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/month80,000 SF apartment complexVacancy rate = 5%PGI = $1*80,000 = $80,000EGI 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

PGI Potential Gross Income- Vac Vacancy Allowance+ MI Miscellaneous Income= EGI Effective Gross Income- OE Operating Expenses= NOI Net Operating Income

NOI ≈ EBITDA

Getting to CF’s

NOI ≈ EBITDA Depreciation expense Interest expense, Debt PMT Taxes

Getting to CF’s

Depreciation Allowances:

Assets Class Depreciable LifeNon-Residential 39 yearsResidential 27.5 yearsLand Improvements 15 years

All done straight-linePersonal property MACRS life

Depreciation

Value: Reduces taxable income, reduces taxes,increases CF

$100K NOI, t = 30%, Debt PMT = $0CF with and without $60K depreciation

expense?

Depreciation

NOI $100K-Depr 0Taxable Inc $100K-Taxes $ 30KNI $ 70KDebtPMT 0CF = (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 CF’s

NOI-Depreciation-Interest ExpenseTaxable Income-Taxes Net Income

Why is NI CF?

Operating CF

1. NI includes Depreciation Expense2. NI includes Interest Expense, but not

Principal Repayment

Operating CF = NOI – DebtPMT – Taxes

Operating CF Example

Year 1:$200K NOI30% tax rateYearly Depreciation = $30KFinanced by 30-year, 7%, $1M loan

Operating CF Example

Monthly Loan PMT = $6,653Yearly Loan PMT = $6,653 * 12 = $79,8361st year’s Interest Expense=CUMIPMT(7%/12,360,1000000,1,12,0)or1 Input 12 AMORT = $69,678

2nd year’s Interest Expense=CUMIPMT(7%/12,360,1000000,13,24,0)13 Input 24 AMORT = $68,944

Operating CF Example

Year 1 2NOI $200,000 $200,000-Interest $69,678 $68,944-Depreciation $30,000 $30,000Taxable $100,322 $101,056-Taxes $30,097 $30,317Net Income $70,255 $70,739

Operating CF Example

Year 1 2NOI $200,000 $200,000-DebtPMT $79,836 $79,836-Taxes $30,097 $30,317Operating 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 = NOI1 ÷ Price0

-- invert to get --

Price0 = NOI1 ÷ Cap Rate

-- generalize to get --

Pricet = NOIt+1 ÷ Cap Rate

Capitalization Rate

If we know market Cap Rate, and we estimate NOI1, we have an estimate of

market value of property. Buying apartment complex:

Cap Rate on San Marcos apartments = 8% Expect NOI1 to be $85,000.

How much to bid?

Capitalization Rate

Cap Rate = NOI1 P0

P0 = NOI1 Cap Rate P0 = $85,000 0.08 P0 = $1,062,500

Capitalization Rate

Apartment Valuation Example again We expect to hold for 10 years, then sell P10 = NOI11 Cap Rate Assume NOI grows 3% per year

P10 = ($85K * (1.03)10) 0.08 P10 = $1.428M

Terminal CF

CF’s 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

CF’s:1. +$2.4M (Selling P)

Terminal CF Example

2. Loan Repayment:Original: 360 N, 7 I/YR, 1.6M PV PMT =

10645Now 60 N, FV =???

Loan Repayment CF = -$1,506,105

Terminal CF Example

3. Capital Gain Tax CF: Original Basis Yearly DeprLand = $200K $0Warehouse = $1.8M 39 years = $46,154

Total Depr = 5 years * $46,154 = $230,770

Gain = Selling P – Original BasisGain = $2.4M -$2M = $400K

Terminal CF Example

3. Capital Gain Tax CF Continued:Gain Tax = Gain * 15% = $400K * 15% = $60KRecapture Tax = $230,770 * 25% = $57,693

CG Tax = $60K + $57,693CF = - $117,693

Terminal CF Example

Net Terminal CF:1. Selling P = +$2,400,0002. Loan Repayment = -$1,506,1053. CG Tax = -$ 117,693Net Terminal CF = +$ 776,202

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