If you don’t get the expenses right when you are analyzing a real estate deal, you are setting yourself up to get into a bad deal.

There are three parts to due diligence for any real estate deal. The first is financial. This is because if a deal is going to die, 72% of the time it is going to die during the financial due diligence.

The second part is the physical due diligence—are all the parts to the property working properly. And, the third part involves legal due diligence—is there a clear title to the property.

For now, let’s narrow our focus on financial due diligence, and more specifically the expenses.

Operating Expenses vs. Capital Expenses

There are going to be two different types of expenses-- Operating Expenses and Capital Expenses.

How you analyze these expenses will determine whether you are going to set yourself up for an easy or difficult operation when or if you take over the deal.

The type of expense will either increase or decrease the value of a property. By the way, if you are considering selling a property, understanding the difference is extremely important for you too.

Operating Expenses are an “above the line” expense. This means that if an expense is an “above the line” or Operating Expense, it is accounted for before debt service (mortgage).

Meanwhile Capital Expenses are a “below the line” expense. As such, they are accounted for after debt service is recorded.

Calculating Net Operating Income

This is an important distinction to remember. When we calculate Net Operating Income, we use the following formula:

Yearly Operating Income
-Yearly Operating Expense (not including debt service)
=Net Operating Income

This formula is important because one of the most important ways we determine value is by using the capitalization rate. To determine the capitalization rate, we use this formula:

Net Operating Income/Capitalization Rate = Value

As you can see, the Net Operating Income (NOI) is a major component of the formula we use to determine value. And, a major component of the NOI formula is the Yearly Operating Expense.

When Operating Expenses increase, NOI decreases. This decreases the value of a property. When Operating Expenses decrease, NOI increases. This increases the value of a property.

So how do Capital Expenses come into play?

First, let me tell you the difference between Operating Expenses and Capital Expenses other than where you account for them.

Operating Expenses occur during the daily operations of the property, hence the term “operating.” This includes minor repairs and maintenance, contractor services, taxes, insurance, administrative expenses, management fees and advertising.

Capital Expenses are replacements or improvements made to the property that will depreciate over twenty-seven years. This means you cannot claim the expense at the end of the year to reduce your tax burden. You must depreciate the expense or divide it by 27. You are only allowed to remove 1/27 from your tax burden.

Capital Expenses include new roofs, appliances, countertops, cabinets, carpet, exterior painting, interior painting, new signage, etc.—any major improvement or replacement.

Many of these capital expenses could fall into a grey area. You could potentially make an argument for considering the expense a capital expense or an operating expense.

When you Want a Capital Expense/When you Want an Operating Expense

When you are operating the property and will be paying taxes on the income of the property at the end of the year, you want as many Operating Expenses that you can claim to decrease the amount of your tax burden.

On the other hand, if you are planning to sell a property, you want as many expenses below the line in the Capital Expense area because this will decrease the amount of your Operating Expenses and increase your Net Operating Income.

This will result in an increase of value for the property.

Author's Bio: 

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