Effects of Income & Expenses on Real Estate Valuation

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

In this lesson we will review the common sources of income and expenses that factor into and determine the price that an investor should pay for a piece of real estate.

Income and Expense Effect on Income Approach to Valuation

Tom is a real estate investor trying to determine how much he should pay for a particular house. Since Tom is buying the property for its business potential, he needs to know how much money the property can make along with how much it costs to operate. This approach to real estate valuation is known as the income approach. The income approach is used to determine the price that an investor who intends to rent the property should pay, not what a retail buyer would pay. Let's go over the income and expenses with Tom and pay attention to how these numbers affect the property value.

The more profit a building makes, the more an investor such as Tom is willing to pay for that property. Increasing income and decreasing expenses lead to greater profit. Both are significant priorities that demand an investor's attention.

Income

The most obvious sources of income are the monthly rent payments. Other sources of income in rental properties may include additional fees such as pet fees or late rent fees. If this were an apartment building, there might be income from sources such as vending machines, laundromats, or extra parking or storage space. In some leases, the landlord pays the utility bill and is then reimbursed periodically by the tenant. For example, Tom would pay the water bill and the tenants would then pay him back each month for their share of the bill.

Expenses

The house Tom is considering has a number of expenses to operate, as do all real estate investments. An ordinary expense can be expected to be paid on a regular monthly or annual basis. Tom intends to pay cash for the property, but if he needed to borrow money then he would have a monthly mortgage payment. He will need to pay property taxes and carry an insurance policy. These expenses exist whether or not a tenant has signed a lease and is paying rent. Fixed expenses are those that don't change in any significant amount for each billing period. A fixed rate mortgage is one example. Expenses that can be expected to change over time, such as taxes, insurance, and any utilities the landlord pays for are examples of variable expenses.

One critical expense that a lot of investors fail to account for is vacancy. Despite Tom's best efforts, there will be times when the property is unoccupied and not collecting rent. This can happen because the property has to be cleaned up and have maintenance performed between tenants. Perhaps the property sits empty for a while because the tenant moves out in the middle of winter. Conservative planning requires Tom to assume that the property will be vacant for some length of time on average each year, such as one out of every 12 months or possibly 10% of the time. This way, Tom isn't upside down on his budget when there is the occasional vacancy; if there is no vacancy, then he realizes a little bit of extra profit.

From his experience as a homeowner, Tom knows homes are in constant need of repairs. Capital expenses include the costs of keeping the building structure in marketable condition. His budget should include a replacement allowance to account for any capital items that he should expect to have to pay for soon, such as a new roof.

Valuation Effects

Let's say the house Tom is looking at purchasing is listed for sale at $100,000. It could realistically rent for $1,200 a month. Tom has a rule of thumb that he won't buy a property unless the estimated profit each month exceeds one percent of the purchase price. The desired profit will vary by each investor; some will want to see cash flow each month while others may be content with just covering expenses while waiting for long-term appreciation of the property.

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