There’s a saying in real estate that every extra penny of profit drops straight to the bottom line. But how does a real estate investor know what the bottom line really is?
That’s not meant to be a philosophical question, because understanding the bottom line has a significant impact on rental property financial performance and potential value.
By having a system in place to track property performance, a real estate investor can accurately measure the profitability of a rental property investment and claim every possible tax deduction.
- Tracking property performance begins with keeping track of income and expenses.
- A paper trail is used to support entries made in a real estate bookkeeping system.
- A rental property chart of accounts includes categories for revenues, expenses, assets, liabilities, and owner equity.
- Real estate investors use rental property software to accurately track property performance.
- Key financial metrics used to monitor performance of a rental property include NOI, cap rate, cash flow, and cash-on-cash return.
Rental property bookkeeping
There are two types of records that real estate investors need for accurate rental property bookkeeping:
- Income and expenses for each property, including rent receipts, and vendor invoices and mortgage payments
- Paper trail of supporting documents that back up each income and expense item, such a copy of each billed paid, a scanned credit card receipt, or copies of IRS Schedule E from previous years
Each income and expense item is posted to the rental property’s chart of accounts. A chart of accounts contains categories for revenues, expenses, assets, liabilities, and owner equity.
For example, a rent payment received would be recorded as revenue, while a rental home purchased would be recorded as an asset with any mortgage debt recorded as a liability. Many real estate investors and asset management software programs like Stessa create a chart of accounts using IRS Schedule E (Form 1040) as a guide.
By using the same income and expense categories as the IRS, real estate investors can accurately claim every tax deduction they’re entitled to, and year-end reporting is a breeze when tax time comes around.
Key financial reports (like the ones listed below) used to track property performance all pull information from the rental property chart of accounts:
- Income statement: Also known as a profit and loss statement or P&L, the real estate income statement lists property income and expenses over a specific period of time, such as a calendar month or year-to-date (YTD).
- Net cash flow statement: Reports rental property cash inflows and outflows for a given time period, and is used with the income statement and balance sheet to monitor the operations and financial performance of a real estate investment.
- Rental property balance sheet: Summarizes all of the assets, liabilities, and equity of a rental property at a given point in time. Items included on a rental property balance sheet include property market value and checking account balance, mortgage debt, and refundable tenant security deposit, and the net equity that an investor has in a rental property.
- Capital expenses report: Also known as a CapEx report, costs that are required to be depreciated over a period of time are reported as capital expenses and added to the cost basis of a rental property. Examples of capital expenses include a new roof or HVAC system, new appliances or carpeting, or erecting a new fence.
How to track property performance
While it’s possible to keep a handwritten journal of income and expenses, and assets and liabilities, most real estate investors use some type of software to help save time and money.
There are four main tools that real estate investors use to track rental property performance:
Spreadsheet software programs such as Microsoft Excel, Google Sheets, Numbers, and OpenOffice Calc are one way to keep track of rental property income and expenses.
For investors who don’t have the time or patience to create a rental property spreadsheet from scratch, the Zillow Rental Income and Expense Worksheet is a free spreadsheet template designed for rental property investors.
While spreadsheets for real estate are usually easy and inexpensive to use, they do come with a couple of drawbacks to consider.
Income and expense information needs to be entered manually and recorded on the correct line item in the chart of accounts. Also, keeping track of rental property depreciation and balance sheet items such as property values and deposits using a spreadsheet can be time consuming and complicated.
Personal finance software such as Quicken, Mint, and Microsoft Money are the next step up from spreadsheet programs. Software systems like these that are used for personal finance are essentially electronic versions of a checkbook used to tabulate income and expenses.
Most finance software programs have an option for downloading bank account transactions to the software, or alternatively directly connecting to a bank account. While generic finance software programs can be quicker and easier to use than a spreadsheet, they do have similar drawbacks such as ensuring income and expenses are booked to the correct account.
Personal finance software programs used for rental property also often require a recurring subscription or sign-up fee to access all of the features a real estate investor might use.
Advanced accounting software such as QuickBooks or NetSuite offer many of the features that tax professionals, financial planners, and certified public accountants use.
However, the abundance of features can also be a drawback for many real estate investors. The software can be difficult to set up, and frequently requires an in-depth knowledge of bookkeeping terminology such as credits and debits, accounts receivable, and accounts payable.
Business accounting software also usually requires a one-time purchase fee or monthly subscription fee for cloud-based versions of the software.
Rental property software
Software specifically designed for property managers and real estate investors includes programs such as AppFolio, Buildium, and Stessa. While all three options do a good job, successful investors often choose Stessa to track property performance.
Stessa’s rental property asset management software was designed by real estate investors for real estate investors and has been featured in business publications including The Wall Street Journal, Inman, and Forbes.
Stessa makes rental property finances simple for every type of real estate investor, including owners with one single-family rental, a multifamily property, a portfolio of dozens of homes, and short-term rentals. Best of all, Stessa is free.
Key rental property performance metrics
There are a wide variety of financial metrics and ratios investors use to track the performance of a rental property. The following five performance metrics can help an investor to monitor hidden risk, measure current property value, and forecast future potential returns:
Net operating income (NOI)
NOI is a pre-tax figure that is calculated by subtracting operating expenses (except for the mortgage principal and interest payment) from total income received.
Net operating income also excludes money spent on capital expenditures to improve property value, and the non-cash depreciation expense investors used to reduce taxable net income.
Capitalization rate (Cap rate)
Capitalization rate is the annual rate of return that a rental property generates or is expected to generate. Cap rate is calculated by dividing the property’s NOI by the purchase price or market value of the property.
For example, if the NOI from a single-family rental home (excluding mortgage and interest payments) is $6,000 per year and the home has a market value of $100,000, the cap rate is 6%.
Strong investor demand for good rental property can push cap rates down because investors are willing to pay more for a home that generates reliable rental income.
On the other hand, a home that needs a significant amount of maintenance or has a high level of tenant turnover may offer a higher cap rate than a similar well-managed and maintained property.
Anyone who has balanced their checking account at the end of each month is familiar with the concept of cash flow. In real estate, cash flow is the money left over at the end of each month after paying for normal operating expenses and the mortgage payment.
Experienced real estate investors know that cash flow from a rental property is rarely the same from one month to the next.
For instance, when a vacant rental property is first purchased, cash flow may be negative for the first couple of months due to no rental income coming in and the leasing fee paid when a tenant is secured.
Cash-on-cash return is an annual property performance metric that measures the amount of pre-tax cash generated from the amount of cash invested. To calculate cash-on-cash return, divide the total amount of annual pre-tax cash profit by the total amount of cash invested.
For example, assume an investor purchases a $100,000 rental home using a 25% down payment. If the home generates a net cash flow before taxes of $3,000 and the cash-on-cash return is 12%, which is calculated by dividing $3,000 by the $25,000 down payment used to purchase the rental property.
Loan-to-value compares the outstanding mortgage debt to the current property value. As a rule of thumb, most investors and lenders look for a maximum LTV of 75%, which is another way of saying that equity in the home must be at least 25% of the property value.
One of the advantages of using Stessa’s real estate balance sheet is that the outstanding mortgage debt balance is updated in real time and the property value is periodically marked to the current market value. This gives an investor a more accurate idea of equity in the property, compared to a static balance sheet that shows the book value of the property using the original purchase price.
Final thoughts on tracking property performance
Tracking rental property performance helps real estate investors to accurately monitor income and expenses, claim every tax benefit offered by the IRS, and keep an eye on changes in owner equity.
Even with just one rental property, it’s easy to forget to record an income item or double-book an expense. Errors like these can unintentionally mis-represent property financial performance, and may result in penalties and interests if an investor is ever audited.
Fortunately, using an asset management system like Stessa to accurately track rental property performance is 100% free.