Insights

Expense recoveries (aka reimbursements or pass-throughs) serve as a customary ingredient in leases for non-residential property. In part 1 of this article, I discussed some of the typical ways such an arrangement might play out.

From our experience, it appears that Internal Rate of Return (IRR) is the metric of choice for many, if not most, real estate investors. However, you may be aware that there are a few issues with IRR that can cause you some vexation: If you expect a negative cash flow at some point in the future, then the IRR computation may simply fail to come up with a unique result; and with your positive cash flows, IRR may be a bit too optimistic about the rate at which you can reinvest them. For these reasons, a variation on IRR, called Modified Internal Rate of Return (MIRR), can be very important. When you see how it works, then you’ll also see that it gives you the opportunity to deal with IRR’s shortcomings.

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.

I had a question recently about a metric called Yield on Cost, aka Return on Cost and also sometimes called Development Yield. So what is it and when and how might it be useful?

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.

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.

We frequently hear a question that goes something like this: “I’m considering the purchase of an income property where the seller will take back a second mortgage for the entire down payment. Why can’t your software figure out the rate of return on a zero-cash-down investment?” You’ve surely heard the excuse, “It’s not the software’s fault” more times than you care to recall. This time, however, the blame really does not fall upon the software, the hardware, the astronauts, Bill Gates, el niño or any of the other usual suspects.

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.