Net Operating Income Archives - Page 2 of 2

The 50% Rule vs. Discounted Cash Flow Analysis

Posted on January 7, 2014 (May 3, 2022) by Frank Gallinelli

I like to read the discussions in a number of online real estate investment forums to see what issues are of interest to investors at all levels of experience. One topic that seems to excite a lot of commentary concerns the relative merits, or lack thereof, of projecting and analyzing the potential future cash flows from an investment property—call it Discounted Cash Flow (DCF) or pro forma analysis. Since I’ve spent a good part of my professional life teaching on this subject and providing software tools to accomplish such analyses, discussions like these jump out at me; and my last post promised a follow-up to my discourse on the income stream, so the saga continues.

I frequently see people lament that a cash flow pro forma is basically pointless. You can’t predict the future; more specifically you can’t predict what a property’s revenue or expenses will be in any given year, so why bother trying? It’s a waste of time, so they say. I think this is an unnecessarily nihilistic take on investing, reducing attempts at thoughtful analysis to the level of palm reading and tarot cards.

The 50% Rule

Recently I have seen a lot of mention of a so-called “50% rule” as an alternative to DCF. If I understand it correctly, this rule says, “Take the gross rent and subtract 50%. That’s your Net Operating Income. Subtract your debt service and that’s your cash flow.”

So, 50% is supposed to account for your vacancy loss, operating expenses, reserves, and capital costs. Actually, these last two items aren’t part of NOI, but why quibble?

Somehow I can’t shake off the image of Michelangelo creating the Sistine Chapel ceiling with a paint roller. Same level of precision.

Clearly, one set percentage—50% or anything else—could not possibly be appropriate for all property types, even in the same market. You would not expect your percentage of operating expenses for a triple-net-leased single-tenant building to be the same as that for an office building. Even within one property type, would you bet the farm on the expense percentage for a 100-unit apartment complex to be identical to that of a 6-unit multi-family house?

Let’s grant that a certain expense percentage might be typical for a given property type in a given location. Would you really be comfortable using that percentage to make a specific purchase decision? It might work out if you were buying the entire market, but would you risk your investment capital on the assumption that the one property you want to buy is truly typical of the entire market?

Sadly, I find too many investors dismiss the importance of doing a Discounted Cash Flow Analysis and opt instead for this sort of very simplified—dare I say oversimplified—approach. Such a technique might suffice as a general guideline for smaller properties, but when one gets involved with true income properties—larger residential or just about any size commercial investment—I don’t see how you can commit a serious amount of cash without performing a DCF analysis as part of your decision-making process.

Due Diligence and DCF

I talk a lot in my books, articles, and podcasts about the importance of due diligence; and that process is really at the heart of making an intelligent and informed cash flow projection. You cannot know your future operating costs precisely, nor perhaps your revenue; but you can certainly make reasonable estimates that are not just global generalities but are specific to the investment you’re considering. Keep in mind that due diligence for a real estate investment has two distinct parts:

The property itself — What is the actual current revenue? Do the leases call for scheduled rent increases? What are the current, verified operating expenses, and what are reasonable estimates going forward? Does the physical condition of the property suggest capital expenditures will be needed during your expected holding period? Will you set aside reserves for those? What are the costs and terms of available financing for this property?
The market — Properties don’t live in a vacuum, so market data is crucial. What are the prevailing rents for this type of property in this market (i.e., what is the competition)? What are the local vacancy levels, cap rates, and general economic trends?

Next, use that data to project current performance along with best-case, worst-case, and in-between scenarios of future performance. This is where you start to take the investment’s vital signs: Under what circumstances will the cash flow be adequate, is the debt coverage ratio strong enough to secure financing with a given down payment, what if a commercial tenant’s shaky business fails before their lease expires?

Use the projections not only to make a decision about an appropriate price and terms for the property, but also use the DCF to demonstrate (i.e., “sell”) your reasoning to the other parties involved in the transaction: to the seller if you’re the buyer, the buyer if you’re the seller; to the lender; or to your potential equity partners.

Investment is all about balancing risk and reward; and these, in turn, require a willingness to make investment decisions in an environment where you necessarily have to work with incomplete or imperfect information. If there were no uncertainties, then everyone would be a winner.

Uncertainties such as these, however, are in the context of the actual property and the actual market. They are not the random application of a universal constant that has no particular connection to the investment under consideration. Buying and operating an investment property involves commitment, and that should start with a thorough financial analysis. Projecting the potential future performance of an investment property, especially with multiple scenarios, is the best way to make an informed and intelligent decision.

— Frank Gallinelli

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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.

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

The Cash-on-Cash Conundrum, Part 2

Posted on September 30, 2013 (May 3, 2022) by Frank Gallinelli

In the first part of our discussion, you looked at the simple math that underlies Cash-on-Cash Return. The short version goes like this: First you calculate your property’s first-year cash flow before taxes—essentially all the cash that comes in from operating the property minus all the cash that goes out. Then you divide that by your initial cash investment, and that percentage is your Cash-on-Cash Return. Nothing could be simpler.

Simplicity is a good part of CoC’s appeal. Unfortunately, that is also part of its weakness. If you are using this metric to help you decide whether a potential income-property purchase is a promising investment or not, then you need to look carefully at the story—or stories—that may lurk behind these numbers. In keeping with our literary metaphor, let’s call them our subplots.

Subplot #1: A Point in Time

Clearly, when you take the first-year’s cash flow and divide it by the cash used to purchase, you are looking at a property’s performance essentially at a point in time, a single year. To be sure, the reliability of your cash flow projection is likely to be greatest in that one, immediate time frame. I often hear investors say that they are not comfortable trying to predict the future, that they would rather just look at what is happening now; and they are quite justified in saying that if the return looks grim or perhaps negative right out of the box, then they have no interest in looking further.

Understandable, but potentially shortsighted—literally. By looking at a single year, you are looking at what may be an improbable investment horizon. Will you keep this property for just one year? If not, if you plan to hold on to it longer, then you’re not taking into account anything having to do with its possible future performance. Do you believe each future year will be exactly like this year, or could reasonably anticipated changes in cash flow (such as schedule increases in commercial lease rents, or large expenditures for needed repairs) push the needle far to one end or the other?

Subplot #2: The Time Value of Money

“All right,” you say, “then I’ll estimate the Cash-on-Cash Return for each of the next several years.” That may look like a step in the right direction, and I talk to a lot of folks who insist on doing just that, but it won’t take into account the time value of money. You’ll be looking at the face value (undiscounted) of expected future cash flows, and weighing them against the present value of your cash investment today. Go back to that original example, where you invested $100,000. If you predict a $20,000 cash flow ten years from now, does that really mean your investment is returning 20%?

To be fair, future-year Cash-on-Cash can impart some useful information. For example, if the metric is both positive and increasing, then you can infer that your cash flow is improving each year. The trend can help inform your decision, but the actual percentage return may not have a great deal of meaning.

Subplot #3: Smoke and Mirrors

You retreat and say, “OK, let’s go back to thinking about just the first year of operation. Surely the Cash-on-Cash should give me a good sense of initial performance.” Do you remember the old computer chestnut, “Garbage in, garbage out?” Your results are only as good as the assumptions and data that you put in the dispose-all, and perhaps things aren’t always (or ever) what they seem.

Consider:

You are looking at in income-and-expense statement (what we call an APOD in real estate investing—Annual Property Operating Data) provided by the seller of the property. The cash flow is based, in part, on operating expenses, one of which is Maintenance and Repairs. The figure in the example above is $6,000; you secure the owner’s tax return and confirm that this is indeed the figure he declared.

That is how much he actually spent, but the figure seems a bit low to you. Does it mean the owner performed as little maintenance as he could get away with and never fixed anything until it was absolutely necessary? Perhaps the owner did this to prop up the property’s cash flow in anticipation of selling. Despite the fact that the expense disclosed is technically correct, you decide you shouldn’t use it as a forward-looking assumption. Instead, you will probably have to project spending more once you take ownership, resulting in a diminished cash flow and a lower Cash-on-Cash Return. In addition, the property may actually be worth less than you assumed, since it does not throw off as much net income as you were led to believe.

Now take a different point of view. Based on your experience, you think the maintenance and repair expenditure shown is surprisingly high. Could there be an explanation for that? Perhaps the owner used the past year to catch up on deferred maintenance so the property would look more presentable when he put it up for sale. You might be tempted (but only in your most private thoughts) to test the impact of lower maintenance costs on your cash flow and CoC return. Once again, the amount that was disclosed, although correct, may not be the amount that gives you the best estimate of future cash flow or Cash-on-Cash Return.

Subplot #4: The Forecast—Cloudy, with a Chance of Cash Flow

Finally, there is the larger issue of the structure of the cash flow statement itself. What you decide to include or exclude in your forecast of future cash flow will almost certainly be driven by your personal agenda in creating that cash flow statement. Are you the seller of the property, looking to make its income stream appear as strong as possible? Are you the buyer, trying to make a realistic projection of how this property will really perform, and perhaps also conveying that stark realism back to the seller as part of your price negotiation?

In either case—as well as in any of several others, such as buyer looking for financing, general partner looking for equity investors, etc.—you might be putting a bit of a spin on the data, the better to support your point of view and the message you want to deliver.

If you’re the seller, then a bit of topspin seems like a good idea to you. In the example shown in Part 1 of this discussion, you might argue that, not only did you provide accurate and verifiable income and expense data, but that you were being exceptionally open and above-board by suggesting an allowance for vacancy and credit loss even though you experienced no such loss. Group hug.

But if you’re the buyer, you might return this with some backspin. You thank the seller for being so forthright, but add that you believe the vacancy and credit loss allowance should be closer to 5%, not 3%. In addition, you point out that routine maintenance is great, but will not prevent big-ticket items from wearing out eventually. For example, the heating boiler is barely hanging on, and the flat roof has less than 10 years of life left in it. Hence you propose reconstructing the cash flow statement to reflect the higher vacancy allowance, as well as need for an immediate capital improvement and an ongoing set-aside of cash flow into a reserve account to deal with future replacements, such as the roof.

What previously was a robust 10.4% return now becomes an anemic 2.1%.

The seller objects that this isn’t entirely fair, since the boiler repair is a one-off event, and removing that cost would bring us up to 6.1%.

The seller’s argument cycles you right back to Subplot #1 about the hazards of relying on a rate-of-return metric that looks only at a point in time in what is probably going to be a long-term investment.

Is There a Bottom Line?

What should you conclude about Cash-on-Cash Return? Is it, as some contend, the only metric worth looking at? Is it of no use at all? The best answer probably lies somewhere in between, that you need to recognize both CoC’s strengths and its limitations, and not rely on it as your sole investment decision-making tool.

On the plus side:

It is quick and easy to calculate.
It can give an immediate comparison to the return on other short-term investments.
It focuses on the most current performance of the property; the more recent the data, the more likely it is to be reliable.

Among the negatives:

It focuses on single point in time; you may be intending to buy and hold for an extended period, and the future performance of the property can differ greatly from the short term.
It does not take into account the time value of money; if you use it beyond the current period, you may be comparing a future, undiscounted cash flow to the amount invested today.
It is easy to manipulate the results; hence, a novice investor who relies on this metric alone can be misled by what a third party chooses to include or exclude from a property’s cash flow statement.

So are there some bottom-line recommendations here? Of course.

Start off by trying to develop a CoC calculation in which you can have reasonable confidence.

To do so, remember that there is no substitute for due diligence. At the most basic level, you need to confirm whether the data you see on the cash flow statement for a particular property is reasonable and accurate. Then you need to go further and examine the physical property and the market to see if there are issues that may affect your confidence in those numbers. Is there any reason to doubt that the current revenue stream will continue as it is now? Is the demand for space in this market changing, for good or ill? Is there deferred maintenance that you will have to deal with? Based on what you find, you may have to reconstruct that cash flow statement.

Don’t just look at what is on the cash flow statement; look for what might be missing. A seller may not volunteer an allowance for vacancy or a need to fund a reserve account, but such items are going to be part of your reality as an owner.

So long as you approach it with sufficient care and due diligence, the Cash-on-Cash Return can give you a useful first look at how a property might perform; but before you commit your investment dollars, you need to do more.

If you plan to operate this property for several years, then you need to take the long view. You should identify your likely investment horizon, and then build a series of pro formas to forecast how the property might perform over time.

A series? Yes. Don’t try to nail your projections of future performance in one pass. Do a best-case, worst-case, and in-between forecast of future cash flows and ultimate resale of the property. Look at the ongoing Debt Coverage Ratio in each case. Examine the IRR or MIRR. Even compare this property to others you might be able to acquire.

Be thorough. Be wary of shortcuts. You’re buying a future income stream; do your homework and run your numbers so you can understand just what it is that you’re buying. Your investment success depends on it.

read my postscript

— Frank Gallinelli

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

The Cash-on-Cash Conundrum, Part 1

Posted on September 25, 2013 (March 15, 2022) by Frank Gallinelli

Life is too complicated; we have too many choices, too many options, too many channels on cable TV. It’s not surprising that sometimes we crave simple answers to complex questions.

I see that mindset very often in my interactions with real estate investors. They yearn to embrace the “50% rule” or the “2% rule” or some other shortcut that will help them cut to the chase and decide if a particular property is a good deal or not.

One metric that is relatively simple and historically very popular is the Cash-on-Cash Return (CoC). I encounter many real estate investors (more than a few of whom have a net worth significantly greater than that of this writer) who zero in on that metric like a heat-seeking missile whenever they consider buying a property. What exactly is Cash-on-Cash Return? How do you calculate it? What are its strengths and weaknesses? Is it a good metric, and perhaps more important, is it good enough?

Cash-on-Cash Return may be one of the few bits of financial terminology whose name could almost serve as its definition. You’re expecting to get a cash return on your cash invested, i.e., to earn cash on your cash. If you express the return as a percentage of the amount invested, then you have the Cash-on-Cash metric.

Let’s see this with some actual numbers. You are considering the purchase of a particular income property. For this discussion, the purchase price of the property is not the number you want to focus on. Rather, it’s the amount of your own money—the cash you actually put on the table—that you’ll be looking at. You need $100,000 to close the deal.

You’ve obtained information about the rental income, the operating expenses and the expense reimbursements paid by the tenants. To that information you’ve added your own allowance for vacancy and credit loss, as well as your expected annual debt service on the mortgage that you’ll need to complete the purchase. You put this all together into a cash flow statement that looks like this:

Now you do the cash-on-cash math:

So now you see your Cash-on-Cash Return is apparently 10.4%. What are you to make of this?

First, you recognize that this was a very quick and easy calculation to perform. You needed just the amount of your cash investment and some basic information about anticipated revenues and expenditures. No heavy lifting here.

Second, you observe that your cash-on-cash (and therefore your cash flow) is a positive number. That’s really important, because it means you don’t expect to reach into your own pocket to pay the bills. You have more coming in than going out.

Third, you recognize that this really quick calculation allows you to compare the first-year return on this investment to that of other short-term opportunities like CDs or T-Bills. You look at 10.4% and that strikes you as a fairly good rate of return.

In short, your initial take here is that this metric was really easy to calculate; that it told you that the property seemed likely to enjoy a positive cash flow in the first year; and that the rate of return on your cash investment appeared to be significantly better than you might get from a bank or a bond.

Are you satisfied that you can make an informed decision to buy or not to buy this property based on your calculations here? You shouldn’t be. Yes, you believe the rent and expense figures are accurate, and you did the math correctly, but are you confident that you’re seeing the complete picture? My continual mantra to my finance students is, “Look beyond the numbers, look for the story that’s behind what you see on the surface.”

It’s tempting to think that this calculation of cash-on-cash has given you an adequate perspective on how this investment will perform, but there is really a great deal more to look at and to think about here. That’s what we’ll do in the next installment.

(to be continued part 2)

— Frank Gallinelli

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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

Posted on September 11, 2013 (September 6, 2022) by Frank Gallinelli

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 recovery—and, 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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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.

Refi Existing Investment Property to Purchase Another?

Posted on November 4, 2011 (March 28, 2022) by Frank Gallinelli

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

Posted on October 21, 2011 (May 2, 2022) by Frank Gallinelli

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.

####

Want to learn more?

Read What Every Real Estate Investor Needs to Know About Cash Flow… and 36 Other Key Financial Measures and Mastering Real Estate Investment

Visit the “Blog” page at www.realdata.com

Finally, check out RealData’s real estate investment and development analysis software.

Making the Case for Your Commercial Refinance, Part 2

Posted on November 7, 2009 (May 3, 2022) 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:

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 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.

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Making the Case for Your Commercial Refinance, Part 1

Posted on October 20, 2009 (May 2, 2022) 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.

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

Posted on August 10, 2007 (May 2, 2022) by Frank Gallinelli

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

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

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

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

Vacancy Loss

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

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

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

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

Credit Loss

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

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

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

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

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

You may not reproduce, distribute, or transmit any of the materials at this site without the express written permission of RealData® Inc. or other copyright holders. The content of web sites displayed or linked from the realdata.com is the copyrighted material of those respective sites.

Understanding Net Operating Income (NOI)

Posted on March 15, 2007 (May 2, 2022) by Frank Gallinelli

In a recent article, we discussed the use of capitalization rates to estimate the value of a piece of income-producing real estate. Our discussion concerned the relationship among three variables: Capitalization Rate, Present Value and Net Operating Income.

We may have gotten a bit ahead of ourselves, since some of our readers were unclear on the precise meaning of Net Operating Income. NOI, as it is often called, is a concept that is critical to the understanding of investment real estate, so we are going to backtrack a bit and review that subject here.

Everyone in business or finance has encountered the term, “net income” and understands its general meaning, i.e., what is left over after expenses are deducted from revenue.

With regard to investment real estate, however, the term, “Net Operating Income” is a minor variation on this theme and has a very specific meaning. You might think of NOI as the number of dollars a property returns in a given year if the property were to be purchased for all cash and before consideration of income taxes or capital recovery. By more formal definition, it is a property’s Gross Operating Income less the sum of all operating expenses.

We have now succeeded in confounding our readers and compounding their problem by replacing one undefined term with two.

Let’s take these two new terms one at a time:

Gross Operating Income: Definitions are like artichokes. You need to peel the layers off one at a time. In this case, take the Gross Scheduled Income, which is the property’s annual income if all space were in fact rented and all of the rent actually collected. Subtract from this amount an allowance for vacancy and credit loss. The result is the Gross Operating Income.

Operating Expenses: This is the term that causes the greatest mischief. Many people say, “If I have to pay it, then it’s an operating expense.” That is not always true. To be considered a real estate operating expense, an item must be necessary to maintain a piece of a property and to insure its ability to continue to produce income. Loan payments, depreciation and capital expenditures are not considered operating expenses.

For example, utilities, supplies, snow removal and property management are all operating expenses. Repairs and maintenance are operating expenses, but improvements and additions are not – they are capital expenditures. Property tax is an operating expense, but your personal income-tax liability generated by the property is not. Your mortgage interest may be a deductible expense, but it is not an operating expense. You may need a mortgage to afford the property, but not to operate it.

Subtract the Operating Expenses from the Gross Operating Income and you have the NOI.

Why all the nitpicking? Because NOI is essential to apprehending the market value of a piece of income-producing real estate. That market value is a function of its “income stream,” and NOI is all about income stream. As heartless as it may sound, a real estate investment is not a felicitous assemblage of bricks, boards, bx cables and bathroom fixtures. It is an income stream generated by the operation of the property, independent of external factors such as financing and income taxes.

In truth, investors don’t decide to buy properties; they decide to buy the income streams of those properties. This is not such a radical notion. When was the last time you chose a stock based upon the aesthetics of the stock certificate? (“Broker, what do you have in a nice mauve filigree border?”) Never. You buy the anticipated economic benefits. The same is true of investors in income-producing real estate.

Those readers who have not yet been lulled to sleep by this dissertation will alertly point out that they have in fact observed changes in the value of income property precipitated by changes in mortgage interest rates and in tax laws. Doesn’t that observation contradict our assertion about external factors?

Go back to our earlier article on the use of capitalization rates, and you will recall that there are two elements to the value equation: the NOI and the cap rate. The NOI represents a return on the purchase price of the property; and the cap rate is the rate of that return. Hence, a property with a $1,000,000 purchase price and a $100,000 NOI has a 10% capitalization rate. However, the investor will purchase that property for $1,000,000 only if he or she judges 10% to be a satisfactory return.

What happens if interest rates go up? In that case, there may be other opportunities competing for the investor’s capital – bonds, for example – and that investor may now be interested in this same piece of property only if its return is higher, say 12%. Apply the 12% cap rate (PV = NOI / Cap Rate), and now the investor is willing to pay about $833,000. External circumstances have not affected the operation of the property or the NOI. They have affected the rate of return that the buyer will demand, and it is that change that impacts the market value of the property.

In short, the NOI expresses an objective measure of a property’s income stream while the required capitalization rate is the investor’s subjective estimate of how well his capital must perform. The former is mostly science, subject to definition and formula, while the latter is largely art, affected by factors outside the property, such as market conditions and federal tax policies. The two work together to give us our estimate of market value.

— Frank Gallinelli

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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.

Tag: Net Operating Income

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Making the Case for Your Commercial Refinance, Part 1

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

Vacancy Loss

Credit Loss

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Understanding Net Operating Income (NOI)

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Vacancy Loss

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