amount for the bookkeeping required on the property. It will include any amounts paid for payroll reporting or for monthly profit and loss statements. This should also include any legal expenses associated with evictions, drafting of leases, etc.

• Advertising, Licenses and Permits

Many larger properties will have ongoing advertising expenses. At the very least there will be some cost at each vacancy. This includes the amount spent for advertising, as well as any licenses or permit charges; e.g., city business license, pool inspections, and/or housing code inspections.

• Supplies

This might include supplies for the vendors mentioned previously: Bug spray, batteries for smoke detectors etc.

• Miscellaneous

That’s right! There should always be a category for those expenses too insignificant to warrant their own category. This would include any additional expenses which were not accounted for elsewhere in the analysis.

• Contract Services

These are services which are supplied by outside vendors not already accounted for under fixed expense categories. These are additional services such as maintenance contracts, design services, appraisals and as many others as necessary.

Here is a list of the more common expenses in alphabetical order. Some of them we list without explanation because they are rather obvious:

• Accounting and Legal expense
• Advertising
• Gas
• Insurance
• Licenses and permits
• Miscellaneous and other expenses Property Insurance
• (Property) Management
• Payroll and Workers Compensation
• Real Property Taxes
• Repairs and Maintenance
• Services
• Sewer
• Supplies
• Telephone
• Utilities (Such as the electric bill)
• Water

Total Operating Expenses

This is the total of the expenses calculated. This is not to include vacancy or credit losses. Remember that what we are attempting is to give as accurate a picture as possible of the property’s financial condition. The property’s value will be dependent upon the ability to produce income, so it is important to be as accurate as possible in estimating both income and expenses.
The total operating expenses are now subtracted from the effective gross income.

Example:
Effective Gross Income $11,400
Total Operating Expenses (4,500)
Net Operating Income $ 6,900

Net Operating Income (NOI)

The net income that a property is capable of producing will be one of the first indicators of the worth of an investment. Later when we begin to apply the capitalization rate to the property, the NOI will be used to estimate total investment value.

The calculation of the net operating income does not take into consideration the effect of any potential financing of the property. This may seem odd at first, but in consideration, it will not take long to realize that the property should have a value that is completely independent of any financing that an investor might use to acquire that property.

Measure NOI correctly in order to properly value property

NOI is arrived at as follows:

Gross Operating Income
- Operating Expenses
- Capital Expenditures
Net Operating Income

Sales Proceeds

The sales proceeds that come from divesting yourself of a property are as follows:

Sales Price
- Selling Expenses
= Net Sales Proceeds
- Adjusted Basis _
= Taxable Gain
- Depreciation _
= Capital Gain / Loss


Data Analysis


Having discussed the income and expense analysis in detail, we will concentrate on the balance of the data and other considerations. The property will be analyzed for the following:

• Income quantity
• Income quality
• Income durability
• Special risks

All of these considerations will be compared to other investments available in order to determine the appropriate rate of return and measures of value for the property being analyzed.

Test Your Knowledge: Data Collection and Income & Expense Analysis Questions

1. What is the chief component in the calculation of effective gross income?

2. How do you come to Effective Gross Income?

3. Circle the following that are considered an operating expense:

Property taxes Insurance The owner’s income taxes
Mortgage debt service Payroll taxes Utilities
Property maintenance

4. How do you arrive at NOI from Gross Operating Income

5. How do you arrive at the capital gain / loss from the sales price?

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