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In a recent post I wrote about how valuable it can be to to keep a personal cashflow statement. I described how it could identify places where money is leaking out of your wallet, your checkbook, etc.
I also wrote another article about balance sheets. What hasn’t been done ’til now is showing how cash flow statements affect a balance sheet. The idea was touched on in the article about cash flow statements when I talked about spending cash on a gold bar and how that’s still an expenditure or outflow of cash even though the gold bar was kept by the purchaser.
Don’t be afraid to go back to those articles and re-read them before you read this. This isn’t an in depth examination of cash flow statements and balance sheets, but a story about improving a property and how cash expenditures, or outflows, can increase the value of an asset on a balance sheet. This story is about improving a real property but the name of the property has been changed to protect the privacy of the property investor.
Welcome to Desertville
Imagine the money leaks that could develop in a rental property that has 84 units and has a worth of over five million dollars. That’s a lotta potential leaks.
For every one of those rental units in that property, there are expenses in the form of repairs, maintenance costs and utility bills. Some of those utility bills are paid through the property manager to the city, such as water, and others are paid by the tenant when the rental unit is occupied and by the property owner when the unit is empty, like electricity and heat in the winter. Another situation arises when the owner of a property offers a rental unit with utilities included.
When utilities are included some of the income from rent has to be shaved off and applied to the expense of the utilities of for that rental unit.
A cashflow statement offers a way to monitor income streams as they are created and grow. In rent alone there are 84 income streams that need to be applied correctly coming from the property mentioned above.
Property managers want people to live in a place they like. They also have a responsibility to people who invest in properties to make them profitable. In the big bad world we live in, if there isn’t a profit margin, no one will invest in properties and people won’t have a place to live. If the overall income of a property isn’t greater than the expenses there isn’t any profit.
Fixing The Leaks In The Money Pipeline
The 84 unit property is called Desertville. At one point in time Desertville had a hodgepodge of cashflow problems. Some of the units had utilities included and some not. It had a laundry that was an expense because taxes had to be paid on the structure. There were also electric, water and sewer expenses associated with the laundry and it wasn’t bringing enough money in to cover those expenses.
The first thing to do was to look at the cashflow statement and see where there was more going out then coming in.
When examined, the cashflow statement showed that the utility expenses for the units that had utilities included exceeded the the utility income for those units. More money going out than coming in is a money leak.
The money leak was fixed by putting the utilities in the tenants names and making them responsible for the bills. The tenants that used less paid less and those who used more paid more. In the end game the tenants got what they paid for and the owner of the property didn’t lose money. In this case the income and expenses for some utilities were both removed from the cashflow statement. It wasn’t the property manager or the property owner’s problem any longer.
Other money leaks were the Internet and cable television bills. These had been offered as part of the rent and there wasn’t any markup on them.
The manager of Desertville realized that he could do more than fix these money leaks. The manager acquired a commercial account for the internet and cable. Then, he resold that service to the tenants at a profit and created an income stream.
An exception to the pattern of tenants being responsible for their own bills are bills that, if neglected, would put the property owner in a tight spot because of a lien against the property. This can happen with city utilities. In this case the manager kept the water, sewer and garbage bills in Desertville’s name to prevent any potential liens.
To assure that the city utilities didn’t become an expense to Desertville, the manager billed separately for them. In this way he collected exactly what was used and didn’t have to worry about shaving off some of the rent income to apply it to the expense of city utilities. Because the income equalled the expense there was no loss in cashflow and the property owner didn’t lose.
Because Desertville’s manager monitored rental rates on comparable properties he recognized the demand for one bedroom and studio apartments was increasing and increased the rent on those units which increased income with no increase in associated expenses. That’s profit.
The manager of Desertville suggested investing capital in improvements on Desertville. He looked at the potential for higher rents and more rental units that would increase existing income and the value of Desertville as an asset.
If the improvements didn’t add enough income to the cashflow statement to exceed the expenses during the owner’s period of ownership, or the expenses weren’t returned to the owner in the increased value of Desertville as an asset by the time it was sold, the manager didn’t recommend them.
Desertville had some appearance problems and potentially some coming structural problems. It needed a roof and siding. It had a gravel parking lot and it needed some paint. While the parking lot was basically functional, tracking the dirt from it into the apartments wasn’t making the flooring surfaces last any longer. This lowered the profitability of Desertville because the flooring surfaces had to be replaced more often.
The Long Game
Because the owner of Desertville considers it a long term investment, he accepted the proposal to replace the roof. This was a large investment in Desertville but a bad roof can cause structural damage that would severely decrease the value of the property when sold.
Replacing the siding added value to Desertville as an asset because of aesthetics and by preserving the structure. The same could be said of paving the parking lot. Paving the lot made Desertville more attractive but it also preserved the flooring surfaces by keeping the gravel driveway from being tracked into the units.
While the siding and the driveway added to the value of Desertville as an asset on the owner’s balance sheet, neither of these capital improvements would fit with a flip strategy. These are high cost improvements and only work for a long term investor.
The immediate impact of the siding and paved lot was more consistent occupancy of rental units. If no one is renting a unit there isn’t any money coming in from it but the underlying expenses associated with it still exist. In addition there are cleaning and repair expenses every time a unit changes renters. Ugly rentals are unoccupied rentals and they cause negative cash flow.
A big win was converting the old laundry space into two rental units. This gained the property $9600 in annual income. This conversion also got rid of the expenses associated with the laundry room which operated at a loss.
The only reason the laundry conversion was a winner was because the owner wasn’t flipping Desertville. Building out two apartments wasn’t cheap but in the long term plan that the owner had he knew he had time to recoup and profit from his investment in the two rental units.
There was a gain on two fronts. The rental income could be directly applied to the expense of the remodel. In addition the remodels added to the value of Desertville as an asset on the owner’s balance sheet.
The End Game
Except for the increases in rents on single bedroom and studio apartments, all of the decisions made about Desertville were the result of consulting Desertville’s cash flow statement and how it would change Desertville’s balance sheet by increasing Desertville’s value as an asset.
These actions wouldn’t have been valid if the owner was trying to flip the property. It takes time to recoup the high cost of major investments unless the property is in a market with values that are increasing at a frightening pace. Major capital improvements in a property are the result of a long term strategy.
The increase in rents on studios and single bedroom units were the result of market knowledge. If the rents had been too high the units would’ve sat empty. If too low the maximum rents wouldn’t have been realized and potential income would’ve been lost.
All of these choices made Desertville an attractive investment property because it makes money and it’s increasing in value.
If you want to benefit from the type of experience that increases a property’s annual income as much as 20.3% the way this property did, contact Kirk Rehfield (Jacobgrant Owner Relations) Kirk@jacobgrant.com or 208-795-8298.