How do you calculate your net income, and the negative impact of getting it wrong?

As an investor one of your most important calculations will be the net income of the property. The calculation of net income in real estate is different than calculating net income of a business. Items like interest charges, depreciation, income taxes are not used in calculating net income for real estate.

We define net income from real estate as all income generated by the property and deducting operating expenses. The importance of calculating the net income properly is that there is a correlation between the value of the property and the net income.  When valuating the property the net income along with the capitalization rate are used to arrive at value. Here is an example of arriving at a market value of a real estate property:

Net Income: $100,000.00 Capitalization Rate: 7%  Value = $ 1, 428,571.00

In the above example the value is calculated by dividing the net income by the capitalization rate. Now, what if the net income was incorrect and was actually $95,000.00, what does that do to the value?

Net Income: $95,000.00 Capitalization Rate: 7% Value = $1, 357, 142.00

A difference of $5,000.00 in net income results in a decrease in value of $71,429.00.

Now that you have an idea how net income can affect your value, lets look at some problem areas when viewing the income and expense statements provided by property owners.

The one problem we see is that there is no uniformity in how the numbers are presented. From my own experience, I find that more often than not I have to view the numbers and then reconstruct the statement to reflect the true picture of the performance of the property.

Here is a list of some items to consider:

1. Is the stated income up to date;
2. Is the vacancy rate realistic for the area;
3. Are the property taxes for the current year;
4. Are all rental items included, such as laundry equipment, hot water tanks, pest control, etc.
5. Is there an expense for repairs and maintenance;
6. Is there a budget for management fees, and is it realistic;
7. Will you get the same insurance premiums,or ;
8. Marketing and advertising to attract tenants;

The other consideration that every real estate investor must keep in mind is the ability to finance the property, and how much mortgage the bank will advance. See, no matter what numbers we show the bank, you can bet they will adjust figures to meet their guidelines.

If you would like to receive an income and expense spreadsheet, that I utilize on a daily basis, then send me an Email Spreadsheet, and I gladly forward you a copy at no charge.

On my next post, I will discuss capitalization rates and how net income will influence how  mortgage financing is calculated.