Real EstateFinancial Analysis

Workbook

Reproduced with Permission ofThe Tuck School of Business at Dartmouth

©2003 Trustees of Dartmouth College. All rights reserved. For permission to reprint, contact the Tuck School of Business at 603-646-3176

Revised June 21, 2010

Contents

A. Introduction ..................................................................3

B. The Characteristics of Real Estate................................4

C. Forms of Profit in Real Estate........................................5

D. The Set-up......................................................................6

E. Real Estate Versus Business Profit & Loss....................8

Exercise 1 …………………………………………………………… 9

F. Debt and Equity.............................................................10

Exercise 2 ……………………………………………………………12

G. Concepts of Leverage....................................................13

H. Types of Mortgages.......................................................14

I. Measurements of Risk and Return................................15

Exercise 3 …………………………………………………………….18

J. Valuation and Cap Rates................................................19

Exercise 4 …………………………………………………………….20

K. Discounted Cash Flow Analysis …………………………………. 21

Exercise 5 …………………………………………………………… 22

L. Partnership Allocations …………………………………………… 23

Exercise 6 …………………………………………………………….24

M. Solutions (To Exercises 1-3) ......................................... 26

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A. Introduction

The financial analysis of real estate is a complex process. This is due to the unique characteristics of real estate as compared to other types of investments. These characteristics include:

1. The long time horizon associated with real estate transactions;

2. The lack of liquidity of real estate assets;

3. The impact of a changing environment on real estate values.

The financial analysis of real estate investments can be divided into three components:

1. Cash Flow: The amount of cash received annually.

2. Tax Effects: The impact of a real estate investment on an investor’s tax liability.

3. Future Benefits: The impact of the sale or refinancing of the property at a future date.

The following workbook contains a brief overview of the concepts of real estate financial analysis and a series of exercises designed to illustrate these concepts. For more in depth review of these concepts, refer to other sources.

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B. The Characteristics of Real Estate

Real estate investments have a number of unique and critically important characteristics. The six key characteristics of real estate are:

1. Fixed Location

2. Non-Standard Pricing

3. Capital Intensive and Often Highly Leveraged

4. Highly Cyclical

5. Locally as well as Nationally Regulated

6. Long Lived and Durable

Consider the financial implications of each of these characteristics and how they impact the value of a real estate investment over the long term.

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C. Forms of Profit in Real Estate

There are a variety of forms of profit that result from the development and ownership of real estate investments. Listed below are five key forms of profit.

Cash Flow Before Taxes: The cash flow generated periodically by the property. Cash flow before taxes consists of the excess of revenues over expenses including the payment of debt service but before the impact of federal income taxes.

Tax Shelter Benefits:........................................................The potential benefits unique to real estate from depreciation allowances and interest deductibility.

Residuals: The proceeds from the sale or refinancing of a property after all debts and other expenses have been paid off.

Equity Build-Up: The growth in an owner’s equity over time as the principal of a mortgage is repaid.

Fees: The expenses associated with a real estate transaction.

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D. The Set-up

The set-up is a real estate term for the combined income and cash flow statement. The set-up provides the basis for analyzing a potential real estate investment. By adjusting the assumptions used in a setup, an investor is able to test their impact on the cash flow.

Gross Revenues

(Vacancy Allowance)

Effective Gross Income

(Operating Expenses)

(Property Taxes)

(Structural Reserve)

Net Operating Income

(Debt Service)

Cash Flow Before Taxes

Components of the Set-up

Gross Revenues – the analysis begins with the projected rental and other revenues assuming 100% occupancy.

Vacancy Allowances – The appropriate percentage is a function of market conditions. It also includes an amount for bad debt and concessions.

Effective Gross Income (EGI) – The Gross Revenues minus the vacancy allowance.

Operating Expenses – This includes administrative, maintenance, repairs, insurance, utilities.

Property Taxes - The current taxes assessed on the subject property. (This line item is sometimes included in the operating expense figure.)

Structural Reserve – Some amount should be set aside for predictable expenses required to maintain the property, like a reserve for roof repairs. Some investors deduct this after net operating income.

Net Operating Income (NOI)or Cash Flow from Operations (CFO) – The Effective Gross Income less operating expenses and property taxes. For our purposes it also includes a structural reserve.

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Debt Service – The annual “constant payment” of principal and interest required to finance the property.

Cash Flow Before Taxes – The Net Operating Income less Debt Service.

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E. Real Estate Versus Business Profit & Loss

It is useful to compare a standard form of profit and loss statement used for business with real estate cash flow analysis. An example of each is presented below:

Real Estate Profit & Loss Business Profit & Loss

Gross revenue Sales (Vacancy Allowance) (Cost of Goods Sold) Effective Gross Income Gross Profit (Operating Expenses) (Sales, General Admin. Exp.) (Propery Taxes) Operating Profit (Structural Reserve) (Depreciation)

Net Operating Income (Interest)(Debt Service) (Rent)Cash Flow Before Taxes (Officer Compensation)

Earnings Before Income Taxes

The business profit and loss statement focuses on matching expenses to revenues. In contrast, real estate profit and loss is represented by a pure cash flow statement. Business profit and loss recognizes depreciation expense while the real estate profit and loss ignores it. The business statement recognizes only interest expenses while the real estate statement deducts total debt service including principal as well as interest. Finally, in business there is a focus on earnings and profit while in real estate cash flow is the primary focus.

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Exercise 1: The Gilbert Building

The Gilbert Building is a two story, 55,000 square foot office building with 50,000 sq. ft. of rentable space. It was recently completed in Madison, Missouri for a total development cost of $5 million. The building is 50% vacant. The building has a $3.5 million, 30 year, fully amortizing mortgage at an 8% interest rate. The debt service payments are approximately $25,682 per month or $308,184 per year. The gross revenues for the building are estimated at $20 per square foot per year. Operating expenses like heat, electric and insurance are estimated at $5.50 per sq. ft. of rentable space. Property taxes are $190,000 per year and the owner needs to fund a $10,000 structural reserve.

1. What does the set-up on this project look like at current occupancy rates?

2. How will the set-up for this building look when the building achieves 95% occupancy?

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F. Debt and Equity

Each real estate investment is financed either with debt or equity, or a combination of the two.

Cost = Debt + Equity

Lenders or owners expect to receive a risk adjusted, rate of return on their investment. The primary source of that return is the project’s cash flow and residual proceeds. The Net Operating Income (NOI) is the cash flow which is available to both the lenders and owners. The lender takes its share of cash flow first in the form of debt service. The owners (or investors) have a right to the cash flow that is left after payment of debt service.

Real Estate Cash Flow and Return on Equity

The most commonly used measure of rate of return by real estate investors is the “Cash-on-Cash” rate of return. It represents the cash return on the investor’s cash investment, that is, the return on their equity contribution.

Cash-On-Cash =

As the setup indicates, the cash flow before tax (CFBT) is the net cash available to the investor after all expenses and debt service have been paid. The equity is the actual cash equity invested into a project.

The Cash-on-Cash rate of return is not an earnings rate of return. The cash flow does not equal the project’s profit. It understates some expenses by ignoring depreciation and income taxes, while overstating other expenses by deducting the principal portion of the debt service, which actually represents equity accumulation.

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The Return on Assets or Free and Clear Return

If a property were not subject to financing, the net operating income (NOI) would represent the project’s cash flow. Here, the measure of return is the Return on Assets or the Free and Clear return, which equals NOI divided by the total cost of the project.

Return on Assets =

In this situation, the investor’s equity is the entire cost of the project and the Free and Clear Return measures the return on equity as if the project was “free and clear” of all debt.

The Debt Constant

Because real estate investors focus on cash flow, they are concerned about the full cost of their debt and not just the interest rate. The debt service component of the setup represents the annual principal and interest payments on the loan secured. The debt “constant” is a measure of the relative annual debt service burden vis-à-vis the original loan amount. It is the annual debt service, principal and interest, divided by the original amount of the mortgage.

Debt Constant =

Because of amortization, the constant is higher than the interest rate. If the loan was interest only, that is, no principal payment is included in the debt service, the interest rate equals the constant.

Cash-on-Cash Return = The return to equity

Return on Assets = The return without debt

Debt Constant = The return to debt

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Exercise 2: The Gilbert Building II

1. What is the debt constant for the Gilbert Building?

2. At 50% occupancy, what is the Return on Assets for the Gilbert Building?

3. At 50% occupancy, what is the Cash-on-Cash Return for the Gilbert Building?

4. If a major tenant were to lease 22,500 square feet of space in the Gilbert Building, at $20 per square foot bringing the occupancy rate up to 95%, what would be the Return on Assets?

5. At 95% occupancy, what would be the Cash-on-Cash Return for the Gilbert Building?

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G. Concepts of Leverage

There are two kinds of financial leverage, positive and negative.

1. Positive leverage increases the annual return on the equity invested. It occurs when the cost of debt is lower than the free and clear return (or the return on total assets).

2. Negative leverage decreases the cash on cash return. It occurs when the cost of debt is higher than the return on total assets.

A review of financial leverage serves as a good first step in determining the most appropriate financial structure for a property.

The amount of the mortgage, the term and the interest rate all affect the cost of debt and subsequently the cash on cash return or first year return on equity.

Utilizing the ratios we have defined:

a. If the Constant is less than the Free-and-Clear return, this represents positive leverage.

b. If the Constant is greater than the Free- and-Clear return, this represents negative leverage.

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H. Types of Mortgages

A key distinction between real estate and other forms of investment is the ability to finance real estate on a long-term basis using outside capital. Long term or permanent debt financing includes the use of several types of mortgage instruments. Depending on the lender’s or investor’s objectives, mortgages vary with regard to their payment patterns of interest and principal. The following are examples of different types of mortgages used in financing real estate.

Level Payment/Self Liquidating – Equal payments consisting of both interest and principal. Initially, the payment is almost entirely interest. Over time, the principal portion of payment increases due to amortization. Payments near maturity consist mostly of principal. This is the most typical mortgage for single family homes.

Balloon - A partially amortized loan, which calls for repayment of principal before it is fully amortized. For example, a loan might have a twenty-five year amortization and a ten-year term, in which case, all of the remaining principal would be due at the end of ten years.

Interest Only Loan – This is the kind of loan that banks sometimes offer to developers who are constructing a new building. The payments are lower because there is no amortization, but at the end of the term (usually 3-5 years) the full amount of the loan is due.

Graduated Payment Mortgage (GPM) – Here, payments begin at a lower level than under a level payment mortgage and step up in a series of fixed raises over the first few years of the loan. After a certain point, the loan will self-amortize.

Adjustable Rate Mortgage (ARM) with Floor/Ceiling – ARM or variable–rate mortgages allow the lenders to vary interest rates over the loan term. These loan are usually subject to a floor and ceiling, that is, a minimum and maximum rate level set forth in the original mortgage agreement.

Zero – Here all payments of interest and principal are paid at maturity. Interest is accrued and added to principal during the loan term.

Amortization

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Amortization is the repayment of the loan principal during the term of a loan. Level payment, self-amortizing loans are those in which the debt service payment is comprised of a shifting combination of interest and principal.

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I. Measurements of Risk and Return

So far, we have defined three key ratios in measuring the rate of return in real estate financial analysis from the investor’s standpoint:

Free-and-Clear Return =

Constant =

Cash-on-Cash Return =

From the lender’s point of view, four additional ratios should be considered:

Loan-to-Value Ratio

This is a measure of the lender’s collateral cushion. It is defined as the ratio of the loan to the value. To determine the value, lenders generally hire an appraiser who uses standard appraisal techniques to calculate the value of the property.

LTV =

The ratio, as a percentage, measures the proximity to 100% of value, that is being financed. Other things being equal, the lower the ratio, the higher the cushion and the more secure the lender’s interest in the deal. The higher the ratio, that is, the less collateral cushion (or less equity), in the capital stack, the greater the risk to the lender. Lenders rarely finance more than 80% of the value.

Loan-to-Cost Ratio

For properties under development, lenders often calculate the loan to cost ratio. In a well-conceived development project, the value upon

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completion will be greater than the cost to build it. Thus, if the lender simply used the loan-to-value ratio, it might end up lending the developer all the money required to build the project. Since lenders usually want the developer to invest real cash equity in the project they do this second calculation of the loan-to-cost to ensure that the developer has cash in the deal.

LTC = Loan Cost

Debt Coverage Ratio

This is a measure of a lender’s income cushion. It is defined as the ratio of Net Operating Income to Debt Service:

Debt Coverage Ratio =

Other things being equal, the higher the debt coverage ratio (i.e. the more income cushion) the lower the risk of default from the lender’s standpoint. Typically lenders require at least a 1.25 debt coverage ratio.

Break-Even Ratio

This ratio measures a project’s operating risk. It is defined as the ratio of operating expenses (including property taxes and the structural reserve) plus debt service divided by the gross revenue:

Break Even Point =

This calculation shows the percent of vacancy a project can withstand at the requested rent levels while still meeting all expenses and debt service. If one holds the vacancy constant then this ratio allows one to calculate how much rent levels can be decreased while still meeting all expenses and debt service.

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Summary:

In sum:

Loan-to-Value Ratio =

Loan-to-Cost = Loan Cost

Debt Coverage Ratio =

Break Even Point =

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Exercise 3: The Gilbert Building III

Based on a 95% occupancy and a $3.5 million mortgage on the Gilbert Building, solve for the following:

1. Loan-to-Value Ratio, assuming that the value of the building when it is 95% leased will be $5.5 million?

2. The Loan to Cost Ratio?

3. Debt Coverage Ratio?

4. The Break-Even Point?

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J. Valuation and Cap Rates

Each real estate project throws off an income stream. This Net Operating Income (NOI) or Cash Flow from Operations (CFO) can be divided among the lenders and owners. Investing in income-producing real estate is essentially the purchase and sale of this income stream. Real estate value can be determined by capitalizing (dividing) an income stream by the overall market rate of return or capitalization rate. The capitalization rate or cap rate is the rate demanded by the market in a typical real estate transaction. It represents the return an investor can expect the asset to generate the first year. The cap rate is often lower than the overall rate of return the investor expects because it does not include appreciation.

Value =

The following are alternative approaches to deriving a cap rate:

a) Band of Investment Approach: In this approach, one looks at the annual rate of return required by equity investors and the interest rate on currently available debt. Each of the rates is weighted by the proportion of total value they represent to determine the capitalization rate. The return on equity should be adjusted for the potential appreciation of the property.

b) Comparable Sales Approach: Here, a cap rate is derived by calculating the capitalization rate on comparable properties that have recently been sold and then making a judgment about the appropriate cap rate for the subject property. This is the approach we will use in the Real Estate course.

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Exercise 4: The Gilbert Building (IV)

Assuming that the Gilbert Building is 95% leased at rents of $20 per square foot, what is the value of the building under the following assumptions:

1. What is the value at a 10% cap rate?

2. What is the value at an 8.5% cap rate?

3. What is the value of the Gilbert Building at a 9% cap rate if the rent increases to $22 per square foot, and the operating expenses, property taxes, structural reserves, and occupancy remain the same?

Note: There is a template in the Real Estate course folder which may save you some time in typing and formatting. You are not required to use it.

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3.Discounted Cash Flow Analysis

In deciding whether or not to invest in a property, investors often look at the potential cash flow from two perspectives. First, they analyze the stabilized cash flow when the building is 90% or 95% occupied. This snapshot which has been the subject of most of this workbook allows them to estimate the initial return they will earn on their equity as well as the value of the property.

The second way that investors analyze the cash flows from a property is to build a model that projects cash flows into the future and then discount them back to the present. The industry standard is a ten (10) year projection with a terminal or sales value based on capitalizing the NOI in the 11th year. For this exercise we will use a five (5) year projection and estimate a sales price based on the NOI in year 6. The proceeds from the sales should be added to the cash flow in year 5.

The discount rate is different and usually higher then the capitalization rate. A capitalization rate represents the initial return on the projects cost whereas the discount rate represents the total return, including appreciation that investors require. It is sometimes called the ‘hurdle rate’.

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Exercise 5: The Gilbert Building (V) The investors in the Gilbert building have a 15% hurdle or discount rate on their equity investments. If they buy the Gilbert Building for $5 million and finance it with a $3.5 million mortgage for 30 years at 8% will the investment exceed their hurdle rate? By how much? What is the internal rate of return?Please fill in the blank spaces in the model below and do a Net Present Value calculation based on the following assumptions:

1. Gross Revenue will increase by 3% per year.2. Operating expenses (including property taxes and the structural

reserve) will increase by 3% per year.3. The vacancy rate will be 20% in year 1, 10% in year 2 and 5%

thereafter.4. The property is sold at the end of year 5 at a 9% cap rate based on the

projected NOI in year 6.5. All projections and return calculations are done on a pretax basis. It is

assumed that cash flows and residual proceeds for each year are all received the last day of the year.

($000)Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Gross Revenue $ 1,000 $1,030Vacancy $ (200)Effective Gross Income $ 800 Operating Expense (Including Property Tax and Structural Res.) $ (475)Net Operating Income $ 5,000 $ 325

Debt Service (8%, 30 years, annual payment) $ 3,500 $ (308)Cash Flow Before Tax $ 1,500 $ 17Net Sales Proceeds (calc. below)Net Present Value (15% discount rate) $ (1,500) $ 17

Calculation of Net Sales ProceedsNOI in year 6/ 9% Cap RateLess Sales Expense (2%)

Less Repayment of Mortgage at the End of Year Five* $ (3,327) Net Sales Proceeds

The Net Present Value of this $1.5 million equity investment discounted at 15% is: $_____________________________.The Internal Rate of Return is: __________%.

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4.Partnership Allocations

Many real estate investments are structured as partnerships or limited liability corporations. One partner (the general partner) puts together and manages the investment. The other partners provide most of the equity capital and may be involved in major decisions like when to sell the property.

In most partnerships, the cash flow and sales proceeds are not allocated proportionately or ‘pari passu’. Rather the cash flow is allocated so that the general partners’ return incorporates a ‘promote’ or a reward for superior performance. The structure of the partnership tries to both align the interests of the different parties and also create incentives for the person managing the deal.

In a typical partnership, the limited partners might invest most of the equity and receive a preferred return on their equity. In most cases, it is a cumulative, preferred return, meaning that if there is insufficient cash flow to pay the full amount of the preferred return in the early years, there is a catchup in later years or from the sales proceeds. Once the partners have received their cumulative (non-compounded), preferred return, the general partner receives a disproportionate share of the profits. These structures can become extremely complex with multiple layers and claw back provisions, but the basic concept that underlies most partnerships is that the proceeds are distributed so that the investors receive a base return on their investment as well as a return of their principal investment before the general partner gets a disproportionate share of the profits.

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Exercise 6: The Gilbert Building (VI)

The Gilbert Building will be purchased by a partnership. The limited partners (LPs) have put up 90% of the $1.5 million to purchase the building (plus 90% of any additional capital that is required.) As an inducement to make this investment, the General Partner (GP) has offered them a cumulative, non-compounded 8% preferred return. (The general partner will also receive an 8% return on his 10% equity investment on a pari-pasu basis.) Once both partners receive this 8% return from the property’s cash flow, additional cash flow will be split 70-30, with 70% of the additional cash flow going to the limited partners. Upon sale or refinancing of the Gilbert Building the net sales proceeds (after payment of sales expenses and the mortgage) will be allocated in the following order: 1. Catch up to ensure that both parties received an 8% preferred return on their investment, 2. Repayment of their original investment (and any additional capital calls), 3. Any remaining profits are then split 70-30.Using the same assumptions you did in Exercise 5, please answer the following questions:

What is the pre-tax, internal rates of return for the limited partners?What is the pre-tax, internal rate of return for the general partner?

To answer these questions we have created a model. Please fill in the blank spaces.(A template is available in the real estate course folder. Please note that for simplicity you need not worry about interest on interest. In other words, if they do not pay the 8% interest in any year, they need to make up that exact amount in future years.)

($000) Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Net Operating Income $ 5,000 $ 325 $ 438 Debt Service $ 3,500 $ (308) $ (308) $ (308) $ (308) $ (308)Cash Flow Before Tax $ 1,500 $ 17 $ 130 Required Return to LP $ 1,350 $ 108 $ 108 Required Return to GP $ 150 $ 12 $ 12 Cumulative (Deficit) or Surplus $ (103) $ (93)Preferred Payment to LP $ 15 $ 117 Preferred Payment to GP $ 2 $ 13 Surplus to LP (70%) $ 0 $ 0 Surplus to GP (30%) $ 0 $ 0

Model Continued On The Next Page

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Partnership Allocation Model (continued)

Allocation of Sale Proceeds: Year 5NOI in year 6/ 9% Cap Rate $ Less Sales Expense (2%) $

Less Repayment of Mortgage at the End of Year Five* $ (3,327) Net Sales Proceeds

Required Catchup on 8% Preference 0Return of Initial LP Capital $ 1,350.0

Return of Initial GP Capital $ 150.0 Profit

Profit to LPs (70%)

Profit to GPs (30%)

Total LP Share of SaleTotal GP Share of Sale

LP IRR (1,350) 15 117 - - -

GP IRR (150.0) 2 13 - - -

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M. Solutions (To Exercises 1-4)

Exercise 1: The Gilbert Building

1. Setup Based on 50% Occupancy:

Gross Scheduled Income $1,000,000

(Vacancy) (500,000)

Effective Gross Income 500,000

(Operating Expenses) (275,000)

(Property Taxes) (190,000)

(Structural Reserve) (10,000)

Net Operating Income 25,000

(Debt Service) (308,184)

Cash Flow Before Taxes (283,184)

2. Setup Based on 95% Occupancy:

Gross Scheduled Income $1,000,000(Vacancy) (50,000)Effective Gross Income 950,000

(Operating Expenses) (275,000)

(Property Taxes) (190,000)

(Structural Reserve) (10,000)

Net Operating Income $475,000

(Debt Service) (308,184)

Cash Flow Before Taxes $166,816

Exercise 2: The Gilbert Building Solution

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1. Debt Constant = = = 8.81%

2. Free and Clear Return = = = 0.5%

3. Cash-on Cash Return = = =

(18.88%)

4. Free and Clear Return = = = 9.5%

5. Cash-on-Cash Return = = =

11.12%

Exercise 3: The Gilbert Building Solution

1. Loan to Value = = 3,500,000 = 63.6%

5,500,000

2. Loan to Cost = Loan = = 70%

Cost

3. Debt Coverage Ratio = = =

1.54

4. Break Even Point = =

Exercise 4: The Gilbert Building Solution

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Setup Based on 95% Occupancy (at $20 per square foot):

Gross Scheduled Income $1,000,000(Vacancy) (50,000)Effective Gross Income 950,000

(Operating Expenses) (275,000)(Property Taxes) (190,000)(Structural Reserve) (10,000)

Net Operating Income $475,000

Value at a 10% Cap Rate: $475,000/ 10% = $4,750,000 or $4.75 Million.

Value at an 8.5% Cap Rate: $475,000/ 8.5% = $5,588,235.

Setup Based on 95% Occupancy (at $22 per square foot):

Gross Scheduled Income $1,100,000(Vacancy) (55,000)Effective Gross Income 1,045,000

(Operating Expenses) (275,000)(Property Taxes) (190,000)(Structural Reserve) (10,000)

Net Operating Income $570,000

Value at a 9% Cap Rate: $570,000/ 9% = $6,333,333.

Note: The value of a property is based on the cash flow from the property. Hence the denominator is the Net Operating Income or Cash Flow from Operations. The amount of debt does not affect the value. If debt did affect the value it would be simple to increase its value by changing the amount of debt.

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