Tag: cash flow

How to Create Best-Case and Worst-Case Property Analyses in REIA Professional

You already know that pro forma property analysis is an essential part of due diligence before jumping in and spending your money on a real estate investment.  You also know the value of the pro forma analysis is only as good as the care and consideration you give to all your assumptions about the purchase, operation and sale of the property.  Part of being a cautious and calculating investor is to consider best-case assumptions, worst case assumptions and some case in between.  Fortunately, this is an easy matter with RealData’s REIA Professional.

Here’s how:

  1. Create your initial analysis with REIA Pro with a complete set of assumptions.  It does not matter whether these are conservative or aggressive, just save the file with an appropriate name such as “300 Main Street conservative.xltm”
  2. After saving, use Excel’s Save As function to save a copy of the file with a new name.  That file might be  “300 Main Street aggressive.xltm”  Repeat the process for your third case.
  3. Adjust the data in the second two files to match the case.  Save the files.
  4. Open our Comparison Analysis add-on for REIA.
  5. Click the Add Property button to include all three of the files you have created for your property.  You will then see a side-by-side comparison of key metrics for all of the three cases.

Also consider using our new Decision Maker worksheet right within REIA Pro.  This unique dashboard tool allow you to see how 21 metrics (such as Cash on Cash and IRR) change as you change key assumptions about your purchase.  Change purchase price, vacancy rate, loan terms, etc.

Use these exercises to determine just how well your property might perform under a variety of future occurrences.


Investing in Real Estate: How Much Analysis Do You Really Need?

More than once – in my writing, my teaching, talking in my sleep – I have been known to say that real estate investing is all about the numbers. There is, of course, great truth in that pithy statement, or so I believe; but there is perhaps more to the story that you should be careful not to overlook.

The data that you collect about an income-property – the current rental income and operating expenses, the financing options, and the resulting cash flows and potential resale– are all essential to making an informed analysis of a property’s value and its appeal as an investment. So too is an understanding of the key metrics. What are the expected Debt Coverage Ratio, Capitalization Rate and Internal Rate of Return, and what do they all mean?

A wise investor realizes that this information represents the foreground, but not the complete picture. There is a context, a background, in which these data reside, and you ignore it at your peril.

When I teach real estate investment analysis to my graduate students, I begin by telling them that they absolutely must learn how to run and interpret the numbers. But I also stress (sometimes to the point of becoming really annoying) that they have to look behind the numbers, to read the information about the property as if it were a story. The financial facts and figures about a property that you uncover today may be entirely accurate, but can you rely on them them to persist? What are the long-term risks and opportunities, the indirect factors, and how do they inform the numbers that you will plug into your projections?

For example, if you have commercial tenants, how strong are their businesses? One of the case studies I give my students is a mixed-use property with retail tenants whose business models are on the decline. Those tenants have leases with options to renew, but if their customer bases are shrinking, isn’t it more prudent to suspect that they may not choose to renew? Shouldn’t you also consider what could happen to your cash flow in a worst-case scenario, where they go bankrupt before their current leases are up?

Rather than simply assuming an ongoing revenue stream from the current leases, perhaps, as I tell my students, you need to look beyond the current numbers. If you see some significant risk going forward, maybe you should build rollover vacancy, leasing commissions and tenant improvements into your projections of future performance. You’re still going to run the numbers, and they still matter; but now, taking a broader view may alter your perspective on possible future cash flows.

One way to widen your field of vision is to go beyond the specific property and take into account some intangibles, both local and global. Real estate, like politics, is very much a local game. How strong is the local economy? Is unemployment a problem? What is the trend in the absorption of space – are vacancies growing or declining? Where is your city or town’s budget heading? Are there bond issues on the horizon that could materially affect your property taxes? The answers to questions like these will connect directly to the kinds of assumptions you make concerning the risk of future vacancy loss, and the rate of growth, if any, in your rents.

Then there’s the global view. You want to look at how the overall economy might affect your property. For example, it is typically the case that in times of tight credit, or in a miserable economy such as we’ve seen for the past several years, demand for apartments tends to increase. There is nothing surprising in this. Folks can’t get mortgages because their incomes have dropped and perhaps because banks aren’t lending freely. People who would otherwise be prospective homebuyers or who would be able to stay in their current homes are now renting apartments, thus reducing vacancy and often pushing rents upward.

The same causes – a wounded economy and lack of credit – might lead to an opposite effect on office and retail space, where businesses have to downsize because their customers have less money to spend.

So, if you find yourself rolling into a particular economic cycle, then you will want to adjust your projections for the future accordingly. In the example above, you would begin with whatever revenue stream you find in place; then, in the case of apartments, you would probably project declining vacancy loss and increasing rental rates for a few years, but you would probably do the opposite for retail and office. Same starting point, but different paths into the future.

What is our takeaway here? First, that real estate investing really is about the numbers. You’re going to scrutinize every lease, every operating expense, every financing option to understand how you believe the property will function on the day you acquire it. There is no substitute for crunching these numbers, and no reason to dismiss what they tell you.

But then you’ll pause to recognize that you’re probably going to own the property well beyond that first day. That’s when you need to look up from your spreadsheet. You need to look both at and beyond the current data and metrics, to visualize the property and your expectations for it in the context of its larger environment. The numbers truly matter, but so does the sometimes dicey, not-so-tidy real world in which they dwell.

–Frank Gallinelli

Copyright 2012, RealData® Inc. All Rights Reserved

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New for 2012: Real Estate Investment Analysis, Version 16

Thirty years of development time, and of listening carefully to what to our customers want.  All this comes together now in the latest version of our most popular and powerful software app for real estate investors: Real Estate Investment Analysis, Version 16

What’s New in Version 16?

    • The Decision Maker

      The centerpiece of v16 is a new module called “The Decision Maker.” Here is how it works: Enter data about the property — revenue, expenses, financing, etc. — as you normally would.  Then go to the new module. The top half of the page will display 12-18 of your key assumptions, like those shown here:

      snippet - input, Decision Maker
      snippet 1 from Decision Maker

      You can now toggle any or all of your assumptions up or down with the arrows, while watching the effect of each change as it displays instantly on the bottom half of the page.

      There you’ll see more than a dozen key metrics, such as cash flow and IRR. These will update in response to your clicking the arrows to raise or lower any of the basic assumptions; the data will display going out 20 years.

      snippet 2, Decision Maker
      snippet 2 from Decision Maker

      For example, toggle the purchase price or the cap rate up and down, and watch the effect on your IRR. Toggle the mortgage interest rate, watch the impact on your cash flow. What better way to decide how — or if — you can make this deal work. Hence the name: Decision Maker

    • Detailed Capital Improvements

      Many users have asked to be able to provide a detailed break-out of anticipated expenditures for capital improvements. Here it is. You can now choose to fill out a complete year-by-year schedule of improvements, or simply enter an annual total.


    • Detailed Closing Costs

      Likewise, the ability to itemize acquisition closing costs has been another common request. You now have two options: itemize or enter a single amount.


    • Improved Reports
      We really do pay attention when users call and say things like, “Why doesn’t the partnership presentation show cash-on-cash return?” We keep track of those requests, and you’ll find several now implemented in v16.


    • Import Data from Your Version 15 Analyses

      Here’s a big one: If you’re upgrading from v15 to v16 you can run a special function that will read all of the user entries from an analysis you did in v15 and transfer that information into the new version.  That’s no small trick, but our super-smart programmers did it.


Upgrade from Version 15

      If you’re currently a registered user of v15, keep your eye out for an email from us with an offer to upgrade at a nominal cost.

Refi Existing Investment Property to Purchase Another?

One of our Facebook fans, Tony Margiotta, posed this question, which I’m happy to try my hand at answering here:

“Could you talk about refinancing an income property in order to purchase a second income property? I’m trying to understand the refinance process and how you can use it to your advantage in order to build a real estate portfolio. Thanks Frank!”


The Good News

Your plan – to extract some of the equity from an investment property you already own and use that cash as down payment to purchase another – is fundamentally sound. In fact, that’s exactly what I did when I started investing back in the ‘70s, so to me at least, it seems like a brilliant idea.

Of course, you need to have enough equity in your current property. How much is enough? That will depend on the Loan-to-Value Ratio required by your lender. The refi loan has to be small enough to satisfy the LTV required on the current property, but big enough to give you sufficient cash to use as the down payment on the new property.

For example, let’s say your bank will loan 70% of the value of your strip shopping center, which is appraised at $1 million. So, you expect to obtain a $700,000 mortgage. Your current loan is $550,000, which would leave you with $150,000 to use as a down payment on another property.

Given the same 70% LTV, $150,000 would be a sufficient down payment for a $500,000 property, i.e. 70% of $500,000 = $350,000 mortgage plus $150,000 cash.

But Wait… Some Issues and Considerations

Unfortunately, it’s not the ’70s or even ’07 anymore, so while the plan is sound, the execution may present a few challenges. Best to be prepared, so here are some issues to consider:

    • In the current lending environment, financing can be hard to find, and the terms may be more restrictive than what you experienced in the past. Notice that I used a 70% LTV in the example above. You might even encounter 60-65% today, while a few years ago it could have been 75-80%.  In order to obtain the loan, you might also have to show a higher Debt Coverage Ratio than you would have in the past – perhaps 1.25 or higher, compared to the 1.20 that was common before.
    • How long have you had the mortgage on the current property?  Some lenders will not let you refinance if the mortgage isn’t “seasoned” for a year or even longer.
    • How long have you owned the property? A track record of stable or growing NOIs over time will support your request for a new loan.  You need to make a clear and effective presentation to the lender showing that the refi makes sense, especially in a tight lending environment.
    • You need to run your numbers and not take anything for granted. For example, will your current property have a cash flow sufficient to cover the increased debt?
    • Keep in mind that you’re adding more debt to the first property, so the return on the new property has to be strong enough to justify the diminution of the return on the first.
    • Have you compared the overall return you would achieve from the two properties using the refi plan as opposed to the return you might get if you brought in some equity partners to help you buy the new property?

In a nutshell, refinancing an existing income property to purchase another is a time-honored and proven technique, but it in a challenging lending environment be certain you do your due diligence and run your numbers with care.

Of course I never miss an opportunity to promote my company’s software, so consider using that not only to analyze the deal and its variations, but also to build the presentations that will optimize your chances of obtaining the financing and/or the equity investors.

Frank Gallinelli

5 Mistakes Every Real Estate Investor Should Avoid

In my nearly 30 years of providing analysis software to real estate investors, and almost a decade of writing books and teaching real estate finance at Columbia University, I’ve had the opportunity to talk with thousands of people who were analyzing potential real estate investments. Some of these people were seasoned professionals, many were beginners or students, but just about all were highly motivated to analyze their deals to gain the maximum advantage.

I’ve seen some tremendous creativity in their analyses, but I’ve also seen some huge missteps. Here are some of the pitfalls you will want to be sure to avoid.

1. The Formula That Doesn’t Compute

If you are attempting any kind of financial analysis, then a full-featured spreadsheet program like Excel is almost certainly your tool of choice. You might opt for professionally built models, like my company’s RealData software, or you could attempt to construct your own.

  • One of the most common problems I see in do-it-yourself models is the basic formula error. A robust financial analysis involves the interaction of many elements, and it is really easy to make any of several errors that are hard to detect. The simplest of these is an incorrect reference.  You entered your purchase price in cell C12 and meant to refer to it in a formula, but you typed C11 in that formula by mistake. You may (or perhaps may not) notice that your evaluation of the property doesn’t look right, but it can be difficult for you to find the source of the problem.
  • You used to have a formula in a particular cell, but you accidentally overwrote that formula by typing a number in its place. The calculation is gone from the current analysis, and if you re-use the model, you’ll always be using that number you typed in, not the calculated value you expect.
  • Cutting and pasting numbers seems innocent enough, but it can scramble your model’s logic by displacing references. Simple rule: Never cut and paste in a spreadsheet.
  • Perhaps the most insidious is the formula that doesn’t do what you thought it did. Let’s say you have three values that you enter in cells A1, B1, and C1. You want to write a formula that adds the first two numbers and divides the result by the third. It’s easy to say this in plain English: “I want A1 plus B1, divided by C1.” So you write the formula as =A1+B1/C1. Wrong. Division and multiplication take precedence, so the division happens first and that result gets added to A1. Not what you expected. The formula that does what you intended would be =(A1+B1)/C1, where the sum of A1 and B1 is treated as a single value, divided by C1.

2. The Modern Art Syndrome

Even if you get all of your formulas correct, your job is only half done. I harangue my grad students constantly with this pearl of wisdom: Sometimes you create a pro forma analysis of a property strictly for your own interest. You will never show it to anyone else. Most of the time, however, successful completion of a real estate investment deal means you have to “sell” your point of view to one or more third parties:

  • You may be the buyer, trying to convince the seller that your offer is reasonable;
  • You may need to convince the lender that the deal should be financed; or
  • You may need to show an equity partner that his or her participation would be profitable.

Most of the homebrew presentations that I see look to me like a Jackson Pollock painting with numbers superimposed. The layout usually has a logic that I can’t discern, and I find myself hunting for the key pieces of information that the presenter should have designed to jump off the page.

The layout needs to be orderly and logical: revenue before expenses and both before debt service.

Labels need to be unambiguous:

  • If you mention capital expenditures, are they actual costs or reserves for replacement?
  • Is the debt service amortized or interest only?
  • When you label a number as “Price,” are you talking about the stated asking price, or your presumed offer? Be clear.

Lenders and experienced equity investors will be looking for several key pieces of information before they scrutinize the entire pro forma, items like Net Operating Income, Debt Coverage Ratio, Cash Flow and Internal Rate of Return.  If these items don’t stand out, or if the presentation is disorganized, you might as well add a cover page that says, “ I’m Just an Amateur Who Probably Can’t Pull This Deal Off.”

3. Errors, We Get Errors, Stack and Stacks of Errors

You may be too young to know Perry Como’s theme song (by the way, it was “letters,” not “errors”), but the tune goes through my head when I look at some investors’ spreadsheets.

  • The #NUM error can appear when you try to perform a mathematically impossible calculation, like division by zero, or also when attempting an IRR calculation that can’t resolve.
  • #VALUE usually occurs when you type something non-numeric (and that can include a blank space, letters, punctuation, etc.) into a numeric data-entry cell. If there are formulas in your model that are trying to perform some kind of math using the contents of that cell, those formulas will fail. In other words, if you try to multiply a number times a plain-text word, you’re violating a law of nature and Excel is going to call down a serious punishment on your head, a sort of high-tech scarlet letter.

It can get really ugly really fast because every calculation that refers to the cell with the first #NUM or #VALUE will also display the error message, so the problem tends to cascade throughout the entire model. Unfortunately, I often see investors who then go right ahead and print out their reports with these errors displayed and deliver the reports to clients or lenders.

Your objective in giving a report to a third party is typically to try to convince the recipient to accept your point of view. You will not accomplish that if your report has uncorrected errors.

4. What’s Wrong with This Picture?

It’s the errors you overlook – the ones that don’t have nice, big, upper-case alerts like #VALUE – that can cause the greatest mischief of all; and these can be troublesome even if the analysis is for your eyes only.

It may be an unwanted and unintended side effect of the computer age that we tend to accept calculated reports at face value. Be honest: How often do you sit at a restaurant with a calculator and verify the addition on your dinner check?

This presumption of accuracy can be dangerous when you are evaluating a big-ticket item like a potential real estate investment. As I discussed earlier, you could have bogus formulas that give you inaccurate results. But even if you use a professionally created tool like RealData’s Real Estate Investment Analysis software, you are still not immune to the classic “garbage in, garbage out” syndrome.

The mistake that I see far too often is a failure to apply common sense. For example:

  • “Gee, this investment looks like it will have a 175% Internal Rate of Return. Looks good to me.”  (Reality: You entered the purchase price as $1,000,000 instead of $10,000,000. You should have been saying to yourself, 175% can’t be right; what did I do wrong?)
  • “Wow, this property shows a terrific cash flow.” (Reality: You entered the mortgage interest rate as 0.07% instead of 7%.) Again, results outside the norm, either much better or much worse than you would reasonably expect, are your tip-off that a mistake is lurking somewhere. It is essential that you develop the habit of examining every financial work-up – those you create, and also those that are presented to you – very closely to see if the calculations appear reasonable.

5. What You Don’t Know CAN Hurt You

The final item in our list of big-time mistakes goes beyond the mechanics of spreadsheets and formulas and into the realm of fundamentals. You can be the most proficient creator of spreadsheet models on the planet, but if you don’t really understand the essential financial concepts that underlie real estate investment analysis, then you will neither be able to create nor interpret an analysis of such property.

The examples that I’ve seen are numerous – I can’t possibly list more than a few here – but they all revolve around the same issue:  A lack of understanding of basic financial concepts as they apply to real estate.  Some of the most important:

  • Net Operating Income – This is a key real estate metric, and calculating it incorrectly can play havoc with your estimation of a property’s value. Basically, NOI is Gross Operating Income less the sum of all operating expenses, but I have frequently seen all kinds of things subtracted when they should not be. These have included mortgage interest or the entire annual debt service, depreciation, loan points, closing costs, capital improvements, reserves for replacement, and leasing commissions. None of these items belongs in the NOI calculation.
  • Cash flow – I have seen NOI incorrectly labeled as “cash flow,” and have seen cash flow miscalculated with depreciation, a non-cash item, subtracted.
  • Capitalization rate – Cap rate is another key real estate metric and is the ratio of NOI to value. Unfortunately, I’ve encountered some folks who have used cash flow instead of NOI when attempting to figure the cap rate and have ended up with a completely erroneous result – not only for the cap rate itself, but then also for the value of the property.

Clearly, there are two vital problems with these kinds of basic errors. First, is that they completely derail any meaningful analysis. If your NOI is not really the correct NOI and your cap rate is not really the correct cap rate, then nothing else about your evaluation of the property can possibly be correct. And second, if you give this misinformation to a well-informed investor or lender, your credibility will evaporate.

The Bottom Line

What is our take-away from these five disasters waiting to happen? You could avoid many of these errors by using the best, professionally developed analysis models – but then, of course, you would expect me to say that because that’s what we do for a living.

Let me suggest three other important steps you can take:

  • Understand that there is no substitute for careful scrutiny of any financial presentation, whether it is someone else’s or your own. Be diligent always and  apply the test of reasonableness.
  • Recognize that any real estate analysis you create is likely to be a representation to a third party of the quality of your thinking and professional competence. You wouldn’t be careless or casual with a resume; you should give the same care to your real estate presentations.
  • Finally, recognize that you need to make a commitment to mastering the fundamental concepts and vocabulary of real estate investing. There is no substitute for knowledge.


Want to learn more?

For Real Estate Investors: A Lesson in Clarity

Recently, I was conducting the last class in my course on real estate investment analysis that I teach in Columbia’s MSRED program.  I had assigned my 55 students a series of case studies (much like those in my book, Mastering Real Estate Investment) and told them to build financial pro forms and discuss the reasoning behind their analyses. After reading and commenting on all those analyses, I felt there was one overarching theme on which I wanted to focus my final remarks to the troops: The theme was “clarity.”

Trying to reduce a course to a single word might seem unrealistic (because it is), but I really had more than one angle on the notion of clarity in mind. Even combined, those notions would not replace the real content of a course in investment analysis, but they might express some essential principles that are sine qua non — “without which, nothing” — for investors.

Be Clear About Your Objectives

Before you fire up your spreadsheet program or sharpen your pencil, you need to be very clear about your objective (or objectives) in analyzing the property. For example:

  • Are you a potential buyer, trying to establish a reasonable offer on a particular property?
  • Are you seller or broker trying to justify your asking price?
  • Are you a buyer or broker, trying to demonstrate to a seller that his or her price and terms would not be acceptable to a reasonable and prudent investor?
  • Are you seeking financing, or refinancing and need to demonstrate to a lender that this loan will meet their underwriting expectations?
  • Are you assembling a partnership and trying to show potential equity investors that this deal will make economic sense to them?

You are not trying to create alternate realities, but you might be harboring more than one objective in a given situation. For example, for your private use you might want to look at a range of possible offers by creating best-case, worst-case and in-between scenarios; but in making a presentation to the seller, you would surely not begin by volunteering what you believe to be the highest price at which the investment might have a chance of success.

In making a presentation to a lender, your focus must be to ensure that your presentation includes items like debt coverage ratio, allowance for possible vacancy, and projected cash flows — items that will have an immediate impact on an underwriting decision. For equity partners, you want to be sure that you can demonstrate not only that the property itself makes sense, but that the particular investor, considering allocations and preferred return, can expect an acceptable rate of return on cash invested.

You are typically trying either to make a personal decision about a property or to “sell” your point of view to a third party. Being clear in your own mind about the purpose of your pro forma allows you to focus on how you analyze the property and what information is of greatest importance to your intended audience.

Be Clear About Your Use of Terminology

Real estate, like most businesses and professions, has its own language – terms that carry very specific meaning. The misuse of real estate investment terminology can have several possible consequences, all of them bad.

  • You can substantially skew the results of an analysis by not being clear in your understanding of important terms. Some of the more egregious examples I have seen include:
    • Not understanding the real-estate-specific definitions of terms like “operating expense” and “Net Operating Income.”  I have often seen investors try to include mortgage payments, capital improvements, or reserves for replacement as operating expenses. This mistake can drastically affect your estimate of a property’s worth.
    •  Not understanding an important term like “capitalization rate.” I have seen investors try to estimate value by applying a cap rate to the property’s cash flow instead of its Net Operating Income. Big mistake.
  • You can bring a dialog or negotiation to a grinding halt by being unclear and offhand in your use of what should be unambiguous terms.  Yes, “price” is a legitimate English word. But if you use it as part of an analysis or presentation, you will leave your reader stumped.  Do you mean the seller’s asking price, the buyer’s offered price, the actual closed selling price?  You can tell me that a building has 20,000 square feet, but do you mean usable square feet or rentable square feet?  It makes a difference.
  • You can establish your identity as a rank amateur. Nothing will earn you a sandwich board with the word “newbie” on it quicker than misusing terms or lapsing into incomprehensibly vague language. Credibility matters — just ask your lender or your equity partners.  Be clear. Be precise.

Be Clear When You Build Your Pro Forma or Presentation

If you insist on being a do-it-yourselfer, and you plan to give your pro forma or presentation to a third party, keep in mind that nothing will unsell your argument faster than a jumbled pile of numbers.  Your information should flow and be segmented in a logical order (e.g., don’t show someone the income after the expenses, or the debt service after the cash flows). The reader should be able to apprehend the key metrics with a quick scan of the page, then go back and fill in the details. If your report turns  into a scavenger hunt for vital information, then you will fail to deliver your message. No loan, no partner, no deal.

Your success as a real estate investor requires serious number crunching, but it doesn’t stop there. You must be able to convey your analysis of a property in terms that are unambiguous, accurate, and relevant to your audience. Clarity is what you need.

–Frank Gallinelli

Get some clarity, as well as accurate calculations and industry-standard reports. Use RealData’s Real Estate Investment Analysis, a market leader for almost 30 years, to run your numbers and create your presentations.

MIRR — How It Works

From our experience, it appears that Internal Rate of Return (IRR) is the metric of choice for many, if not most, real estate investors. However, you may be aware that there are a few issues with IRR that can cause you some vexation: If you expect a negative cash flow at some point in the future, then the IRR computation may simply fail to come up with a unique result; and with your positive cash flows, IRR may be a bit too optimistic about the rate at which you can reinvest them.

For these reasons, a variation on IRR, called Modified Internal Rate of Return (MIRR), can be very important. When you see how it works, then you’ll also see that it gives you the opportunity to deal with IRR’s shortcomings.

Our support folks have had a number of calls from users of our Real Estate Investment Analysis software asking for guidance in using and understanding MIRR. How does it work, and how do I choose the “safe” and “reinvestment” rates that it asks for?

Let’s start with some definitions:

safe rate The interest rate obtainable from relatively risk-free investments, such as U.S. Government Treasury Bonds.” source: The Complete Real Estate Encyclopedia by Denise L. Evans, JD & O. William Evans, JD; 2007, McGraw-Hill (btw, this is an excellent reference book)

reinvestment rate When analyzing the value of an income producing property, it is the rate an investor is assumed to be able to earn on intermediate cash flows. …” Ibid

There is an alternative name sometimes used for the safe rate — “finance rate” — and the rather opaque definition given in the Excel help for MIRR doesn’t seem particularly helpful: “…the interest rate you pay on the money used in the cash flows.” Frankly, I’m not sure I understand what that is supposed to mean, but I believe if you focus on the term “safe rate,” you will be able to follow this discussion easily. The reinvestment rate also sports an alias — “risk rate” — which seems clear enough, but I believe again that you will find it easier to stick with the more common term, “reinvestment.”

Let’s begin with the safe rate and pose the question, “Why and when does the safe rate come into play?” The answer has to do with negative cash flows. Usually, you expect an investment to put cash into your pocket (positive cash flow), but sometimes it pulls money out of your pocket instead (negative cash flow). In real life, you can’t leave a negative cash flow sitting there and just move on to the next year. The property has to pay its bills, so you as the investor have to pick up the tab. In other words, you have to make an additional cash investment in the property. Herein lies the key.

Five More Rules of Thumb for Real Estate Investors

In a previous article – Six Rules of Thumb for Every Real Estate Investor – I offered some guidance that might reasonably be held dear by every income-property investor. Woe to him or to her who doesn’t take a property’s vital signs, such as Debt Coverage Ratio, Loan-to-Value, or Cap Rate, to heart before making an investment decision.

Hidden below these very objective measures, however, is a sub-stratum of more subjective issues to consider when you invest. It would be a stretch to suggest that these considerations apply to every investor or to every situation. Your mileage may vary. Still, these are issues that should be worthy of your attention whenever you invest in real estate.

Small Property or Large?

By “small” and “large” I am referring to the number of rental units, not to the physical size of the property. I often hear from people who are investing in real estate for the first time and are choosing to buy a single-family home to use as a rental property. I suspect that these folks have not taken a pencil to paper (or even better, used one of RealData’s investment analysis programs) to see if they could reasonably expect to enjoy a positive cash flow from that property.

Although it’s possible to get a good cash flow from a one-family house, it is certainly not something you should take for granted. Whether you’re purchasing a single-family house or a 40-unit apartment building, that structure is going to sit on a single piece of land; and typically, the land cost-per-unit is likely to be higher – perhaps much higher – with a single-family house.

The more you pay per unit for the land, the more rental revenue per unit you will need to generate to cover your costs. In short, generating a positive cash flow in this scenario could prove to be a challenge. The deck may be stacked against you, so run your cash flow projections before you buy. Add up the cost of your mortgage payment, property taxes, insurance, maintenance and miscellaneous expenses. Will your rent be greater than the total of these costs?

Another perilous characteristic of the single-family as a rental property concerns vacancy. Simply put, if you lose one tenant, then 100% of your property is vacant. Consider again that 40-unit apartment building: Lose one tenant there and you lose just 2.5% of your revenue.

Finally, there is the issue of what drives value. A single-family house’s value is customarily based on market data, i.e., comparable sales, while the so-called commercial property (generally defined as one having more than four rental units), is valued based on its ability to produce income. This difference is important to you as an investor because you have the opportunity to create value by enhancing the commercial property’s income stream, an opportunity you will not have with that single-family.

All this is fine and makes good sense, but you may just not be built for starting off your investment career on a large scale. If thatss the case, then consider a multi-family house – ideally one with more than four units, but even smaller if you must – as your starter investment. Learn from that, then move on to bigger things.

Residential or Commercial?

I used the term “commercial” above to refer to properties with more than four units. Such properties are commercial in the sense that they are bought and sold for their ability to produce income. In more common parlance, however, the term “commercial” is often used to describe real estate that is occupied for business purposes and not as dwellings for families or individuals.

In a separate full-length article, I discuss in some detail the pros and cons of investing in each property type, but for our discussion here let’s just consider a few key points. If you’re a first-time investor, the most basic issue is that of comfort level. It is very likely that you have a good deal of personal familiarity with residential property. Chances are that you already know something about residential rent, leases, security deposits, utility bills, and the like. If you have never had similar experience with commercial property – renting your own office or retail space, for example – then you may feel more comfortable dealing with a property type that is more familiar to you.

There are plenty of potential advantages to owning commercial property, such as longer-term leases with built-in escalations, and tenant responsibility for certain operating expenses. Once you have expanded your comfort zone by owning and operating investment property, commercial real estate can be a very good long-term strategy.

Local Market vs. Hot Market

It seems like everyone is telling you that the demand for real estate is running wild in Last Ditch, Wyoming. Should you head, checkbook in hand, straight for the Ditch or stay close to home? Keep in mind an old axiom that applies to all kinds of investing: By the time you or I hear of a great deal, all the money that’s going to be made already has been made by someone else.

I have no doubt that you can find investors who have made a killing in some remote real estate market. You can probably also find someone who has won the Irish Sweepstakes. An important part of your strategy should be to optimize your chances of success, and you will do that best by staying close to home – perhaps very close.

I usually tell new investors that they should choose a location where they know every crack in the sidewalk. Information that you may take for granted can prove to be truly priceless. You probably know how well local businesses are doing, if the city needs to spend money soon on new schools or infrastructure, if a major employer is thinking of moving in or out of town, if a new transportation hub is nearing the final stages of approval, or if the local college is increasing its enrollment. In short, you know the likely trends that will drive demand for residential and commercial space, and you have a sense of where local property taxes are headed. You’re plugged in to your market, and nothing is more valuable to an investor.

Equity Partner vs. Debt Partners

Unless you have the resources to buy property for all cash, you have partners. When you finance an investment property, the bank (or whoever is lending you money) is your “debt partner.” They will very definitely get a piece of the action. In fact, they will expect their piece even if there is no action – no cash flow – at all.

In the current economy and with the state of the financial markets as it has been, we see an increasing number of experienced investors looking for more equity partners and less financing. It may not be as romantic as going entirely on your own, but it can be more successful. Financing has been difficult to obtain of late; the less you ask for in relation to the value of the property, the better your chances of securing it and the better the terms are likely to be. With less financing, you improve your chances of achieving a positive cash flow, even if you have to share it with your partners. Partnering up may be a good strategy for the times.

Professional Management vs. Do-It-Yourself

The question of whether or not to hire a professional property manager is one that you need to answer on a case-by-case basis. There may be no better way to learn how rental property works than to roll up your sleeves and run it, personally, like a business. But as with any business, you need to weigh the risks of on-the-job training.

For example, it may be prudent for you to use an experienced agent to find tenants and to check their references. That can be time-consuming work, and signing up a troublesome tenant can prove costly and consume even more of your time.

On the other hand, getting involved directly in overseeing maintenance, repairs and general management can help you recognize if your property is a good and desirable product in the marketplace. What is the appeal of your property, compared to others that compete for tenants in the same market? Your tenants will probably let you know if you work with them directly.

In addition, I have always believed that most tenants will not respect your property unless you do. You are more likely to sign up and retain responsible tenants if they see that you care about keeping the property in top shape and that you will respond to reasonable requests for maintenance or repair. As in any business, when you are directly involved in setting the tone and the standards, you have best chance of seeing those standards met. Eventually, as you build your real estate empire, you may have too many units for this hands-on approach to be practical; but if you are just starting out, this can be an effective way to develop your set of expectations for whoever will manage in your name in the future.

The Bottom Line?

True confession: These five rules are not really set-in-stone rules at all, but options that every real estate investor needs to weigh on his or her personal balance scale. Unlike a nice metric such as Debt Coverage Ratio, there is not really an unambiguous choice for any of these. You must take into account your own personal skills, experience and resources, your available time, and the nature of the property in which you are investing – and then choose wisely.

Copyright 2010, 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.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

Six Rules of Thumb for Every Real Estate Investor

Life can be hard, especially as we try to climb out of the Great Recession. Real estate investing can be a challenge, as well; and while we surely won’t presume to suggest how to deal with life’s big issues, we can offer a few thoughts as to how you might maintain some equilibrium when you look at investment property.

Those of you who follow our content at RealData.com — newslettersbooksFacebook and software — know that we stress maximizing your chances for success through understanding the metrics of investment property. We don’t tell you that you’ll get rich by thinking positive thoughts, raising your self-confidence, and charging fearlessly into the fray. Instead we urge you to learn about the the financial dynamics that are at work in income-producing real estate. Whether you’re scrutinizing a piece of property you already own, one you want to sell, or one you may choose to buy or develop, you need to master the metrics. The numbers always matter.

And so here are our “6 Rules of Thumb for Every Real Estate Investor.”

1. Vacancy

— Let’s begin with a simple one. What percentage of the property’s total potential gross income is being lost to vacancy? Start off by collecting some market data, so you will know what is typical for that type of property in that particular location. Does the property you own or may buy differ very much from the norm? Obviously, much higher vacancy is not good news and you want to find out why. But if vacancy is far less than the market, that may mean the rents are too low. If you’re the owner, this is an issue you need to deal with. If you’re a potential buyer, this may signal an opportunity to acquire the property and then create value through higher rents.

2. Loan-to-Value Ratio (LTV)

— When the financial markets return to some semblance of normalcy, they will probably also return to their traditional standards for underwriting. One of those standards is the Loan-to-Value Ratio. The typical lender is generally willing to finance between 60% – 80% of the lesser of the property’s purchase price or its appraised value. Conventional wisdom has always held that leverage is a good thing — that it is smart to use “Other People’s Money.”

The caution here is to beware of too much of a good thing. The higher the LTV on a particular deal, the riskier the loan is. It doesn’t take much imagination to recognize that in the post-meltdown era, the cost of a loan in terms of interest rate, points, fees, etc. may rise exponentially as the risk increases. Having more equity in the deal may be the best or perhaps the only way to secure reasonable financing. If you don’t have sufficient cash to make a substantial down payment, then consider assembling a group of partners so you can acquire the property with a low LTV and therefore with optimal terms.

3. Debt Coverage Ratio (DCR)

— DCR is the ratio of a property’s Net Operating Income (NOI) to its Annual Debt Service. NOI, as you will recall is your total potential income less vacancy and credit loss and less operating expenses. If your NOI is just enough to pay your mortgage, then your NOI and debt service are equal and so their ratio is 1.00. In real life, no responsible lender is likely to provide financing if it looks like the property will have just barely enough net income to cover its mortgage payments. You should assume that the property you want to finance must show a DCR of at least 1.20, which means your Net Operating Income must be at least 20% more than your debt service. For certain property types or in certain locations, the requirement may be even higher, but it is unlikely ever to be lower.
Not to preach, but planning a budget with a bit of breathing room might be a good principle for every government agency, financial institution and family to follow.

4. Capitalization Rate

— The Capitalization Rate expresses the ratio between a property’s Net Operating Income and its value. Typically it is a market-driven percentage that represents what investors in a given market are achieving on their investment dollar for a particular type of property. In other words, it is the prevailing rate of return in that market. Appraisers use Cap Rates to estimate the value of an income property. If other investors are getting a 10% return, then at what value would a subject property yield a 10% return today?
Remember first that the Cap Rate is a market-driven rate so you need to interrogate some appraisers and commercial brokers to discover what rate is common today in your market for the type of property you’re dealing with. But you also need to recognize that Cap Rates can change with market conditions. In our long and checkered careers we have seen rates go as low as 4-5% (corresponding to very high valuations) and as high as the mid-teens (very low valuations), with historical averages probably bunched closer to 8-10%. If you are investing for the long term, and if the cap rate in your market is presently pushing the top or the bottom of the range, then you need to consider the possibility that the rate won’t stay there forever. Look at some historical data for your market and take that into account when you estimate the cap rate rate that a new buyer may expect ten years down the road.

5. Internal Rate of Return (IRR)

— IRR is the metric of choice for many real estate investors because it takes into account both the timing and the size of cash flows and sale proceeds. It can be a bit difficult to compute, you may want to use software or a financial calculator to make it easy. Once you have your estimated IRR for a given holding period, what should you make of it? No matter how talented you are at choosing and managing property, real estate investing has its risks — and you should expect to earn a return that is commensurate with those risks. There is no magic number for a “good” IRR, but from our years of speaking with investors, we think that few would be happy with anything less than a double-digit IRR, and most would require something in the teens. At the same time, keep in mind the “too good to be true” principle. If you project an astoundingly strong IRR then you need to revisit your underlying data and your assumptions. Are the rents and operating expenses correct? Is the proposed financing possible?

6. Cash Flow

— Cash is King. If you can first project that your property will have a strong positive cash flow, then you can exhale and start to look at the other metrics to see if they suggest satisfactory long-term results.

Negative cash flow means reaching into your own pocket to make up the shortfall. There is no joy in finding that your income property fails to support you, but rather you have to support your property. On the other hand, if you do a have a strong positive cash flow, then you can usually ride out the ups and downs that may occur in any market. An unexpected vacancy or repair is far less likely to push you to the edge of default, and you can sit on the sideline during a market decline, waiting until the time is right to sell.

Overambitious financing tends to be a common cause of weak cash flow. Too much leverage, resulting in greater loan costs and higher debt service can mark the tipping point from a good cash flow to none at all. Revisit LTV and DCR, above.

We’re all thumbs, so to speak, so if you found these rules helpful check out more of our booksarticlessoftware, Facebook page and other resources.

Copyright 2009, 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.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

New Educational Videos

RealData founder Frank Gallinelli teaches real estate finance at the Columbia graduate school, as well as investment analysis in public and professional seminars. For the benefit of visitors to www.realdata.com we will be posting a series of video clips from some of his public classes. The first two clips cover due diligence (i.e., doing your homework before you make an offer) and basic real estate investment terminology, wrapping up with a discussion of the APOD form.

You can find these clips on the Learn page at realdata.com. Be sure to come back often to catch new clips as they become available.

If you would like to discuss having Frank address or teach a seminar to your group, contact him directly via email at seminar.realdata at gmail.com.