Creating a Profit & Loss Statement to Create
the Net Operating Income & Value of an asset
In this game you will establish the value of an asset based on the NOI or the Net Operating Income and using a desired rate of return. The NOI is the income AFTER expenses are subtracted. Once you have both the NOI and your desired rate of return (or also called the capitalization rate of return) you can establish the value of the asset based on the current cash flows.
Similar in math we can use the NOI divided by the price of the asset to establish the rate of return. (another way to look at the equation with a different set of eyes) These are the must have METRICS for any investor when purchasing REAL ESTATE. This method is based on cash flows and an excellent barometer of value!
THIS IS YOUR MEASURING TOOL. Use this method to make brilliant decisions by posting the annual property operating data and comprehending the results using simple basic math. There are other ways to establish the of value real estate including Comps or comparable market analysis (CMA). At another level is highest and best use of the asset which may include a zone change or redevelopment.
In Level 2 you will take it a step further by investing in Asset improvements to increase the income. Then you will study how that will affect your future equity. This changes your overall rate of return and adds an entire new dimension to your equation! Finally adding the passage of time to this metric helps you make an informed accurate decision and visionary!
In Level 3 for the advanced investor using leverage by borrowing thus less cash out of your pocket may increase your rate of return. Further, when all these methods are compounded including the addition of depreciation you will have hit a grand slam homerun!
All these methods are important considerations and are detailed throughout The Lemonade Game. In any case, you as a professional Real Estate investor will want to master all the methods to guaranty your success.
You will begin with Level 1 and become fully aware of the Profit & Loss and what it represents in correlation to the value of an asset based on cash flows.
You will be breaking down the cash flow coming in based on rents and other income generation from your ownership of an asset (in the first example a 4 Plex or a Quad). Then you will examine the cash flows going out (OPERATING EXPENSES called OPEX). Opex are expenses that occur in the normal operations of running/maintaining a building day to day & month to month. Many expenses are billed quarterly, semiannually, or once a year. Keeping track and measuring this is key!
From those two sets of numbers, (the comprehensive gross income and the detailed expenses) you will establish the NOI or Net Operating Income. REPEAT, this is the golden nugget!
NOI is the Gross Scheduled Income (GSI) minus the OPEX expenses. Once we have established the NOI, you can input the desired rate of return to establish the current value based on a capitalization rate. Or conversely, you can divide the NOI by the price you paid to establish the current rate of return.
This simulation provides us with a tool that does the work for you automatically. Just post the numbers in the cells and then extrapolate those TOTALED results into the equations provided under this P&L. Very easy!
For this simulation we will assume that you are paying cash with no debt service, interest expense, nor amortization for any financing. The reason is that you want to establish the value of the asset based on the net cash flow it creates. Financing and debt service rates/costs change based on the borrower credibility, the APR of the loan, and the terms of payback. Here you are isolating the value of the asset solely based on the building’s income and expenses!
Furthermore, if the rent roll and or the expenses were to change over time, what would the future value of the asset become? To achieve that result you create a prediction, or the future values sometimes referred to as “pro-forma “. At a much deeper level how much time will it take? This will become relevant in the advanced versions and future simulations. The increase in the overall rate of return in either cash flow, equity, or BOTH often creates wealth! (Important, in advanced lessons of becoming a professional investor you also need to establish what doesn’t work)
Many times, you should invest in capital expenditures such as a new kitchen and bathroom remodel as examples to achieve the pro-forma numbers. This is called CAPEX or CAPITAL EXPENDITURE. Capex is money put into the asset to improve it. Then it may become more desirable, and raise the future cash flows from rents etc. This is explored in in level 2 as we compound the cash flows by investing that money back into the units to increase the future equity.
You are provided a set of data of how the building operates both monthly and extrapolated annually. This is sometime referred to as The Profit and Loss statement or P&L.
Sometimes the information is reduced to an APOD. The APOD is an acronym for Annual Property Operating Data and is a condensed form of the building income and expenses.
Let’s get started. You find a nice building and the rents are below market. To purchase the building, you create an LLC and invite your friends, family and outside investors. How much should you pay for this building for it to be a great investment? You will learn how to solve this using the below data that will be relevant to determine this.
Draw four boxes. Label each one as apartment A, B, C, And D
Unit A, B and C rent for $1,900 each per month. Unit D is larger and has two bedrooms with 2 bathrooms and rents for $2300 per month. All 4 units are rented with solid tenants and the income from those units is collected for each month as scheduled rent called GSI (Gross Scheduled Income).
Draw 4 more boxes label them as parking income, storage income, laundry income, and other income.
There is additional income from the 4 parking spaces at $50.00 per month per parking space. There is income from the laundry room at an average of $60.00 per month in total for the whole building. Additionally, there is income from your 2 storage rooms equal to $ 30.00 per month for each one. Those are rented to the tenants living at unit A and B.
Finally, in the other income place $160.00 from interest earned for the whole year paid each year on December 31st. This is due to you because you made sure all rents and deposits were kept in an interest-bearing savings account.
Great! Now let’s post the expenses,
First and foremost is the property tax paid in two installments each being $7,800.00 per installment. One is paid in October of each year and the other is in April. (Never miss this or be late as there is a large penalty!)
The next bill is insurance which is paid in quarterly installments of $1,500 each. They are payable in January, April, July, and October. This is important as you will want to protect your assets to the maximum possible.
Your property manager will get paid $400 per month for helping you run the whole property. In addition, there is a maintenance man who gets paid $800.00 per month for fixing things, small repairs, cleaning up, taking out the garbage etc.
Nowadays Tenants want high speed internet, so you have contracted with a major data provider (like ATT or Verizon or T-Mobile) for a fiber optic connection which costs $80.00 per month for a single router that is provides a signal that all the tenants can use.
Each tenant pays their own respective electricity and gas. However, the water is master metered which means there is only one water meter and that makes it a challenge for the owner Landlord to bill the tenants for individual usage. In this case the Landlord must pay for the bill which comes quarterly in January, March, July, and October. The bills average approximately $200.00 per quarter.
The landscape/gardener comes every other week and charges $100.00 per month for the service for the entire property.
Similar is the pesticide control company who charges $100.00 per month to come spray for insects and other problematic bugs and termites.
To file all necessary reports, we have engaged a CPA who keeps track of all our income and expenses and completes all the required filings with the proper governmental authority. Since we are a limited liability company there are K1’s (annual documentation and reporting of a partners capital account) to be issued to each of our investors. The CPA fee is $750.00 per year, and we pay her immediately after the April 15th reporting deadline.
In our business it is critical to have little vacancy as this is potential income that will not be generated when it should be! This is money out the window because every night that there is a vacancy is the equivalent of not collecting $70.00 to $80.00 for that night. When multiplied over 4 apartments and several months the amount adds up quickly.
Moreover, this is representative of how effectively you operate your building and the opportunity cost to create the most cash flow possible. Many profit and loss spreadsheets have a provision for a vacancy allowance which can eat up between 3-5% of income which when subtracted from the GSI . That adjusted number becomes the effective income. (In our example you are assuming full occupancy because you are such a good operator) In the essence of simplicity, this is not included in this example however it will be added to more advanced simulations.
Therefore, to keep maximum occupancy, you maintain a professional website. This is for the marketing /advertising of your rental business with gorgeous photographs of the units which costs $40.00 per month including the cost of your domain name.
Besides the accounting and CPA fees as above, there are fees for business licenses, and registration fees with the Secretary of State as well as other permits that may be required from each city and state to state. In our example, use $350.00 per year for the company charter to be a licensed LLC and for the certificate of good standing.
Legal and other professional fees vary and can be expensive to hire an attorney for an eviction. Being very good at selecting good tenants matters and is a required skill to master. Discuss with your mentor how to conduct a tenant interview and what questions to ask) Sometimes it is just as important to turn down potential problematic tenants. Being smart, you became a specialist at vetting and turning down those with credit problems and heavy debt loads resulting in your minimal legal fees. Based on your ability to discern accurately, you did not have any legal fees this year.
Cleaning fees are required each time you have a turnover and need to freshen up the apartment. They average about $300.00 per moveout. A good way to help mitigate this is by adding a clause to the lease whereby you can deduct the cleaning fee from the tenant’s security deposit when they move out. Even so some people are messy and may require additional cleaning time. Many times, you must replace a few items that just could not be cleaned. Some units require a paint and patch to fix holes in the wall. In our case we had a charge of $250.00 in February for one apartment and a charge of $400.00 for another in August.
You have office supplies to cover the cost of folders, copies, envelopes, pens, legal pads, and other items. You also have some inventory as we like to provide a few essentials when people move in such as toilet tissue, a roll of paper towels, some dish soap, a few bottles of water and other items that people like when they move in. These supplies average $25.00 per year per apartment.
Earlier when new tenants moved into our building, we collected security deposits generally equal to one month of rent and it was posted as income. In some jurisdictions you must pay interest to the tenant for the security deposit received and credit their deposit year after year. When you return the unused portion of the security deposit, you post it under security deposits returned (as an expense).
Finally, there are other miscellaneous expenses like postage, doc-u-sign, zoom, security monitoring, fire dept inspections and other items that come out of the woodwork. Included in this are appliance parts and replacements, air filters, fire and smoke detectors, services for current legal forms like AOA (Apartment Owners Association) which are constantly updating their forms.
For our example let’s use $100.00 per year for business communications including Postage (fed ex etc.), use $400.00 per year for security monitoring, and $500.00 per year for Doc-U-Sign including an AOA subscription
All these expenses can be referred to as OPEX or operational expenses. OPEX is the cost of maintain the building and continuing to rent it out in the same condition year after year with reasonable wear and tear expected.
After posting all these detailed examples of your Gross Income to the P&L spreadsheet and then the total expenses scroll down to the valuation equation under the expenses. Place your numbers in the appropriate boxes there. Select a desired rate of return such as 5%. Establish this buildings value at that ROI with these numbers? Create the value at a cap rate of 4% and at 6% with a couple of clicks in seconds and compare.
You can also do the math using the purchase price paid for the asset and with those numbers to create the R.O.I. There is a metric to complete the equation in that manner.
This game and the exercise is for you to master the art of measuring the value of your building and the price you should purchase the build or sell the building for with a comprehensive understanding of what those number represent. CONGRATULATIONS on completing this 1st phase of P&L
This building block for investing in multifamily real estate and the sample P&L we have used is extremely accurate in valuations of assets that are similar. More importantly you can use it to create pro-forma and manage expectations of when to buy, when to sell, and when to add leverage.
For other purposes the P&L may change in the commercial, retail and the office market but the principals are the same. Those leases may have different income and expense entries and may call for a C.A.M. charge (Common Area Maintenance) added to the tenant’s rent. Other lease provisions may call for rent based on percentages and expenses allocated differently. These may be called triple net, double net, percentage, and gross leases. All of these will affect the value of the asset and the ratio of NOI to the value.
To really understand the importance of this game and the exercise you have just completed let us proceed to the next lesson in part 2 whereby you will invest Capex (Capital Expenditures) from the rents to bring up the income and change the future equity. In our simulation this is called Delta Equity, and you measure that change and factor the time factor into our equation on a graph.
Many people do not do this or realize that this is the hidden secret in owning multifamily property and how the change in rents results in significant upside to the asset. Here is another GOLDEN NUGGETT
When do you make money in real estate? Think about it… What is your answer?
You may consider remodeling the kitchen and bathrooms to establishing better return ratios. Remember, CAPEX and significant improvements to the building are not normal operating expenses. They could be considered investment into your future equity. if If done smartly that will compound and add value to the asset
OH, and by the way. the answer to the question two paragraphs ago. You make your money on the BUY. You create the pro-forma when you purchase and know the exit strategy years in advance with the change in Equity being your profit as well as the cash flow!
As you progress you will examine how to do this and the effect on the future value of the asset! Continue on to level 2 after you master these concepts.
Creating Equity by Increasing Effective Income by investing in Selective Capital Expenditures
In this level 2 game you will establish the new value of an asset 3 years after the purchase by making some very selective improvements. Mostly what attracts new tenants at a higher rental rate are upgraded kitchens and the bathrooms.
This remodel is posted as CAPEX which stands for Capital Expenditures . It is different than OPEX as these moneys are being spent to upgrade the asset to achieve a maximum rent roll within a strict budget. This is different than the day to day operational expense (OPEX) of running the building which you discovered in level 1.
These days construction, materials, and labor is very expensive; therefore, you will put on your savings hat to mitigate the high cost in every way possible. One great way to do this is establish a fictious firm name so that you are remodeling as a home improvement business. You are the owner, builder, and private contractor (which is permitted in almost every county even if you are not a licensed contractor if you are working on your own property) This may entitle you to many discounts for this being your side business. Moreover, easy to set up by a simple recording at your County Clerk’s Office to set up a fictious firm.
From there set up a pro account at Home Depot and any other major suppliers. This should be done at the paint store, import cabinet shop, tile supplier, granite yard, plumbing and pipe company and at dozens of other vendors. Also, with a pro number there is a permanent record of all your construction receipts and easy to close out the year for the cost of the materials and it is all documented automatically.
Even better, I generally charge the materials on a credit card that gives me airline miles and other rewards. I even purchase gift cards for the workers to use for other materials like drywall, concrete, supplies, pipes etc using the credit card. At the end of the year, I have enough miles for a pair of free tickets to Europe. Every cost must be compounded, documented, monitored and maximized.
For example, let’s establish a faux company: (The Lemonade Company) TLC HOME RENNOVATION. It is catchy name and doubles for cute tender loving care making it memorable. People remember these kinds of things especially the vendors. This is only a name with a simple business license, and you should establish your new vendor accounts using this name.
This is also great for preventing identity theft including opening a new checking account with an EIN (employee Identification Number) No need to use or broadcast your social security number. Also establish a post office box for all mailings. No one needs to know the details of your personal life or residence. Again, this is only a D.B.A. or (doing business as)
After a year of running our building from the last simulation you have amassed $60,000.00 in positive cash flow and it is time to put that to work in your building. You will use all the skills you have learned in the lemonade game and mostly the laws of compounding and the theory of equity.
You have budgeted $25,000 per apartment or $100,000.00 in total for the remodel and upgrades. Here is how you allocated the CAPEX slam homerun!
this section is currently under construction
| January | February | March | April | May | June | July | August | September | October | November | December | Total | |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Income | |||||||||||||
| Rents Received Unit A | $0.00 | ||||||||||||
| Rents Received Unit B | $0.00 | ||||||||||||
| Rents Received Unit C | $0.00 | ||||||||||||
| Rents Received Unit D | $0.00 | ||||||||||||
| Parking | $0.00 | ||||||||||||
| Laundry Room Income | $0.00 | ||||||||||||
| Tenant Storage Fees | $0.00 | ||||||||||||
| Security Deposits Received | $0.00 | ||||||||||||
| Miscl, Interest, Other Income | $0.00 | ||||||||||||
| Total Income | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 |
| Operating Expenses | |||||||||||||
| Property Taxes | $0.00 | ||||||||||||
| Insurance | $0.00 | ||||||||||||
| Property Manager | $0.00 | ||||||||||||
| Maintenance Worker | $0.00 | ||||||||||||
| General Repairs | $0.00 | ||||||||||||
| Garbage Collection | $0.00 | ||||||||||||
| Internet, Cable, TV Package | $0.00 | ||||||||||||
| Heating and Gas | $0.00 | ||||||||||||
| Water | $0.00 | ||||||||||||
| Electricity | $0.00 | ||||||||||||
| Gardening / Landscaping | $0.00 | ||||||||||||
| Pesticide and Bug Service | $0.00 | ||||||||||||
| Accounting Fees | $0.00 | ||||||||||||
| Web Hosting & Development | $0.00 | ||||||||||||
| Licenses and Legal Filings | $0.00 | ||||||||||||
| Legal and Professional Fees | $0.00 | ||||||||||||
| Cleaning Fees | $0.00 | ||||||||||||
| Landlord Storage Fees | $0.00 | ||||||||||||
| Security Deposits Returned | $0.00 | ||||||||||||
| Office Supplies & Inventory | $0.00 | ||||||||||||
| Security Monitoring | $0.00 | ||||||||||||
| Doc-U-SIgn, Copy, Postage | $0.00 | ||||||||||||
| Vacancy & Allowances | $0.00 | ||||||||||||
| Total Operating Expenses | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 |
| Income - Operating Expenses | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 |
Current Market Value—
Capitalization Rate—
Expense Ratio—
|
|||||||||||||
| CAP X | |||||||||||||
| Permits | $0.00 | ||||||||||||
| Construction, Demolition, | $0.00 | ||||||||||||
| Architecture & Civil Engineering | $0.00 | ||||||||||||
| Appliances | $0.00 | ||||||||||||
| Furnishings | $0.00 | ||||||||||||
| Upgrade Electric, EV Charge, AC | $0.00 | ||||||||||||
| Painting | $0.00 | ||||||||||||
| Lighting, Security, Miscl | $0.00 | ||||||||||||
| Fencing | $0.00 | ||||||||||||
| Counter tops | $0.00 | ||||||||||||
| Cabinets, Baseboards,Molding | $0.00 | ||||||||||||
| Bathroom Remodel | $0.00 | ||||||||||||
| Plumbing Upgrade | $0.00 | ||||||||||||
| Miscl | $0.00 | ||||||||||||
| TOTAL CAP X | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 |
| New section | |||||||||||||
| Starting Property Basis | $0.00 | ||||||||||||
| Add Capex to Basis | $0.00 | ||||||||||||
| Subtract Depreciation from Basis | $0.00 | ||||||||||||
| NEW Adjusted Basis | $0.00 | ||||||||||||
| Total | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 | $0.00 |