When you first look at a property, especially a multi-unit or commercial property, you will usually be given a list of income and expenses. This is a good place to start but should be only a starting point for several obvious reasons. Before you commit too many resources to any due diligence, you should ask for a full income statement from the seller. Oftentimes the list of income and expenses can be deceiving, either for intentional or unintentional reasons.
If the seller does not have an income statement (and small real estate investors do not have monthly, quarterly or even annual income statements) then suggest the seller give you copies of their income tax returns for the last 2 years. The income tax return is probably the most reliable source of financial information. Most sellers will not provide tax returns until after a contract is signed because they want to know the buyer has at least committed to signing the contract.
When you do sign a contract, you should insert a provision that within 10 days of signing the contract, the seller has to provide copies of the two most recent years of income tax returns for the property. Of course, if the seller is an individual, the return will be a Schedule E from his IRS Form 1040. If the seller is an S corporation, it will be an IRS Form 1120S; and if the seller is a partnership or LLC, it will be an IRS Form 1065. Do not be afraid to ask for a signed copy.
It is important to cross-check the income statements you received before you sign the contract to the tax returns you receive after the contract is signed. If there is a difference, you obviously must ask the seller about the difference. How do you analyze a tax return? You will probably only get specific pieces of a tax return. If you are dealing with a sole proprietor you will probably get a Schedule E. It is really important to get more than one year so you can make some comparisons. If you are dealing with an LLC or an S-Corp you want to obtain IRS Form 8825, Rental Real Estate Income and Expenses. Schedule E and IRS Form 8825 are very similar.
What should you look for? First, start by looking at Gross Rents. Compare last year’s rents to this year. Did the rents go up or down? If the rents went up was it due to an annual increase in tenants’ rents or were there fewer vacancies? If rents went down, were there additional vacancies or are tenants no paying their rent timely? You should find out when tenants’ leases are going to expire.
Next, you should look at expenses. Was there an increase in advertising? This may be an indication that there were vacancies attempting to be filled. Look at all the expenses. Do any of them jump out at you as being excessive? If so – which ones? Pay close attention to repairs. Were there any major repairs? What about maintenance? Are there any large items in maintenance? If so you need to prepare a list of questions for the seller. Do not be afraid to ask questions, it’s the only way you are going to find out what’s going on. Do not try and guess as to what happened.
How do you determine the cash flow from looking at a Schedule E or IRS Form 8825? You start with the net income or net loss on the forms. It would be line 26 for Schedule E and line 21 for IRS Form 8825. To this number you want to add back depreciation, amortization and interest expense. This sum will be a good indication what this property’s cash flow is before debt service. Next you need to determine what your monthly payments are going to be and if you need to borrow the funds to buy the property. Banks generally require you to come up with 20% as a down payment. The term of a rental real estate property loan is usually 20 years. If the loan payments are less than the cash flow then this property should produce a positive cash flow. If the loan payments are greater than the cash flow you will know to walk away from this property.
Making the decision to purchase an apartment building is a large commitment. You need to make sure that what your being told as to what the numbers are actually in reality what they are. Do not go by someone’s word or what they have written down. Getting good at analyzing apartment financials takes practice. In time, you will be able to go over the numbers with ease.