Cap Rate - Add back depreciation/Amor?

Question

Hey,

If I am looking at a properties income statement, do I add back depreciation and amortization into net income before non cash items?

For example, I have a friend who's dad wants to sell his 100 unit property for close to 5MM. I am taking a look at the income statement. Net income before non cash items is roughly $110M, that is a cap rate of roughly 2% cap rate- horrible. He told me that I need to add depreciation/amor into that net income before non cash items.... is that true?

I thought depreciation / amortization was not even taken out of the net income before non cash items so how could you add that back?

Net income is ($57,000) after you deduct depreciation/amortization.

Am I right or is he?

Thanks

Account Closed · Answer

Interest is not an operating expense. This is part of the cost of financing (debt service)

Account Closed · Answer

This does sound like an awful deal. You may want to check out this link that discusses how to calculate net operating income. http://www.property-investing.org/net-operating-income.html

Account Closed · Answer

Billy, you will quite likely review many financial statements over time. One of the thing you will probably note in time is that they are not prepared properly. I have reviewed and corrected many, many financial statements over the years. A company may employ a bookkeeper to handle the books. This is still far from a guarantee that entries are recorded properly. I would say that at least 8 times out of 10 it is necessary for me to reclass entries before doing a tax return. There is often some back and forth just to understand the nature of a transaction so that it can be recorded properly. Accounting for rental properties is fairly easy but still doesn't always get done correctly. Part of the due diligence process is reviewing the financials for completeness, accuracy and reasonableness. The financial statements can tell you far more than many realize but hey can also hide a lot if misrepresented.

Jon Holdman · Answer

Absolutely not. "Net Operating Income" is the OPERATING income. On an actual basis, its collected rents less operating expenses. Usually an allowance for capital items would be included too. For estimating for a deal, its gross scheduled rents less vacancy allowance less estimated expenses and capital reserves. A really easy way to estimate NOI is 50% of gross scheduled rent. That's about the best you can hope if you do things right. Cap rate is simply NOI divided by the purchase price. That's it.

Bill Gulley · Answer

So true Charles! I only got 2 out of 10 that were prepared by CPAs, lol. You need to ask for more than the financial statement before you buy, make it a requirement in the contract. You need bank statements for the property for the past year rent receipts and expense ledgers as well as past tax returns on the property. Many sellers will balk at first, they can use a magic marker and mark out balances of accounts and other deposits, you need to see what was taken to the bank on a property. I have seen people claim higher income on properties and actually reported higher incomes, paying tax on it (no law against claiming and paying more than you make) to justify the sale price next year! Make sure it all jives.... I think that Charles ought to write a short book, The Auditor's Handbook for Real Estate Investors. How to audit information that sellers lie about, Realtors mistakenly provide and Bankers overlook. You might consider getting some assistance on this one, it isn't a 3/2 home, it's significant bucks! Bill

Bill Gulley · Answer

Hi, Charles, good find on the article, thanks. Follow the article provided by Charles. The ratio analysis does not consider the money borrowed in an investment by the seller (or a buyer since it should be a cash on cash analysis). Watch what the seller expensed or amortized as a capital expense. A roof for example should be in the sale price as a condition of the property and amortizing it again may throw off you assumptions as to real expenses. You should have an allowance as the new owner for maintenance and capital expenses. Follow the example given as referrenced by Charles. And, they are right, no, it's not a deal....Bill

Billy W. · Answer

They have it in the operating expenses and it is included in the net income... Should I subtract the interest out of the operating expenses then?

Billy W. · Answer

Gross Receipts were roughly $550K... Operating expenses were (it seems to me) high @ $435K which leaves roughly NOI of $115K. ~$180K of that expense was interest. Still with that Cap would be 2.2%... I just want to make sure I am reading this right. :)

Jon Holdman · Answer

Truly awful. I'm sure you can get 2.2% on CDs. My grandma just got 2.6% on one. Further, I bet you're getting that NOI number from the seller. Rest assured its as high as the seller can make it without flat out lying. If its more than 50% of the gross scheduled rents, its high.

J Scott · Answer

Yup...exactly what Jon and Charles said... :)