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”
❶ Estimate Gross Rent
❷ Subtract Estimated Vacancy
❸ Add Other Income
= Effective Gross Income
❹ Subtract Operating Expenses
= Net Operating Income or “NOI”
❺ Subtract Debt Service
= Cash Flow Before Taxes
❻ Add the Mortgage Principal Repaid to BTCF
❼ Subtract Depreciation
= Taxable Income
❽ 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