Accounting and investing in real estate are the inseparable tools of the trade.Accounting for real estate is not difficult, but you need to meet special requirements to comply with tax-reporting. There are some calculations that do not apply to other types of businesses, such as depreciation, a breakdown between mortgage principal and interest and sometime the allocation of expenses between two or more properties. All standards of accounting are governed by general accepted accounting principles (GAAP) that prescribe the use of financial documents that evolved over years in reaction to the economic environment. The three most useful financial statements for income producing properties are:
Operating statements are not always available for one reason or another, and when they are, they are not always accurate, especially on smaller properties where no formal accounting system is used. The seller or their brokers should be able to provide at a minimum the most recent 12-month period of operating data. By examining in detail each of the past 12 months, investors can gauge the relative stability of the revenues, expenses, and the Net Operating Income (NOI). With a Capitalization Rate in mind, say 10% (0.1) divide the NOI by 0.1 to get the Fair property value (or easier, in this case multiply) Assume $20,000 pretax NOI x 10% = $200,000 property value. This is how I calculate an income property valueI take half or less of the total annual rents and multiply by 10.I look at the listed price and take the smaller number between the two, and think about an offer starting 20% smaller. It does not work all the time. Income StatementThe Income Statement is used to measure revenues and expenses over a specified period of time (12 months). Simply stated: Gross income(total rents) less total operating expenses is equal to the property's Net Operating Income (NOI). This definition is too vague and confused me at the beginning of my accounting life. For me the Pretax NOI is the income remaining after all operating expenses have been subtracted, except taxes and mortgage interest expenses. This is the income available to the new investors to pay for the new mortgage and new assessed taxes. Investors are not concerned with how much tax the owner or seller of the property is paying because their tax rate would be different. Although NOI is generally just a single line item, this is the most important element of an income statement and is used to calculate the capitalization rate or to valuate an income property. This link is an example of an
Income Statement
with depreciation subtracted to demonstrate a "paper loss."
Balance StatementThe investor use the balance statement or balance sheet to scrutinize the property's assets, liabilities, and equity at a specific day in time (end of year, quarter end, etc.). Assets are buildings, land, and equipments owned. Liabilities are the short and long term debts (insurance, taxes, mortgages). Equity or Net Worth is the difference between asset value and total debt (liability). Equity is value remaining after all obligations have been satisfied. Assets = Liability + Equity Assets - Liability = Equity Assets - Equity = Liability Observe that the two sides of the equation are equal, hence the name balance statement. Introduction to RatiosAll ratio analyses are based on NOI and Balance Sheet numbers: assets, liability and equity (net worth in some books).There are two sets of ratios to measure and control a rental business: Liquidity ratios measure the amount of cash available to cover expenses both current and long term.
Profitability ratios measure and control income generated from the operations or how well the money is used.
Return on the owner's investment (ROI) is good to be more than 20% to fund future growth from within the business. ROI = NOI / total equity (down payment)
Statement of cash flowsThe statement of cash flows is used to measure the cash inflows and outflows produced by various operating, investing, and financing activities of a business. The balance statement is a static instrument that reflects a company's financial position at a specific day in time. The income statement and statement of cash flows, on the other hand, reflect financial changes over a period of time, 12 months is standard. There are no rules as to when to use ratios in your analysis, they are just good tools. All this information is here to help you understand how investing in real estate uses financial statements. By using all three financial statements together, both the inside managers and owners, and investors from outside can better evaluate the strengths and weaknesses of a real estate business. Receive monthly real life Tips.
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