Tag: operating expenses

10 Mistakes To Avoid When You Invest in Real Estate

I’ve been involved in real estate for more than 40 years, much of it teaching about real estate investing, answering questions online, and supporting folks who use my company’s investment analysis software —so I’ve gotten to see a lot about how people think (and sometimes don’t think). From that experience, I want to share my list of “greatest hits,” mistakes that can really trip you up:

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1. Admiring the King’s New Clothes

I see a lot of first-timers get wrapped up in the aesthetics of a property. Is it an attractive, solid building? Is it in a desirable location? Would I be proud to tell people that this my property? Unfortunately, for some new investors, that’s where their critical evaluation ends. They see only what they want to see.

It’s nice to feel good about the commitment you’re going to make, but that warm feeling will quickly turn cold if the property is a money-draining albatross. Start, at the very least, by estimating its initial cash flow—all the money that will come in for the first year minus all the money that will go out. If that number isn’t comfortably positive, reconsider.

 

2. Almost Doing Your Due Diligence

Most investors will check out the physical condition of the property. Most will also check out the rent data and verify at least some of the expenses. But have you actually read the leases? Are you going to get yourself locked into a dicey deal with below-market rents for a number of years; or maybe with a tenant’s right of first refusal if you want to sell, or even a tenant bail-out option?

 

3. Almost Doing Your Due Diligence, Part 2

OK, you did a good job vetting the property, its finances and its leases. So what did you forget? Maybe you forgot about the market. This property doesn’t live in a vacuum, so you absolutely need to be looking at the ecosystem around it.

What are other landlords getting for units in similar properties? What’s your competition for tenants? What is the prevailing cap rate for properties of this type? What’s the business climate—are companies moving in, moving out—is employment strong? As the anvil salesman says in The Music Man, “You gotta know the territory.”

4. Using the Wrong Lingo

Deals frequently unravel because the parties are not speaking the same language. Real estate investing, like other business professions, has a vocabulary all its own—terms whose meaning is agreed upon by those who buy, sell, broker, or finance property on a regular basis. I’ve seen things like “net operating income after debt service.” The rest of us probably call that “cash flow.” Who knew?

If you misuse standard terms, or if you use terms that don’t exist in nature, you’re either going to…

     … experience what I call the Cool Hand Luke Syndrome (“What we’ve got here is a failure to communicate”) and never reach a meeting of the minds, or

     …  paint yourself as someone who has never done a deal before, doesn’t know what he or she is talking about, and shouldn’t be taken seriously (and maybe should be taken advantage of).

 

5. Not Looking at the Deal from the Perspective of the Other Players

Whether you’re trying to buy, sell, finance, or raise equity, you have to recognize that your point of view isn’t the only one that matters. You need to put yourself in the shoes of the other interested parties.

Try to understand what are the sticking points, the potential deal killers from their perspective. Perhaps then you can come up with a solution. Do you have a property to sell, and does your potential buyer seem concerned about some vacant space? How about guaranteeing the rent for a period of time?

 

6. Can’t See the Forest… 

I notice this one with a lot with folks who are trying to vet their first income property. You can think of this as another “perspective” mistake—in this case you need to adopt the perspective not of a potential buyer but rather of someone who has already bought this property and now is trying to run it. It was nice that the seller or broker gave you a list of operating costs, and most of them were probably accurate, but is that list complete?

Go back to it and think about costs that nobody volunteered. Who gets rid of the snow, manicures the landscaping, vacuums the hallways, hauls the trash, services the HVAC? And often you’ll see no line item for property management (“Oh, I do that myself”), but you need to figure in an allowance for management even if no cash currently changes hands. An appraiser would routinely add management as an expense, and you should, too, because it will effect the estimate of value.

 

7. Thinking About Your Rental Property the Way You Think About Your Home

I usually ask my grad students how many own their own home. After a few proudly raise their hands, I tell them they’re at a disadvantage and need to try to forget what they think they know about real estate. Bummer.

The value of a personal residence is driven by economic factors—some national, most local. That’s why an appraiser will use the “comparable sales” approach when estimating the value of a home. If all your neighbors’ houses have sold for around $300k, then yours will probably sell for something like that as well.

But income-producing property is valued on its ability to produce net income. It’s not going to rise in value just because of the passage of time. Too many novice investors think their investment properties are going to “appreciate” on their own, over time, just because. Think again.

You can create value in an income property by enhancing its cash flow. Very few investment vehicles give you this power, but you have to understand how it works if you want to take advantage of this wealth-building potential.

8. Being Nearsighted  

Current-year data is important, but I hear a lot of investors who insist that they will focus only on the current income and expenses when evaluating a potential investment property. They say that this data is concrete and verifiable, and any prediction about future performance is just an exercise in fortune telling.

Yes, an appraiser is going to look at the current revenue, expenses, and market cap rate to estimate value. But remember this: The appraiser’s job is to estimate value at a point in time. You, on the other hand, are almost certainly investing for a period that extends beyond the current moment, and should be interested in how you believe this property will perform over a number of years.

So, in addition to looking at current performance, you should be making several projections as to future performance—best case, worst case, and in-between scenarios. This is a topic for more detailed discussion, so stay tuned for that.

 

9. Missing the Obvious in Your Analysis

You’ve taken my advice to heart and done both short-term and long-term projections of cash flows. Now, get your head out of your spreadsheet and use your common sense. Ask yourself if the figures in your analysis actually make sense. Do they look reasonable?

Is that cash flow way less than you expected, is your IRR in the stratosphere, is your mortgage payment merely a pittance? If so, then chances are you’ve either messed up a formula or a cell reference, or entered data incorrectly. When I look at my students’ work, it’s not uncommon to see that some of them have entered the total monthly rent, when they really needed the annual amount. Or they’ve put too many decimal places in the mortgage rate. Don’t assume, just because you used a spreadsheet, that the results are correct. Garbage in…

 

10. Forgetting that Real Property is a Real Business

After all that hard work—property search, due diligence, financial analysis, negotiation, financing, closing—you are finally the owner/operator of an investment property. Perhaps this is the first business you have ever run. You need to treat it like a business.

The top line of your P&L—revenue—needs to be the top line of your to-do list. Is someone not paying the rent, giving you excuses? Don’t let it slide. Your chances of collecting decrease exponentially with the passage of time.

Keeping records on sticky notes? Poor record-keeping can be your undoing, especially at tax time. Invest in some bookkeeping software, such as Quickbooks, rather than relying on a DIY spreadsheet. And once you’ve got it, use it.

Keep your tenant applications, leases and other documents in an organized file. If you really want to be good, scan them and store them on a removable hard drive.

In short, if you want your real estate investment business to succeed, then treat it like a serious business.

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These are the ten real estate investor mistakes I’ve seen most often, but maybe you’ve seen (or committed!) some of your own. I invite you to share your cautionary tales and add them to our list – let’s call it Everything Else that Real Estate Investors Should Avoid.

 

—-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. Find out more at www.realdata.com.

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Copyright 2018,  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 and blog posts that appear on realdata.com is provided as general information and 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.

 

New Podcast: Investing in Income-Producing Real Estate

I had the privilege recently of recording a video podcast with REICLub, where we discussed investing in income-producing real estate: deciding what kind of property you should buy, how to begin the analysis process, understanding the income stream, estimating value or worth, dealing with long-term projections, recognizing common pitfalls, investing with partners.

I invite you to view it here:

http://www.REIClub.com/FrankGallinelli

—Frank Gallinelli

Real Estate Expense Recoveries—What are they, how do they work? (part 2)

Expense recoveries (aka reimbursements or pass-throughs) serve as a customary ingredient in leases for non-residential property. In part 1 of this article, I discussed some of the typical ways such an arrangement might play out.


The Simple Pass-Through

Fotolia_84790892_XS_split_costsIn a single-tenant property the tenant may be expected to pay all or a portion of certain operating expenses, such as property taxes and insurance, in addition to its base rent. If the tenant is obliged to pay just a portion of the expense, that amount is the excess over what is called an “expense stop.” Let’s say the property taxes are $12,000 and the lease requires the tenant to pay the excess over an expense stop of $4,000. The tenant would have to pay $8,000.

property tax expense — expense stop = expense reimbursement

$12,000 — $4,000 = $8,000 expense reimbursement

If this were a multi-tenant property, the recoverable amount would typically be pro-rated among the tenants—that is, it would be divided up according to the square footage of each tenant’s space in relation to the whole.


Base-Year Expense Stop

A variation on the expense-stop theme is the “base year expense stop.” In this scenario, the parties agree that the landlord will pay the full amount of the recoverable expenses for the first year, and in future years the tenant will pay any increase over that base.

An arrangement like this certainly seems straightforward enough, but prospective tenants sometimes view it with a jaundiced eye. What if the landlord tries to maneuver the timing of base year expenses in order to minimize them? Then the excess in subsequent years would be artificially inflated. If that’s a concern, then perhaps the tenant would prefer a pre-defined expense stop, as in the earlier example.

Keep in mind that the tenant does not pay these expenses directly to the original source of the bill. The landlord pays the tab and passes the appropriate charge through to the tenant, hence the term “expense recovery” or “reimbursement.”


Common Area Maintenance

furniture in small spaceNot every property will fit into a nice, neat, divisible mold. Take, for example, an office building or a larger shopping center. Properties like these may include areas such as lobbies, hallways, elevators, escalators, rest rooms, and parking lots—areas provided for the benefit of all the tenants, as well as for the public served by those tenants (i.e., their customers or clients). In addition, there may be services that the landlord provides for everyone’s benefit, such as security, trash removal, and janitorial. How does the property owner pass these costs through to tenants?

One approach is to bundle up the cost of common services into an item called CAM— Common Area Maintenance charges— and to pass that charge through based on square footage, just as one might pass through a property’s tax expense. Let’s take a tenant who occupies 2,000 square feet out of a total of 10,000; and let’s also say that we have identified $1,000 in total CAM charges for a given time period.

pro rata share of space x CAM charge
= expense reimbursement

20% x $1,000 = expense reimbursement

= $200 expense reimbursement

This method may be fine in situations where the CAM charges are based mainly on services, but the property owner might be less than satisfied with this approach if the property has a significant amount of physical area devoted to common use. Why?


Usable vs. Rentable

Perhaps the answer lies in that we mean by “space.” Let’s pause for two definitions:

usable square feet (usf): The amount of space physically occupied by a tenant.

rentable square feet (rsf): The amount of space on which the tenant pays rent.

The common area represents space from which the tenants benefit, but that space is not part of their private, usable square footage. The common space is being used for lobbies and hallways and rest rooms, so it’s not available to lease out and earn rental income. This would not appear to be an ideal business plan for the landlord. Should the landlord absorb the loss? Is there an alternative?

The answer, and more, in our final installment about expense reimbursements.

—-Frank Gallinelli

Want to learn more? Visit learn.realdata.com

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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. Find out more at www.realdata.com.

Copyright 2016,  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.

Real Estate Expense Recoveries—What are they, how do they work? (part 1)

If you’ve gotten involved as a landlord or tenant with non-residential real estate, such as retail or office buildings, then you have probably encountered a phenomenon that may go by any of several names: expense recoveries, expense reimbursements, pass-throughs, or common area maintenance (CAM) charges. What exactly is this phenomenon and how does it work?

The typical commercial lease will specify a base rent, sometimes as a dollar amount per month or year, but more often as an annual number of dollars per rentable square foot of space occupied by the tenant. Many leases also call for additional rent over the base amount in the form of expense reimbursements.

How it Works—The Math

Vector modern flat business background. Eps 10Let’s take a simple example. Say that you own a single-tenant property with 10,000 rentable square feet. The lease specifies a base rent of $30 per square foot. It also says that the tenant is obligated to reimburse you, the landlord, for all property taxes in excess of $4,000 per year. The $4,000 cut-off is called an expense stop.

In the first year of the lease, the total property tax bill is $12,000. How much will the tenant pay during the first year? Start with the base rent:

area x rate = base rent

10,000 square feet x $30 per sf = $300,000 base rent

Now calculate the reimbursement:

property tax expense — expense stop = expense reimbursement

$12,000 — $4,000 = $8,000 expense reimbursement

So the tenant is going to pay a total of $308,000 in the first year.

What happens if the space is divided among multiple tenants? While the leases for these tenants could be structured in any way to which the parties agree, the most common arrangement would be to allocate the reimbursements according to each tenant’s pro-rata share of the total rentable square footage.

Let’s say now that instead of occupying the entire rentable area, the tenant we’ve been discussing takes up only 2,000 square feet and the remainder is rented to other businesses. The calculation of the base rent works just as it did before (area x rate = base rent), but the reimbursement involves an additional factor, the tenant’s pro rata share. Since the tenant occupies 2,000 of the 10,000 square feet total, its share is 20%

pro rata share x (property tax expense — expense stop)
= expense reimbursement

20% x ($12,000 — $4,000) = expense reimbursement

20% x $8,000 = $1,600 expense reimbursement

As before, we add that to the tenant’s base rent

2,000 square feet x $30 per sf = $60,000 base rent

to get a total of $61,600.

In this example, we have been passing through just one expense, but the landlord and tenant can agree to pass through as many or as few as they like. Property tax is probably the most common, and a lease that has just that single reimbursement is called a net lease. If the lease passes through both taxes and insurance, it is called a net-net lease. And if it adds tenant responsibility for repairs and maintenance into the deal, it is called a triple-net lease.

 


How it Works—The Practical Issues

All this is nice in theory, but how does it work in practice? Does the property owner let the tenant pay the bills?

doodle building earthquakeHardly ever. If you as a property owner pass property taxes or insurance cost–or any other expense for which you are responsible–on to a tenant, what you should do is pay those expenses directly yourself and send your tenant a bill for the reimbursable amount. A moment’s reflection will make the reason for this immediately obvious. Do you really want to rely on a third party to pay your tax or insurance bill on time? What if they don’t? You’re probably already picturing the nightmare scenario, where the insurance bill was left unpaid by the tenant, and then a catastrophic uninsured loss occurred. Or the tax bill was ignored, and you end up with a lien against your property and a black mark on your credit. If it’s your bill, pay it yourself and then collect from the tenant.

More…

Now that we’ve nailed down the basic mechanics of expense reimbursements, we want to go a bit further. There are some variations we should look at, like base-year reimbursements and CAM charges; there are some accounting and presentation issues worth considering; and there is the fundamental question as to why commercial landlords and tenants follow this pass-through practice at all. Come back for Part 2 to find out more.

—-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 2015,  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.

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

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

The Cash-on-Cash Conundrum, Part 2

In the first part of our discussion, you looked at the simple math that underlies Cash-on-Cash Return. The short version goes like this:  First you calculate your property’s first-year cash flow before taxes—essentially all the cash that comes in from operating the property minus all the cash that goes out. Then you divide that by your initial cash investment, and that percentage is your Cash-on-Cash Return. Nothing could be simpler.

Simplicity is a good part of CoC’s appeal. Unfortunately, that is also part of its weakness. If you are using this metric to help you decide whether a potential income-property purchase is a promising investment or not, then you need to look carefully at the story—or stories—that may lurk behind these numbers. In keeping with our literary metaphor, let’s call them our subplots.

Subplot #1: A Point in Time

Clearly, when you take the first-year’s cash flow and divide it by the cash used to purchase, you are looking at a property’s performance essentially at a point in time, a single year. To be sure, the reliability of your cash flow projection is likely to be greatest in that one, immediate time frame. I often hear investors say that they are not comfortable trying to predict the future, that they would rather just look at what is happening now; and they are quite justified in saying that if the return looks grim or perhaps negative right out of the box, then they have no interest in looking further.

Understandable, but potentially shortsighted—literally. By looking at a single year, you are looking at what may be an improbable investment horizon.  Will you keep this property for just one year? If not, if you plan to hold on to it longer, then you’re not taking into account anything having to do with its possible future performance.  Do you believe each future year will be exactly like this year, or could reasonably anticipated changes in cash flow (such as schedule increases in commercial lease rents, or large expenditures for needed repairs) push the needle far to one end or the other?

Subplot #2: The Time Value of Money

“All right,” you say, “then I’ll estimate the Cash-on-Cash Return for each of the next several years.” That may look like a step in the right direction, and I talk to a lot of folks who insist on doing just that, but it won’t take into account the time value of money.  You’ll be looking at the face value (undiscounted) of expected future cash flows, and weighing them against the present value of your cash investment today. Go back to that original example, where you invested $100,000. If you predict a $20,000 cash flow ten years from now, does that really mean your investment is returning 20%?

To be fair, future-year Cash-on-Cash can impart some useful information. For example, if the metric is both positive and increasing, then you can infer that your cash flow is improving each year. The trend can help inform your decision, but the actual percentage return may not have a great deal of meaning.

Subplot #3: Smoke and Mirrors

You retreat and say, “OK, let’s go back to thinking about just the first year of operation. Surely the Cash-on-Cash should give me a good sense of initial performance.” Do you remember the old computer chestnut, “Garbage in, garbage out?” Your results are only as good as the assumptions and data that you put in the dispose-all, and perhaps things aren’t always (or ever) what they seem.

Consider:

You are looking at in income-and-expense statement (what we call an APOD in real estate investing—Annual Property Operating Data) provided by the seller of the property. The cash flow is based, in part, on operating expenses, one of which is Maintenance and Repairs. The figure in the example above is $6,000; you secure the owner’s tax return and confirm that this is indeed the figure he declared.

That is how much he actually spent, but the figure seems a bit low to you. Does it mean the owner performed as little maintenance as he could get away with and never fixed anything until it was absolutely necessary?  Perhaps the owner did this to prop up the property’s cash flow in anticipation of selling. Despite the fact that the expense disclosed is technically correct, you decide you shouldn’t use it as a forward-looking assumption. Instead, you will probably have to project spending more once you take ownership, resulting in a diminished cash flow and a lower Cash-on-Cash Return. In addition, the property may actually be worth less than you assumed, since it does not throw off as much net income as you were led to believe.

Now take a different point of view. Based on your experience, you think the maintenance and repair expenditure shown is surprisingly high. Could there be an explanation for that? Perhaps the owner used the past year to catch up on deferred maintenance so the property would look more presentable when he put it up for sale.  You might be tempted (but only in your most private thoughts) to test the impact of lower maintenance costs on your cash flow and CoC return.  Once again, the amount that was disclosed, although correct, may not be the amount that gives you the best estimate of future cash flow or Cash-on-Cash Return.

Subplot #4: The Forecast—Cloudy, with a Chance of Cash Flow

Finally, there is the larger issue of the structure of the cash flow statement itself. What you decide to include or exclude in your forecast of future cash flow will almost certainly be driven by your personal agenda in creating that cash flow statement.  Are you the seller of the property, looking to make its income stream appear as strong as possible? Are you the buyer, trying to make a realistic projection of how this property will really perform, and perhaps also conveying that stark realism back to the seller as part of your price negotiation?

In either case—as well as in any of several others, such as buyer looking for financing, general partner looking for equity investors, etc.—you might be putting a bit of a spin on the data, the better to support your point of view and the message you want to deliver.

If you’re the seller, then a bit of topspin seems like a good idea to you. In the example shown in Part 1 of this discussion, you might argue that, not only did you provide accurate and verifiable income and expense data, but that you were being exceptionally open and above-board by suggesting an allowance for vacancy and credit loss even though you experienced no such loss.  Group hug.

But if you’re the buyer, you might return this with some backspin. You thank the seller for being so forthright, but add that you believe the vacancy and credit loss allowance should be closer to 5%, not 3%. In addition, you point out that routine maintenance is great, but will not prevent big-ticket items from wearing out eventually. For example, the heating boiler is barely hanging on, and the flat roof has less than 10 years of life left in it. Hence you propose reconstructing the cash flow statement to reflect the higher vacancy allowance, as well as need for an immediate capital improvement and an ongoing set-aside of cash flow into a reserve account to deal with future replacements, such as the roof.

coc2-1

What previously was a robust 10.4% return now becomes an anemic 2.1%.

coc2-2

The seller objects that this isn’t entirely fair, since the boiler repair is a one-off event, and removing that cost would bring us up to 6.1%.

coc2-3

The seller’s argument cycles you right back to Subplot #1 about the hazards of relying on a rate-of-return metric that looks only at a point in time in what is probably going to be a long-term investment.

Is There a Bottom Line?

What should you conclude about Cash-on-Cash Return? Is it, as some contend, the only metric worth looking at?  Is it of no use at all? The best answer probably lies somewhere in between, that you need to recognize both CoC’s strengths and its limitations, and not rely on it as your sole investment decision-making tool.

On the plus side:

  • It is quick and easy to calculate.
  • It can give an immediate comparison to the return on other short-term investments.
  • It focuses on the most current performance of the property; the more recent the data, the more likely it is to be reliable.

Among the negatives:

  • It focuses on single point in time; you may be intending to buy and hold for an extended period, and the future performance of the property can differ greatly from the short term.
  • It does not take into account the time value of money; if you use it beyond the current period, you may be comparing a future, undiscounted cash flow to the amount invested today.
  • It is easy to manipulate the results; hence, a novice investor who relies on this metric alone can be misled by what a third party chooses to include or exclude from a property’s cash flow statement.

So are there some bottom-line recommendations here?  Of course.

Start off by trying to develop a CoC calculation in which you can have reasonable confidence.

To do so, remember that there is no substitute for due diligence. At the most basic level, you need to confirm whether the data you see on the cash flow statement for a particular property is reasonable and accurate. Then you need to go further and examine the physical property and the market to see if there are issues that may affect your confidence in those numbers. Is there any reason to doubt that the current revenue stream will continue as it is now? Is the demand for space in this market changing, for good or ill? Is there deferred maintenance that you will have to deal with? Based on what you find, you may have to reconstruct that cash flow statement.

Don’t just look at what is on the cash flow statement; look for what might be missing. A seller may not volunteer an allowance for vacancy or a need to fund a reserve account, but such items are going to be part of your reality as an owner.

So long as you approach it with sufficient care and due diligence, the Cash-on-Cash Return can give you a useful first look at how a property might perform; but before you commit your investment dollars, you need to do more.

If you plan to operate this property for several years, then you need to take the long view. You should identify your likely investment horizon, and then build a series of pro formas to forecast how the property might perform over time.

A series? Yes. Don’t try to nail your projections of future performance in one pass. Do a best-case, worst-case, and in-between forecast of future cash flows and ultimate resale of the property. Look at the ongoing Debt Coverage Ratio in each case. Examine the IRR or MIRR. Even compare this property to others you might be able to acquire.

Be thorough. Be wary of shortcuts. You’re buying a future income stream; do your homework and run your numbers so you can understand just what it is that you’re buying.  Your investment success depends on it.

— 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 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.

The Cash-on-Cash Conundrum, Part 1

Life is too complicated; we have too many choices, too many options, too many channels on cable TV. It’s not surprising that sometimes we crave simple answers to complex questions.

I see that mindset very often in my interactions with real estate investors. They yearn to embrace the “50% rule” or the “2% rule” or some other shortcut that will help them cut to the chase and decide if a particular property is a good deal or not.

One metric that is relatively simple and historically very popular is the Cash-on-Cash Return (CoC). I encounter many real estate investors (more than a few of whom have a net worth significantly greater than that of this writer) who zero in on that metric like a heat-seeking missile whenever they consider buying a property.  What exactly is Cash-on-Cash Return? How do you calculate it? What are its strengths and weaknesses? Is it a good metric, and perhaps more important, is it good enough?

Cash-on-Cash Return may be one of the few bits of financial terminology whose name could almost serve as its definition. You’re expecting to get a cash return on your cash invested, i.e., to earn cash on your cash. If you express the return as a percentage of the amount invested, then you have the Cash-on-Cash metric.

Let’s see this with some actual numbers.  You are considering the purchase of a particular income property. For this discussion, the purchase price of the property is not the number you want to focus on. Rather, it’s the amount of your own money—the cash you actually put on the table—that you’ll be looking at. You need $100,000 to close the deal.

You’ve obtained information about the rental income, the operating expenses and the expense reimbursements paid by the tenants. To that information you’ve added your own allowance for vacancy and credit loss, as well as your expected annual debt service on the mortgage that you’ll need to complete the purchase. You put this all together into a cash flow statement that looks like this:

coc1-1

Now you do the cash-on-cash math:

coc1-2

So now you see your Cash-on-Cash Return is apparently 10.4%. What are you to make of this?

First, you recognize that this was a very quick and easy calculation to perform. You needed just the amount of your cash investment and some basic information about anticipated revenues and expenditures. No heavy lifting here.

Second, you observe that your cash-on-cash (and therefore your cash flow) is a positive number. That’s really important, because it means you don’t expect to reach into your own pocket to pay the bills. You have more coming in than going out.

Third, you recognize that this really quick calculation allows you to compare the first-year return on this investment to that of other short-term opportunities like CDs or T-Bills. You look at 10.4% and that strikes you as a fairly good rate of return.

In short, your initial take here is that this metric was really easy to calculate; that it told you that the property seemed likely to enjoy a positive cash flow in the first year; and that the rate of return on your cash investment appeared to be significantly better than you might get from a bank or a bond.

Are you satisfied that you can make an informed decision to buy or not to buy this property based on your calculations here? You shouldn’t be. Yes, you believe the rent and expense figures are accurate, and you did the math correctly, but are you confident that you’re seeing the complete picture? My continual mantra to my finance students is, “Look beyond the numbers, look for the story that’s behind what you see on the surface.”

It’s tempting to think that this calculation of cash-on-cash has given you an adequate perspective on how this investment will perform, but there is really a great deal more to look at and to think about here. That’s what we’ll do in the next installment.

(to be continued)

— Frank Gallinelli

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Copyright 2013,  Frank Gallinelli and RealData® Inc. All Rights Reserved

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