On the face of it, assessing the state of a real estate investment is easy. It boils down to one question; do rents cover expenses and debt service with a little extra cash left over to make it worth your while? However, whether the answer to this question is "yes" or "no", it takes more to analyze your investment and make adjustments to maximize the value. As you may have guessed it all starts with sound and detailed bookkeeping. Let's start with the revenue side. It's not enough to know your net revenue; you need a breakdown of how that is derived. There are four major components to this number that can tell you a lot about how you stack up to your competition: Gross Potential Rent, Vacancy, Concessions, and Bad Debt. This will help you to determine your Economic Occupancy, the real measure of your performance in the rental market. Let's take a closer look.
Gross Potential Rent
Let's say you own an apartment building that has 50 units (30 - 2Beds & 20 - 3Beds). You charge $400 per month for the 2's and $600 for the 3's. The math is simple. You have the potential to receive $24,000 per month. This is your baseline, or constant. Most likely your monthly Net Revenue will be less than this. How significantly less and why are where you'll want to focus your attention.
The first and most obvious is Vacancy. If all you are taking in every month is $12,000 and half of your units are vacant it's not a stretch to figure out the problem. But, if your bookkeeper is providing this information to you then you can address the issue. Are your asking rents too high compared to your competition, are your units smaller or outdated, does your property have a bad reputation in the local community? The list goes on but it is key to get this turned around not only to increase revenue but vacancy can quickly snowball as current and prospective tenants will be leery about renting units in an increasingly empty building.
Ok, you have very little vacancy but your net revenue is still significantly less than your gross potential rent. The answer could lie in the concessions (or discount) you are offering to prospective tenants. If everyone gets a free month's rent when they move in this will take a significant bite out of your revenue, particularly if you have high turnover. Unlike vacancy, concessions aren't always bad. It's a great way to entice prospective tenants but it needs to be monitored because, ideally, you'll want to phase this out and reach your full potential. If you run a trend analysis on your concessions you should see a steady decline and increase in occupancy. If you're not seeing this you will obviously want to know why. The reasons are many but you won't know where to start unless you have this information available.
Let's say all of the above items are in order but you are still having revenue problems. Check your Bad Debt line. This is where you capture your unpaid rent and can tell you a lot about your investment. Like the discussion up until this point, this isn't rocket science. You can charge maximum rents and have no vacancy but if your tenants aren't paying you things might get a little difficult. I've seen this scenario played out many times. It usually starts with rising vacancy and the owner or management company gets desperate and relaxes their tenant requirements (i.e. no background check, credit check, etc.). This is a dangerous path to go down that can have irreversible consequences. Like vacancy, there is a snowball effect here. If you let down your guard people are going to find out and what you'll end up with is a building full of deadbeats and a reputation that you don't want.
All this leads to calculating your Economic Occupancy (1-((Vacancy+Concessions+Bad Debt)/Gross Potential Rent)). On a quarterly, if not monthly, basis your bookkeeper should be providing this to you. Compare it to your Physical Occupancy. If Economic Occupancy is lower, find out why and don't settle for a lack of information. If you hired a 3rd party property management company this is a great way to measure performance and remember, they are probably charging you a fee based on revenue. Be sure it's net (many times concessions and bad debt are treated as expenses).
I'm not going to focus on any accounts in particular as I did above; rather, I want to stress the importance of accruing properly. A cash flow statement exists for a reason. I like to think of it as a report card. When used in conjunction with your balance sheet it lets you know exactly where you stand at a given point in time. An income statement, on the other hand, is more like a progress report. You want to use it as a guide to ensure you are keeping pace with your financial goals. If your income statement is on a cash basis it's like telling someone they are failing a class in the first week of the semester because they haven't passed all their tests yet.
I see this a lot with real estate taxes. For the most part, real estate taxes are paid semi-annually. Let's say your first payment was made in February. If you have a cash basis income statement your February income statement is probably going to paint a bleak picture (or at least not as rosy). You want to see this expense spread out evenly over the course of a year so you'll be able to accurately track how your investment is doing and project how you will end the year.
Speaking from experience, for those that have investor reporting requirements, it is critical that your bookkeeping is sound. When I receive property financial reports that are on a cash basis it immediately raises a red flag. It tells me the accountants are unsophisticated, lazy, or using outdated software. Regardless, it doesn’t allow me to analyze the properties operations efficiently. When I submit my reports they are riddled with caveats that are not generally warmly received. More importantly, it raises concerns that the property itself is not properly managed. If detailed information is not provided to all parties involved how is it even possible for the property’s performance to be maximized? On the flip side when I receive detailed financials with properly accrued expenses it tells me I’m dealing with an accountant (and/or management company) that is on top of this investment. Essential information is right at everyone’s fingertips so problems can be addressed immediately. It’s especially helpful if expenses are properly capitalized and I can get an accurate look at the projected depreciation and tax loss for the year. After all, this is real estate and tax losses are big part of the investment, particularly if you are in the Affordable Housing (LIHTC) business.
There’s not much need for a detailed summary here. What’s been laid out is simple and intuitive. It’s the expectation of fundamentally sound accounting from your bookkeeper. If you’re not getting this kind of reporting, give us a call. The true potential of your investment is at stake.