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Reconstructed Income & Expense Statement for Apartments

Instructor: Joseph Alfe

I hold a J.D., LL.M. (real estate) and have 15 years executive experience in the areas of real estate finance, acquisition, and disposition.

Building financial models is just as important as brick and mortar. This lesson will discuss reconstructing income and expense statements for multi-family real estate.

Reconstruction

Say Irving the investor is working with Stacie who wants to sell her 10 unit apartment building. He receives an Income & Expense Statement that reports rental income as:

Rental Income $1,000/mo * 10 units = $10,000
Vacancy Rate of 3% $1000 * 0.03 = $300
Gross Income $9,700

However, Irving is a prudent investor and knows not to rely on a seller's representation of what the property's income or expense actually is. There might be market changes, mistakes, misrepresentation, incorrect assumptions, or a Stacie's income and expense statements may not accurately depict investment performance.

Irving needs to reconstruct these statements, in other words, to apply more accurate numbers to better predict financial performance. Let's follow how he'll do this.

Examining Reported Rental Income

When examining a seller's set of financials, care must be taken to adequately determine if the rental income provided is in-line with market conditions. Frequently, especially with long-time renters, income is low and can be adjusted.

Proper due diligence of market conditions uses one of the property valuation methods: Income Approach, Sales Comparable Approach, Gross Rent Multiplier, or Cost Approach. These methods use market data aggregators such as Multiple Listing Service (MLS) or Argus (a private commercial platform) or other data collection services to produce accurate estimates of income.

Vacancy Rates and Collection Losses

First, Irving must verify the vacancy rates and collection losses with market data. He searches and compares other like properties that have sold in the last 90 days within Stacie's property's geographic area. He uses only data from sold properties so he can get accurate information rather than estimates.

He's also careful to limit searches within the immediate neighborhood to avoid comparing unlike properties. Even a few streets over can mean a totally different neighborhood valuation.

Once Irving determines what the market data provides for accurate vacancy and collection losses, he will use a simple formula to plug these numbers into his reconstructed Income & Expense statement.

Let's say the market data reveals that comparing 5 like properties provides a 5% vacancy/loss rate for the area. From the Income & Expense statement, Irving sees that the rental income is $10,000. The calculation to apply is then:

$10,000 * 0.05 = $500

Right? Not so fast. First, Irving must also reconstruct the rental income using the same technique described above.

Reconstructing Rental Income

Using the same data sources that determined vacancy/loss rates, Irving compares 5 like properties and finds that the average rental lease per unit is actually $1,200 per month. Therefore, Stacie's income reporting must be restructured as follows:

Rental income = $1,200 per unit/month * 12 months
= $14,400

He discovers that the new vacancy rate is 5% from this new rental income number, expressed as:

Rental Income $14,400
Vacancy Rate of 5% $14,400 * 0.05 = $720
Gross Income $13,680

Irving isn't done restructuring yet. He now must turn his attention to the operating expenses provided by Stacie and perform the same due diligence.

Operating Expenses

Operating expenses typically cover vacancy rate (also determined with market data), management services, scavenger, utilities, maintenance, insurance, etc. These expenses can be fudged to look lower than they really are, or bad management and deferred maintenance could skew numbers. Irving does his own research and estimates up-to-date, realistic expenses.

Tax Expenses

Tax expense is a critical expense often overlooked by novice investors. Once a property is sold, it is reassessed, frequently altering tax expenses drastically. Research into the municipal taxing agency's multiplier calculation and tax rates can predict future tax expenses, as most property taxes are paid in arrears.

From these numbers, after-tax cash flows (ATCF) can be calculated using depreciation. Here, allowable depreciation and interest deductions often exceed income Return on Investment (ROI), effectively eliminating tax burdens. This changes after a few years to a positive tax expense, and checking allowable depreciation and interest deduction in your state will help Irving make this determination.

Restructuring Operating Expenses

Now Irving can write his restructured operating expenses as:

Mortgage P&I (principal and interest) = $2,200

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