Tag: real estate investment analysis

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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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.

 

Real Estate Investing: Time to Remember the Lessons of History

As the summer 2013 begins to cool off, many real estate markets are finally starting to heat up. For a lot of folks, who have slogged through five of the worst economic years in memory, it feels a bit like we’ve just been released from the locked trunk of a car.

The temptation now is to celebrate our release from investing confinement by jumping back into the market with both feet. Before we do so, however, it would be wise to reflect on a few of the lessons of recent history.

There were many reasons for the financial meltdown, but one of the biggest surely was the belief that real estate inexorably increases in value over time. To many people, that looked like a law of nature. The reality turned out to be different, and now, as property values start to rise, we have to resist the temptation to start believing this all over again. If not, we will simply create another bubble and repeat the cycle.

Another cause of that meltdown was the tendency to dismiss or completely ignore investment fundamentals.  Real estate simply couldn’t fail to do well (after all, they’re not making any more of it), and we didn’t really need to think too hard about our investments because, surely, they would work out happily in the end.

Savvy investors always knew that this wasn’t necessarily true; they knew that income-producing real estate could go up, down, or sideways.  Time, all by itself, does not create value; the ability of a property to produce income is what creates value, and so the prudent investor would take nothing for granted and always carefully weigh a property’s prospects for generating income today and in the future.

The beginnings of a general economic recoveryand, in particular, a real estate recovery may signal that we can and should get back into the game, but it doesn’t mean that we can return to pre-2008 thinking and disregard the fundamentals that ought to guide our investment decisions:  For example:

Due Diligence: This is just as important in good times as in bad. We need to examine thoroughly and critically all of the financial data we can get our hands on about a potential investment property.  Are the rents really as represented? Are the operating expenses as portrayed by the seller reasonable and complete? Have we done a thorough assessment of the property’s physical condition?

It is essential to remember that a property doesn’t live in a vaccum, so our due diligence needs to extend beyond the individual property and include the local market as well.  What is the prevailing capitalization rate for properties of this type in this market? What kind of rents are similar buildings actually getting, and what are the asking rents in properties that may be in competition with us for tenants? What is the current vacancy rate in this market, and has it been rising or falling? What is the general business climate, and in what direction is it headed?

Cash Flow:    We always need to make hard-headed projections about the prospects for current and future cash flow. Too often we see investors, motivated to make a purchase and get on the presumed gravy train, put together the numbers they want to see.  They ignore the potential for vacancy and credit loss. They ignore setting some of their potential cash flow aside each year as a reserve to pay for that new roof or new HVAC system a few years down the road. We should make best-case, worst-case, and in-between projections to give ourselves a sense of the range of possible outcomes.

It is important to be realistic about cash flow projections. Excessive leverage may seem like a great advantage on the day you close the purchase, but the high debt service may also result in very weak or even negative cash flow. Are you really prepared to support your property out of your own pocket, to absorb unexpected expenses or loss of revenue?

The Long View: We seldom buy an income property with the expectation of flipping it for short-term profit. Rather, our plan is probably to buy and hold so we can derive an annual cash flow plus a long-term gain when we sell. If that is indeed our plan, then we need to forecast the property’s performance not just for one year, but for a likely holding period—perhaps five, seven or ten years—and to compute an Internal Rate of Return for that holding period. Doing so can be especially valuable when we are looking at more than one property that we might purchase.  Which one appears likely to give us the best overall return within our investment horizon?

The Last Word: Investing in real estate can be a profitable move in just about any economic climate if we proceed wisely, so to answer our initial question: Yes—if we’ve been on the sidelines, then this is a fine time to get back in.  But as with any other kind of investment, we can just as easily lose money as make it if we charge ahead without doing our homework and without going through the kind of fundamental analysis and projection that is essential to smart investing. Success in real estate investing, as in most endeavors, doesn’t just happen by good luck or chance. We have to work at it and have our head in the game. The luck will follow.

— 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.

Real Estate Investment Courses Enter the E-Learning Revolution

As many of you know, I teach real estate investment analysis in the Master of Science in Real Estate Development program at Columbia University. About a year ago I agreed to teach a similar course at a new online school dedicated exclusively to commercial real estate: Homburg Academy.

During the past several months I’ve been busy recording lectures for their academic program. The more I’ve worked with these folks, the more impressed I’ve become with their professionalism and their commitment to providing quality education for our industry.

On May 16, they are launching an online e-learning portal as an extension of the Academy; the courses in this portal will be available on-demand.

I’m very honored that they’ve chosen my course as one they are including in the launch. Attached below is a copy of their announcement; I encourage you to check them out. You’ll find a link at the bottom where you can sign up if you would like to attend the launch online.

Frank Gallinelli

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Real Estate Investment Courses Enter the E-Learning Revolution!

Homburg Academy, an online university specialized in commercial real estate, will launch its proprietary e-learning portal on 16 May. This is an extension of the university’s efforts to provide accessible, affordable real estate education entirely online.

The portal will provide real estate investors and students with 24/7 worldwide access to the entire body of Homburg Academy’s online course materials and video lectures. These courses encompass a wide range of pertinent and interconnected subjects in real estate accounting, appraisal, capital markets, finance, investment analysis, management, risk and portfolio management – to name a few.

Homburg Academy’s current faculty includes 70 of the world’s top real estate professors and professionals in 13 countries – numbers that will continue to grow as new online programs and courses are launched in the coming months. Faculty members include such renowned experts as Frank Gallinelli, author of the bestselling guide, What Every Real Estate Investor Needs to Know about Cash Flow (McGraw-Hill, 2004), and Mastering Real Estate Investment: Examples, Metrics And Case Studies.

Each course contains 10 hours of lecture presentation. They are professionally produced by a team of course designers and multimedia editors to make viewing engaging and interesting. E-learning specialists have optimized each course to maximize knowledge and understanding. Each hour is broken down into easily digestible segments of 15 minutes, followed by a self-assessment quiz. There is also a discussion forum that is open to everyone taking that course to encourage discussion.

By providing easy access to courses by real estate industry’s most qualified experts, the Homburg On-Demand portal ensures that real estate investors can enrich their knowledge base with the highest quality courses available, by leading experts, giving them an edge in today’s competitive global marketplace.

Join the launch event! The Homburg On-Demand launch will stream live on the internet on May 16th at 2 PM (Atlantic Standard Time). Anyone interested may sign up for the live broadcast through Homburg Academy’s On-Demand sign-up page at: http://www.homburgacademy.org

Ten Commandments for Real Estate Investors: Commandment #1

Recently I had the honor of being asked to speak at the BiggerPockets Real Estate Investment Summit in Denver. Although I tried to warn them that I was a graduate of the Fidel Castro School of Public Speaking and could talk for four hours from a three-by-five note card, my time was limited. My plan was to conclude with “Ten Commandments for Real Estate Investors,” which I did, but briefly. Thanks to the wonders of modern blog posting, however, I can now share the unabridged version.

Commandment #1: Thou shalt take nothing for granted.

There is a witticism attributed to American humorist Finley Peter Dunne, “You trust your mother but you cut the cards.” In real estate, of course, the parallel concept is due diligence. If you assume that things are as they appear and if you fail to vet your potential deals independently, you’re setting yourself up for unwelcome and expensive surprises.

The cast of characters you may encounter in a real estate deal is almost archetypal. First there is the liar. I still remember well the kindly grandmother who recited to me her property’s rent roll. When I uncovered her perfidy, she explained that she had been telling me how much her tenants should be paying.

Another character is one I call the alchemist. He wants you to look at lead paint and see gold leaf, so he tries to take uncomfortable information and give it a positive spin. “It’s not too small; it’s compact and requires less maintenance.”

Finally there is the person who simply doesn’t volunteer information. He’ll tell you the truth if you ask, but assumes – perhaps justifiably – that it’s not his responsibility to supply the right questions as well as the right answers.

If you have a plan for due diligence and stick to it then you won’t have to rely on information from parties whose interests may not be in concert with yours. That plan should involve both the property and the market in which it is located.

Start with a physical inspection of the property. Deferred maintenance can cut both ways. On the one hand, it represents an expense and may signal that tenants are unhappy.  On the other, it can be an opportunity to remedy a problem, increase revenue and create value. Also look for capital improvements, both completed and needed. Check for code and zoning compliance, and certainly don’t assume that the property’s current use is permitted.

Then consider the financial issues. Examine the leases and look for unusual provisions. Commercial leases in particular can harbor some exotic covenants.  If possible, require estoppel certificates where the tenants can tell you if the lease terms are true and accurate and if there are any outstanding issues or litigation with the landlord. Independently verify expenses like property taxes and assessments, insurance costs and utility expenses. Ask to see historical rent and expense data.

Many investors neglect to go to the next important step, which is to scrutinize the market. What are the prevailing lease rates for properties of this type in this area? How much space like this is vacant in this market? What are the local cap rates for this type of property? What’s going on with employment and municipal budgets? You should know everything possible about the economics and politics of the area where you are buying property – or as I’ve told many investors, you should know where the cracks in the sidewalk are.

And so our first commandment is to take nothing for granted. Rely on your own independent research about the local market and about the particular property. Ronald Reagan may have said it best when negotiating a nuclear treaty with the former Soviet Union: “Trust, but verify.”

The complete “10 Commandments for Real Estate Investors” is available as an ebook on Kindle, Nook, and iBooks.

(c) Copyright 2012 Frank Gallinelli All Rights Reserved
All content in this blog is provided for entertainment and informational purposes only and with the understanding that the writers are not engaged in rendering, legal, professional, financial or investment advice. The owner of this blog makes no representations as to the accuracy or completeness of any information on this site or found by following any link on this site.

New for 2012: Real Estate Investment Analysis, Version 16

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

What’s New in Version 16?

    • The Decision Maker

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

      snippet - input, Decision Maker
      snippet 1 from Decision Maker

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

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

      snippet 2, Decision Maker
      snippet 2 from Decision Maker

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

    • Detailed Capital Improvements

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

 

    • Detailed Closing Costs

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

 

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

 

    • Import Data from Your Version 15 Analyses

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

 

Upgrade from Version 15

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

Frank Gallinelli to Speak at BiggerPockets Real Estate Investing Summit and Expo, March 23-24, 2012

BiggerPockets — an 85,000-member community of real estate investors — is having its first Real Estate Investing Summit in Denver, March 2012, and has invited Frank Gallinelli as a featured speaker. Frank is the founder of RealData Software and the author of What Every Real Estate Investor Needs to Know About Cash Flow… and Mastering Real Estate Investment. He will speak on, “Real Estate Investment Analysis, Methods and Mindset — What to Know, What to Do.”

According to BP founder Josh Dorkin, “BiggerPockets is planning on having dozens of expert investors, commentators and educators speak to an audience that is expected to include hundreds of attendees from around the country. Through lectures, roundtables, and other session formats, the event will cover topics including rehabbing, landlording, investing in notes & mortgages, real estate financing & capital raising, commercial investing, and much more.”

You can sign up to attend by following this link. Hope to see you there.

Refi Existing Investment Property to Purchase Another?

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

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

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The Good News

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

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

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

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

But Wait… Some Issues and Considerations

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

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

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

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

Frank Gallinelli

5 Mistakes Every Real Estate Investor Should Avoid

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

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


1. The Formula That Doesn’t Compute

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

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


2. The Modern Art Syndrome

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

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

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

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

Labels need to be unambiguous:

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

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


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

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

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

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

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


4. What’s Wrong with This Picture?

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

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

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

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

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


5. What You Don’t Know CAN Hurt You

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

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

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

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


The Bottom Line

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

Let me suggest three other important steps you can take:

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

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For Real Estate Investors: A Lesson in Clarity

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

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

Be Clear About Your Objectives

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

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

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

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

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

Be Clear About Your Use of Terminology

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

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

Be Clear When You Build Your Pro Forma or Presentation

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

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

–Frank Gallinelli

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The Flavor of the Month: Apartment Investing

It comes as no surprise to those of us who are a bit long in the tooth: The recent economic environment has been bad for almost everything, but it’s good for multi-family investment property.

When credit flows freely, almost anyone who can buy a house will buy a house. (Whether they can pay for it after the closing is of course another matter.) On the other hand, when credit tightens or dries up almost completely, then the subprime prospects are frozen out of the housing market, along with a sizeable group of perfectly responsible borrowers who now find they can’t clear the considerably elevated qualification standards. It doesn’t take tremendous insight to realize that most of these people are now candidates for apartment space. Remember Econ 101?  Supply, demand, etc.

If you read the financial press (or follow our tweets) then you’ve seen ample evidence lately that apartment properties are hot. The Wall Street Journal  cites a Marcus and Millichap report stating the the values of apartment buildings rose 16% in 2010 after falling 27% between 2006 and 2009. In that same article, WSJ says that the supply of new apartment buildings is at a two-decade low. There’s that supply and demand thing again.

Reuters  recently reported that apartment vacancies showed a steep drop in the first quarter of 2011. At the same time, Investor’s Business Daily noted that even the smallest buildings — those with four units or less — were in high demand. An advantage here for the small investor is that this kind of property can usually qualify for Fannie- or Freddie-backed financing, and perhaps on even more favorable terms if the investors lives in one of the units.

After a long period when it seemed like investors were in duck-and-cover mode, it’s good to see this resurgance of activity.

(self-serving footnote: If you’re doing an apartment deal, be sure to run the numbers first, Either the Express or Professional Edition of Real Estate Investment Analysis will do a great job with apartment buildings. If you’re raising capital from equity partners, then use the Pro Ediiton — it will give you presentations for individual partners.)