Financial analysis begins with a review of Income Statements, the Balance Sheets and the Rent Roll. We will typically consider the last two years. The current twelve month period is the best indication of recent performance which should serve to establish the market value of the property.
The capitalization rate (cap rate) also known as the income approach is the most commonly used method to estimate the current market value of the income property.
An Income statement is the summary of one property’s revenues and expenses; the net income or loss over a specific time period. The components of the income statement are:
Income from the property is called the Gross Scheduled Income (GSI). It is the total of the potential income a multi residential unit could produce if every unit was occupied and tenants paid 100% of rents. The effective Gross Income is GSI less vacancy loss, which is the income lost due to vacant units, delinquent rents and collection expenses. Other Income is from late fees, application fees, laundry rooms, vending machines, payments collected for utilities, etc.
- Operating Revenues
This includes a list all expenses associated with operation and maintenance of the property. This may include: Repairs/maintenance, administration, legal & accounting, advertising & marketing, property management, payroll, utilities, real estate & payroll taxes, and insurance.
- Operating Expenses
Net operating income (NOI) is the remaining income after paying all operating expenses.
- Net Operating Income
Net Operating Income = Effective Gross Income – Total Operating Expenses
Includes principal and interest of any debt payments being made on the property.
- Debt Service
The capital improvements to the property. Used to estimate the reserve requirement.
- Capital Improvements
The Balance Sheet
The Balance Sheet will show you the property’s financial position over a specific period; monthly, quarterly or annually. The three parts of the balance sheet:
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.
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.
The equity in the property is the financial value remaining after all obligations have been satisfied.
Equity = Assets – Liabilities
The Rent Roll should give you the number of units, the unit number, tenant’s name, number of bedrooms, scheduled rent, collected rent, date paid, and other income such as utilities, application fees and late fees.
This document will give you an idea of the stability of the property, the efficiency of collections, and the occupancy rate. The timely and efficient collection of rents is essential in meeting cash-flow needs. A high occupancy rate will depict a well-managed property, a short supply of rentals units in the area, below market rents or a combination of the above.
Calculating the value of Investment Properties
There are a number of methods that can be used to determine value:
1. Cap Rate “Capitalization Rate”. This is a quick way to compare the property you are contemplating to other similar properties recently sold in the same area. This method yields a percentage which can be used for comparison and also establishing prevailing market condition. A low cap rate tells you it is an expensive neighbourhood, more than likely low risk with good long term capital appreciation.
*Be careful and ensure the information supplied is actual.
|Capitalization Rate =
||Net Operating Income (NOI)
2. 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:
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.
|Cash ROI =
||Remaining Cash after Debt Service
3. 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.
The total ROI provides a measurement of the total return on your invested capital by capturing both the cash and noncash portions.
|Total ROI =
||Remaining Cash after Debt Service + Principal Reduction
4. Debt Service Coverage Ration (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:
Lenders like this ratio; if there is not adequate cash flow to service the debt, they won’t give you a loan.
||Net Operating Income
5. Gross Rent Multiplier (GRM)
The GRM measures the relationship between the total purchase price of a property and its 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.
|Gross Rent Multiplier =
|Gross Scheduled Income
The gross rent multiplier (GRM) is often used for single family income property and duplexes.
6. Price per Apartment
This method utilizes the average price per apartment for a similar building in the same area. For example a 5 unit apartment building sold for an average of $125,000 per unit then the value of your 6 apartment building would be valued at $750,000