chapter 14 cash flow analysis

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

Chapter 14

Cash Flow Analysis


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


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


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


Steps to Develop a ProformaStep 1. Estimate Gross RentStep 2. Subtract Estimated VacancyStep 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 BTCFStep 7. Subtract DepreciationStep 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)


Five Important Notes to Understand Industry Practices

1. An Alternative Calculation of Taxable Income

2. A Note on REIT (Real Estate Investment Trust)

3. The treatment of Management Expense when Self-Managed

4. Tenant Improvement Expenditures, Leasing Commissions

5. Reserves for Replacement, Reserve Games and Capital Improvements


Summary of Proforma

Potential Gross IncomeLess Vacancy = Effective Gross IncomeLess Operating Expenses= Net Operating IncomeLess Debt Service= BTCF or CTOE

BTCFPlus Principal Loan RepaidLess DepreciationLess amortization of pointsEquals Taxable Income

Net Operating IncomeLess Mortgage Interest paidLess DepreciationLess Amortization of pointsEquals Taxable Income

Then to Calculate Taxable Income

OR


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)


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


LTV Ratio

Loan To Value Ratio = --------------------------------Mortgage Loan Balance

Purchase Price


Debt Coverage Ratio (DCR)

Debt Coverage Ratio = --------------------------------Net Operating Income (NOI)

Debt Service

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


Breakeven Point

Breakeven Pt. = --------------------------------------------------Operating expenses + Mortgage payments

Gross Rent


Expense Ratio

Expense Ratio = ---------------------------------------Operating expenses

EGI (Effective Gross Income)


Cash on Cash

Cash on Cash = -------------------------------Before Tax Cash Flow

Cash Equity*

* Cash Equity = Purchase price- Mortgage+ points


After Tax Return on Equity

After Tax Return on Equity = ---------------------------------------After Tax Cash Flow

Cash Equity


Going In Cap Rate or

Return on Asset

Return on Asset = ---------------------------------------Net Operating Income

Purchase Price or Value


Value

Value = -----------------------------Net Operating Income

Cap Rate


Multiple Period Return Measures

CF1 CF2 Projected Resale CFT

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

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


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


Multiple Period Return (Contd.)

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


Example: One Year

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

EXCEL SHEET


Example: Ten Year Proforma

EXCEL SHEET


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


Tenant Year 1 2 3 4 5 6 7 8 9 10

ABC Option to Renew at change in CPI estimated at 3%

28,982 28,982 28,982 28,982 28,982

Pass Through with a $5000 cap for 5 years

4,600 4,900 5,000 5,000 5,000 6,600 7,000 7,400 7,800 8,200

XYC Replacement Tenant with more supply expected

6,500 6,500 6,500 6,500 6,500

Summary to be collected

35,600 36,080 36,365 36,556 36,753 35,582 35,982 36,382 36,782 37,182

25,000 25,000 25,000 25,000 25,000

6,753

ABC Co. base rent

XYZ Co. Base rent Increasing at CPI no pass throughs

6,000 6,180 6,365 6,556

Example: Lease Analysis



The Impact of Cycles, marketing and Management on Cash Flows


Spreadsheets and Software

ARGUS from the REALM– www.therealm.com

REAL DCF– www.realdcf.com

PLANEase– www.planease.com/index.asp


END

chapter 14 cash flow analysis

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