Step 2 Verify Expenses

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Expenses are the second important variable to consider. As I mentioned earlier, the definition of net operating income is income minus expenses. In the previous section, we showed you the specifics you need to review to estimate the income potential of a property. In this section, you'll see how to assess the expenses.

Just as we did when we verified income, you'll want to get a picture of the current expenses. Unlike the income calculation where our goal was to be 100 percent on the money in terms of accuracy, with expenses the goal is to get reasonably close. We'll find out all the minute details later in the game. This is another area where your team of pros can help you.

Regardless of whether you will be using a property management company or not, calling one to visit the property and help you assess everything involved in running the place is a good idea, particularly if you are looking at a multi-unit building. Just call and say, "I'm looking at buying an eight-unit building, and I'm not sure if I want to run it myself or hire a company to do it. I'd like to show you the building and talk with you about it." The hour or so you spend with the property management representative will be a good investment of time. And if you have to pay that person an hourly consulting fee, it's worth it. Make the objective of the meeting twofold. First, you'll want to learn what it will take to run the property, and second, you'll want to get insight on how to minimize expenses.

Keep in mind, at this point in the process your goal is to get an idea of the ongoing services and repairs as well as upgrades the building may need. Later in the process, you'll go into lots more deiail. This is ihe lime to put rough numbers on paper and ana lyze if the cost of the needed repairs will still allow you to be profitable. There is a real balancing act between spending enough to get the place in shape and overspending. Again, your property management representative can help you determine many of these costs.

The goal throughout this whole exercise is to get a picture of where your expenses are and try to find ways to do things better, smarter, and for less money. Those increase your net income and increase your profitability. So what are the expenses? To answer that question, we'll turn to the pro forma expense table. It shows the seller's anticipated expenses for the coming year (the pro forma column) and the actual expenses for the prior year. Here's what this table looks like for the property in Phoenix we're using as our real-world example:

Expenses

Per Unit

Seller Pro Forma

Prior Year Actuals

Repairs and Maintenance

$838

$6,700

$8,010

Utilities

$409

$3,273

$3,273

Real Estate Taxes

$425

$3,400

$3,400

Insurance

$125

$1,000

$1,000

Replacement Reserve

$150

$1,200

Total Expenses

$l,947/unit

$15,573

$15,683

$2.88/sq. ft.

Let's analyze these figures in much more detail and add our pr< >-jected expenses. First we'll look at "Repairs and Maintenance."

Seller Prior Year Our Per Unit Pro Forma Actuals Projected

Repairs and Maintenance $838 $6,700 $8,010 $8,010

The first thing that caught my eye on this table was a seller pro forma value lower than the prior year actuals number. For some reason this seller or broker wants buyers to believe that the repairs and maintenance will actually go down! In fact, this seller predicts repair and maintenance to go down by over $1,300 from the actual prior year costs. Here's a rule of thumb: As properties age, repair and maintenance costs go up. Common sense says expenses in the coming year will be the same or more. We'll keep it simple here. For purposes of my projections I will use the prior year actuals number of $8,010 knowing that even this number could be low. Time will tell.

Next we'll look at the utilities-.

Seller Prior Year Our Per Unit Pro Forma Actuals Projected

The seller's pro forma utilities figure appears to be in line with the actual expenses from the prior year, but let me caution you that utilities normally have standard rate increases from year to year. In this pro forma the seller projects no increases. For now, we'll use the seller pro forma number, but you can get a very realistic projection simply by contacting the utility companies.

I low about the next line in our expense table: "Real Estate Taxes"?

Seller Prior Year Our Per Unit Pro Forma Actuals Projected

Real estate tax expenses are simple to determine with almost pinpoint accuracy. The data is usually available on the Internet in most areas. Simply go to the county assessor Web site and locate the property search area of the site. Then just type in the property address to get the current figures. In most cases you'll see not only the prior year property tax amounts, but also projections for one or two years out. Focus on the future and use the next year's assessment as your projection.

Understand that property sales often trigger tax increases, so you may want to consult with your real estate tax team member about this. For the purpose of the expense evaluation, I'll just say I found the seller's figures to be accurate. Next is the insurance expense line.

Seller Prior Year Our Per Unit Pro Forma Actuals Projected

Insurance is a fast-moving business and rates can vary widely from company to company. My suggestion is that you get a couple of insurance agents to bid on the property and use that number in your projections. As your business grows you can bundle all your properties under a bulk insurance program, which generates substantia] savings. We do !hi.s and secure bids annually. For our expense analysis on the Phoenix property, we will increase our projected figure to $1,200 per year based on my personal experience.

Finally, we'll look at "Replacement Reserve":

Seller Prior Year Our Per Unit Pro Forma Actuals Projected

Replacement Reserve $150 $1,200 $1,200

The replacement reserve is the funds you put aside for the inevitable replacement of capital items such as appliances, carpets, countertops, roofs, and so on. I get really nervous when I see that the seller did not spend a dime on the property in the prior year as this table indicates. Moreover, the broker or seller projected an additional $1,200 for the new buyer and trust me, this is no gift. This tells me that this property has some deferred maintenance and it's probably more than the $1,200 figure. For purposes of this offer, I will keep the number at $1,200 for now, but after I walk the property I may have a very different opinion.

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Responses

  • michelle
    Do property management companies verify expenses?
    8 months ago

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