FINANCIAL TERMINOLOGY

So, what are these ‘NUMBERS’ everyone keeps talking about?

Of course, we can get as detailed and complicated as you want. But from my 37 years in the real estate business, I have found that there are only a few basic terms, or ‘numbers’, that really matter to investors. I’m going to try to present them in logical order, starting with INCOME, followed by EXPENSES, then the resulting NET. Next up is DEBT SERVICE, then RETURN ON INVESTMENT (roughly in the same order that they occur in nature). Simply put, no matter how complicated a set of books, it always boils down to the same thing: Income minus Expenses equals Net Operating Income (NOI). Out of that, you pay your Debt Service (ie: Note payment). Your Net Income is divided into the total money invested equals your Return on Investment. It’s really that simple. But, as always, there’s more to it than that:

FINANCIAL TERMINOLOGY

“INCOME”

GROSS INCOME – Gross Income is the total amount of the Actual Income that comes in from all sources, including Space Rent, Unit Rent, Storage Income, Laundry Income, Utility Income, Security Deposits collected, New Tenant Application Fees, Late Fees etc.

GROSS SCHEDULED RENTS – Gross Scheduled Income is the maximum amount of Rental Income that you could receive if every unit were full all the time, and you were collecting 100% of it when due.
WHAT TO LOOK OUT FOR: Many Sellers and/or Agents will quote Gross Scheduled Rents in place of the Actual Income, which is generally less, due to vacancies, collections, etc.

PROFORMA INCOME – Proforma Income, also spelled Pro Forma, is Projected Income if certain things happen in the future (ie: a Rent Increase, or filling Vacancies). Proforma Income is usually higher than Actual Income & is sometimes unattainable, simply because too many things must occur perfectly over time, every time.
WHAT TO LOOK OUT FOR: Many Sellers and/or Agents will quote Proforma Income as if it were Actual Income. Always look for the word ‘Proforma’ or ‘Pro Forma’ & don’t be afraid to ask if the numbers they are providing are Actual or Proforma.

EXAMPLE

INCOME STATEMENT:

“EXPENSES”

OPERATING EXPENSES – Also referred to simply as “Expenses”, any expense that it takes to operate your Business, Investment Property or Mobile Home Park, is technically an Operating Expense. These can include Management, Maintenance, Salaries to Employees, Advertising, Utilities, Insurance, Property Taxes, Legal (Evictions), etc. Operating Expenses do not include Capital Improvements or Debt Service (Mortgage Payments).

CAPITAL IMPROVEMENTS – Technically, Capital Improvements don’t show up as an Expense on an Income & Expense Statement. These are supposed to be one-time expenses for things that improve the property in some way; not normal, regular operating expenses. An example would be paving a gravel driveway, clearly an improvement. Borderline ‘improvements’ are things like a new roof, which could be seen as a repair, since there was always a roof. Unless the new roof is an improvement, in some way.

Defining it one way or another can affect the ‘Net Income on Paper’ & therefore the value of the Property. As an expense, it hurts the Net Income, as an Improvement it doesn’t, on paper. Income taxes are also affected (consult an expert), as Capital Improvements are added to the Base Value of the Property when calculating Capital Gains.
WHAT TO LOOK OUT FOR: Often Sellers and/or Agents will define certain Operating Expenses as Capital Improvements so that they don’t have to count them as an Expense. This improves the NOI on paper, making the Property appear to be worth more.

PROFORMA EXPENSES – Proforma-‘anything’ is always an estimate, or a projection of what it could be if certain things were to happen just right. In the case of Proforma Expenses, these would usually be lower than Actual Expenses because certain cost-saving measures were either proposed, or are ‘in the works’. These could include cutting back on salaries, changing utilities or trash pickup, fixing a big water leak, getting a reduction in property taxes, insurance, etc.

EXAMPLE

EXPENSE STATEMENT:

EXPENSE RATIO – This is one of those “Rules of Thumb” we use in the MHP business. It’s a rough formula that we use to quickly judge Mobile Home Parks. Divide the Expenses into the Income & get a percentage of the Income that is used up by Expenses. This is the Expense Ratio. Most well-run Mobile Home Parks run at 30% to 40%. In the example above, Expenses of $84K equals about 39% of the $216K Income, so we’d say “It’s running at 39%”. When we don’t know the expenses up front, we usually estimate them at around 40% of Income, or 50% if we want to play it safe, just to get an idea of what the park makes or ‘nets’. This is a ‘rule of thumb’ only and by no means accurate.

WHAT TO LOOK OUT FOR

Have you ever heard the expression, “if it’s too good to be true…”? Well, if you’re looking at a park to buy, and the numbers the seller, or his agent, has provided you show the Expenses running at 25%, it may be too good to be true. Either they’re giving you ‘massaged’ numbers, or the seller has been running it himself for years.

In these cases, the seller may live near the park and manages it himself. He also does all the maintenance himself, and pretty much everything else that you’re going to have to hire people to do. So, even if he really is running it all himself for 25% of Gross Income, you won’t be able to run it for less than 35 or 40%, just like everyone else. Again, there are always exceptions, but looking for them is not an efficient way to make money.

Stick with the basics and you won’t be far off. In this case, that means assume it’s going to cost 35% to 50% to operate a typical park. MHPs with few or no park-owned homes (POHs) generally run cheaper dollar-wise. But, if done right, POHs can produce so much income that they vastly outweigh the added expense, so the Expense Ratio as a percentage, can be lower than parks with no POHs. Again, every case is different.

“NET”

NET OPERATING INCOME – Also known as ‘the N.O.I.’ or more commonly ‘NOI’. To arrive at the NOI of a Property, take all the Actual Income & subtract Operating Expenses (but not Debt Service or true Capital Improvements). So, the NOI is what the property ‘Nets’, on a regular ongoing basis, before considering financing. Unless otherwise specified, it is expressed as an Annual figure, that is the amount the Property Nets in a year.

NET INCOME – Also called “Net” or “The Net”, or “Net-Net”. It refers to the Net Operating Income (NOI) after Debt Service. If the Property is financed, this is the real Net that is left over each year, after paying all the Expenses and making the note payment.

OWNER DRAW – An Owner Draw is the amount of the Net Income that the Property Owner chooses to take out for himself each month or annually. He may choose to take out every dime as it comes in, or leave some in the business as a Reserve. Some choose to place themselves on a steady monthly income. It’s entirely up to them.

“RETURN ON INVESTMENT (ROI)”

CAPITALIZATION RATE or CAP RATE – Cap Rate is short for Capitalization Rate. Known most commonly as the ‘Cap Rate’, it is essentially the return (expressed as a percentage) an Investor would get on a given Property, if he paid cash (no financing). To arrive at the Cap Rate, divide the NOI (Net Operating Income) into the Sales Price of the Property. It will come up on a calculator as a decimal. For instance 0.08 would be an 8% Cap Rate or an ‘8-Cap’. This means the annual Net from the Property equals 8% of the Value or the Price paid for the Property. On the sale, the higher the Cap Rate, the better for Buyers & the worse for Sellers. In other words, the higher the Cap Rate, the lower the price. The lower the Cap, the higher the price.

ADJUSTMENTS

Often Capital is added after the purchase. For instance, if you purchased a MHP for $700,000 then bought 5 additional Mobile Homes to put in for a total of $50,000, then you would divide the NOI into $750K, the total amount invested, rather than just the purchase price.

WHO CARES ABOUT CAP RATE?

It’s a valid question. If the Cap Rate is essentially the return of the property as if there were no financing against it, and most properties will, in fact, be financed, they why is it relevant? Because it compares apples-to-apples, so to speak. Financing is different on every deal, and for every buyer. It must be taken out of the equation before properties can be compared for their own merit, which is the park’s Return on Investment, irregardless of financing. So, it allows one MHP to be compared to another on their abilities to produce a return, relative to each other.

HOW CAP RATE EFFECTS PRICE & VICE VERSA

There are basically 3 numbers here: 1.) The NOI; 2.) The Value/Price/Total Investment; and, 3.) the Cap Rate. The one number that is fixed is the NOI, that’s a hard number, we know what it is (refer to your Profit & Loss Statement).

As a seller, you can pull a price out of the air, or you can calculate it based on a given Cap Rate that you are offering investor/buyers. If your NOI is $100K annually, and you want to offer your property at an 8% Cap Rate (called “an 8-Cap”), then the price would be $1,250,000 ($100,000 / .08). But, investor/buyers may want a higher rate of return than that (think about it, if you were an investor/buyer, you’d want the best return you could get, wouldn’t you?). So, maybe you bite the bullet and offers it at a 9-Cap, yielding a price of $1,111,111. In the end, the buyer wouldn’t settle for less than a 10-Cap, for a price of $1,000,000.

So, as you can see, the higher the Cap Rate the better for the investor/buyer and the worse for the seller. To get the higher return when the NOI is a fixed number, the price must come down. In stronger real estate markets (like pre-2008) investors were willing to accept much lower Cap Rates than they are today.

IMPROVING THE CAP RATE

If the NOI is fixed, then the Cap Rate can be improved (made higher) by lowering ,BR>the price, which makes it more attractive to Buyers. Raising the price lowers the Cap Rate, because an Investor would have to pay more for the same Net, thereby dropping the Rate of Return on that Investment.

WHAT TO LOOK OUT FOR

Sellers and/or Agents sometimes ‘juggle’ the Income and/or Expenses to improve the Cap Rate. Make sure you are looking at actual, verifiable numbers.

SO, LET’S LOOK AT THE FORMULA, SO FAR:

EXAMPLE

INCOME & EXPENSE STATEMENT:

“DEBT SERVICE”

Debt Service is technically the amount of money it takes to pay all the Mortgage Payments (usually expressed as an annual figure, but it could be monthly if so specified). Depending upon the structure & Terms of the Financing, Debt Service could include only Interest (called an Interest-only loan), or Principal and Interest (called an Amortized loan). It may be expressed either as a Monthly figure or as an Annual figure. It is essentially the total of your monthly payments for the financing on your park for a year. Debt Service should never show up in the Expense column. It is always taken out of of the NOI as a separate entry, under the line. This way it doesn’t affect the NOI.

“CASH-ON-CASH RETURN”

If the Cap Rate tells you how well the Property performs, Cash-on-Cash Return tells you how well your money performs. Divide the Net Income (after deducting Debt Service) into the amount of Cash you have Invested in this Property to arrive at a percentage. Good Cash-on-Cash Returns begin at 9% these days & go up to 15%, 20%, 25% or even higher. Leverage (financing) is what makes this possible. Cap Rates are fine, but most investors want to know how much they are going to make on their money.

EXAMPLE

Simply put, you are receiving $84,480 Cash each year on your $528,000 Cash investment, which works out to a 16% return, Cash-on-Cash.

HOW CAN YOU MAKE A 16% RETURN ON A 10% CAP RATE?

THE POWER OF “LEVERAGE”

In a word, it’s “Leverage”. In this case, it’s using someone else’s money to help pay for it (60% Loan-to-Value) & that’s Leverage, you didn’t need to have ALL the money yourself. But it goes much farther than that. In the above example, the Property is generating a 10% Cap Rate, but you borrowed 60% of its value, $792,000, at only 6%. So, you actually make ‘the spread’ between the 10% the Property generates & the 6% you borrowed the money for, on that portion of the deal, or 4% on $792,000 ($31,600). You were already earning 10% on your actual Down Payment, $528,000 in this example ($52,800). When you add the the two numbers together, you get your Net Income of $84,480, but you only had the $528K invested in your own cash, which boosts your Rate of Return on this Cash to 16%. It’s a textbook example of using making money on someone else’s money.

USE SOME LEVERAGE OF YOUR OWN

Knowledge can be a very powerful leverage. This is a complicated subject, don’t guess, or wonder what to do next. We deal in numbers, and finances, and getting our clients the highest rates of return possible. And we can help you to do the same thing. No matter what your financial goals, the Positive Cash Flow provided my Mobile Home Parks can help you reach those goals faster. Call me, Sierra Tallone, today with your questions. I have the answers: (925) 413-7704 or email at sierralynntallone@gmail.com.