As a commercial real estate insider, you will need to evaluate income producing properties. You do this by analyzing the income and expense sheets of the subject property in which you are interested.
Income and expense sheets do not involve fancy finance or numbers, and you do not have to take a difficult finance class in order to decipher the numbers and what they mean to the end user.
It is very important for you to understand the basics of income and expense sheets so you can verify how much money the property is actually producing, as well as spending on expenses such as maintenance, perhaps utilities, and other such costs.
With most properties you will be able to get the income and expense sheets from the broker or even owner of the property. If the property does not have one, then it is probably extremely mismanaged and is need of many changes. This might be a great fixer upper property, as long as you recognize the risk that comes along with it.
Most income and expense sheets will look similar for real estate. However, if ever there is an item you do not understand, or it seems odd to the property, simply ask the broker or agent for assistance in explaining that item. The item could possibly be something specific to the property, or a scam that the accountant is trying to play to make the property appear either better, or even worse than it really is. Do not pass up an item because you do not understand it. Get the details, and treat it like an important part of your investigation.
The most important aspect of income and expense sheets is the result between the two categories. This is expressed in the following simple equation:
Gross Rents (Income) – Operating Expenses= Net Operating Income (NOI)
Net operating income is how you determine how well a property is performing, as well as determine the cap rate, which is used to find the selling price of a property.
So let’s look at the income and expense sheet to understand the basic items that you will find.
Income: The income is all the money a property generates through rent, laundry rooms, vending machines, utilities (if tenants pay own utilities), perhaps game rooms, if the property is a hotel, and any source that generates cash for the owner. This is recorded in a specific period, often weekly, monthly, quarterly, or year-to-date. Be sure to know which period the specific income and expense sheet is for because it makes a huge difference if the numbers are from a month or a full year.
When evaluating a property, it is a good idea to view the yearly income and expense sheets, as well as the three to five before it. You want to view how the property has performed overall, and identify any odd changes or trends in the numbers. Remember that income is often separated by each department in which it is generating cash. This is where you might find odd items and need to get clarity before making a decision on the property’s performance.
Operating expenses: Expenses are often divided into two different categories, operating and fixed expenses. Operating expenses are the activities that cost money to operate the actual property. They can differ from month to month, depending on the activity and changes in the property. Management and other such expenses can be considered operating expenses- what ever costs are associated with operating the property itself. When these expenses are reduced, then you can increase your overall income.
Net Operating Income: The NOI is the balance on the property after the Operating Expenses have been subtracted from the total income. Notice the NOI is only the gross income, minus the operating expenses. If the number is negative, as shown in parentheses ($20,000), then it is considered a loss. If the number is positive, $60,000, then it is shown without parentheses. The NOI is the unleveraged return that any owner or investor would yield if the property were operated in the exact same fashion as it is currently.
Fixed expenses: Fixed expenses are the costs a property has every month, independent of activity and operations. These are expenses outside the business of operations. Debt service and income tax paid are two examples of fixed expenses. Sometimes income and expense items may be in the wrong place, so be sure to put them under the right category yourself, and calculate the results.
Cash at end of year: This is the overall cash that is available to the owner to do with what he or she will, after all expenses have been subtracted from the total income. This amount is determined with depreciation in the equation. So if you had subtracted it earlier, then be sure to add it back to the net income.
A few notes on the expenses found:
Repair and maintenance expenses: By looking at the repair and maintenance expense, you can determine how well a property has been taken care of, in addition to inspecting the property yourself. Each year there should be about 5% of the total income spent on maintenance and repair. If there are bigger jumps than that, the property may have undergone a major change or renovation. You can ask the owner or broker as to why the numbers either drastically increased or decreased during a certain period, and they should be able to tell you.
Management expense: Management expenses should be identified on the income and expense sheet, and if they are not, then the validity of the report needs to be questioned. Always include an amount you would pay someone or yourself to manage the property because it is a viable expense if the owner managed the property as well, then perhaps he or she did not put in a number in the way of management, but it is absolutely necessary.
As you can see, income and expense sheets are not difficult to read. What can be difficult is getting the support for some odd numbers that you will occasionally see on these reports. Ask questions and investigate the numbers if need be, to get a solid idea of how the property is exactly performing, and how much the property is actually worth. To practice, ask a broker for a few income and expense sheets he or she may have from prior properties. Review them and see if you can identify all the major categories, what they mean, and how they are used. You will have the reviewing of income and expense sheets down in no time, and will be successful in determining a property’s value.
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