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Financial Statements
Financial analysis begins with reviewing the
Income Statement, Balance Sheet, and Rent Roll for the property,
typically
for the two most recent years. The current twelve month period
is the best assessment of recent performance, which is the basis
for the value
of the property.
Data from the Income Statement is both analyzed for what it may
reveal about the operation of the property, and used with various
ratios to
analyze the financial viability, and therefore the market value,
of the property. The capitalization rate (cap rate), also known
as the
income approach, is the most widely used method to estimate the
current value of a multi-family residential income property.
I. The Income Statement
The income statement is a summary of a property’s revenues
and expenses, and therefore net income or loss, for a specified
time period.
The components of the income statement are:
- Operating Revenues
Income from the property is defined as:
Gross Scheduled Income (GSI), which is 100% of the potential
income a multi-unit property could produce if every unit were
occupied
and tenants paid 100% of rents due.
Effective Gross Income is GSI less vacancy loss, which is the
income lost due to vacant units, delinquent rents, collection
expenses,
etc.
Other Income is from late fees, application fees, laundry rooms,
vending machines, payments collected for utilities, etc
- Operating Expenses
Lists all expenses associated with operating and maintaining
the property, such as:
Repairs and maintenance, general & administrative, legal & accounting,
advertising & marketing , property management, payroll, utilities,
real estate & payroll taxes, and insurance.
- Net Operating Income
Net operating income (NOI) is the remaining income after
paying all operating expenses.
Net Operating Income = Effective Gross Income – Total
Operating Expenses
- Debt Service
Includes principal and interest of any debt payments being
made on the property.
- Capital Improvements
The capital improvements to the property. Used to estimate
the reserve requirement.
II. The Balance Sheet
The Balance Sheet states the property’s financial position
at monthly, quarterly, and annual intervals. The
three components are:
- Assets
The assets are the economic resources owned
by the business. Current assets are those that
are used within
one
year, and include
cash, accounts
receivable, utility deposits, prepaid insurance premiums,
and supplies. Fixed assets are
those whose benefits extend longer than one-year, and include
the buildings, equipment, and land.
- Liabilities
The
liabilities of a business are its debts plus any outstanding
claims. Current liabilities
will
use current assets or
will be paid within
one year, and include accounts payable, wages owed to employees,
invoices from contractors,
security deposits made by tenants, and taxes payable. Long-term
liabilities are longer than one year in duration,
and include mortgage debt secured
against the
property, loans for capital improvements, and equipment
financing.
- Equity
The equity in the property is the financial
value remaining after all obligations have been satisfied.
Equity = Assets - Liabilities
III. Rent Roll or Rent Schedule
The Rent Roll or Rent Schedule should provide the following
data:
The unit or apartment number, tenant’s name, number
of bedrooms, scheduled rent, collected rent, date paid,
and
other income such as
utilities, application
fees and late fees.
The Rent Roll reflects the stability of the property,
the efficiency of collections, and the occupancy rate.
The
timely and efficient
collection of rents is crucial
in meeting cash-flow needs. A high occupancy rate can
reflect a well managed
property, a short supply of rentals units in the area,
below market rents, or a combination of these.
RATIOS USED TO ANALYZE INCOME PROPERTIES
- Capitalization
Rate (Cap Rate)
Capitalization Rate
= |
Net Operating Income (NOI) |
|
Sales Price |
Cap rate in this form is equivalent to a the yield on
invested capital when comparing other investments to
real estate.
In addition, this
ratio is a
tool for converting
the net operating income of a property to its equivalent
market value by estimating future net operating income
from the Income
Statement
and prevailing
market conditions,
and estimating a cap rate by examining similar properties.
Sales
Price = |
Net
Operating Income (NOI) |
|
Capitalization
Rate |
Be careful to note whether the data supplied is actual
or pro forma.
- Cash Return On Investment (Cash ROI)
Also known as the cash on cash return. It is the ratio
of the remaining cash after debt service to invested
capital:
Cash
ROI = |
Remaining
Cash after Debt Service |
|
Cash
Investment |
The cash ROI is different from net operating income
(NOI) and the cap rate in that the cash ROI is calculated
after
debt service,
while the
cap rate
is calculated
before debt service. So while the cap rate is an
important ratio used in determining relative property
values, the
cash ROI is
an
important
ratio
used to determine
your cash rate of return on invested capital.
- Total
return on Investment (Total ROI)
The total return on investment accounts for principle
reduction. The total ROI is the ratio of the remaining
cash after
debt service plus
principal
payments
to invested capital.
Total ROI = |
Remaining Cash after Debt
Service + Principal Reduction |
|
Cash Investment |
The total ROI provides a measurement of the total
return on your invested capital by capturing both
the cash and
noncash portions.
- Debt Service Coverage Ratio (DSCR)
The debt service coverage ratio, also known as the
debt service ratio, measures the relationship of
the amount
of cash available
to service
the debt payments,
which is the net operating income, to the required
debt payment:
DSCR = |
Net Operating
Income |
|
Debt Payments |
This ratio is key to lenders because if there is
not adequate cash flow to service the debt, they
will not
issue a loan.
- Gross Rent Multiplier (GRM)
The GRM measures the relationship between the total
purchase price of a property and its Gross Scheduled
Income.
Gross
Rent Multiplier
= |
Purchase
Price |
|
Gross
Scheduled Income |
The GRM can be calculated either an “as is” basis
with no changes or improvements to the property,
or on a pro forma basis,
which includes
both improvements and the expected increase in
revenue that will result from the
improvements.
The gross rent multiplier (GRM) is often used
for single family income property and duplexes.
Other Evaluation Approaches
There are two other approaches to determine property
value. Each has its place and serves a unique
function in determining
value
depending on the
type of property
being appraised and for what purposes.
- The sales
comparison approach compares the subject property with comparable
properties
and adjusts
value based upon
similarities and
differences.
This method is used most often in valuing
single-family, especially owner-occupied, homes.
- The replacement
cost approach is based upon
the premise that a property is worth what
it would cost
to duplicate,
with adjustments
to age,
condition, location,
etc. This approach to value is particularly
use for appraising new
or nearly new improvements.
Sources:
1. Berges, Steve. The Complete Guide to
Buying And Selling Apartment Buildings.
Hoboken,
New Jersey: John Wiley & Sons,
Inc. 2005.
2. Betts, Richard M. and Ely, Silas J.
Basic Real Estate Appraisal. Mason, Ohio:
Thomson,
2005.
3. Bond, Robert J., McKenzie, Dennis
J., and Gavello, Alfred. California Real
Estate
Finance.
Mason,
Ohio: Thomson, 2007. |