What is "Good Income" vs. "Bad Income" in Multifamily and Apartment investing?

Taken from one of the Multifamily Investing Academy's Owner Forum weekly group coaching calls.

I want to come up with a rule that everybody can use and keep in their back pocket. When you're analyzing a deal and you're trying to figure out exactly what to do, you can apply this rule and it's going to give you the answer towards how this works.  

So, what is the rule that we apply to make a determination? What you learned was that to capitalize the income, you increase the value of the property, and you pay more for it if you do it wrong. You don't want to be in that situation! So what rule can we use to come up with a solution so we know exactly how to do it?

Here's a new rule : If the tenant modifies their behavior the next month and then the income disappears, it's not income worthy of capitalization (ergo, it's Bad Income). 

So always ask yourself the question - What if the tenant changed their behavior? What if the tenant started to perform under the terms of the contract? What happens next month with this income? Do I still get it or does it go away? And, if it goes away, why capitalize it? 

It means that the guy has bad tenants, he's trained his tenants poorly and now you have to capitalize that bad income because this guy's a lousy manager? 

To heck with that. 

We're not going to do that. 

Because remember guys, when we do that, we're taking money out of our kid's future and giving it to little Johnny. We don't want to be that guy. 

Now, take that rule and apply it to the following incomes :

Late Fees? 

Remember, if the tenant paid on time, will we get that money next month? No! So it’s a BAD Income.

NSF Fees? BAD Income.

Utility Income 

GOOD. This is why I always say we got to get a TRAILING 12. You've got to look at that utility income over a 12-month period where you will see all the fluctuations. What happens during the seasons? Sometimes the guy might give you a T3 income. The income can be really high for the utilities but he applies it against 12 months of income.

Laundry Income? VERY GOOD.  

Maintenance recovery income? 

It's a charge back to the tenant that mitigates the calls. Somebody gets a toilet backed up and you find out they got a toilet backed up because the kid stuck something down there. The tenant is going to pay. Good income or bad income? BAD Income.

Admin income?

Some landlords will charge this instead of, in lieu of a security deposit. So, they can pocket this money and then they won't have a security deposit, So, think about it! The worst BAD income you can possibly get. If you see this on a TRAILING 12, the first thing you want to do is contact the broker and say "Hey, can you explain this admin income for me?" And if he comes back and says, "Oh, the owner does it in lieu of security deposits." This is the worst income possible and you might need to modify your purchase and sale agreement and here's why. 

What's happening is the guy is going to sell his property and he turns a lot of units because it's a C class property. So, he's constantly turning units. When he decides to prepare for the sale, he's no longer going to take security deposits. Because he doesn't want to deal with the hassle of having to record and transfer those at the closing. So, he decides he's not going to charge the security deposits. He advertises to everybody but instead he charges an admin income. And virtually the same value as a security deposit, but it's not a deposit. 

Remember deposit shows up on the accounting books as a liability. It appears on the balance sheet. A security deposit does not appear on the income and expense statement unless you realize it as income. Now the admin income fee though, goes on the income statement and right in the seller's pocket. It increases the net operating income one-time for every admin income unit that you get. So you get this money in, you increase the NOI, that money gets capitalized. You're now paying more for the property than it's worth. When that tenant finally moves out, you have no way of getting that money back. You're now paying out of your pocket to fix the unit and you got screwed. Admin income is the biggest scam going. Don't fall for it. BAD income.  

Pet Income?

Guess it’s bad income? It's continuous. It shows up every month. That's GOOD income.

Pet Deposit Fee Income?

I think it's good but the problem is it's not recurring but you get it one time. So, you got to take that into consideration. Usually a very small number on the income. It's not a security deposit and It goes right in your pocket. You don't account for it separately. You don't put in a separate bank account. It is not a liability on your balance sheet.You write it in the lease, so it's non-refundable.

Security deposits always transfer to the new owner. When you've got the rent roll, the rent roll will show the security deposits the lease will show what the actual security deposit is. So, when you're going to do your audit during the due diligence, one of the things you need to do is take the rent roll and match it up to the security deposits on the lease. And make sure they tie together. If they don't, which document governs?

The lease - it always governs. That's the contract. The rent roll is nothing more than an Excel spreadsheet - junk in junk out. So, make sure you understand that! So, Pet Deposit Fee Income? I would say that this is GOOD but I wouldn't count it.

Month to Month? GOOD.

Storage Fee Income? GREAT income.

Key Recovery fee? BAD.

Bad Debt Income?

Very BAD. No way to build a business on bad debt income

Security Deposit Forfeiture Fee Income? BAD.

Cleaning Fee Income? BAD.

So, if you ask me, do you recommend reading through every lease in the property? Absolutely!

Reading through every lease in the property is more important than walking the units. What are you buying? You're buying the lease contract. You better know what it says since some of these guys will throw curve balls with you and put certain things in the lease. You better know about it!

You go through every single lease file. You're going to walk through every single unit but you can have somebody back in the management office going through every single lease file and that's the most important job. It's a lot of reading but you're going to make sure they're using the same template document and that they’re just going through all the places where they fill it in and make sure they're not crossing anything out or initialing any changes. 

You want to make sure that if they've been there for years, if there are renewal terms, and every year, they get a new renewal lease, You can tell how well a business is being run just by looking at the quality of the files. As Dave Barker says, “it often doesn't match up.” The rent rolls and the leases do not match up completely. Absolutely it's your responsibility guys. You can't blame it on anybody else if you don't do the work okay.