Financial Analysis
Life is a series of cash flows. Learn to become their master, not their slave.
—STEVE BERGES
T
his is probably the most crucial
chapter in the entire book. Because the scope of this book is narrowly lim-
ited to multifamily properties, only one chapter is devoted to the principles
of financial analysis. While an abundance of books are written on how to
buy and sell real estate, the market is virtually devoid of any works that
specifically address the principles of finance and value as they apply to real
estate. These topics are, however, covered in The Complete Guide to Real
Estate Finance: How to Analyze Any Single-Family, Multifamily, or
Commercial Property (Hoboken, NJ: Wiley, 2004), which is written with an
emphasis on the concepts of financial analysis as they pertain to real estate
and is intended to help fill this current void. The book takes the theories of
real estate finance discussed in other books and demonstrates how they can
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CHAPTER 7
be used in real-world situations. In other words, it is the practical applica-
tion of these theories that really matters to investors. An in-depth examina-
tion of a variety of case studies in The Complete Guide to Real Estate
Finance: How to Analyze Any Single-Family, Multifamily, or Commercial
Property provides the learning platform necessary for investors to make the
transition from the theory of real estate finance to its practical application.
For now, however, let us focus on buying and selling apartment buildings.
The key to your success in buying and selling apartment buildings is a thor-
ough and comprehensive understanding of value. Proper valuation is the
basis for all investment decisions, whether it be an investment in the stocks
of various companies, precious metals, or real estate. You absolutely must be
able to understand how value is derived in order to make prudent invest-
ment decisions. Without this vital skill, you will find yourself at a tremen-

aging 97 to 98 percent occupancy with minimal turnover. By the tenth
month, it was time to begin implementing my exit strategy. I would do one
of two things—either sell the property outright, or refinance it to pull as
much of my equity out of it as possible. I already had a broker in mind whom
I knew from a previous transaction. He happened to work for one of the
nation’s largest commercial real estate brokerage firms. He was a respected
and active broker who knew the apartment market well, or so I thought.
My own analysis of the financial statements for my apartment complex sug-
gested a value of approximately $2 to $2.1 million. For what I had into it, I
thought I would probably list it at a price of $2.05 million and would be will-
93
Financial Analysis
ing to settle for $1.9 to $1.95 million. To my utter dismay, the broker I was
about to engage to represent me suggested a value of only $1.8 million on
the high side and said I would be lucky to get $1.65 million. I must admit
that I was temporarily devastated by his analysis. This was a broker I trusted
and felt certain was competent. A sales price of $1.65 million was not at all
what I had in mind. I began to question myself and wondered where I had
gone wrong. After all, I had spent a great deal of time and energy, not to
mention money, on this project. Was all of this for naught? My feelings of
despair lasted for all of about 10 minutes.
I have been knocked down enough times to know that I have two choices—
I can either stay down, or I can get back up. I chose the latter. It was time
for a second opinion, and while I was at it, I thought I might as well get a
third opinion, too. I quickly contacted two other brokers who I knew were
active in that market and faxed my financials to them. I was careful not to
prejudice their opinions with my own as related to the value. The first bro-
ker came back with a value of $2 to $2.1 million, while the second broker
estimated the value to be $2 to $2.2 million. Bingo! Aahhh, life was good
again. My analysis had proven to be right on target and was corroborated by

this approach is heavily dependent upon the availability of data on recent sales
of properties similar in location, size, and utility to the appraised property.
The sales comparison approach is premised upon the principle of substitu-
tion—a valuation principle that states that a prudent purchaser would pay no
more for real property than the cost of acquiring an equally desirable substi-
95
Financial Analysis
*Excerpts in this section are from a private annual appraisal report by Butler Burgher, LLC, Houston, Tex., July
2000. Reprinted here with permission.
tute on the open market. The principle of substitution presumes that the pur-
chaser will consider the alternatives available to them, that they will act ratio-
nally or prudently on the basis of his information about those alternatives, and
that time is not a significant factor. Substitution may assume the form of the
purchase of an existing property with the same utility, or of acquiring an
investment which will produce an income stream of the same size with the
same risk as that involved in the property in question.... The actions of typ-
ical buyers and sellers are reflected in the comparison approach.
In short, the sales comparison approach examines like properties and
adjusts value based on similarities and differences. This method is used
most often in valuing single-family homes. Say, for example, you decide to
sell your house. To help you determine what price you should list your
house for, your broker will pull up all of the current listings in your neigh-
borhood, as well as recent sales, and calculate a range of prices based on
average sales per square foot. Then the broker will consider factors such as
the overall condition and the various amenities of your home. Does it have
a fireplace, or a swimming pool? Is it a two-car garage or a three-car
garage? And so goes the process, adding and subtracting until a final value
is determined.
The use of sales comparisons, or sales comps, as they are called, is an impor-
tant factor to consider in the overall analysis to determine the value of multi-

Replacement Cost Approach
Butler Burgher, LLC, defines the replacement cost approach as follows:
The cost approach is based on the premise that the value of a property can
be indicated by the current cost to construct a reproduction or replacement
for the improvements minus the amount of depreciation evident in the struc-
tures from all causes plus the value of the land and entrepreneurial profit. This
approach to value is particularly useful for appraising new or nearly new im-
provements.
The replacement cost approach is typically not used to value income-
producing properties such as apartment complexes. It is most appropriately
used when estimating the actual costs associated with replacing all of the
physical assets. For example, if the building were to be completely destroyed
by fire, the value established by the replacement cost approach would be
useful in helping to determine exactly how much an insurance company
would pay for the resulting damages. While not related to our valuation dis-
cussion, you should know that most insurance companies will include some
compensation to you for the loss of income incurred as a direct result of the
fire (or for any other reason as may be expressly stated in your policy).
Check with your agent to ensure that your policy does in fact include cover-
THE COMPLETE GUIDE TO BUYING AND SELLING APARTMENT BUILDINGS
98
age of this sort. The loss of rental income from some or all of your units
resulting from some natural disaster does not absolve you of your responsi-
bilities to your debtors. While they may empathize with you in your unfor-
tunate circumstances, your debtors will nevertheless continue to demand
payment.
Income Capitalization Approach
Once again, I will rely on the appraisal firm of Butler Burgher, LLC, to
define the income capitalization approach, or income approach, as it is also
known.

income approach. Remember, proper and accurate valuation is the key to
your success in this business. Without this very crucial key, the door will
remain locked, and you will be left standing on the outside wondering why
you cannot open the door. Take comfort in the fact that the case studies that
follow in Chapter 8 outline in detail exactly how this valuation process
works.
Let us break down the income approach to its most fundamental level by
examining a basic financial instrument. For example, assuming a market
interest rate of 5 percent, how much would you be willing to pay for an
annuity yielding $10,000 per annum? The answer is easily solved by taking
a simple ratio of the two values, as follows:
Present value == =$200,000
In other words, if you purchased a certificate of deposit (CD) for $200,000
that yielded 5 percent annually, you could expect to earn an income stream
of $10,000. It does not matter, by the way, whether the income continues
indefinitely, or perpetually; the present value remains the same. If you
changed the rate to 10 percent and the annuity generated the same $10,000
income stream, the instrument should be worth even more, right? After all,
$10,000
ᎏ
0.05
income
ᎏ
rate
THE COMPLETE GUIDE TO BUYING AND SELLING APARTMENT BUILDINGS
100
you are now earning a rate twice what you were receiving. Surely this must
be worth more. Let us do the math:
Present value == =$100,000
Okay, you ask, how can that be? Examining this equation as an investor,

rate
101
Financial Analysis
the additional risk associated with property ownership. If an investment in an
apartment building yielded the same 5 percent, would you invest in a CD, or
in the apartment building? Unless you just felt compelled to buy apartments,
there would be no reason to invest in them. Clearly, you would invest in the
CD, because it is a risk-free instrument with little to no effort required on your
part. Why buy an apartment building, which requires a great deal of time and
energy on your part, if it generates the same level of income as an instrument
that requires virtually no effort? You would not buy it. There must be some
additional incentive or premium paid to offset the additional risk, time, and
energy required for ownership of a multifamily property.
In summary, each of the three traditional valuation approaches serves a
unique function by using different methodologies to derive value. If a full
and formalized appraisal were to be conducted, all three approaches would
be employed, with varying weights applied to each one. Butler Burgher
affirms, “The appraisal process is concluded by a reconciliation of the
approaches. This aspect of the process gives consideration to the type and
reliability of market data used, the applicability of each approach to the type
of property appraised and the type of value sought.” For our purposes, we
will rely primarily on the income approach.
Financial Statements
Financial statements represent the end product of the accounting process.
There are a number of issues to consider, as well as various approaches
employed, to report an entity’s financial condition, most of which are cov-
ered under what are known as generally accepted accounting principles
(GAAP). Financial accounting and reporting assumptions, standards, and
practices that an entity uses in preparing its statements are all governed by
GAAP. The standards for GAAP are prescribed by authoritative bodies such

103
Financial Analysis
for investment-related decisions. The income statement presents a summary
of an apartment’s earnings activities for a given period of time. It reports all of
the revenues earned, as well as the expenses incurred to earn them. Operating
revenues less operating expenses is equal to the apartment’s net operating
income. An in-depth analysis of the income statement will provide insight into
the property’s level of existing profitability, as well as an indication of future
profitability. The income statement can be divided into five main categories.
Five Essential Components of an Income Statement
1. Operating revenues.
2. Operating expenses.
3. Net operating income.
4. Debt service.
5. Reserve requirements.
Operating revenues consist of all sources of revenue, such as gross scheduled
income, vacancy loss, and other income. Gross scheduled income represents
100 percent of the potential income an apartment complex could produce if
every single unit were occupied. In other words, if the vacancy rate were zero
and all tenants paid 100 percent of their respective rent, the rental income for
the property would be maximized. Vacancy loss represents the amount of
income lost due to unleased units. Promotional discounts and concessions,
as well as delinquencies, also fall under the vacancy loss category. Other
income includes income from late fees, application fees, laundry rooms,
vending machines, and any payments that may be collected for utilities.
Second, operating expenses include all of the expenses having to do with
actually operating the property, such as general and administrative
expenses, payroll, repairs and maintenance, utilities, and taxes and insur-
ance. It does not include depreciation expenses, interest expenses, or any
THE COMPLETE GUIDE TO BUYING AND SELLING APARTMENT BUILDINGS

Financial Analysis
Net operating income is the remaining income after all operating expenses
have been disbursed. It is also the amount of income available to service any
associated debt—that is, to make any loan payments. Finally, net operating
income is the numerator in the quotient used to calculate the capitalization
rate, which is discussed in greater detail later in this chapter under Five Key
Ratios You Must Know.
The fourth component of the income statement is debt service, which is fairly
self-explanatory. It includes both the principal and interest portions of any
debt payments being made on the property. In addition, it is the denomina-
tor in the quotient used to calculate the debt service coverage ratio, which is
also discussed in greater detail under Five Key Ratios You Must Know.
Finally, the reserve requirements portion of the income statement is used to
cover any capital improvements to the apartment complex. Lenders will often
figure into their calculations a budgeted amount deemed appropriate to
make necessary capital improvements. The reserve requirement is estimated
on an annual basis, and often is broken down into a per-unit figure, such as
$250 per unit per year. Under this scenario, on a 100-unit apartment com-
plex, you would have a total of $25,000 budgeted for improvements.
Study Table 7.2 to better understand how the various components of an
income statement work together. By examining as many income statements
as possible, you will soon begin to get a feel for a property with just a quick
perusal.
Balance Sheet
The balance sheet, or balance statement, as it is sometimes known, reports
a property’s financial position at a specific point in time. In effect, it pro-
vides a snapshot of the apartment’s position on a specific date, usually at
THE COMPLETE GUIDE TO BUYING AND SELLING APARTMENT BUILDINGS
106
107

Payroll taxes 834
834 834 834 3,337
Total salaries and payroll 11,884 10,985 11,884 11,884 46,638
Utilities
Electric 11,465 17,878 26,504 17,880 73,727
Gas 3,880 3,147 2,160 2,880 12,067
Water and sewer 9,222 9,910 11,879 11,546 42,557
Trash 1,425 1,425 1,425 1,425 5,700
Telephone 255
245 277 246 1,023
Total utilities 26,247 32,202 42,245 33,977 134,671
Other
Real Estate Taxes 7,905 7,905 7,905 7,905 31,620
Insurance 2,556
2,556 2,556 2,556 10,224
Total Other 10,461 10,461 10,461 10,461 41,844
Total Operating Expenses 66,625 72,320 82,630 74,707 296,283
Net Operating Income 57,342 58,017 58,514 64,918 238,790
Debt Service 38,400 38,400 38,400 38,400 153,600
monthly, quarterly, and annual intervals. The balance sheet can be instru-
mental in providing information about an entity’s liquidity and its financial
flexibility, which can at times be crucial in meeting unexpected short-term
obligations. Examining the debt-to-equity ratio, for example, may indicate
that the business is already highly leveraged and that no remaining borrow-
ing capacity exists. The balance sheet is also useful in measuring profitabil-
ity. For example, by relating a company’s net income through the use of
ratios to the owner’s equity or to the total assets, returns can be calculated
and used to assess the company’s level of profitability relative to similar
businesses. The balance sheet can be divided into three main categories.
Three Essential Components of a Balance Sheet

the operating cycle. Noncurrent or fixed assets are those whose benefits
extend over periods longer than the one-year operating cycle. As related to
a multifamily property, current assets include amounts owed but not yet col-
lected (accounts receivable), cash, security deposits (with utility companies
or suppliers, for example), prepaid items such as insurance premiums, and
supplies. Fixed assets include items such as buildings, equipment, and land.
The liabilities of a business are its debts, or any claim another business or
individual may have against the operating entity. Liabilities can also be clas-
sified as current or noncurrent. Current liabilities are those that will require
the use of current assets or that will be discharged within a relatively short
period of time, usually one year. Noncurrent or long-term liabilities are those
longer than one year in duration. Current liabilities include amounts owed
to creditors for goods and services bought on credit (accounts payable),
salaries and wages owed to employees or contractors, security deposits
(deposits made by the tenants prior to moving in), taxes payable, and notes
payable. Long-term liabilities include mortgages payable and any kind of
secondary financing secured against the property, such as loans for capital
improvements or equipment financing.
The equity of a business represents that portion of value remaining after all
obligations have been satisfied. In other words, if your position in an entity
were to be liquidated by selling off all of the assets and subsequently satisfy-
109
Financial Analysis
ing all of the creditors, any remaining proceeds would represent your equity.
Because the law gives creditors the right to force the sale of the assets of the
business to meet their claims, your equity is considered to be subordinate to
the debt. In the event a company declares bankruptcy, obligations to the
creditors will be satisfied first, and obligations to owners or shareholders
will be satisfied last.
The two primary categories of equity are (1) owner’s contributions and (2)

Operating cash 30,580
Petty cash 498
Accounts receivable 1,127
Supplies 588
Prepaid insurance 6,594
Utility deposits 17,885
Total current assets 57,272
Fixed
Buildings 1,950,000
Equipment 46,500
Land 225,000
Total fixed assets 2,221,500
Total Assets 2,278,772
Liabilities
Current
Accounts payable 2,665
Wages payable 3,200
Employee taxes payable 496
Property taxes payable 22,300
Security deposits 15,600
Total current liabilities 44,261
Long-term
Mortgages payable 1,422,558
Notes payable—secondary financing 156,452
Notes payable—capital improvements 95,545
Total long-term liabilities 1,674,555
Total liabilities 1,718,816
Equity
Capital
Owner’s contributions 325,000

seasonality (more move-outs in the summer months). Low turnover sug-
gests that the tenants are happy and content with their overall living accom-
modations. If they were not, they would move. If they moved, the turnover
rate would be higher. If the turnover rate were higher, the property would
not be as efficient, because higher turnover results in higher make-ready
26 move-outs
ᎏᎏ
100 units
THE COMPLETE GUIDE TO BUYING AND SELLING APARTMENT BUILDINGS
112
costs, higher maintenance costs, and higher advertising costs. A close exam-
ination of the rent roll will tell you exactly how many people are moving in
and out each month. This is one case where less is more.
The rent roll should provide information about when the rents were col-
lected. Most complexes collect rents at the beginning of the month. An
inspection of the Date Paid column on the rent roll will quickly tell you
whether rents are, on average, being collected when they are due. If they are
not, this could very well be indicative of underlying problems within the
management organization. The timely and efficient collection of rents is
crucial in meeting your cash-flow needs. An effective manager will require
strict enforcement of collections and be willing to proceed with the eviction
process if necessary. Poor collection of rents may provide you with an
opportunity to create value, but remember: the price you pay for the apart-
ment complex should reflect the value of the property as it is currently oper-
ating, not what it would be if all of the rents were being collected. The value
is created only after you have acquired the property and made the necessary
changes to improve collections.
A high occupancy rate is usually, but not always, indicative of a well-
managed property, a tight rental market, below market rents, or a combina-
tion of the three. A proficient manager will work hard to keep the units fully

116 A. Lincoln 2-2 850 950.00 950.00 75.00 1,025.00 01/02 Reported loose balcony railing
117 A. Johnson 2-2 850 950.00 950.00 75.00 1,025.00 01/05
118 U. Grant 2-2 850 950.00 950.00 75.00 25.00 1,050.00 01/06
119 R. Hayes 2-2 850 950.00 950.00 75.00 1,025.00 01/05
120 J. Garfield 2-2 850 950.00 950.00 75.00 1,025.00 01/05
121 C. Arthur 2-2 850 950.00 950.00 75.00 1,025.00 01/04
122 G. Cleveland 2-2 850 950.00 950.00 75.00 1,025.00 01/02
123 B. Harrison 2-2 850 950.00 950.00 75.00 1,025.00 01/05
115
124 G. Cleveland 2-2 850 950.00 950.00 75.00 1,025.00 01/02
125 W. McKinley 2-2 850 950.00 950.00 75.00 1,025.00 01/04
126 T. Roosevelt 2-2 850 950.00 950.00 75.00 1,025.00 01/03
127 W. Taft 2-2 850 950.00 950.00 75.00 1,025.00 01/03
128 W. Wilson 2-2 850 950.00 950.00 75.00 1,025.00 01/03
129 W. Harding 2-2 850 950.00 950.00 75.00 1,025.00 01/02
130 C. Coolidge 2-2 850 950.00 950.00 75.00 1,025.00 01/02
131 H. Hoover 2-2 850 950.00 950.00 75.00 1,025.00 01/03
132 F. Roosevelt 2-2 850 950.00 950.00 75.00 1,025.00 01/04 Asked to renew lease a 4th term; denied
133 H. Truman 2-2 850 950.00 950.00 75.00 25.00 1,050.00 01/06
134 D. Eisenhower 2-2 850 950.00 950.00 75.00 25.00 1,050.00 01/06
135 J. Kennedy 2-2 850 950.00 950.00 75.00 1,025.00 01/05 Complained about inadequate security
136 L. Johnson 2-2 850 950.00 950.00 75.00 1,025.00 01/05
137 R. Nixon 2-2 850 950.00 950.00 75.00 1,025.00 01/04 Work order to repair water, gate
138 G. Ford 2-2 850 950.00 950.00 75.00 25.00 1,050.00 01/10 Loose carpet—tripped on stairway
139 J. Carter 2-2 850 950.00 950.00 75.00 1,025.00 01/03
140 R. Reagan 2-2 850 950.00 950.00 75.00 25.00 1,050.00 01/12
141 G. Bush Sr. 2-2 850 950.00 950.00 75.00 1,025.00 01/04
142 W. Clinton 2-2 850 950.00 582.26 50.00 632.26 01/02 Job transfer—vacated 1/19/01
143 G. W. Bush 2-2 850 950.00 367.74 25.00 25.00 417.74 01/20 New move-in—1/20/01
Other Income—laundry, vending, fund raisers, etc. 1,465.00 1,465.00