Introduction to Cash Flow Analysis and Real Estate Investing
Getting Rich in Real Estate
– “get-rich-quick” methods of real estate investment often assume self-management while ignoring your opportunity cost of time and the risks of high leverage – Many make more money off of the seminars than they do on their real estate investments
Real Estate Does Provide Many Opportunities Including
Adding Value Through:
– – – – – – – Real estate acquisition Development Financing Site Analysis Controlling Operating Costs Innovative Marketing Innovative Management
No Secret Way To Attain
Success Only hard work with good research and systematic analysis
Business Goals Might Include
Maximize Long Term Shareholder Wealth Short-Term Financial Goals, I.e. cash flow Or Non-financial goals such as
Non-Financial Goals
Maintain a family friendly place to work Maintain affirmative action hiring policies Retain quality employees through tough markets
and tough times Develop or own only the highest quality properties in prestige locations Be the largest owner in terms of market share of a certain type of property in a local market
Short Term Financial Goals Might Include
Satisfy the requirements of the lender in terms of
pre-leasing or debt coverage cash flows Satisfy the minimum required first year cash on cash returns required of investors Project minimum internal rates of return for the entire holding period of some minimum percentage Maintain occupancy levels above 95% in all portfolio properties
Financial Analysis Decision Models
Single period model such as – Cash on Cash – Gross Rent Multipliers – Capitalization “Cap” Rate Multiple period model – IRR - Internal Rate of Return
IRR Model
Multiple period return on investment Calculates the average discount rate that
equates all future returns over the projected holding period back to the present value of the initial equity investment Should be used for capital allocation and initial investment decisions
Real Estate Financial Analysis
Developer’s Goal: To invest capital in
projects that generate after tax returns that exceed those of alternative risk-adjusted investment Investor’s Goal: To buy property assets or property securities for less than their intrinsic value (the present value of a firm’s future free cash flows)
The “Pro-Forma”
Estimate Gross Rent
Subtract Estimated Vacancy
Add Other Income
Effective Gross Income Subtract Operating Expenses Net Operating Income or “NOI” Subtract Debt Service Cash Flow Before Taxes Add the Mortgage Principal Repaid to BTCF Subtract Depreciation Taxable Income Less taxes due or plus taxes saved After Tax Cash Flow
“Pro-Forma” (cont.)
Should forecast previous numbers for at
least 5 to 10 years
Important Financial Ratios
Used to determine financial feasibility – Gross Rent Multiplier
– – – – – – – – – Loan to Value (LTV) Ratio Debt Coverage Ratio Breakeven Point Expense Ratio Cash on Cash After Tax Return on Equity Return on Asset Internal Rate of Return Resale Price
Leverage and Operating Ratios
Loan to Value Ratio Debt Coverage Ratio Breakeven Point Expense Ratio
Gross Rent Multiplier
Purchase Price over Gross Rent The lower the better A very simple comparison number
insufficient for anything but general screening
Loan to Value Ratio
Measures real estate
financial risk Default risk rises proportionally with the LTV ratio Typical LTV in the industry is 75%
Mortgage Loan Balance -----------------------------Purchase Price
Debt Coverage Ratio
Must exceed 1.0 in
order for the property to make the mortgage payment Most lenders require a debt coverage ratio of around 1.1 to 1.3
Net Operating Income --------------------------Debt Service
Breakeven Point
Percentage of
occupancy that a building must achieve in order to be able to pay all of it’s cash expenses and carry the assumed financing Normally in the 65% to 95% range
Operating Expenses + Mortgage Payments -----------------------------Gross Rent
Expense Ratio
Used in comparison
with other property alone it tells very little Should be sufficiently high to keep up the property while not wasting capital on uncontrolled expenses, such as energy costs
Operating Expenses ----------------------------Effective Gross Income
Single Period or “Static” Profitability Measures
Cash on Cash After Tax Return on Equity Return on Asset or Going in Cap Rate
Cash on Cash
Measures initial
profitability The higher the better Typical first year cash on cash return range from 4 to 10 percent For REITs, the funds from operation (FFO) is a similar measure
Before Tax Cash Flow --------------------------Cash Equity
After Tax Return on Equity
Similar to cash on
cash Takes into account tax shelter Typically range from 5% to 12% in the first year
After Tax Cash Flow -------------------------Cash Equity
Return on Asset
“Cap Rate” How much debt a
property can carry Overall returns The higher the return rates, the more debt a property can support Typical cap rates run from 8% to 12%
Net Operating Income ----------------------------Purchase Price or Value
Multiple Period or “Dynamic” Return Measures
Internal Rate of Return (IRR) Consider Appreciation Through Resale
Price or Refinancing
Internal Rate of Return
The most frequently used measurement of
projected holding period overall returns Delivers in one number an investment return that integrates rental growth rates and property value appreciation Should be compared to the required rate of return Typical IRRs range from 12% to 15% Can reach over 20% for new, speculative investments
IRR (cont.)
CF1 CF2 CFT Projected Resale CFT Equity = Pve = -------- + -------- + ... + -------- + ------------------------1+irr (1+irr)2 (1+irr)T (1+irr)T An IRR can be before or after tax using before or after tax cash flows.
Resale Price Calculation
Where R is the “going
out” cap rate on the property From the expected resale price, it is important to deduct reasonable selling costs Tax considerations need to be noted
Net Operating Income Projected for the Next Year --------------------------R