Introduction to Cash Flow Analysis and Real Estate Investing

1
Introduction to Cash Flow Analysis and Real
Estate Investing
2
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

3
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

4
Business Goals Might Include

• Maximize Long Term Shareholder Wealth
• Short-Term Financial Goals, I.e. cash flow
• Or Non-financial goals such as

5
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

6
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

7
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

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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

9
Real Estate Financial Analysis

• Developers Goal To invest capital in projects
  that generate after tax returns that exceed those
  of alternative risk-adjusted investment
• Investors Goal To buy property assets or
  property securities for less than their intrinsic
  value (the present value of a firms future free
  cash flows)

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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

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Pro-Forma (cont.)

• Should forecast previous numbers for at least 5
  to 10 years

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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

13
Leverage and Operating Ratios

• Loan to Value Ratio
• Debt Coverage Ratio
• Breakeven Point
• Expense Ratio

14
Gross Rent Multiplier

• Purchase Price over Gross Rent
• The lower the better
• A very simple comparison number insufficient for
  anything but general screening

15
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

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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

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Breakeven Point

• Percentage of occupancy that a building must
  achieve in order to be able to pay all of its
  cash expenses and carry the assumed financing
• Normally in the 65 to 95 range

• Operating Expenses Mortgage Payments
• ------------------------------
• Gross Rent

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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

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Single Period or Static Profitability Measures

• Cash on Cash
• After Tax Return on Equity
• Return on Asset or Going in Cap Rate

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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

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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

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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

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Multiple Period or Dynamic Return Measures

• Internal Rate of Return (IRR)
• Consider Appreciation Through Resale Price or
  Refinancing

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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

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IRR (cont.)

• CF1 CF2
  CFT Projected Resale CFT
• Equity Pve -------- -------- ...
  -------- -------------------------
• 1irr (1irr)2
  (1irr)T (1irr)T
• An IRR can be before or after tax using before or
  after tax cash flows.

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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