In the first part of our discussion, you looked at the simple math that underlies Cash-on-Cash Return. The short version goes like this: First you calculate your property’s first-year cash flow before taxes—essentially all the cash that comes in from operating the property minus all the cash that goes out. Then you divide that by your initial cash investment, and that percentage is your Cash-on-Cash Return. Nothing could be simpler.
Not all partnerships include a preferred return but, in those that do, its purpose is to counterbalance the risk associated with investing capital in the deal. Typically, the investor is promised that he or she will get first crack at the partnership’s profit and receive at least a X% return, to the extent that the partnership generates enough cash to pay it. In most partnership structures, the cash flow is allocated first to return the invested capital to all partners. The preferred return is paid next, before the General Partner or Managing Member receives any profit.
A while back, I posted a two-part series called “The Cash-on-Cash Conundrum.” In the first installment I explained the calculation and underlying logic of CoC, and in the second I discussed some of the pitfalls of overreliance on this particular measure.
It may sound like a nit-picking detail: Where and how do you account for “reserves for replacement” when you try to value – and evaluate – a potential income-property investment? Isn’t this something your accountant sorts out when it’s time to do your tax return? Not really, and how you choose to handle it may have a meaningful impact on your investment decision-making process.
Since we released the original version of our Real Estate Investment Analysis software in 1982, our focus has been on pro forma financial analysis of real estate investments and of development properties – projecting the numbers out over time to help users gain a sense of what kind of investment performance they might expect from a particular property or project. And for lo, these many years, our customers (and from time to time, we ourselves) have used the software to help make decisions as to whether or not to buy a property, and at what price and on what terms. Customers have used it to model how things might play out in the worst case, or in the best case, or somewhere in between. They have used it also to compare alternative investment opportunities.
In Part 1 of this article, you learned what information you need to assemble to get started with the process of refinancing your commercial property — information about your property’s income, expenses and loan balance, and about the prevailing cap rate in your market. You also learned to use some of that information to estimate the current value of the property, then learned to take that result to determine if the property will likely satisfy the lender’s Loan-to-Value requirement. You got acquainted with Debt Coverage Ratio and mortgage constants and saw how to combine those to test your property’s income stream to find out if it’s strong enough to support your loan request.
In a recent article, we discussed the use of capitalization rates to estimate the value of a piece of income-producing real estate. Our discussion concerned the relationship among three variables: Capitalization Rate, Present Value and Net Operating Income.
We may have gotten a bit ahead of ourselves, since some of our readers were unclear on the precise meaning of Net Operating Income. NOI, as it is often called, is a concept that is critical to the understanding of investment real estate, so we are going to backtrack a bit and review that subject here.
Why do you invest in income-producing real estate? Perhaps you are looking for cash flow. Possibly you anticipate some tax benefits. Almost certainly, you expect to realize a capital gain, selling the property at some future time for a profit. Your projection of the future worth of the property, therefore, can be a vital element in your investment decision.
You might employ the Back Door approach if you have a use looking for a site. You know what you want to build and can reasonably estimate the kind of rental revenue it can generate. The question for you as the developer is, “Will that revenue be sufficient to justify the cost of development?” Presumably, this technique is called “back door” because you’ll back into the maximum project cost that the use will support. Then, like Hamlet examining Yorick’s skull, you’ll ponder it until you decide if you can actually do the deal. In short, if your intended use will support a project that costs $x and no more, you must decide if you can you develop it for those $x.
In an earlier article we discussed the first of two ways that developers traditionally use to look at the feasibility of income-property projects. That one was called the “Back Door” approach. It will come as no surprise to learn that we call the other method the “Front Door” approach. The difference between these two approaches lies in what you consider to be the unknown variable. With the Back Door, you believe you know the rental rate that you can obtain for the space once it is built. You also know the cost of financing your project and what you consider to be an acceptable rate of return on your own equity investment. Blend this all together and what you’re really saying is that you know the revenue stream and want to figure out is the maximum total project cost that you can support with that revenue stream.