New Short-Term Analysis Mode in REIA Pro

Today we are releasing build 1.07 for Windows and build 1.13 for Macintosh of our REIA Professional product to add a third “short term” analysis mode.  This is a free update for all those who have a license for REIA Pro v17.

Select the mode on the General Settings worksheet:

By making this selection, the software reveals a set of worksheets that are specific to a 24 month analysis.  In a typical short-term scenario, you plan to purchase a property, do some renovations, and then resell within two years.

With the addition of this feature, we can now say that REIA Pro has all the features that REIA Express has, plus many more.  See a feature comparison of the two REIA Products for more information.

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“Reserves for Replacement” and Income-Property Investing

It may sound like a nit-picking detail: Where and how do you account for “reserves for replacement” when you try to value – and evaluate – a potential income-property investment? Isn’t this something your accountant sorts out when it’s time to do your tax return? Not really, and how you choose to handle it may have a meaningful impact on your investment decision-making process.


What are “Reserves for Replacement?”

Nothing lasts forever. While that observation may seem to be better suited to a discourse in philosophy, it also has practical application in regard to your property. Think HVAC system, roof, paving, elevator, etc. The question is simply when, not if, these and similar items will wear out.

A prudent investor may wish to put money away for the eventual rainy day (again, the roof comes to mind) when he or she will have to incur a significant capital expense. That investor may plan to move a certain amount of the property’s cash flow into a reserve account each year. Also, a lender may require the buyer of a property to fund a reserve account at the time of acquisition, particularly if there is an obvious need for capital improvements in the near future.

Such an account may go by a variety of names, the most common being “reserves for replacement,” “funded reserves,” or “capex (i.e., capital expenditures) reserves.”


Where do “Reserves for Replacement” Fit into Your Property Analysis?

This apparently simple concept gets tricky when we raise the question, “Where do we put these reserves in our property’s financial analysis?” More specifically, should these reserves be a part of the Net Operating Income calculation, or do they belong below the NOI line? Let’s take a look at examples of these two scenarios.

reserves for replacement, after NOI

Now let’s move the reserves above the NOI line.

reserves for replacement, befeore NOI

The math here is pretty basic. Clearly, the NOI is lower in the second case because we are subtracting an extra item. Notice that the cash flow stays the same because the reserves are above the cash flow line in both cases.


Which Approach is Correct?

There is, for want of a better term, a standard approach to the handling capital reserves, although it may not be the preferred choice in every situation.

That approach, which you will find in most real estate finance texts (including mine), in the CCIM courses on commercial real estate, and in our Real Estate Investment Analysis software, is to put the reserves below the NOI – in other words, not to treat reserves as having any effect on the Net Operating Income.

This makes sense, I believe, for a number of reasons. First, NOI by definition is equal to revenue minus operating expenses, and it would be a stretch to classify reserves as an operating expense. Operating expenses are costs incurred in the day-to-day operation of a property, costs such as property taxes, insurance, and maintenance. Reserves don’t fit that description, and in fact would not be treated as a deductible expense on your taxes.

Perhaps even more telling is the fact that we expect the money spent on an expense to leave our possession and be delivered to a third party who is providing some product or service. Funds placed in reserve are not money spent, but rather funds taken out of one pocket and put into another. It is still our money, unspent.


What Difference Does It Make?

Why do we care about the NOI at all? One reason is that it is common to apply a capitalization rate to the NOI in order to estimate the property’s value at a given point in time. The formula is familiar to most investors:

Value = Net Operating Income / Cap Rate

Let’s assume that we’re going to use a 7% market capitalization rate and apply it to the NOI. If reserves are below the NOI line, as in the first example above, then this is what we get:

Value = 55,000 / 0.07

Value = 785,712

Now let’s move the reserves above the NOI line, as in the second example.

Value = 45,000 / 0.07

Value = 642,855

With this presumably non-standard approach, we have a lower NOI, and when we capitalize it at the same 7% our estimate of value drops to $642,855. Changing how we account for these reserves has reduced our estimate of value by a significant amount, $142,857.


Is Correct Always Right?

I invite you now to go out and get an appraisal on a piece of commercial property. Examine it, and there is a very good chance you will find the property’s NOI has been reduced by a reserves-for-replacement allowance. Haven’t these people read my books?

The reality, of course, is that diminishing the NOI by an allowance for reserves is a more conservative approach to valuation. Given the financial meltdown of 2008 and its connection to real estate lending, it is not at all surprising that lenders and appraisers prefer an abundance of caution. Constraining the NOI not only has the potential to reduce valuation, but also makes it more difficult to satisfy a lender’s required Debt Coverage Ratio. Recall the formula:

Debt Coverage Ratio = Net Operating Income / Annual Debt Service

In the first case, with a NOI of $55,000, the DCR would equal 1.41. In the second, it would equal 1.15. If the lender required a DCR no less than 1.25 (a fairly common benchmark), the property would qualify in the first case, but not in the second.

It is worth keeping in mind that the estimate of value that is achieved by capitalizing the NOI depends, of course, on the cap rate that is used. Typically it is the so-called “market cap rate,” i.e., the rate at which similar properties in the same market have sold. It is essential to know the source of this cap rate data. Has it been based on NOIs that incorporate an allowance for reserves, or on the more standard approach, where the NOI is independent of reserves? Obviously, there has to be consistency. If one chooses to reduce the NOI by the reserves, then one must use a market cap rate that is based on that same approach.


The Bottom Line – One Investor’s Opinion

What I have described as the standard approach – where reserves are not a part of NOI – has stood for a very long time, and I would be loath to discard it. Doing so would seem to unravel the basic concept that Net Operating Income equals revenue net of operating expenses. It would also leave unanswered the question of what happens to the money placed in reserves. If it wasn’t spent then it still belongs to us, so how do we account for it?

At the same time, it would be foolish to ignore the reality that capital expenditures are likely to occur in the future, whether for improvements, replacement of equipment, or leasing costs.

For investors, perhaps the resolution is to recognize that, unlike an appraiser, we are not strictly concerned with nailing down a market valuation at a single point in time. Our interests extend beyond the closing and so perhaps we should broaden our field of vision. We should be more focused on the long term, the entire expected holding period of our investment – how will it perform, and does the price we pay justify the overall return we achieve?

Rather than a simple cap rate calculation, we may be better served by a Discounted Cash Flow analysis, where we can view that longer term, taking into account our financing costs, our funding of reserves, our utilization of those funds when needed, and the eventual recovery of unused reserves upon sale of the property.

In short, as investors, we may want not just to ask, “What is the market value today, based on capitalized NOI?” but rather, “What price makes sense in order to achieve the kind of return over time that we’re seeking?”

How do you treat reserves when you evaluate an income-property investment?

—-Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2014,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
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The Cash-on-Cash Conundrum – a Postscript

A while back, I posted a two-part series called “The Cash-on-Cash Conundrum.” In the first installment I explained the calculation and underlying logic of CoC, and in the second I discussed some of the pitfalls of overreliance on this particular measure.

big pile of dollars

I try to keep my ear to the ground by reading and sometimes contributing to investor forums, where I continue to see a good deal of discussion on the question of what is or what should be the metric of choice for real estate investors. My unofficial and unscientific gauge of the general sentiment is that most investors agree that cash flow is king. Although I would be reluctant to crown any single measure as the absolute be-all and end-all for property analysis, I agree that cash flow is indeed a critical measure of the health of an investment property.

So what’s the big deal? What concerns me is that I see a kind of tunnel vision on this topic. I frequently hear some variation of these two statements bundled together: “Cash-on-cash return is the only reliable metric and the only one I really need,” and “IRR and Discounted Cash Flow analysis are bogus – they’re a waste of time because you just can’t predict the future.” To put it simply, these folks are saying that they trust CoC because it looks at the here and now, and they distrust IRR/DCF because it tries to look into the future.

On the surface, that argument might seem reasonable enough. Cash-on-Cash return is the property’s expected first-year cash flow before taxes, divided by the amount of cash invested to make the purchase; it’s quick and easy to calculate, and it does indeed focus on a more-or-less tangible present. A strong CoC unarguably provides a good sign that your investment is off on the right foot.

Is that the end of the story – or should it be? I think this narrow focus can cause an investor to miss some vital issues.

By adopting the “can’t predict the future” argument, aren’t you ignoring what investing is all about? You don’t have a crystal ball, but still — isn’t investing about the future, and isn’t the ability to make sensible choices in an uncertain environment a key trait of the successful investor?

I find it difficult to accept the argument that I should make a decision to buy or not to buy an investment property based on its first-year cash flow alone and without regard to projections of future performance. Ironically, there is a hidden message in this point of view: If the first year performance data is sufficient, then apparently I should believe that such data will be representative of how well the property will perform all the time. In other words, it really is OK to predict the future, so long as I believe the future will always be like the present.

I would argue that it is in fact less speculative to make the kind of projections that you typically see in a Discounted Cash Flow analysis, where you look at the anticipated cash flow over a period of time and use those projections to estimate an Internal Rate of Return over the entire holding period.

With any given property, there may be items that you can forecast with a reasonable degree of confidence. For example, on the revenue side you may have commercial leases that specify the rent for five years, ten, or even more. You may even be able to anticipate a potential loss of revenue at a point in the future when a commercial lease expires and you need to deal with rollover vacancy, tenant improvements, and leasing commissions.

You could be looking at a double- or triple-net property where you are insulated from many or most of the uncertainties about future operating expenses like taxes, insurance and maintenance.

Or, with residential property, you may have a history of occupancy percentage and rent increases that permit a credible forecast of future revenue.

Then there is the more basic question, why are you analyzing this property at all? Why are you running the numbers and making this CoC calculation? Are you trying to establish a current market value, as a commercial appraiser might? Or are you trying to make a more personal decision, i.e., will this particular property possibly meet your investment goals? And what are those goals?

Seems like I just took a nice simple metric and wove it into a more complicated story. Sorry, but in your heart of hearts you know if investing really were that simple, then everyone with a pulse would be a huge success. At the same time, it doesn’t have to be so complicated either, so long as you approach it in a reasonable and orderly way.

That orderly approach begins with deciding what you are looking to get out of this investment. Maybe you want to hold it for a few years to get strong cash flow and then sell it, hopefully for a profit. Perhaps you intend to hold it long term, less concerned with immediate cash flow (so long it as it positive), and then sell the property much later to fund your children’s college costs or your own retirement. In either case, if your plan is to buy and hold then there is one thing you can’t ignore: the future.

This approach continues with projection of the revenue, expenses, potential resale, and rate-of-return metrics, running out to your intended investment horizon. Perhaps key here is the realization that you shouldn’t really expect to nail your projections with a single try. Consider several variations upon future performance: best-case, worst-case and somewhere in-between scenarios to give yourself a sense of the range of possible outcomes.

All this brings us back to the duel between the Cash-on-Cash metric and DCF/IRR. I believe if you rely only on the former, then you are not just saying, “You can’t predict the future.” You’re saying, “If the first year looks good, then that’s all I need to know.” This is, quite literally, a short-sighted investment strategy. The takeaway here is that there should be no duel between metrics at all; that prudent investors can use Cash-on-Cash to get an initial reading of the property’s immediate performance, but they should then extend their analysis to encompass the entire lifecycle of the investment. To quote the folks at NASA (who, after all, really are rocket scientists), “It takes more than one kind of telescope to see the light.”

—-Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2014,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
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C / I Development build 1.12 “Better in Blue”

Today we are releasing a build 1.12 of Commercial Industrial Development in version 6. In this build we have completely changed the color / theme from green to blue.  At one time, we used color to differentiate the products but currently we are standardizing on a business blue appearance.

This update also includes a number of fixes to the printed reports and provides a bit more uniformity in the presentation.  It’s a free update for anyone who has a license of version 6 of the software.

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New, Improved PDF Printing for Macintosh Products

Yesterday, we released free updates across all of our Macintosh products that brings new PDF printing functionality and ease of use for PDF report creation.  Our new solution includes a utility file (called rdpdfutil) which resides in the same folder as the RealData software product and replaces the need for CUPS-PDF.

What exactly does this new utility do?

In short, it wraps up individual PDF files into one single document just as we do on our Windows products.  It also allows you to save your reports to any location that you choose, unlike CUPS.  Printing to PDF on a Mac now is equivalent to the advanced functionality we have had on Windows.

How does it work?

Print reports like you have always done by opening the RealData Menu and selecting Print Reports.  Tick the “Print to PDF” checkbox, then click the Print button.

PDF print dialog

 

Soon after, a dialog box will appear that asks you where you would like to save the PDF report.  Be sure to rename the report to something that makes sense for your project.

What else do I need to know?

When you install your Mac product, by default we prompt you to save the product to your Mac’s Applications folder.  Some users may wish to move this folder to another location, but note that in order for our PDF printing solution to work, you must retain the default install location with Applications.  Do not change the folder name.  Unfortunately, this is a limitation of the Mac OS that we could not work around.

 

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Crowdfunding Real Estate Investments

Pooling of resources, passing the hat — call it what you will, but collaborative underwriting has probably been around for a couple of centuries. Never one to leave well enough alone, the internet has again risen to the role of game-changer, extending a global reach to individuals and companies looking for backers.

You have probably heard of the crowdfunder Kickstarter, which is a popular donation-based site, aimed primarily at creative projects. Backers who donate to such projects don’t become shareholders or expect any financial return. They may be more akin to patrons than to investors.

But investment-based crowdfunding sites have also emerged. I can’t say that I knew much about them, but I recently attended the annual Yale Alumni Real Estate Association’s National Conference where one of the sessions was devoted to this subject, with presentations by two of the top players in this field: Daniel Miller of Fundrise and Rodrigo Nino of Prodigy Network.

Although this method of funding real estate projects may be just a blip on the radar at present, it does appear that more and more real estate crowdfunding sites like these are cropping up and deals actually are getting funded. So just what is this all about and how is it supposed to work? I’ve tried to take what I learned at the Yale conference and have expanded on it a bit; and so, the following are a few observations from an interested outsider.

For the Project Developer Seeking Financing

Among the top arguments for crowdfunding a real estate project are these:

  • It offers an opportunity to get a project financed more quickly and easily than it would through more conventional channels.
  • By eliminating some of the middlemen usually involved, it can lower transaction costs.

The arguments seem credible, since most bank and institutional financing has become a test of endurance. Some crowdfunding sites offer both debt and equity investments, and most are quite specific as to the types of properties with which they deal. The process may not be entirely a walk in the park, because the typical site screens developers by taking them through a rigorous application and evaluation process.

For the Investor

One attraction for investors is that they typically don’t have to pony up a huge commitment to participate in a single project. Hence, they could spread smaller chunks of cash among several properties or even several developers, thus spreading their risk.

There would appear to be a few murky areas, however. Successful commercial real estate investors generally apply a laser focus on their due diligence. In a crowdfunded scenario one should expect that the developer will be doing that, carefully vetting the property and supplying detailed financial information and projections to the potential investor; but how much detail will they provide and can the investor independently verify that information? With the proliferation of crowdfunding sites, will there be consistency among them in the amount and quality of data they provide? A prudent investor must be certain at least to take a very careful look at the track record of the developer.

Investing through crowdfunding may have particular appeal to inexperienced investors. They should be particularly cautious, understanding that there is not likely to be any liquidity, that their cash could be tied up for a considerable time, and of course that there is no guarantee of an acceptable return or of recovering the initial investment. Sometimes deals simply fail.

How is Crowdfunding Even Possible?

It should come as no surprise that there are plenty of regulations that govern these investment offerings. It appears that most of the crowdfunding sites have been operating under SEC Regulation D, which limits general solicitation and restricts participation to “accredited investors.” These generally include investors with a net worth of at least $1 million (not including the value of their home) and income of $200,000 for the past two years, or $300,000 together with spouse.

One site, which at present seems to be unique, is Fundrise. They have been able to use an obscure SEC Regulation A that allows non-accredited investors to participate in community-based deals with investments as little as $100. There is apparently plenty of hoop-jumping for them to deal with, since this regulation also involves state approvals as well as a limit on capital that can be raised in a 12-month period.

In 2012, Congress passed the JOBS Act (Jumpstart Our Business Startups)  and in September 2013, Title II of that act became effective. Title II allows general solicitation, but only to accredited investors.

Title III of the JOBS Act is called the “Crowdfunding Exemption.” Expected to work its way through the SEC rule-making process sometime later this year, it would allow non-accredited investors to participate in equity offerings. The proponents of investment crowdfunding see this as the real game-changer.

Conclusion

Crowdfunding could revolutionize how real estate investments are financed, but not everyone is convinced that it is the Next Big Thing. A recent BusinessWire article cites a number of concerns, including one that this writer has seen elsewhere:  “Will crowdfunding expose innocent, small-time investors to fraudsters and scam artists?”

Both real estate crowdfunding itself and the regulatory environment that will govern it are in their infancy, so how this will all play out must be a matter of conjecture for now. On the one hand, the real estate industry — to put it as politely as possible — has a long history of being resistant to change. On the other, technology in the 21st century has had a habit of sweeping away things that we confidently viewed as permanent cultural fixtures. To be convinced, I need only to rummage in my basement to dig out my old rotary-dial wall phone and my case of incandescent lightbulbs.

Time will tell the story.

—- Frank Gallinelli

Read more in the recent press about real estate crowdfunding:

Crowdfunding’s Latest Invasion: Real Estate

How Crowdfunding Could Reshape Real Estate Investing

The Big Five in Real Estate Crowdfunding

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2014,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
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Residential or Commercial? What Type of Property is Right for You?

We’ve discussed this topic before, but it seems never to get old. Every day we encounter folks who are getting started in real estate investing, and who want to figure out the best path for them: residential property or commercial? Will residential require a lot of hands-on management? Is commercial really a different game? Is financing similar for residential and commercial?

Of course we recognize that there isn’t one type of property that is right for everyone, but we think our discussion of the pros and cons of investing in each type can help you make a personal choice that you can be comfortable with.

And so… we’ve refreshed our earlier article and invite you to visit it here:

Investing in Real Estate: Should you Buy Residential or Commercial Property?

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Copyright 2010, 2014,  Frank Gallinelli and RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
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Results of our first real estate investor survey

We would like to thank all those who took a few minutes to respond to the first of our investor surveys; and we’d like to share the results:

Q1: What type of real estate investment property do you buy, or plan to buy? Check all that apply.

Multifamily, 2-5 units 52%
Apartment Building, >5 units 54%
Mixed-Use 20%
Retail Strip Center 26%
Retail, Larger Shopping Center 9%
Free-Standing NNN 4%
Office Building 30%
Self-Storage 24%
Industrial 7%
Hotel 9%
Other (please specify)
    Single-family 22%
    Land 2%

Keep in mind that we asked respondents to “check all that apply,” so that is why these don’t–and shouldn’t– add up to 100%.  The results show that many investors buy more than one type of property.

Clearly, residential property was more popular than commercial, and what may have been a bit surprising to us was the number of “write-in” votes for single-family.  Combining these with the 2-5 unit multifamilies, it would appear that many investors are currently leaning toward smaller residential–at least among our pool of survey-takers. This may be a reflection of the inventory of homes that ended up in foreclosure, and could perhaps be purchased at prices that woulf make them attractive to investors.

Q2: Thinking about your cash flow projections for your potential investment, why do you make those projections? Check all that apply.

To decide if I believe the property is worth considering. 87%
To help me to decide on an appropriate offer price (or selling price). 78%
To show to a lender in support of my request for financing. 61%
To show to a potential equity partner. 48%
I don’t make cash flow projections. 7%

We’re certainly not surprised to see that the great majority of  investors want to vet their deals and scrutinize the pricing by performing a cash flow analysis; and also that a good pro forma can bring you some credibility when dealing with a lender.

We find it very interesting that almost half of our respondents said they use a cash flow projection to show to a potential equity partner. That would certainly seem to suggest that a lot of investors are pooling their resources in order to do deals. Just anecdotally, we believe we’ve seen a lot more investment partnerships since the 2008 meltdown, probably because of the difficulty that many have encountered finding financing.

One general note: Before the statisticians in the audience take us to task, we should impose a caution in regard to interpreting these survey results. A truly scientific study would have avoided what is called “self-selection,” where responses come strictly from those who are willing to volunteer their point of view.

Nonetheless, we believe this simple and informal survey offers a fairly good window into investor thinking.

We would be very interested in hearing your take on these survey results. We hope you’ll send us your comments.

And finally, we didn’t forget about that bonus:  We promised to give away three signed copies of What Every Real Estate Investor Needs to Know About Cash Flow… , and that’s up next.  This week we’ll pick three email addresses from among those who opted-in to the drawing and contact them so we can send them their copies.  If you participated, please keep an eye out for that email from us.

 

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Podcast: “Learn the key principles to effectively analyzing and evaluating your real estate deals”

I had the pleasure of recording a podcast recently with real estate entrepreneur Kevin Bupp. We discussed what I feel are some of the key principles that every real estate investor ought to understand — and so, I invite you to listen to that podcast here.

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NPV, PI, IRR, FMRR, MIRR, CpA – Stirring the Alphabet Soup of Real Estate Investing, Part 4

In the previous three installments (review them here if you like: Part 1, Part 2, Part 3) we covered the most common methods of measuring the return on a real estate investment. There is yet another that is a bit more esoteric and complex; so if you’re up for it, grab your double espresso and jump in.

Capital Accumulation Comparison–CpA

Let’s say that you’re contemplating a purchase and want to decide between two properties, one requiring a cash investment of $100,000, the other $60,000. Clearly, you must really have $100,000 in hand if you’re considering both options. To make an “apples-to-apples” comparison of these two mutually exclusive scenarios, you should invest the entire $100,000 no matter which property you choose.

If that’s the case, then when you evaluate the option that requires only $60k for the property purchase, your analysis should involve both the return you expect to receive from that property plus the return you expect from the $40k cash that you were free to invest elsewhere.

Likewise, if you project that you will hold one property for 4 years but the other for 5, you should look at the after-tax proceeds from selling the 4-year property and take into account the return you could earn with those proceeds if you invest them elsewhere for one more year.

In short, you are saying that a straight-up comparison of these two investment alternatives should presume that you commit the same amount of cash in each case, and that you keep that cash committed for the same length of time.

A Capital Accumulation Comparison (CpA) is one way you might address these issues. This method allows you to compare investment alternatives not with a rate-of-return measurement but rather in terms of dollars, even if those dollars don’t remain in the original property investment.

Consider two mutually exclusive investment opportunities, Property A and Property B, with the following cash flows:

Cash Flows

To perform a Capital Accumulation comparison, you begin by eliminating the negative cash flows as you saw in the MIRR example above. This time you choose a safe rate of 4%.

Capital Accumulation Comparison

Next, you compound all positive cash flows to the end of your holding period, Year 5. You decide on a reinvestment rate of 9%.

CpA Property A

CpA Property B

You have one last issue to deal with: Clearly, you must be starting out with $100,000 cash in your pocket or you wouldn’t be considering the purchase of Property A. If you decide to buy Property B, then you’ll have $40,000 left over to work with. To make a true comparison of these alternatives, you need to commit the same amount with either choice. You do that by assuming that you’ll invest the remaining $40k for the 5-year holding period; for consistency, you may use your reinvestment rate of 9% as the expected return on this cash.

Your final series of cash flows, after discounting negatives and compounding positives, looks like this:

CpA Comparison calculation

Let’s have an instant replay of what you did here, first using just Property A. If some of this is starting to sound familiar, you’ve probably noticed that this process of computing CpA looks a great deal like what you saw for FMRR in the last insatllment of our series, except instead of looking for a rate of return you’re looking for a total accumulation of cash.

In the example above, you first needed to eliminate the negative cash flow of $15,000 that occurred in year 3. You did that by discounting it back at 4% per year until its discounted amount could be absorbed by an earlier positive cash flow. In this case you had to go back only one year. Negative 15,000 discounted at 4% for one year is negative 14,423, which could be absorbed by Year 2’s positive 15,000, leaving a net for Year 3 of the difference, 577.

(If you had some amount of negative cash flow that you could not absorb into positive cash flows, you would discount the negative cash back to Year 0 and add it to initial investment amount, again as described in FMRR.)

Next you compounded each of Property A’s positive cash flow forward to Year 5 at the reinvestment rate of 9%. Why five years, when you expect to hold the property for just four? Because you’re comparing Property A to an alternative (and mutually exclusive) investment that you would hold for five years. So to keep the alternatives in balance you need to keep your EOY 4 money in play (at the reinvestment rate) for the same amount of time as in Property B.

When you were done, your entire accumulation was a combined negative 100,000 and positive 281,287, or 181,287.

Property B worked the same way, but required one additional step: Equalizing your cash commitment by investing elsewhere the $40,000 that was not required to purchase Property B. By investing that $40k, you were able to compare two investment scenarios, each requiring $100k of cash.

CpA Comparison calculation

As you can see, the total capital accumulation for Property A ($181,287) is greater than that for Property B ($163,815), so Property A is your preferred choice according to the CpA method. Interestingly enough, if you were to do an IRR on the original cash flows, you would find that Property B, with 33.7% is greater than A’s 30.0%, while the B’s MIRR of 25.2% wins by a nose over A’s 24.8%.

Why might that be so? The answer should lie in one or both of the “equalizing” factors: holding period or initial investment. Perhaps in this example $40,000 is working harder for you invested in Property A than it is when invested independently if you chose Property B.

As promised in Part 1 of this series, we’ve really stirred the alphabet soup – NPV, PI, IRR, FMRR, MIRR and CpA. Is CpA a silver bullet? Indeed is any one of these the only measure you’ll ever need?

Probably not. They all require judgments on your part – about cash flows, resale proceeds, perceived risk, and sometimes discount rate, safe rate or reinvestment rate. In regard to any specific deal you may be more confident about some of these judgments than you are about others, and that confidence – or lack of it – can influence how much you want to rely on any one metric. The smart investor will understand them all, consider them all, and use the one (or several) that seems best suited to the actual investment decision at hand. After all, you wouldn’t keep just one kind of screwdriver or one size wrench in your basement toolbox. Do no less with your investments.

—Frank Gallinelli

P.S. If the calculation of CpA is not your idea of fun, RealData offers an add-on module to its Real Estate Investment Analysis, Professional Edition software that will do the heavy lifting for you.

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

Need to calculate Capital Accumulation Comparison (CpA)? Use the Comparison Add-on for Real Estate Investment Analysis, Professional Edition.

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