Profit & Loss Checklist: These 8 Items Will Help You Calculate Your P&L!
Today hosts Braden Cheek, Brain Duck and Joel Thompson discuss 8 major things you need to know when considering profit & loss in commercial real estate.
like you said you can be cash flow positive and you can be making a profit. But in the eyes of the I. R. S. You're actually losing money and so you can actually, you know be writing off and getting a tax refund even though you're making hundreds of thousands of dollars because of this big thing called appreciation. All right. Welcome back to how to invest in commercial real estate. The boy's back in town now Britain had a birthday yesterday. Birthday yeah, comment love you think I'm closer to, what what is it, what is it if Joel is closer to me or brian in age? Get a good look at us Now also in one out of 10 and looks whether he's closer, let's not have him do that. Also to give you a hint. I saw Brandon, I watched Brandon get I. D. At dinner last night before the guy was serving a cocktail. I did you know that happens. They normally I. D. Everyone else at the table just so that you guys don't feel left out. I didn't get I did. I said normally you're obviously old enough to drink. You know true story.
I'm in the bar at the airport, traveling overseas and they have the sign that says we I. D. Everyone and this guy sits down next to me and no joke. He might have been 90 years old. No hair on his body was not 100% white wrinkles all over his face. Maybe he was 85 could barely walk and he orders a beer and she id's him and he complains And she's like, well we have to I. D. Everyone and I'm like, you don't have any room for common sense at all. There's no common sense here. I don't know why we're talking about that. Anyway. Anyway, another really exciting thing is the criterion building is finishing up. So that's obviously our new HQ up in Oo. So they finished up the parking lot today. We should have plans in the ground soon. Certificate of occupancy or the first certificate of occupancy here in the next couple of weeks. But more importantly, we opened up an awesome coworking company up on the third floor. So it's got this massive balcony, tons of shared space, private offices, conference rooms.
You know, everything you would you would find at a normal coworking space anyway, if you are in the Tulsa area, feel free to drive up to also check it out. We're accepting reservations now, we only have one office left. There's room for tons more people, just not an office and if you mentioned you heard about it on the podcast, we'll give you a special little deal. Alright, cool. What are we talking about today? So today is, you know, going down to the fundamentals. One of the most important things you have to be able to do is understand a profit loss, understanding P and L. Understanding in income statement, whatever you wanna call it, you've got to be able to decipher where the money is coming from, where it's going how much it's in your pocket yada yada yada. You've got to be able to understand that. So we're gonna go through the list today. There's about eight items that you need to know what they are what they do and more importantly where they go. And we still we still get asked about this all the time. This is kind of one of the number one questions people ask me are about real estate terms and understanding where the money is coming in and the expenses. And every once a while we still have bankers that we don't know if they understand exactly real estate P.
And L. And how that works. So yeah let's get let's get into it. We'll keep it simple. We're just talking about a real estate P. And L. Today. So obviously the first and most important one is gross income right? You've got to have revenue. You've got to have income from somewhere. Where is it coming from your tenants? Right? So if it's an apartment complex they pay a monthly rent. If it's a commercial shopping center or really anywhere else there's a monthly at least base rent. And there may be additional things if it's a retail center or an industrial deal or any sort of triple net type lease. You're gonna have um additional things that you're paying right they're gonna reimburse you for. Well it could be as simple as a laundromat at a multi family right that would go towards gross income. Yeah. Your first task is to decide or to understand, we say gross income, you can interchange that with revenue revenue, gross income or gross revenue. All of those are encompassing all the income that you might be able to collect on this property. So yeah, you have base rent, but they may pay extra things in an apartment complex, you may have pet rent, uh You may have non refundable deposit income.
Uh You may have utility income with all those things are rolling up into gross income or gross revenue. Yeah, they're there, you're gonna see that in the offering memorandum, they're gonna have the gross income for the next year. Probably broken out there once you get in contract, they'll probably give you the trailing 12 months of financials to where you can see the previous 12 months of income. So you should be able to get a pretty good understanding of just the income. Okay? And then so is uh so if you get a P. And l. You said you typically get the previous 12 months, you don't get back three years or something like that. Like we asked three years might do we ask for three years I think in the contract, but the previous year is most important. You want to make sure it's training in a good direction. There's not anything weird. Yeah, but you can Get three years, I think I'd like to see more than 12 months of that. Absolutely. Yeah. And then obviously once you get a good understanding of income, you need to understand how much it costs to operate that property. You have obligations as the landlord, whether it's any, any asset, you have obligations in that lease that most likely cost you money.
And these are gonna go in the expense category. Obviously the expense categories right below the income category, but there's multiple different types of expenses, right? They're not all equal, there's expenses that maybe you as the landlord pay 100% of whether that goes up or down, you don't get reimbursed from the tenant. Well, we'll talk about multi family for example. So when you buy an apartment complex, it is so crucially important that you adjust the P. And L. For your uh real estate taxes at your basis, right? Because the seller most likely is a lower basis and it's paying a lower property tax bill. So that's the first one, right right away. When you buy an apartment complex, you can't go to the hundreds of tenants and say, hey, you owe me an extra $5.75 a month because the property taxes went up, that doesn't happen. So you need to understand the impact of expenses that will stay the same, that will be reimbursed and that you will be responsible for. I think, yeah, multi family, you have payroll which you wouldn't necessarily have on a retail center, retail center, you would you would translate that into, you know, management fee.
But yeah, lots of those. Well I'd like to put up a couple of sample P and L's during the show when people are watching. So you've got maybe give them a sample retail piano and a sample multi family just so they can kind of see the differences. Yeah. And one of the bigger things in in the retail piano, if you're buying a triple net deal, which most of the retail shopping centers, we buy all of the tenants are on triple net leases, which if you haven't been watching the show for the past year, you may not know what that means. Triple net just means they're reimbursing you for the insurance, the common area maintenance and the property taxes. So if all of your tenants are on triple net leases, you can pretty much skip over the expense section, you just operate over. That doesn't matter, tend to pay for it. You just have to make sure the tennis player because you're, well, they pay for it. But you you would collect the income so that income which show up in the gross income, you would have base rent and you would have triple net income, then you would have the triple net expenses and then the operating expenses. Uh So let's talk about an owner expense that you may experience in retail even with a triple net lease, right?
Like you're probably gonna have to file a tax return. So you're gonna have 1000 or two in in bookkeeping or accounting or tax prep or whatever you wanna call it, you're probably gonna have some attorneys fees, renew some leases you big like roof maybe parking lot, maybe H. V. A. C. Units maybe. Again, all of this is in the lease. So you need to look at the leases and see what is supposed to be happening. And you'll find pretty quick that that doesn't always translate over to the P. And L. You find some opportunity or you find some slippage and you have to bring that to the seller's awareness. If it's slippage, if it's opportunity, you may just want to keep that to yourself and that's your value add. Right? Okay. So we've talked about gross income or gross revenue, we've talked about expenses. Then you come to the all important line after that which is net operating income. I think it's important that you called it the line, we're gonna refer to that a lot. The N. O. I. Or the net operating income is the line and it's strictly gross income minus expenses. Right? As simple as that. Right? I mean there's a lot of expenses and a lot of things that go into it, just like we talked about.
But yeah, the only thing that you could consider an expense that is not above this. Ny line is that the one that we're gonna talk about in a second which is debt service or your loan payment. The NY. Is absent of the any of any loan. So let's just bridge this gap while we're talking about you know I and and debt service. Why is the debt service blow line? Well the net operating income is used to value commercial real estate and since everyone is going to be getting different debt, maybe they don't get any debt at all. Then it's not relevant to valuing the property. And so that's why they want to keep the N. O. I clean because someone may get 30% loan, someone may get an 80% loan. The interest rates might be different. Yeah, someone might want to put a 20 year am amortization on it. Someone may want to, you know put a 30 year amortization on it and so that varies the debt payment and it has no relevance on the value of the property. So we keep it out of the N. O. I. Line in order to to value the property appropriately. Without all that mess. Let me ask a done a really dumb question right now.
Why is no, I used to value the property. You said N. Y. Is used to value the property. Why are we coming up the value from the net operating income. Well, I can already see the comments in the comment section which you don't use uh you know, N. O. I. Always to value the property. But it is one of the three actually the three ways they value property, the income approach, the comp sale approach and the cost replacement approach. But in our world the reason the N. O. I. Is uh used to value the property is because that's what you're buying. You're buying an income stream and that's what I mean. That's how we see it is we're buying cash flow, we're buying an income stream. And so it's all relative to what multiple someone is willing to pay for that income stream. And that leads us to the next term. That's super important is comments are rolling already. People hate us is the cap rate. You guys are using cap rate wrong. Let's see if we can talk about it one time without someone telling us that we're I want someone to comment about how we use cap rate that's got a bigger portfolio of real estate than us.
And then maybe and I know there's plenty of people that have bigger real estate portfolios that we don't know what we're doing. It's Like Dirk the Great 75 on YouTube man. Well, and so we capture it really isn't part of the P. And L. Experience. So we're not let's not spend a lot of time on that. But it's so the Ny line is so valuable to the cap rate because they're they're in, you know, there are two pieces to a three part puzzle, you have value and you have N. Y. And you have cap rate and and those all work together. Uh So if you have the cap rate and you have the purchase price, you can determine the N. Y. If you have any y. And purchase price, you can determine the cap rate. And so they're all three parts are working together there. Yeah. And and cap rate is quite literally used in appraisals to value property. What they do is they assign a market cap rate which is basically like an earnings ratio for stocks, right? You can look up their earnings ratio of all of these companies and it's where they trade versus how much money they make.
If you can track that pe ratio is something obviously use the same stocks. It's very similar to a separate in real estate. Okay, let's keep going. The next one I put down here is debt service. Uh So now you've got your N. Y. But remember we keep the debt service below the line and your debt service is just your your mortgage payment essentially for a real estate deal, just like you have on your house. It is, it's literally just the mortgage payment. There's no escrow. I mean there may be, it's not over complicated, it's the mortgage payment, it's the mortgage payment because the s crows that is you have those separated out in commercial real estate where they all may be lumped together in your your home mortgage payment. But those are separate in real estate. So the debt payment is just your principal and your interest. So it's it's important to calculate this because the principal is obviously, you know you're kind of paying the loan down. So that's a return in in a sense right? I mean that's adding into the I. R. R. At the end of the deal is is we're paying down this debt this amount every single year.
So that's a number that we can pull for every single property. How much are we paying down the debt this year? That's almost the same as as free cash flow theoretically if you can sell the deal. So is um and maybe I'm skipping ahead but is so would um net operating income minus debt service, would that be considered cash flow? I mean is that uh is that a proper term? That's that's what I would call the net cash flow. We may get we may get comments. But yeah I think that's as simple as it is cash flow. Is the money that you have at the end of every month at the end of every year um In a y is is is theoretical because once again the debt payment takes away from that. But cash flow doesn't cash flow is after your mortgage, what do you get in your pocket. Well it's theoretical because if the three of us had three different real estate companies and we went and bought the same deal, odds are we each end up with a different loan in a different cash flow, but the same net operating income. So there's a lot of kind of magic in the debt service and there's a lot of value to be had simply by getting a better loan.
Or I got a question for you guys, is there any difference between profit and cash flow? And if so, what is it? Yeah, there's a massive difference between profit and cash flow. Okay, what is it? Right, because profit is what profit is like in a y right, right. Cash flow is what you're actually putting in your pocket. So you can be profiting like criterion, for example, criterion profits, a ton of money, but we're constantly reinvesting it back in. So our cash flow isn't the same thing about this. Okay, well, you're going to try to make, well, you said it's the same as in hawaii and it's not necessarily because you know, why isn't isn't profit if you have, if you have a debt on it, like the interest is an expense. So profit is your uh your n y minus your interest expense, but not the the the principal payment portion for tax purposes. The principal proportion is considered profit, even though it's not included in cash flow because it isn't money that you're getting, it's going to the bank to pay down the loan.
Uh So that just so, you know, profit is different than cash flow in that cash flow is lower, it's lower than the profit because the profit includes the principal pay down. But we're not calling taxable income profit. Right? All right. Let me think. You're not calling taxable interest. Yeah, taxable income is not equal to profit. No. And why is that Brandon the next point? The next point? Which may be the last 1? Yeah. Amortization and depreciation, depreciation. That's right. So depreciates is one that you need to understand. It does not impact cash flow, it does impact profit for tax for tax purposes. So I'm glad we saved this one for last because I think this is one of the beauties of real estate is the fact that you can be cash flowing at a certain number, but you could potentially lose money on your tax return. And, and that is because of depreciation.
So somebody break down depreciation in, in the simplest form possible brian, you want to try go ahead. So, uh, depreciation, it's in the eyes of the government for tax purposes. They're considering these commercial buildings are depreciating or going down in value over time, but you don't always have to spend that money every year. Let's say the roof is $1 million. I may have a new roof on right now, that new roof is deteriorating over time, but I haven't spent any money on the roof, but the government allows us to say okay the roof is worth less than it was last year and they allow us to then say okay well you kind of lost money on the roof. We're gonna allow you to depreciate or deduct that loss of value in the roof on your tax return this year, even though you didn't pay the money. And if you can do that across all the building systems, that appreciation can be a big number similar to how business might appreciate some of their equipment, right?
Yes. Or trucks, cars. Yeah. I mean if you're not a business owner, if you haven't been in business, you're not gonna understand that point either. So I don't know how we would relate it to someone that that doesn't understand it, but but basically it is a way to the entire premise of the show. Yeah. Uh But it's important because like you said, you can be cash flow positive and you can be making a profit but in the eyes of the I. R. S. You're actually losing money and so you can actually you know be writing off and getting a tax refund even though you're making hundreds of thousands of dollars because of this big thing called appreciation. So I have a couple questions. The first one is what happens when you put a new roof on tax wise? Do you start depreciating that or do you just add it in as improvements and does it have the same depreciation schedule or I mean you obviously just can't write it off like they can't allow you to appreciate it and then just write off. Yeah. So if you spend, let's say you spend that million dollar In 5, 10 years, you don't get to write off that million dollars in that year.
You have to then start depreciating that again over time. So are you saying if you do replace the roof and you spend that money, you can depreciate, you depreciate that on on the new schedule. If it's got a, you know, we are not tax professionals, but we do uh we do get the benefit of the power of depreciation to offset our income. If you own more than than one house that you live in, you need to have an accountant do your taxes. Okay? I'm not we don't do our own taxes. We have an understanding of it, right? But like why would you try to, why would you even try to do your own taxes? A good accountant should save you more money than anyway. I'm off. I'm off. All right, let's let's round it up because I want to keep these, these shows short real quick. The power of sending somebody, let's say $100,000 in distributions and they get a K. One and its negative negative $50,000. We get a phone call. It seems like every time from an investor that doesn't quite understand that. Hey brian, we sent you you said $100,000 last year.
This this says I don't know any taxes. What how did that happen? We didn't lose money did we? Well it's like well those those checks cleared didn't they? And this is the K. One and that's the beauty of investing in real estate, right? If you're high W two earner and you're in a job, let's just say you're making half a million dollars a year, half of that is gone. So if you can make half a million dollars a year in real estate, it's almost like making a million dollars as a W. Two employee. You can you can settle with making half because your tax less. Yeah. Real estate is a great investment for everyone. But if you're making a huge W. Two income it should be part of your focus to get involved in in real estate. Because you can begin to write off uh if you have enough real estate losses and you can qualify for someone, your spouse can qualify as a real estate professional, you can ride off those losses against your W. Two income. Now you're really really making money. Alright. Alright. Gross income or gross revenue then we've got expenses. Both the ones that you have to pay and the ones that even the tenants reimburse you for.
We have the net operating income which is the important line below that. Well we talked about cooperating how income or sorry net operating income cap rate and value or purchase price all in interchange. Then we've got debt service, we've got amortization, cash flow and appreciation. It's pretty simple when you think about, I mean income minus expenses equals and y you're you're dangerous just with that calculation right there and then you start throwing in our cap rate ideology and everyone's gonna, last point I'll make is kids get out of high school and some get out of college without ever having the ability to read a financial statement or a profit and loss state. I did. Uh And it's so important in looking at a lot of different investing opportunities. So educate yourself. Call us with questions comment if you, if you want to like comment about right And don't forget is Joel closer to my age or brian's age? This could be a fun comment below. Alright guys next time see you next time
