As much as this episode is entitled The 7 Ways to Measure Financial Outcomes from Rental Property, I really could have named it, “How to Find Out About an Asset When You Don’t Have Any Information.”
As much as this episode is entitled “7 Ways to Measure Financial Outcomes from Rental Property” I really could have named it "how to find out about an asset when you don't have any information". That's a little bit long winded but what we are presenting here are data collection points that if you were to obtain these, even if you never obtained Profit/Loss, a rent roll or any other financials from the property, you can assess the income side of a deal from the information that we're about to collect in this episode. The seven measures are:
[00:00:55] Going down the track that you have normalized financial information from the seller and everything is available to you then the information that we're collecting here just further validates the strength of income based on the financial data that we must review. We can correlate that with these areas to see what the strength of income is, to see if there's a lot of good things going on; such as positive revenue and revenue growth, low turnover and a high renewal rate. Or, the negative things that can be going on such as; high levels of collection activity, high levels of late fee revenue and high levels of eviction activity.
[00:01:37] In a perfect world you have all the financial information that you need to reach conclusions on NOI (Net Operating Income). Still, that's not everything you need to come to a conclusion about the strength of income. Looking at these seven measures will assist you in further determining if the deal is a quality deal and if it has a high level of quality income. For a more complete read on the topic, pick up my book: How to Read a Rent Roll.
[00:02:03] Another way to consider the data points that we're presenting here through these seven ways to measure financial outcomes is to make the presumption that everyone is not a fair player. Sorry to say but it's true, we do live in a cold harsh world and sometimes the information that's presented to us, although we'd like to take it at face value, very often we cannot do so, at least we can't do so as a reasonable person.
[00:02:32] What we have to do is attack the information with the tools at our disposal so that we can come up with valid and reasonable outcomes, or decision points or quantitative data, or valid data sets (or valid data points) that we can believe in. Knowing turnover, knowing revenue and revenue growth, understanding the renewal rate, reviewing the leases, having the collections activity (at least a barometer for such) and understanding that late fee revenue when it's high is not a positive and recognizing that eviction activity is very deteriorating, in terms of its toll on cash, and on the property as a whole, understanding- how these measures affect an asset gives you a better feel for how the asset is being run, how the asset is being operated and what you can do about it (post acquisition) before you ever buy the deal.
[00:03:42] That's the whole point to due diligence; to understand the deal we're getting into before we put our hard, cold cash into the deal. Obtaining a loan and buying the asset is not the point in time where we want to understand the financial levers and what's occurring on property.
[00:04:05] We're talking about this topic because in some instances everything is not clear cut. There's situations, like in any other business, the real estate business can be messy. Whereas there's a property that looks good that you want to purchase, that doesn't mean that all the paperwork is there to make it a solid deal. It may be that you're attempting to buy a foreclosure. It may be that you've been charged with purchasing a property because it's adjacent to another property owned and the inside scoop is buy it at any cost. Well, nobody wants to pay "any cost". We want to pay a set certain costs.
[00:04:46] But what if that particular property that shows all the signs of being something that you want to purchase doesn't really have any paperwork to go with it? How are you going to measure the financial output of that property if you don't have anything to go on? If there's just a little bit of this and a lot of that- no one's providing you with rent rolls, you don't really have financials, there's no tax returns. But yet still, you have to determine a value for that property and you've only got so many days to do it. So, here's seven ways to measure financial outcomes from a rental property when the paperwork is sticky or bad.
[00:05:25] Turnover #1. Number one you want to talk with everyone that you can that interacts with the property including ownership and management residents or tenants; anyone that can give you some insight into how operations are going. I know you may be saying "this is not the way to go about buying a property". Well, that may be true but if you have to buy it, for whatever reason, and there's no documentation for you to review what are you going to do? You're going to figure it out. And these measures that we're presenting assist you with figuring out the financial viability of the asset even when the paperwork is not very good. Let's look first at turnover. While it's a nice catch phrase, in the rental business increases in turnover means we're burning cash. So anything we can do to understand the level of turnover is a real positive.
[00:06:19] Revenue and revenue growth - #2. Another is revenue and revenue growth. Again, remember for this episode, we're presuming that the documentation is kind of sketchy. You have to do what you can to determine what actual revenue is and then you have to be guided to determine if there has been rent growth. Here's how you strip down revenue and revenue growth: as much as you know what rents are, and it's imperative to know what rents are, we still want to know about every other potential source of income that's currently occurring; that's presently occurring. And with that we can start to build the revenue stream. We can start to document the revenue stream, and see where we stand.
[00:07:03] Renewals and renewal rates - #3. Item 3 is renewals and renewal rates. Renewals really are the cornerstone of stability. What's the year over year renewal rate? For rental property a number north of 75 percent is very good. The national average is about 50 percent turnover. Saying that a different way is a 50 percent renewal rate. High renewal rates convert’s to low turnover rates; they act in tandem. Anything we can do to increase renewal rates is definitely a positive. Lower turnover converts to higher gross margins and less turnover expenses. That's why it's important to know and understand what the renewal rate is at a property.
[00:07:50] Lease start dates and lease end dates – Item #4. We also want to know the lease start dates and lease end dates. Even if there's no other documentation coming your way for a particular asset there still should be leases in place. Now, if there's no leases in place it truly is the Wild West and all bets are off. But if that's all you can get your hands on, you can start to build the finances around the leases that you have in hand. And this is separate and distinct from renewals. As much as renewals are important it's far more important to have existing leases with those to start and end dates in hand so that you can build your financials from that information.
This category (leases) says much about the potential of unlocking value. Once you have those leases in hand you can determine average length of tenancy (is it 12 months, 18 months?). It's very important to have that information in hand so you can build a database, so that you can build the financial data around those leases.
[00:08:55] Collections and collections activity – Item #5. Next is collections activity. Collections refers to only collections for rent and not the other income categories. Because, remember, we're still trying to build a financial statement here. We want to know not only what's collected but we also want to know about collections activity occurring on the property specific to rent.
[00:09:14] Late fee revenue – Item #6. Next is a late fee revenue. This is not so much important from a revenue perspective as much as it's an indicator of future collections activity. So, knowing if there is late fee revenue and if it's collected consistently and on what percentage of the leases tells us a lot about the quality of residency, or the quality of tenants, and it also feeds back into the collections activity and we can start to get a barometer, or kind of triangulate, what's going on by knowing what late fee revenue is concurrent with collections activity.
[00:09:52] Evictions – Item 7. Lastly is evictions and evictions activity. If we roll this up, looking at late fees and collections also, this gives us a very good barometer of what's going on at the property.
[00:10:05] Let's build an example. Let's say that we're talking about a 100-unit building. And you're not getting financials from the owner or the broker because there's none to be had. They've just kind of been using the asset as a cash machine and not really keeping track. That's not your problem unless you're trying to buy the asset. If you have to buy the asset, then this really becomes a problem. The seven measures discussed here will assist you in building, (or putting together) a financial statement even if there is no financial information forthcoming from ownership or representation.
[00:10:47] To recap we want to know as much as we can about turnover, about revenue and revenue growth, renewals and renewal rates, lease start and end dates. It's very important to have those leases in hand to understand what our future revenue stream is based on the in-place leases.
[00:11:05] And then, on the red side of the coin, we want to know about collections activity, late fee revenue and evictions. It's important to know those because they are a reflection of what's occurring on the revenue side of the transaction.
[00:11:23] This has been John Wilhoit on Real Estate.