When it comes to magic tricks and investing in rental property, the first rule of thumb is not to fool yourself. The same rule applies when selecting rental property acquisition candidates. There are no short-cuts. Some people are so excited to “get in the game” of rental property they miss some necessary steps in the process; they waste time and money only to see opportunity costs soar because of forgetting the real reason to purchase a rental property in the first place; income.
The objective of rental income validation is to remove uncertainty.
Granted, real estate investors don’t come out of the gate validating income even though it’s at the top of the list in the due diligence process. So why dance around? Get started! Let’s step back just a bit and look at motivations pre-purchase. If you are performing due diligence on rental income, that is a clear sign you’ve decided to buy an asset. The presumption being, you are or will soon be a rental property investor/owner. That said, you can rush the process even though everyone around you makes it seem as if being in a hurry is normal.
The pace, or cadence, of your purchase must fit you. If the speed doesn’t suit you, there will always be that doubt that someone else is in charge. When it is your money at risk, you must be in charge, on point. Yes, you hire professionals to do their part; bankers, appraisers, inspectors, for example. What good is a stack of reports if there is never any time to review the documents from these professionals?, Someone has to read the loan documents, review the inspection reports, see and read every page of that appraisal. If not you, who?
There is really no such thing as a passive real estate investor.
Completing the acquisition of a quality rental property asset can be an arduous task. There are numerous moving pieces and many “metrics” to measure, but we always start with determining rental income. Why? Because you are purchasing an income stream of X over many years in exchange for X dollars paid now. It’s the time-value-of-money calculation that is played out over and over again in transactions across industries.
By revenue, I mean rental income. In another blog post, I discuss “other income” and “incremental income.” Determining the value of a rental income property candidate rest squarely on rental income. Rental income is the focus of this blog post.
There are many different names for rental income. Here are some familiar names: Income, Gross Rents, Gross Potential Rents, Revenue, Rental Revenue. For purposes of this blog, they mean the same thing. Here are three places to begin the process of getting to that real number.
The Rent Roll
Rent Roll. How do you see clear with the consistent “smoke” of glossy reports, fancy brochures, and the deluge of information? Start with the rent roll.
An income/expense statement is a starting point for determining value. Use the rent roll as a guide to deciding revenue generation. One of the first things to review is whether rental income from the income statement matches the rent roll. If not, why not.
Yes, most deviations between the rent roll and profit/loss statement can are accounted for with an explanation. But when the numbers begin to widen (large monthly differentials between the income statement and rent roll), further proof is required to address the disparity.
The bottom line is if the two never match, how do you know which document to believe; the income statement or the rent roll? Further, due diligence would include a review of 100% of leases files, random conversations with tenants, supervised calls to tenants, etc. These actions are all designed to validate, validate, and validate revenue numbers.
The Bank Statements
Bank Statements. Let us say the numbers seem to be a bit bouncy. They’re just not adding up. The fastest way to see your way forward is to review bank statements. Statement deposits should correlate quickly with receipts. If not, why not? If yes, you can move on to reviewing expenses with confidence that rental income is secure having three sources of validation:
- The leases – a review of in-place leases correlates with the rent roll.
- The rent roll
- Bank statements
Would I walk away from a deal where a review of bank statements is turned down? That depends on my intentions. If it’s a redevelopment deal, I have my market study so I’m not caring too much about what the seller has to say about in-place rents however if my sole intentions are to acquire the asset because of perceived stable in-place rental income, any momentum that threatens that post-sale reality is a red flag.
Sometimes you will hear much murmuring with this request for bank statements. Be reasonable, make it a doable thing, but convey its necessity to tie off your due diligence. When buying a long-term asset- it’s your money—what better time to ask hard questions? Don’t be shy about acquiring facts and figures.
The Unit Inspections
Unit Inspections. For “real-time” validation of current rental income, there’s nothing that can replace an inspection of one hundred percent (100%) of all units on the property. That’s right- going inside every last unit on the property. I have personally made this mistake, seeing 100% occupancy “on paper” and visiting completing the unit inspections after closing finding empty units. Never again – that was a one-time thing. Was my gaff recoverable? Barely. Don’t let this be you – ever.
If you can’t look behind every door in person, don’t buy the asset.
Are the units occupied? Do people live here? A property walk-through accomplished after validation of numbers, but if it’s a property with potential but suspect revenue numbers, best to do this earlier in the decision-making process. Granted, unit inspections are done later in the due diligence process. Unit inspections are time-consuming, but so is chasing a deal where sellers are having a hard time delivering credible paperwork. This allows you to cut your losses (of time and energy) quickly when necessary.
Most often, random inspection of X units start this process (5-15% of units). Keep records, so there is no need to duplicate later when the 100% inspection is scheduled.
There is always more to do to increase one’s comfort level with the numbers. These are some starting points to get the buyer beyond the pretty pictures and reports that were generated three, maybe even six months before the property being placed on the market.