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Chapter 14 Cash Flow Analysis

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“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

- 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

- 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

- 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

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)

- 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

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

Net Operating Income

Less Mortgage Interest paid

Less Depreciation

Less Amortization of points

Equals Taxable Income

OR

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

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/ 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

Mortgage Loan Balance

Purchase Price

Loan To Value Ratio = --------------------------------

Net Operating Income (NOI)

Debt Service

Debt Coverage Ratio = --------------------------------

- Supportable Mortgage with a given DCR = NOI/ DCR/ 12/ Monthly Mortgage Constant (MMC)

Operating expenses + Mortgage payments

Gross Rent

Breakeven Pt. = --------------------------------------------------

Operating expenses

EGI (Effective Gross Income)

Expense Ratio = ---------------------------------------

Before Tax Cash Flow

Cash Equity*

Cash on Cash = -------------------------------

* Cash Equity = Purchase price

- Mortgage

+ points

After Tax Cash Flow

Cash Equity

After Tax Return on Equity = ---------------------------------------

Net Operating Income

Purchase Price or Value

Return on Asset = ---------------------------------------

Net Operating Income

Cap Rate

Value = -----------------------------

CF1 CF2 Projected Resale CFT

Equity = PVe = ---- + -------- + ---- + -----------------------

(1 + irr) (1 +irr)2 (1 + irr)T

- 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

- Reversion Value
- R is the "going out" cap rate on the property
- R =, > or < Initial Year Cap Rate, depending on perception

NOIT+1

Resale Price T = -----------

R

Assume there are two studio apartment units renting at $600 per month…

EXCEL SHEET

EXCEL SHEET

- 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

- 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

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner