cash flow Archives - Page 2 of 4

How to Look at Reserves for Replacement When You Invest in Income-Property

Posted on April 9, 2014 (May 3, 2022) by Frank Gallinelli

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.

What are “Reserves for Replacement?”

Nothing lasts forever. While that observation may seem to be better suited to a discourse in philosophy, it also has practical application in regard to your property. Think HVAC system, roof, paving, elevator, etc. The question is simply when, not if, these and similar items will wear out.

A prudent investor may wish to put money away for the eventual rainy day (again, the roof comes to mind) when he or she will have to incur a significant capital expense. That investor may plan to move a certain amount of the property’s cash flow into a reserve account each year. Also, a lender may require the buyer of a property to fund a reserve account at the time of acquisition, particularly if there is an obvious need for capital improvements in the near future.

Such an account may go by a variety of names, the most common being “reserves for replacement,” “funded reserves,” or “capex (i.e., capital expenditures) reserves.”

Where do “Reserves for Replacement” Fit into Your Property Analysis?

This apparently simple concept gets tricky when we raise the question, “Where do we put these reserves in our property’s financial analysis?” More specifically, should these reserves be a part of the Net Operating Income calculation, or do they belong below the NOI line? Let’s take a look at examples of these two scenarios.

reserves for replacement, after NOI

Now let’s move the reserves above the NOI line.

reserves for replacement, befeore NOI

The math here is pretty basic. Clearly, the NOI is lower in the second case because we are subtracting an extra item. Notice that the cash flow stays the same because the reserves are above the cash flow line in both cases.

Which Approach is Correct?

There is, for want of a better term, a standard approach to the handling capital reserves, although it may not be the preferred choice in every situation.

That approach, which you will find in most real estate finance texts (including mine), in the CCIM courses on commercial real estate, and in our Real Estate Investment Analysis software, is to put the reserves below the NOI – in other words, not to treat reserves as having any effect on the Net Operating Income.

This makes sense, I believe, for a number of reasons. First, NOI by definition is equal to revenue minus operating expenses, and it would be a stretch to classify reserves as an operating expense. Operating expenses are costs incurred in the day-to-day operation of a property, costs such as property taxes, insurance, and maintenance. Reserves don’t fit that description, and in fact would not be treated as a deductible expense on your taxes.

Perhaps even more telling is the fact that we expect the money spent on an expense to leave our possession and be delivered to a third party who is providing some product or service. Funds placed in reserve are not money spent, but rather funds taken out of one pocket and put into another. It is still our money, unspent.

What Difference Does It Make?

Why do we care about the NOI at all? One reason is that it is common to apply a capitalization rate to the NOI in order to estimate the property’s value at a given point in time. The formula is familiar to most investors:

Value = Net Operating Income / Cap Rate

Let’s assume that we’re going to use a 7% market capitalization rate and apply it to the NOI. If reserves are below the NOI line, as in the first example above, then this is what we get:

Value = 55,000 / 0.07

Value = 785,712

Now let’s move the reserves above the NOI line, as in the second example.

Value = 45,000 / 0.07

Value = 642,855

With this presumably non-standard approach, we have a lower NOI, and when we capitalize it at the same 7% our estimate of value drops to $642,855. Changing how we account for these reserves has reduced our estimate of value by a significant amount, $142,857.

Is Correct Always Right?

I invite you now to go out and get an appraisal on a piece of commercial property. Examine it, and there is a very good chance you will find the property’s NOI has been reduced by a reserves-for-replacement allowance. Haven’t these people read my books?

The reality, of course, is that diminishing the NOI by an allowance for reserves is a more conservative approach to valuation. Given the financial meltdown of 2008 and its connection to real estate lending, it is not at all surprising that lenders and appraisers prefer an abundance of caution. Constraining the NOI not only has the potential to reduce valuation, but also makes it more difficult to satisfy a lender’s required Debt Coverage Ratio. Recall the formula:

Debt Coverage Ratio = Net Operating Income / Annual Debt Service

In the first case, with a NOI of $55,000, the DCR would equal 1.41. In the second, it would equal 1.15. If the lender required a DCR no less than 1.25 (a fairly common benchmark), the property would qualify in the first case, but not in the second.

It is worth keeping in mind that the estimate of value that is achieved by capitalizing the NOI depends, of course, on the cap rate that is used. Typically it is the so-called “market cap rate,” i.e., the rate at which similar properties in the same market have sold. It is essential to know the source of this cap rate data. Has it been based on NOIs that incorporate an allowance for reserves, or on the more standard approach, where the NOI is independent of reserves?

Obviously, there has to be consistency. If one chooses to reduce the NOI by the reserves, then one must use a market cap rate that is based on that same approach. If the source of market cap rate data is the community of brokers handling commercial transactions, then the odds are strong that the NOI used to build that market data did not incorporate reserves. It is likely that the brokers were trained to put reserves below the NOI line; in addition, they would have little incentive to look for ways to diminish the NOI and hence the estimate of market value.

The Bottom Line – One Investor’s Opinion

What I have described as the standard approach – where reserves are not a part of NOI – has stood for a very long time, and I would be loath to discard it. Doing so would seem to unravel the basic concept that Net Operating Income equals revenue net of operating expenses. It would also leave unanswered the question of what happens to the money placed in reserves. If it wasn’t spent then it still belongs to us, so how do we account for it?

At the same time, it would be foolish to ignore the reality that capital expenditures are likely to occur in the future, whether for improvements, replacement of equipment, or leasing costs.

For investors, perhaps the resolution is to recognize that, unlike an appraiser, we are not strictly concerned with nailing down a market valuation at a single point in time. Our interests extend beyond the closing and so perhaps we should broaden our field of vision. We should be more focused on the long term, the entire expected holding period of our investment – how will it perform, and does the price we pay justify the overall return we achieve?

Rather than a simple cap rate calculation, we may be better served by a Discounted Cash Flow analysis, where we can view that longer term, taking into account our financing costs, our funding of reserves, our utilization of those funds when needed, and the eventual recovery of unused reserves upon sale of the property.

In short, as investors, we may want not just to ask, “What is the market value today, based on capitalized NOI?” but rather, “What price makes sense in order to achieve the kind of return over time that we’re seeking?”

How do you treat reserves when you evaluate an income-property investment?

—-Frank Gallinelli

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Your time and your investment capital are too valuable to risk on a do-it-yourself investment spreadsheet. For more than 30 years, RealData has provided the best and most reliable real estate investment software to help you make intelligent investment decisions and to create presentations you can confidently show to lenders, clients, and equity partners. Learn more at www.realdata.com.

The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

Podcast: “Learn the key principles to effectively analyzing and evaluating your real estate deals”

Posted on February 25, 2014 (November 6, 2023) by Frank Gallinelli

I had the pleasure of recording a podcast recently with real estate entrepreneur Kevin Bupp. We discussed what I feel are some of the key principles that every real estate investor ought to understand — and so, I invite you to listen to that podcast here.

Understanding Net Operating Income

Posted on January 15, 2014 (May 2, 2022) by Frank Gallinelli

My recent discussions here of cash flow, DCF, pro formas and the like have prompted some readers to ask for a review of the key metrics that underlie a good and thorough income-property analysis.

One of the downsides of hanging around in business too long — we’re closing in on our 33rd anniversary — is that some of our best material is now lurking off in the archives. So, after digging around in our virtual attic, I’ve found several topics that go to the heart of the matter, and that attracted quite a few readers when they first appeared.

Topping that list is our article about Net Operating Income. Here is a trailer of sorts, with a link to the complete article:

Understanding Net Operating Income

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.

Everyone in business or finance has encountered the term, “net income” and understands its general meaning, i.e., what is left over after expenses are deducted from revenue.

With regard to investment real estate, however, the term, “Net Operating Income” is a minor variation on this theme and has a very specific meaning. …

read the rest of the article here—>>

—Frank Gallinelli

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The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

The Cash-on-Cash Conundrum, Part 2

Posted on September 30, 2013 (May 3, 2022) by Frank Gallinelli

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.

Simplicity is a good part of CoC’s appeal. Unfortunately, that is also part of its weakness. If you are using this metric to help you decide whether a potential income-property purchase is a promising investment or not, then you need to look carefully at the story—or stories—that may lurk behind these numbers. In keeping with our literary metaphor, let’s call them our subplots.

Subplot #1: A Point in Time

Clearly, when you take the first-year’s cash flow and divide it by the cash used to purchase, you are looking at a property’s performance essentially at a point in time, a single year. To be sure, the reliability of your cash flow projection is likely to be greatest in that one, immediate time frame. I often hear investors say that they are not comfortable trying to predict the future, that they would rather just look at what is happening now; and they are quite justified in saying that if the return looks grim or perhaps negative right out of the box, then they have no interest in looking further.

Understandable, but potentially shortsighted—literally. By looking at a single year, you are looking at what may be an improbable investment horizon. Will you keep this property for just one year? If not, if you plan to hold on to it longer, then you’re not taking into account anything having to do with its possible future performance. Do you believe each future year will be exactly like this year, or could reasonably anticipated changes in cash flow (such as schedule increases in commercial lease rents, or large expenditures for needed repairs) push the needle far to one end or the other?

Subplot #2: The Time Value of Money

“All right,” you say, “then I’ll estimate the Cash-on-Cash Return for each of the next several years.” That may look like a step in the right direction, and I talk to a lot of folks who insist on doing just that, but it won’t take into account the time value of money. You’ll be looking at the face value (undiscounted) of expected future cash flows, and weighing them against the present value of your cash investment today. Go back to that original example, where you invested $100,000. If you predict a $20,000 cash flow ten years from now, does that really mean your investment is returning 20%?

To be fair, future-year Cash-on-Cash can impart some useful information. For example, if the metric is both positive and increasing, then you can infer that your cash flow is improving each year. The trend can help inform your decision, but the actual percentage return may not have a great deal of meaning.

Subplot #3: Smoke and Mirrors

You retreat and say, “OK, let’s go back to thinking about just the first year of operation. Surely the Cash-on-Cash should give me a good sense of initial performance.” Do you remember the old computer chestnut, “Garbage in, garbage out?” Your results are only as good as the assumptions and data that you put in the dispose-all, and perhaps things aren’t always (or ever) what they seem.

Consider:

You are looking at in income-and-expense statement (what we call an APOD in real estate investing—Annual Property Operating Data) provided by the seller of the property. The cash flow is based, in part, on operating expenses, one of which is Maintenance and Repairs. The figure in the example above is $6,000; you secure the owner’s tax return and confirm that this is indeed the figure he declared.

That is how much he actually spent, but the figure seems a bit low to you. Does it mean the owner performed as little maintenance as he could get away with and never fixed anything until it was absolutely necessary? Perhaps the owner did this to prop up the property’s cash flow in anticipation of selling. Despite the fact that the expense disclosed is technically correct, you decide you shouldn’t use it as a forward-looking assumption. Instead, you will probably have to project spending more once you take ownership, resulting in a diminished cash flow and a lower Cash-on-Cash Return. In addition, the property may actually be worth less than you assumed, since it does not throw off as much net income as you were led to believe.

Now take a different point of view. Based on your experience, you think the maintenance and repair expenditure shown is surprisingly high. Could there be an explanation for that? Perhaps the owner used the past year to catch up on deferred maintenance so the property would look more presentable when he put it up for sale. You might be tempted (but only in your most private thoughts) to test the impact of lower maintenance costs on your cash flow and CoC return. Once again, the amount that was disclosed, although correct, may not be the amount that gives you the best estimate of future cash flow or Cash-on-Cash Return.

Subplot #4: The Forecast—Cloudy, with a Chance of Cash Flow

Finally, there is the larger issue of the structure of the cash flow statement itself. What you decide to include or exclude in your forecast of future cash flow will almost certainly be driven by your personal agenda in creating that cash flow statement. Are you the seller of the property, looking to make its income stream appear as strong as possible? Are you the buyer, trying to make a realistic projection of how this property will really perform, and perhaps also conveying that stark realism back to the seller as part of your price negotiation?

In either case—as well as in any of several others, such as buyer looking for financing, general partner looking for equity investors, etc.—you might be putting a bit of a spin on the data, the better to support your point of view and the message you want to deliver.

If you’re the seller, then a bit of topspin seems like a good idea to you. In the example shown in Part 1 of this discussion, you might argue that, not only did you provide accurate and verifiable income and expense data, but that you were being exceptionally open and above-board by suggesting an allowance for vacancy and credit loss even though you experienced no such loss. Group hug.

But if you’re the buyer, you might return this with some backspin. You thank the seller for being so forthright, but add that you believe the vacancy and credit loss allowance should be closer to 5%, not 3%. In addition, you point out that routine maintenance is great, but will not prevent big-ticket items from wearing out eventually. For example, the heating boiler is barely hanging on, and the flat roof has less than 10 years of life left in it. Hence you propose reconstructing the cash flow statement to reflect the higher vacancy allowance, as well as need for an immediate capital improvement and an ongoing set-aside of cash flow into a reserve account to deal with future replacements, such as the roof.

What previously was a robust 10.4% return now becomes an anemic 2.1%.

The seller objects that this isn’t entirely fair, since the boiler repair is a one-off event, and removing that cost would bring us up to 6.1%.

The seller’s argument cycles you right back to Subplot #1 about the hazards of relying on a rate-of-return metric that looks only at a point in time in what is probably going to be a long-term investment.

Is There a Bottom Line?

What should you conclude about Cash-on-Cash Return? Is it, as some contend, the only metric worth looking at? Is it of no use at all? The best answer probably lies somewhere in between, that you need to recognize both CoC’s strengths and its limitations, and not rely on it as your sole investment decision-making tool.

On the plus side:

It is quick and easy to calculate.
It can give an immediate comparison to the return on other short-term investments.
It focuses on the most current performance of the property; the more recent the data, the more likely it is to be reliable.

Among the negatives:

It focuses on single point in time; you may be intending to buy and hold for an extended period, and the future performance of the property can differ greatly from the short term.
It does not take into account the time value of money; if you use it beyond the current period, you may be comparing a future, undiscounted cash flow to the amount invested today.
It is easy to manipulate the results; hence, a novice investor who relies on this metric alone can be misled by what a third party chooses to include or exclude from a property’s cash flow statement.

So are there some bottom-line recommendations here? Of course.

Start off by trying to develop a CoC calculation in which you can have reasonable confidence.

To do so, remember that there is no substitute for due diligence. At the most basic level, you need to confirm whether the data you see on the cash flow statement for a particular property is reasonable and accurate. Then you need to go further and examine the physical property and the market to see if there are issues that may affect your confidence in those numbers. Is there any reason to doubt that the current revenue stream will continue as it is now? Is the demand for space in this market changing, for good or ill? Is there deferred maintenance that you will have to deal with? Based on what you find, you may have to reconstruct that cash flow statement.

Don’t just look at what is on the cash flow statement; look for what might be missing. A seller may not volunteer an allowance for vacancy or a need to fund a reserve account, but such items are going to be part of your reality as an owner.

So long as you approach it with sufficient care and due diligence, the Cash-on-Cash Return can give you a useful first look at how a property might perform; but before you commit your investment dollars, you need to do more.

If you plan to operate this property for several years, then you need to take the long view. You should identify your likely investment horizon, and then build a series of pro formas to forecast how the property might perform over time.

A series? Yes. Don’t try to nail your projections of future performance in one pass. Do a best-case, worst-case, and in-between forecast of future cash flows and ultimate resale of the property. Look at the ongoing Debt Coverage Ratio in each case. Examine the IRR or MIRR. Even compare this property to others you might be able to acquire.

Be thorough. Be wary of shortcuts. You’re buying a future income stream; do your homework and run your numbers so you can understand just what it is that you’re buying. Your investment success depends on it.

read my postscript

— Frank Gallinelli

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The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

The Cash-on-Cash Conundrum, Part 1

Posted on September 25, 2013 (March 15, 2022) by Frank Gallinelli

Life is too complicated; we have too many choices, too many options, too many channels on cable TV. It’s not surprising that sometimes we crave simple answers to complex questions.

I see that mindset very often in my interactions with real estate investors. They yearn to embrace the “50% rule” or the “2% rule” or some other shortcut that will help them cut to the chase and decide if a particular property is a good deal or not.

One metric that is relatively simple and historically very popular is the Cash-on-Cash Return (CoC). I encounter many real estate investors (more than a few of whom have a net worth significantly greater than that of this writer) who zero in on that metric like a heat-seeking missile whenever they consider buying a property. What exactly is Cash-on-Cash Return? How do you calculate it? What are its strengths and weaknesses? Is it a good metric, and perhaps more important, is it good enough?

Cash-on-Cash Return may be one of the few bits of financial terminology whose name could almost serve as its definition. You’re expecting to get a cash return on your cash invested, i.e., to earn cash on your cash. If you express the return as a percentage of the amount invested, then you have the Cash-on-Cash metric.

Let’s see this with some actual numbers. You are considering the purchase of a particular income property. For this discussion, the purchase price of the property is not the number you want to focus on. Rather, it’s the amount of your own money—the cash you actually put on the table—that you’ll be looking at. You need $100,000 to close the deal.

You’ve obtained information about the rental income, the operating expenses and the expense reimbursements paid by the tenants. To that information you’ve added your own allowance for vacancy and credit loss, as well as your expected annual debt service on the mortgage that you’ll need to complete the purchase. You put this all together into a cash flow statement that looks like this:

Now you do the cash-on-cash math:

So now you see your Cash-on-Cash Return is apparently 10.4%. What are you to make of this?

First, you recognize that this was a very quick and easy calculation to perform. You needed just the amount of your cash investment and some basic information about anticipated revenues and expenditures. No heavy lifting here.

Second, you observe that your cash-on-cash (and therefore your cash flow) is a positive number. That’s really important, because it means you don’t expect to reach into your own pocket to pay the bills. You have more coming in than going out.

Third, you recognize that this really quick calculation allows you to compare the first-year return on this investment to that of other short-term opportunities like CDs or T-Bills. You look at 10.4% and that strikes you as a fairly good rate of return.

In short, your initial take here is that this metric was really easy to calculate; that it told you that the property seemed likely to enjoy a positive cash flow in the first year; and that the rate of return on your cash investment appeared to be significantly better than you might get from a bank or a bond.

Are you satisfied that you can make an informed decision to buy or not to buy this property based on your calculations here? You shouldn’t be. Yes, you believe the rent and expense figures are accurate, and you did the math correctly, but are you confident that you’re seeing the complete picture? My continual mantra to my finance students is, “Look beyond the numbers, look for the story that’s behind what you see on the surface.”

It’s tempting to think that this calculation of cash-on-cash has given you an adequate perspective on how this investment will perform, but there is really a great deal more to look at and to think about here. That’s what we’ll do in the next installment.

(to be continued part 2)

— Frank Gallinelli

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The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

Real Estate Investing: Time to Remember the Lessons of History

Posted on September 11, 2013 (September 6, 2022) by Frank Gallinelli

As the summer 2013 begins to cool off, many real estate markets are finally starting to heat up. For a lot of folks, who have slogged through five of the worst economic years in memory, it feels a bit like we’ve just been released from the locked trunk of a car.

The temptation now is to celebrate our release from investing confinement by jumping back into the market with both feet. Before we do so, however, it would be wise to reflect on a few of the lessons of recent history.

There were many reasons for the financial meltdown, but one of the biggest surely was the belief that real estate inexorably increases in value over time. To many people, that looked like a law of nature. The reality turned out to be different, and now, as property values start to rise, we have to resist the temptation to start believing this all over again. If not, we will simply create another bubble and repeat the cycle.

Another cause of that meltdown was the tendency to dismiss or completely ignore investment fundamentals. Real estate simply couldn’t fail to do well (after all, they’re not making any more of it), and we didn’t really need to think too hard about our investments because, surely, they would work out happily in the end.

Savvy investors always knew that this wasn’t necessarily true; they knew that income-producing real estate could go up, down, or sideways. Time, all by itself, does not create value; the ability of a property to produce income is what creates value, and so the prudent investor would take nothing for granted and always carefully weigh a property’s prospects for generating income today and in the future.

The beginnings of a general economic recovery—and, in particular, a real estate recovery— may signal that we can and should get back into the game, but it doesn’t mean that we can return to pre-2008 thinking and disregard the fundamentals that ought to guide our investment decisions: For example:

Due Diligence: This is just as important in good times as in bad. We need to examine thoroughly and critically all of the financial data we can get our hands on about a potential investment property. Are the rents really as represented? Are the operating expenses as portrayed by the seller reasonable and complete? Have we done a thorough assessment of the property’s physical condition?

It is essential to remember that a property doesn’t live in a vaccum, so our due diligence needs to extend beyond the individual property and include the local market as well. What is the prevailing capitalization rate for properties of this type in this market? What kind of rents are similar buildings actually getting, and what are the asking rents in properties that may be in competition with us for tenants? What is the current vacancy rate in this market, and has it been rising or falling? What is the general business climate, and in what direction is it headed?

Cash Flow: We always need to make hard-headed projections about the prospects for current and future cash flow. Too often we see investors, motivated to make a purchase and get on the presumed gravy train, put together the numbers they want to see. They ignore the potential for vacancy and credit loss. They ignore setting some of their potential cash flow aside each year as a reserve to pay for that new roof or new HVAC system a few years down the road. We should make best-case, worst-case, and in-between projections to give ourselves a sense of the range of possible outcomes.

It is important to be realistic about cash flow projections. Excessive leverage may seem like a great advantage on the day you close the purchase, but the high debt service may also result in very weak or even negative cash flow. Are you really prepared to support your property out of your own pocket, to absorb unexpected expenses or loss of revenue?

The Long View: We seldom buy an income property with the expectation of flipping it for short-term profit. Rather, our plan is probably to buy and hold so we can derive an annual cash flow plus a long-term gain when we sell. If that is indeed our plan, then we need to forecast the property’s performance not just for one year, but for a likely holding period—perhaps five, seven or ten years—and to compute an Internal Rate of Return for that holding period. Doing so can be especially valuable when we are looking at more than one property that we might purchase. Which one appears likely to give us the best overall return within our investment horizon?

The Last Word: Investing in real estate can be a profitable move in just about any economic climate if we proceed wisely, so to answer our initial question: Yes—if we’ve been on the sidelines, then this is a fine time to get back in. But as with any other kind of investment, we can just as easily lose money as make it if we charge ahead without doing our homework and without going through the kind of fundamental analysis and projection that is essential to smart investing. Success in real estate investing, as in most endeavors, doesn’t just happen by good luck or chance. We have to work at it and have our head in the game. The luck will follow.

— Frank Gallinelli

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The information presented in this article represents the opinions of the author and does not necessarily reflect the opinions of RealData® Inc. The material contained in articles that appear on realdata.com is not intended to provide legal, tax or other professional advice or to substitute for proper professional advice and/or due diligence. We urge you to consult an attorney, CPA or other appropriate professional before taking any action in regard to matters discussed in any article or posting. The posting of any article and of any link back to the author and/or the author’s company does not constitute an endorsement or recommendation of the author’s products or services.

How to Create Best-Case and Worst-Case Property Analyses in REIA Professional

Posted on September 10, 2013 by chris

You already know that pro forma property analysis is an essential part of due diligence before jumping in and spending your money on a real estate investment. You also know the value of the pro forma analysis is only as good as the care and consideration you give to all your assumptions about the purchase, operation and sale of the property. Part of being a cautious and calculating investor is to consider best-case assumptions, worst case assumptions and some case in between. Fortunately, this is an easy matter with RealData’s REIA Professional.

Here’s how:

Create your initial analysis with REIA Pro with a complete set of assumptions. It does not matter whether these are conservative or aggressive, just save the file with an appropriate name such as “300 Main Street conservative.xltm”
After saving, use Excel’s Save As function to save a copy of the file with a new name. That file might be “300 Main Street aggressive.xltm” Repeat the process for your third case.
Adjust the data in the second two files to match the case. Save the files.
Open our Comparison Analysis add-on for REIA.
Click the Add Property button to include all three of the files you have created for your property. You will then see a side-by-side comparison of key metrics for all of the three cases.

Also consider using our new Decision Maker worksheet right within REIA Pro. This unique dashboard tool allow you to see how 21 metrics (such as Cash on Cash and IRR) change as you change key assumptions about your purchase. Change purchase price, vacancy rate, loan terms, etc.

Use these exercises to determine just how well your property might perform under a variety of future occurrences.

Investing in Real Estate: How Much Analysis Do You Really Need?

Posted on November 26, 2012 (March 15, 2022) by Frank Gallinelli

More than once – in my writing, my teaching, talking in my sleep – I have been known to say that real estate investing is all about the numbers. There is, of course, great truth in that pithy statement, or so I believe; but there is perhaps more to the story that you should be careful not to overlook.

The data that you collect about an income-property – the current rental income and operating expenses, the financing options, and the resulting cash flows and potential resale– are all essential to making an informed analysis of a property’s value and its appeal as an investment. So too is an understanding of the key metrics. What are the expected Debt Coverage Ratio, Capitalization Rate and Internal Rate of Return, and what do they all mean?

A wise investor realizes that this information represents the foreground, but not the complete picture. There is a context, a background, in which these data reside, and you ignore it at your peril.

When I teach real estate investment analysis to my graduate students, I begin by telling them that they absolutely must learn how to run and interpret the numbers. But I also stress (sometimes to the point of becoming really annoying) that they have to look behind the numbers, to read the information about the property as if it were a story. The financial facts and figures about a property that you uncover today may be entirely accurate, but can you rely on them them to persist? What are the long-term risks and opportunities, the indirect factors, and how do they inform the numbers that you will plug into your projections?

For example, if you have commercial tenants, how strong are their businesses? One of the case studies I give my students is a mixed-use property with retail tenants whose business models are on the decline. Those tenants have leases with options to renew, but if their customer bases are shrinking, isn’t it more prudent to suspect that they may not choose to renew? Shouldn’t you also consider what could happen to your cash flow in a worst-case scenario, where they go bankrupt before their current leases are up?

Rather than simply assuming an ongoing revenue stream from the current leases, perhaps, as I tell my students, you need to look beyond the current numbers. If you see some significant risk going forward, maybe you should build rollover vacancy, leasing commissions and tenant improvements into your projections of future performance. You’re still going to run the numbers, and they still matter; but now, taking a broader view may alter your perspective on possible future cash flows.

One way to widen your field of vision is to go beyond the specific property and take into account some intangibles, both local and global. Real estate, like politics, is very much a local game. How strong is the local economy? Is unemployment a problem? What is the trend in the absorption of space – are vacancies growing or declining? Where is your city or town’s budget heading? Are there bond issues on the horizon that could materially affect your property taxes? The answers to questions like these will connect directly to the kinds of assumptions you make concerning the risk of future vacancy loss, and the rate of growth, if any, in your rents.

Then there’s the global view. You want to look at how the overall economy might affect your property. For example, it is typically the case that in times of tight credit, or in a miserable economy such as we’ve seen for the past several years, demand for apartments tends to increase. There is nothing surprising in this. Folks can’t get mortgages because their incomes have dropped and perhaps because banks aren’t lending freely. People who would otherwise be prospective homebuyers or who would be able to stay in their current homes are now renting apartments, thus reducing vacancy and often pushing rents upward.

The same causes – a wounded economy and lack of credit – might lead to an opposite effect on office and retail space, where businesses have to downsize because their customers have less money to spend.

So, if you find yourself rolling into a particular economic cycle, then you will want to adjust your projections for the future accordingly. In the example above, you would begin with whatever revenue stream you find in place; then, in the case of apartments, you would probably project declining vacancy loss and increasing rental rates for a few years, but you would probably do the opposite for retail and office. Same starting point, but different paths into the future.

What is our takeaway here? First, that real estate investing really is about the numbers. You’re going to scrutinize every lease, every operating expense, every financing option to understand how you believe the property will function on the day you acquire it. There is no substitute for crunching these numbers, and no reason to dismiss what they tell you.

But then you’ll pause to recognize that you’re probably going to own the property well beyond that first day. That’s when you need to look up from your spreadsheet. You need to look both at and beyond the current data and metrics, to visualize the property and your expectations for it in the context of its larger environment. The numbers truly matter, but so does the sometimes dicey, not-so-tidy real world in which they dwell.

–Frank Gallinelli

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New for 2012: Real Estate Investment Analysis, Version 16

Posted on January 10, 2012 (March 28, 2022) by Frank Gallinelli

Thirty years of development time, and of listening carefully to what to our customers want. All this comes together now in the latest version of our most popular and powerful software app for real estate investors: Real Estate Investment Analysis, Version 16

What’s New in Version 16?

The Decision Maker
The centerpiece of v16 is a new module called “The Decision Maker.” Here is how it works: Enter data about the property — revenue, expenses, financing, etc. — as you normally would. Then go to the new module. The top half of the page will display 12-18 of your key assumptions, like those shown here:

snippet 1 from Decision Maker

You can now toggle any or all of your assumptions up or down with the arrows, while watching the effect of each change as it displays instantly on the bottom half of the page.

There you’ll see more than a dozen key metrics, such as cash flow and IRR. These will update in response to your clicking the arrows to raise or lower any of the basic assumptions; the data will display going out 20 years.

snippet 2 from Decision Maker

For example, toggle the purchase price or the cap rate up and down, and watch the effect on your IRR. Toggle the mortgage interest rate, watch the impact on your cash flow. What better way to decide how — or if — you can make this deal work. Hence the name: Decision Maker
Detailed Capital Improvements
Many users have asked to be able to provide a detailed break-out of anticipated expenditures for capital improvements. Here it is. You can now choose to fill out a complete year-by-year schedule of improvements, or simply enter an annual total.

Detailed Closing Costs
Likewise, the ability to itemize acquisition closing costs has been another common request. You now have two options: itemize or enter a single amount.

Improved Reports
We really do pay attention when users call and say things like, “Why doesn’t the partnership presentation show cash-on-cash return?” We keep track of those requests, and you’ll find several now implemented in v16.

Import Data from Your Version 15 Analyses
Here’s a big one: If you’re upgrading from v15 to v16 you can run a special function that will read all of the user entries from an analysis you did in v15 and transfer that information into the new version. That’s no small trick, but our super-smart programmers did it.

Upgrade from Version 15

If you’re currently a registered user of v15, keep your eye out for an email from us with an offer to upgrade at a nominal cost.

Refi Existing Investment Property to Purchase Another?

Posted on November 4, 2011 (March 28, 2022) by Frank Gallinelli

One of our Facebook fans, Tony Margiotta, posed this question, which I’m happy to try my hand at answering here:

“Could you talk about refinancing an income property in order to purchase a second income property? I’m trying to understand the refinance process and how you can use it to your advantage in order to build a real estate portfolio. Thanks Frank!”

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The Good News

Your plan – to extract some of the equity from an investment property you already own and use that cash as down payment to purchase another – is fundamentally sound. In fact, that’s exactly what I did when I started investing back in the ‘70s, so to me at least, it seems like a brilliant idea.

Of course, you need to have enough equity in your current property. How much is enough? That will depend on the Loan-to-Value Ratio required by your lender. The refi loan has to be small enough to satisfy the LTV required on the current property, but big enough to give you sufficient cash to use as the down payment on the new property.

For example, let’s say your bank will loan 70% of the value of your strip shopping center, which is appraised at $1 million. So, you expect to obtain a $700,000 mortgage. Your current loan is $550,000, which would leave you with $150,000 to use as a down payment on another property.

Given the same 70% LTV, $150,000 would be a sufficient down payment for a $500,000 property, i.e. 70% of $500,000 = $350,000 mortgage plus $150,000 cash.

But Wait… Some Issues and Considerations

Unfortunately, it’s not the ’70s or even ’07 anymore, so while the plan is sound, the execution may present a few challenges. Best to be prepared, so here are some issues to consider:

In the current lending environment, financing can be hard to find, and the terms may be more restrictive than what you experienced in the past. Notice that I used a 70% LTV in the example above. You might even encounter 60-65% today, while a few years ago it could have been 75-80%. In order to obtain the loan, you might also have to show a higher Debt Coverage Ratio than you would have in the past – perhaps 1.25 or higher, compared to the 1.20 that was common before.

How long have you had the mortgage on the current property? Some lenders will not let you refinance if the mortgage isn’t “seasoned” for a year or even longer.

How long have you owned the property? A track record of stable or growing NOIs over time will support your request for a new loan. You need to make a clear and effective presentation to the lender showing that the refi makes sense, especially in a tight lending environment.

You need to run your numbers and not take anything for granted. For example, will your current property have a cash flow sufficient to cover the increased debt?

Keep in mind that you’re adding more debt to the first property, so the return on the new property has to be strong enough to justify the diminution of the return on the first.

Have you compared the overall return you would achieve from the two properties using the refi plan as opposed to the return you might get if you brought in some equity partners to help you buy the new property?

In a nutshell, refinancing an existing income property to purchase another is a time-honored and proven technique, but it in a challenging lending environment be certain you do your due diligence and run your numbers with care.

Of course I never miss an opportunity to promote my company’s software, so consider using that not only to analyze the deal and its variations, but also to build the presentations that will optimize your chances of obtaining the financing and/or the equity investors.

Frank Gallinelli

Tag: cash flow

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