cashflow real estate by rickman3

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									    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      Mortgage Loan Balance
  financial risk            ------------------------------
 Default risk rises        Purchase Price
  proportionally with the
  LTV ratio
 Typical LTV in the
  industry is 75%
Debt Coverage Ratio
 Must exceed 1.0 in       Net Operating Income
  order for the property   ---------------------------
  to make the mortgage     Debt Service
  payment
 Most lenders require a
  debt coverage ratio of
  around 1.1 to 1.3
Breakeven Point
 Percentage of            Operating Expenses +
  occupancy that a            Mortgage Payments
  building must achieve    ------------------------------
  in order to be able to   Gross Rent
  pay all of it’s cash
  expenses and carry the
  assumed financing
 Normally in the 65%
  to 95% range
Expense Ratio
 Used in comparison           Operating Expenses
  with other property -        -----------------------------
  alone it tells very little   Effective Gross Income
 Should be sufficiently
  high to keep up the
  property while not
  wasting capital on
  uncontrolled expenses,
  such as energy costs
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          Before Tax Cash Flow
  profitability             ---------------------------
 The higher the better     Cash Equity
 Typical first year cash
  on cash return range
  from 4 to 10 percent
 For REITs, the funds
  from operation (FFO)
  is a similar measure
After Tax Return on Equity
 Similar to cash on       After Tax Cash Flow
  cash                     --------------------------
 Takes into account tax   Cash Equity
  shelter
 Typically range from
  5% to 12% in the first
  year
Return on Asset
 “Cap Rate”               Net Operating Income
 How much debt a          -----------------------------
  property can carry       Purchase Price or Value
 Overall returns
 The higher the return
  rates, the more debt a
  property can support
 Typical cap rates run
  from 8% to 12%
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     Net Operating Income
  out” cap rate on the       Projected for the Next
  property                   Year
 From the expected       ---------------------------
  resale price, it is                  R
  important to deduct
  reasonable selling
  costs
 Tax considerations
  need to be noted

								
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