Chapter 14 Cash Flow Analysis

Major Topics How to develop a multiyear proforma that estimates cash flows from real estate investment How to estimate the revenues, expenses and debt service that feed into a proforma Important financial ratios such as the debt service coverage ratio Key financial return and ratio measures

Introduction Cash flow drives values for income property Current and future returns are a based upon cash flow estimates Appreciation is driven by increases in the cash flow Development, acquisition, leasing, marketing and management decisions are all driven by or intended to influence cash flows Value of any asset equals…

Reconstructed Operating Statement Appraiser estimates stabilized revenues and expenses Potential Gross Income = Market rent * Space available Effective Gross Income = PGI – Vacancy Allowance Vacancy Allowance estimated as a % of PGI Miscellaneous Income Parking, laundry, etc.

PGI and EGI Apartment rent = $1/SF/month 80,000 SF apartment complex Vacancy rate = 5% PGI = $1*80,000 = $80,000 EGI Vacancy allowance = 5% * $80K = $4,000 EGI = $80,000 - $4,000 = $76,000

Expenses Operating Expenses Fixed Property taxes, hazard insurance Variable Utilities, maintenance, supplies Capital Expenditures ( replacement reserve) = allowances for replacements and alterations that increase asset life/value New roof, new fridge, new AC Prorated as a constant annual expenditure

Reconstructed Operating Statement PGIPotential Gross Income - VacVacancy Allowance + MIMiscellaneous Income = EGIEffective Gross Income - OEOperating Expenses = NOINet Operating Income NOI EBITDA

Getting to CFs NOI EBITDA Depreciation expense Interest expense, Debt PMT Taxes

Getting to CFs Depreciation Allowances: Assets ClassDepreciable Life Non-Residential39 years Residential27.5 years Land Improvements15 years All done straight-line Personal propertyMACRS life

Depreciation Value: Reduces taxable income, reduces taxes, increases CF $100K NOI, t = 30%, Debt PMT = $0 CF with and without $60K depreciation expense?

Depreciation NOI$100K -Depr 0 Taxable Inc$100K -Taxes$ 30K NI$ 70K DebtPMT 0 CF = (NOI-Tax-PMT)$ 70K $100K $ 60K $ 40K $ 12K $ 28K 0 $ 88K

Depreciation Value of $60K Depreciation = $18K Depreciation Expense * tax rate= $18K Value of Depreciation = DeprExpense * t

Finally, Operating CFs NOI -Depreciation -Interest Expense Taxable Income -Taxes Net Income Why is NI CF?

Operating CF 1. NI includes Depreciation Expense 2. NI includes Interest Expense, but not Principal Repayment Operating CF = NOI – DebtPMT – Taxes

Operating CF Example Year 1: $200K NOI 30% tax rate Yearly Depreciation = $30K Financed by 30-year, 7%, $1M loan

Operating CF Example Monthly Loan PMT = $6,653 Yearly Loan PMT = $6,653 * 12 = $79,836 1 st years Interest Expense =CUMIPMT(7%/12,360, ,1,12,0) or 1 Input 12 AMORT = $69,678 2 nd years Interest Expense =CUMIPMT(7%/12,360, ,13,24,0) 13 Input 24 AMORT = $68,944

Operating CF Example Year12 NOI $200,000 $200,000 -Interest $69,678 $68,944 -Depreciation $30,000 $30,000 Taxable$100,322$101,056 -Taxes $30,097 $30,317 Net Income $70,255 $70,739

Operating CF Example Year12 NOI $200,000 $200,000 -DebtPMT $79,836 $79,836 -Taxes $30,097 $30,317 Operating CF $90,067 $89,847

Leverage ratios Loan to Value Ratio = Loan ÷ Price Equity buffer Debt Coverage Ratio = NOI1 ÷ Yearly PMT Income buffer Breakeven Point = (OpExp + PMTs) ÷ PGI OpExp Ratio = OpExp ÷ EGI

Value Ratios Going-in Cap Rate = NOI 1 ÷ Price 0 -- invert to get -- Price 0 = NOI 1 ÷ Cap Rate -- generalize to get -- Price t = NOI t+1 ÷ Cap Rate

Capitalization Rate If we know market Cap Rate, and we estimate NOI 1, we have an estimate of market value of property. Buying apartment complex: Cap Rate on San Marcos apartments = 8% Expect NOI 1 to be $85,000. How much to bid?

Capitalization Rate Cap Rate = NOI 1 P 0 P 0 = NOI 1 Cap Rate P 0 = $85, P 0 = $1,062,500

Capitalization Rate Apartment Valuation Example again We expect to hold for 10 years, then sell P 10 = NOI 11 Cap Rate Assume NOI grows 3% per year P 10 = ($85K * (1.03) 10 ) 0.08 P 10 = $1.428M

Terminal CF CFs realized from selling property 1. Selling P received 2. Loan repayment 3a. Capital Gains Tax = CG Tax rate * Gain Gain = Selling P – Original Basis 3b. Depreciation Recapture Tax = Ordinary Income Tax r * Total Depr taken

Terminal CF Example 5 years ago, bought $2M property -- warehouse ($1.8M) & land ($200K) - - financed by $1.6M 30-year 7% loan Today, selling for $2.4M Tax rates = 25% Ordinary, 15% CG CFs: 1. +$2.4M (Selling P)

Terminal CF Example 2. Loan Repayment: Original: 360 N, 7 I/YR, 1.6M PV PMT = Now 60 N, FV =??? Loan Repayment CF = -$1,506,105

Terminal CF Example 3. Capital Gain Tax CF: Original Basis Yearly Depr Land = $200K $0 Warehouse = $1.8M 39 years = $46,154 Total Depr = 5 years * $46,154 = $230,770 Gain = Selling P – Original Basis Gain = $2.4M -$2M = $400K

Terminal CF Example 3. Capital Gain Tax CF Continued: Gain Tax = Gain * 15% = $400K * 15% = $60K Recapture Tax = $230,770 * 25% = $57,693 CG Tax = $60K + $57,693 CF = - $117,693

Terminal CF Example Net Terminal CF: 1. Selling P = +$2,400, Loan Repayment= -$1,506, CG Tax = -$ 117,693 Net Terminal CF= +$ 776,202

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