Investment Property Financial Analysis
After analyzing the market, you must examine the property’s financial analysis or performance. This provides the basis for estimating the property’s value, based on return criteria you established. Assembling the data is the most time-consuming part of the analysis process. You must review the property’s financial history, as well as rent data, financial results, and amenities for competing properties. The first step after assembling the data is to prepare a one-year financial statement for the property.
Estimate Potential Gross Income
By multiplying the amount of space in the building by the base rental rate for that type of space, you can estimate rental income for each type of space found in the building. For example, for residential properties, you multiply the number of studio, one-bedroom, and two-bedroom apartments by the rent of each type. The total of the estimated rent amounts from each type of space is the potential gross income (PGI) for the entire property.
Estimate Effective Gross Income
Effective gross income (EGI) is potential gross income minus vacancy and collection losses plus other income. Vacancy and collection losses are forecast from the experience of the subject property and of competing properties in the market, assuming typical, competent management. A good balance of supply and demand is a 95% occupancy rate (long term rentals). Occupancy rates change based on changing economic conditions, such as rising unemployment rates or overbuilding. Other income from sources such as vending machines and laundry areas is added to potential gross income after subtracting vacancy and collection losses.
Estimate Operating Expenses
The next step is to calculate the property’s operating expenses (OE). Operating expenses are divided into three categories: fixed expenses, variable expenses, and reserves for replacements (see the next paragraph). Ad valorem taxes and property insurance are examples of fixed operating expenses. Their amounts normally do not vary with the level of the property‘s operation. Variable expenses include items such as utilities, maintenance, trash removal, snow removal, supplies, janitorial services, and management. These expenses are determined in a direct relationship with the level of occupancy. Regional normas for these expenses are available through trade journals and professional property management associations.
Establish Necessary Reserves for Replacement
If the level of expenses fluctuates widely from year to yeat, based on major maintenance and replacements of property components, it is difficult for the analyst to get a clear picture of typical expenses. To be meaningful, the expense figure must be stabilized. This is accomplished by establishing reserves for replacements category of expenses. The most accurate way to establish reserves is to divide the cost of each item and piece of equipment by its expected useful life in years.
Estimate Net Operating Income
The net operating income (NOI) is obtained by deducting operating expenses (fixed, variable and reserves) from effective gross income.
Determine Before-Tax Cash Flow
Income properties normally are purchased with mortgage financing, so owners must make mortgage payments from the NOI. When an annual mortgage payment is subtracted from NOI, the remaining amount is called before tax-cash flow (BTCF), sometimes called cash throwoff.
Constructing a Financial Statement for a Residential Investment
Ratio Analysis
Ratio analysis helps evaluate different investment opportunities. Some of the important ratios include capitalization rate, equity dividend rate, cash breakeven ratio, and debt coverage ratio.
The Capitalization Rate
Capitalizing net operating income is a basic approach to estimating value. While an appraiser uses a rate determined by verified sales in the marketplace, you as an investor, need to set the rate that provides an acceptable return using subjective criteria that you establish.
The capitalization rate is the one-year before-tax operating return on real property investment without considering debt service on the property.
If you pay all cash for a $300,000 investment and the net operating income is $30,000, the rate of return is 10%. This is calculated by dividing the net operating income by the value ($30,000 / $300,000).
Assume, however, that you would not purchase the property unless it yielded 12%. By dividing the net operating income by the rate desired ($30,000 / 0.12), you would agree to only pay $250,000.
Equity Dividend Rate
The equity dividend rate differs from the capitalization rate when a mortgage is considered in the analysis. If no mortgage exists, the capitalization rate is the same as the equity dividend rate. To calculate the equity dividend rate, divide the before-tax cash flow by the equity (value minus the mortgage).
Therefore, a property returning $14,000 after the owner makes the mortgage payment and having equity of $102,000 returns 13.7% on the equity ($14,000 / $102,000). This percentage sometimes is called the cash-on-cash return.
Many investors believe that equity should return 50% more than current mortgage rates. If mortgages are currently 8%, for example, you should look for at least 12% return.
Differences Between The Capitalization Rate and The Equity Dividend Rate
If the equity dividend rate is higher than the capitalization rate, then you have achieved positive leverage. If the equity dividend rate is lower than the capitalization rate, negative leverage exists. You want positive leverage.
You can increase the return by borrowing money with a favorable repayment rate. The repayment rate is called the annual mortgage constant, with a symbol of k. The annual constant is calculated by dividing the annual debt services by the original mortgage balance.
For example, if your property’s annual debt service is $87,235 and the mortgage is $800,000; k is 10.9% (the interest rate is 10%, and principal amortization accounts for the balance). The rule then becomes simple. To achieve positive leverage, k must be lower than the capitalization rate.
Cash Breakeven Ratio
This ratio should be extremely important to you because it shows the level of occupancy required to generate enough revenue to make the required payments for expenses and debt service. it is calculated by dividing the cash outflows (expenses and debt service) by the potential gross income. The operating expenses should show only those expenses required to be paid in cash. Reserves for replacements usually are not a cash expense.
Assume that a small retail strip center has a potential gross income of $100,000, annual expenses of $40,000, including $4,000 in reserves for replacements, and annual debt service of $47,000. What is the breakeven ratio? Divide the total cash expenses ($40,000 – $4,000 = $36,000) plus the debt service by the potential gross income: $36,000 + $47,000 / $100,000 = 0.83 or 83%.
If all bays in the center rent for the same amount, the developer knows that the occupancy rate must be greater than 83% or the developer will have to use his own funds to make up the shortfall.
Debt Service Coverage Ratio
A lender is concerned if a property has a net operating income that is too low to allow the owner to make mortgage payments easily. The lender wants a cushion so that even if vacancies or expenses increase, enough income will remain to make the mortgage payment. The debt coverage ratio demonstrates the amount of cushion. It is calculated by diving the net operating income by the annual debt service.
Assume the strip center has a 5% vacancy rate, the net operating income is $55,000 and the annual debt service is $47,000. The debt service coverage ratio is 1.17. That means the net operating income is 117% of the amount needed to cover the mortgage payment (a 17% cushion). A lender feels more comfortable with a coverage ratio of at least 1.3.
The ratios discussed above should not be used solely to report on a property’s status. You should use those ratios to help determine the price you would be willing to pay based on income and cash flows.
Estimating the Amount of Available Financing Base on Lender Standards
To determine the financing, you need to know the lender’s requirements for the debt service coverage ratio and also you need to calculate the mortgage loan constant (k) based on current lending rates. Dividing the NOI by the required debt coverage ratio generates the allowable annual debt service. Diving that figure by the loan constant results in the available loan amount.
Assume that the mortgage market will allow a commercial building a 25-year loan at a rate o 8%. The monthly payment factor is 0.00772 and the annual factor is 0.09261. The second factor is k. With a net operating income of $55,000, a required debt coverage ratio is 1.3, and an annual loan constant of 0.0261, the annual debt service can be $42,308 as below:
- Net operating income / Debt coverage ratio = Annual debt service
$55,000 / 1.3 = $42,308
2. Annual debt service / Mortgage loan constant = Mortgage loan amount
$42,308 / 0.09261 = $456,840
Calculating the Down Payment Based on Your Return Standards
The next step is to calculate the maximum down payment. Once the mortgage amount is determined, you need to subtract the annual debt service from the net operating income to get before-tax cash flow. If you divide that figure by the required equity dividend rate, the result is the down payment that you will be willing to make.
In the example below, it is estimated that the debt service allowed by the lender is $42,308. The net operating income is $55,000. Deducting the debt service of $42,308 results in a $12,692 cash flow. If your required return is 15%, the down payment would be $84,613 as calculated below:
- Net operating income – Debt service = Before-tax cash flow
$55,000 – $42,308 = $12,692
2. Before-tax cash flow / Required rate of return = Down payment
$12,692 / 0.15 = $84,613
Calculating the Purchase Price
Once the above two steps are complete, the purchase price is simply the addition of each figure. Continuing the example, the calculation is as follows:
Mortgage amount available from lender $,456,840
+ Your down payment $84,613
= Purchased price offered $541,453
This technique for valuating income property is superior to simply calculating net income.
Other Financial Analysis Techniques
More sophisticated discounted cash flow techniques require the use of financial tables or a financial calculator and include the net present value, the internal rate of return, and the financial management rate of return. In general, after-tax cash flows for future periods, including sales proceeds, are discounted back to the present value so that the pattern of receipts does not distort the analysis.
