I like to read the discussions in a number of online real estate investment forums to see what issues are of interest to investors at all levels of experience. One topic that seems to excite a lot of commentary concerns the relative merits, or lack thereof, of projecting and analyzing the potential future cash flows from an investment property—call it Discounted Cash Flow (DCF) or pro forma analysis. Since I’ve spent a good part of my professional life teaching on this subject and providing software tools to accomplish such analyses, discussions like these jump out at me; and my last post promised a follow-up to my discourse on the income stream, so the saga continues.
I frequently see people lament that a cash flow pro forma is basically pointless. You can’t predict the future; more specifically you can’t predict what a property’s revenue or expenses will be in any given year, so why bother trying? It’s a waste of time, so they say. I think this is an unnecessarily nihilistic take on investing, reducing attempts at thoughtful analysis to the level of palm reading and tarot cards.
The 50% Rule
Recently I have seen a lot of mention of a so-called “50% rule” as an alternative to DCF. If I understand it correctly, this rule says, “Take the gross rent and subtract 50%. That’s your Net Operating Income. Subtract your debt service and that’s your cash flow.”
So, 50% is supposed to account for your vacancy loss, operating expenses, reserves, and capital costs. Actually, these last two items aren’t part of NOI, but why quibble?
Somehow I can’t shake off the image of Michelangelo creating the Sistine Chapel ceiling with a paint roller. Same level of precision.
Clearly, one set percentage—50% or anything else—could not possibly be appropriate for all property types, even in the same market. You would not expect your percentage of operating expenses for a triple-net-leased single-tenant building to be the same as that for an office building. Even within one property type, would you bet the farm on the expense percentage for a 100-unit apartment complex to be identical to that of a 6-unit multi-family house?
Let’s grant that a certain expense percentage might be typical for a given property type in a given location. Would you really be comfortable using that percentage to make a specific purchase decision? It might work out if you were buying the entire market, but would you risk your investment capital on the assumption that the one property you want to buy is truly typical of the entire market?
Sadly, I find too many investors dismiss the importance of doing a Discounted Cash Flow Analysis and opt instead for this sort of very simplified—dare I say oversimplified—approach. Such a technique might suffice as a general guideline for smaller properties, but when one gets involved with true income properties—larger residential or just about any size commercial investment—I don’t see how you can commit a serious amount of cash without performing a DCF analysis as part of your decision-making process.
Due Diligence and DCF
I talk a lot in my books, articles, and podcasts about the importance of due diligence; and that process is really at the heart of making an intelligent and informed cash flow projection. You cannot know your future operating costs precisely, nor perhaps your revenue; but you can certainly make reasonable estimates that are not just global generalities but are specific to the investment you’re considering. Keep in mind that due diligence for a real estate investment has two distinct parts:
- The property itself — What is the actual current revenue? Do the leases call for scheduled rent increases? What are the current, verified operating expenses, and what are reasonable estimates going forward? Does the physical condition of the property suggest capital expenditures will be needed during your expected holding period? Will you set aside reserves for those? What are the costs and terms of available financing for this property?
- The market — Properties don’t live in a vacuum, so market data is crucial. What are the prevailing rents for this type of property in this market (i.e., what is the competition)? What are the local vacancy levels, cap rates, and general economic trends?
Next, use that data to project current performance along with best-case, worst-case, and in-between scenarios of future performance. This is where you start to take the investment’s vital signs: Under what circumstances will the cash flow be adequate, is the debt coverage ratio strong enough to secure financing with a given down payment, what if a commercial tenant’s shaky business fails before their lease expires?
Use the projections not only to make a decision about an appropriate price and terms for the property, but also use the DCF to demonstrate (i.e., “sell”) your reasoning to the other parties involved in the transaction: to the seller if you’re the buyer, the buyer if you’re the seller; to the lender; or to your potential equity partners.
Investment is all about balancing risk and reward; and these, in turn, require a willingness to make investment decisions in an environment where you necessarily have to work with incomplete or imperfect information. If there were no uncertainties, then everyone would be a winner.
Uncertainties such as these, however, are in the context of the actual property and the actual market. They are not the random application of a universal constant that has no particular connection to the investment under consideration. Buying and operating an investment property involves commitment, and that should start with a thorough financial analysis. Projecting the potential future performance of an investment property, especially with multiple scenarios, is the best way to make an informed and intelligent decision.
— Frank Gallinelli
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