Fuzzy Math: Income Producing Real Estate
Dan Harkey, at DanHarkey.com writes great articles about real estate on his website. You can read more articles by visiting his website. In this article, he discusses “Fuzzy Math: Income Producing Real Estate”
“Fuzzy Math” was first introduced to the public during the televised debates between George W Bush and Al Gore, in the 2000 U.S. presidential election. “This man has been disparaging my plan with all this Washington fuzzy math.” How many of you remember this humorous interface? Since then, these terms are frequently used by politicians and others to suggest that their opponent’s numbers are doubtful or are otherwise inaccurate.
How does “Fuzzy Math” relate to real estate ownership? Sometimes deceptive calculations can result in wide differences in financial outcomes, tax considerations and the ultimate disposition of real estate.
Here are three definitions of rents:
Current Rent: What you’re collecting now.
Economic Rent: What the market says you’ll should receive in rent.
Proforma Rent: What a seller will represent to a buyer that they should be able to get.
- Current Rents: The current rent, also referred to as contract rents, relates to the income generated by the existing owner. These current/contract rents may vary based upon owner’s management skills or involvement, property condition, existing leases, and overall economic conditions.
- Economic Rents: Otherwise known as market rents is estimated based upon comparable properties in the unique marketplace. This involves compiling current information by property managers or appraisers, considering comparable rental units, and adjusting for quality, location, amenities, and condition of the overall property in a unique market. This is sometimes referred to as “What will the market bare?”
- Proforma Rents: Sometimes called projected rents or potential gross income. A proforma rent calculation should be the same as “economic rent or projected rent.” Proforma rents are used interchangeably by owners, brokers, appraisers, and lenders. “Projected rents” is a term used to denote what a prospective new owner, or new property manager may collect upon taking over ownership or management of the property. In some cases, these projected amounts are based on property upgrades, rehabilitation, and possibly more intensive management of the asset. There may be significant variations in the estimation of expected future possible rents.
The property owner’s goal is to maximize actual net operating income, which begins with maximizing rent collected. Gross scheduled income, less vacancy, less expenses equals net operating income.
When a property owner does his tax returns at the end of the year, they are interested in minimizing the income, but maximizing the expenses, to reduce the federal and state tax burden.
When a property owner loses interest in, or mismanages the property, the rents will go down, primarily because of vacancy and diminished condition of the property.
When an owner approaches a lender for financing, the owner gets interested in maximizing the rents, so that the property will appraise for more, hence a larger loan amount.
When the property owner passes away, his estate planners and attorneys work ferociously to attempt to lower estate taxes. This may involve showing lower rents and significantly poorer property condition for tax purposes.
If the economy remains strong, the population grows, and there’s a solid demand for rentals, actual rents will eventually rise to the level of proforma rents.
If the economy doesn’t continue to boom, or worse, goes into the tank, unemployment rises, vacancies rise, and rental amounts collapse, then those proforma rents were simply someone’s optimistic illusion.
Understanding the differences in Current Rent, Economic Rent, Proforma Rent makes us more a valuable professional while representing borrowers and lenders. You will stand out when you are able to convert “Fuzzy Math” into “Solid Math” calculations.