Introduction to

Cash Flow Analysis and
Real Estate Investing

Getting Rich in Real Estate

“get-rich-quick” methods of
real estate investment often
assume self-management
while ignoring your
opportunity cost of time and
the risks of high leverage

Many make more money
off of the seminars than
they do on their real estate
investments

Real Estate Does Provide Many
Opportunities Including
v
Adding Value Through:

Real estate acquisition

Development

Financing

Site Analysis

Controlling Operating
Costs

Innovative Marketing

Innovative Management
v
No Secret Way To Attain
Success
v
Only hard work with good
research and systematic
analysis

Business Goals Might Include
v
Maximize Long Term Shareholder Wealth
v
Short-Term Financial Goals, I.e. cash flow
v
Or Non-financial goals such as

Non-Financial Goals
v
Maintain a family friendly place to work
v
Maintain affirmative action hiring policies
v
Retain quality employees through tough markets
and tough times
v
Develop or own only the highest quality properties
in prestige locations
v
Be the largest owner in terms of market share of a
certain type of property in a local market

Short Term Financial Goals
Might Include
v
Satisfy the requirements of the lender in terms of
pre-leasing or debt coverage cash flows
v
Satisfy the minimum required first year cash on
cash returns required of investors
v
Project minimum internal rates of return for the
entire holding period of some minimum
percentage
v
Maintain occupancy levels above 95% in all
portfolio properties

Financial Analysis Decision
Models
v
Single period model such as

Cash on Cash

Gross Rent Multipliers

Capitalization “Cap” Rate
v
Multiple period model

IRR - Internal Rate of Return

IRR Model
v
Multiple period return on investment
v
Calculates the average discount rate that
equates all future returns over the projected
holding period back to the present value of
the initial equity investment
v
Should be used for capital allocation and
initial investment decisions

Real Estate Financial Analysis
v
Developer’s Goal: To invest capital in
projects that generate after tax returns that
exceed those of alternative risk-adjusted
investment
v
Investor’s Goal: To buy property assets or
property securities for less than their
intrinsic value (the present value of a firm’s
future free cash flows)

The “Pro-Forma”
0
Estimate Gross Rent
O
Subtract Estimated Vacancy
O
Add Other Income
=
Effective Gross Income
O
Subtract Operating Expenses
=
Net Operating Income or “NOI”
O
Subtract Debt Service
=
Cash Flow Before Taxes
O
Add the Mortgage Principal Repaid to BTCF
O
Subtract Depreciation
=
Taxable Income
O
Less taxes due or plus taxes saved
=
After Tax Cash Flow

“Pro-Forma” (cont.)
v
Should forecast previous numbers for at
least 5 to 10 years

Important Financial Ratios
v
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

Leverage and Operating Ratios
v
Loan to Value Ratio
v
Debt Coverage Ratio
v
Breakeven Point
v
Expense Ratio

Gross Rent Multiplier
v
Purchase Price over Gross Rent
v
The lower the better
v
A very simple comparison number
insufficient for anything but general
screening

Loan to Value Ratio
v
Measures real estate
financial risk
v
Default risk rises
proportionally with the
LTV ratio
v
Typical LTV in the
industry is 75%
Mortgage Loan Balance
------------------------------
Purchase Price

Debt Coverage Ratio
v
Must exceed 1.0 in
order for the property
to make the mortgage
payment
v
Most lenders require a
debt coverage ratio of
around 1.1 to 1.3
Net Operating Income
---------------------------
Debt Service

Breakeven Point
v
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
v
Normally in the 65%
to 95% range
Operating Expenses +
Mortgage Payments
------------------------------
Gross Rent

Expense Ratio
v
Used in comparison
with other property -
alone it tells very little
v
Should be sufficiently
high to keep up the
property while not
wasting capital on
uncontrolled expenses,
such as energy costs
Operating Expenses
-----------------------------
Effective Gross Income

Single Period or “Static”
Profitability Measures
v
Cash on Cash
v
After Tax Return on Equity
v
Return on Asset or Going in Cap Rate

Cash on Cash
v
Measures initial
profitability
v
The higher the better
v
Typical first year cash
on cash return range
from 4 to 10 percent
v
For REITs, the funds
from operation (FFO)
is a similar measure
Before Tax Cash Flow
---------------------------
Cash Equity

After Tax Return on Equity
v
Similar to cash on
cash
v
Takes into account tax
shelter
v
Typically range from
5% to 12% in the first
year
After Tax Cash Flow
--------------------------
Cash Equity

Return on Asset
v
“Cap Rate”
v
How much debt a
property can carry
v
Overall returns
v
The higher the return
rates, the more debt a
property can support
v
Typical cap rates run
from 8% to 12%
Net Operating Income
-----------------------------
Purchase Price or Value

Multiple Period or “Dynamic”
Return Measures
v
Internal Rate of Return (IRR)
v
Consider Appreciation Through Resale
Price or Refinancing

Internal Rate of Return
v
The most frequently used measurement of
projected holding period overall returns
v
Delivers in one number an investment return that
integrates rental growth rates and property value
appreciation
v
Should be compared to the required rate of return
v
Typical IRRs range from 12% to 15%
v
Can reach over 20% for new, speculative
investments

IRR (cont.)
CF
1
CF
2
CF
T
Projected Resale CF
T
Equity = Pv
e
= -------- + -------- + ... + -------- + -------------------------
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.

Resale Price Calculation
v
Where R is the “going
out” cap rate on the
property
v
From the expected
resale price, it is
important to deduct
reasonable selling
costs
v
Tax considerations
need to be noted
Net Operating Income
Projected for the Next
Year
---------------------------
R