RE 310 Principles of Real Estate Introduction to Investment 1 Cash is King a The ultimate goal of any real estate investment is to generate cash flows b Three types of cash flows to consider c Income taxes and real estate In this class we will ignore income taxes and focus only on before tax cash flows As a general rule however income taxes generally don t alter real estate investment decisions Two exceptions Low income housing tax credits Historic preservation tax credits 2 Common Lease Jargon see handout in Downloads section of the website a Rent Base rent Asking rent Contract rent Market rent b Rent adjustments Indexed leases Step leases Percentage leases and overage rent c Expense Allocations Gross full service lease Net hybrid lease Double net lease Triple net absolutely net lease Expense stops Common area maintenance CAM charges d Other Common Lease Terms 2 Rent Concessions Tenant improvements 3 Building Measurement Terms The terms outlining how office spaced is measured are based on standardized definitions created by the Building Owners and Managers Association BOMA More information can be obtained from their web site at http www boma org a Gross building area Also known as gross measured area or gross square feet b Total rentable area Also known as gross leasable area or rentable square feet c Usable area Also known as office area or usable square feet d Common areas e Load factor Also known as the add on factor or the common area factor Efficiency percentage 3 4 Pro Forma Operating Statement a The pro forma is the key tool used in calculating cash flows from operations The primary goal of this statement is to calculate Net Operating Income NOI and Before tax Cash Flow BTCF Net Operating Income b Layout of the pro forma Potential Gross Income PGI Vacancy Collection Allowance V C Effective gross income EGI Operating Expenses OE Net Operating Income NOI Annual Debt Service ADS Before tax cash flow BTCF 4 c Example Calculate the NOI for an office building with the following characteristics The building has a total of 15 840 square feet GLA Of this 10 800 square feet rent for 12 psf while the remaining 5 040 square feet rent for 10 psf All leases are gross leases The vacancy and collection loss allowance is 10 of PGI Operating expenses include Property taxes 15 900 Insurance 12 000 Utilities 13 900 Cleaning maintenance 23 000 Management expenses 8 100 Reserves for replacement 8 100 The purchase price of the building is 885 000 Financing is available for 75 percent of the purchase price at 9 percent interest amortized over 30 years with monthly payments Monthly debt service 5 341 Annual debt service 64 088 5 5 What is the Building Worth a Cap Rates In general the value of the property ought to be equal to the discounted present value of the NOI forever into the future V NOI 3 NOI 1 NOI 2 2 1 r 1 r 1 r 3 t 1 NOI t 1 r t To calculate the value of the property you estimate the expected NOI for each year in the future and discount it back to today If you plan on selling the property that is no problem because future purchasers will value it in the same way at that time If we assume that NOI is constant forever into the future this formula simplifies to V NOI r This can be rearranged to write R NOI V This shorthand known as the capitalization cap rate is simply ratio between a property s net operating income first year and its value acquisition price 6 b Using Cap Rates Cap rates are typically used to compare different investment alternatives to see if their price is in line with current earnings If other similar properties in the market are selling at a 10 percent cap rate does this appear to be a good investment Cap rates can also be used to estimate the value of a property If other similar properties in the market are selling at a 10 percent cap rate how much is this building worth 7 c Cap Rate Limitations The primary value of cap rates is their simplicity Cap rates do not account for a property s Risk Income growth over time Example Consider two properties each with 100 000 in NOI expected next year The NOI for property A is expected to grow by 3 percent per year while property B s NOI is expected to grow by 5 percent per year Which property will sell for a higher price Which will have a higher cap rate 8 6 Other Investment Ratios and Multipliers a Cash on cash return equity dividend rate Mortgage constant Financial leverage An investment has positive financial leverage if When an investment has positive financial leverage additional debt the COCR An investment has negative financial leverage if When an investment has negative financial leverage additional debt the COCR An investment has neutral financial leverage if When an investment has neutral financial leverage additional debt the COCR 9 b Operating expense ratio Measures how expensive it is to operate the property c Breakeven ratio Frequently called the default ratio d Debt coverage ratio e Limitations of ratio analysis Ratios are good for measuring against benchmarks but should not be used as hard and fast rules The main problem is that they ignore changes in the sizes of and in the timing of cash flows Better method Discounted cash flow analysis taught in RE618 10 7 Thoughts about Small Property Investment a Two key investment rules to remember You make all your money the day your purchase a property The best real estate deals you ever do are the ones you don t b Do your research Pick and neighborhood and learn it really well Build a database of properties in the neighborhood Owner or renter occupied Sale price Physical characteristics Size bedrooms bathrooms condition etc Rent charged how long vacant 11 c Estimating the inputs to the pro forma Use your research to estimate rents vacancy rates Do you want to get the highest rent possible or do you want to keep the unit occupied Operating expenses Property taxes insurance Property management Include a management fee even if you manage it yourself Maintenance repairs depend on condition of the property If you do the work yourself make sure you pay yourself a wage for your work Reserves for major repairs Utilities Legal professional fees 12