Transcript Chapter 14 Cash Flow Analysis

Chapter 14
Cash Flow Analysis
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Major Topics
 How to develop a multiyear proforma
that estimates cash flows from real
estate investment
 How to estimate the revenues,
expenses and debt service that feed
into a proforma
 Important financial ratios such as the
debt service coverage ratio
 Key financial return and ratio
measures
 Assumption games investors play
when presenting proformas
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Introduction
 Cash flow drives values for income property
 Current and future returns are a based upon
cash flow estimates
 Appreciation is driven by increases in the
cash flow
 Development, acquisition, leasing,
marketing and management decisions are
all driven by or intended to influence cash
flows
 Estimating cash flows over time is the focus
of this chapter
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Developing a Proforma
 Proforma is an accounting style
projection of the operating statement
over time
 Proformas start with the initial
operation of the property after the
development and lease phase
 Typically derived on an annual
projection basis although it could be
done monthly
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Steps to Develop a Proforma
Step 1. Estimate Gross Rent
Step 2. Subtract Estimated Vacancy
Step 3. Add other income
= EGI (Effective Gross Income)
Step 4. Subtract Operating Expenses
= NOI (Net Operating Income)
Step 5. Subtract Debt Service
= BTCF (Cash Flow before Taxes)
Step 6. Add the Mortgage Principal Repaid to BTCF
Step 7. Subtract Depreciation
Step 8. Subtract the Amortization Points, Leasing
Commissions and TI (tenant improvements)
= Taxable Income
Step 9. BTCF +/- Taxes (depending on taxable
income)
= ATCF (After Tax Cash Flow)
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Five Important Notes to
Understand Industry Practices
1.
2.
3.
4.
5.
An Alternative Calculation of Taxable
Income
A Note on REIT (Real Estate Investment
Trust)
The treatment of Management Expense
when Self-Managed
Tenant Improvement Expenditures,
Leasing Commissions
Reserves for Replacement, Reserve
Games and Capital Improvements
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Summary of Proforma
Potential Gross Income
Less Vacancy
= Effective Gross Income
Less Operating Expenses
= Net Operating Income
Less Debt Service
= BTCF or CTOE
Then to Calculate Taxable Income
BTCF
Plus Principal Loan Repaid
Less Depreciation
Less amortization of points
Equals Taxable Income
OR
Net Operating Income
Less Mortgage Interest paid
Less Depreciation
Less Amortization of points
Equals Taxable Income
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Proforma Summary (Contd.)
Taxable Income Times the Tax Rate
= Taxes Owed if Taxable Income is positive
= Taxes Saved if Taxable Income is Negative
BTCF
Less Taxes Due OR Plus Taxes Saved
= After Tax Cash Flow (ATCF)
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Financial Feasibility
 Financial feasibility/ performance of a real estate
investment can be judged by financial ratios
 Leverage and Operating Ratios:
 Loan to Value Ratio (LTV)
 Debt Coverage Ratio (DCR)
 Breakeven Point
 Expense Ratio
 Single Period Profitability Measures:
 Cash on Cash
 After Tax Return on Equity
 Return on Asset (ROA)
 Value
 Multiple Period Return Measures:
 NPV
 IRR
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
LTV Ratio
Mortgage Loan Balance
Loan To Value Ratio = -------------------------------Purchase Price
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Debt Coverage Ratio (DCR)
Net Operating Income (NOI)
Debt Coverage Ratio = -------------------------------Debt Service
Supportable Mortgage with a given DCR =
NOI/ DCR/ 12/ Monthly Mortgage Constant
(MMC)
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Breakeven Point
Operating expenses + Mortgage payments
Breakeven Pt. = -------------------------------------------------Gross Rent
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Expense Ratio
Operating expenses
Expense Ratio = --------------------------------------EGI (Effective Gross Income)
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Cash on Cash
Before Tax Cash Flow
Cash on Cash = ------------------------------Cash Equity*
* Cash Equity = Purchase price
- Mortgage
+ points
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
After Tax Return on Equity
After Tax Cash Flow
After Tax Return on Equity = --------------------------------------Cash Equity
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Going In Cap Rate
or
Return on Asset
Net Operating Income
Return on Asset = --------------------------------------Purchase Price or Value
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Value
Net Operating Income
Value = ----------------------------Cap Rate
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Multiple Period Return Measures
CF1
CF2
Projected Resale CFT
Equity = PVe = ---- + -------- + ---- + ----------------------(1 + irr) (1 +irr)2
(1 + irr)T
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Multiple Period Return (Contd.)
 The Equity IRR is compared to the
required rate of return and if the IRR
is equal to or greater than the
required rate of return on equity the
investment is acceptable
 Typical IRRs are in the 12% to 15%
range
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Multiple Period Return (Contd.)
 Reversion Value
Resale Price T
NOIT+1
= ----------R
 R is the "going out" cap rate on the
property
 R =, > or < Initial Year Cap Rate, depending
on perception
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Example: One Year
Assume there are two studio apartment
units renting at $600 per month…
EXCEL SHEET
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Example: Ten Year Proforma
EXCEL SHEET
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Lease Analysis and Cash Flow
Projection
 Reliable cash flow projections require
tenant by tenant – Lease analysis
 Evaluation of existing leases on basis
of comparisons to the market rent for
similar credit risk and size tenants
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Example: Lease Analysis
Tenant
ABC Co. base rent
ABC Option to Renew
at change in CPI
estimated at 3%
Pass Through with a
$5000 cap for 5 years
XYZ Co. Base rent
Increasing at CPI no
pass throughs
XYC Replacement
Tenant with more
supply expected
Summary to be
collected
Year 1
2
3
4
5
6
7
8
9
10
25,000 25,000 25,000 25,000 25,000
28,982 28,982 28,982 28,982 28,982
4,600
4,900
5,000
5,000
5,000
6,000
6,180
6,365
6,556
6,753
6,600
7,000
7,400
7,800
8,200
6,500
6,500
6,500
6,500
6,500
35,600 36,080 36,365 36,556 36,753 35,582 35,982 36,382 36,782 37,182
“Real“Real
Estate
Estate
Principles
Principles
for the
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the New
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Economy”:
Norman
Norman
G. Miller
G. Miller
and David
and David
M. Geltner
M. Geltner
The Impact of Cycles, marketing
and Management on Cash Flows
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Spreadsheets and Software
 ARGUS from the REALM
– www.therealm.com
 REAL DCF
– www.realdcf.com
 PLANEase
– www.planease.com/index.asp
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
END
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner