Numbers Count. Do you care? How to Determine Effective Gross Rental Income (Part 3.)

by Tim Herriage

Numbers Count. Do you care? How to Determine Effective Gross Rental Income (Part 3.)

by Tim Herriage

by Tim Herriage

The gross income must exceed expenses to produce a net income or net yield, otherwise why invest?
The basic idea behind a real estate investment cash flow analysis is to ensure the property you wish to purchase generates positive cash flow from the first month. More specifically, the rents collected from the property should pay for the monthly operating expenses of the property and pay any loans taken to purchase of the property.  Here are the cost elements that need to be understood to get to effective gross income.
If purchased properties do not generate positive cash flow from the date of acquisition, it can be argued that someone buying this property is not a real estate investor but a speculator. They are betting that appreciation will occur and cover any operating or ownership losses. These standards we are discussing here are focused on real estate investing.
Based upon much of the marketing information and analysis used by professionals and vendors of real estate investments, it is apparent that some professionals and the investing public are neither knowledgeable on the subject nor skilled in the preparation of real estate financial analysis. To address this issue this chapter discusses cash flow analysis to determine the rental income versus the rental expenses and thus the yield.
The standards were generally developed around accepted accounting principles and mirror those practices generally used in the commercial, multi-family and now the institutional single-family rental business. Do not let any software vendor or real estate professional tell you there is another way to do this. Your banker, accountant and any IRS examiner expect you to use these accounting terms and methods.
Rental Accounting Terms & Quantifying Rental Income
These terms apply equally to a single-family dwelling (house) or multi-family units.
Rental Income – This is also known as “Scheduled Rents” or “Gross Scheduled Rents.” This number represents the total rental revenue that the property would achieve upon the collection of the rents from tenants of the occupied units as well as the potential market rents from all of the vacant units. This is determined based on a 12-month period using the current market rental rates for your particular property.
In Practice – Facts inevitably intervene between theory of no vacancies and practice to cause some income shrinkage between rents “scheduled to be paid” and “actual rents collected.” 
Market Rent – This is the amount of rent that can be charged for the property given its physical and other market characteristics. Market rents are derived from known rents currently charged for a similar property in this market. Rents are generally determined by the market and competition, hence the term market rent. 
In Practice – A single family home should generate a monthly rental rate of between 1.00% and 1.33% of the purchase price to support a 100% financed transaction. For example, if you purchase a home for $100,000 you should ideally rent the home from between $1,000 to $1,300 per month to have a positive cash flow.
Future Improvements – If the property in question is currently not generating market rent, there are changes can be made to bring it into line with market rents. This means determining any costs necessary to bring the property up to par. This cost should be included on the capital investment side (or property purchase cost) of any cash flow analysis.
Gross Rental IncomeRepresents the total of Rental Income plus Other Income.
Other Income – Other Income comes from revenue sources other than rental of the property or rental units. Such income may include late fees for single-family dwellings or in the case of multi-family properties, any coin-operated equipment such as washers and dryers, soft drink and candy machines, cable TV service and electronic games. This category also includes any rents from storage lockers, boat docks, and parking for which tenants may pay.
Effective Gross Income – Represents Gross Rental Income less the Vacancy Allowance and represents the best estimate of the available funds which will be collected during the year and available to pay operating expenses and debt service.
Vacancy Allowance – It is unlikely that the single-family dwelling or all of the multi family dwelling units will be rented and occupied 100% of the time. It is important to factor the vacancies and downtime the investment property is estimated to have over a year’s accounting period. Allowances are made for tenants moving in and out of properties (lag time) or units and any time it takes to ready the unit for leasing to a new tenant, This is especially important as we have already assumed in our Rental Income estimate that 100% of our units are leased at the beginning of the year. A lack of urgency in leasing standards and tolerable vacancy levels by a property manager can negatively affect an investor.
It is important to have a good understanding of the submarket in which the property is located. For a well-located property where there is demand for rental property, use a 4% to 6% vacancy allowance. This allows for 15 to 20 vacant days per year per dwelling unit. For a less desirable location where there are multiple competing properties for lease you may allot a 15% to 20% vacancy rate that would equate to 55 to 73 days vacant.
The time it takes to lease a property will have a significant impact on the cash flow of your investment property. This is why it is important to purchase investment grade property in attractive areas where people actually want to live.
The other factor to include in your Vacancy Allowance estimate is an allowance for uncollectable rents. This is why sometimes this category is also referred to as “Vacancy and Collection Allowance”. This may be not be a factor if you are purchasing property in great locations with high demand from credit worthy tenants; however if your property is located in less desirable area with less qualified tenants, this figure could add another 2% to 3% to your Vacancy Allowance.
Leasing incentives also count against gross scheduled rent. This is the inevitable “one month’s FREE” rent. This means a loss of one month’s income over the course of the lease. This is typically applied as a lease-free month in the last month of the lease.
In Practice – If information related to vacancy rates is not readily available, many investors use a vacancy rate of between 4%-6%. This vacancy rate rule of thumb is only applicable to existing properties as if you were building an apartment building from scratch and leasing up the building for the first time the vacancy rate would be much higher.
 

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