1201 6th Avenue W, Suite 100

Bradenton, FL 34205 

     

© 2020 by Pursuit CRE, LLC

Search
  • George Kruse

What exactly is all this "Other Income"?

Updated: Jun 10, 2019


Is all income good income?

Last week, we took a look at the vacancy factor when underwriting a multifamily investment. However, we only viewed that from the standpoint of the revenue that can be achieved through the traditional rental rates at the property. While rent is the vast majority of the revenue you can expect to achieve, there is “other income” that can be generated as the owner of an apartment complex.


Any time you can hold an asset that allows for multiple revenue streams, you are positioning yourself well as it allows for multiple ways to improve the bottom line and, therefore, the value of the asset. You will see Other Income in many of your Offering Memorandum reviews, especially with larger properties. What you need to be able to understand, however, is where this other income came from, whether it is always a good thing and how to cover your ass when underwriting the future of this income stream.


At Pursuit, we place Other Income into three primary buckets.

You may see this income as a lump-sum in a package or you may, ideally, see it broken out. If it’s not broken out, you’d better find out exactly what it’s comprised of, especially if it’s a large number. Our three buckets are: Positive Other Income, Neutral Other Income and “Negative” Other Income.



Positive Other Income is the extra revenue the property can generate that is accretive to the value of the asset and to the enjoyment of the property by the tenants. This can include laundry income, covered/dedicated parking spots, pet fees, resort fees and really anything else that can be charged to a tenant in exchange for a service or product offered.


This income is great as they are typically a profit center for the property. I would only caution you to ensure any potential expenses associated with these services are accounted for. For example, if there is laundry income, ask whether the units are under a lease or property-owned. If it’s a lease, check that the number shown is the “net” revenue. If they are owned, check that the expenses for maintenance and replacement are in the P&L because your tenants will beat the hell out of those things.



Neutral Other Income is the revenue that comes in one door and out the other. These include credit/background check fees, utility reimbursements and other fees that are essentially collected for third-parties. While a property owner may skim a few bucks here and there (eg charge $50 for a background check when the service costs $40), they shouldn’t move the needle too much.


For the most part, this is only “revenue” by the nature of a tenant handing a check to the property at one time. If they are included in the income section of the P&L, make sure they are included in the expense section as well. Believe me, I’ve seen extreme examples of “Water Reimbursement” as other income on the top and a $0.00 “Water Expense” on the bottom with a little note that says “Tenant pays all water expenses”. If they’re paying directly to the water company due to individual meters, this is true and there shouldn’t be other income. If it’s not “technically” true, it should still be here and it should closely approximate the Water Reimbursement other income, which makes it a zero-sum Neutral Income line item.



Negative Other Income may sound strange. How can any income be “negative” for a property owner? Well, these come from sources such as surrendered security deposits, late fees and bounced check fees. Ideally, you do not want to see the “benefits” of this other income item. There are real costs to incurring this revenue. The cost to continuously re-tenant a unit can be upwards of one month’s rent per occurrence. The additional turn-over costs and repairs from delinquent and/or evicted tenants, coupled with the legal fees of removing those tenants, can add up and often exceed the balance of the security deposit being surrendered.


Further, if this line-item is so large that the selling agent decided to include it in the Offering Memorandum, there is most likely a fundamental problem with the property and/or tenant base that you’ll be inheriting upon ownership. There could be a systematic issue with the handling of applications or a lack of proper checks when moving in new tenants. You could also just be reviewing a property that lends itself to tenants that are more likely to default on a lease. Yes, these negative other income items are technically revenue, but make sure you truly understand what you’re buying into and the potential expenses you’ll incur with this income.



Now you’ve reviewed all the “Other Income” the Offering Memo has included. You’re happy with the positive income, you’ve verified the passthrough of the neutral income and you’ve gotten comfortable that any negative income is not going to be problematic. At this point, I’d ask you to look at three underwriting tricks that could impact your valuation of the property relative to this income line.


First, and this sounds ridiculous, make sure this other income ACTUALLY EXISTS. I’ve seen packages show laundry income with no laundry on-site. Upon questioning, we were told that a new owner COULD put a laundry in and, therefore, make this “proforma” other income. Seriously. I’ve also seen proforma Utility Reimbursements where none exist today. Yes, a new owner could issue future lease agreements with this reimbursement, but it’s not there today with the current tenants. One, good luck getting existing tenants to swallow this on renewal. Two, this reimbursement is essentially more rent in the eyes of cost-conscious tenants. A new owner MAY be able to increase rents $50 to “market rent” and they MAY be able to institute a $50 Reimbursement program, but they will most likely not be able to do both if the market rents are at complexes that don’t charge for water. Tenants are not as stupid as some owners want you to believe they are.


Second, I see a lot of proformas putting the Other Income BELOW the vacancy line. Agents want to treat this as a fixed income stream that’s not affected by the fluctuating vacancy of the overall property. This is simply not true.

Less tenants means less people to pay for laundry, less application/pet/parking fees and even less neutral fees from background checks.

Further, if you’re underwriting utility reimbursements, any vacant unit has no one to pay for those utilities. Know who does, the property owner. Yes, utility usage drops dramatically in an empty unit, but it doesn’t drop to zero. Assuming a $50/unit/mo reimbursement as income when it will actually be $10/unit/mo additional expense due to the vacancy is a $720/yr swing in NOI. Cap that one unit at 7% and that’s over $10,000 of value miscalculated in the wrong direction for the buyer.


Third, watch out for “growth rate” assumptions. A proforma will assume annual growth rates for rental revenue, as they should. Some markets have seen rents grow at 5-8%+ year-over-year in the recent past. Those same markets, however, have certainly not seen laundry income grow at that same rate. In fact, I would argue that most markets have seen an almost flat other income line over time. Fees have consistently hung in the +/-$50 range. Pet fees have been shown around $200-300. Laundry has charged $2.00 for a wash and $1.50 for a dry. These income sources have been more or less static for years and you’d be remiss to assume any different for your future hold period. You will see this inflated growth snuck in either by actually putting a growth rate on the Other Income line items or, even trickier, setting the Other Income to a constant percentage of rental revenue, which essentially captures the rent growth. To be conservative, your best bet is to make a majority of the Other Income flat and tie the variable items (such as utility reimbursement) directly to the respective expense item in the P&L.



Other Income is a standard addition to any P&L. It’s fairly common and there are a lot of positives around this number. It gives the owner an additional revenue stream and it can imply the availability of additional amenities for current and future tenants. Just be sure, when reviewing your opportunity, to understand where this income comes from and make sure both the income itself and the associated expenses, are properly accounted for. Remember, if you’re using a cap rate to determine your value, you’re capping the bottom-line Net Operating Income. The NOI doesn’t discriminate against any dollars that drop down there. An inflated income source will lead to an inflated NOI which will lead to an inflated valuation. Do your diligence on the Other Income and you’ll cover your ass.


Related Video: LINK



Next Week: We move to expenses and show our appreciation to the County for NOT adjusting our Real Estate Taxes!



4 views