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What You Should Know about Analyzing Investment Properties for the Real Estate License Exam

As a real estate agent (and for Real Estate License Exam purposes), you’ll be called upon to provide information to investors about investment properties. Building condition, maintenance issues, and location issues are important in any real estate purchase, but much of the information in a real estate investment is about income and expenses for the property.

Although you probably won’t conduct an investment analysis yourself, you’re still expected to know something about the numbers and how they’re analyzed by investors. The agent’s role is to provide the necessary information to the potential investor so that the investor or the investor’s accountant can perform the analysis.

The beginning of a real estate investment analysis is the operating statement, which also is called the income and expense statement. This statement, which usually is prepared to keep track of finances for the building and for income tax purposes, tracks the actual annual income and expenses for a building.

The income tracked on the operating statement is called the contract or scheduled rent, which is the actual rent paid by the tenants. Because the operating statement is used for income tax purposes, it usually contains information about depreciation and debt service (mortgage payments).

The second piece of information in a real estate investment analysis is the current rent roll. The rent roll is information about the leases that exist, the rents for each lease, and the term or length of time remaining on each lease.

A third piece of information in the analysis is the market rents, which are what the market would pay for the kind of space or apartment in the building. Market rents may be different from contract rents for that particular building.

The final piece of information in an investment analysis is one that’s created by the investor or the person doing the analysis on the investor’s behalf. Called the pro forma, it’s a financial statement of the building’s potential income and expenses. By looking at the market rents for the kind of space being leased rather than the scheduled rents, a projection is made of the investment’s future.

A few noteworthy characteristics of the pro forma are

  • Market rents, rather than actual or contract rents, are generally used, but actual rents for existing leases may also be used under certain circumstances.

  • Income figures are based on the building being 100 percent occupied, even if it currently isn’t, and the figures may include other building income such as that from laundry machines.

  • Other income, such as income to the building for something other than the regular rents (for example a microwave antenna rental on the roof) is usually added after the vacancy and collection loss calculation is applied.

  • A vacancy and collection allowance is used, even if the space in the building is 100 percent rented.

  • Expenses generally are rounded off.

  • All figures are annual.

  • Depreciation and debt service aren’t accounted for. The value of the depreciation may vary with the owner’s financial position, and the mortgage is more about the owner’s financial position than the value of the building.

The basic numbers that you’re looking for in a pro forma are the net operating income and cash flow. The basic formula for finding net operating income on a pro forma follows, but it will help you understand the formula if you first know the details behind some of the numbers called for in the formula.

  • Potential gross income: Market rent at 100 percent occupancy; may also include other building income such as laundry machines or separate parking space rental

  • Vacancy and collection loss: Used to account for periods of rent loss due to vacancies or bad debts; determined by examining other pro formas for the number they use

  • Effective gross income: Also called effective rental income

  • Operating expenses: Don’t include depreciation or debt service

  • Debt service: Refers to the mortgage payment

Potential gross income – vacancy and collection loss = effective gross income

Effective gross income – operating expenses = net operating income

Net operating income – debt service = before-tax cash flow

If you calculate the taxes owed on this cash flow and subtract it, you get what is called after-tax cash flow.

In analyzing a building for investment, the return (the money you’re going to make on your investment as well as the money you’ll get back that you invested — return of investment) is calculated for a one-year period and for the project holding period, which is the length of time the investment will be owned.

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