Massaging the Numbers on Rental Properties

My last post explained the income capitalization method of evaluating rental properties. This one concentrates on the "income" angle of things.

You will recall I explained that Net Operating Income was all of the operating revenues from a property (gross rent, fees, and other revenues such as billboard rental, roof rights, etc.) minus all of the operating expenses. Operating expenses do not include things like mortgage payments, marketing expenses, commissions or capital expenses. These are legitimate income tax expenses for a property (except for the capital expenses), and they are legitimate things to consider when calculating your actual or potential cash flow. But, for purposes of placing a value on property using the income capitalization approach, they are not considered when using that tool.

Often, you will receive an accountant's Profit and Loss for a property when deciding whether to buy it or not. Or, you will review your own P&L to calculate an asking price if you are selling. Part of the accountant's job is to minimize taxable income.  A property seller, on the other hand, wants income as high as possible.

When buying or selling properties, you should carefully examine all of the expenses and disregard those that are not legitimate operating expenses for purposes of NOI calculations. That might include capital expenditures (significant roof repairs or replacement), payroll expenses for relatives who have few management responsibilities, owner's expenses such as auto lease, health insurance, corporate overhead allocation, etc.  You should also disregard loan payments, loan interest, depreciation and amortization, late fee and penalty expenses, marketing and advertising, and leasing commissions.

There is nothing unsavory about this.  It is not a "double set of books."  At most, you are making what is commonly referred to as "tax to book adjustments" or "book to tax adjustments."  We call this "recasting the financials."

Here is the impact of my advice:

• Accountant's P&L shows gross rental revenues of $12,000, fee income of $500, property taxes and insurance of $2,000, repairs and maintenance of $1,500, office expenses of $300, and mortgage interest of $3,000.  Net income is $5,700. Investor A, with only a very cursory understanding of the income capitalization tool, applies a cap rate of 8%, and puts the property on the market for a calculated value of $71,250
  
• Investor B knows to disregard the mortgage interest, so recalculates net income to be $8,700. Using the same cap rate, this investor puts the property on the market for a calculated value of $108,750.
  
• Investor C knows that some of the other expenses are not truly operating expenses of this particular property. This investor adds back to income his auto insurance paid by the company ($500), the office expenses that really belong to all his business activities ($300) and the new refrigerator he bought for the unit ($1,000).  Now the NOI is $10,500 and the indicated value is $131,250.
  
• Investor D knows that his rents are below market, and all other rents in the area for comparable properties are $1,075 per month, not the $1,000 he has been charging. He has raised the rent for the current tenant, effective next month. The tenant has already signed a renewal lease. The pro forma NOI (meaning the future net operating income for the next year, not a past year) will be larger by $75 per month, or an extra $900 per year. All expenses will remain the same, resulting in a pro forma NOI of $11,400 and an indicated value of $142,500.

If you are that investor, would you rather sell your property for $71,250 or $142,500?

My next post will discuss the pros and cons of WHICH NOI you use--last calendar year, the immediately preceding twelve months (trailing twelve NOI) or future numbers (pro forma NOI). It will also tell you how to argue in favor of pro forma NOI if you are selling, and how to argue against it if you are buyingr.