We talked about the Profit and Loss statement in part 1. Today, we will go deeper into the Income side. When we think of single-family rentals, there is usually only one line under Income: the rent. Simply take the monthly rent and multiply it by twelve. It couldn’t be easier. In the multifamily realm, it gets tougher (a little).
Now that you are evaluating apartments, you have to think about what you are getting when you evaluate the financials the seller is giving you. There are going to be a bunch of units rather than just one. These units might be different sizes and arrangements. This is called the unit mix.
Many apartment buildings have a mixture of different unit types. Usually these are distinguished by number of bedrooms and bathrooms. The next differentiation might be square footage. For some places, a certain location in the building will give a better view and will command a higher rent. The seller will enumerate each unit type and assign a rent. Ideally, this will be what the seller is getting for income. When reported by sellers, some will sneakily give you what they think the apartment should be getting in rent. They might say something like “I keep the rents low because I have great tenants.” Don’t believe it. They haven’t raised the rents for whatever reason. The market may bear more, but you don’t know that. Believing what the seller is saying may mean you’ll pay too much. Ask for the actual income and work with that. This will be easy to verify, but we will talk about that later.
Now, take all the unit types, their rents, multiply by 12, and add them up. This will give you the Gross Scheduled Rent. Some sellers call this the base rental income, or just income.
Gross Scheduled Rent
This is the annual income that is brought in by rent in the hypothetical case that there is no vacancy or credit loss. If tenants never left and always paid their bills, this would be the amount of income annually. Unfortunately, the more units you have, the more are going to be vacant at any one time. And, the more tenants will be missing rent payments. This needs to be accounted for.
There can be a lot of line items here. This could be garage rent, appliance rent, pet rent, late fees, and laundry income.
It seems like this is an expense, but it really isn’t. It is money that you didn’t bring in because you didn’t have a tenant. It shows up as a negative line item under Income. If the seller is giving you actual number (you usually have to demand this) they will show you the total vacancy loss. This is just the rent that didn’t come in over the entire property because of vacancy. When tenants aren’t in units we call it Physical Vacancy. High physical vacancy might mean the rents are too high, or unresponsive management, or a building in need of updating. Buying a high physical vacancy building may mean you have to spend a lot in updates and advertising, and decrease the rent. Don’t pay too much!
Very similar in the idea to Vacancy Loss, the Credit Loss is what the seller didn’t bring in due to tenants missing rent payments. This is a very important line item because it tells you how good the seller is at collecting rent. Of course, economic conditions like a pandemic can affect this as well. If tenants can’t pay because they have no jobs, then the loss goes up here. When tenants aren’t paying we call it Economic Vacancy. High economic vacancy means that the owner is not doing a good job collecting the rents, economic conditions are bad, or the owner is not screening tenants well and getting poor credit tenants in. Buying a high economic vacancy property may mean you have to do a lot of evictions.
This line item is conveniently left off many seller’s statements. This is the amount of money the owner paid to entice prospective tenants. Drive around town and you will likely see “Three months free!” or “Your last month free!” or some other concession that the owner makes to get someone in the unit. These all represent lost income. While concessions aren’t bad to use, they decrease income and need to be reported.
This is the total income that the owner was paid back by the tenants. This might be programs where the owner pays utilities, but bills back some of it to the tenants.
Effective Gross Income
Total up all the previous items and you arrive at what you normally think of as the income. This will be the amount that was actually received by the owner. Gross means it is before expenses. This is the line to which you subtract all the expenses to arrive at the Net Operating Income.
Take the time to obtain all these from sellers. They are highly motivated to maximize what they are reporting for income because it raises the NOI and the building’s valuation. No multifamily property ever achieves all the rental income that is scheduled and you need to remind the seller of that. Getting this information is done in diligence, which we will talk about later.