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## The Case of the Mysterious Sinking IRR

Users of our Real Estate Investment Analysis program sometimes call us with questions that are not about the software but about the underlying analysis. If we had a “greatest hits” list for those questions the all-time winner would be this: “My cash flow goes up each year; the value of the property goes up each year; but when I look at the Internal Rate of Return, it goes down almost every year. What’s up with that?” To see how this can happen, let’s take a look at two very simple examples.

Example #1: We purchase a property for \$100,000 all cash. It has a Net Operating Income of \$10,000, so the capitalization rate is 10%. We are going to assume that 10% is the right cap rate for this market (primarily because it make the math in our example easy to follow). Because we bought the property for cash there is no debt service and so we can also assume that the cash flow is the same as the Net Operating Income. For those who require an instant (and very abbreviated) refresher course on these concepts, use the following:

• Gross Income less Operating Expenses equals Net Operating Income
• Net Operating Income less Debt Service equals Cash Flow
• Net Operating Income divided by Capitalization Rate equals the property’s Present Value

The property is in good shape and is running well when we buy it. Our initial cash flow occurs on Day One when we spend \$100,000 in cash to make the purchase. We project that we can raise the rent 4% during the first year to \$10,400. The property is well-located, so we believe we can get a bit more aggressive over time. We’ll project that we can increase the revenue 5% in the second year, 6% in the third, 7% in the fourth and 8% in the fifth. Here is what our projections look like:

Notice that, if we sell the property at the end of one year for its full value (i.e., with no selling costs, to keep matters simple), our Internal Rate of Return (IRR) is a pleasing 14.4%. If we sell at the end of year two, our IRR for that holding period is even better, 14.92%. If we hang on to the property for five years, we see that we can expect a 16.38% IRR. The rents go up each year, the value goes up and so does the IRR. All is right with the world.

Example #2: At the same time we buy another property, also for \$100,000 cash. It too has a \$10,000 NOI, but this property needs immediate management improvements to control expenses and to get rents in line with the market. We feel sure that we can get the NOI (and hence the cash flow) to \$12,000 in the first year. That should get it on a stable footing, from which we expect a more modest 3% increase in rent each year thereafter. The rents go up each year, the value goes up each year, but what about the IRR?

At the end of the first year, we’re thrilled by a robust IRR of 32%. We worked hard; we deserve it. But if we hold the property for a second year the Internal Rate of Return drops to 22.76% — still not shabby but significantly lower than at the end of the prior year. Indeed, the longer we hold the property, the lower the IRR becomes. What, to coin a phrase, is wrong with this picture? Nothing is wrong, actually. The numbers are correct. Remember that Internal Rate of Return is a time-sensitive measurement. The biggest jump in cash flow and in the property’s value came early. The earlier it arrives, the less severely it gets discounted — it’s the “time value of money” concept. The increases that occur in years two through five are smaller to begin with and they get discounted over a greater number of years, shrinking their worth to us today even more.

Simply put, if we hold the property two years instead of one, then that second year dilutes the overall rate of return because it didn’t contribute as much (especially after an extra year of discounting) as the first year did. If we hold the property for three years, the return gets diluted still further.

At this point, someone in the back of the room is surely asking the insightful question, “So what?” Here’s what: The first property is telling us that it will perform better as an investment if we hold onto it for a while. Its rent increases are accelerating each year. Even though the increases have to be discounted — it’s that time value of money again — they’re growing at a pace that makes them worth waiting for. Hence the IRR gets higher with each year we hold on. The second property, however, has a bit more of a roman candle quality to its performance. The big flash comes early; after that, it just sputters along.

Does this mean you should immediately sell such a property? If you’re happy with the long-term IRR and could not find a replacement property with a greater yield, it might make sense to hold. Or you might be more comfortable following the words of immortal Janis Joplin: Get it while you can. To put that in more businesslike terms, you might decide to sell the property when the IRR peaks; then take the proceeds and reinvest them. Whichever way you go, the important thing is that you’ll be making an informed decision.

Better than being like this guy.

If you found this example helpful, I have a lot more educational material for real estate investors and developers. For example, check out these video lessons…

Real Estate Investment Case Studies where I take you step-by-step through the evaluation of five different property types: apartment, mixed-use, triple-net leased, retail strip center, and single-family property

Value-Add Real Estate Investments where I show how you might do something tangible or intangible to a property, but in either case, something that increases how much a person would pay to acquire that asset from you when you’re done.

Or if you’re ready for a complete training series in real estate investment, development, finance, partnerships, and more, consider Mastering Real Estate Investing.

—— Frank Gallinelli

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

## Real Estate Investing: Time to Remember the Lessons of History

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

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

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

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

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

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

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

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

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

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

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

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

— Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

## Investing in Real Estate: How Much Analysis Do You Really Need?

More than once – in my writing, my teaching, talking in my sleep – I have been known to say that real estate investing is all about the numbers. There is, of course, great truth in that pithy statement, or so I believe; but there is perhaps more to the story that you should be careful not to overlook.

The data that you collect about an income-property – the current rental income and operating expenses, the financing options, and the resulting cash flows and potential resale– are all essential to making an informed analysis of a property’s value and its appeal as an investment. So too is an understanding of the key metrics. What are the expected Debt Coverage Ratio, Capitalization Rate and Internal Rate of Return, and what do they all mean?

A wise investor realizes that this information represents the foreground, but not the complete picture. There is a context, a background, in which these data reside, and you ignore it at your peril.

When I teach real estate investment analysis to my graduate students, I begin by telling them that they absolutely must learn how to run and interpret the numbers. But I also stress (sometimes to the point of becoming really annoying) that they have to look behind the numbers, to read the information about the property as if it were a story. The financial facts and figures about a property that you uncover today may be entirely accurate, but can you rely on them them to persist? What are the long-term risks and opportunities, the indirect factors, and how do they inform the numbers that you will plug into your projections?

For example, if you have commercial tenants, how strong are their businesses? One of the case studies I give my students is a mixed-use property with retail tenants whose business models are on the decline. Those tenants have leases with options to renew, but if their customer bases are shrinking, isn’t it more prudent to suspect that they may not choose to renew? Shouldn’t you also consider what could happen to your cash flow in a worst-case scenario, where they go bankrupt before their current leases are up?

Rather than simply assuming an ongoing revenue stream from the current leases, perhaps, as I tell my students, you need to look beyond the current numbers. If you see some significant risk going forward, maybe you should build rollover vacancy, leasing commissions and tenant improvements into your projections of future performance. You’re still going to run the numbers, and they still matter; but now, taking a broader view may alter your perspective on possible future cash flows.

One way to widen your field of vision is to go beyond the specific property and take into account some intangibles, both local and global. Real estate, like politics, is very much a local game. How strong is the local economy? Is unemployment a problem? What is the trend in the absorption of space – are vacancies growing or declining? Where is your city or town’s budget heading? Are there bond issues on the horizon that could materially affect your property taxes? The answers to questions like these will connect directly to the kinds of assumptions you make concerning the risk of future vacancy loss, and the rate of growth, if any, in your rents.

Then there’s the global view. You want to look at how the overall economy might affect your property. For example, it is typically the case that in times of tight credit, or in a miserable economy such as we’ve seen for the past several years, demand for apartments tends to increase. There is nothing surprising in this. Folks can’t get mortgages because their incomes have dropped and perhaps because banks aren’t lending freely. People who would otherwise be prospective homebuyers or who would be able to stay in their current homes are now renting apartments, thus reducing vacancy and often pushing rents upward.

The same causes – a wounded economy and lack of credit – might lead to an opposite effect on office and retail space, where businesses have to downsize because their customers have less money to spend.

So, if you find yourself rolling into a particular economic cycle, then you will want to adjust your projections for the future accordingly. In the example above, you would begin with whatever revenue stream you find in place; then, in the case of apartments, you would probably project declining vacancy loss and increasing rental rates for a few years, but you would probably do the opposite for retail and office. Same starting point, but different paths into the future.

What is our takeaway here? First, that real estate investing really is about the numbers. You’re going to scrutinize every lease, every operating expense, every financing option to understand how you believe the property will function on the day you acquire it. There is no substitute for crunching these numbers, and no reason to dismiss what they tell you.

But then you’ll pause to recognize that you’re probably going to own the property well beyond that first day. That’s when you need to look up from your spreadsheet. You need to look both at and beyond the current data and metrics, to visualize the property and your expectations for it in the context of its larger environment. The numbers truly matter, but so does the sometimes dicey, not-so-tidy real world in which they dwell.

–Frank Gallinelli

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 blog posts and 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.

## Refi Existing Investment Property to Purchase Another?

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

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

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The Good News

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

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

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

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

But Wait… Some Issues and Considerations

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

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

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

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

Frank Gallinelli

## 5 Mistakes Every Real Estate Investor Should Avoid

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

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

1. The Formula That Doesn’t Compute

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

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

2. The Modern Art Syndrome

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

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

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

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

Labels need to be unambiguous:

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

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

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

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

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

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

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

4. What’s Wrong with This Picture?

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

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

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

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

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

5. What You Don’t Know CAN Hurt You

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

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

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

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

The Bottom Line

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

Let me suggest three other important steps you can take:

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

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## Making the Case for Your Commercial Refinance, Part 2

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:

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%.

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.

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.

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:

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.

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?

 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:

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.

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:

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.

## 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)

 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.