The first step of looking at property is to determine the amount of income that it will produce. Income determines everything. Since my strategy is a long-term hold strategy, the properties need to break-even or have positive cash flow. It is important that you determine income and expenses before you get too far into the purchase of a building. One of the things that I do want you to be aware of is that over analysis can kill. In fact, I had many clients who suffered from paralysis of analysis. Many transactions have been lost by not saying “YES” quickly enough.
It is important that you become skillful in working the numbers quickly. Determining the income is more an art than reality. There are two types of income that you want to look at – existing income and potential income. Existing income is what the current owner, whether efficient or not, is really bringing in from the investment. Potential income is what happens after genius management and talented changes are made. One of the most important skills that an investor can possess is the ability to examine a building and accurately forecast its operating income.
As an “insider,” it is smart to use a checklist because your familiarity with buildings may cause you to forget important aspects. Sellers and their real estate agents generally provide prospective purchasers with projected operating statements as part of their marketing effort. As “insiders” always know, you need to ignore these statements! The forms almost always include exaggerated income figures and under-realized expenses. No matter how much confidence you have in the owner or the cooperative real estate agent, the operating statement is too important for you to rely on anything but your own “insider” eye. It is virtually impossible for anyone to predict your operating expenses but you, because some of them will vary according to the way you manage. You might want 100% occupancy, but others might accept vacancies in order to get top dollar rents.
Constructing an accurate operating statement is a three-step process. First, you must identify all the incoming expense items that apply to the property. Next, you must verify the items which can be verified. Finally, you must estimate the things that vary according to the way you manage the property.
Rent is not the only type of income. Any of the other items on the next list are or could be produced by the building. Also, be alert to income types not listed here.
Garage rent: $___________________
Laundry income: $___________________
Swim club income: $___________________
Rent on stores or offices: $___________________
Oil royalties: $___________________
Cellular towers: $___________________
Security and pet deposits: $___________________
Rent increases coming from repairs
or construction changes: $___________________
The next step is to determine the expenses on the property. What follows is a list of the expenses that I have had on my properties. I use this checklist to make certain that I did not forget any potential expenses. Please use this list as your guideline to make certain that all areas are being accounted for.
Health permit: ____________________________________________________
Accountant’s fees: _______________________________________________
Attorney’s fees: ___________________________________________________
Government inspection fees: ______________________________________
Property management fees: ______________________________________
Business license: __________________________________________________
Rent control board:_______________________________________________
Boiler insurance: __________________________________________________
Fidelity bond insurance:___________________________________________
Fire and casualty insurance:_______________________________________
Liability insurance: ________________________________________________
Worker’s compensation: __________________________________________
Umbrella policy: __________________________________________________
Air conditioning services:__________________________________________
Heating system service:____________________________________________
Pest or termite control:_____________________________________________
FICA (Social Security Tax): _________________________________________
FUTA (Federal Unemployment Tax):_________________________________
Leasing agent payroll:_____________________________________________
State Disability Tax: ________________________________________________
State Unemployment Tax:__________________________________________
Include personal property taxes:___________________________________
Common area interior painting:____________________________________
Hot water heater:_________________________________________________
Your vacancy rate will be a function of the rent you charge and the overall quality of management and the building. If the present owner is enjoying a consistent 100% occupancy rate and you plan to charge similar rents, there is no point in adding a 5% vacancy rate into your calculations. On the other hand, if you plan to raise rents substantially, you should probably include a vacancy estimate. You can verify the present owner’s vacancy rate by checking the dates on his leases:______________________________________________________
- Advertising (newspaper, signs, rental agency, internet):________________________________________________________
- When the building is not located on a high traffic street, owners often obtain permission from the owner of a property on a strategic corner to pitch a sign that will direct prospective tenants to the property. These signs can be extremely important to your marketing effort, and the monthly rental fee paid to the landowner is an unavoidable expense that can be easily overlooked:_________________________
- Apartment Owners Association dues: _____________. Some associations assess their members for a flat dollar amount for each apartment. Be sure to include this incremental cost in your annual expense.
- Credit Reports:____________________________________________
- Security Deposit Interest:____________________________________
Many states require that all or part of this interest be paid to tenants.
5. Homeowner’s assessments:______________________________
Some expenses can be verified by speaking with the appropriate supplier or government agency. Do not hesitate to do so. Call the municipal government and ask about the following:
What is the total property assessment?_____________________________
Assessment for land? ______________________________________________
Will the property be reassessed upon sale? _________________________
If not, when is the next reassessment scheduled? ___________________
What is the current tax rate?_______________________________________
Any indications of next year’s rate?________________________________
Are there any municipal improvements pending?___________________
Is the municipal government considering rent control legislation?____
Speak with the municipal water and sewage departments and other utilities (electricity, trash removal, and so forth), and ask if they will give you figures for your prospective property for the past three years. Find out any information you can about future rate increases.__________________________________________
Call all service vendors from the last year and ask if all recommended service was carried out.____________________________
As you can see, there is a substantial amount of research necessary to determine the amount of income and expenses involved with a property. I must let you know as an “insider,” most of my purchases had to be made quickly and verifications were done after I had tied up the property.
Please make your offer subject to your verification of income and expenses, and prior to having all your ducks in a row. I was very successful in determining what repairs will be needed for a property to bring in market income. With your “insider” insights, you should be able to increase your income based upon all the experience of client’s properties that you have seen as you negotiated other contracts for your buyers and sellers.
As far as expenses are concerned, I consistently used a 40% expense factor in my thirty years of investing. This is a 15% increase over what the banks utilize on income producing property, but my figure is correct. When you look at all the expenses that I have on the checklists on the previous pages, you will find that those expenses many times will equal 35 to 40%, even more than 40% in tough areas. This is why I feel that 40% of potential income is a very good estimate, if you need to make a decision quickly.
Do not let paralysis of analysis lose a great transaction for you. Remember, one of the greatest gifts that you are given as an “insider” is your introduction to property that other people are not introduced to, but you may have to move fast and confidently. It is to your advantage to use your experience to make fast decisions. After the contract has been negotiated, you can go back and cross your “t’s” and dot your “i’s.”
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