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Understanding Gross Operating Income (GOI)

February 7, 2012

The gross operating income (GOI) of a rental property is an essential part of any real estate analysis because it represents the actual annual income an investor can expect to collect from the property for rented space and other income after deductions for vacancy and credit loss. In other words, gross operating income reflects the annual rental income collected from all the occupied units as well as income from any other source (i.e., coin-operated laundry facilities).

Here’s a typical way you might see it presented in a real estate cash flow analysis.

Gross scheduled income (GSI)
less Vacancy and credit loss
= Effective gross income (EGI)
plus Other income
= Gross operating income (GOI)

Example

You are evaluating the income and cash flow performance on a ten-unit apartment complex that is currently fully rented at $700 per unit per month and generates another $100 per month from coin-operated washers and dryers. You want to know the property’s GOI but to be on the safe side you feel it necessary to include a vacancy and credit loss of 3%.

You first need to know the gross scheduled income. Bear in mind that gross scheduled income always represents the potential income as if the units were fully occupied so you would always account for vacant units at a market rent. But in this case, since you have no vacant units to account for, you can simply multiply the monthly income by the number of units by 12 to find the annual amount:

Gross Scheduled Income = (700 x 10) x 12 = 84,000

Next, you need to figure the 3% vacancy and credit loss of the gross you estimate will likely occur during the year and subtract that amount from the gross to determine the effective gross income.

Vacancy and Credit Loss = 84,000 x 0.03 = 2,520.
Effective Gross Income = 84,000 – 2,520 = 81,480

Finally, you add the annual income generated from the laundry facilities (100 x 12 = 1,200) to the EGI to arrive at the GOI.

Gross Operating Income = 81,480 + 1,200 = 82,680

Okay, now understand why this income and cash flow is important to derive when evaluating a rental income property. Picture what occurs next.

Gross operating income less operating expenses equals net operating income less debt service equals cash flow before taxes.

In other words, the gross operating income of a rental property represents the actual annual income generated from which the real estate investor must ultimately cover all the property’s annual operating expenses and mortgage payments. Obviously when this amount is sufficient the real estate investor can at least count on the property covering itself without having to feed it; otherwise the investor will have to cover the negative cash flows out-of-pocket.

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Vacancy and Credit Loss | How It Impacts a Real Estate Analysis

January 30, 2012

The reality of owning rental property is that you will rarely encounter a situation where the property is occupied all of the time or where tenants can always be counted upon to pay their rent. The reality about investment property is that real estate investors will suffer potential rental income loss due to both vacancies and nonpayment of rent by tenants in what is formally known as Vacancy and Credit Loss.

In any real estate analysis this is factored in as a deduction from gross scheduled income (i.e., the property’s potential rental income at total occupancy) and results in the gross operating income (i.e., the amount of actual revenue expected to be collected).

Gross Scheduled Income
less Vacancy and Credit Loss
= Gross Operating Income

This is true for income properties consisting of one unit or a multitude of units; whether the property is residential (i.e., occupied by tenants as a residence such as a single-family home or apartment building) or non-residential (i.e., occupied as a place of business such as an office building or strip center). Real estate investors always account for an estimate of future losses resulting from turnover and noncollectable rent and factor it in to their real estate analysis as vacancy and credit loss.

There is, of course, no one rate that correctly applies to all income properties because it is market-driven. That is, in one location where the supply for residential or commercial property is limited, demand will tend to be high and the vacancy rates low accordingly; whereas in locations where developers exceed demand with an over supply, the opposite is true.

Economic times also play a part. In times like ours, for instance, where house foreclosures have run rampant over the past several years, the demand for residential rental space has increased; all the while because jobs have been lost, businesses have closed or are reluctant to expand, thus reducing the absorption of commercial space or in many cases caused tenants to default on their payments to their landlords.

How to Calculate

Vacancy and credit loss is generally estimated as a percentage of gross scheduled income. For example, if we assume that your property would generate $50,000 a year fully occupied and want to allow for a 5% vacancy and credit loss, we would estimate your loss of revenue to be $2,500 revenue for that year.

$50,000 x .05 = $2,500

What to Consider

Always plug in a rate for vacancy and credit loss whenever you are doing a real estate analysis regardless what you may think or what the current owner is projecting for the property. In other words, even when the owner can prove that he or she has experienced zero (or very low) vacancy as the landlord, bear in mind that every property experiences vacancy from time to time for any number or reasons. Your local market will dictate what’s reasonable so be sure to use it.

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Which Returns Should Investors Consider Crucial When Buying Real Estate?

January 20, 2012

The art of successful real estate investing is not rocket science. The investor locates a property, crunches the numbers, and makes an investment decision based upon whether those numbers indicate a positive return that meets or exceeds the investor’s investment strategy.

Fair enough.

Nonetheless it can be illusive and confusing for novice investors who have little or no experience to crunch the numbers. For them, trying to discern whether or not a rental income property might be a good and profitable investment, or even warrant a second look based upon the numbers can be daunting.

This is not the fault of the novice real estate investor.

Investment property analysis reports typically yield a host of returns, measures, and ratios that are not listed in order of importance. A real estate analysis could easily place debt coverage ratio (which is not necessarily a profitability indicator), for instance, ahead of the cash-on-cash return (which is more significant to profitability).

It seems like a good idea, therefore, to assign some of the more popular real estate investing returns and measures to the category where they commonly associate. The list is by no means exhaustive, and certainly is not scientific, but it should help you get a better idea of what to look for about the profitability of income-producing property.

For our purpose, we’ll keep it simple and create just three categories.

  1.     Mortgage related
  2.    Value related
  3.     Cash flow related

Mortgage Related

Getting a favorable mortgage is certainly important to an investor because the loan will have a direct impact upon a property’s financial performance. But the numbers associated with mortgages themselves, although major benchmarks for lenders, don’t reveal much about the health of an investment.

  1.     Loan to Value (LTV) – This is the ratio between the property’s mortgage financing and its value. It is used by lenders to control the amount of your investment equity.
  2.     Debt Coverage Ratio (DCR) – This is the ratio between annual net operating income and annual debt service. It is used by lenders to measure the relationship between the income generated and the loan payment.
  3.     Break-even Ratio (BER) – This reveals the proportion between income and expenses. Its purpose is essentially to estimate how vulnerable a property is to defaulting on its debt should rental income decline.

Value Related

The desire of any investor is being able to purchase rental income property at or below the market value, and absolutely never to pay more than its worth. This requires a good understanding of what the local market value is for rental income properties and then to make a comparison.

Several indicators are commonly used to accomplish this but these are market-driven (i.e., the results in one region are inconsequential to properties outside the region) so by themselves they say little about the subject investment potential. They merely help you to assess fair market value. Just bear in mind that you must always apply these measures to similar-type properties (i.e., apartments to apartments, etc.).

  1.     Gross Rent Multiplier (GRM) – This is a ratio between gross scheduled income and property value. It is not the best valuation technique but does provide a quick and easy first glance.
  2.     Cap Rate – This expresses the relationship between a property’s value and its net operating income. This is the technique most commonly used by appraisers and property tax assessors for valuation purposes.
  3.     Cost per Unit – This takes the property’s price and divides it by the number of rental units. This can provide a quick overview of apartment complexes because they tend to be more uniform in their ability to generate income. Commercial properties are more apt to look at cost per square foot. Either way it should be used as a secondary valuation technique at best.

Cash Flow Related

Okay, this where the rubber meets the road. Cash flow is what real estate investors are purchasing and ultimately what determines the profitability of income property. It may be a positive monthly or annually cash flow (depending on the investor’s personal financial needs) or maybe even a negative cash flow (depending on the investor’s personal income tax needs).

Nonetheless, at the end of the day, the profitability of any real estate investment boils down to cash flows—generated both during ownership and upon re-sale. Here are some of the returns you want to look for to measure profitability, but bear in mind that no one approach to investment decision-making will provide all the answers.

  1.     Cash on Cash (CoC) – This is the ratio between a property’s cash flow and the amount of the initial capital investment. It is not particularly powerful but can be used as an easy comparison to other types of investment.
  2.     Internal Rate of Return (IRR) – This is the rate of return your actual cash investment will yield based upon forecasted future cash flows. It is probably the most widely used measurement by real estate investors.
  3.     Net Present Value (NPV) – This is the difference between the present value of all future cash flows and the amount of cash invested to purchase those cash flows. The result is a dollar amount that in essence tells you whether the yield you desire on your cash investment is achieved by those future cash flows.
  4.     Profitability Index – This is similar to net present value as a method of measuring return except it results in a ratio between the present value of all future cash flows and the amount of cash invested. It is typically used by investors to compare two investment opportunities that require different initial investments.
  5.     Cash Flow After Tax (CFAT) – This is the actual amount of cash you can pocket after satisfying your income tax liability from the operation of the property. You can also pocket cash flows before taxes (CFBT) but remember that it is subject to taxation so you may have to part with some of it at tax time.
  6.     Sale Proceeds – This is what you hope to get when you sell your property but is subject to taxation. Sale proceeds after taxes are what you hope to keep after settling up with Uncle Sam. The easiest way to determine both proceeds is with a real estate investment software solution that creates a proforma income statement. This will allow you to make projections out over (say) ten years and reveal the sale proceeds in both cases.
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