realestate finance101 01
TRANSCRIPT
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Introduction to
Cash Flow Analysis and
Real Estate Investing
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Getting Rich in Real Estate
– “get-rich-quick” methods of
real estate investment often
assume self-management
while ignoring your
opportunity cost of time andthe risks of high leverage
– Many make more money
off of the seminars than
they do on their real estate
investments
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Real Estate Does Provide Many
Opportunities Including Adding Value Through:
– Real estate acquisition
– Development
– Financing
– Site Analysis
– Controlling Operating Costs
– Innovative Marketing
– Innovative Management
No Secret Way To AttainSuccess
Only hard work with goodresearch and systematicanalysis
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Business Goals Might Include
Maximize Long Term Shareholder Wealth
Short-Term Financial Goals, I.e. cash flow
Or Non-financial goals such as
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Non-Financial Goals
Maintain a family friendly place to work
Maintain affirmative action hiring policies
Retain quality employees through tough marketsand tough times
Develop or own only the highest quality properties
in prestige locations
Be the largest owner in terms of market share of a
certain type of property in a local market
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Short Term Financial Goals
Might IncludeSatisfy the requirements of the lender in terms of
pre-leasing or debt coverage cash flows
Satisfy the minimum required first year cash oncash returns required of investors
Project minimum internal rates of return for the
entire holding period of some minimum
percentageMaintain occupancy levels above 95% in all
portfolio properties
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Financial Analysis Decision
ModelsSingle period model such as
– Cash on Cash
– Gross Rent Multipliers – Capitalization “Cap” Rate
Multiple period model
– IRR - Internal Rate of Return
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IRR Model
Multiple period return on investment
Calculates the average discount rate that
equates all future returns over the projectedholding period back to the present value of
the initial equity investment
Should be used for capital allocation andinitial investment decisions
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Real Estate Financial Analysis
Developer’s Goal: To invest capital in
projects that generate after tax returns that
exceed those of alternative risk-adjustedinvestment
Investor’s Goal: To buy property assets or
property securities for less than theirintrinsic value (the present value of a firm’s
future free cash flows)
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The “Pro-Forma”
Estimate Gross Rent
Subtract Estimated Vacancy
Add Other Income
Effective Gross Income
Subtract Operating Expenses
Net Operating Income or “NOI”
Subtract Debt Service
Cash Flow Before Taxes
Add the Mortgage Principal Repaid to BTCF
Subtract Depreciation
Taxable Income
Less taxes due or plus taxes saved
After Tax Cash Flow
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“Pro-Forma” (cont.)
Should forecast previous numbers for at
least 5 to 10 years
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Important Financial Ratios
Used to determine financial feasibility
– Gross Rent Multiplier
– Loan to Value (LTV) Ratio
– Debt Coverage Ratio
– Breakeven Point
– Expense Ratio
– Cash on Cash
– After Tax Return on Equity
– Return on Asset
– Internal Rate of Return
– Resale Price
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Leverage and Operating Ratios
Loan to Value Ratio
Debt Coverage Ratio
Breakeven Point
Expense Ratio
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Gross Rent Multiplier
Purchase Price over Gross Rent
The lower the better
A very simple comparison numberinsufficient for anything but general
screening
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Loan to Value Ratio
Measures real estate
financial risk
Default risk rises
proportionally with the
LTV ratio
Typical LTV in the
industry is 75%
Mortgage Loan Balance
------------------------------
Purchase Price
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Debt Coverage Ratio
Must exceed 1.0 in
order for the property
to make the mortgage
payment
Most lenders require a
debt coverage ratio of
around 1.1 to 1.3
Net Operating Income
---------------------------
Debt Service
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Breakeven Point
Percentage of
occupancy that a
building must achieve
in order to be able to
pay all of it’s cash
expenses and carry the
assumed financing Normally in the 65%
to 95% range
Operating Expenses +
Mortgage Payments
------------------------------
Gross Rent
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Expense Ratio
Used in comparison
with other property -
alone it tells very little
Should be sufficiently
high to keep up the
property while not
wasting capital onuncontrolled expenses,
such as energy costs
Operating Expenses
-----------------------------
Effective Gross Income
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Single Period or “Static”
Profitability MeasuresCash on Cash
After Tax Return on Equity
Return on Asset or Going in Cap Rate
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Cash on Cash
Measures initial
profitability
The higher the better
Typical first year cash
on cash return range
from 4 to 10 percent
For REITs, the fundsfrom operation (FFO)
is a similar measure
Before Tax Cash Flow
---------------------------
Cash Equity
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After Tax Return on Equity
Similar to cash on
cash
Takes into account tax
shelter
Typically range from
5% to 12% in the first
year
After Tax Cash Flow
--------------------------
Cash Equity
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Return on Asset
“Cap Rate”
How much debt a
property can carry
Overall returns
The higher the return
rates, the more debt a
property can support
Typical cap rates run
from 8% to 12%
Net Operating Income
-----------------------------
Purchase Price or Value
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Multiple Period or “Dynamic”
Return MeasuresInternal Rate of Return (IRR)
Consider Appreciation Through Resale
Price or Refinancing
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Internal Rate of Return
The most frequently used measurement of
projected holding period overall returns
Delivers in one number an investment return that
integrates rental growth rates and property value
appreciation
Should be compared to the required rate of return
Typical IRRs range from 12% to 15%
Can reach over 20% for new, speculative
investments
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IRR (cont.)
CF1 CF2 CFT Projected Resale CFT
Equity = Pve = -------- + -------- + ... + -------- + -------------------------
1+irr (1+irr)2 (1+irr)T (1+irr)T
An IRR can be before or after tax using before or after tax cash flows.
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Resale Price Calculation
Where R is the “going
out” cap rate on the
property
From the expected
resale price, it is
important to deduct
reasonable sellingcosts
Tax considerations
need to be noted
Net Operating Income
Projected for the Next
Year
---------------------------
R