I see mistakes all the time in calculating the return of a real estate investment. Today the topic is how to properly to account for reserves when one calculates the return on investment. You see brokers and investors calculating the annual return on a real estate investment that has been acquired with no financing as follows:
GROSS INCOME
less VACANCY AND COLLECTIONS
equals GROSS EFFECTIVE INCOME
less OPERATING EXPENSES
equals NET OPERATING INCOME
RETURN = NET OPERATING INCOME/PRICE PAID FOR THE PROPERTY
Using a simple example, let's say a residential property was purchased for $200,000 and it generates in Gross Income $18,000.00 per year, a 5% vacancy and collections is applied for a Gross Effective Income of $17,100.00. Let's assume that Operating Expenses are $6,300.00 per year (this is property taxes, Insurance, maintenance,etc). Then the Net Operating Income is $10,800.00 which will show a Return on the Investment of 5.4% on the first year operation and using a simple cash on cash return. This figure is totally wrong and misleading to an investor. We should account for reserves for replacement, a non-tax deductible deduction that must be applied to the investment every year as a cost for when replacement of items will become necessary in the future. Also from a cash flow standpoint, it is necessary to actually put the funds aside for when the time comes in the future to replace an item. Reserves for replacement are reserves based on the cost and life expectancy of items that must be replaced in a property such as driveways, roofs, air conditioning units, appliances, other equipment and paint. If the cost of a roof is $15,000.00 and its useful life is 25 years, assuming in our example this property ha a new roof then we must account for a roof reserve of $600.00 per year. Let's also assumed that the expected remaining life of an air conditioning unit in our property is 4 years and the cost of an A/C unit is $3,500.00 and that all appliances have an expected remaining life of 5 years with a total cost of $3000.00 then our total reserves for replacement will be $600 for the roof, $875 for the A/C unit and $600.00 for appliances for a total yearly reserves for replacement of $2,075.00. Then the real Cash on cash Return on the Investment is Net Operating Income of $10,800.00 less $2,075.00 in reserves for replacement over what we paid for the Investment ($200,000.00).
Net Operating Income = $10,800.00
less Reserves for Replacement = ($2,075.00)
Net Investment Income = $8,725.00
Return on the Investment = $8,725.00/$200,000.00 = 4.3625% (before taxes)
Then 4.3625% is the actual cash on cash return on the investment before taxes and not 5.4%. Then applying the proper tax rates one can obtain the return after tax and in the event a portion of the purchase is financed the return will be affected by the principal and interest paid and we will discuss this as well as Internal rates of Return in the future in other blogs.
The point here is that real estate brokers and managers must use an accurate way to calculate the return of an investment for an investor and must include not only all operating expenses an account for vacancies but also account for reserves for replacements.
