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Ch 12

Ch 12. Real Estate Investments, Part II. Page 57. R. E. investment analysis requires. Compute current year after-tax cash flow. Forecast future after-tax cash flow for each year of the holding period (5 – 10).

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Ch 12

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  1. Ch 12 Real Estate Investments, Part II Page 57

  2. R. E. investment analysis requires • Compute current year after-tax cash flow. • Forecast future after-tax cash flow for each year of the holding period (5 – 10). • Forecast the future cash flow upon disposition at the end of the holding period (Net Sale Proceeds). • Convert all estimated after tax cash flows into a series of performance indicators.

  3. Formula • GSI Gross scheduled income: • -OE Operating expenses (TIMMUR) • EGI GOI Gross scheduled income • -V/BD Vacancy & bad debt (uncollectible) • NOI Net operating income • -DS Debt service (loan payment) • GSI Gross spendable income • -Dep Depreciation • CFBT Cash flow before taxes • -Tx Income taxes due on taxable income • CFAT Cash flow after taxes

  4. Terms Described • Gross scheduled income • Maximum amount of income, if fully occupied. • Gross operating income • Gross scheduled income less vacancy factor and uncollectible rents. • Net operating income • Gross operating income less annual expenses. • Net income or loss • Net operating income less interest on the loans and depreciation for the year of operation. • Gross spendable income • Net operating income less principal and interest payments for the year (annual debt service). • Net spendable income • Before tax cash flow less annual income taxes due on taxable income for the year, if any. • OR • Before tax cash flow plus annual income taxes saved because of the tax loss for the year, if any. Page 57 Page 58

  5. GROSS RENT MULTIPLIER Gross Monthly Rent Multiplier (GMRM) Comp. Sales Price Comp. Monthly Rent Comp. Sales Price Comp. Annual Rent THEN Gross Scheduled Income (GSI) x Gross Rent Multiplier (GRM) = Estimated Value ($) FAILS TO CONSIDER VACANCIES AND EXPENSES = Gross Annual Rent Multiplier (GRM) =

  6. Gross Rent Multiplier Example Sales Price $350,000 = $2,000 Sales Price $350,000 = Annual Rent $24,000 ($2,000 X12mo.) 175 Gross Monthly Rent Multiplier (GMRM) 14.58 Gross Annual Multiplier (GRM)

  7. PROJECTED ANNUAL OPERATING STATEMENT Scheduled gross annual income $84,000 GSI Vacancy allowance and collection losses 4,200 --Vac/BD Effective Gross Income $79,800 = EGI Operating Expenses (OE=TIMMUR) • Property Taxes 9,600 T • Hazard and liability Insurance 1,240 I • Property Management 5,040 M • Maintenance and Repairs 5,000 M • Janitorial, Pool & Gardener Services 1,500 • Gardener 1,200 • Utilities 3,940 U • Trash pickup 600 • Electric, Gas, Water • Reserves for replacement R • Furniture & furnishings 1,200 • Stoves & refrigerators 600 • Furnace &/or air-conditioning system 700 • Plumbing & electrical 800 • Roof 750 • Exterior painting 900 • Other 1,300 Total Operating Expenses $34,400 --- OE Net Operating Income $45,400 = NOI Operating Expense Ratio: $34,400 ÷ $79,800 = 43.1%Capitalization Rate

  8. I = V R Capitalization Rate I = R X V • The higher the cap rate, the lower the value. $300,000 I $300,000 I 10% R 5% R Or Net Operating Income (I) Asking Price ( R) = Capitalization Rate (V) The higher the risk, The higher the capitalization rate. = $300,000 = $600,000

  9. Price per : Unit: Asking price Number of rental units = Price per unit Square foot: Asking price Building square footage = Price per sq. ft. Bed (hospital) (retirement home), storage unit (mini warehouse), Room (convalescent home) (boarding house), pad (mobile home) (RV park)

  10. Debt Coverage Ratio Net Operating Income annual debt service = Debt Coverage Ratio The higher the ratio, the better the cash flow. More cash to cover loan payment. Lenders determine if the property’s cash flow justifies the loan by using DCR.

  11. Expense Ratio Annual operating expenses Gross scheduled income = Expense ratio The lower the expense ratio, usually the better the cash flow. Over time, the expense ratio tends to increase. Watch Out!! The seller often overstates the income and understates the true expenses,. Always verify income and expenses with property management records or with the owner’s Schedule E income tax record for subject property.

  12. Before Tax Cash-on-Cash Rate of Return Before tax cash flow = Before tax % for that year of cash invested The higher the rate, the better the investment.

  13. After Tax Cash-on-Cash Rate of Return After tax cash flow = After tax % for that Year for cash invested The higher the rate, the better the investment. A better indicator than the before tax rate

  14. Equity Yield Rate of Return for the year (After tax cash flow) + (Principal paid) Net spendable income + Equity build up + Appreciation Cash invested = Equity Yield For that year The higher the rate, the better the investment. This is an indicator of performance. Principal payments and appreciation are NOT cash, and are only received when sold or with a refinance. Closing costs must be considered and calculated in to determine true net.

  15. Multiple Year Analysis • Solve for IRR and the financial management rate of return, using discounted cash flow analysis. • This method requires analysis for the investor’s entire holding period, not just a single year. • The discounting process takes into consideration the Time Value of Money to produce a more realistic rate of return.

  16. #1:First year cash flow analysisCase study-Problem 1: 8 unit apt. GSI ($700 x 8 units x 12 mo/yr) $67,200 + Other income + 800 = Total GSI $68,000 • Vac/BD (68,000 x 5%) 3,400 = GOI $64,600 • OE 24,200 = NOI $40,400 • DS ($3072/12mo) 36,864 = CF BT $ 3,536

  17. #2: Gross Rent Multiplier = Comp. Sales Price Gross Annual Rent Multiplier Comp. Annual Rent (GRM) $500,000 $ 67,200 ($700 x 8 units x 12 mo/yr) = 7.44 GRM/Yr OR Comp. Sales Price Gross Monthly Rent Multiplier Comp. Monthly Rent (GMRM) = $500,000 $5,600 ($700/mo x 8 units) 89.29 =

  18. Capitalization RateI = R X V I = R V $40,440 8.088 % = $500,000 Or 8.1% I = Net Operating Income V = Asking Price R = Return on Investment

  19. #2: Commercial Property#1-Operating Expenses T - Property taxes $4,700 $3900 (existing) + $800 (increase) I - Property insurance $1,000 M - Maintenance $2,000 Supplies $ 500 $2,500 M – Management $51,000 x 4% $2,040 U – Utilities: Water, Trash & gardening $1,680 ($140 mo x 12 mo) Operating Expenses (OE) $11,920

  20. #2: Commercial Property#2-Net Operating Income GSI $51,000 + Other income + 0 = Total GSI $51,000 • Vac/BD (67,200 x 5%) - 0 = GOI $51,000 • OE - 11,920 • NOI $39,080

  21. #2: Commercial Property#3-Before Tax Cash Flow • NOI $39,080 • DS ($3100/12mo=$34000) 37,200 = CF BT $ 1,880

  22. #2: Commercial PropertyIncome Tax Aspects NOI $39,080 - Interest - 34,000 • Depr - 29,000 = Taxable income/loss for the year <-23,920> X Investor tax bracket 43% = Taxes saved/paid for the year $10,286 + CF BT 1,880 = CF AT $12,166 #4 - After-Tax Cash Flow

  23. #2: Commercial Property#5 - Property Value I = R X V I = V R $39,080 9% = $434,422 I = Income R = Rate of Return expected V = Value of Property

  24. #3: Forecasting Cash Flow

  25. #3: Tax Aspects

  26. #3: New Spendable Income

  27. #3#1 Seller’s net from escrow Future resale price $553,000 Less: seller’s closing costs - 44,240 ($553,000 x 8%) Less: Outstanding loan balance -392,774 Equals: Net proceeds from escrow $115,986

  28. #3:#2: Net Sales Proceeds Net proceeds from escrow $115,986 Less: Tax owed on resale - 27,649 (553,000-436,000-44,240= 72,760 x 38%) Equals: Net sales proceeds $88,337

  29. #3 -IRR Worksheet Net sale proceeds $ 88,337 Investment $80,000 Smaller Rate 10% $85,670 $85,670 Present Value Amount Larger Rate 15% $75,651$80,000 Investment Difference 5% ÷ $10,019 $5,670 ÷ 10 = 12.83% IRR

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