Tag: discounted cash flow

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.

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.

Making the Case for Your Commercial Refinance, Part 2

In Part 1 of this article, you learned what information you need to assemble to get started with the process of refinancing your commercial property — information about your property’s income, expenses and loan balance, and about the prevailing cap rate in your market. You also learned to use some of that information to estimate the current value of the property, then learned to take that result to determine if the property will likely satisfy the lender’s Loan-to-Value requirement.

You got acquainted with Debt Coverage Ratio and mortgage constants and saw how to combine those to test your property’s income stream to find out if it’s strong enough to support your loan request.

Now you have some idea of what your property is worth and how likely it is to appeal to an equity partner or to satisfy a lender’s underwriting requirements. Your next task is to convey your evaluation to that potential partner or lender. You need to make your case with a professional presentation that is easy to grasp but also provides enough detail to support your evaluation of the property and your request for financing.

Unless you’re a “flipper,” you can expect to be involved with this property for the long haul, more or less. It should come as no surprise, therefore, that a lender or investor will appreciate getting a sense of how you believe this property will perform over time. You’re not going to predict the future with precision, but in most situations you should be able to make some reasonable and realistic “pro forma” projections of future performance. There is no hard-and-fast rule, but I believe your projections should go out five to ten years. With commercial properties that have long-term leases in places, 20 years would not be unthinkable.

As we develop the pro-forma presentation through the rest of this article, we’ll be using the Standard Edition of RealData’s Real Estate Investment Analysis (REIA) software. Those readers who are familiar with the software will also note that I’ve taken a few liberties with the material I display, editing some of the images (for example, removing multiple mortgages) to allow you to keep your focus on just the key elements of this example.

Where to start? You’re dealing with rental property, so a rent roll would be a good place to begin. And let’s assume that “today” is January 1, 2009. List your rental units (or groups of units, if you have a large number) with the current rent amount and your estimate of how those rents will change over time. You’ll recall from the APOD you constructed earlier that you expect the total gross scheduled rent for this property to be $219,600 in the first year. For the sake of making this example worthwhile, assume that the property contains both residential and non-residential units, and therefore the total amount of revenue is divided between the two types.

With residential units — apartments, for example — the process of building your rent roll will be fairly straightforward. The rent for each unit of this type is usually a fixed monthly amount. Residential tenancy agreements are seldom long term, most often a one-year lease or even month-to-month occupancy. It’s reasonable to assume that you will try to increase your overall rents on an annual basis. For the first year, you have the following:

sample residential rents, first year

Demand for your apartments has always been strong, but you decide you want to be conservative in your estimate of how much more you can charge each year so you decide to project that these rents will rise at an annual rate of 3%.

sample residential rents, five years

This is a mixed-use property, which means it contains commercial as well as residential rentals. At street level, below the apartments, you have two retail spaces. The first of these is a hardware store, Nuts & Bolts. This store occupies 1,000 rentable square feet and currently pays $21.60 per square foot per year. Its lease calls for a rent increase to $23.50 in July of 2011 The second tenant is Last National Bank, which occupies 2,800 square feet at $25.00 per foot. This tenant’s rent is scheduled to rise to $28.00 per square foot in September of 2012.

Note how your handling of commercial rentals differs from residential. One difference is that you typically charge rent by the square foot rather than by the unit. In most U.S. markets, the rent is expressed in terms of dollars per square foot per year, although in some it is per square foot per month. A second difference is in the length of the lease. As noted earlier, a residential tenant’s commitment may be as little as month-to-month, and generally is not more than one or two years. Commercial tenants, in order to maintain and operate a business from their space, need the certainty that they can continue to occupy for a reasonable length of time. They also need to be able to plan their future cash flow. Hence a commercial lease will usually run for at least a few years, up to as many as 20 or 30.

With the information you have in hand about these commercial leases, you should be able to project the rent from the two commercial units for next several years.

sample commercial rents

The image above is a screen shot from a data-entry portion of the REIA software. This is one image where I haven’t done any editing, i.e., I haven’t removed line items unrelated to our example. I’ve left it complete so you could see that there are other considerations you might need to take into account when you deal with a commercial lease, such as expenses passed through to tenants, leasing commissions, and improvements to the space made by the landlord on behalf of the tenant. We don’t want this article to morph into a full-scale textbook, so we’ll continue to keep our example relatively simple. However, for more information on these and similar topics, you can view our educational articles at realdata.com or refer to the software user’s guide forReal Estate Investment Analysis.

You now have a forecast of the revenue from both the residential and commercial units, and can consolidate this data to include as part of your presentation to your lender or potential partner.

sample combined income

Recall that when you were estimating the value of the property you used something called an Annual Property Operating Data (APOD) form. That form displayed the total rental revenue, an allowance for vacancy and credit loss, and the likely operating expenses for the current year. To fit the needs of your extended presentation you can expand this form to as many years as you want.

For the purpose of this discussion you’ve been projecting out five years, so you’ll do the same with the APOD. You may want to refine your estimates on an almost item-by-items basis. For example, if property taxes, maintenance and insurance are among your greatest expenses, it makes sense to estimate their rates of growth individually. You probably have some history with these items that you can use for guidance. For some other expenses, such as accounting or trash removal, you may want to apply a general, inflation-based estimate. In this example, property management is one of your biggest costs. You know that it will be billed at $15,740 for the first year, but then as a percentage of collected rent — 7% in this case — for future years, so your estimate will just require that you apply the same rate. If you estimate the future rent reasonably well, then the property management fee will follow.

Let’s say you believe that property taxes will increase at 5% per year, and insurance and maintenance at 4%. For all other expenses, you project a 3% annual increase. Your extended APOD should look something like this:

sample APOD

If you owned this property debt-free, your analysis would be nearly complete. But in fact, your objective here is to build an effective case for refinancing your existing loan, so you really need to demonstrate what kind of cash flow this property will throw off with a new loan in place. You need to take this at least one step further.

Recall from the first section of this article that you estimated the value of the property at $1.45 million, and that you need to refinance your $975,000 loan at 7.75% for 15 years. With that information in hand you can complete the taxable income and cash flow sections of your pro forma.

sample taxable income

sample cash flow

These projections should help you make a strong case for approval of your new loan. With that new loan in place, your debt coverage ratio is more than ample in the first year, and improves each year thereafter. Your cash flow is strong, and it too grows each year. It’s strong enough, in fact, that you could even survive the loss of one of your commercial tenants without plunging into a negative cash flow.

Your Net Operating Income is also going up smartly. Perhaps your lender is concerned that the current prevailing cap rate of 11% will rise to 14% by 2013, possibly reducing the value of the property dangerously close to the amount of the mortgage. Does that look like a genuine cause for anxiety?

Remember your cap rate and LTV formulas for the first part of this article.

Value = Net Operating Income / Capitalization Rate
Value in 2013 = 177,839 / 0.14
Value = 1,270,279

So, if cap rates rise to 14% and your NOI is indeed 177,839, then the property should still have a value of about 1.27 million. This is not good news for you, but does the lender have reason to lose sleep?

What will your loan balance be at the end of 2013? You will have been dutifully paying it down from now until five years hence, so surely you will have made a dent. If you return to the REIA software, you’ll find that it includes amortization schedules for all of your property loans. It also tracks the end-of-year balance for each loan as part of its resale analysis, so let’s look at that:

sample mortgage payoff

You will owe $764,719 at the end of 2013. Your property, if cap rates do rise to 14%, will be worth about $1,270,000. Recall that your lender required a Loan-to-Value Ratio of 75% when you applied for the loan. Will it be time to reach for the antacids?

Loan-to-Value Ratio = Loan Amount / Property’s Appraised Amount
Loan-to-Value Ratio at EOY 2013 = 764,719 / 1,270,000
Loan-to-Value Ratio at EOY 2013 = 60.2%

Your LTV looks even better at EOY 2013 than it did when you originally applied for the loan. It’s time to find a polite way to tell the lender to stop looking for excuses. Your loan request is solid and needs to be approved.

You’ve assembled a good deal of data to support your loan request, but don’t forget that a major part of your objective here is to present it in the most effective way. Start by trying to boil it all down. Simplify and summarize. Think of this part of the process as the real estate equivalent of the “elevator pitch.” Ultimately you’re going to need to provide the loan officer with every detail, but you may not get a chance to tell the whole story unless you can convey the essentials in the time it takes to ride the elevator. You need an executive summary.

sample executive summary

This report gives a very direct one-page summary of basic information about the property and its financial metrics. Your lender can see immediately the amount of the loan you’re looking for, the LTV and Debt Coverage Ratio, the Net Operating Income and the cash flow. This report doesn’t supply the underlying supporting data to justify these numbers — that’s why it’s a summary — but taken at face value it tells the loan officer whether there is any reason to give your request a serious look.

An alternative is a report we call the “Real Estate Business Plan,” and it too looks very different from the rows and columns of numbers usually associated with a pro forma. You might assemble information into a report like this in a situation where you still want to make your initial approach with what is essentially still an overview of the property, but one that provides a bit more detail than the one-page summary. Just as with the Executive Summary, you want to provide enough information to be effective, but not so much that you discourage the recipient from actually reading the document.

We designed this report to focus on property description, sources and uses of funds, financing, cash flows, and rates of return, and to simplify its presentation by displaying only the data that is pertinent to the holding period you specify. So, even though the software can deliver projections of up to 20 years, if you want a report based on a five-year holding period, you get a nice, clean presentation with no extraneous labels or data, as you see in this excerpt:

sample business plan, part 1

 

sample business plan, part 2

 

sample business plan, part 3

 

At the beginning of our discussion of pro formas and presentations, I said that you needed to deliver a package that is easy to grasp but also provides enough detail to support your evaluation of the property and your request for financing. You may have already inferred from the progress of this article that the process of building the presentation runs in a direction that’s essentially opposite from the process of delivery. You need to begin, as we did here, at the most granular level of detail: defining individual unit rents and item-by-item operating expenses, first as they currently exist, then as you project them to grow.

That is why you built your rent roll first, then your extended APOD, then your cash flow projections. Next, you distilled this information into summary formats — the Executive Summary and the Real Estate Business Plan.

You built your case by going from the specific to the general. You’ll typically present your case for financing, however, by going the other way. You start with the Summary or Business Plan type of report, which provides enough information to introduce your request without burying the loan officer in a mountain of tiny numbers. When that loan officer says, “Where did you get these revenue projections?” you’ve got your rent roll. When she says, “How did you come up with this NOI?” you’ve got your APOD. And you can do the same for your cash flow and debt coverage, and resale value and rates of return, and more.

You’ve got it all covered.

Before we conclude this discussion, a brief reality check is in order. The example we just worked through was a happy case study because the property’s income stream justified the financing you sought. All the number crunching in the world, however, won’t transform a troubled investment into a good one. A detailed analysis can, however, still be helpful because it can show you what level of revenue you need to reach, or what level of cost-cutting you have to achieve to bring the property into positive cash flow territory and get it back on its feet. But whatever you do, don’t try to “enhance” the numbers to make the property look good. You’re not going to fool the lender and there’s not much point in fooling yourself.

So, what did you learn in Part 2 of this article? You learned to build a rent roll, one style for residential units and another for commercial. You learned to develop pro forma projections by extending your current-year estimates of revenue, operating expenses, and cash flows into the future. Perhaps most important, you learned about creating presentations out of those pro forma projections — presentations that are readable and effective, and that can help you make you case for financing your investment property.

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.

NPV, PI, IRR, FMRR, MIRR, CpA — Stirring the Alphabet Soup of Real Estate Investing, Part 2

IRR – Internal Rate of Return

Internal Rate of Return (IRR) seems to befuddle many investors, but if you understand Discounted Cash Flow and Net Present Value, then you already understand IRR. That’s because it is really the same process, but one where you are solving for a different unknown.

In DCF, you believe you know what the future cash flows will be, and you believe you know the rate at which those cash flows should be discounted. Your mission is to figure the Present Value of the cash flows.

With IRR, you still believe you know what the future cash flows will be, but now you know the Present Value and want to find the discount rate. How is it that you know the Present Value? This is a deal happening in the real world. The PV is the amount of cash you are paying for those future cash flows.

When you solve for the IRR, you are looking for the discount rate that accurately describes the relationship between those future cash flows and the money you put on the table on Day One.

When you’ve found the discount rate that makes the PVs of the future cash flow equal to your initial investment, you’ve found the IRR. You can express this another way: When you’ve found the discount rate that makes the NPV equal zero, you’ve found the IRR.

Admittedly, the math to find the IRR is ugly, but if you’re reading this then you probably have a computer (or a highly sensitive gold filling that also picks up the BBC on the Internet); there are plenty of tools, including Microsoft Excel and our own RealData software that will do the job for you.

IRR is the measurement of choice for many investors because it take into account both the timing and the magnitude of your cash flows. Consider this example:

You still have that $300,000 to invest, and you can invest it in the property you saw in the first example, yielding these cash flows and IRR:

Year 0 Initial Investment:
(300,000)
Year 1 Cash Flow:
10,000
Year 2 Cash Flow:
20,000
Year 3 Cash Flow:
25,000
Year 4 Cash Flow:
30,000
Year 5 Cash Flow:
385,000
(includes the proceeds of sale)
IRR = 10.32%

Or you can acquire this property:

Year 0 Initial Investment:
(300,000)
Year 1 Cash Flow:
80,000
Year 2 Cash Flow:
50,000
Year 3 Cash Flow:
30,000
Year 4 Cash Flow:
10,000
Year 5 Cash Flow:
300,000
(includes the proceeds of sale)
IRR = 12.97%

If you add up the cash inflows and outflows for both properties, you will find that each has $300,000 going out in Year 0, and a total of $470,000 coming in over the next five years. However, the second property shows a significantly higher IRR. Both properties have the same total number of dollars going out and coming in over five years, but the second property shows a greater return on investment. Why?

Because IRR is indeed sensitive to both the timing and amount of cash flow. The first property has a big payday, but you have to wait five years to get the money. In the meantime, annual cash flows are relatively modest.

In the sale year the second property returns combined cash from operation and resale that is only as much as you originally invested to acquire the property. However, the intervening cash flows are much larger, especially the earlier ones. The early cash flows are especially valuable because you don’t have to wait long to receive them and therefore you don’t have to discount their values so greatly.

But Wait…

This sounds terrific; we’ve found the perfect way to measure our investment’s return. But wait – on closer inspection, IRR has a few warts. Sometimes its results are imperfect, sometimes even misleading. In the third installment of this series, we will look at the problems with IRR and at some potential solutions. We’ll examine FMRR and Modified IRR, and how they provide us with a means of dealing with the shortcomings.

—Frank Gallinelli

####

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 2008, 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.

NPV, PI, IRR, FMRR, MIRR, CpA – Stirring the Alphabet Soup of Real Estate Investing, Part 1

NPV, PI, IRR, FMRR, MIRR, CpA–It may seem like a witch’s brew of random letters, but truly, it’s just real estate investing. You can handle it. Any or all of these measures can be useful to you, if you understand what they mean and when to use them.

NPV – Net Present Value

NPV, or Net Present Value, is connected to what all good real estate investors and appraisers do, namely discounted cash flow analysis (aka DCF, if you’d like some more initials).

Discounted Cash Flow is a pretty straightforward undertaking. You project the cash flows that you think your investment property will achieve over the next 5, 10, even 20 years. Then you pause to remind yourself that money received in the future is less valuable than money received in the present. So, you discount each of those future cash flows by a rate equal to the “opportunity cost” of your capital investment. The opportunity cost is the rate you might have earned on your money if you didn’t spend it to buy this particular property.

Consider this example, where you invest $300,000 in cash to earn the
following cash flows:

Year 1 Cash Flow:
10,000
Year 2 Cash Flow:
20,000
Year 3 Cash Flow:
25,000
Year 4 Cash Flow:
30,000
Year 5 Cash Flow:
385,000
(includes the proceeds of sale)

If you discount each of these cash flows at 10%, then add up their discounted values, you’ll get 303,948:

Year 1, Discounted:
9,091
Year 1, Discounted:
16,529
Year 1, Discounted:
18,783
Year 1, Discounted:
20,490
Year 1, Discounted:
239,055
Total PV of Cash Flows:
303,948

Now you have the Present Value of all the future cash flows. However, you also had a cash flow when you initially purchased the property (call that Day 1 or Year 0) – a cash outflow of $300,000, your initial investment. To get the Net Present Value, you find the difference between the discounted value of the future cash flows (303,948) and what you paid to get those cash flows (300,000).

NPV = PV of future Cash Flows less Initial Investment
NPV = 303,948 – 300,000 = 3,948

What does that mean to you as an investor? If the NPV is positive, it suggests that the investment may be a good one. That’s because a positive NPV means the property’s rate of return is greater than the rate you identified as your opportunity cost. The more positive it is in relation to the initial investment, the more inclined you’ll be to look favorably on this investment. Your result here is not stellar, but it is at least positive.

If the NPV is negative, the property returns at a rate that is less than your opportunity cost, so you should probably reject this investment and put your money elsewhere.

That’s all fine, to the extent that you’re confident about that discount rate, your opportunity rate. You estimated 10% in the example above. What if you adjust that estimate by one-half of one percent either way?

NPV @ 9.5%
= 10,284
NPV @ 10.0%
= 3,948
NPV @ 10.5%
= (2,244)

How about one full percent?

NPV @ 9.0%
= 16,789
NPV @ 10.0%
= 3,948
NPV @ 11.0%
= (8,238)

Clearly, the NPV here is very sensitive to changes in the discount rate. If you revise your thinking just slightly about the appropriate discount rate, then the conclusion you draw may likewise need to be revised. As little as a half-point difference could change your attitude from luke-warm to hot or cold. The prudent investor will test a range of reasonable discount rates to get a sense of the range of possible results.

While we’re beating up on NPV, let’s also note that it doesn’t do you much good if your goal is to compare alternative investments. To have some kind of meaningful comparison, you need at least to keep the holding period for both properties the same. But what if one property requires that $300,000 cash investment, but the alternative investment requires $400,000?

PI – Profitability Index

Fortunately, NPV has a cousin that can help you with that problem: Profitability Index. While the NPV is the difference between the Present Value of future cash flows and the amount you invested to acquire them, Profitability Index is the ratio. It doesn’t tell you the number of dollars; it tells you how big the return is in proportion to the size of the  investment.

So where the NPV in the example above was equal to 303,948 minus 300,000, the Profitability Index looks like this:

PI = 303,948 / 300,000 = 1.013

If, quite improbably, you expected exactly the same cash flows from the property that required a 400,000 investment, you would expect your Profitability Index to be much worse, and it is.

PI = 303,948 /400,000: = 0.760

A Profitability Index of exactly 1.00 means the same as an NPV of zero. You’re looking at two identical amounts, in one case divided by each other so they give a result of 1.00 and in the other case subtracted one from the other, equaling zero.

An Index greater than 1.00 is a good thing, the investment is expected to be profitable; an Index less than 1.00 is a loser. When you compare two investments, you expect the one with the greater Index to show the greater profit.

There is a good deal more stirring about in our alphabet soup, so join us for the next installment when we look at IRR – Internal Rate of Return.

—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 2008, 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.

 

Understanding Net Operating Income (NOI)

In a recent article, we discussed the use of capitalization rates to estimate the value of a piece of income-producing real estate. Our discussion concerned the relationship among three variables: Capitalization Rate, Present Value and Net Operating Income.

We may have gotten a bit ahead of ourselves, since some of our readers were unclear on the precise meaning of Net Operating Income. NOI, as it is often called, is a concept that is critical to the understanding of investment real estate, so we are going to backtrack a bit and review that subject here.

Everyone in business or finance has encountered the term, “net income” and understands its general meaning, i.e., what is left over after expenses are deducted from revenue.

With regard to investment real estate, however, the term, “Net Operating Income” is a minor variation on this theme and has a very specific meaning. You might think of NOI as the number of dollars a property returns in a given year if the property were to be purchased for all cash and before consideration of income taxes or capital recovery. By more formal definition, it is a property’s Gross Operating Income less the sum of all operating expenses.

We have now succeeded in confounding our readers and compounding their problem by replacing one undefined term with two.

Let’s take these two new terms one at a time:

Gross Operating Income: Definitions are like artichokes. You need to peel the layers off one at a time. In this case, take the Gross Scheduled Income, which is the property’s annual income if all space were in fact rented and all of the rent actually collected. Subtract from this amount an allowance for vacancy and credit loss. The result is the Gross Operating Income.

Operating Expenses: This is the term that causes the greatest mischief. Many people say, “If I have to pay it, then it’s an operating expense.” That is not always true. To be considered a real estate operating expense, an item must be necessary to maintain a piece of a property and to insure its ability to continue to produce income. Loan payments, depreciation and capital expenditures are not considered operating expenses.

For example, utilities, supplies, snow removal and property management are all operating expenses. Repairs and maintenance are operating expenses, but improvements and additions are not – they are capital expenditures. Property tax is an operating expense, but your personal income-tax liability generated by the property is not. Your mortgage interest may be a deductible expense, but it is not an operating expense. You may need a mortgage to afford the property, but not to operate it.

Subtract the Operating Expenses from the Gross Operating Income and you have the NOI.

Why all the nitpicking? Because NOI is essential to apprehending the market value of a piece of income-producing real estate. That market value is a function of its “income stream,” and NOI is all about income stream. As heartless as it may sound, a real estate investment is not a felicitous assemblage of bricks, boards, bx cables and bathroom fixtures. It is an income stream generated by the operation of the property, independent of external factors such as financing and income taxes.

In truth, investors don’t decide to buy properties; they decide to buy the income streams of those properties. This is not such a radical notion. When was the last time you chose a stock based upon the aesthetics of the stock certificate? (“Broker, what do you have in a nice mauve filigree border?”) Never. You buy the anticipated economic benefits. The same is true of investors in income-producing real estate.

Those readers who have not yet been lulled to sleep by this dissertation will alertly point out that they have in fact observed changes in the value of income property precipitated by changes in mortgage interest rates and in tax laws. Doesn’t that observation contradict our assertion about external factors?

Go back to our earlier article on the use of capitalization rates, and you will recall that there are two elements to the value equation: the NOI and the cap rate. The NOI represents a return on the purchase price of the property; and the cap rate is the rate of that return. Hence, a property with a $1,000,000 purchase price and a $100,000 NOI has a 10% capitalization rate. However, the investor will purchase that property for $1,000,000 only if he or she judges 10% to be a satisfactory return.

What happens if interest rates go up? In that case, there may be other opportunities competing for the investor’s capital  – bonds, for example –  and that investor may now be interested in this same piece of property only if its return is higher, say 12%. Apply the 12% cap rate (PV = NOI / Cap Rate), and now the investor is willing to pay about $833,000. External circumstances have not affected the operation of the property or the NOI. They have affected the rate of return that the buyer will demand, and it is that change that impacts the market value of the property.

In short, the NOI expresses an objective measure of a property’s income stream while the required capitalization rate is the investor’s subjective estimate of how well his capital must perform. The former is mostly science, subject to definition and formula, while the latter is largely art, affected by factors outside the property, such as market conditions and federal tax policies. The two work together to give us our estimate of market value.

— 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 2005, 2013,  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.

 

Understanding Real Estate Resale

One topic that often gets less attention than it deserves from real estate investors, however, is resale. Some tend be dismissive, looking at resale as speculation, but many others simply find it difficult to focus seriously on the matter of selling a property they haven’t yet purchased.

It may take a little extra discipline to work a consideration of resale into your investment mindset, but it is just such discipline that often separates the successful investor from the sorry.

You care about the potential cash flow, the financing, the operating costs and the tax benefits. You had better care also about whether the property will be saleable after you buy it. Often one hears, “Yes, but I plan to keep it for 15 years, or until my toddlers graduate from med school, or until the Federal Reserve Board dances figure-eights on ice with the devil.”

That’s fine; may all your plans go without a hitch. But what if you need to sell this property next year? What if a better opportunity comes along in five years, and you want to cash out? Recite this mantra whenever you consider purchasing an income property: If it’s not worth selling, then it’s not worth buying.

The world may not be perfect, but at least it’s flat – flat, as in “level playing field.” You can reasonably assume that if you would scrutinize a property’s income, operating expenses, financing and various measures of return before you purchase, then tomorrow some equally astute investor will apply a similarly jaundiced eye to your numbers if you choose to sell. It pays, therefore, to run tomorrow’s numbers today, and to see just what this investment will look like to a future buyer.

So, what are the numbers that should concern you when you analyze the potential resale of an income property? The most obvious, and the most important, is the selling price. If you have followed some of our other articles, you know that with most income properties, you can estimate the value by applying a reasonable capitalization rate to the net operating income. (If you have not read the articles, you will get probably get more out of this discussion if you go back and read them first. Their links are Understanding Net Operating Income and How to Estimate Resale Value – Using “Cap” Rates.)

In brief, you first determine the property’s Net Operating Income (NOI). Next you must estimate the capitalization rate (i.e., the rate of return) that the buyer would reasonably expect. The NOI is the amount of the return and the cap rate is the rate of return. Hence, if the market expects a 10% return and your property produces a NOI of $12,000, your estimate of its selling price would be $120,000. Another way of articulating the algebra involved is to say, “$12,000 represents 10% of what?”

A curious phenomenon exists in the real world. Buyers and sellers can look at the same information and see different meanings. This, I suspect, is the closest that commercial real estate will ever come to poetry. Not only might you have a different notion of “reasonable rate of return” as a seller, you might also change your perspective on NOI. It is common for a buyer to estimate value by capitalizing the current year’s NOI, and for a seller to capitalize next year’s expected NOI. The buyer typically takes the position, “I am buying the income stream that just happened, and the property’s value is based on that income stream. If the income goes up next year, that’s my business.” The seller, as a rule, will assert, “You didn’t own the building last year. You’re buying next year’s higher income stream. The value of what you’re buying should be based on that.”

You decide.

Once you develop your estimate of the resale price, the rest of the analysis of resale is fairly straightforward. You will need to calculate the estimated tax liability at the time of sale. Then, with that number in hand you can project the sales proceeds and the overall rate of return for the holding period.

If you use RealData®’s Real Estate Investment Analysis software, you will have all of these calculations done for you. Equally important, the program will test a potential resale each year, allowing you to identify an optimum holding period. Let’s look at just the first four years of such an analysis.

Our first task is to figure the gain. We do this by taking the selling price and subtracting from it the property’s Adjusted Basis.

resale1.gif (7956 bytes)

What is the Adjusted Basis? It is the property’s original cost, plus capital improvements, plus closing costs and costs of sale, less accumulated depreciation. Essentially the Adjusted Basis is what you spent to purchase, improve and sell the property, less the amount you have already written off. If you sell the property for more than this amount, you have a taxable gain.

resale2.gif (2048 bytes)

In calculating your tax liability at the time of sale, there are certain deductions that may come into play. For example, you may have had operating losses in prior years that you were not allowed to take because they exceeded your “passive loss allowance.” If you could not deduct them earlier, you can deduct them at the time of sale. You may also have had loan points and leasing commissions that you were amortizing (i.e., deducting over time). If you have an unamortized balance on these items, you can deduct it when you sell.

resale3.gif (3324 bytes)

Now you have enough information to compute the tax liability due on sale.

resale4.gif (1707 bytes)

No doubt your greatest concern is the amount of cash you will realize from the sale. To determine that figure you must take the selling price, subtract the costs of sale (such as legal fees and sales commissions), subtract the outstanding balances of all mortgages and add back any unused funds left over in your reserve account. Now you have your Before-Tax Sale Proceeds. Subtract the Federal tax liability and you have the After-Tax Sale Proceeds.

resale5.gif (5646 bytes)

The timing as well as the amount of your resale are important to your overall return. In this example, the software is computing that overall return for different holding periods and you can see that the timing can make a substantial difference.

resale6.gif (5519 bytes)

Internal Rate of Return (IRR) is one of the most commonly used methods of measuring the quality of a real estate investment. Others include Present Value, Return on Equity, Cash-on-Cash Return and Debt Coverage Ratio. Some of these measures are fairly sophisticated, while others are quite simple. Check the “articles” section of our blog for more about these topics.

Copyright 2004, 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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