Financial Analysis of Residential Income Properties
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:
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
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
1. Capitalization Rate (Cap Rate)
Cap rate in this form is equivalent to 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.
Be careful to note whether the data supplied is actual or pro forma.
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.
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.
4. 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:
This ratio is key to lenders because if there is not adequate cash flow to service the debt, they will not issue a loan.
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. 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.
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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.