In the first part of our series on Buy and Hold investments, we looked into various tricks that can help you quickly narrow down the properties to invest in. But when it is time to decide, there’s no substitute for a profit and loss statement (also called an income statement in some circles).
A profit and loss statement is basically a list of rent income and expenses related to the property. Expenses incurred by landlords might include property taxes, utilities, insurance, and property management fees. Since these are all paid every month, a P&L statement typically has both monthly and yearly figures.In part one, we cautioned you about using pro-forma statements. Why? Take a look at a pro-forma and an actual P&L statement: The pro-forma P&L omits two very important items: the maintenance reserve and a vacancy reserve.
Why are these important?
Things break down in real life. As a landlord, you might find yourself shelling out money for repairs and maintenance, either expected or unexpected. This is cash out of your pocket, and makes the investment less attractive. The maintenance reserve is a very real expense that you should look for in a P&L statement.
It is not realistic to expect a property to be fully rented 30 days per month, and 12 months per year. And even if you are lucky enough to get tenants so quickly, you can’t expect prompt regular payments. Inevitably, you can expect delays in payment, or if you’re really unlucky, deadbeat tenants. All of these reduce the rent you collect. Any P&L statement without this reserve is overstating rent income.
One final note about the vacancy reserve – this depends on where the property is located. A rental in Beverly Hills is probably going to be fully-occupied all year round, with tenants who pay on time. A rental in inner-city downtown Detroit? Not so much, which means your vacancy reserve should be much higher here.
The bottom figure you’re getting is a percentage. There are actually two measures, return on investment (ROI) and the capitalization rate (cap). The ROI divides net income (which is rent minus all expenses and reserves) by the acquisition cost of the property. The cap rate divides net income by the property’s current value. Obviously, the bigger the numbers are, the more attractive the investment.
However, there is also such a thing as “too good to be true”. Don’t believe any cap rates above 12%. In fact, our rule of thumb is we discount any cap rates people tell us about by 50%. If someone tells you about this great 10% cap investment, mentally divide that by two. If you’re happy with 5%, good for you – the rest will all be gravy.
Now that you know how to scan through a set of investments, and finally use a P&L to evaluate each investment, the final step is to assemble a capable team. Next time, in the third and final part of this series!
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