Do you know how to read and interpret property financials?
We’re starting with the basics to give you a ground-up understanding of how property financials are interpreted by asset managers and owners and investors.
Let’s start off with the various components of an income statement.
Components of an Income Statement
There are three financial statements that you will contend with in property management — and every other business, for that matter. You have your income statement, a cash flow statement, and then you have a balance sheet.
We’ll mostly discuss the income statement, but we’ll also cover the implications of cash flow and balance sheets in your property financials.
The Income Statement
The income statement is what most people think of when they think about how their property is doing.
First, you have revenue. Revenue starts with gross market rent. You subtract loss to lease from that to get to gross potential rent.
From gross potential rent, you’re going to subtract your vacancy losses and concessions. That gets you to scheduled rent. Then you subtract your expenses from scheduled rent.
You have two types of expenses — controllable expenses and fixed expenses. Once you subtract your expenses, you get to net operating income.
To get to actual income or free cash flow from net operating income, you subtract debt service and ownership expenses. That gets you to net cash flow. From that, you subtract depreciation and amortization, which usually gets you to your net income, net loss number.
And from that, you subtract capital expenses and any other random cash items. That will get you to free cash flow. And free cash flow is your taxable number that gets reported to the IRS.
There’s a lot between net cash flow, which is very close to the actual cash that you will take home on a monthly basis, and free cash flow. There’s a big difference there, but that’s generally the outline of your income statement.
Now let’s talk about each one of these items separately.
Gross Market Rent
We’ll start with gross market rent. Gross market rent is the highest monthly rent that an individual unit can command in its competitive market.
That means, if you were to lease a unit today, what is the highest nominal value you could achieve for that unit? It is probably going to be different than what the unit’s achieving right now.
Gross market rent is sort of a judgment call. It’s not a hard and fast number. It’s your best guess as to what that unit is worth.
What kind of rent can you command for that unit, given your understanding of the competitive market and how your features and finishes compare to the property next door? How do your amenities influence pricing compared to the property down the street? So gross market rent is a little bit of a fuzzy number.
If you’re an honest owner and investor, you will try to set that gross market rent as close to what you believe it to be as possible so that you can gauge your potential upside in that property. How much more money can you be making from that property if as units roll and turn? What is the likely trajectory of the income at that property?
Gross Market Rent in the Marketplace
If you’re trying to sell the property or you’re buying a property, your gross market rent might be a little more optimistic. Because if you’re a seller, you might want to entice your buyer.
You might say that your units are worth far more than what you’re achieving right now. You’re a terrible manager, you’re super conservative, you never push rents. These units can all earn much more than you’re earning right now because you care more about being 99.9% occupied than about rent.
Those are all stories the seller tells you to entice you to buy a property. And as a buyer, you want to discount whatever the gross market rent number is in their rent roll. You need to make your own judgment. Look at the comps and do your own study.
The Role of Revenue Management Software in Property Financials
Over the last 10 years, there’ve been great advances made in revenue management software. You can use that software to do two things.
Number one, you can take some of the guesswork out of gross market rent. Revenue management software still relies on looking at what the market will bear and comparing against comps. That’s still part of the equation.
Revenue management software will also take advantage of upcoming vacancies. It will take advantage of what the market vacancies will be and shortages, either at your property or in the market in general, to push up that market rent when it sees an opportunity to do that.
Also, revenue management software providers will tell you that the difference between a property that has revenue management software in place and one that doesn’t can be as much as 10% in terms of rent. That’s been proven.
If you’re an institutional class owner, which is to say you have a property with 50 units, a hundred units or more, and you’re not using revenue management software, you’re probably leaving money on the table.
Anyway, that’s gross market rent. It’s the best guess at what the total rent would be if every unit at that property were rented at its highest possible rental rate. But you also have gross potential rent.
Gross Potential Rent
Gross potential rent is the maximum possible monthly rent given that some of your units are leased at a lower rate, and if every vacant unit that you have were least suddenly at its individual market rent.
In other words, your gross potential rent is what you could make today if you suddenly leased everything and given what your in-place rents are, which is usually called your loss to lease. For every unit that is renting for something below the market rent, that’s called your loss to lease. And that represents your gross potential rent.
Your scheduled rent is the actual rent you expect to be collected. First of all, that takes vacancies into account. You subtract that and any concessions from your gross potential rent. A concession might mean that you’re giving somebody one month free, and this is the month you’re giving them free. So you subtract that month from your gross potential rent.
You can also have amortized concessions. You give them one month free, but you are amortizing that one month over the year. So they’re getting one-twelfth of that month every month.
You can also have an accrual allocation of a concession, which means maybe they’re getting the entire concession this month. In this case, you’re following accrual accounting principles, which means you take that concession and spread it out over 12 months, even though all of it is being actually taken in this month.
Whichever format your property financials are following, you subtract concession loss of lease from gross potential rent and you get to scheduled rent. Scheduled rent is more or less all of the rent that you should expect to collect every month, and you can consider that to be your revenue number.
Expenses in Property Financials
On the expense side, as we mentioned, you have controllable and fixed expenses.
Controllable expenses, as you might imagine, are expenses that the property management company has some influence in setting, like maintenance, payroll, and advertising. These are considered controllable expenses because the property management company decides how much to spend every month on those costs.
The other side is fixed or non-controllable expenses. Those are essentially insurance and taxes. Managers don’t have any say in those numbers. They’re set annually and they generally remain fixed for a 12-month period.
Those are the two broad definitions of expenses that you need to know.
Net Operating Income
Now we get to income. If you subtract your controllable expenses and your fixed expenses from your scheduled rent, you get to net operating income (NOI).
Net operating income is a special number. It’s not actual income, despite what it might say. It’s not the actual money that’s going into your pocket every month. But NOI influences a number of very important metrics.
One of them is your debt service coverage ratio (DSCR).
Your DSCR is the ratio of your NOI to your monthly debt payment.
This is important to lenders. They will want to see a ratio of at least 1.10, sometimes 1.15, sometimes 1.20, but rarely more than that unless you’ve got something odd going on in your property financials.
In other words, your NOI needs to be 10 to 20% more than what your debt payment is. This gives the bank or the lender a level of comfort. If you have a bad month and some people move out, you have some vacancies, you can still make the debt payment, which is really important to them.
When you buy or acquire a property, you have to project what your NOI is going to be. You have to project what your DSCR is going to be.
There are a lot of really interesting hijinks that go on here when you’re buying a value-add property. You’re trying to convince a bank that you’re going to be able to raise rents such that, eventually, the rents will be able to produce an NOI that that meets their minimum DSCR.
Often your value-add properties, which are properties that you buy because you believe there is an upside, are purchased at a price that does not cover the DSCR. But you present a plan to the lender that shows that your market rent is a certain amount above where your current rents are. Your plan says that you can increase the amount of rent over time by adding stainless steel appliances, brand new orange shag carpet, etc. You can achieve an NOI that will provide an acceptable DSCR to the bank.
Bridging the DSCR Gap
There are a number of ways that the bank will allow you to bridge that time period. They’ll have reserves or some other things. The point, however, is that NOI is a key number from a financial institution’s perspective. It establishes how that property is performing and how much debt that property can support.
If your NOI falls below a certain DSCR, there are usually a number of really bad covenants in the loan that can kick in.
For example, you may have to take all the rents that you collect and put them in a lockbox that the bank controls. They’ll pay themselves first and then give you money to pay expenses. So monitoring NOI and understanding what’s happening with NOI is very important.
Again, NOI is not income. It is not necessarily the money that you’re putting in your pocket.
Debt Service Expense in Property Financials
One of the most important things missing from NOI, which we just talked about, is your debt service expense.
NOI excludes the payments that you make on your loan. If you own a property in cash, for example, NOI can be very close to your net cash flow. If you have no debt, then the NOI might be the same as your net cash flow. But there’s usually a debt service piece.
There may be other ownership expenses that come out of NOI before you get to what’s called net cash flow. And there might be asset management fees that you have to pay either partners or other owners. There are also taxes and similar concerns.
Those are not part of your expense bundle. They come out what’s sometimes referred to as below the line. They come out below NOI. So after you take out debt service expense, after you take out ownership expenses, then you’re left with net cash flow.
That said, even net cash flow doesn’t always represent the cash that you have. We’ll talk about accrual versus cash accounting, in part two, but keep in mind that net cash flow doesn’t always mean that’s the actual cash that you put in your pocket.
In part two, we’ll talk about the importance of the different items on the income statement. We’ll talk about cash versus accrual accounting. And we’ll talk about the other financial statements. But that’s a wrap on today’s lecture. We look forward to seeing you again at part two of our financial discussion.