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The Operating Budget of Real Estate Investment
By eric | November 14, 2007
This really sounds much more complicated than it is. I taught you how to read a seller’s pro forma and make an offer. The steps to the budget are not all that different. You calculate the property income by using the information you obtained on the income statement, rent survey, rent roll, and operating statements. Then you look at expenses based on the actual and projected expenses you’ve gleaned from the due diligence process.
Let’s look at income first and revisit some of our concepts in a new light.
ACTUAL POTENTIAL INCOME
The main source of income on most any property is usually the rent existing residents are paying. That’s the actual potential income of the property For that reason, you’ll want your rent figures to be as accurate as possible based on the information that you have. The easiest way to get this information is to get the existing rent roll or schedule of what each resident is paying, put the units in numerical order, and add up the rent amounts. Another way is to physically review each lease at the property and write down the rent each occupant is paying and mark off all vacant units. It’s a good idea to do this anyway just to make sure that all the residents listed have binding lease agreements.
Once your analysis is completed, your spreadsheet should look something like this:
| Apt # | Type of Unit | Size / sq.ft | Monthly Rent | Resident | ||
| Unit 1 | 1 bedroom |
650 |
$410 |
Kivosaki | ||
| Unit 2 | 1 bedroom |
650 |
$410 |
Hopkins | ||
| Unit 3 | 1 bedroom |
650 |
$410 |
Beckel | ||
| Unit 4 | 1 bedroom |
650 |
$430 |
VACANT | ||
| Unit 5 | 1 bedroom |
650 |
$425 |
McCallister | ||
| Unit 6 | 1 bedroom |
650 |
$420 |
Flanagan | ||
| Unit 7 | 2 bedroom |
750 |
$490 |
Lechter | ||
| Unit 8 | 2 bedroom |
750 |
$470 |
Stuck | ||
| Total |
5,400 |
$3,492 |
|
|||
Based on this rent roll, the actual potential income including the vacant unit is $3,492 per month. Use this number as your actual potential income in your budget.
OTHER INCOME OPPORTUNITIES
Most properties have other income opportunities. These should also be factored into your budget. The most common examples of other income budget items include the following:
- Laundry income.
- Parking income.
- Water and sewer income.
- Late fees.
- Non-sufficient funds fees.
- Cable income.
- Internet revenue.
- Telephone income.
From the operating statements and individual ledger cards for each resident you should get an idea of what other types of income exist at the property. After all, somebody has to deposit this money into the bank account, so there is a paper trail somewhere.
Sometimes this information is difficult to get from the seller. Not everyone is a good bookkeeper. If this is the case with the property you are buying, you will need to re-create the records from the facts you do know. For example, if there is a laundry room with coin operated washers and dryers and you do not see the laundry income on the seller’s income and expense statements, you will need to go directly to the company that services the machines and collects the coins to find out how much you should expect on a monthly basis.
Finding the other income sources can take some time. Kim Kiyosaki just told me recently that she was buying a property from a seller whose books showed that for over four years the laundry company had not paid anything to the sellers. The washers and dryers were there. People were using them. You can bet this detail was flushed out during due diligence and a realistic income number was entered into an operating budget before Kim bought the property.
This is the process of uncovering and entering onto a spreadsheet your income opportunities. Each opportunity should have its own line. Once you have exhausted all the existing income opportunities, you enter lines for any new income opportunities you may add once you take over the property. With income out of the way, you do just as we did before when we were valuing the property, you turn to the expenses.
Expenses
Just as you created a new line for each income opportunity for your property, you’ll create a new line item in your spreadsheet for each expense. In the sections that follow, I’ll list and describe most of the most typical expenses you will encounter with your new property.
PAYROLL
Payroll covers the salaries and wages you pay yourself or your staff. A typical management staff, depending on the size of the property, can include several people. First there are the on-site managers and leasing agents. Then there’s the housekeeping staff that assist with unit turnover and upkeep of common areas. There are also maintenance people who complete minor repairs of buildings and grounds. Again, the property management expert on your team can tell you how much management and maintenance you can expect and the kinds of costs you’ll incur. In addition to the actual wages for yourself and your staff, if you have one, you’ll want to factor in state and federal taxes, worker’s compensation, health and dental insurance, as well as possibly a 401(k) plan.
ADMINISTRATIVE
Administrative costs include the fees you pay for special professional services such as an attorney to help you establish partnerships and assist you with evictions. Accountants will help you manage accounts receivable and accounts payable as well as guide you through tax laws and tax reporting. If you plan to manage the property yourself, your accountant will come in handy. In addition to these professional services, all the things you do to run the property on a day-to-day basis are considered administrative expenses. These include everything from Post-it notes and postage stamps to criminal and credit background checks.
MARKETING AND ADVERTISING
You can ask the property owner to show you the advertising costs for the past year and you may or may not get usable information. Better than that, ask the management company representative to give you an estimate of projected costs to advertise the property. He or she will know all the advertising vehicles in your market, the costs, and have a good feel for just how competitive the market is. You should know that as well, but the management company will put those abstractions into marketing dollars. The more competitors there are in your market, the more you need to advertise to get noticed. That costs more money
MANAGEMENT COSTS
Management costs include the fees you pay to a professional management company or the salaries and wages you pay to yourself or your own staff. Again, when you meet with your property management representative, this person can give you insight on how much your management fees will be, what maintenance costs you can expect, and the nature of those costs.
REPAIR AND MAINTENANCE COSTS
Repair and maintenance expenses will vary depending on your unit turnover or how many move-outs and move-ins you experience in a given year. Other factors that affect repair and maintenance costs are your resident profile, property condition, and the responsiveness of the manager to resident repair requests. If you keep your property in top condition, you will spend less in the long run on things like carpet cleaning, interior painting, electrical repairs, plumbing, appliance repairs, heating and air conditioning repairs and service. Landscaping, pool service and supplies, and pest control also fall under this category.
PROPERTY TAXES
There are two kinds of property taxes: real property taxes, which are on the real estate property, and personal property taxes, which are taxes on the contents of the property like refrigerators, stoves, dishwashers, and other appliances. There are two ways to get these numbers. First they are typically listed on the financials you receive from the owner, or you can get them from the tax assessor’s office. One thing to know is that taxes usually go up after you purchase the property because the assessors use the new purchase price as the new assessed value. Yet another reason to make sure you don’t overpay for the property! So when you are entering in the property tax costs into your analysis, you may want to inflate them. Your property tax team member can give you insight on how much to raise the tax costs.
INSURANCE
This is an important line item expense and it’s a critical one. Why? First, insurance is expensive, and second because usually the bank requires you to have insurance locked and loaded before signing the loan. This number is easy to get. Just call up a few insurance agents and get some quotes. The kind of insurance you will need includes property/casualty and general liability. Deductibles are what will make your insurance costs vary. We vary our deductibles depending on the property. As a rule, you’ll want to have insurance for the big things that can go wrong. You don’t want to pay high premiums for all the small things that you could afford to pay out of pocket. Talk with your insurance agent about the proper coverage for your property and the risks of having high deductibles.
UTILITIES
Identify all the utilities used in the building. This can include electric, gas, trash, sewer, water, cable, and phone. Check to see if the utilities are individually metered, which means each rental unit has its own meter, or if the utilities are master-metered. If they are master-metered, there is one meter for the entire building. Individually metered is the better scenario because the resident pays their own bills. Individually metered buildings mean lower expenses to you because every resident pays for their own utilities. In master-metered buildings there is no incentive for the tenants to keep utility costs down.
I stay clear of buildings that are master-metered for this very reason. Ask the owner to provide you with the financially for the property and these numbers should be there, but again, I always verify them. To verify the figures all you need is the building address and the utility companies can supply you the bills for the previous year. If they won’t disclose the information, call the owner and ask him or her to contact the utility company and authorize the release. Be sure to get all the bills. Sometimes there are seasonal differences, especially for heating and air conditioning. Let’s not have any surprises!
CAPITAL REPAIRS
These are the major improvements needed to keep or bring the property up to standard. Often properties in need of some work are the best buying opportunities, but you’ll want to have a realistic assessment of just how much money it will take to get the place livable and looking good. I’m talking repairs to roofs, parking areas, sidewalks, driveways, lighting, and purchases of carpeting, appliances, hot water heaters, air conditioners, and so on. This is all the stuff you would look at when buying a home-except you’re evaluating it on a much bigger scale.
When you finish entering all the expenses into your operating budget, total the income and total the expenses. Subtract the expenses from the income and you will get a good picture of your cash flow and net operating income. If it’s really big, go back and make sure your calculations are correct. And if it’s negative, don’t be discouraged. This is where creative accounting comes in. Not the kind that will land you in a white-collar-crimes prison, but the kind that makes you reassesses your business model.
Once the budget is finished you’ll want to compare it to the actual operating income and expenses of, your property and look for any glaring errors or omissions. If you have tried every which way to make the bottom line a positive number or, let’s face it, a number that you’re happy with and the deal still isn’t working, you may want to consult with your team. If you’ve exhausted their ideas or the ideas they have presented are so far-fetched, you may have to lower the offer price further or simply walk away from the deal if you can’t realize a positive cash flow or a cash flow you will be satisfied with. The last thing you’d want to do is move forward and pray for a miracle. That’s not how miracles work. Lucky breaks come to those who do their homework and through preparedness recognize opportunities.
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Topics: Agent, Company, Dollar, Land, Market, Property, Rental, Residential, United States | 5 Comments »
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