Well, last post we discussed financial statement analysis as part of the due diligence process when purchasing income producing commercial real estate. Today let's delve into some of the common areas for the astute buyer to check for, and how to best use financial statements to help ensure a great purchase.

When buying income producing commercial real estate, it is highly likely the buyer will have to reconstruct the seller's income statements to arrive at a more realistic statement of net income.

Probably the most commonly manipulated area of financial statements is the maintenance expense section. Because of the substantial amount of dollars going into maintenance annually, this section offers a large amount of maneuvering room. As mentioned in the previous blog post, owners may under-maintain a building in the two or three years before selling in an attempt to increase income and therefore, apparent market value. This is relatively easy to work around. Work with a good commercial real estate agent who can provide you with a normal range of values for annual maintenance expenses.

This concept also holds true for other manipulated areas. If the owners are doing most of the ongoing maintenance and repairs, rent collection, etc., themselves, are they deducting a management expense? Somebody has to do that work and whoever does it, their time is worth money. If the owners do it themselves without pay, you still need to deduct a management expense, time is worth money.

There are numerous areas where expenses can be artificially "trimmed" with the intent of shoring up income in the year or two before a sale. Using a good real estate agent as your buyer's agent will help ensure you accurately re-construct the financial statements.

The other side of the coin is when owners accidentally include too many expenses as part of their operating statement, and this is where the buying opportunities lie.

A common area to check is where seller's mistakenly include capital expenses as part of their operating expenses. Capital expenses are expenses that are not considered to be required to "operate" the building. These are generally things like upgrading the boiler from standard efficiency to high efficiency, replacing windows, constructing an addition, etc. These are expenses that are to be added to the value of the building and amortized over its remaining economic life. This is a great area of opportunity for the astute buyer. By adding capital expenses to operating income, the Seller accidentally states net income of the property lower than it actually is. If their real estate agent is not familiar with this common error, they may be asking less than the property is actually worth.

In an effort to keep operating expenses low for tax purposes, many sellers add in non-essential expenses. For example, going out for lunch while working on the building, they may add in the lunch expenses as well as vehicle expenses.

Another common error is the adding in of mortgage interest as an expense. Oh it is an expense but not a strict operating expense. Since every owner carries different levels of debt on their buildings, mortgage interest needs to be deducted after first determining EBITDA which is simply nothing more than accounting lingo for earnings before mortgage interest and amortization.

Speaking of amortization, many building owners deduct depreciation off their building's income. While this is allowed, it is not a real expense. Experience has shown that buildings actually appreciate over time, so deducting depreciation is really only a tax deferral - sooner or later, you will have to pay taxes on that depreciation you claimed.

These are probably the most common areas of income statement analysis. The things to remember are, where an owner understates expenses, the buyer will likely overpay for the building. Where the owner overstates expenses, the buyer may underpay. I wish the opportunities to "underpay" were actually that common. They are not, they are very uncommon. Human nature being what it is, we all tend to think our buildings are worth more than they are and even owners who understate their net income seem to be acutely aware of asking prices for other buildings. BUT that is okay. Your greatest enemy as a buyer is trying to find that "great deal" Invariably, the alleged great deal is a sucker play and you are the bait. The real return on investment with real estate is not the great deal you get when you buy, but the slow, steady accumulation of income and capital value over time. In a few short years, this will far outstrip the few dollars you "could have" saved getting that "great deal". Forget the great deal, find a good building at a fair price.

Next blog post - Balance Sheet analysis.