UNDERSTANDING REAL ESTATE TERMS AND FORMULAS

ANALYSING THE FINANCIAL STATEMENT

this exciting world of investment Real Estate, understanding financial statements terms, formulas and strategies will assist you in making a wise investment.

In this article, we will cover Operating Expenses which are the important factors in determining the investment cash flow of a building.

Operating Expenses

As apartment building specialists, we come across many financial reports on investment properties. It never ceases to amaze us how many operating expenses are "streamlined" to expand the "Net Income", thus artificially increasing the market value of the property. In addition to expenses for heat, hydro, water, taxes, etc., the next time you review an income statement, also look for the following expenses.

• Management Fees - Whether you intend to manage the building yourself or hire a property manager, this item should always be expensed at 3% to 5% of the gross income. Your time and effort are worth money!!!

• Superintendent/Janitor Wages - Again, whether or not you intend to do the work yourself, always expense this wage to determine the true operating expenses. Use approximately $20 per unit per month as a guideline.
  

• Maintenance/Repairs - This cost will vary depending on the type, age and condition of property, as well as quality of tenants and the past maintenance level of the building. A good guideline is approximately $500 per unit per year. Often the cost of elevator maintenance and garbage disposal charges are missed in a statement.

• Insurance Coverage - The property must be insured for fire and other hazards (tenants should cover their own contents). Premiums will vary depending on age and size of building and be aware that premiums are on the rise.

• Laundry Expenses - On many occasions, you will find the laundry income included in the gross revenues. However, the laundry rentals are often forgotten in the expense column and unless the laundry equipment is owned, look for rental charges of approximately $50 a pair per month.

• Advertising/Promotions, etc. - In a tough rental market, you must allocate a reasonable monthly charge for advertising or costly promotions.

A good "rule of thumb" for expenses in a building can vary from 45% to 55% of the "Effective Gross Income" (a term that will be discussed in a later issue). There are always exceptions where income is higher (and expenses lower) because tenants pay the hydro costs. Always remember that it is the Net Operating Income (N.O.I.) that sets the probable value of the building.

GROSS RENT MULTIPLIER & LEVERAGE

GROSS RENT MULTIPLIER

The "gross income multiplier" is what you get by dividing the gross rent into the sale price of a building. For example an investment property sells for $1,000,000.00 with gross rents of $250,000.00, which tells us that the "Multiplier" is 4 times the gross income ($1,000,000.00 divided by $250,000.00). This number can be a good thumbnail approach to valuing other buildings when you know their gross income.

The problem with this method of valuing buildings is that the gross income does not allow for expenses, and the best example would be in comparing two buildings, one where the tenant pays hydro and the other building where the owner pays hydro. If hydro was $600.00 per year, the net operating income in a building where the owner pays hydro would be that much less than the building with the tenant paying their own hydro. The impact on the value of the building where the owner pays will be significant. This income, if capitalized at 10% would represent about $60,000 ($600.00 divided by 10%) in less value than the building where tenants pay the hydro costs.

In summary, the GRM (Gross Rent Multiplier) may be used as a benchmark but the conclusion amongst investors is that the best approach to valuing buildings is by capitalization of the net operating income, which will be discussed in a later article.

LEVERAGE

The beauty of using leverage in a real estate venture is that for a small amount of cash you can purchase a large investment property, for example $100,000.00 can purchase a building worth $1,000,000.00, (so long as the income is able to support the venture). As time goes by, you will benefit from both mortgage reduction, and as history has proven, value will increase.

Cautionary words, however - With leverage you may run the risk of unexpected capital expenditures or reduced cash flow that could destroy the investment. Remember that "cash flow" is king, and unless you have deep pockets, a good reserve fund or easy access to cash, you should avoid this approach to investment.

NET OPERATING INCOME & CAPITALIZATION RATE

NET OPERATING INCOME

The net operating income (N.O.I.) is the amount of cash available after deducting the operating expenses from the Effective Gross Income. We obtain the true net operating income by expensing such things as taxes, hydro, insurance, management fees, superintendent wages, along with other fixed and variable expenses. Statements are not always accurate and if you are not careful you can easily be fooled by a lean expense ratio that can show an artificially high net income. Next months article will deal exclusively with expenses and how they can affect value.

CAPITALIZATION RATE

This is the most important term in the industry and investors should be familiar with it. Mostly referred to as the "Cap Rate", this term represents the percentage return on investment in an ALL CASH PURCHASE.

For example, if you purchase a 20 unit apartment building which generates an annual net income of $60,000 with a purchase price of $600,000, you are looking at a 10% Cap Rate, or in other words, you will earn a 10% return on the $600,000 investment.

Net Income $60,000 / 10% Cap Rate Purchase Price $600,000

The market capitalization rate is what an appraiser looks for in his research of the market since it is the capitalization rate that is given the greatest amount of weight when determining the value of investment properties. The Cap Rate will fluctuate with the market forces of supply and demand along the political climate.

EFFECTIVE GROSS INCOME

EFFECTIVE GROSS INCOME

When we purchase a Real Estate investment, we are really buying the potential rental income, and not the bricks and mortar. As we had discussed in the previous issue, the gross income multiplier is sometime used to determine the market value of an investment property. However, in the real world, the gross potential rents are not always achieved due to factors such as vacancy and bad debt.

The effective gross income is the amount of actual income after deducting vacancy and bad debt.

VACANCY AND BAD DEBT

Every rental property experiences tenant turnover. The frequency in which it occurs will depend on many factors such as; location, condition, rental charge, economic forces, tenant profile (age, etc.), and property management experience, etc. It is very important that you become familiar with the vacancy rate of the area of the subject property and also the track record of the property turnover rate.

Be sure to also investigate the monthly collection reports to assess the delinquency factors (non-paying tenants) to truly assess the bad debt ratio.

Vacancy rates will vary from one community to another, and statistics for vacancy rates are available through C.M.H.C. or should be available from any experienced apartment building realtor. As a rule of thumb, a vacancy factor of 3-5% would be used in the Hamilton market, unless in extreme cases where other factors come into play as mentioned above.

This finally brings us to the Effective Gross Income. This represents the Gross Potential Rents less the vacancy and bad debt adjustment, providing us with a more accurate income base.