For all you veteran ComREI's, I've seen PNL's that have included Capital Improvements (although, they were not categorized under Expenses, they were a Sub-category of Other Costs)....so the question is, to include or not include Capital Improvements when calculating NOI?
Bonus: I've also seen Contractors as an Expense (sometimes individually listed like Paint Contractors, Roof Contractors and sometimes just all lumped together into one). How can you know which Contractor Expenses are related to operational expenses and which ones are related to Capital Improvements?
So you can really find the difference in these things in the tax code. A improvement is depreciated over a period of time, and a expense is counted against the income in the same year. Now the lines are blured a bit, but follow this...
If I patch a home in a rental property, and then paint around that patch it is a expense. Now if I patch the same hole, and paint the same wall in, and lets say the wall is in the kitchen, along with replacing the cabinets, counter-tops and flooring- now the whole job is a capital improvement. Capital Improvements do not count against your NOI if you account for them correctly. You will get some benefit back on them in the form of depreciation, the amount of depreciation really depends on your accountant. That is a whole new subject, and I am not a accountant...
I use a discounted cash flow model when analyzing a buy and hold property. The model has considerations for capital expenses. Whenever I look at a deal I complete the model as completely as possible in order to gauge the best understanding of how profitable a prospect is.
Mark,
That is a great point. I use two types, one that is really an APOD, and the other is a program that can figure out partnerships interests, interests that are held in a IRA etc.... It also plots my minimum requirement for return on equity and tells me in what year I will loose that minimum.
Now I should note, I play only in the multi family sand-box, so I always look at 3 exit stratigys and run the analysis on all;
One is a flip- so ownership under a year
The second is a short term hold, so a sale in 1-5 years
The last is the long term hold... plan on owning it forever
The last point- is all three need to work for me or I do not want to own the property... UNLESS I am building upside into a community, then I am always looking at the last two options because I know I am feeding time, money and effort into the first year or two...
Also- the programs are inexpensive- so everyone should own them and know how to use them...
Jim, to clarify are you using some software programs to run your analysis? Are these software programs available to buy at retail stores (Staples, Fry's, etc.)? If not, how could I get access to said programs?
I use 2 kinds- one is a APOD, it has a 10 year analysis built in but I like my other programs analysis better... the APOD program is from "Real Benefits". Google Real Benefits APOD and it comes up...
Second program is Cash Flow Analyzer, which I got from landlord software dot com.
They have a flippers and rehabber's analyzer as well, which I have never tried.
While many defend their favorite way of calculating alternates, cap rate traditionally includes operating expenses only; not capital expenses. This can produce opportunities since not everyone understands the difference between the two. Instead of merely screening properties using the cap rate, it occasionally makes sense to review the expenses behind the calculation.
Not long ago, I was presented with an extremely undervalued deal from a very large commercial brokerage that didn't appear so at first blush from the cap rate. In this case, the P&L included capital expenses which dramatically understated the NOI, the associated cap rate, and the resulting cash flow - thereby leaving a lot of meat on the bones. (As an aside, I was screwed by my broker who was apparently such a good friend with the seller's broker that he revealed my financial evaluation to him. The seller's broker promptly called to thank me, as if I was his good friend, and changed his offering brochure and price. To say I was steamed would be an understatement. But I digress…)
Cap rate should not be used to value, but instead should be used to screen.
They're all over the internet, Daniel, but I suggest you completely understand how to evaluate property finances on your own before you rely on canned software. I have at least two reasons for this:
1) You don't know if the person who wrote the software knew what he was doing and it's often hard to check. Out of curiosity, I downloaded the Real Benefits software noted above and it's consistent with others I've seen - the formulas are hidden and password protected. They do this so no one copies the spreadsheets - as if a P&L, cash flow, or amortization table is proprietary.
In fact, there are some calculations, such as capital gains and the resulting taxes that are personalized and subject to interpretation, so you have to know what the software assumes. Depreciation is another. While spreadsheets as these are impressive and lenders and the uninitiated love to see them, you generally only need a few simple calculations to evaluate a deal and it's safest to do them by hand on your own.
2) Canned software does not necessarily provide you with the metrics important to you. For example, I use ROI to buy and ROE to sell. That is, when the anticipated ROI exceeds my investment criteria, I pursue the deal. My exit strategy includes selling when the ROE falls below a certain level. You can't customize canned software to provide these calculations or modify it as your criteria changes. I suggest it's better to be able to calculate these values by hand and write your own spreadsheet to automate them, than rely on someone's interpretation.
My longstanding recommendation to review 100 properties on your own, before you make your first commercial offer, still stands. Good luck.
Nov 12 '09, 05:46 AM
