Common Size Analysis

What is Common Size Analysis?

Common size analysis is a powerful financial statement analysis technique used by real estate investors to evaluate the proportional relationships within a property's financial performance. Instead of looking at absolute dollar figures, this method expresses each line item on a financial statement as a percentage of a base figure. For an Income Statement, the base figure is typically total revenue (or Gross Rental Income for a property). For a Balance Sheet, the base figure is total assets. This normalization allows for meaningful comparisons between properties of different sizes, or for tracking a single property's performance over various periods, revealing underlying trends and structural changes.

Why is Common Size Analysis Important for Investors?

For real estate investors, common size analysis is an indispensable tool for several reasons. It helps to cut through the noise of varying property scales, providing a standardized view of financial health and operational efficiency. Without it, comparing a small duplex to a large multifamily complex would be like comparing apples to oranges. By normalizing the data, investors can identify key insights that might otherwise be obscured by absolute dollar amounts.

• Facilitates Comparison: Easily compare the financial structure and performance of properties regardless of their size or revenue generation.
• Identifies Trends: Spot changes in cost structures, revenue streams, or asset composition over time for a single property, indicating improving or deteriorating performance.
• Highlights Inefficiencies: Pinpoint areas where expenses are disproportionately high compared to revenue or industry benchmarks, signaling potential operational issues.
• Supports Due Diligence: Provides deeper, more granular insights into a target property's financial health during the acquisition process, revealing potential red flags or opportunities.
• Enhances Benchmarking: Allows investors to compare their property's expense ratios and profitability against industry averages or competitor properties within the same market.

How to Perform Common Size Analysis

Performing common size analysis involves a straightforward process of converting absolute figures into percentages. The primary financial statements used are the Income Statement and the Balance Sheet.

Key Financial Statements

The Income Statement (also known as the Profit & Loss statement) details a property's revenues and expenses over a period, culminating in Net Operating Income (NOI). The Balance Sheet provides a snapshot of a property's assets, liabilities, and equity at a specific point in time. Both are critical for a comprehensive common size analysis.

Step-by-Step Process

1. Gather Financial Statements: Obtain the Income Statement and Balance Sheet for the property or properties you wish to analyze. Ensure they cover comparable periods if you're performing a trend analysis.
2. Identify Base Figures: For the Income Statement, the base figure is typically the Gross Rental Income or Total Revenue. For the Balance Sheet, the base figure is Total Assets.
3. Calculate Percentages for Income Statement: Divide each line item on the Income Statement by the Gross Rental Income. For example, if operating expenses are $50,000 and gross rental income is $200,000, the common size percentage for operating expenses is 25% ($50,000 / $200,000).
4. Calculate Percentages for Balance Sheet: Divide each line item on the Balance Sheet by Total Assets. For instance, if cash is $10,000 and total assets are $1,000,000, cash represents 1% of total assets ($10,000 / $1,000,000).
5. Analyze and Interpret: Compare the calculated percentages across different properties, against industry benchmarks, or over different periods for the same property. Look for significant deviations or trends.

Real-World Example: Comparing Two Multifamily Properties

Let's consider two multifamily properties, Property A (20 units) and Property B (50 units), both located in a similar market. We want to compare their operational efficiency using common size analysis, focusing on their Income Statements for the past year.

Property A (20 Units)

Raw Data:

• Gross Rental Income: $240,000
• Vacancy & Credit Loss: $12,000
• Effective Gross Income: $228,000
• Operating Expenses (Property Management, Repairs, Utilities, Taxes, Insurance): $91,200
• Net Operating Income (NOI): $136,800

Common Size Calculation (as % of Gross Rental Income):

• Gross Rental Income: 100%
• Vacancy & Credit Loss: 5% ($12,000 / $240,000)
• Effective Gross Income: 95% ($228,000 / $240,000)
• Operating Expenses: 38% ($91,200 / $240,000)
• NOI: 57% ($136,800 / $240,000)

Property B (50 Units)

Raw Data:

• Gross Rental Income: $600,000
• Vacancy & Credit Loss: $24,000
• Effective Gross Income: $576,000
• Operating Expenses (Property Management, Repairs, Utilities, Taxes, Insurance): $270,000
• Net Operating Income (NOI): $306,000

Common Size Calculation (as % of Gross Rental Income):

• Gross Rental Income: 100%
• Vacancy & Credit Loss: 4% ($24,000 / $600,000)
• Effective Gross Income: 96% ($576,000 / $600,000)
• Operating Expenses: 45% ($270,000 / $600,000)
• NOI: 51% ($306,000 / $600,000)

Interpretation

By comparing the common size percentages, we can see that Property B has a slightly lower Vacancy & Credit Loss (4% vs 5%) and a higher Effective Gross Income percentage (96% vs 95%). However, Property B's Operating Expenses are significantly higher as a percentage of gross income (45% vs 38%). This leads to a lower Net Operating Income percentage for Property B (51% vs 57%). This analysis suggests that while Property B might be better at tenant retention, its expense structure is less efficient than Property A's, warranting further investigation into its operating costs.

Interpreting Results and Strategic Implications

Once the common size percentages are calculated, the real value comes from interpretation. Investors should compare these percentages to industry benchmarks, historical data for the same property, or similar properties in their portfolio. Significant deviations often signal areas requiring attention or offering opportunities.

• Expense Management: High common size percentages for specific operating expenses (e.g., repairs, utilities, property management fees) indicate potential areas for cost reduction or negotiation.
• Revenue Optimization: A low effective gross income percentage might suggest high vacancy rates or inadequate rent collection, prompting strategies to improve tenant retention or rent increases.
• Risk Assessment: Consistently high debt-to-asset ratios on a common size balance sheet could signal higher financial risk, especially in volatile markets.
• Investment Decisions: Insights from common size analysis can inform buy, sell, or hold decisions, helping investors select properties with stronger operational fundamentals or identify underperforming assets.

Limitations and Considerations

While common size analysis is a powerful tool, it's important to be aware of its limitations to avoid misinterpretations.

• Industry Specifics: Benchmarks for common size percentages vary significantly by property type (e.g., multifamily, retail, industrial), location, and property class. What's normal for one might be an outlier for another.
• Non-Operating Items: Common size analysis of the income statement primarily focuses on operational aspects and does not directly account for financing costs (like mortgage payments) or depreciation, which are crucial for overall profitability and cash flow.
• Data Quality: The accuracy of the analysis is entirely dependent on the quality and consistency of the underlying financial statements. Inaccurate or manipulated data will lead to flawed conclusions.
• External Factors: The analysis doesn't directly account for external market shifts, economic changes, or specific property events (e.g., a major renovation) that could impact financial performance.