Commercial Real Estate is a great avenue to invest your money. But as an investor you need to know what you are putting your money on. You can always hire a consultant but to know the numbers yourself is the key to your success. One of the challenges for a new investor is reading a financial statement and making sense of the numbers. So to learn how to read and understand a financial statement is very important. There are a vast variety of commercial properties available in the market and each one of them has its own uses. So the financial statements tend to differ depending on the commercial property you are investing in. In this writing we will be focusing on Multifamily.
As an investor what do we all really care about? The bottom line! In other words, what goes in my pocket once all the monthly expenses have been paid. It is easy to figure this out if you are investing in a single family home. But when you are talking commercial property, the financials are a little more complex. That should not be the reason for you not to invest as a commercial property can provide a very lucrative opportunity for you. I have done my best to break down the expenses and income line items for a multifamily property. Please keep in mind some of these line items maybe named differently in some cases but the meaning of it will not change. So analyzing the statement with care and having an open channel of communication with the current owner is very important.
So let’s begin. Two important acronyms that you will see a lot when dealing with all commercial investments are:
- DSCR: “Debt Service Coverage Ratio” or DCR. Essentially this is a mini-metric a bank uses to qualify you for a loan. Banks care a lot about this acronym, so be able to speak the language of “DSCR/DCR” to lenders. Actually DCR is very simple; much simpler than its name. In a nut shell, DCR is the borrower’s ability to pay debt service (principal, interest). The simple formula to calculate it is: Net operating income divided by debt service. Banks want to ensure that you can pay back the mortgage they lend you. RULE OF THUMB: The higher the DSCR, the easier it is to get a mortgage.
- Net operating income: It is simply the income generated from the property after deducting all the expenses. This will make more sense after reviewing the below scenario.
Multi-Family Financial Statement
A property that has more than 5 units is considered a multifamily property. Multi-family properties –apartment and condo buildings– are in high demand in the commercial Real estate market, as a lucrative investment. Types of properties: Apartments, mobile home parks and co-ops.
Below is a breakdown of line items from a financial statement of a 200 unit apartment building:
The 8 metrics below will help you understand the performance of the property.
- Effective Gross Income (add up everything on the income side)
This is the total income the property yields. Not taking the expenses into consideration.
- Operating Expense (add up everything on the expense side)
Total expenses the property incurs.
- Net Operating Income (Effective gross income minus operating expense)
This number shows you how much income is left after expenses are paid but this number does not include the debt service.
- Capital Expenditure
Money spent on the upkeep of the building like renovations or add ons.
- Cash Flow (Net operating income minus Capital Expenditure)
Cash Flow the property produces after expenses and capital expenditure is taken out
- Debt Service (Payment of your Loan)
This number shows you the mortgage payment of the loan you will take out to buy the property.
- Cash Flow after Debt Service (Cash Flow minus Debt Service)
This will be the realest number of them all. This is the truth! It tells you what will come in your pocket after everything.
- DSCR (Net operating income/Debt Service)
This percentage shows the lender if you can pay the mortgage with ease or difficulty. Most lenders will consider a 1.10 threshold but it varies depending on scenario.
So if you have a negative number for the “cash flow after debt service” you should think very hard before investing in that property. I say this because the financials don’t always tell you the whole story but they tell you a lot. Other factors play an important role as well. For example if you really see an area that is developing and you suspect the rents to increase or the property values to rise. In that case you want to purchase the property and ride the wave and profit from the upturn of the market. But that is a decision you will need to make depending on how much risk you can handle given your financial situation.
Commercial investment can be risky but also very rewarding. Analyzing the statement is just one of your jobs as there are many other factors that play a role in the selection of a property such as location, local economy, cycles of a market and etc. Doing the legwork on the property is your responsibility. And it may be a great idea to ask for help from other investors or folks active in the industry. I hope this article was helpful in understanding the financials of a multifamily property, our next article will be on analyzing the statements for lodging (hotels). Stay tuned folks….