CH. 19: Concept Checks
* non-recurring capital expenses & tenant improvements in cash flow projections can be describe be various different terms (3):
"capital costs" "capital expenditures" "reserve for capital expenditures"
* why do BTCF estimates significantly OVERSTATE the amount of cash that investors will actually net from the investment?
... because: the estimated tax liability is a significant percentage of the before-tax cash flow
* estimated tax liabilities are NOT calculated by applying the assumed tax rate to the BTCFs - WHY?
... because: cash flow is NOT THE SAME as taxable income
Why might an real estate investor borrow to help finance an investment even if they could afford to pay 100% cash?
BORROWING = the use of "other peoples' money" (or, the use of financial LEVERAGE) if the overall return on the property exceeds the cost of debt, the use of leverage can significantly increase the rate of return investors earn on their invested equity ... this expected magnification of return often induces investors to partially debt-finance even if they have the wealth to pay all cash for the property
* why is BTCF considered a levered cash flow?
BTCF represented CF to the equity investor AFTER the effects of financial leverage (i.e. debt service) have been subtracted ... in contrast, NOI is an UNLEVERED CF because it represents the return on the entire investment, not just the portion of the investment financed with equity capital
* financial ratio: DEBT COVERAGE RATIO (DCR)
DCR = [NOI] / [DS] shows the extent to which net operating income can DECLINE before it is insufficient to service the debt; provides indication of safety associated with use of borrowed funds provides the investor (and lender) with a safety margin
* what's the difference between the EDR and Ro?
DIFFERENCE: the effects of debt financing have been subtracted from both the numerator and the denominator of the EDR ... thus, the CF in the numerator measures the amount received by the equity investor after paying all operating and capital expenses AND after servicing the debt ... this "residual" cash flow is then compared to the equity investors' cash investment (AKA "cash-on-cash" return)
* profitability ratio: EQUITY DIVIDEND RATE (EDR)
EDR = [BTCF] / [EQUITY INVESTMENT] EDR shows investors what percentage of their equity investment is expected to be returned to them in cash (before income taxes) also referred to as the "CASH-ON-CASH" RETURN
Summarize the calculation of net operating income
Effective gross income is equal to potential gross income minus vacancy and collection losses, plus miscellaneous income ... Net operating income is equal to effective gross income minus operating expenses and capital expenditures ... PGI (VC) + MI ------ EGI (OE) (CAPX) *{above-line treatment} ------- = NOI **below-line treatment of CAPX: EGI (OE) ------- = NOI (CAPX)
* cash flow multiplier: GROSS INCOME MULTIPLIER (GIM) (used more frequently than NIM)
GIM = [ACQUISITION PRICE] / [EGI] To compare gross income multipliers, the properties should be traded in the same market and should be equivalent in expense patterns, risk, location, physical attributes, time, and terms of sale
* while multipliers vary greatly, what is the normal range for annual gross income multipliers? what is the range for normal net income multipliers (typically office properties)?
GIM: between 4 - 8 NIM: between 5 - 12
* financial ratio: LOAN-TO-VALUE RATIO (LTV)
LTV = [MORTGAGE BALANCE] / [ACQUISITION PRICE] measures % of acquisition price (or current market value) encumbered by debt if property values DECLINE after the origination of the mortgage, the LTV ratio may INCREASE even though scheduled principal amortization is reducing the remaining mortgage balance
* who has the superior claim on cash flows in a real estate investment?
MORTGAGE LENDERS have a claim on CFs that is superior to the claim of the EQUITY INVESTOR
* cash flow multiplier: NET INCOME MULTIPLIER (NIM)
NIM = [ACQUISITION PRICE] / [NOI 1] NIM is the reciprocal of the cap rate ... overall cap rate: Ro = [NOI 1] / [ACQUISITION PRICE] properties with a relatively high cap rate (overall return) sell for a lower multiple of NOI
* how do you find before-tax cash flow?
NOI (DS) ----- = BTCF
* how do you find after-tax cash flow?
NOI (DS) ----- BTCF (TAX) ------ = ATCF
* financial ratio: OPERATING EXPENSE RATIO (OER)
OER = [OE] / [EGI] (expresses operating expenses as a % of effective gross income) the greater the OER, the larger the portion of effective rental income consumed by operating expenses
What is the major shortcoming of most ratios when they are used to make investment decisions?
a major short coming of using ratios to make investment decisions is that they generally IGNORE cash flows beyond the 1st year of operations ... thus, unlike NPV & IRR, ratios are not able to capture the magnitude and timing of all expected future cash flows
What is the more traditional treatment of CAPX?
the more traditional treatment of NON-RECURRING capital expenditures is to treat them above line with an estimated reserve for replacement the creation of spreadsheet programs and software made the construction and estimation of multi-period discounted cash flow models feasible... thus, instead of estimating an annual reserve, analysts may choose to make explicit forecasts of future capital expenditures
* how are financial risk ratios helpful to lenders?
these ratios are helpful in assessing the risk of lending to investors on particular projects
* when a mortgage loan in obtained, the cash down payment (i.e. EQUITY) required at property acquisition is equal to:
Equity Down Payment: E = [ACQUISITION PRICE] - [NET LOAN PROCEEDS] Net Loan Proceeds = the face (stated) amount of the loan, minus up-front financing costs paid to the lender (i.e. discount points)
* single-year return measures and ratios that are widely used by real estate investors can be grouped into 3 categories:
PROFITABILITY RATIOS (determine an investment's capacity to produce income in relation to the capital required to obtain that income) MULTIPLIERS (income multipliers can be used to provide quick assessment of whether a property is priced reasonably in relation to its gross or net income) FINANCIAL {risk} RATIOS (measure the income-producing ability of the property to meet operating and financial obligations)
* what type of questions should investors consider when estimating rents, vacancies, operating expenses, and capital expenditures? why?
answers to these questions will assist in the evaluation of the completeness and accuracy of the pro forma cash flow projections: 1. are the sources of income and expenses appropriate? (should relate directly and entirely to the income producing ability of the property) 2. have the trends for each revenue and expense item been considered? (should avoid considering only recent events in the detriment of long-term trends) 3. what about comparable properties? (should obtain information about revenue and expense items for comparable properties whenever possible - otherwise it is often too narrow a perspective) 4. what are the prevailing social and legal environments? (an understanding of current local controls and regulations - zoning, land use, environment controls - is a prerequisite for successful real estate investing, even if changes are difficult to predict)
* why does use of the capitalization rate as a measure of profitability have limitations?
because many commercial property investors involve the use of mortgage funds and because the cost of mortgage debt may differ across investment opportunities
* investors receive only the property CFs that are left after the lender(s) and the state and federal governments collect their (substantial) share of cash flows ... how is this relevant to investors' cash flow?
consequently, the measure of cash flow MOST relevant to investors in the after-tax cash flow (ATCF) from property operations
* The property's current and projected future NOI is the fundamental determinant of VALUE, to what could NOI be compared to in an analogy to the STOCK MARKET?
in an analogy to the stock market, NOI is the annual "dividend" expected to be produced by the property it must be sufficient to provide the investor with an acceptable first-year rate of return
* Describe: tenant improvement allowance ("TI")
most office leases provide a new tenant with "tenant improvement allowance" - a lease provision that obligates the landlord to incur a pre-specified dollar amount of expenditures to improve the space to the tenant's specifications
Define net loan proceeds:
net loan proceeds equal the face amount of the loan minus all costs associated with obtaining the mortgage; it can be thought of as the actual cash the borrower nets from the lender at closing ... recall, however, that mortgage payments are based on the face value of the loan, NOT the net loan proceeds
Why do class B properties sell at higher going-in cap rates than class B properties?
relative to class A properties, class B properties are more RISKY and/or expected to produce smaller rental increases over time ... both effects reduce the amount a rational investor is willing to pay today per dollar of current net operating income when values/prices fall relative to current net operating income, CAP RATES INCREASE
To calculate the expected income tax liability in a given year, why can't the analyst simply apply the investor's tax rate to the estimated BTCF?
the analyst cannot simply apply an investor's tax rate to the estimated before-tax cash flows to calculate income tax liability in a given year BECAUSE some cash expenditures that reduce BTCF, such as capital expenditures and the principal portion of mortgage payments, are NOT deductible in the calculation of taxable income from property operations ... on the other hand, tax law allows investors to take deductions for several items that are not associated with actual cash expenses ... in short, taxable income can vary significantly from BTCF, so the analyst cannot simply multiply the estimated BTCF by the investor's tax rate
* profitability ratio: CAPITALIZATION RATE
the going-in capitalization rate on an acquired property, known as the overall cap rate Ro = [NOI 1] / [ACQUISITION PRICE] Ro = the (first year) cash flow return on the total investment, AKA the return on funds supplied by both equity investors and lenders it measures the overall income-producing ability of the property
Why is BTCF a better measure of investor cash flow than NOI?
the investor does not get to pocket the NOI of the property if the acquisition has been partially debt financed ... rather, the investor/borrower must pay the promised mortgage payment out of the property's NOI ... thus, BTCF better reflects the amount of cash the investor will net from the investment after servicing the debt, but before income taxes
Why is the estimation of property level cash inflows and outflows often just the first step in determining the cash flows and returns expected by various investors in the ownership entity?
the majority of commercial properties in the U.S. are not purchased by individuals, but by multiple investors in the form of partnerships, LLCs, and other ownership entities... thus, the property level cash inflow and out flow must be allocated to various investors in order to calculate a particular investor's going-in IRR and NPV