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Income Property
Income Property is defined as real estate developed or purchased to produce income, such as a rental unit.
There are four major ways that income property finances are analyzed: Liquidity, Leverage, Activity and Profitability
Income Property Liquidity
In order to determine liquidity of income property, current assets are compared to current liabilities. A liquidity ratio of 2 to 1 (current assets are twice the liabilities) or better is recognized as safe and acceptable for income property. Cash and accounts and notes receivable due within one year are “current” assets; liabilities due or payable within one year are considered “current.”
Income Property Leverage
Leverage is the ability of the borrower, real estate investor to control a large income property investment with a small amount of his or her own equity capital and a large amount of other people’s money. The more money borrowed in relation to value of the income property, the greater the leverage. Leverage tests reveal how much of the total financing for the income property project is supplied by the owner and how much is supplied by creditors such as the mortgage lender.
Income Property Debt-to-equity ratio.
Leverage tests in connection with analysis of a borrower’s financial statements are completed by comparing the owner’s equity interest and the total value of the capital investment to the long term debt and the value of the total capital investment. The purpose is to find how much of the total investment in income property is ownership and how much is debt. To determine the original equity ratio, divide the down payment by the purchase price. To determine the debt ratio, divide the loan amount by the purchase price.
It is common for equity investors to seek debt ratios in excess of 75-80% for income property. Lenders, looking at risk factors, carefully scrutinize loan proposals to assure a safe equity ratio based on income property characteristics and borrower’s repayment record. The rule of thumb ratio for debt to equity ratio will be something between 3:1 and 4:1. The borrower often wants a more extreme ratio because it reduces the amount of his or her own money that is being risked. Real estate investment in income property examples have been presented where ratios of 1 to almost 0 are achieved by borrowers. This is usually a very dangerous situation for the lender. An exception of course would be where the repayment of the loan is guaranteed or insured by some reputable third party in the transaction, such as the FHA or VA or a financially strong company such as a major chain store or oil company.
Some lenders are willing to risk entering a high debt to equity loan situation in anticipation of market prices going up, which automatically achieves growth in the owner’s equity and a more moderate ratio is automatically achieved. Experience has repeatedly shown that this expectation is not always borne out, especially in unstable economic conditions.
Coverage of fixed expenses is a test of how many times net income before income taxes and fixed expenses (gross income minus operating expenses) will cover the fixed expenses. It reveals how low income can drop before the income property (or the borrower) will be unable to meet the fixed expenses such as real estate taxes, insurance, license and permit fees.
Net income after operating expenses is divided by fixed expenses to get this ratio. If the ratio is 1:1, the net income after operating expenses is just barely able to cover the fixed expenses.
Income Property Activity
Activity tests are designed to reveal just how hard and effectively assets are working. There are several tests for this but the most widely used is the income to total asset ratio of the income property. This ratio is found by dividing total income by the value of total assets of the income property
Income Property Profitability
Profitability tests are designed to see how much net profit results from the operation. The following are several of a variety of ratios and tests that are used to inquire into profitability.
Income Property Return on net worth. This is the ratio of net profit (after taxes) to the net worth of the income property project. This will yield a percentage return on investment which can be compared with the return available from other investments of comparable risk.
Income Property Yield analysis. This is a form of analysis well suited to determining profitability of income property real estate projects because it is relatively easy to compute and takes into consideration three factors unique in their combination to real estate investment: cash return, equity return, and tax shelter. It involves dividing the total return (net spendable cash income, principal reduction of mortgage loans, and tax shelter) by the investor’s equity.
Source: California Department of Real Estate
This is a blog post for Real Estate Professionals, Investors, Landlord, Property Manager, and Property Management Companies. Income Property is brought to you by SimplifyEm Pay Rent Online and Property Management SoftwareYou might also want to read:
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