Prudential Commercial Real Estate FL

Analyzing the Investment Property

The Lesson: If the Numbers Don't Make Sense, Don't buy the Property

How is the property performing on a yearly basis?

The annual operation of the property will be presented in two ways, the Owners Representation and the Brokers/Investors Reconstruction .

The owner's statement is a reflection of the way the owner is currently operating the property. The broker's reconstruction is a statement of how the real estate broker, thinks the property should be performing.

Usually there is a big difference between the owner's operating statement and the broker's reconstruction of the operating statement.

Obviously the owner is trying to portray the operation of the property in its best light. The broker wants as realistic a presentation as is possible. The reason being, the performance of the property, for the most part, determines the value of the property. Of course, the owner wants the highest value the broker wants the most realistic.

The operating statement, whether owner, or broker will reflect the following on an annualized basis:

The Gross Operating Income
The Vacancy and collection estimate (usually expressed in a per-cent)
Any additional income from sources such as vending, laundry, etc. and
All operating expenses

The end result of the Annual operating statement is to provide the net operating income of the property for the year. The most typical problem with the owner's statement is that the owner will usually not charge the property for work that they are providing.

For example, if the owner is the manager, there is no management expense reflected on the annual operating statement. Maintenance, lawn care, and pool care are some other items often handled by the seller. Because they are not paying someone to handle these functions, they are not included in the statement. In order to properly judge the performance of the property, however, it is necessary to charge the property for all labor that is involved with its running, whether performed by the owner or not. Consequently, the broker, or investor must "reconstruct" the expense portion of the statement reflecting the charges that would be appropriate.

The same should be done with the gross income, estimate of vacancy and collection, and other income. You will even find that in some cases the rents are below that which you know the property can get. The reconstruction should reflect a realistic schedule. Don't forget, if rents are adjusted upward the amount used for vacancy and collection may need to adjusted upward. V & C will probably increase with a rent increase. If the property is continually operating at 100% there is a good possiblity that the rents are to low.

Once the operational aspects of the property have been established, the total cash flow through the property after sale must be examined.

Operating Cash Flows

Gross Rental Income
PLUS
Other Income
EQUALS
Gross Operating Income

LESS
The Operating Expenses
EQUALS
Net Operating Income

LESS
The Annual Debt Service
EQUALS
Cash Flow Before Taxes

LESS
Tax on Taxable Income
EQUALS
Cash Flow After Taxes

Cash Flows from Disposition

Ultimate Sale Price
LESS
Costs of sale
LESS
Outstanding Mortgage Balance
EQUALS
Proceeds of Sale Before Taxes

LESS
Tax Liability on Sale
EQUALS
Proceeds after Taxes

Measures

CASH ON CASH

Cash on cash is a simple, widely used investment measure. It is a measure of return on equity.

Pre Tax Cash Flow divided by Equity Investment EQUALS Cash on Cash Return

(Note: After Tax can also be measured. Ask your investor if they look at before, or after tax cash on cash return.)

Cash on Cash could be compared to the dividend on stock, or the interest payment on a bond. Its' biggest advantage is that most investors are "cash" orientated. Most will readily identify with Cash on Cash. Its' disadvantages are that it does not take into account:

Appreciation
Income Tax Ramifications
Risk
The Amortization of a Mortgage

Gross Rent Multiplier

Gross rent multiplier is the result of the sales price divided by the Scheduled Rental Income.

The Gross Rent Multiplier is a common measure used to compare income properties. It does not reflect other factors such as expenses, V & C, financing or taxation.

Price per Unit

The price per unit method determines value by the number of units in the investment. This measurement is typically a multi-family measurement. To determine the price per unit, divide the sales price by the unit count.

The Sales Price Divided by the Number of Unites EQUALS the Price per Unit

The price per unit should be considered only a crude reference point to the properties value.

Price per Square Foot

The price per square foot is similar to the price per unit in that is a unit of measurement in this case square footage is divided into the Price.

The Sales Price divided by the Square feet in the building EQUALS the Price Per Square Foot.

As with price per unit, the price per square foot should only be considered a crude indicator of value. It does not take into account numerous factors related to the operation of the property that will enhance, or detract from its' value.

Income Capitalization

One of the more widely accepted methods of valuing an income property is through Income Capitalization. In order to estimate a value using income capitalization, the net operating income (N.O.I.), either known or estimated is discounted by using a rate of return commonly acceptable to buyers of similar properties.

NET OPERATING INCOME divided by the Price EQUALS Cap Rate

For example, the net income of a property is $20,000 per year. Dividing the $20,000 N.O.I. by a sales price of $200,000 equals a 10% rate of capitalization. The net income is found on the completed Operating Statement (APOD). The capitalization rate, or cap rate that is most acceptable in your market, is usually determined by dividing the N.O.I. of comparable properties by the sales price of those properties as in the example above. As with any comparable, the properties should be as similar as possible, and adjustments should be made for differences in the properties. It is also a good idea to work with at least three comparable properties.

Band of Investments Method

Another way of computing an appropriate rate of capitalization (cap rate) is by using the Band of Investments Method. With the Band of Investments method two factors are considered, and then brought together, The "Market Rate" for mortgage money, and return demanded by the investor. If the "market rate" for mortgage money is 12%, 12% would be multiplied by the actual, or anticipated loan to value to get the first factor:

12% (Market rate for mortgages) X 75% (The Loan to Value)
The resulting factor would be 9%

If the investor is demanding a 15% return on capital then the 15% return would be multiplied by the remaining equity to value, in this case 25%.

15% (Investors desired return X 25% (Equity to value)
The resulting factor would be 3.75%

To get the cap rate add the two resulting factors:

9.00% Plus 3.75% EQUALS 12.75% is the resulting cap rate

Internal Rate of Return

The Internal Rate of Return is simply the rate of discount at which present value of the future cash flows is exactly equal to the initial capital investment. It takes into account a return of invested capital, and return on invested capital. If $100,000 is invested, and $100,000 is returned the internal rate of return would be zero.

(An argument could be made that if only the invested capital is returned, but at a later date, the IRR would be a negative number, given the alleged time value of money.)

Money in/Money out

Final Thought on Measures

Observe that in the computation of Net Operating Income debt service is not considered. It is purely a product of gross operating income minus expenses. Financing is a choice that is made by the individual investor and as such is not a part of the property operations.

One final thought on the use of the different methods of valuation. You, as a competent Investor, should be comfortable and knowledgeable about the use and limitations of all of them. If not, you should consult a professional.

Financial Analysis Techniques: Reality Check

It is real easy to get so involved in the numbers that we neglect to see what is really happening in the investment. The more you want the transaction to occur, the easier it becomes to justify the numbers that you are presenting. Fight that tendency! You are have to analyze investment opportunities.

When all is said and done with the "NUMBER CRUNCHING", sit back and take a REALITY BREAK. Forgetting the numbers - does this thing really make sense?

Some of the points to check for on your reality break are:
1. Does the income cover the mortgage payment?
2. Can a user rent a similar space for less?
3. Is the replacement cost of the land, and the building less than the asking price?
4. Is there sufficient demand in the market?
5. Is the market over built?
6. Am I too anxious to get the deal?

Don't make the mistake of getting caught up in the numbers