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Six Rules of Thumb for Every Real Estate Investor

Posted on by Frank Gallinelli

Life can be hard, especially as we try to climb out of the Great Recession. Real estate investing can be a challenge, as well; and while we surely won’t presume to suggest how to deal with life’s big issues, we can offer a few thoughts as to how you might maintain some equilibrium when you look at investment property.

Those of you who follow our content at RealData.com — newsletters, books, Facebook and software — know that we stress maximizing your chances for success through understanding the metrics of investment property. We don’t tell you that you’ll get rich by thinking positive thoughts, raising your self-confidence, and charging fearlessly into the fray. Instead, we urge you to learn about the financial dynamics that are at work in income-producing real estate. Whether you’re scrutinizing a piece of property you already own, one you want to sell, or one you may choose to buy or develop, you need to master the metrics. The numbers always matter.

And so here are our “6 Rules of Thumb for Every Real Estate Investor.”

1. Vacancy

— Let’s begin with a simple one. What percentage of the property’s total potential gross income is being lost to vacancy? Start off by collecting some market data, so you will know what is typical for that type of property in that particular location. Does the property you own or may buy differ very much from the norm? Obviously, much higher vacancy is not good news and you want to find out why. But if vacancy is far less than the market, that may mean the rents are too low. If you’re the owner, this is an issue you need to deal with. If you’re a potential buyer, this may signal an opportunity to acquire the property and then create value through higher rents.

2. Loan-to-Value Ratio (LTV)

— When the financial markets return to some semblance of normalcy, they will probably also return to their traditional standards for underwriting. One of those standards is the Loan-to-Value Ratio. The typical lender is generally willing to finance between 60% – 80% of the lesser of the property’s purchase price or its appraised value. Conventional wisdom has always held that leverage is a good thing — that it is smart to use “Other People’s Money.”

The caution here is to beware of too much of a good thing. The higher the LTV on a particular deal, the riskier the loan is. It doesn’t take much imagination to recognize that in the post-meltdown era, the cost of a loan in terms of interest rate, points, fees, etc. may rise exponentially as the risk increases. Having more equity in the deal may be the best or perhaps the only way to secure reasonable financing. If you don’t have sufficient cash to make a substantial down payment, then consider assembling a group of partners so you can acquire the property with a low LTV and therefore with optimal terms.

3. Debt Coverage Ratio (DCR)

— DCR is the ratio of a property’s Net Operating Income (NOI) to its Annual Debt Service. NOI, as you will recall is your total potential income less vacancy and credit loss and less operating expenses. If your NOI is just enough to pay your mortgage, then your NOI and debt service are equal and so their ratio is 1.00. In real life, no responsible lender is likely to provide financing if it looks like the property will have just barely enough net income to cover its mortgage payments. You should assume that the property you want to finance must show a DCR of at least 1.20, which means your Net Operating Income must be at least 20% more than your debt service. For certain property types or in certain locations, the requirement may be even higher, but it is unlikely ever to be lower.
Not to preach, but planning a budget with a bit of breathing room might be a good principle for every government agency, financial institution and family to follow.

4. Capitalization Rate

— The Capitalization Rate expresses the ratio between a property’s Net Operating Income and its value. Typically, it is a market-driven percentage that represents what investors in a given market are achieving on their investment dollar for a particular type of property. In other words, it is the prevailing rate of return in that market. Appraisers use Cap Rates to estimate the value of an income property. If other investors are getting a 10% return, then at what value would a subject property yield a 10% return today?
Remember first that the Cap Rate is a market-driven rate so you need to interrogate some appraisers and commercial brokers to discover what rate is common today in your market for the type of property you’re dealing with. But you also need to recognize that Cap Rates can change with market conditions. In our long and checkered careers we have seen rates go as low as 4-5% (corresponding to very high valuations) and as high as the mid-teens (very low valuations), with historical averages probably bunched closer to 8-10%. If you are investing for the long term, and if the cap rate in your market is presently pushing the top or the bottom of the range, then you need to consider the possibility that the rate won’t stay there forever. Look at some historical data for your market and take that into account when you estimate the cap rate rate that a new buyer may expect ten years down the road.

5. Internal Rate of Return (IRR)

— IRR is the metric of choice for many real estate investors because it takes into account both the timing and the size of cash flows and sale proceeds. It can be a bit difficult to compute, you may want to use software or a financial calculator to make it easy. Once you have your estimated IRR for a given holding period, what should you make of it? No matter how talented you are at choosing and managing property, real estate investing has its risks — and you should expect to earn a return that is commensurate with those risks. There is no magic number for a “good” IRR, but from our years of speaking with investors, we think that few would be happy with anything less than a double-digit IRR, and most would require something in the teens. At the same time, keep in mind the “too good to be true” principle. If you project an astoundingly strong IRR then you need to revisit your underlying data and your assumptions. Are the rents and operating expenses correct? Is the proposed financing possible?

6. Cash Flow

— Cash is King. If you can first project that your property will have a strong positive cash flow, then you can exhale and start to look at the other metrics to see if they suggest satisfactory long-term results.

Negative cash flow means reaching into your own pocket to make up the shortfall. There is no joy in finding that your income property fails to support you, but rather you have to support your property. On the other hand, if you do a have a strong positive cash flow, then you can usually ride out the ups and downs that may occur in any market. An unexpected vacancy or repair is far less likely to push you to the edge of default, and you can sit on the sideline during a market decline, waiting until the time is right to sell.

Overambitious financing tends to be a common cause of weak cash flow. Too much leverage, resulting in greater loan costs and higher debt service can mark the tipping point from a good cash flow to none at all. Revisit LTV and DCR, above.

We’re all thumbs, so to speak, so if you found these rules helpful check out more of our books, articles, software, Facebook page and other resources.

Copyright 2009, RealData® Inc. All Rights Reserved
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide  legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

Real Estate Partnerships and Preferred Return

Posted on by Frank Gallinelli

Q. Can you explain more about how preferred return works in a real estate partnership? Does it always have to go only to the limited partner or non-managing partner?

A. The first point to make about real estate partnerships – whether limited, general or LLC – is that there is certainly no single, pre-defined structure used by all investors. In fact, you may be hard pressed to find two partnership agreements whose provisions are exactly the same.

Not all partnerships include a preferred return but, in those that do, its purpose is to counterbalance the risk associated with investing capital in the deal. Typically, the investor is promised that he or she will get first crack at the partnership’s profit and receive at least a X% return, to the extent that the partnership generates enough cash to pay it. In most partnership structures, the cash flow is allocated first to return the invested capital to all partners. The preferred return is paid next, before the General Partner or Managing Member receives any profit.

There are some variations as to exactly how the preferred return might be set up. If the partnership does not earn enough in a given year to cover the preferred return, the typical arrangement is to carry the shortfall forward and pay it when cash becomes available. If necessary it is carried forward until the property is sold, at which time the partners receive their accumulated preferred return before the rest of the sale proceeds are divided. Again, that assumes that the sale proceeds are in fact sufficient to pay the preferred return. If not, the limited partners have to settle for whatever cash is available.

The return may also be compounded or non-compounded. In other words, if part or all of the amount due in a given year can’t be paid and has to be carried forward, the amount brought forward may or may not earn an additional return (similar to compound vs. simple interest). The usual method is for it to be non-compounded. Hence the unpaid amount carried forward does not earn an additional return, but remains a static amount until paid.

An alternative but less common approach is to wipe the slate clean each year. If there isn’t enough cash to pay the preferred return, then the partnership pays out whatever cash is available and starts over from zero next year.

Real estate partnerships will typically define percentage splits between General (i.e., managing) and Limited (i.e., non-managing) partners for profit and sales proceeds. These splits do not come into play until the obligation to pay the preferred return has been met.

For example, let’s say that a limited partner invests $100,000. She is promised a 5% preferred return (non-compounded), 90% of cash flow after the return of capital and payment of preferred return, and 70% of sale proceeds. In the first five years, the partnership generates just enough cash to return the invested capital to all partners. Hence, all future cash flows represent profit. The partnership has a $16,000 cash flow the sixth year, a $20,000 cash flow the seventh year and also sells the property at the end of the seventh year with total proceeds of sale of $150,000. Here is what happens:

year 6 and 7 distributions to LP

The Limited Partner should receive a preferred return of $5,000 per year (5% of her $100,000 investment). By the end of year 6 she hasn’t received any of this return so she is owed $30,000. In the sixth year the partnership cash flow is only $16,000, so that is all she gets; the balance due is carried forward to year 7. In that year the partnership cash flow of $20,000 is sufficient to pay the $14,000 owed from year 6, the $5,000 from year 7 and still leave enough ($1,000) to split 90/10 with the General Partner. Finally, the property is sold at the end of year 7 with $150,000 proceeds to split 70/30 with the General Partner.

Regarding the question, “To whom does the preferred return go?” it is of course possible to structure a partnership so that it goes either to the General or the Limited partner or to Donald Duck if you think that’s a good plan. The presumed purpose of the preferred return is to encourage non-controlling investors to risk their capital in your project; and that encouragement often takes the form of a conditional promise of a minimum return, the “preferred return.” It seems to me that you would have a difficult time raising money from investors if your underlying message were, “This deal is so shaky that I need full control plus first dibs on the cash flow. If there’s anything left, you can have some.”

Run the numbers, but think beyond them. A good partnership is one where all the parties can enjoy a reasonable expectation of success.

Copyright 2009, RealData® Inc. All Rights Reserved
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide  legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

Continuing Ed.: Is an Investment Class Right for You?

Posted on by Frank Gallinelli

From time to time I teach a series of continuing education classes for Connecticut brokers and agents.  The courses are entitled “Understanding Real Estate Investments” — there is a Level 1 (introductory) and Level 2 (intermediate), each for 3 credit hours as electives. I’ll be doing so again from late March to mid-May, 2010.

Something I often hear is, “Oh, I’m a residential agent so I guess that’s not for me.” Of course, I have just the opposite in mind. The residential agent or broker is the ideal candidate for these classes. 

To explain why, I’d like to share a few observations I make to my students before I get into the meat and potatoes of my classes’ subject matter: What are these courses about? Why do I teach them?  And, why should you even care? (more…)

Real Estate Value – Market Data vs. Income

Posted on by Frank Gallinelli

Trying to estimate the value of a piece of real estate seems to be everyone’s favorite pastime. I’ve discussed this subject in detail in my books, What Every Real Estate Investor Needs to Know About Cash Flow and Mastering Real Estate Investment; in previous articles here on realdata.com; on PBS’s Wealthtrack; in line at the supermarket, and just about everywhere else I’m allowed to talk out loud. Although I thought I had covered the waterfront pretty well on this topic, I continue to be surprised by the number of people who still don’;t fully understand that there are several approaches to estimating value, and that it is important to choose the one best suited to the particular property you have in mind.

First, some necessary preliminaries. Any (actually, every) real estate appraiser will tell you that there are three approaches to value: the cost approach, the market data approach, and the income approach. While they will often try to reconcile these approaches when appraising a particular property, in many cases it is clear that one of the three methods stands out as the most appropriate for that property.

The Cost Approach

The cost approach uses the cost of reconstructing the property at today’s prices (land included) and then whittles that number down because of factors such as physical depreciation and functional obsolescence. In my experience it tends to be most useful if the property is squeaky new (i.e., you haven’t yet scraped the labels off the plate glass windows) but tends to become more subjective as the property becomes less than brand new. The adjustments also tend to be pretty subjective, which may be all right if the person making those adjustments does so for a living all day long (for example, a professional appraiser), but are not likely to be so reliable otherwise. Also, you’ll need a solid estimate of the land value, often a difficult task in its own right.

For the typical investor or developer, cost may be useful to confirm valuations made with other approaches but otherwise may be difficult to apply in a way that’s reliable enough to be the basis of an investment decision. So, for the purpose of our discussion, let’s skip this approach and focus instead on the distinction that I find tends to muddle the understanding of value for many novice — and some not-so-novice — investors. When do you use the market data approach to value and when do you use the income approach? The question may sound academic. It’s not. It’s the difference between recognizing the realistic value of a property or perhaps missing it by a country mile.

The Market Data Approach

The market data approach is based on comparable sales. In other words, you can reasonably expect that a property will sell for something close to the price of similar properties located close to the subject, i.e., comparables located in the same market. You would of course make adjustments for distinguishing features — the presence or absence of certain amenities found in the comparable properties — but it is the market as much if not more than the property itself that drives the value.

When do you use this method to value a property? The poster child for the market approach is the single-family home. When you shop for such a home, you look at the amenities that the house has to offer and you look at how much other houses in the neighborhood have sold for. You might say, “Other four-bedroom colonials in this neighborhood have sold recently between $680,000 and $720,000 and I should base my offer on that information.” It’;s unlikely, however, that you would say, “I can probably get $2,000 per month rent for this, so I’ll base my offer on whatever price gives me a positive cash flow.”

You would also take note of the local economy when considering how the value of this property might grow over time. Strong employment for example might increase demand and therefore increase prices. If prices in a neighborhood have recently increased on average by about 5%, chances are good that most individual properties have indeed increased by a similar amount. Likewise, chances are good that future increases or decreases will affect most properties in that neighborhood more or less equally. A rising tide lifts all boats. Again, it’s the dynamics of the market at work here.

The Income Approach

Now consider an altogether different kind of property: an office building or shopping center or fairly large apartment building. You are not going to look for comparable sales of regional shopping malls to decide how much to offer. Income properties are bought and sold strictly for their ability to produce a net income. So long as the property’s main appeal is not for the use or occupancy of the owner, it is in the purest sense an income property. A person who buys a garden apartment complex, an office tower, or a shopping center is probably not looking for a place for his family, his office, or his store to occupy. He is looking for an income stream, a cash flow.

This investor will capitalize the property’s anticipated Net Operating Income to arrive at an estimate of value. You’ll find the mechanics of this process discussed in detail in my Cash Flow book and you can use any of our Real Estate Investment Analysis programs (Express or Standard Edition) to perform the calculations. Indeed, these programs are frequently used as valuations tools for income property.

Some Examples

It should be clear enough that you would use the market data approach when buying a home and the income approach when buying a shopping center or office building. It’s the gray areas that are tricky and can trip you up. Let me describe some typical situations that we hear most often:

You buy a single-family house for investment as a rental property. Unless the neighborhood is made up entirely of pure rental properties, you do not want to base your estimate of the property’s value on its rental income. If the other houses in the neighborhood are being bought and sold as personal residences, then prices will be driven by comparable sales, not by potential rental income. In other words, when you buy this property you will pay a price based on the market for homes in the area; and when you sell it you can expect a price driven by that same market.

Even though the price at which you buy and the price at which you sell will not be a function of the property’s rental income, it is still critically important to perform the kind of cash flow and resale projections that you can do with our RealData investment analysis software. The house may not be an income property in the purest sense, but that is how you’re using it. You’re buying an income stream and you need to estimate what you can expect as yearly cash flows and how much you’ll derive from the final cash flow: the proceeds of sale. That’s what investment analysis is all about.

You buy a multi-family house for investment as a rental property. This one is trickier yet. You need to ask yourself, “Who is the most likely buyer of this property? — an owner/occupant or an absentee-owner/investor?” One neighborhood might be characterized by a preponderance of 3- to 6-unit multi-family, larger apartment buildings and small commercial properties. The most likely buyer here would probably be an investor; hence the income approach would be best for estimating value.

Another neighborhood might contain a good number of single-family homes along with duplexes (many of them owner-occupied) and some triplexes. The buyer of a multi-family here is probably going to be an owner/occupant, someone who is buying a home that has rental income as one of its amenities. The value of this property will probably be driven by comparable sales, not by the potential rent income.

You buy a small commercial property. Commercial is commercial, right? That means investment, that means the rent income determines its value. Usually, but not always. This situation is analogous to the owner-occupied multi-family. Consider a small professional office or a small, free-standing retail building. The prime prospect for the office might be a doctor or lawyer, using the space for his or her practice. The retail building might be attractive to a local store owner. Once again, if the appeal is to an owner/occupant rather than an absentee investor, it is less likely that the value will be determined by the rent potential and more likely that it will be a function of the local market for similar properties.

Conclusion

As I said at the outset, understanding when one approach to value might be more appropriate than another is not just an academic exercise. So often we hear people talk about how they expect the value of their income property investments to rise because “real estate (i.e., their home) is going up.” As Gershwin could tell you, it ain’;t necessarily so. An example I’ve used before (but I’m allowed to repeat myself) is that of a rapidly growing community where local developers feel inspired to build office space — so much space that office rents and office building values decline even while home prices rise.

Similarly, we find folks who are surprised that a duplex or triplex will sell at a price much too high for an investor to achieve a positive cash flow, not realizing that the property is selling as a home that incidentally has rental income and not as a strictly commercial income property.

Estimating the value of a piece of real estate will probably always remain part art and part science. Matching the right methodology to a particular property is an essential first step for anyone trying to make real-world investment decisions he or she can live with.

Copyright 2006, 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.

 

Making the Case for Your Commercial Refinance, Part 2

Posted on by Frank Gallinelli

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

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

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

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

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

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

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

sample residential rents, first year

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

sample residential rents, five years

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

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

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

sample commercial rents

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

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

sample combined income

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

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

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

sample APOD

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

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

sample taxable income

sample cash flow

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

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

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

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

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

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

sample mortgage payoff

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

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

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

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

sample executive summary

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

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

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

sample business plan, part 1

 

sample business plan, part 2

 

sample business plan, part 3

 

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

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

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

You’ve got it all covered.

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

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

Copyright 2009, RealData® Inc. All Rights Reserved
The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide  legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.
You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

Making the Case for Your Commercial Refinance, Part 1

Posted on by Frank Gallinelli

Since we released the original version of our Real Estate Investment Analysis software in 1982, our focus has been on pro forma financial analysis of real estate investments and of development properties – projecting the numbers out over time to help users gain a sense of what kind of investment performance they might expect from a particular property or project.

And for lo, these many years, our customers (and from time to time, we ourselves) have used the software to help make decisions as to whether or not to buy a property, and at what price and on what terms. Customers have used it to model how things might play out in the worst case, or in the best case, or somewhere in between. They have used it also to compare alternative investment opportunities.

This type of decision-making process has by far been the most common use of our software. More and more, however, we’ve seen an increased use of these pro formas for the purpose of making presentations to potential equity partners and to lenders.

Which brings us at last to the point of this article. When the economy is blazing away at warp speed, everything is – or at least seems – a bit easier. Forecasts are easier to meet, and partners and lenders are easier to find. But sometimes the economy is not so good, and presents us with new challenges. At this writing, we find ourselves in the middle of a bad case of credit lockjaw. Nothing lasts forever (which in this instance is a good thing), so eventually our credit markets and overall economy will rediscover their equilibrium.

This is all fine, unless you’re holding a property today with a mortgage that will balloon in the near future. In that case, you need to find a new loan, and you’re probably going to have to work for it. That means doing some homework, understanding the process, and building the most compelling case you can for approval of that new loan.

If you were trying to refinance your home, you would be dealing with recent sales of comparable houses, your personal income and debt, and your credit score. With the possible exception of working to get your credit report in order, there’s not a great deal you would do personally to build a case for your re-fi. With an income property, however, a carefully prepared presentation can go a long way in helping you convince a lender – or even a new equity partner – that you have a viable investment.

Re-enter your friend, the pro forma analysis. You may have thought he was on vacation until sales of real estate revived, but in fact he’s as busy as ever with financing and partnerships. If the numbers do indeed work for a property whose balloon is coming due – and sorry, don’t expect to transform a bad investment into a good one with just a pile of color charts – then a detailed pro forma may be that property’s best friend.

Don’t even think about starting that pro forma until you’ve done a bit of legwork and preparation. First you’re going to need some information that is external to the property itself. You need to know the prevailing market capitalization rate for properties of the same type as yours (i.e., office, retail, apartment, industrial, etc.) and in the same market. This information will be critical to estimating the current value of the property. Perhaps the best place to seek this information is from a local commercial appraiser. The bank will certainly use an appraiser, and the appraiser will certainly use a cap rate, so don’t get left out of the party. For the sake of the example we’re going to construct here, say that the commercial appraiser tells you the prevailing cap rate for properties like yours in your market is 11%.

Next you need to learn about underwriting criteria from your potential lenders. Specifically, you need to know the probable interest rate and term of the new loan; the lender’s maximum Loan-to-Value Ratio; and the lender’s minimum required Debt Coverage Ratio. Don’t assume that these criteria will be identical across all lenders or across all property types. In fact, they probably will not. It should not surprise you that different lenders quote different interest rates, but you must also recognize that the same lender may be willing to lend 80% of the value of an apartment complex, but only 65% of the value of a shopping center. Know the lender’s terms before you ask for the loan.

For the purpose of this example, let’s say you’ve called your current lender and found that their maximum Loan-to-Value Ratio for a property like yours is 75%. They require a Debt Coverage Ratio of at least 1.20, and if all looks good, they will loan at 7.75% for 15 years.

We’ll discuss these criteria in detail in a moment, but for now let’s stay focused on collecting information, this time about the property itself. You need to assemble the amount of actual current rent income from each unit and identify the market rent of currently vacant units. You need to make realistic estimates of rental income for the next several years, taking into account the terms of leases now in place. You must figure your current year’s operating expenses, keeping in mind that certain expenditures such as debt payments, capital improvements and commissions should not be included. Nor should you include depreciation or amortization of loan points, which are deductions but not operating expenses. Once again, you have to make some realistic estimates as to how these expenses may change over the next several years. Finally, of course, you have to learn the balance of your current mortgage, so you’ll know how much of a re-fi you require.

Let’s return now to the underwriting criteria you identified, and start with the Loan-to-Value Ratio (LTV):

Loan-to-Value Ratio = Loan Amount / Lesser of Property’s Appraised Amount or Actual Selling Price

If this is a re-fi, then there is no “selling price,” so the value here will be the amount for which the property is appraised. If your financial institution has not taken leave of its senses (in general, if it has not appeared in the headlines or before a Congressional subcommittee in the last six months), then it should be reluctant to loan you or anyone else 100% of the value of a property. They expect you to have some skin in the game, and the question is merely how much.

The lender will quote you their maximum LTV, and before you get anywhere near an application form, you are going to perform your own calculation with your particular property. How much of a loan do you need to replace the existing financing, and how does that relate to the current value of the property?

It should be clear enough that the lower your actual LTV, the more likely you are to secure the loan. The lower the LTV, the more you, the borrower have to lose and the less likely you are to walk away. A low LTV may even earn you more favorable terms. You know how much of a loan you need, so to determine the LTV of your proposed loan, you must estimate the value of the property. Find that value with the same method the lender’s appraiser is likely to use: by applying a capitalization rate to the Net Operating Income (NOI). You already called around to find the prevailing market cap rate, so now you need to calculate the NOI. The most direct way to do this is with the venerable APOD form, where you list your annual income and expenses:

sample APOD for commercial refinance

The total of your scheduled rent income for this year should be $219,600, but because of vacancy and credit losses you will actually collect $210,816. Your various operating expenses total $51,050, leaving you a Net Operating Income of $159,766.

Remember that an appraiser told you the prevailing cap rate for this type of property in your market area is 11%. You have what you need to estimate the value of the property:

Value = Net Operating Income / Capitalization Rate
Value = 159,766 / 0.11
Value = 1,452,418

Round that off to $1.45 million.

You’re ready now to perform your first underwriting calculation. Recall that your lender’s maximum Loan-to-Value Ratio is 75%. Your current loan – the one that is about to balloon – has a balance of $975,000.

Loan-to-Value Ratio = Loan Amount / Lesser of Property’s Appraised Amount or Actual Selling Price
Loan-to-Value Ratio = 975,000 / 1,450,000
Loan-to-Value Ratio = 67.2%

Assuming the lender’s appraiser agrees with your estimate of value, you’ve cleared your first hurdle. Being a cautious individual, however, you want to know your worst-case scenario. What is the lowest appraisal that would still allow your $975,000 re-fi to meet the lender’s LTV requirement? Simply transpose the formula to solve for a different variable:

Property’s Appraised Amount = Loan Amount / Loan-to-Value Ratio
Property’s Appraised Amount = 975,000 / 0.75
Property’s Appraised Amount = 1,300.000

Any appraisal over $1.3 million will be good enough to satisfy the 75% Loan-to-Value requirement.

You will want to build a pro forma that goes out a least five years, so you can demonstrate to the lender that your anticipated cash flow and debt coverage are solid and likely to stay that way. Before you do so, however, there is a formula you can use that will give you a quick estimate of the maximum loan amount that the property’s current income can support. Remember that the strength of an income property lies in the strength of its income stream. This is how the lender will look at your proposal, so it’s what you need to do as well. Here is the formula:

Maximum Loan Amount = Net Operating Income / Minimum Debt Coverage Ratio / (Monthly Mortgage Constant x 12)

You know that your Net Operating Income is $159,766, and the lender has told you the Minimum Debt Coverage Ratio is 1.20. But what’s this Monthly Mortgage Constant?

A mortgage constant is the periodic payment amount on a loan of $1 at a particular interest rate and term. If you know the constant for a loan of $1, you can multiply it by the actual number of dollars of the loan to find the payment amount.

Readers of my books have access to a web site with a variety of tools, including a table of mortgage constants. You can also calculate the Mortgage Constant using this formula in Microsoft Excel:

=PMT(Periodic Rate, Number of Periods, -1)

In the Excel formula, the amount of the loan must be entered as a negative number. In the case of a mortgage constant, we want to use a loan of $1, hence the -1. In the case of a loan at 7.75% for 15 years, the formula would look like this:

=PMT(0.0775/12, 180, -1) = 0.00941276

Since this loan is going to be paid monthly, you express both the rate and the number of periods as monthly amount. Format your answer to display at least eight decimal places.

Now you have all the elements to plug into the formula for maximum loan amount: the Net Operating Income, the minimum Debt Coverage Ratio, and the Mortgage Constant.

Maximum Loan Amount = Net Operating Income / Minimum Debt Coverage Ratio / (Monthly Mortgage Constant x 12)
Maximum Loan Amount = 159,766 / 1.20/ (0.00941276 x 12) Maximum Loan Amount = 133,138.33 / (0.00941276 x 12)
Maximum Loan Amount = 133,138.33 / 0.11295312 Maximum Loan Amount = 1,178,704

Keep in mind that rounding could alter your answer by a few dollars.

(An aside: If you’re the sort of person who does not like to play with long formulas, or who tends to tap calculator keys with a closed fist, we have a solution for you. The RealData Real Estate Calculator – Deluxe Edition, will do all of these underwriting calculations for you, as well as perform a host of other useful real estate functions, including amortization schedules for loans with a variety of terms. There are sixteen modules in the Calculator. Find more info at http://realdata.com/p/calculator.)

Your lender will surely round this result, probably down to something like $1.175 million. But you’re looking for just $975,000, so it appears that your income stream will support this loan request. You will want to verify this by calculating the property’s Debt Coverage Ratio going out five or more years. You’ll do that as part of your property pro forma, in the next installment of this article.

Up to this point, however, you’ve accomplished quite a bit: You learned what information you need to assemble about your lender’s underwriting process, about your property’s income, expenses and loan balance, and about the prevailing cap rate in your market. You’ve learned to use some of that information to estimate the current value of the property, then taken that result to determine if the property will likely satisfy the lender’s Loan-to-Value requirement.

You’ve learned about another underwriting metric, Debt Coverage Ratio, and about mortgage constants. You’ve seen how to combine those to test your property’s income stream to see if it’s strong enough to support your loan request.

Not bad for an hour or two of work.

Next time you’ll see how to assemble this information and more into the kind of professional presentation you can give to a potential lender or equity partner.

Copyright 2009, RealData® Inc. All Rights Reserved

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

Cash Flow Analysis — Annual or Monthly?

Posted on by Frank Gallinelli

A reader of one of my books wrote to me recently with a very worthwhile question.  When we build a pro-forma analysis of future cash flows from a real estate investment, why do we annualize those cash flows instead dealing with them on a monthly basis?  After all, rent is typically collected and bills paid monthly.

The quick and facile answer, of course, is because we’ve always done it that way. Back in the day, we didn’t have powerful personal computers and sophisticated real estate software, so one might argue that this annual approach is just a holdover from a golden age that has passed us by.

Then again, there may be some wisdom inherent in this approach. To make monthly estimates of future cash flows requires monthly, rather than annual, estimates of income, expenses and debt service. The task is not impossible, but collecting, organizing, and deploying this amount of data will surely take much greater time and effort, presumably up to twelve times as much. And we all know that time is money.

Is it practical to do this, and if so, is it worth the effort?  It’s important to keep in mind that you’re not performing an accounting function but rather making projections about what’s going to happen in the future. It’s often difficult enough to estimate your annual cost for heating fuel or electricity five years hence. Trying to estimate such costs by the month can be even more problematic and time-consuming.

Assuming that someone else hasn’t already closed on this property while you were playing Hamlet, did you in fact gain any additional insight or advantage as a reward for your extra effort?

A monthly projection of future cash flows substantially increases your “degrees of freedom” in making estimates, so the monthly estimates are not only more difficult to make, but they also provide you with many more opportunities to be wrong. To put it another way, you are just as likely to introduce errors in timing as you are to add precision, thus offsetting at least some if not all of the benefit of your considerable extra effort.

Having said all this, it is also true that a dramatic skewing of cash flow toward the beginning of a year could make a noticeable difference in a particular discounted cash flow calculation. One might feel that is justified to handle such an atypical income stream differently.

For what it’s worth, my opinion is that the conventional wisdom here actually makes sense. Forecasting the future is an imperfect art; in most situations, annualizing the net cash flow is a reasonable compromise with reality and a task of more manageable proportions.

Frank Gallinelli

Making the Case for Your Commercial Refinance

Posted on by Frank Gallinelli

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.

New investment analysis service — and data form

Posted on by Frank Gallinelli

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 using the form in the right sidebar >>.

Frank Gallinelli
realdata.com

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

Posted on by Frank Gallinelli

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

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