Evaluating Deals Part 4: The Expenses

Expenses. Everyone hates them. If you are a Buyer, you hate them more. This is the area where Sellers fudge the numbers the most. Like a patient who comes in and tells you that sure, he has been taking all his medications. You can call the pharmacy and find out that he has been filling his prescriptions. You can check the bottles and count the pills. In the end, you have no way of knowing if he actually has been putting the right pills in the mouth at the right time and swallowing. You just have to make certain assumptions based on your prior knowledge and apply that to find what is expected. If the expected numbers don’t match, then you have found a problem, and you better negotiate.

“You’ve been telling me you are taking your metoprolol every day, yet your blood pressure is through the roof. Could it be possible you miss a dose here or there and failed to tell me?”

Sellers do the same thing all the time. They will fail to tell you about the electricity utility expense or leave off the management fee. There’s always some lame excuse, like the seller didn’t think it would be the same price for a buyer, so he helpfully left it off. Of course, omitting that one expense increases the valuation of the building (in his mind) of many thousands.

When we talk about Expenses here, we are talking about Operating Expenses, the month-to-month outflow of cash to keep the place running. Not every property will have certain expenses. For instance, some will have electric heat only and there won’t be a gas bill. The seller should be able to provide this information to you early in the process. Here’s a list of the expenses I keep on my evaluation spreadsheet:

  1. Property Tax
  2. Electricity
  3. Heat (Gas)
  4. Water / Sewer
  5. Garbage
  6. Hazard Insurance (Property Insurance)
  7. Lawn
  8. Snow
  9. Accounting
  10. Marketing
  11. Cleaning
  12. Pest Removal
  13. Legal
  14. Internet
  15. Bank Fees
  16. Elevator
  17. Telephone
  18. Management
  19. Repair
  20. Other

Debt Service, Income Tax, Capital Expenditures, Depreciation, and Vacancy are off this part as they are not Operating Expenses. There will certainly be other expenses that the seller might come up with for his particular property. I give them line items at the bottom of the spreadsheet and add them up and put them in the Other category.

Evaluating the Expenses

You will need to get receipts to verify the expenses. Get the tax records for at least three years. Tax returns won’t itemize the expenses but the total expenses on the return will give you an idea. Keep in mind that line item will be total expenses, not just operating expenses. If the numbers aren’t close than you have questions to ask the Seller. You might also get vendor receipts.

After you have a few properties you will start to get an idea about how much costs go out for a typical unit of a certain size. You will start to have a per bedroom amount for each of these expenses. At this point, you can compare your expected expenses based on number of units with the seller’s reported amounts. If they are far off, you have more questions to ask.

Look for every missing penny. $100 of extra expenses decreases the value of the property by almost $1,500! You can see how the Seller has an incentive to ‘miss’ putting in every expense. This evaluation is done even before talking to the Seller. If the numbers are close, the Seller is more likely to be giving you honest numbers in other areas. More likely, that is, but not for sure. Trust but verify. Reading here is the first step.

Dr. Equity

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