Spirepoint Properties

Analyzing a Real Estate Deal (Part 2)

This is the second in a series of articles explaining exactly how we analyze our deals. In the last article, we discussed what types of income we consider, as well as some calculations for Gross Operating Income (GOI) and Effective Gross Income (EGI). In this article, we'll discuss the expenses we include, as well as the verification process for all the numbers we're collecting.

Expenses
While each building can include different expenses, there are generally a few main categories that are common across most of them:

  • Maintenance - All buildings will require some form of maintenance sooner or later. We factor at least 10% for older buildings, less for newer buildings.
  • Management - Always factor in something, even though you may manage a property yourself. That way, if you change your mind, you will already have factored in the cost into your deal. We typically use 4%-10% depending on the building.
  • Property Taxes - While it's okay to use the seller's tax bill to get a ballpark of what the amount will be, always base it on the next year's tax assessment (if available).
  • Insurance - Don't assume that just because the seller has a cheap insurance policy, that you'll be able to get the same. Get quotes from multiple companies, including the one the seller used.
  • Water/Sewer - Look at the historical usage for the property over 1 or 2 years for a good idea of the real cost. Make sure you have the same number of tenants as used for the historical figures.
  • Heat - This can sometimes be paid by the tenant, but if not, as with water, look at 1 to 2 years of historical usage. If the furnace is old, this figure can sometimes drop as much as 40% with the installation of a new high efficiency furnace.
  • Electricity - This is usually paid by the tenant, but there can be common areas you have to pay for.
  • Misc - Depending on the property, you may want to include amounts for lawn care, snow removal, condo fees, garbage collection, etc.
Add up the above numbers to determine your Total Operating Expenses (TOE).

Take a look at one of the Cash Flow Proformas in the Real Estate Deals section of our website to see this formula being used on a real-life property.

Verification
Once the income and expense analysis is complete, many investors forget to do the most important step - verify the numbers are accurate! Why is this important?

Sellers, realtors, appraisers... they're all human beings who can make mistakes. More importantly, some people exaggerate income and understate expenses to get a higher sale price (if the property makes more money, it's worth more). When would you rather know about inaccurate numbers -- before you buy or afterwards?

Verifying the numbers is usually a condition of your agreement of purchase and sale, and it usually takes place after the offer is accepted. Verification consists of obtaining the following items:

  • Tenant acknowledgements - This is usually a letter that the tenant signs stating what they pay in rent, if any discounts apply, any arrears owing, problems they have, etc. While time consuming to collect, it is the most accurate form of income verification for a rental property. Alternatively, rent rolls can be provided by the seller along with copies of all leases.
  • Utility statements - The amounts shown in the listing almost never match the actual amounts. So review each and every statement, watching for missing months, and add them all up. It's sometimes a challenge getting all the statements from the seller.
  • Property tax bills - As mentioned previously, try to get the current year's tax bill but always adjust the amount for the tax increase for the following year.
  • Insurance bills - Look for the previous year's bill, but as mentioned, always obtain quotes to get an accurate estimate of what the expense will be.
  • Property management contracts - If you decide to use the same company as the vendor, examine the contract and fees in detail. Remember to include leasing fees. Otherwise, use a company you know and trust.
  • Repair bills - This is a tricky one. Some landlords will hold off on repairs for long periods of time. They sell you the building and shortly afterwards, everything breaks. Watch for regular maintenance being done. If there are no bills, be prepared for large expenses! Ensure your property inspection is very thorough.
  • Seller's Tax Return T776 Schedules - While some vendors may stretch the truth on property listings, they're less likely to do so with CRA. Tax returns may be hard to get, but if you can, cross-reference the amounts with your other verification steps.
When you've finished this task, you'll have a much clearer picture as to what the actual income and expenses are for the property. You'll probably wonder where the vendor found all his numbers! If the totals are worse than you expected, you can go back to the vendor and ask for a discount based on the true numbers. If the vendor isn't willing to budge, don't be afraid to walk away!

Next time we will discuss financing in detail, as well as some of the calculations that we use.


This article is copyright © 2004-2010 Spirepoint Properties. All rights reserved.

Paul Blacquiere and Joanne Beehler are full time real estate investors and have been investing in Ottawa, Ontario, Canada since 2002.  They are owners of Spirepoint Properties, a Canadian real estate investing company dedicated to making real estate investing easy.

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