Twice in the last 24 hours, once on TV and once in something I read, I’ve seen absolutely false info passed on as gospel. When beginning real estate investors hear something for the first time they tend to take it to heart. Imagine their chagrin when learning they’ve been told north on the map can be found on the bottom.
Oh, that’s why the numbers never seem to work out. 
So today is for some pretty basic definitions. There is so much misinformation out there. Of course, if I put something here a little off, there are more than a few vets out there who will immediately and with great glee offer a correction. I’ll try to remain on my toes. Pretend I have a chalkboard, as I’ve always wanted one anyway.
Gross Scheduled Income — GSI — Sometimes called Potential Income, and a few other bastardizations. It merely means what the property will receive in rent for a year. (always annual, ok?) If it’s projected it should clearly say so when you’re doing the analysis.
Note: You may want to include ‘Other Income’ just below GSI. This would include stuff like income from a laundry setup.
Vacancy Rate — I know, probably self explanatory, but it should be explained just the same. It’s the percentage of vacancies any particular property experiences — express in terms of dollars. It’s expressed in dollars in the actual analysis, but only after the percentage is clearly stated. Don’t mess with this figure, as it will come back to bite you in the butt sooner or later. Take the attitude that, ‘it is what it is’ and move on. Also, many pros, including this one, put the actual vacancy rate used in the ‘assumptions’ portion of the analysis.
Gross Operating Income — GOI This is what you get when you subtract the income losses from vacancies from the GSI. Pretty straightforward.
Operating Expenses This includes taxes, insurance, any utilities paid by the owner, management, repairs & maintenance, and the list goes on. This number may be the biggest lie on a property’s income and expense statement. We do our own — period, no exceptions, go fish. It’s not that we don’t trust the seller — but we do our own, thank you. (The whole, ‘boots on the ground’ thing.)
Net Operating Income — NOI Simply take your GSI (plus any other income) minus your Vacancy Rate (in dollars) minus all your Operating Expenses and you arrive at your NOI. Please, don’t make the mistake rank amateurs make quite often. They think NOI comes after taking away your financing, (or debt service or your monthly payments, however you wanna say it.) Doing that will take you to Istanbul when you just wanted to get a few things at the store down the street.
Annual Debt Service It’s 12 months of loan payments — not including taxes and insurance. Beginners sometimes make that mistake which means they’ve
taken taxes and insurance out twice. (in Operating Expenses) Very uncool. The ref will surely throw a flag on that move. Again — this comes after you’ve arrived at your NOI. Taking Annual Debt Service out in order to arrive at NOI will screw your numbers up like Hogan’s goat. (Don’t ask — Dad used to say it constantly, so I just figured it was something he heard from Moses when he was a kid. I’m guessing maybe goats must screw up a lot?) It’s a beginner’s mistake, so take care.
Cash Flow Before Taxes This is one of the cool numbers you’ve been waiting for. Just take your newly found NOI and subtract the Annual Debt Service. That number is your Cash Flow Before Taxes. The Rule: No crying if it’s negative.
I’m not gonna get into Cash Flow After Taxes. Why? It’s not for the beginner’s class. I will say this though. There are times when you might have a very slight negative cash flow which will magically turn into a very nice round positive number when your tax savings are added into the equation. Tax savings? Oh, that. It’s what comes after Tax Shelter is applied to a real estate investor’s tax return. A whole ‘nuther post altogether.
The idea isn’t to get into negative cash flow properties, ‘cuz I recommend against that with incredibly rare exceptions.
Just know that your tax savings can and often will make a fairly significant difference in your after tax return. And your after tax return is the only return that matters. The rest is just arithmetic — doing numbers without a final conclusion — Conclusion = Cash Flow After Taxes.
That will lead to Internal Rate of Return. Forget I said that. Also, ‘nuther post.
Related posts:
- Beginning Real Estate Investors — 3 Things To Avoid
- #1 Reason Real Estate Investors Cause Their Own Train Wrecks
- San Diego Real Estate Investors — How’s That Income Property Workin’ For Ya So Far?
- Can Regular Folks Become Real Estate Investors?
- Tax Shelter — Real Estate Investors Should Beware the Professional Investor Trap
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Oh, come on Jeff…not ready to explain IRR in one sentence? (It can be as abused a term as cap rate.) Seriously, though, a very nice summary of some key terms.
It’s not the one sentence explanation that’s the problem. It’s the can of worms it opens.
How did you get there? What do you mean it’s really a lie? Is there a better one? And on and on and…
See, now THIS is the kind of stuff everyone hopes they’ll find when they first get into real estate. Tag, grab or chisel this one.
Matthew — Ironically, this post was born of acute irritation. I’d gone to a so called investment site which lately seems to put out info so egregious in nature, I swear it’s personal.
Thanks for your words — I try to come up with this kinda thing more often, but it’s a lot more difficult than one might think.
I’ll try harder. Thanks again.
Ah the strain of excellence… don’t hurtcherself.
Well thanks again for the contribution.
Excellent, Jeff. Just excellent. Thanks to Matthew for passing this along to me.
Thanks Russell, I appreciate it. And thanks again to you, Matthew.
The pain of vacancy rate can be further compounded by the Property Manager’s leasing fee. That should go in there, somewhere. (I know you know.)
Great post.
Chris — leasing fees are not known for the most part in So Cal. I’d been in the biz over 30 years before I ran into a leasing fee. I was flabbergasted. In CA the management firms do their dang jobs.