1. Ch 12 Real Estate Investments, Part II Page 57

2. R. E. investment analysis requires 1.Compute current year after-tax cash flow. 2.Forecast future after-tax cash flow for each year of the holding period (5 – 10). 3.Forecast the future cash flow upon disposition at the end of the holding period (Net Sale Proceeds). 4.Convert all estimated after tax cash flows into a series of performance indicators.

3. Formula GSI Gross scheduled income:GSI Gross scheduled income: -OEOperating expenses (TIMMUR)-OEOperating expenses (TIMMUR) EGIGOI Gross scheduled incomeEGIGOI Gross scheduled income -V/BDVacancy & bad debt (uncollectible)-V/BDVacancy & bad debt (uncollectible) NOINet operating incomeNOINet operating income -DS Debt service (loan payment)-DS Debt service (loan payment) GSI Gross spendable incomeGSI Gross spendable income -DepDepreciation-DepDepreciation CF BT Cash flow before taxesCF BT Cash flow before taxes -TxIncome taxes due on taxable income-TxIncome taxes due on taxable income CF AT Cash flow after taxesCF AT Cash flow after taxes

4. Terms Described Gross scheduled incomeGross scheduled income –Maximum amount of income, if fully occupied. Gross operating incomeGross operating income –Gross scheduled income less vacancy factor and uncollectible rents. Net operating incomeNet operating income –Gross operating income less annual expenses. Net income or lossNet income or loss –Net operating income less interest on the loans and depreciation for the year of operation. Gross spendable incomeGross spendable income –Net operating income less principal and interest payments for the year (annual debt service). Net spendable incomeNet spendable income –Before tax cash flow less annual income taxes due on taxable income for the year, if any. –OR –Before tax cash flow plus annual income taxes saved because of the tax loss for the year, if any. Page 58 Page 57

5. GROSS RENT MULTIPLIER Comp. Sales Price Comp. Monthly Rent Comp. Sales Price Comp. Sales Price Comp. Annual Rent THEN Gross Scheduled Income (GSI) x Gross Rent Multiplier (GRM) = Estimated Value ($) FAILS TO CONSIDER VACANCIES AND EXPENSES = = Gross Monthly Rent Multiplier (GMRM) Gross Annual Rent Multiplier (GRM)

6. Gross Rent Multiplier Example Sales Price $350,000= Sales Price $350,000= $2,000 $2,000 Sales Price $350,000= Sales Price $350,000= Annual Rent $24,000 Annual Rent $24,000 ($2,000 X12mo.) ($2,000 X12mo.) 175 Gross Monthly Rent Multiplier (GMRM) 14.58 Gross Annual Multiplier (GRM)

7. PROJECTED ANNUAL OPERATING STATEMENT Scheduled gross annual income $84,000 GSI Vacancy allowance and collection losses 4,200--Vac/BD Effective Gross Income $79,800= EGI Operating Expenses (OE=TIMMUR) –Property Taxes 9,600 T –Hazard and liability Insurance 1,240 I –Property Management 5,040 M –Maintenance and Repairs 5,000 M Janitorial, Pool & Gardener Services 1,500Janitorial, Pool & Gardener Services 1,500 Gardener 1,200Gardener 1,200 –Utilities 3,940 U Trash pickup 600Trash pickup 600 Electric, Gas, WaterElectric, Gas, Water –Reserves for replacement R Furniture & furnishings 1,200Furniture & furnishings 1,200 Stoves & refrigerators 600Stoves & refrigerators 600 Furnace &/or air-conditioning system 700Furnace &/or air-conditioning system 700 Plumbing & electrical 800Plumbing & electrical 800 Roof 750Roof 750 Exterior painting 900Exterior painting 900 Other 1,300Other 1,300 Total Operating Expenses $34,400 --- OE Net Operating Income $45,400 = NOI Operating Expense Ratio: $34,400 ÷ $79,800 = 43.1% Capitalization Rate

8. Capitalization Rate The higher the cap rate, the lower the value.The higher the cap rate, the lower the value. $300,000 I $300,000 I 10% R 5% R 10% R 5% R I = R X V The higher the risk, The higher the capitalization rate. I = V R = $300,000= $600,000 Or Net Operating Income (I) Asking Price ( R) = Capitalization Rate (V)

9. Price per : Unit: Asking price Number of rental units Square foot: Asking price Building square footage Bed (hospital) (retirement home), storage unit (mini warehouse), Room (convalescent home) (boarding house), pad (mobile home) (RV park) = Price per unit = Price per sq. ft.

10. Debt Coverage Ratio Net Operating Income annual debt service annual debt service The higher the ratio, the better the cash flow. More cash to cover loan payment. Lenders determine if the property’s cash flow justifies the loan by using DCR. = Debt Coverage Ratio

11. Expense Ratio Annual operating expenses Gross scheduled income The lower the expense ratio, usually the better the cash flow. Over time, the expense ratio tends to increase. Watch Out!! The seller often overstates the income and understates the true expenses,. Always verify income and expenses with property management records or with the owner’s Schedule E income tax record for subject property. = Expense ratio

12. Before Tax Cash-on-Cash Rate of Return Before tax cash flow = Before tax % for that year of cash invested The higher the rate, the better the investment.

13. After Tax Cash-on-Cash Rate of Return After tax cash flow = After tax % for that Year for cash invested The higher the rate, the better the investment. A better indicator than the before tax rate

14. Equity Yield Rate of Return for the year (After tax cash flow) + (Principal paid) Net spendable income + Equity build up + Appreciation Cash invested Cash invested The higher the rate, the better the investment. This is an indicator of performance. Principal payments and appreciation are NOT cash, and are only received when sold or with a refinance. Closing costs must be considered and calculated in to determine true net. = Equity Yield For that year

15. Multiple Year Analysis Solve for IRR and the financial management rate of return, using discounted cash flow analysis.Solve for IRR and the financial management rate of return, using discounted cash flow analysis. This method requires analysis for the investor’s entire holding period, not just a single year.This method requires analysis for the investor’s entire holding period, not just a single year. The discounting process takes into consideration the Time Value of Money to produce a more realistic rate of return.The discounting process takes into consideration the Time Value of Money to produce a more realistic rate of return.

16. #1:First year cash flow analysis Case study-Problem 1: 8 unit apt. GSI ($700 x 8 units x 12 mo/yr) $67,200 + Other income + 800 =Total GSI $68,000 -Vac/BD (68,000 x 5%) 3,400 =GOI $64,600 -OE 24,200 =NOI $40,400 -DS ($3072/12mo) 36,864 = CF BT $ 3,536

17. #2: Gross Rent Multiplier Comp. Sales PriceGross Annual Rent Multiplier Comp. Annual Rent(GRM) $500,000 $ 67,200 ($700 x 8 units x 12 mo/yr) = =7.44 GRM/Yr Comp. Sales PriceGross Monthly Rent Multiplier Comp. Monthly Rent(GMRM) = $500,000 $5,600 ($700/mo x 8 units) = 89.29 OR

18. Capitalization Rate I = R X V I = R = RV $500,000 = $40,440 8.088 % Or 8.1% I = Net Operating Income V = Asking Price R = Return on Investment

19. #2: Commercial Property #1-Operating Expenses T - Property taxes$4,700 $3900 (existing) + $800 (increase) I - Property insurance$1,000 I - Property insurance$1,000 M - Maintenance$2,000 Supplies$ 500$2,500 Supplies$ 500$2,500 M – Management $51,000 x 4%$2,040 U – Utilities: Water, Trash & gardening$1,680 Water, Trash & gardening$1,680 ($140 mo x 12 mo) Operating Expenses (OE) $11,920

20. #2: Commercial Property #2-Net Operating Income GSI $51,000 + Other income + 0 =Total GSI $51,000 -V-V-V-Vac/BD (67,200 x 5%) - 0 =GOI $51,000 -O-O-O-OE - 11,920 -N-N-N-NOI $39,080

21. #2: Commercial Property #3-Before Tax Cash Flow -NOI $39,080 -DS ($3100/12mo=$34000) 37,200 = CF BT $ 1,880

22. #2: Commercial Property Income Tax Aspects NOI $39,080 NOI $39,080 - Interest - 34,000 -Depr - 29,000 = Taxable income/loss for the year = Taxable income/loss for the year X Investor tax bracket 43% = Taxes saved/paid for the year $10,286 + CF BT 1,880 = CF AT $12,166 #4 - After-Tax Cash Flow

23. #2: Commercial Property #5 - Property Value I = R X V I = V R $39,080 9% =$434,422 I = Income R = Rate of Return expected V = Value of Property

24. #3: Forecasting Cash Flow Yr 1 Yr 2 Yr 3 GSI GSI72,0007704082,433 - Vac/BD - Vac/BD-3,60038524,122 GOI GOI68,4007318878,311 - OE 18,9042003821241 NOI NOI49,4965315057070 - DS 48,00048,00048,000 CF BT CF BT1,4965,1509,070

25. #3: Tax Aspects Yr 1 Yr 2 Yr 3 NOI NOI$49,496$53,150$57,070 - Interest/yr - Interest/yr-$46,456-$46,266-$46,052 - Depreciation - Depreciation-$14,000-$14,000-$14,000 Tax loss/yr Tax loss/yr<-$10,960<-$7,116<-$2,982 x Tax bracket 38%38%38% Taxes saved/yr $4,165-$2,704-$1,133

26. #3: New Spendable Income Yr 1 Yr 2 Yr 3 CF BT / yr CF BT / yr$1,496 $5,150 $5,150 $9,070 $9,070 + Tx saved/yr $4,165 -$2,704 -$2,704 - $1,133 - $1,133 Net Spendable/yr $5,661 $ 7,854 $ 7,854 $10,203 $10,203

27. #3 #1 Seller’s net from escrow Future resale price$553,000 Less: seller’s closing costs- 44,240 ($553,000 x 8%) Less: Outstanding loan balance-392,774 Equals: Net proceeds from escrow$115,986

28. #3: #2: Net Sales Proceeds Net proceeds from escrow$115,986 Less: Tax owed on resale- 27,649 (553,000-436,000-44,240= 72,760 x 38%) Equals: Net sales proceeds $88,337

29. #3 -IRR Worksheet Net sale proceeds $ 88,337 Investment $80,000 End of year Cash Flow 10%discAmt $20%discAmt $ 1 5,661 5,661.90915,146.8696 4,923 4,923 2 7,854 7,854.82646,491.7561 5,938 5,938 398,540.751374,033.657564,790 Total85,67075,651 Smaller Rate10%$85,670 $85,670 Present Value Amount Larger Rate15%$75,651 $80,000 Investment Difference 5% ÷ $10,019 $5,670 ÷ 10 = 12.83% IRR