“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Chapter 14 Cash Flow Analysis

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Major Topics  How to develop a multiyear proforma that estimates cash flows from real estate investment  How to estimate the revenues, expenses and debt service that feed into a proforma  Important financial ratios such as the debt service coverage ratio  Key financial return and ratio measures  Assumption games investors play when presenting proformas

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Introduction  Cash flow drives values for income property  Current and future returns are a based upon cash flow estimates  Appreciation is driven by increases in the cash flow  Development, acquisition, leasing, marketing and management decisions are all driven by or intended to influence cash flows  Estimating cash flows over time is the focus of this chapter

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Developing a Proforma  Proforma is an accounting style projection of the operating statement over time  Proformas start with the initial operation of the property after the development and lease phase  Typically derived on an annual projection basis although it could be done monthly

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Steps to Develop a Proforma Step 1. Estimate Gross Rent Step 2. Subtract Estimated Vacancy Step 3. Add other income = EGI (Effective Gross Income) Step 4. Subtract Operating Expenses = NOI (Net Operating Income) Step 5. Subtract Debt Service = BTCF (Cash Flow before Taxes) Step 6. Add the Mortgage Principal Repaid to BTCF Step 7. Subtract Depreciation Step 8. Subtract the Amortization Points, Leasing Commissions and TI (tenant improvements) = Taxable Income Step 9. BTCF +/- Taxes (depending on taxable income) = ATCF (After Tax Cash Flow)

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Five Important Notes to Understand Industry Practices 1.An Alternative Calculation of Taxable Income 2.A Note on REIT (Real Estate Investment Trust) 3.The treatment of Management Expense when Self-Managed 4.Tenant Improvement Expenditures, Leasing Commissions 5.Reserves for Replacement, Reserve Games and Capital Improvements

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Summary of Proforma Potential Gross Income Less Vacancy = Effective Gross Income Less Operating Expenses = Net Operating Income Less Debt Service = BTCF or CTOE BTCF Plus Principal Loan Repaid Less Depreciation Less amortization of points Equals Taxable Income Net Operating Income Less Mortgage Interest paid Less Depreciation Less Amortization of points Equals Taxable Income Then to Calculate Taxable Income OR

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Proforma Summary (Contd.) Taxable Income Times the Tax Rate = Taxes Owed if Taxable Income is positive = Taxes Saved if Taxable Income is Negative BTCF Less Taxes Due OR Plus Taxes Saved = After Tax Cash Flow (ATCF)

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Financial Feasibility  Financial feasibility/ performance of a real estate investment can be judged by financial ratios  Leverage and Operating Ratios:  Loan to Value Ratio (LTV)  Debt Coverage Ratio (DCR)  Breakeven Point  Expense Ratio  Single Period Profitability Measures:  Cash on Cash  After Tax Return on Equity  Return on Asset (ROA)  Value  Multiple Period Return Measures:  NPV  IRR

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner LTV Ratio Loan To Value Ratio = Mortgage Loan Balance Purchase Price

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Debt Coverage Ratio (DCR) Debt Coverage Ratio = Net Operating Income (NOI) Debt Service  Supportable Mortgage with a given DCR = NOI/ DCR/ 12/ Monthly Mortgage Constant (MMC)

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Breakeven Point Breakeven Pt. = Operating expenses + Mortgage payments Gross Rent

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Expense Ratio Expense Ratio = Operating expenses EGI (Effective Gross Income)

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Cash on Cash Cash on Cash = Before Tax Cash Flow Cash Equity* * Cash Equity = Purchase price - Mortgage + points

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner After Tax Return on Equity After Tax Return on Equity = After Tax Cash Flow Cash Equity

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Going In Cap Rate or Return on Asset Return on Asset = Net Operating Income Purchase Price or Value

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Value Value = Net Operating Income Cap Rate

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Multiple Period Return Measures CF 1 CF 2 Projected Resale CF T Equity = PV e = (1 + irr) (1 +irr) 2 (1 + irr) T

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Multiple Period Return (Contd.)  The Equity IRR is compared to the required rate of return and if the IRR is equal to or greater than the required rate of return on equity the investment is acceptable  Typical IRRs are in the 12% to 15% range

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Multiple Period Return (Contd.)  Reversion Value  R is the "going out" cap rate on the property  R =, > or < Initial Year Cap Rate, depending on perception NOI T+1 Resale Price T = R

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Example: One Year Assume there are two studio apartment units renting at $600 per month… EXCEL SHEET

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Example: Ten Year Proforma EXCEL SHEET

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Lease Analysis and Cash Flow Projection  Reliable cash flow projections require tenant by tenant – Lease analysis  Evaluation of existing leases on basis of comparisons to the market rent for similar credit risk and size tenants

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Example: Lease Analysis “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

The Impact of Cycles, marketing and Management on Cash Flows

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner Spreadsheets and Software  ARGUS from the REALM –  REAL DCF –  PLANEase –

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner END