GUEST POST: Carter Froelich, CPA www.thepropertyledger.com

Operating expenses are the expenses which are paid by a real estate investor which keep the property generating revenues on a monthly basis.  Operating expenses do not include mortgage payments, depreciation and/or capital improvements.  The table below illustrates some of the typical operating expense categories for a standard residential rental property. These categories were taken from the standard default operating expense analysis from The Property Ledger™, to the extent that a specific operating expense category or property expense is not shown below, The Property Ledger™  may be customized by the user to add such categories and/or expenses.



The most common operating expenses as they related to residential real estate analysis include:

Property taxes – Represents the property taxes which you as a property owner will pay on an annual basis related to the operation of state, county, municipal government as well as school district operations.  You may obtain a property’s current property tax bill by going on line to the respective county’s treasurer or county assessor’s website and searching for the property’s tax bill by parcel number, owner and/or address.  Remember, when you are purchasing a property at a price other than that which the originally owner paid and/or the current assessed valuation of the property, your property tax payment will vary from that which is shown on  the current tax bill based upon your purchase price.  Make sure you take this into account when estimating your prospective investment’s property tax payment or you may under estimate this expense.  In my mind it is always better to be conservative (meaning selecting a higher number) when estimating operating expenses.

Also See: Analyzing a Single Family Home

Property Insurance – Property insurance is necessary to protect both you and your lender from loss in the case of a fire, flood, earthquake or other catastrophe which may damage or destroy your investment property.  It also includes liability insurance to protect you in the case that a tenant or tenant’s guest is injured while on your property.  As is the case with property taxes, if you are paying more for a property than that of the original owner, your insurance premiums will likely be higher than that of the current owner.  The best way to zero in on this expense is to call your property insurance specialist and give them the details related to your purchase along with the coverage you desire for the property. They will then be able to give you an exact quote related to this expense category.

Also See: Analyzing a Multi Family Property

Repairs and Maintenance – Repairs represent the items which need to be fixed over the course of a tenant’s use and include such things as leaky faucets, heating and cooling repairs, minor plumbing repairs, electrical and/or appliance repairs.  Repairs and maintenance represents those costs necessary to keep every running for the tenants use of the facility.  They do not include replacement of an air conditioning unit, remodeling   of a bathroom, replacement of windows or other improvements which increase the useful life of the property.  These  types of improvements are capital improvements and must be depreciated over their useful life as outlined in the federal tax code.

Also See: Replacing Proforma Estimates with Actual Operating Results

Management Fees – Management fees represent the fees paid to an outside party to manage and lease your property.  Typically, these rates range from 5% to 10% of the effective gross income generated by the property.  Even if you manage the property yourself you should factor in a management fee as your time is valuable and you should recognize the economics of your time.  I can assure you that when you sell your property, should you present your property’s profit and loss (“P&L”) statement to a prospective buyer and a management fee is not shown on your P&L, the buyer will add one to his or her analysis thus increasing the operating costs of the property and reducing the price which they can pay for the property.

Utilities – Utilities relate to electricity, natural gas, heating oil, water, sewer, and potentially trash pick-up.  Depending upon the type of property you are analyzing, the tenant may pay a majority of these costs.  I know that for all my single family residential units the tenants pay all of the aforementioned utility costs.  In order to get a good indication of what the tenant’s typically pay in relation to a potential acquisition, look at their individual leases.  Typically, the tenant’s responsibilities related to utilities will be spelled out in the lease.  Additionally, in most states you can call the respective utility company and they will provide with the actual utility billings for the property in question for the last year.

Additionally, you will want to look at the seller’s tax returns related to the property in question and compare their tax return to what the seller and the real estate broker are representing in terms of operating costs. Obviously if their costs are much higher on their tax return than their selling proforma you will want to investigate the difference.  When in doubt use the higher figures as these typically will be more reflective of actual operating costs.

In  our next issue we will discuss how a property’s net operating income is calculated.

Video Tutorials on Real Estate and Financial Analysis

Why Financial Literacy is Important

How To Estimate Effective Gross Income

How To Estimate Operating Expenses

Estimating Net Operating Income

The Difference Between Taxable Income and Cash Flow

Carter Froelich, CPA is the founder of The Property Ledger™ a web basedreal estate investment software.  To get a free 30 day trial  of  The Property Ledger™  see our web site.

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GUEST POST: Carter Froelich, CPA www.thepropertyledger.com

The basic premise behind preparing a cash flow analysis related to a real estate investment is that you want to purchase a property such that the cash flow generated from the real estate investment is positive from the first month.  More specifically, you want  the rents collected from the property to not only pay for the monthly operating expenses of the property, but  also the  debt service on funds which may have been borrowed to purchase the property.  In my mind, if an individual is purchasing properties which do not generate a positive cash flow from the date of acquisition, that individual is not an investor in real estate but is rather a speculator in real estate.  Our articles are going to focus on real estate investing and not real estate speculating.

The Property Ledger™ was developed to provide real estate investors with an accessible financial tool which would not only crunch the numbers related to the cash flow of a single real estate asset but also that of your entire real estate portfolio.  However, when teaching course on how to utilize The Property Ledger™ it became apparent that many investors were not fully up to speed on the financial terms which are utilized in the preparation of a cash flow analysis.  To address this issue I  will be presenting a series of articles which deal with the terms, concepts and fundamentals of cash flow analysis. The first of these articles will deal with key financial terms utilized in cash flow analysis revolving around the determination of rental income.

Rental Income – This is also known as “Scheduled Rents” or “Gross Scheduled Rents” and represents the total rental revenue which the property would achieve upon the collection of the rents of the occupied units as well as the potential market rents from all of the vacant units for a 12 month period using the current market rental rates for your particular property.  Market rents are derived from your investigation of the market in which your property is located.  Additionally, if the property in question is currently not achieving market rents you would need to determine the costs necessary to bring  the property up to current market rental rates and included this cost in  your cash flow analysis.  Using The Property Ledger™ this is done in the “Future Improvements” section of the cash flow analysis.  As a general rule of thumb, a single family home should generate a monthly rental rate of between 1.00% and 1.33% of the purchase price to support a 100% financed transaction.  For example, if you purchase a home for $100,000, you should ideally rent the home from between $1,000 to $1,300 to have a positive cash flow.  Remember that all market rents are determined by the market so it is important to have working knowledge of the market in your area.  In performing your market analysis you may want to utilize our Real Estate Navigation Forms™ .

Other Income – Other income comes from sources other than rental of the units.  Such income may include coin-operated equipment such as washers and dryers, soft drink and candy machines, and electronic games. This category also includes rents from storage lockers, boat docks, and parking for which tenants pay as well as late fees.

Gross Rental Income – Represents the total of Rental Income plus Other Income.

Vacancy Allowance – As we all know it is unlikely that all of our units will be occupied 100% of the time.  As such, it is important to factor into the cash flow analysis the downtime which an investment property is estimated to experience during the year to account for the fact that tenants move out of units and that it takes time to ready the unit for leasing and to lease the unit to a new tenant.  This is especially important in that we have already assumed in our Rental Income estimate that 100% of our units are leased at the beginning of the year.  Here again, it is important for you to have a good understanding of the submarket in which your property is located.  In a well located enchanted area in which there is a huge demand for rental property, you may want to utilize a 4% to 6% vacancy allowance.  This would allow for a 15 to 20 vacant days per year per unit.  If you are in a less desirable area in which there are multiple competing properties for lease you may need to use a 15% to 20% vacancy rate which would equate to 55 to 73 days vacant.  The time it takes to lease a property will have a significant impact on the cash flow of your investment property.  This is why it is important to purchase investment grade property in enchanted areas.  For more information on this topic you may want to review the Lynch Pins of Real Estate Investing.

The other factor to include in your Vacancy Allowance estimate is an allowance for uncollectable rents.  This is why sometimes this category is also referred to as “Vacancy and Collection Allowance”.  This may be not be a factor if you are purchasing property in great locations with high demand from credit tenants, however,  if your property is located in less desirable area with less qualified tenants, this figure could add another 2% to 3% to your Vacancy Allowance.

Effective Gross Income – Represents Gross Rental Income less the Vacancy Allowance and represents your best estimate of the available funds which will be collected during the year and available to pay operating expenses and debt service.

The subject of operating expenses will be discussed in our next issue.

Carter Froelich, CPA is the founder of The Property Ledger™ a web based real estate investment software.  To get a free 30 day trial  of  The Property Ledger™  see our web site at www.thepropertyledger.com.

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801-318-3131

kevinw@moneywisecommercialfunding.com

Check out my blog      http://brokersneeded.blogspot.com/

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Direct: (216) 285-0331
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