As I travel throughout the country, I realize how many cash buyers are buying income generating properties without ALL of the numbers being disclosed. I think this is very unfortunate and saddens me that others in the industry think it is okay to sell a newer cash buyer on fictitious numbers. So, I have decided to write this post to help clear up which numbers you really need to see before you go and buy an income generating property. These are the bare minimum numbers that should be disclosed and the respective return that the property returns with ALL of those expenses accounted for in the P & L (Profit & Loss).
- Gross Rents is the starting point. You will subtract all of the holding costs associated with the property from this number. The Gross Rents should include anything that you are collecting monthly for that property. It should not include inconsistent late fees. It should include rent each month, yet it might also include monthly storage fees, or monthly pet fees too.
- (-) Property Management is an expense that should be subtracted from the Gross Rents. It is the cost associated with the monthly management of the property. Even if you are planning on managing the property yourself, you should still include this expense. When you go to sell the property, your buyer will want to see that you have accounted for a property management fee each month. I usually recommend that you pull at least 10% of Gross Rents to cover this expense. Ten percent is a pretty common amount charged.
- (-) Maintenance should always be pulled for any income generating property. Even if the property is brand new or recently remodeled, you will still incur some maintenance costs. When someone moves out, you will be grateful for this slush fund too. Typically, I will account for 5% of Gross Rents, if the property is new or recently remodeled. Whereas, I will pull 10% of Gross Rents for rentals that might need some updating. If you have a savvy tax preparer, they might recommend capital improvements at certain times too. Therefore, it would be in your best interest to have a slush fund available to fund these upgrades, instead of it coming out of your pocket.
- (-) Taxes should be pulled out as an expense too. You want to make sure the property still makes sense as an income generating property with this amount pulled out. There are some areas where the taxes are so high that they really do not cash flow very well.
- (-) Insurance is another critical expense to ensure is accounted for on your income generating property. You will want to ensure that you have the appropriate and adequate insurance coverage for each of your income generating properties. In some areas, you will need flood insurance, where others need earthquake insurance, in addition to a standard landlords policy. You might even decide to include liability insurance too. The increase of premiums will impact your cash flow. FEMA has been changing the requirements and boundaries for certain types of coverage, which might impact how much you will to allot for your income generating property.
- (-) Miscellaneous fees are those fees that may or may not apply to certain income generating properties. I will include HOA fees (Home Owners Association) or PUD fees (Planned Unit Development), Utilities, and a Vacancy Factor Fee as I see that it applies to the respective income property I am buying. HOA fees or PUD fees will apply in some areas where as not in others. You should look into where the property is located in an area where these fees apply and how much they are per year. It is a cost that is required to be paid on that property. In order to rent out some of our properties, we have to include utilities in the rent amount. If this is the case, you need to account for those costs. In some cases, your multi unit may not be sub metered, thus you have to pay for utilities initially and then back bill your tenants. You need to account for this cost, incase you can not collect the money from your tenants. You should always account for a vacancy factor. Even if the property is supposedly always 100% occupied, you might have a vacancy at some point and that will cost you money to market it, to show it, and to repair it. It is always nicer that the property is able to pay for that expense instead of it coming out of your pocket.
The result of all of the above listed expenses pulled from the Gross Rents will provide the NOI (Net Operating Income). It is in your best interest to require that any seller show you all of these numbers, so you can make an educated decision on the income generating property. If they just give you numbers with gross rents and the NOI doesn’t match yours, you know that they have not accounted for all of the expenses that you will incur with that property and they are trying to make it look like it performs at a higher return than it actually is performing at right now. Do adequate due diligence before you by, so you ensure you are not taking on someone elses nightmare.