TERMS AND DEFINITIONS: INCOME AND EXPENSES

Video Transcript

 

Hey guys. It's Kris Benson. Welcome to video number four on our real estate education series. Today we're talking about income and expense term and definitions. That is a continuation of our last video where we're giving you a vocabulary lesson so that you, as an investor, are empowered to go out and have real estate investing discussions and understand what people are talking about.

 

As we mentioned, there's a lot of acronyms around real estate investing and goal is to demystify that for you and give you a little bit more of an understanding. So today, we're going to start with the income and expense side of terms and definitions. In the first one, I'd like you to think of it as a bucket. So, gross potential rents essentially is all of the revenue that comes in at the top of the bucket. So, if there were - let's use a storage example. 100% of the units paying market rent.

 

That is the gross potential rent that exists for that property. It's the most money the property can make if 100% of the units are full and everyone is paying market rate. So let's use a quick example. So, we have 1,000-unit storage facility and each one of those, just to make the math easy, each one of those units is paying $100 a month. That's our market rent and there are 1,000 units.

 

Well, that's pretty straightforward. The gross potential rent for that facility is $100,000 a month. Now, one thing you want to factor in is when you're talking about real estate investments is, occupancy and the vacancy that you expect to have in a property because we don't have any properties that are 100% full. There is always some portion of it that is vacant. And so, this $100,000 is, sort of, a pie in the sky number. And then you need to find out what the net rental revenue would be. So essentially, how much is coming out of the facility because you have empty units. And so, let's assume a vacancy of 10%.

 

So, in our example, that would be 100 units. So, 100 units times $100, that's $10,000 a month. So, that would be our vacancy. That would be the cost of having 100 units vacant. So, our gross potential rent is $100,000 a month. We're taking out $10,000 a month because of our our vacancy. So we're left with $90,000 a month in net rental revenue, and that is net rental revenue. So essentially, after you take out the vacancy, that's what's left to pay our bills. So let's go into some of the expenses, side of things. So, now we have a bucket of money - that $90,000. Now we have to take out our expenses.

 

And the expenses are pretty straightforward. It's not too much different than what you pay at your own home. So, we're paying things like utilities and real estate properties all over the world are paying things like utilities, taxes, payroll, marketing. And typically, the thing you want to think of when you're evaluating expenses is, if you're looking at a home, you should have the broker be able to provide you individual examples of those expenses because it's really easy to overflate the income or over - I'm sorry, basically make the income inflated and have the expenses deflated. So it shows that the property's making more money than it actually is.

 

So, what you want to make sure of when you're looking at expenses - are those fair representations of what the expenses are on that particular property. So nothing crazy there but I think the things you want to look for with expenses is - or the second thing you want to look for is, is there growth when there's a projection year over year? Because typically, most expenses, especially things like taxes, they don't stay stagnant. So year 1 taxes may be $5,000, year 2 they may be $5,200. And so you want to factor in that expense growth as you're looking at these individual projections for your real estate investments. The second expense that's going to come out of your net rental revenue is fees. So, if you're investing in a syndication, which we talked about in a previous video of a a way that you can invest in real estate, if there is a fee structure, that's going to come out of the rental revenue before the remaining profit to pay you as the investor.

 

And so, I just want to walk through a couple of fees that I think you'll see as you start to evaluate real estate investment deals. There is an acquisition fee and I'll do my best to write this legibly. And typically, an acquisition fee is some percentage of the purchase price or the cost of the property that you're buying. And what that does is, if you're partnering with a company like Reliant, on a self-storage property for example, there are costs for us to go out and buy that facility.

 

There's reporting. There are costs and deposits that we put down to hold the property so that the seller doesn't sell it out from under us. And those fees help reimburse Reliant for the cost of going out and finding that property and purchasing it. Typically in the marketplace, I've seen anywhere from 1.5 to 3%. Reliant typically charges 2% on the total cost of the property - for the properties that we're buying. Another fee that you'll probably see is a investment management fee. Sorry about that. So, investment management fee. I'm going to abbreviate for purposes of time, or an asset management fee.

 

And when you partner with a professional real estate company, they're going to charge you to essentially run the investment arm of their business. So, there are all kinds of expenses in managing investors. We have to produce your K-1s at the end of the year. There are people on the payroll who are managing investor relation questions, and this fee typically helps the real estate operator reimburse or cover the costs of those so we can service the investor. The asset management fee is typically a gross - I'm sorry, a percentage of the gross revenues on a property or a percentage of the equity raised.

 

So, the total amount of money that you raised on a particular property. And, you just need to understand the structure. They're structured in different ways, but, you want to understand how the operator is earning their fee structure with the asset management fee. And then the last one is the management fee. And I'm going to abbreviate again for brevity. But, the management fee is - let me use Reliant as an example. We are vertically integrated, meaning, we manage our own properties. So, we're not only buying them, but we have employees who are running that facility.

 

And typically, the management fee is what you pay for a management company to run your facility. Now, if you're buying your own duplex or your own residential real estate and renting it, you may hire a management company to manage the tenant issues, get tenants in the facility, any issues that come up with the tenants. They have a plumbing issue, they call the management company. Well typically, that management fee is paid as a percentage of the revenues of the project. So, it would be a percentage of rental revenues. And my goal in telling you the fee structure is, just to understand that there are fees out there and you want to understand, as an investor, whether you're a direct investor or a passive investor, what that impact is on your investment, what the fee impact and why the operator is charging you.

 

If it doesn't make sense or it just seems egregious. It probably is. The fee structure - there's  pretty much an industry standard and if you look at multiple projects, you're going to see what that structure on the fee-based investment may be. And so, if there's two things that I can help you understand on the income and expense side - there are two terms I really want you to get familiar with. One is called net operating income, or in our case we call it NOI. So you'll hear people throw around that acronym all the time.

 

It just stands for net operating income. So, net operating income really is an indicator to whether or not a property is profitable or not. Because what it does is, it takes all of the cash flows of the property, after you've paid expenses, but before you've paid your debt and taxes. And essentially, that's how we look at our property to understand the profitability of it - is truly NOI. Because, you can have different debt terms, you can have different interest rates but this NOI is sort of a clean look at the cash flow of the property before you add in debt and taxes. So, let's do an example of what NOI may look like.

 

So, if we have a facility that does $200,000 in income and $50,000 in operating expenses. And that would be things like utilities, payroll, marketing, those kinds of things. What our NOI would look like is, that $150,000. So NOI on that particular property equals $150,000. And what's key to know is, that NOI doesn't mean profit. That just means what you have available to now pay your debt and taxes. Now, the reason I want you to understand net operating income so strongly is, commercial real estate - that is how they value the property. So, if you bought a home, typically residential homes are valued by the comp method - the comparable method where they'll chart out all of the homes in your area and say, hey, your cost per square foot or your house is worth X number of dollars per square foot multiplied by the number of square feet in your home and that's how much your house is worth.

 

With commercial real estate, it's all based off how much revenue the property can generate, which is great. So, we are measured - or our value can be built, grown or declined based on net operating income. So, our goal as a professional real estate operator is to grow NOI. And, there's really only two ways to do it. You have to grow the revenue side or reduce expenses. So, you know, the net operating income is a critical step to understand how a professional real estate operator, if you're looking at an investment, how a professional real estate operator is going to grow value in that particular property.

 

And then the second thing that I think is a critical piece for you to understand as a real estate investor, because it has the most impact on projected returns for an investor is the capitalization rate. And you'll hear two terms - some people call it cap rate. You'll hear two terms, the "going in" cap rate and the "exit" cap rate. And the going in cap rate, essentially just means - what is the cap rate that you're buying the property at? And so, all cap rate is, is the annual net operating income divided by the purchase price. And that comes up with a cap rate. And really, the cap rate is an indicator of how much demand is in the market. A lower cap rate means that prices are going up. A higher cap rate means that prices are going down. So, it's a really good indicator to how much demand there is for that particular asset class. In the last five years, we've seen cap rates, in storage compress and why that's happening.

 

So, they're getting lower. And why that's happening is, there's more and more demand for people to buy self-storage because it's a pretty stable investment opportunity. So there's a lot of money coming into the market saying, hey, we want to buy storage and that's pushing cap rates down. So, cap rate, again, just a quick definition - it's the annual net operating income, which we just went over, divided by the purchase price of the property and that's going to give you your capitalization rate.

 

We're going to put a link in the video to an article where I think you can read some great information on cap rates and then how you should use them in your evaluation. So, I want to go through a cap rate example with you to show you how important it is and how it can affect the valuation of your real estate investment. So, I'm going to start with a quick example here at the top. We bought a million dollars property and that property is kicking off $100,000 of net operating income. So basically - and I'm going to get rid of this for a second. That means that is a 10% cap rate  because I'm just taking the NOI divided by the purchase price. So, that's 10%. And so, my 10% cap rate - that's fantastic. That's a pretty high cap rate in the storage world. So let's assume Reliant buys a property at a 10 cap and we grow that $100,000 NOI to $150,000. So that goes to $150,000 and let's assume the cap rate in the marketplace stays at 10%.

 

And, I want to show you what happens to the valuation of this property when the cap rate changes. So, if it stays the same, we're going to say, now our property, $150,000 divided by 10%. Now that's 1.5 million. So we've got a $500,000 gain, which is fantastic. Now, watch what happens if the NOI stays the same but cap rates compress. Let's say it goes down to 8%. So now, my $150,000 is divided by 8% and now that's 1.875 million. Another $375,000 or an $875,000 appreciation.

 

Now, nothing changed. The property still is kicking off $150,000 of net operating income but the cap rate is compressed. And, this is a huge lever as you're evaluating real estate opportunities to understand how the operator is projecting the cap rate. Because, we can manipulate the value we think we're going to give you based off our cap rate and if it's not accurate to what's happening in the marketplace, then essentially you have an opportunity to see numbers that are potentially inflated. So, it's something you want to be aware of. So that's all we have for the income and expense side of the terms and definitions. In our next video, we're going to go through some debt terms and definitions so you can understand how debt is structured or how they're referring to debt and how you should be looking at it in your next investment. So, we'll see you in the next video.