Tag: real estate investment analysis

Making the Case for Your Commercial Refinance

Many of you surely have commercial property loans that are coming up for refinance during 2009.  We have a new article (actually, the first installment of a two-part piece) on realdata.com that we think you’ll find helpful.

In Part One of “Making the Case for Your Commercial Re-Finance,” we tell you what information you must gather before you apply for the loan. We help you understand the loan underwriting process as the lender sees it, and show you how to estimate the maximum amount of financing you can reasonably expect to get.

In Part Two, we’ll demonstrate the process of building a presentation that you can use to make a strong case for your commercial refi.

To view this article, go to realdata.com and click on the “Learn” tab.  You’ll find a link to this and a whole library of articles for investors and developers.

Excel 2007 – New File Types, Macro Security and Other Mysteries

When Microsoft released Excel 2007 it deployed some of the most extensive changes to the product in many years.  It introduced an entirely new user interface, a new menu format called the “Ribbon,” enhanced security, and an entirely new data structure for its files.  With this new data structure came an array of new file types.

Many of these changes have implications that are not always obvious to the user and, from our point of view at least, are not always entirely welcome.

This will be the first of what may be several posts on the RealData blog where we try to address what we feel are some of critical changes you need to know about in Excel 2007 so that you can use it successfully.  We’re writing these posts with users of RealData software in mind – particularly users of our more sophisticated Excel-based products like “Real Estate Investment Analysis,” “On Schedule” and “Commercial/Industrial Development” – but we feel strongly that it’s information all Excel users should have.

So – let’s begin with by comparing the file types in the old Excel vs. the new Excel.

How Things Were:  Two Key Facts to Remember

  1. If you have used earlier versions of Excel, you probably know that you used workbooks, called .xls files – and templates, called .xlt files.  Workbooks are collections of worksheets, sometimes accompanied by built-in programming code called “macros.”  Templates are a special kind of workbook.  When you launch a template, it leaves the original unchanged and presents you with a new workbook file based on that template.  That way you don’t accidentally overwrite the original.
  2. If you used RealData software, or perhaps certain other commercial Excel-based applications, the Excel file included hidden macro code.  You never saw it, but you know it was there because Excel would ask you if you wanted to enable the macros. Such code is typically essential for the functioning of a complex Excel-based program.  For example, our “Real Estate Investment Analysis” uses more than 12,000 lines of such code to provide menus, format reports, add/delete data records, and so on – functions that can’t be accomplished with simple spreadsheet formulas.  If you lose the code, the program will no longer function properly.

How Things Are: The New File Formats and How They’re Different

New to Excel 2007 are the .xlsx, .xlsb and .xlsm formats which Excel refers to as “Excel Workbook,” “Excel Binary Workbook” and “Excel Macro-Enabled Workbook,” respectively.  It’s important to understand the differences among these file types, and which can be used with RealData software products.

Each of these new formats is based on what Microsoft calls an “Open XML File Format.”  Without getting more technical than we need to here, the short version is that one can openly view and read the data from these files and convert them to other formats if necessary.  This ability is part of a trend toward an open and universal standard for documents so that data is not tied to a particular proprietary software product or company.

If you used earlier versions of Excel, then you know you customarily saved your workbook as a .xls file.  Let’s look at each of the new file formats and compare them to that original .xls Excel file format:

1. The .xlsx format is a lot like the old .xls format, but with one key difference:  It intentionally does not support macro code and will remove any macro code from a file that contains it. Remember what we said about RealData software and other products that rely on macros to provide their advanced functionality?  Right.  Without the macros these programs won’t work.  If you open a macro-driven .xls file and save it in the new Excel .xlsx format, the macros will be deleted and the program will no longer work as expected.

Fortunately, if you do try to save a file in this format, you will receive a warning message before the macro code is deleted:

Keep in mind that macros can be used by malefactors to deliver viruses. If you download an Excel file from some source other than a trusted commercial vendor, you run a risk as you would downloading a file from any unfamiliar source.  You’ll want to keep the macro code in a program from a trusted source like RealData, but you should be wary of any file containing macros if it comes from a source with which you’re not familiar and confident.

If you want to be certain to keep the macros intact in your RealData program, the simplest and most certain solution is this: Click “No” and return to the “Save” dialog.  Where you see a pulldown that says “Save as type,” choose “Excel 97-2003 Workbook (.xls).”

2. In contrast, the .xlsb and .xlsm formats do support macro code.  The .xlsb file is a streamlined format intended to speed up the process of opening and saving the file.  Like the .xlsm format, it can save an equivalent Excel workbook in a significantly smaller file size than the traditional .xls format.  The information in each of the cells is saved as plain text (you could view the information in Notepad if you wanted to) but the  macro code is encrypted.

Is it all right for you to save your RealData program as a .xlsb or .xlsm file and save some disk space?  The answer is a resounding maybe.

To re-open one of these files once you’ve saved it as .xlsb or .xlsm, Microsoft requires that you have installed on your computer an antivirus product capable of scanning and reviewing encrypted macro code before the file opens.  If this scan process does not happen, then the macros will be disabled in your software.  If you’re alert, you’ll  know this is so because of an inconspicuous warning message that appears in a horizontal bar above the Excel work area:

Click on “Options” and you should see something like this:

The default choice is “Help protect me….”  If you are confident that this file came from a trusted source, you can choose “Enable this content.”  If the file has a security certificate attached, the details of that certificate will be displayed and you can choose “Trust all documents from this publisher.”  RealData does have a security certificate attached to its program files.

Unfortunately, not all antivirus software is able to scan encrypted macro code. From our own experience we can confirm that Version 8.0 of the AVG  product appears to work without problems ( http://www.avg.com).

If you were getting ready to breathe a sigh of relief, hold it.  What we describe above is how .xlsb and .xlsm are supposed to behave.  Some users, however, have reported to us that, if they see the “macros disabled” message and click the options button, they get only one choice, and it’s not the one they want:

Why does this happen sometimes, but not always?  If we could answer questions like that, we’d be so famous you wouldn’t even be able to talk to us.  Seriously.

Which brings us back to bullet-point #1, worth repeating;

If you want to be certain to keep the macros intact in your RealData program, the simplest and most certain solution is this: Click “No” and return to the “Save” dialog.  Where you see a pulldown that says “Save as type,” choose “Excel 97-2003 Workbook (.xls).”

This should be your choice if you want your analysis to be compatible with both Excel 2007 and other computers which may have an earlier version of Excel installed on them.  RealData software products automatically detect if you are using Excel 2007 and set the default file type to be .xls, although you can override this if you so choose.

The Short Version

  1. RealData delivers its macro-powered programs using the Excel 97-2003 file format, i.e., .xls. If you always save your work in that format, you should have no problems with Excel 2007 opening or running the macros in RealData programs.
  2. If you save a file in .xlsx format, Excel will strip out all of the macro code and that particular RealData file will no longer function properly.
  3. If you save in .xlsb or .xlsm format, then when you re-open the file, Excel will be looking for antivirus software to scan the encrypted macros.  If it doesn’t find it, you will have to instruct Excel to open this content; some users have reported being unable to do so.


Excel Template Formats

As mentioned above, RealData delivers it programs as template (.xlt) files. When you launch a template, it leaves the original unchanged and presents you with a new workbook file based on that template.  That way you don’t accidentally overwrite the original.

Excel 2007 contains two new template file formats, so now there are three flavors:

  1. .xltx called “Excel Template”
  2. .xltm called “Excel Macro-Enabled Template”
  3. .xlt called “Excel 97-2003 Template”

RealData software is currently distributed in .xlt format.  You could convert this file to .xltm and it should work fine on your computer, assuming that you have anti-virus software capable of scanning encrypted macros.

But why tempt fate for no reason? We recommend that you stick with the .xlt format.

Excel 2007 File Icons

Each of the file formats has its own icon.  As you can see from the image below, these icons are very similar in appearance.  The template file types share a common horizontal yellow bar across the top edge.  You may find these images helpful when you try to recognize different Excel file types by their icons.

Stayed tuned to our blog for more about Excel 2007.

realdata.com

New investment analysis service — and data form

If you subscribe to our e-newsletter, the RealData Dispatch, then you know that we just launched a new service where we will run a property analysis for you, using your data and our software.

All you do is download a questionnaire, fill it in with the particulars about the property you want to evaluate, and email it or fax it back to us. We’ll run your information through the Standard Edition of “Real Estate Investment Analysis” and send the reports back via email.

You can get more details here.

Even if you don’t plan to use the service right now, I’d like to suggest that you download the form. I think you’ll find it to be a helpful guide for collecting data whenever you need to do an investment analysis, whether you’re working with our software or scribbling on the back of an envelope.

And speaking of our newsletter, just one more comment. If you subscribed but haven’t been receiving it, then it’s probably getting stuck in your spam box. It seems to me that spam filters have been getting more aggressive. I know it’s necessary to fight the growing tide, but I’ve been finding more “real” mail getting swept away with the junk.

I would urge that you go to your email program or service and “whitelist” realdata.com. For example, if you’re using Yahoo mail, go to “Options” and add a filter that tells Yahoo to direct anything from realdata.com to your inbox. With Gmail, you go to “Settings” and do the same thing.

That way, our newsletter will reach you. In addition to providing announcements about our products, upgrades, etc., we use the newsletter to tell you when we have new educational content and when we’ve found an online resource that might be valuable to you as as an investor or developer.

If you aren’t already subscribed, you can do so here.

Frank Gallinelli
realdata.com

Download sample chapters from my new book, “Mastering Real Estate Investment”

Hello All —

I thought you might like an opportunity to see some sample chapters from my new book, so I’m making two downloads available.

The first section of the book is devoted to 37 key formulas that every real estate investor should understand and know how to use.  One of the most important of these is capitalization rate. 
Chapter 10 discusses cap rate and gives you several examples that you can work through.

The second part of the book provides case studies where I take you step by step through different kinds of property investments.  In Chapter 38 I discuss using a single-family house as a rental property.  This download is a seven-page excerpt from the chapter, which continues with a thorough discussion of the single-family rental.

I hope you find these samples useful, and welcome your comments.

Frank Gallinelli
realdata.com

Stirring the Alphabet Soup of Real Estate Investing, Part 1

UPDATE: I’ve re-written this multi-part blog post and it’s now available in a convenient “flip book,” readable in your browser:

5 Metrics Every Real Estate Investor Needs to Know

 

PV, NPV, DCF, PI, IRR–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.

Learn more about real estate investing metrics in my free flipbook, 5 Metrics Every Real Estate Investor Needs to Know

—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, 2017, 2021  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 Mortgage is Due, but Nobody’s Home – What You Should Know about Vacancy and Credit Loss

In an earlier article, Understanding Net Operating Income, I made a passing reference to an allowance for vacancy and credit loss. This allowance is one of the line items that ultimately lead to figuring a property’s Net Operating Income, a key metric of income-property investing. NOI as you will surely recall (read the article and also Understanding Cap Rates if you don’t) is at the heart of estimating the value of an income property, so anything that contributes to getting that number right deserves more than just an offhand comment.

The math surrounding vacancy and credit loss allowance is certainly simple enough. You start with your top line – Gross Scheduled Income – which represents a perfect-world situation where all units in your property are rented and all your tenants pay on time with good checks. From that you subtract an allowance to account for the warts of an imperfect world, in this case the potential rent that may be lost to vacancy and the revenue lost due to the failure of tenants to pay. Typically you will estimate the allowance as a percentage of the Gross Scheduled Income.

The result is called the Gross Operating Income (also known as Effective Gross Income). From that subtract the property’s operating expenses and the result is the Net Operating Income, the number you will capitalize in order to estimate the property’s value. An example should make this easy to see:

one
In this example you’ve assumed that about 3% of your potential income will be lost to vacancy and credit. As you examine this table, you’ll recognize that the greater the vacancy and credit loss, the lower the NOI and hence the lower the value of the property. There’s a lesson here, of course. The vacancy and credit loss projections you make, for the current year and for the future, are going to have a direct impact on your estimate of the property’s value. If you’re careless about these projections you risk skewing that estimate of value.

Vacancy Loss

Behind the numbers are some truisms that you want to keep in mind. The first, of course, is that vacancy and credit loss are generally unwelcome. Loss is loss. However, experienced investors will usually not fall on their swords at the first sign of an empty unit. Conventional wisdom among veterans is, “If you never experience a vacancy, your rents are too low.” I’ve never seen anyone break out the champagne upon learning of a vacancy, but there is some merit in this seemingly self-delusional chestnut. One certain way to find the top of the market is to push past it. When you reach a rate where you no longer can find tenants in a reasonable amount of time, you can pull back. The vacancy you experience will cost you something, but you’ll be sustained by your expectation that the loss will be offset by the higher revenue you can earn by maximizing your rent.

Another reality to keep in mind is that not all vacancy allowances are created equal. In general, commercial space takes longer to rent than does residential and larger spaces take longer to rent than smaller. If you have a large retail space whose lease is coming up for renewal, it might not be unreasonable to allot six months or more of rent as a potential vacancy loss. At the other extreme, a properly priced studio apartment should rent quickly in most markets, so a minimal allowance would suffice.

When making projections about future vacancy, start by looking backward. How quickly has new space been absorbed in the past? Then look forward and consider what might change. What is the likelihood of new, competing space being built? Are there reasons to expect demand to rise or fall – reasons such as new employers moving in or established businesses moving out?

Remember that your objective is to forecast as accurately as possible how this property will perform for you in the future. You can and should look at best-case, worst-case and most-likely scenarios for vacancy just as you would for income and expenses, and don’t try to convince yourself that only the best case is real.

Credit Loss

Avoiding credit loss is a problem you get one shot at solving, and that shot occurs before you sign the lease. Would you sell me your used car in exchange for an I.O.U. or a personal check? You would expect cash or a bank draft. Why would you turn over an even more valuable asset, your rental property, without similar caution? That caution, at minimum, takes the form of a credit check and some good faith money up front in the form of security deposit and advance rent.

There are numerous companies online with whom you can establish an account for checking an applicant’s credit history. Any reputable source of credit reports will expect you to provide proof of your identity and to present written authorization from the prospective tenant to obtain the report. The simplest way to accomplish the latter is to include that authorization as part of the signed rental application. A landlord association often can help you gain access to a reliable source of credit reporting.

Credit losses are a part of doing business and you’re not likely to succeed in eliminating them completely. Your best single defense against is to establish minimum acceptable credit standards and then resist the temptation to trust your instincts and make exceptions. Everyone has a dog-ate-my-homework explanation for poor credit history. Some of the stories are probably true. Nonetheless, the single best predictor of a collection problem is past history. If he didn’t pay his cell phone bill, he probably won’t pay you either.

Some investor’s simply ignore vacancy and credit loss when making their cash flow projections. You might want to call that the emperor’s-new-clothes approach, where you see what you want to see and pretend you don’t notice what’s missing. That’s not much of an investment strategy and it won’t work for very long – reality has a habit of happening whether you plan for it or not. The more prudent investor will do his or her best to minimize these losses, but at the same time work with projections that are realistic.

 

Copyright 2005, 2010 RealData® Inc. All Rights Reserved

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

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

####

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.

 

Estimating the Value of a Real Estate Investment Using Cap Rate

Why do you invest in income-producing real estate? Perhaps you are looking for cash flow. Possibly you anticipate some tax benefits. Almost certainly, you expect to realize a capital gain, selling the property at some future time for a profit.

Your projection of the future worth of the property, therefore, can be a vital element in your investment decision.

APPRECIATION

A fairly simple approach to this issue is the use of an appreciation rate. You bought the property today for X dollars. You make a conservative estimate as to the rate of appreciation, apply that rate to your original cost and improvements and come up with presumed future value.

The use of appreciation as a predictor of future value typically makes sense when the desirability of the subject property is based on something other than its rental income. The most common example, of course, is the single-family residence. Consider also a single-user rental property such as a small retail building on a main thoroughfare. The owner of a business operating as a tenant in such a location is probably willing to spend more for the building than an investor would pay. In general, rate of appreciation as a predictor of future value may be appropriate when comparable sales work well as a measure of present value (i.e., “Commercial buildings on Main Street are selling for $200 per square foot by next year they will be up to $225.”).

INCOME CAPITALIZATION

With most other types of income-producing real estate, what you paid for the property is not likely to make much of an impression on a new buyer. Witness the rapid run-up and even faster collapse of prices in the late ‘80s, and again in 2008. The typical investor will be interested in the income that the property can generate now and into the future. He or she is not buying a building, but rather its income stream.

That investor is likely to use capitalization of income as one method of estimating value. You have probably heard this referred to as a “Cap Rate” method. It assumes that an investment property’s value bears a direct relation to the property’s ability to throw off net income.

Mathematically, a property’s simple capitalization rate is the ratio between its net operating income (NOI) and its present value:

Cap. Rate = NOI/Present Value

Net operating income is the gross scheduled income less vacancy and credit loss and less operating expenses. Mortgage payments and depreciation are not considered operating expenses, so the NOI is essentially the net income that you might realize if you bought the property for all cash. If you purchase a property for $100,000 and have a NOI of $10,000, then your simple capitalization rate is 10%.

To use capitalization to predict value requires just a transposition of the formula:

Present Value = NOI/Cap. Rate

The projected value in any given year is equal to the expected NOI divided by the investor’s required capitalization rate.

To use capitalization rate as a predictor of future value, in short, is to use this logic: “I am buying this property with the expectation that its net operating income will represent a return on my investment. It is reasonable to assume that whoever buys the property from me in the future will have a similar expectation. That new investor will probably be willing to purchase the property at a price that allows it to yield his or her desired rate of return (i.e., capitalization rate).”

If you project that the property will yield a NOI of $27,000, and that a new buyer will require a 9% rate of return (capitalization rate), then you will estimate a resale price of $300,000.

You must never forget that, while the algebra involved here is simple, the judgments you need to make in order to achieve an accurate prediction of value are more complex. Your assumptions as to future years’ income and expenses have to be realistic.

The same is true of your estimate of a new buyer’s required cap rate. Look at the investment from the new buyer’s point of view and remember that there are other opportunities competing for his dollar. Would you buy an office building with a projected cap rate of 9% if you could buy a bond that yields 7%? What if mutual funds are rocking and rolling at 15% and more? To attract a buyer, your property may need to be priced so that its cap rate is competitive with alternative investment options. The higher the cap rate, the lower the price. In our example above, the property with the $27,000 NOI capitalized at 12% might attract an offer of $225,000.

Our discussion here has been limited to simple or “market” capitalization rates. If you would like to delve further into this topic you may want to look into “band of investment” or derived cap rates. In addition, follow our blog as we go into greater depth as to how investors look at a property’s projected long-term income stream when deciding if and on what terms to purchase an income property.

—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, 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.

 

Rate of Return on No Money Down (and Other Tales from the Deep Woods)

We frequently hear a question that goes something like this: “I’m considering the purchase of an income property where the seller will take back a second mortgage for the entire down payment. Why can’t your software figure out the rate of return on a zero-cash-down investment?”

You’ve surely heard the excuse, “It’s not the software’s fault” more times than you care to recall. This time, however, the blame really does not fall upon the software, the hardware, the astronauts, Bill Gates, el niño or any of the other usual suspects.

The problem lies in the question itself: “What is the rate of return on a zero-cash-down investment?” Let’s try posing this query a few other ways:

“What’s my return on investment when I make no investment?”

“What’s my rate of return on nothing down?”

“What’s my rate of return on nothing?”

You can see where we’re going with this. You cannot calculate the return because there is no such thing as a zero-cash-down investment. If you invest nothing, then you have no investment. You might just as well ask, “What is the height of an adult unicorn?” because you would get the same answer. No such animal.

This is not just clever semantic swordplay. Fundamental to the concept of investment is that you put your own capital at risk. (For the alert reader, capital could take a form other than cash. I once witnessed a deal where the buyer signed over a sports car as his down payment. For the sake of simplicity, we’ll just refer to the buyer’s investment as cash, with or without wire wheels.)

No-money-down violates the letter, the spirit and the algebra of conventional investment. Return on investment, by its simplest definition, is the amount of the return divided by the amount of the investment. Anything divided by zero is infinity. Hence, even a one-cent return on a zero-dollar investment would be an infinite rate of return.

In short, if you as the buyer put no cash into the deal, you have made no investment and hence you cannot calculate a rate of return. Even if the acquisition of an income property with no outlay of cash should not be called an investment, such deals do happen and can even succeed (although perhaps not as effortlessly as in the mountain of books and tapes showing how you too can amass great wealth with no cash).

If you cannot measure the potential success of a no-money-down deal using rate of return, is it time to put away your computer, trust your instincts and not bother with any kind of financial analysis? Quite the contrary. Even if you can’t measure the rate of return, you can still perform some essential analysis. In fact, caution may demand that a “non-investment” such as this, with little margin for error, be scrutinized with even greater than usual care.

In particular, there are two important issues that require careful examination: Cash flow and resale. If you are going to try to finance 100% of a property’s purchase price, you are obviously going to have to service more debt than you would if you had put some meaningful amount down. Can the property’s income cover all of its operating expenses as well as these debt payments? If not, then you’ll have to reach into your own pocket to make up the difference (so much for the “no cash, no problem” scenario).

Here is where you have to take a very hard look at the numbers. The burden of debt payments on a property with 100% financing leaves you very little wiggle room. Are the income figures realistic? Are you relying on immediate rent increases to cover your costs, increases that could initially result in vacancies rather than additional revenue? Are your expense projections based on verifiable sources and do you have the resources to handle unwelcome surprises?

A second key issue is the property’s potential resale value. (If you haven’t done so already, you should read our previous articles on “Understanding Net Operating Income,” and “Understanding Real Estate Resale.” and even take our e-course or read my books to help you understand the relationship between income and value.) Since your financing is likely to eat up most of your cash flow, the eventual resale of the property is where you will typically have the greatest chance of making money. Once again, realism is of paramount importance. Why might a new buyer give you more than you paid? Can you make physical improvements and management improvements that will make this property attractive and more valuable to an investor?

To recycle an old saying, if no-money-down deals were easy, everyone would do them. Even though you can’t calculate a conventional rate-of-return, be sure that you do the rest of your homework — cash flow projections and estimated resale — before you take the plunge.

The math surrounding vacancy and credit loss allowance is certainly simple enough. You start with your top line – Gross Scheduled Income – which represents a perfect-world situation where all units in your property are rented and all your tenants pay on time with good checks. From that you subtract an allowance to account for the warts of an imperfect world, in this case the potential rent that may be lost to vacancy and the revenue lost due to the failure of tenants to pay. Typically you will estimate the allowance as a percentage of the Gross Scheduled Income.

The result is called the Gross Operating Income (also known as Effective Gross Income). From that subtract the property’s operating expenses and the result is the Net Operating Income, the number you will capitalize in order to estimate the property’s value. An example should make this easy to see:

one

In this example you’ve assumed that about 3% of your potential income will be lost to vacancy and credit. As you examine this table, you’ll recognize that the greater the vacancy and credit loss, the lower the NOI and hence the lower the value of the property. There’s a lesson here, of course. The vacancy and credit loss projections you make, for the current year and for the future, are going to have a direct impact on your estimate of the property’s value. If you’re careless about these projections you risk skewing that estimate of value.

Vacancy Loss

Behind the numbers are some truisms that you want to keep in mind. The first, of course, is that vacancy and credit loss are generally unwelcome. Loss is loss. However, experienced investors will usually not fall on their swords at the first sign of an empty unit. Conventional wisdom among veterans is, “If you never experience a vacancy, your rents are too low.” I’ve never seen anyone break out the champagne upon learning of a vacancy, but there is some merit in this seemingly self-delusional chestnut. One certain way to find the top of the market is to push past it. When you reach a rate where you no longer can find tenants in a reasonable amount of time, you can pull back. The vacancy you experience will cost you something, but you’ll be sustained by your expectation that the loss will be offset by the higher revenue you can earn by maximizing your rent.

Another reality to keep in mind is that not all vacancy allowances are created equal. In general, commercial space takes longer to rent than does residential and larger spaces take longer to rent than smaller. If you have a large retail space whose lease is coming up for renewal, it might not be unreasonable to allot six months or more of rent as a potential vacancy loss. At the other extreme, a properly priced studio apartment should rent quickly in most markets, so a minimal allowance would suffice.

When making projections about future vacancy, start by looking backward. How quickly has new space been absorbed in the past? Then look forward and consider what might change. What is the likelihood of new, competing space being built? Are there reasons to expect demand to rise or fall – reasons such as new employers moving in or established businesses moving out?

Remember that your objective is to forecast as accurately as possible how this property will perform for you in the future. You can and should look at best-case, worst-case and most-likely scenarios for vacancy just as you would for income and expenses, and don’t try to convince yourself that only the best case is real.

Credit Loss

Avoiding credit loss is a problem you get one shot at solving, and that shot occurs before you sign the lease. Would you sell me your used car in exchange for an I.O.U. or a personal check? You would expect cash or a bank draft. Why would you turn over an even more valuable asset, your rental property, without similar caution? That caution, at minimum, takes the form of a credit check and some good faith money up front in the form of security deposit and advance rent.

There are numerous companies online with whom you can establish an account for checking an applicant’s credit history. Any reputable source of credit reports will expect you to provide proof of your identity and to present written authorization from the prospective tenant to obtain the report. The simplest way to accomplish the latter is to include that authorization as part of the signed rental application. A landlord association often can help you gain access to a reliable source of credit reporting.

Credit losses are a part of doing business and you’re not likely to succeed in eliminating them completely. Your best single defense against is to establish minimum acceptable credit standards and then resist the temptation to trust your instincts and make exceptions. Everyone has a dog-ate-my-homework explanation for poor credit history. Some of the stories are probably true. Nonetheless, the single best predictor of a collection problem is past history. If he didn’t pay his cell phone bill, he probably won’t pay you either.

Some investor’s simply ignore vacancy and credit loss when making their cash flow projections. You might want to call that the emperor’s-new-clothes approach, where you see what you want to see and pretend you don’t notice what’s missing. That’s not much of an investment strategy and it won’t work for very long – reality has a habit of happening whether you plan for it or not. The more prudent investor will do his or her best to minimize these losses, but at the same time work with projections that are realistic.

Copyright 2005, 2010 RealData® Inc. All Rights Reserved
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

 

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.
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.