Introduction to

Cash Flow Analysis and

Real Estate Investing
Getting Rich in Real Estate
– “get-rich-quick” methods of
real estate investment often
assume self-management
while ignoring your
opportunity cost of time
and the risks of high
leverage
– Many make more money
off of the seminars than
they do on their real estate
investments
Real Estate Does Provide Many
Opportunities Including
 Adding Value Through:
– Real estate acquisition
– Development
– Financing
– Site Analysis
– Controlling Operating Costs
– Innovative Marketing
– Innovative Management
 No Secret Way To Attain
Success
 Only hard work with good
research and systematic
analysis
Business Goals Might Include
 Maximize Long Term Shareholder Wealth
 Short-Term Financial Goals, I.e. cash flow
 Or Non-financial goals such as
Non-Financial Goals
 Maintain a family friendly place to work
 Maintain affirmative action hiring policies
 Retain quality employees through tough markets
and tough times
 Develop or own only the highest quality properties
in prestige locations
 Be the largest owner in terms of market share of a
certain type of property in a local market
Short Term Financial Goals
Might Include
 Satisfy the requirements of the lender in terms of
pre-leasing or debt coverage cash flows
 Satisfy the minimum required first year cash on
cash returns required of investors
 Project minimum internal rates of return for the
entire holding period of some minimum percentage
 Maintain occupancy levels above 95% in all
portfolio properties
Financial Analysis Decision
Models
 Single period model such as
– Cash on Cash
– Gross Rent Multipliers
– Capitalization “Cap” Rate
 Multiple period model
– IRR - Internal Rate of Return
IRR Model
 Multiple period return on investment
 Calculates the average discount rate that
equates all future returns over the projected
holding period back to the present value of
the initial equity investment
 Should be used for capital allocation and
initial investment decisions
Real Estate Financial Analysis
 Developer’s Goal: To invest capital in
projects that generate after tax returns that
exceed those of alternative risk-adjusted
investment
 Investor’s Goal: To buy property assets or
property securities for less than their
intrinsic value (the present value of a firm’s
future free cash flows)
The “Pro-Forma”
 Estimate Gross Rent
 Subtract Estimated Vacancy
 Add Other Income
 Effective Gross Income
 Subtract Operating Expenses
 Net Operating Income or “NOI”
 Subtract Debt Service
 Cash Flow Before Taxes
 Add the Mortgage Principal Repaid to BTCF
 Subtract Depreciation
 Taxable Income
 Less taxes due or plus taxes saved
 After Tax Cash Flow
“Pro-Forma” (cont.)
 Should forecast previous numbers for at
least 5 to 10 years
Important Financial Ratios
 Used to determine financial feasibility
– Gross Rent Multiplier
– Loan to Value (LTV) Ratio
– Debt Coverage Ratio
– Breakeven Point
– Expense Ratio
– Cash on Cash
– After Tax Return on Equity
– Return on Asset
– Internal Rate of Return
– Resale Price
Leverage and Operating Ratios
 Loan to Value Ratio
 Debt Coverage Ratio
 Breakeven Point
 Expense Ratio
Gross Rent Multiplier
 Purchase Price over Gross Rent
 The lower the better
 A very simple comparison number
insufficient for anything but general
screening
Loan to Value Ratio
 Measures real estate Mortgage Loan Balance
financial risk ------------------------------
 Default risk rises Purchase Price
proportionally with the
LTV ratio
 Typical LTV in the
industry is 75%
Debt Coverage Ratio
 Must exceed 1.0 in Net Operating Income
order for the property ---------------------------
to make the mortgage Debt Service
payment
 Most lenders require a
debt coverage ratio of
around 1.1 to 1.3
Breakeven Point
 Percentage of Operating Expenses +
occupancy that a Mortgage Payments
building must achieve ------------------------------
in order to be able to Gross Rent
pay all of it’s cash
expenses and carry the
assumed financing
 Normally in the 65%
to 95% range
Expense Ratio
 Used in comparison Operating Expenses
with other property - -----------------------------
alone it tells very little Effective Gross Income
 Should be sufficiently
high to keep up the
property while not
wasting capital on
uncontrolled expenses,
such as energy costs
Single Period or “Static”
Profitability Measures
 Cash on Cash
 After Tax Return on Equity
 Return on Asset or Going in Cap Rate
Cash on Cash
 Measures initial Before Tax Cash Flow
profitability ---------------------------
 The higher the better
Cash Equity
 Typical first year cash
on cash return range
from 4 to 10 percent
 For REITs, the funds
from operation (FFO)
is a similar measure
After Tax Return on Equity
 Similar to cash on After Tax Cash Flow
cash --------------------------
 Takes into account tax Cash Equity
shelter
 Typically range from
5% to 12% in the first
year
Return on Asset
 “Cap Rate” Net Operating Income
 How much debt a -----------------------------
property can carry Purchase Price or Value
 Overall returns
 The higher the return
rates, the more debt a
property can support
 Typical cap rates run
from 8% to 12%
Multiple Period or “Dynamic”
Return Measures
 Internal Rate of Return (IRR)
 Consider Appreciation Through Resale
Price or Refinancing
Internal Rate of Return
 The most frequently used measurement of projected
holding period overall returns
 Delivers in one number an investment return that
integrates rental growth rates and property value
appreciation
 Should be compared to the required rate of return
 Typical IRRs range from 12% to 15%
 Can reach over 20% for new, speculative
investments
IRR (cont.)
CF1 CF2 CFT Projected Resale CFT
Equity = Pve = -------- + -------- + ... + -------- +
-------------------------
1+irr (1+irr)2 (1+irr)T (1+irr)T

An IRR can be before or after tax using before or after tax cash flows.
Resale Price Calculation
 Where R is the “going Net Operating Income
out” cap rate on the Projected for the Next
property Year
 From the expected ---------------------------
resale price, it is R
important to deduct
reasonable selling costs
 Tax considerations
need to be noted