Investment Real Estate
Investment Real Estate
· List the characteristics that affect the value of an investment site and describe the structural components of an income property building and the types of problems that might be observed by the broker
· Understand the use of expense stops and rent concessions and calculate the additional rent required from financing a tenant improvement
· Describe the various methods an investor can use to reduce the annual debt service on a mortgage
· Describe the priorities of leases compared with mortgages on the same property
· Describe the most common problem areas that the broker must scrutinize when reviewing an owner’s operating statement and construct an annual operating statement for an income property
· Calculate the appropriate financial and investment ratios for an evaluation of the one-year statement
· Describe the process used to estimate the after-tax equity reversion
· Calculate the present value of a series of unequal cash flows and the net present value of an investment
· Describe the differences between net present value and the internal rate of return
Matching Investment Properties with Investor Needs
To understand the buyer of an investment property, the broker must know how much money the buyer has to invest and what types of risks the buyer is willing to take.
Sample Investor Questionnaire:
Name __________________________ Address_______________________
Phone Number ____________________Email _______________________
What is your existing asset portfolio? __________________________________________________________________________________________
What are your current liabilities, such as debts and existing obligations? _______________________________________________________________
Basic investor situation
The existing asset portfolio of the buyer is all those assets he now owns either personally or with others. These can include anything of value, such as property, stocks, bonds, coin collections, vintage cars, etc. Looking at the current assets of the buyer gives the broker an idea of the types of investments and risks the buyer likes
The current liabilities include all loans on the property, leases on vehicles and equipment, co-signs, etc. A buyer who is already stretched thin with the number of liabilities he currently has will be able to invest less.
Cash will be needed for contingent necessities; so this will be cash diverted from investment funds.
The type of risk a buyer wants to take will depend in part on his age. Most buyers who are under 45 are more willing to take a higher risk than older buyers because there is time to recover if the investment does not work. Some buyers like to take high risks and some buyers do not, regardless of age.
Earning potential evaluates the future earning power of the buyer. This is particularly important if a buyer-such as a doctor or dentist–has a potential high professional future earning base. A new doctor may not have the money to invest, but he may wish to take a greater risk because his future earnings will increase.
Management capabilities come into play with apartment building investment, especially since a small apartment building will not have enough tenants to justify a professional property manager. In the beginning, the buyer/investor may have to do all the management himself. If he does not have the ability or the time to do this, he will have to hire the job done, which will affect his profits.
Many buyers have specific investment goals which they want to achieve. The broker should know these goals and help the buyer plan to achieve them. Knowing what the goals make it possible to pick properties specific to achieving those goals.
Property characteristics
Each property that a broker and a potential investor look at has certain characteristics. These should be carefully analyzed to see if the characteristics match the needs of the investor.
Return. There must be not only a return OF an investment but a return ON that investment sufficient enough to make it worthwhile to an investor. For this reason, the investor should be able to distinguish the difference between an investment and mere speculation. Perhaps a good way to remember the difference is that an investment can be purchased with future cash flows whereas speculating happens when something is purchased with the hope of a future profit. A rental property might be considered an investment, while the stock market, or maybe even vacant land, is speculation. Regardless of the type of real estate, a good return is an important element when making the decision to invest.
Risk. With every nickel of reward, there will be a nickel at risk. Risk is another consideration when making the decision to invest. Risk is seen as the difference between the projected and the actual amount of income and expenses of an investment. If an investment is new and does not have a track record, it is viewed as a bigger risk than a property that has an income history.
Liquidity. When buying an investment property, the client not only expects a positive cash flow during ownership but a profit when the property eventually sells. Investors do not purchase real estate to lose money, but sometimes it does happen. During the recent economic crisis, property values have declined by as much as 30%. Being able to sell a property in a fairly short period (within one year) and getting the original investment back is known as LIQUIDITY
Marketability. The broker should not confuse liquidity with marketability. Marketability simply means that a property can be sold for whatever the market is willing to pay. A property that is marketable does not necessarily mean that it can provide liquidity.
Tax factors. Many investments have tax benefits for the investor to help shelter his income. The investor will have to look at the before-tax cash flow and after-tax cash flow to see the potential benefit. The investor will also need to look at items, such as tax incremental financing, as a possible investment hedge. In addition to positive cash flows the investor should consider current Federal Income Taxes and the tax shelters that are available. A tax-sheltered real estate investment is one in which taxable income is less than the cash flow generated by the investment. Tax shelter may occur when depreciation allowances, along with other expenses, are deducted from gross income.
Time required. Managing an investment is a very large consideration. If the client can manage his or her own properties, expenses can be reduced. Management fees can account for a very large part of a property’s operating expenses. These fees can range from 10% to 50% of a property’s effective gross income, depending on the type of property and location.
Objectives. Indirect effects on the investor. Is this a prestigious investment to own? Will the investor be overwhelmed by the amount of work needed for this investment so that he fails and it ruins his reputation and credit? Does the investor have the experience and skill needed to manage and keep this investment? Acquiring any investment carries certain risks. Even buying real estate as an investment will carry some risk, especially if it is purchased without sufficient analysis. Investing in real estate should be based on its economic soundness and not emotion. Investment real estate should have cash flows when they are purchased, cash flows that continue into the future, and appreciation at a modest rate each year. Although tax shelters are important, it is not the primary consideration when buying investment real estate
Leases and Lease Terminology
Calculating the Rent: As part of the investment analysis, the broker has to understand current market rents and a variety of property types. Obviously, the broker will analyze an apartment complex differently from that of an office building or shopping center. One basic difference is that in an apartment complex, the tenant typically pays a flat rent fee and the landlord pays for all of the property’s operating expenses. This is known as a GROSS LEASE.
When the broker analyzes an office building or shopping center, the tenant will typically pay not only a base rent but may also be required to pay some or all of the property’s operating expenses. This is known as a NET LEASE or TRIPLE-NET LEASE. Sometimes leases can be a combination of the gross and the net lease. If a landlord wants to control the amount of expenses to be paid in the future, such as taxes, utilities, and insurance, the landlord will stipulate a maximum amount for the landlord to pay in the lease and anything above that amount will be the tenant’s responsibility. This is known an EXPENSE STOP.
When a broker is trying to determine the proper calculation for rent on an office building or shopping center, the GROSS LEASABLE AREA must first be ascertained. This will provide the necessary information to establish common areas and how the tenants will share that expense. Next, the broker must determine the actual space that will be leased to tenants. This is known as NET LEASABLE AREA. Remember, in most commercial properties, the tenants will share the cost of the common area maintenance (CAM) and be totally responsible for the individual spaces they occupy.
Brokers will typically charge rent based on an annual cost per square foot. That figure is then divided by 12 to get a monthly rent amount. This is known as the base rent. The base rent plus any CAM fees will be the tenant’s monthly rent. The tenant, however, may have other charges.
In many shopping centers, the landlord may add a “kicker” to the total rent. The tenant will pay an additional fee based on his or her gross income or gross revenues. It is almost like a tax but paid to the landlord. The percentage will vary, depending on the tenant and the volume of income generated from sales. The percentage lease is an excellent vehicle for new businesses trying to get started. The landlord will charge a minimum rent and, in return, a percent of the income as the new enterprise grows. In order for the landlord to verify the tenant’s income, the company books will be subject to routine audits.
Example: The tenant has entered into a lease for a space that is 1,500 square feet at an annual rate of $15 per square foot. In addition, the tenant has agreed to pay 3% of the gross revenues generated by the business. Assume the business generated $18,000 for this month’s calculations. The monthly rent will be:
1,500 sq. ft. x $15 = $22,500 annually ÷ 12 = $1,875 base rent each month
$18,000 x 3% = $540 overage
$1,875 + 540 = $2,415 Total Rent Due
One big problem for a landlord is attracting quality tenants, especially in shopping centers and office buildings. Sometimes the broker or landlord will offer RENT CONCESSIONS. Good examples include free rent, delayed rent, moving expenses, or lease buyouts. If the broker offers any of these rent concessions, the tenant generally is required to enter into a long-term lease.
Expenses: Operating expenses must be scrutinized for every investment opportunity. This is done through analyzing the operating expense ratio which is the relationship between operating expenses and the effective gross income.
The broker should remember that different types of properties carry different responsibilities for the payment of expenses. In an apartment building, the landlord pays for the expenses while, in a shopping center or office complex, the tenants who occupy spaces pay the expenses. For example, if a property is 90% occupied, the tenants pay 90% of the total expenses while the landlord pays the expenses for the vacant units. There are occasions in which, regardless of the occupancy, the tenants will share the burden of all expenses incurred.
Tenant Upgrades: If a tenant requires upgrades, that additional expense can either be paid out of pocket at the time the work is done or be pro-rated over the life of the lease. Frequently, financing of tenant upgrades will carry an interest charge. This can be done by applying a monthly loan constant to the total upgrade cost and adding it to the monthly rent payment.
Example: A tenant will require $6,000 in upgrades and has agreed to pay them over a two-year period at 8% interest. The loan constant based on this information is .04523. The additional tenant improvement payment will be:
$6,000 X .04523 = $271.36
When tenants lease retail or office spaces, they are anticipating not only being in business for a long time but also expecting to grow in size. Most long-term leases provide the tenant the opportunity to renew at specified intervals. Any increase in rent is commonly based on the Consumer Price Index (CPI). 1% to 5% increase each year is not unusual. In addition, as the business grows, the landlord could make available additional space to the tenant depending on current leases that are expiring or vacant space that is already available.
Options: Many leases give the tenants options to renew their leases or options to expand.
Renewal option
Whether you are a landlord or a tenant, one of the crucial terms to consider when negotiating a lease is the renewal clause. The renewal clause grants the tenant an option, or several consecutive options, to renew the lease for a set term or several set terms after the expiry of the initial term of the lease. It is important for a landlord to ensure that the renewal clause is drafted to maximize the rent payable during the renewal term and to deny a troublesome tenant the ability to exercise the option to renew. Conversely, a tenant wants to ensure that the renewal rent can be fairly negotiated or determined and that the option to renew cannot be revoked for minor infractions under the lease.
Expansion option
Whether your business is just starting out or you have hopeful plans to expand existing operations, you may need more space before your lease ends. Ideally, you should plan at the time you sign the lease to take more space if you need it. That’s the function of an option to expand clause, also known as a “pure” option. It reserves other space owned by your landlord for your business, either in the same building or elsewhere. If you end up deciding that you don’t want the space, you’re not obligated to take it.
Unless the commercial real estate market is awash with vacancies, you won’t see an expansion option in your landlord’s lease. That’s because the clause ties up rental space. The landlord will have to make sure that whatever space is described by your option right is open and available at the time(s) that you may exercise your option. To do so, the landlord will have to either leave the space vacant or lease it to a tenant who will accept a lease term that ends when you might pick up space, which will make the space difficult to rent and not as lucrative as a long-term lease.
Mortgages (existing or stipulated as part of the transaction)
Basic terms
One of the basic advantages of buying real estate as an investment is the ability of the investor to leverage the property. The theory is that your money can be put to better use if it is invested wisely. That is to say, the return of the investment should be greater than the cost of borrowing. In more specific terms, anytime the capitalization rate is greater than the loan constant, the investor has created positive leverage. This is known as positive leverage. When interest rates are low, it makes sense to leverage a property. As a bonus, any interest that is paid toward the debt is deductible from any taxable income earned. Banks are like any other investor; their yield (interest rates) is based on the relationship between supply and demand. In other words, the marketplace will dictate the cost of borrowing.
Interest rates can be calculated in several ways. SIMPLE INTEREST can best be defined as the interest that is computed on the principal only. Many credit card companies, however, compute the interest earned on both the principal and interest that is due. This is known as compound interest. NORMAL INTEREST RATE is the interest rate that is described in the promissory note and is the actual interest rate charged to the borrower.
Although the real estate broker is not required to have the same knowledge that a mortgage banker or mortgage broker has, a basic understanding of loan underwriting and borrowing money is important. The principal and interest paid to a lender for one year is known as a loan’s debt service. Mortgage payments that are interest-only are considered term or straight term mortgages. Generally speaking, interest-only loans are for short periods of time.
Most mortgage payments consist of both principal and interest and are amortized over the term of the loan. The relationship between the annual debt service and the original loan balance is known as the loan constant. The formula is
Debt Service
—————————
Loan Amount x Loan Constant
If you know two parts of the formula, you can find the third or missing part.
The principal and interest payment can be expressed as a percent. This is known as the loan constant. Amortized loans can be repaid over a longer period of time (10-30 years).
Example: What is the loan constant for a $100,000 loan when the annual debt service is $8,024.26?
8,024.26 / 100,000 = .08024
The loan constant is made of two components: principal and interest. In this example, the interest was .08 (8%) while.00024 (.024%) is the principal portion of the payment. The principal portion (.024%) is also known as the sinking fund factor. Without the sinking fund factor, the mortgage payments would be interest only. The longer the term of the loan, the smaller the sinking fund will be.
The amortized loan that causes the loan to be paid in full on the last payment of the agreed term is known as a fully amortized mortgage. Most residential loans and some commercial loans provide this feature.
By and large, most commercial loans will terminate in a fairly short period of time (3-5 years). If the loan payments do not pay the full debt at the end of the agreed term, a final payment that will include the unpaid balance is required. This final payment is called a balloon payment.
Basic terms
Most real estate professionals today have computers and calculators that can figure mortgage payments, future values, balloon payments, and total interest earned on any given mortgage situation. Therefore, most financial calculators have the following characteristics and features that will calculate monthly mortgage payments:
N = number of payments (15 years/180 payments)
I = monthly interest amount (8% annual /.67% monthly)
PMT = payments (monthly)
PV = present value (loan amount)
FV = future value (balloon payment after the 7th year)
Example: Bill purchased a duplex for $100,000 and the lender required him to invest $15,000 as a down payment. The remaining $85,000 was financed for fifteen years at an 8% annual interest rate with monthly mortgage payments. Bill intends to hold the property for seven years. The calculation would be as follows:
N
I PMT
PV FV
180 .0067
$812.30 $85,000 $57,461
Had this same loan been amortized over a 30-year period, the monthly mortgage payment would have been $623.70. The significance of this comparison is two-fold:
1. The longer the term, the smaller the debt service will be.
2. The longer the term, the greater the cash flow but with a slower equity build-up.
The balloon payment, after seven years on a 30-year amortization, would be $78,606 compared to the balloon payment of $57,461 on a 15-year amortization. Delayed gratification is one secret to wealth building.
Many investment real estate brokers perform a sensitivity analysis. This compares various borrowing choices that best suit the investor’s needs. It will compare the effect of the terms (time) of the debt (30-year loan payments vs. 20-year or 15-year loan payments), the effect of varying down payments (25% compared to 10%), and compare different interest rates that may be available depending on the loan term and down payment. Not only will each of the factors have an impact on the investor’s debt service, but each will also provide valuable insight into the investor’s yield on the investment. This is known as the equity dividend rate or cash-on-cash return.
Cash Throw-Off
—————
Down Payment
Recourse Provisions
Most lenders require loans to have a personal guarantor on the note in case there is a default. There are, however, situations regarding certain investment property that the borrower will not be held personally liable in the event of default. Some lenders and life insurance companies will make non-recourse loans if the property has enough equity and the owner can verify that the cash flow is sufficient to pay any debt service and expenses the property might incur. This is a loan that contains an exculpatory clause that does not require the borrower to become personally liable for the debt, and the lender agrees not to seek a deficiency judgment against the borrower. If the buyer defaults, the lender can take the property back and manage it until it sells to a qualified buyer.
Lease Priority
If an investment property has tenants who are under leases and the property sells, the new owner must honor those leases. If the owner of an investment property defaults on the loan and is foreclosed, the priority of the mortgage or lease will determine if the lease is honored. If the lease was entered into prior to the mortgage, the lease should be honored. Leases and mortgages have their priority based on chronological order.
Bankruptcy, however, is another matter. If the owner has to file bankruptcy, the bankruptcy courts take control of the property and any other interests in the property are extinguished.
Prepayment Clause
Residential loans have a built-in feature that allows the borrower to pay either some or all of the principal balance of the debt early. This is known as the prepayment clause. Prior notice is not necessarily required. If the lender requires a penalty for early payment, the details of the penalty must be described in the mortgage and note. In Florida, if the mortgage and note are silent regarding prepayment, the borrower cannot be denied the opportunity without penalty. Many commercial/investment loans contain prepayment penalties because they have a certain desired yield that corresponds to a balloon payment. Brokers and investors need to be aware of short-term loans because many have a prepayment penalty.
Estoppel Certificate
When a local mortgage company makes a loan for an investment property, it can either warehouse the loan (keep in house as part of the bank’s portfolio) or sell the loan to a secondary market investor. If the loan is sold to the secondary market, the loan balance must be verified. This task can be accomplished by requesting an estoppel certificate from the mortgagor (borrower). In addition, the secondary market investor will also want to verify all income and expenses over the past two to five years. This can be accomplished by having an audit of income tax returns provided by the seller.
Structural Knowledge
The investment buyer should not consider buying an investment property without having a building inspection, i.e. having a structural engineer examine the property. It is also wise to have a heating and air conditioning specialist inspect the building.
These types of inspections should involve:
The type and condition of the roof: Is it new, does it meet fire codes, is there evidence of leaking?
The type and condition of the HVAC system (the heating, ventilating, and air conditioning systems): Are the units large enough to support the tenant demand? Are the units in working condition and available for use? Are the units up to current environmental standards?
The nature and capacity of electrical systems: Are the systems up to code? Are they large enough to meet today’s needs of electronic equipment, including burglar alarms?
The nature and capacity of telephone systems: The telephones of today are much different than ten years ago. Will the building’s system handle the volume of calls and will it support cell telephones as well?
Nature and condition of elevators: Is the building structurally sound enough to support the elevator systems? Have they had routine inspections? Are they up to the current code? Is there an emergency plan to escape the building in a hurricane, fire, or earthquake?
Insulation: Does the building have adequate insulation to make it energy-efficient? Is insulation safe and free from environmental hazards?
Sources of the utilities: Is the building located in an area with adequate electricity and water supply? Who is the supplier in that area and are they well prepared to provide enough entities for the needs of the building? Are the providers close enough to provide support in case of a hurricane, fire, or earthquake?
Adequate storm drainage systems: Florida frequently has large rainstorms. Does the property have a planned drainage system installed? Does the water flow away from the building and provide a safe entrance to any customers the business may have? The condition of the appliance and special equipment: Is all equipment to be purchased with the building in good working condition? Is it current and up to date? Is there special equipment needed by this business that is not present?
The condition and needs of drives and parking areas: Is there enough parking for customers and staff? Is the paving in good position? Are the driveways up to the BOCA code?
Survey: A careful buyer and a prudent lender will insist on a survey of the land and the building, making sure to verify (measure) the size of buildings and determine if there are encroachments or easements of any type which may not be disclosed on a title search.
Property Expenses
Operating Expenses: Anyone who buys an investment property should be afforded the opportunity to verify all current property expenses. This is known as a due-diligence period which can be done by examining receipts of past expenses and comparing that information to income tax returns. Operating expenses fall into three categories. They are:
1. Fixed Expenses (FE): Items that will be incurred regardless of occupancy. The two common fixed expenses are real estate taxes and property insurance.
2. Variable Expenses (VE): These are items that will fluctuate with occupancy. The most common types of variable expenses include utilities, management, and maintenance.
3. Reserves for Replacement (R): Money set aside to pay for things that will break or wear out in the future.
NOTE: Debt service reserves for replacement and depreciation are not considered to be operating expenses.
Operating Expense Ratio: Many sellers of investment properties are motivated to increase their net operating income in order to maximize the ultimate selling price. One way to accomplish this goal is to postpone spending money on certain expense items through the process known as deferred maintenance. Brokers need to remember that this is a common practice among some owners of investment properties. A good method to identify any deferred maintenance is to analyze the property’s operating expense ratio over a period of 3 to 5 years. The operating expense ratio is a relationship between a property’s operating expenses and its effective gross income. If the operating expense ratio is too high, the manager should be questioned about excessive spending. If the operating expense ratio is too low, this may be an indication that there is some deferred maintenance involved. If this is the case, the broker needs to identify those areas of concern.
Investment Analysis
An investment property broker also must understand investors’ needs and the ways they make their investment decisions.
Investment Pro Forma: The property’s pro forma statement is one of the most important analyses that a broker can develop for a client regarding particular investment property. The pro forma gives an analysis of a property’s current financial condition and is used to project incomes and expenses that a property should produce into the future. The projections are based on a broker’s experience, knowledge, and understanding of historical data. The problem with setting up an operating statement for an investor is determining what is fact and what is fiction regarding income and expenses. For this reason, the broker should be able to review income tax returns for at least the past two years if possible.
The annual operating statement focuses on the income and expense history of a property in order to forecast expected future earnings both before taxes and after taxes. The appropriate information to be analyzed is usually the income statements for the past three to five years.
The following steps are used to calculate a property’s pro forma statement:
1. Potential Gross Income (PGI) is the maximum income that a property can generate under the very best of situations. The rents used will be based on either contract rent or market rent. Contract rent is used when current tenants are under a long-term contract (more than one year). Market rent is calculated by comparing properties that are similar and current rents collected. Some brokers may use a combination of both.
2. Effective Gross Income (EGI) is the actual amount of revenues that are generated by the property. In order to calculate EGI, the broker will take the property’s PGI and subtract any vacancy losses. If the property has any other kinds of income (vending machines, laundry rooms, etc.) that will be added after the vacancy has been subtracted. Remember vacancy losses should only be calculated and subtracted from the PGI.
3. Net Operating Income (NOI) is calculated by subtracting operating expenses from Effective Gross Income. The NOI is used by the appraiser and real estate broker to determine an investment property’s value.
Particular care should be taken to include all expenses necessary to assure that the property continues to perform over an extended period of time. Frequently overlooked items include management expenses, repairs, and reserves for replacements. The broker/analyst should be able to explain the causes for unusually low or high amounts of any line item. An indication that an item requires an explanation might be an unusual rate of growth for any one type of income or expense.
Although Debt Service must be addressed, it is not considered an operating expense. Once the net operating income has been determined, the before-tax cash flow can be calculated. Net operating income minus the Debt Service will provide a cash flow amount before income taxes are paid. This figure is also known as cash throw off.
Potential Gross Income
– Vacancy and collection losses
+ Other Income
= ————————————-
Effective Gross Income
– Operating Expenses (including reserves)
= ————————————-
Net Operating Income
– Debt Service
= ————————————-
Before-Tax Cash Flow (Cash Throw Off)
Taxes (+/-)
= ————————————-
After-Tax Cash Flow
Income Taxes
The only calculation remaining for Beachside Apartments is to determine the amount of income taxes that will be due and the investor’s after-tax cash flow. There are two major deductions that an investor has when determining taxable income: interest on the mortgage and depreciation. All depreciation is straight-lined which means that the investor can deduct the same amount of depreciation each year. Accelerated forms of depreciation provide a greater tax shelter but were done away by Congress as part of the 1987 Tax Reform Act. If the property is residential, the depreciation period is 27.5 years. Residential properties are defined as properties where individuals or families reside. An apartment building is considered residential.
If the property is non-residential or commercial, the depreciation period is 39 years. Office buildings and shopping centers are examples of non-residential properties. Two things that should be remembered: vacant land does not depreciate and depreciation for tax purposes has little to do with a building actually losing market value. In Beachside Apartments example, assume the building represents 80% of the total purchase price. Since reserves are funds that are set aside to pay for things in the future and have not yet been spent, they are taxable.
The gain in the sale of real property can be categorized as either realized or recognized. Realized gain is the amount of gain that occurs when a property is sold and is the difference between the adjusted basis and the net sales price. The realized gain may or may not be taxed. If it is a principal residence, some or all of the gain may not be taxable. If the gain is taxable, it is not only realized but is said to be recognized. If the property was purchased for investment, the gain is not only realized but will be recognized and taxed.
Real estate brokers should always keep in mind that the value of a property to an investor is driven by personal goals. The investor evaluates a property based on the cash flow during ownership as well as the anticipated value of the property when it sells.
Productivity Analysis
The following are an investment and financial ratios that a broker should understand. If a broker or sales associate is uncomfortable discussing these issues, perhaps turn the transaction over to a professional and take a referral fee or seek advice from someone who is an expert. Remember, the Florida Real Estate Commission (FREC) does not want licensees representing themselves as experts in business transactions in which they are unfamiliar.
The following ratios are part of the productivity analysis of a property:
1. Loan to Value Ratio is the relationship between the amount of money being borrowed and the value of the property. Remember, the value is determined by either the contract price or the appraised value, whichever is less.
Loan $2,000,000 80%
Value $2,500,000 Loan to Value Ratio
2. The Debt Service Coverage Ratio is the relationship between a property’s net operating income and the annual mortgage payment. Banks will always be concerned about the gap between income and mortgage payments. The debt service coverage ratio from 1.2 to 1.3 may be typical during an expansionary period and 1.4 to 1.6 during periods of tight money.
Net Operating Income $294,690 1.46
Debt Service $202,526 Debt Service Coverage Ratio
3. The Operating Expense Ratio is the relationship between a operating expenses and the property’s effective gross income.
Operating Expenses $241,110 45%
Effective Gross Income $535,800 Operating Expense Ratio
4. The Cash Break-Even Ratio provides the lender and investor with a measure of all paid expenditures against potential gross income. Reserves are subtracted from the operating expenses since they are not cash expenses. Also, the investor’s mortgage payment is a requirement in order to keep the doors open. If the break-even ratio is 1.0 or greater, the rents cannot pay for the expenses even under the very best of conditions.
$241,110 – $11,000 + $202,526
Operating Expenses – Reserves + Debt Service 76%
Potential Gross Income Cash Break-Even Ratio $570,000
The margin of safety is the amount of vacancy that can be allowed to break even.
5. The Equity Dividend Rate, also known as the “cash on cash” return, compares the Before-Tax Cash Flow to the investor’s equity. It is an important and widely used ratio in real estate investment analysis because it is an indication of the investor’s rate of return on his or her equity (down payment).
Before-Tax Cash Flow $92,164 18%
Equity (down payment) $500,000 Equity Dividend Rate
If the investor wants to know how long it would take to recoup the equity, the equity dividend rate formula would be reversed. This is known as the Payback Period. $500,000 divided by $92,164 equals 5.43 years.
6. The Overall Capitalization Rate provides the investor with an estimate of the value of a property based on its income. It’s based on taking a property’s NOI and dividing it by either a cap rate derived by the market or by the investor’s personal criteria.
Net Operating Income $294,690 $2,455,750
Capitalization Rate .12 Value of the apartment
If the investor chose an 11% cap rate the value would then be $2,679.000. If the net income remains constant, the greater the desired return and the less an investor will be willing to pay for an investment.
7. The loan constant is a percentage (expressed as a factor) of the original loan that is paid periodically for principal and interest. The loan constant is comprised of two components: the interest rate and a sinking fund factor. Lenders are interested in two things when a loan is made. First and foremost, the lender wants the original loan amount repaid in full. This is known as “a return of the investment.” Secondly, the bank would like to make a profit for the risk taken for making the loan. This is known as yield or “a return on the investment.” The sinking fund factor is the part of the payment that amortizes or pays off the loan. Without the sinking fund factor applied to the payment, the loan would never be paid (interest-only loan).
Internal Rate of Return (IRR) and Net Present Value (NPV)
These are advanced investment calculations that most brokers will not be required to manage. Those brokers, however, who have obtained the CCIM (Certified Commercial Investment Member) designation may be called upon by some sophisticated investors for an in-depth analysis that will use these tools. The following is a brief explanation of the two concepts. Brokers should use caution when applying these principles if they are not fully understood.
The NET PRESENT VALUE can be defined as the difference between the DISCOUNTED CASH FLOW (present value of future earnings from operations, tax savings, and reversions) and the initial investment (equity) in the property.
The INTERNAL RATE OF RETURN can be defined as the procedure required to determine the exact rate of return that causes the present value of the cash flows to equal the initial investment.
Sensitivity Analysis
The different borrowing alternatives that an investor has available is known as a sensitivity analysis. Perhaps the most valuable way to use after-tax cash flow projections is to calculate alternate scenarios for the property and determine their effects on after-tax cash flows. Usually, potential gross income and vacancy rates are the most uncertain numbers in the analysis followed by operating expenses. It can be extremely helpful in analyzing a property to think through the best-case and worst-case scenarios for these numbers and then project cash flows accordingly.
SUMMARY
The characteristics that affect the value of an investment property are good return, the ability to leverage, limited risk, and the ability to sell an investment and get at least the initial investment back (liquidity).
Real estate brokers are able to control operating expenses by setting limits to the amount of expenses the property will pay. In addition, any tenant improvement is paid by the tenant over the lease period and is amortized by using a loan constant to calculate the payment (principal and interest).
Investors can reduce their annual debt service by extending the terms of the loan, putting more down (financing less), and negotiating a lower interest rate.
Leases are typically not recorded, but they may have a priority if the property is foreclosed.
The financial and investment ratios that are the most appropriate when evaluating a one-year operating statement is the Operating Expense Ratio, Debt Service Coverage Ratio, and Equity Dividend Rate.
The most common problem that a broker has when reviewing and constructing an owner’s operating statement is the accuracy of the data provided. Brokers should be able to verify income and expenses over the past 3 to 5 years.
The calculation to estimate the after-tax equity reversion is:
Net sales price Net sales price
– Adjusted basis – Loan balance
Capital gain – Tax liability
X Tax rate Cash reversion
Tax liability
Net present value is the difference between the original investment in a property and the present value of future cash flows.
*The Internal rate of return is the exact rate of return that happens when the original investment equals the discounted value of any future income (net present value equals 0).
Vocabulary List: add-on interest,discounted cash flow analysis,expense stop,gross leasable area,gross lease,internal rate of return,net leasable area,net lease,net present value,nominal interest rate,percentage lease,rent concession,simple interest,triple-net lease