When you're buying a home, you may be looking for a modern kitchen or a large master bath. When you're buying an investment property, you want to look for an attractive real estate income statement. You may want to invest in a specific type of property or in a certain area, but the income statement is going to tell you whether it's a good investment.
Reviewing real estate income statements
No two properties are the same, and the income and expenses can vary greatly from one to the next. A real estate income statement can tell you a lot about an individual property and how well you can expect it to perform as an investment.
The income statements will give you the information you need to calculate how much money you can make from a property. It's also useful to decide how much you should pay for the property.
Lenders will also review these income statements when deciding whether to give you a loan to purchase the property.
Knowing which statements to look at, and understanding the information they provide, is an important skill when you're deciding which property to purchase. This skill will also help you keep a closer eye on your current properties to keep them profitable.
Profit and loss statement
A real estate profit and loss statement simply breaks down the income and expenses of a property and shows you how much the investment is profiting or losing.
The first section of a profit and loss statement shows the gross income for the period. The gross income includes rental income along with any other types of income received from the property. Other forms of income may include pet fees, laundry, late fees, covered parking, etc.
The different sources of income will normally be listed separately as their own line item. Each line item is added together to show the total gross profit.
The next section of a profit and loss statement will list out all of the different operating expenses. Operating expenses are the money that was paid to operate the investment property.
Operating expenses will vary some, depending on the type of property. For instance, commercial real estate will likely have expenses you won't see for a single-family rental property.
The most common real estate operating expenses are:
- Property taxes.
- Property insurance.
- Management fees.
- Cleaning and maintenance.
- Leasing commissions.
- Licenses and permits.
- Professional fees.
- Auto expenses.
- Travel and meals.
- Lawncare and snow removal.
- Garbage removal.
- Loan interest.
There are certain expenses that you can "add back" for the purpose of understanding how much the property is actually making. The two most common expenses you can add back are depreciation and interest. These are additional expenses the Internal Revenue Service (IRS) allows you to deduct on your tax returns.
Depreciation can be added back because it's not an annual expense. Depreciation just allows you to reduce your income tax liability.
Loan interest is an expense that will be different for each investor. To accurately analyze a property, you'll want to add back the current interest expense, then do your calculations based on what the interest will be on your loan.
Net operating income
The last section of a profit and loss statement will show the net operating income (NOI). The NOI is the profit, or loss, on the property. The NOI is the number you'll use for your calculations when analyzing an income property.
You'll divide the net operating income by the purchase price to find out what the capitalization rate is. You can also divide the net operating income by the cap rate you want to figure out what the right purchase price for you would be.
The net operating income is also an important number for lenders when they're deciding whether to give you a loan on the property. The lender will use the NOI to calculate the debt service coverage ratio (DSCR).
The DSCR basically tells them whether the property nets enough income to be able to make the loan payments. They usually want to see that the property makes more than it needs to in order to make the loan payments. The lender wants to see that you can make the loan payments as well as cover any unexpected costs or handle any vacancies.
To calculate a DSCR, you divide the NOI by the annual debt service. The annual debt service is the total amount you will pay in a year on your loan. If your loan payments are $1,000 per month, your annual debt service would be $12,000.
For example, if the NOI is $15,000 and your annual debt service is $12,000:
$15,000 / $12,000 = 1.25. Your debt service coverage ratio would be 1.25.
You'll also use the NOI to figure out what your net cash flow will be. Subtracting your annual debt service from the net operating income will tell you how much money you'll actually see at the end of the day.
Types of profit and loss statements
There are different types of profit and loss statements you can use to see the financial performance of an investment property.
Year-end: This is a basic profit and loss statement that shows the income and expenses for a calendar year.
Year-to-date (YTD): A YTD statement shows what the total income and expenses are from January 1 of the current year through the end of the previous month. For example, on June 9 you would see an income statement that shows what the income and expenses were from January 1 through May 31.
Trailing 12-month (T12): A T12 goes back 12 months from the most recent month. For instance, on June 9 you would see the income and expenses from June 1 of the previous year to May 31 of the current year.
Month-over-month: Any of these types of real estate income statements can also be shown month over month, so you can see what the total income and total expenses were for each month instead of just the total for the period.
As a real estate investor, you'll typically want to review each of these statements to compare how the property is performing now versus six months ago or a year ago. You may also want to look at the past three years of year-end profit and loss statements.
Some things to look out for on a profit and loss statement are drastic changes in the income or any of the expenses. A decline in income is obviously a bad sign. Any significant increases in any of the expenses might mean that there are some issues to address.
You also want to make sure the maintenance and repairs expenses aren't too low. Sure, lower maintenance and repairs expenses mean a higher net income, but it may also mean that things have been neglected. If very little repairs have been made, you may find yourself having to pay for those once you purchase the property.
A balance sheet simply compares an entity's assets versus liabilities. It's basically a personal financial statement for the property.
A balance sheet may not be extremely relevant when you're doing your due diligence on a property, because the liabilities will change once you purchase the property. However, it's a good statement to keep track of once you own the property.
The asset column will list the fair market value of the property. The liabilities column will list the principal balance due on any loans, as well as any other outstanding debts. The liabilities are subtracted from the assets, and the bottom number is the owner's equity in the property. As the loan is paid down and the property value increases, the equity will increase.
Lenders will often want to look at your balance sheet for all of your properties when you're applying for loans to acquire more real estate. The lender will want to see how much equity you have in your properties. Having more equity means they have more options to collect from you if you default on a loan.
As you build equity in your real estate portfolio, you become less of a risk to lenders when trying to finance more properties. Building equity over time makes it easier to get financing to acquire more properties.
A pro forma is what you expect your profit and loss statements to look like in the future. You know how the property has performed in the past, but you need to have a good idea of how it will perform moving forward.
To create a real estate pro forma, you'll estimate the gross income based on what the current rents are and how much you expect to be able to increase them each year. You may also look at what market rents are in your area if you plan on rehabbing the property and use those numbers as your projection.
You'll also have to estimate your operating expenses. Your property taxes are likely to go up some once you purchase the property due to uncapping. A lot of other expenses will remain pretty stable and increase with the rate of inflation.
This will give you a projected NOI. You'll use this number to calculate your capitalization rate and DSCR, just like you did with the historical numbers.
It's smart to be conservative with your pro forma. You can hope for the best-case scenario but have to be prepared for higher expenses and potentially lower income. You shouldn't have to stretch the numbers to make it work. If the deal still looks profitable when you're extra conservative with your pro forma, it's likely a good investment.
Putting it all together
A real estate investment can only be successful if the numbers work in your favor. Knowing how to review a real estate income statement will help you make smart investing decisions as well as keep a close eye on your investment. As you become more familiar with reviewing real estate income statements, you'll be able to quickly spot anything off with a property you're considering buying as well as with your own properties.
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