Chapter 14 Cash Flow Analysis

1. Chapter 14Cash Flow Analysis “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

2. 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

3. 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

4. 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

5. 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)

6. Five Important Notes to Understand Industry Practices • 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

7. 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 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

8. 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

9. 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

10. LTV Ratio Mortgage Loan Balance Purchase Price Loan To Value Ratio = --------------------------------

11. Debt Coverage Ratio (DCR) Net Operating Income (NOI) Debt Service Debt Coverage Ratio = -------------------------------- • Supportable Mortgage with a given DCR = NOI/ DCR/ 12/ Monthly Mortgage Constant (MMC)

12. Breakeven Point Operating expenses + Mortgage payments Gross Rent Breakeven Pt. = --------------------------------------------------

13. Expense Ratio Operating expenses EGI (Effective Gross Income) Expense Ratio = ---------------------------------------

14. Cash on Cash Before Tax Cash Flow Cash Equity* Cash on Cash = ------------------------------- * Cash Equity = Purchase price - Mortgage + points

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

16. Going In Cap Rate orReturn on Asset Net Operating Income Purchase Price or Value Return on Asset = ---------------------------------------

17. Value Net Operating Income Cap Rate Value = -----------------------------

18. Multiple Period Return Measures CF1 CF2 Projected Resale CFT Equity = PVe = ---- + -------- + ---- + ----------------------- (1 + irr) (1 +irr)2 (1 + irr)T

19. 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

20. 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

21. Example: One Year Assume there are two studio apartment units renting at $600 per month… EXCEL SHEET

22. Example: Ten Year Proforma EXCEL SHEET

23. 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

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

25. The Impact of Cycles, marketing and Management on Cash Flows

26. 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

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