Re: cash flow analysis…need some help here - Posted by Ed Garcia

Posted by Ed Garcia on April 02, 2006 at 11:19:06:

Nate,

We have a commercial forum that is an excellent place to post your question.

Don?t get me wrong. We have commercial expertise here as well but I just want you to be aware of Ray Alcorn and his section of the CREonline site.

Nate, there are various tools or methods for analyzing commercial properties. Some lenders will use a Goss Rent Multiplier, others Cap rate, as a determining factor of property values. This information will be given by the appraiser but the lender will determine which method is more appropriate in their area.

Obviously Cash-flow evolves in the usage of either of these methods. With either method the lender will require a 1.5 Debt Coverage Ratio will be a minimum requirement in obtaining a commercial loan.

DEBT COVERAGE RATIO

A ratio used in underwriting loans for income producing property which is created by dividing net operating income by total debt service. Ratios of at least 1.20 are generally required with ratios of 1.50 and higher considered the norm. These ratio?s can vary from lender to lender but most lenders will abide by what I?ve give you do to they feel interest rates to be on the rise.

GROSS RENT MULTIPLIER

If you’ve been looking for income property, you have probably seen the phrases “8 times gross,” or “8 x gross,” or even “8x GRM.” Anything that short and cryptic probably isn’t too important, right? Wrong.

Most income property is valued by how much revenue it generates. One of the fastest ways to calculate market value of income generating real estate is with the Gross Rent Multiplier (GRM).

Definition

The gross rent multiplier is a number that when multiplied by the gross rent (Gross rent is income before any expenses are deducted.) generated by the property gives a rough value of the property.

Example 1

Let’s take an example. “Building A” has a gross rent of $50,000. The owner wants to sell the building for 10 times the gross rent, or a gross rent multiplier of 10. Then the owner will sell this real estate for $500,000.

Gross Rent = $50,000

Gross Rent Multiplier = 10

Sale Price of Property = $500,000

Gross Annual Income x Gross Rent Multiplier = Property Value

$50,000 x 10 = $500,000

Quick Definitions

Gross Rent Multiplier:

A number that when multiplied by the gross rent generated by the property gives a rough value of the property.

Gross Rent:

Gross rent is income before any expenses are deducted.

CAP RATE

You take your NOI which stands for (Net Operating Income).

Divide it by the Cap Rate you desire.

This helps you decide the value of the property based on the income.

Example:

You have a property that nets you $2500. a month after expenses.

You then multiply $2500. times 12 months = $30,000.

Lets say you want a 8 cap rate.

You then take $30,000. divide it by .08 = 375,000.

At an 8 cap the value of your property is $375,000.

Now here is a more detailed explanation.

Why do you in invest in income-producing real estate? Perhaps you are

looking cash flow. Possibly you anticipate some tax benefits. Almost

certainly, you expect to realize a capital gain, selling the property

at some future time for a profit.

Your projection of the future worth of the property, therefore, can be

a vital element in your investment decision.

INFLATION

A fairly simple approach to this issue is the use of an inflation rate. You bought the property today for X dollars. You make a conservative estimate as to the rate of inflation, apply that rate to your original cost and improvements and come up with presumed future

value.

The use of inflation as a predictor of future value typically makes sense when the desirability of the subject property is based on something other than its rental income. For example, consider a single-user property such as a small retail building on a main

thoroughfare. The owner of a business operating as a tenant in such a

location is probably willing to spend more for the building than an investor would pay. In general, rate of inflation as a predictor of future value may be appropriate when comparable sales work well as a measure of present value (i.e., “Commercial buildings on Main Street are selling for $200 per square foot by next year they will be up to $225.”).

CAPITALIZATION

With most other types of income-producing real estate, what you paid for the property is not likely to make much of an impression on a new buyer. Witness the rapid run-up and even faster collapse of prices in the late’s. The typical investor will be interested in the income that the property can generate now and into the future. He or she is

not buying a building so much an income stream.

That investor is most likely to use capitalization of income as the method of estimating value. You have probably heard this referred to as a “Cap Rate” method. It assumes that an investment property’s value bears a direct relation to the property’s ability to throw off

net income.

Mathematically, a property’s simple capitalization rate is the ratio between its net operating income (NOI) and its present value:

Cap. Rate =NOI/Present Value

Net operating income is the gross scheduled income less vacancy and credit loss and less operating expenses. Mortgage payments and depreciation are not considered operating expenses, so the NOI is essentially the net income that you might realize if you bought the property for all cash. If you purchase a property for $100,000 and have a NOI of $10,000, then your simple capitalization rate is 10%.

To use capitalization to predict value requires just a transposition of the formula:

Present Value =NOI/Cap. Rate

The projected value in any given year (i.e., the “present value” in that year) is equal to the expected NOI divided by the investor’s required capitalization rate.

To use capitalization rate as a predictor of future value, in short, is to use this logic: “I am buying this property with the expectation that its net operating income will represent a return on my investment. It is reasonable to assume that whoever buys the property from me in the future will have a similar expectation. That new investor will probably be willing to purchase the property at a price that allows it to yield his or her desired rate of return (i.e., capitalization rate).”

If you project that the property will yield a NOI of $27,000, and that a new buyer will require a 9% rate of return (capitalization rate), then you will estimate a resale price of $300,000.

You must never forget that, while the algebra involved here is simple, the judgments you need to make in order to achieve an accurate prediction of value are more complex. Your assumptions as to future years’ income and expenses have to be realistic.

The same is true of your estimate of a new buyer’s required cap rate. Look at the investment from the new buyer’s point of view and remember that there are other opportunities competing for his dollar. Would you buy an office building with a projected cap rate of 9% if you could buy a bond that yields 8%? What if mutual funds are rocking and rolling at 15% and more? To attract a buyer, your property may need to be priced so that its cap rate is competitive. The higher the cap rate, the lower the price. In our example above, the property with the $27,000 NOI capitalized at 12% would be worth only $225,000.

Ed Garcia