Cash Flow and Financing Analysis for Real Estate Investment by Huffman Forrest

Author:Huffman, Forrest [Huffman, Forrest]
Language: eng
Format: epub
Publisher: UNKNOWN
Published: 2016-10-23T16:00:00+00:00

CHAPTER 7 DECISION MAKING: RATIO AND DCF ANALYSIS

The objective of an analysis of real estate asset cash flows is an attempt to determine the acceptance or rejection of the real estate asset as an investment. The analysis can be a very general comparison of the cash flow items relative to acceptable standards or a more detailed analysis of the cash flows over a forecasted multi-year holding period.

CASH FLOW RATIO ANALYSIS

There are a number of simple analyses of cash flow items that allow us to determine the financial strength and risk exposure associated with the investment property. The primary sectors of analysis are the examination of property performance, risk (primary financial risk), and investment returns. We begin with an analysis of property performance.

There are two ratios that we can examine to assess property performance. The vacancy rate is an obvious point of analysis. The vacancy rate is vacancy losses divided by the potential gross income. This ratio has two reference points or benchmarks. The first is cross-sectional comparisons of the property’s expected vacancy rate relative to any industry benchmarks for the type of property under consideration. The analysis of local markets and comparative properties can also be used to develop appropriate vacancy rate benchmarks.

The second method of analysis is a temporal or time-based analysis by examining the vacancy rate for the property over the forecasted holding period. Any increase in the vacancy rate is an indication that the property is performing poorly such that vacancy allowances are increasing faster than potential gross income.

The second performance ratio is the operating expense ratio (OER). The OER is the property’s operating expenses divided by the property’s effective gross income. The OER is also examined relative to industry benchmarks as well as temporally. Both the vacancy rate and the OER can also be used to estimate breakeven points relative to net operating income.

Both vacancy rate and OER benchmarks also can be identified by surveys of similar property as preformed and published by professional organizations such as the Institute of Real Estate Management (IREM) or BOMA (the Building Owners Management Association).

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FIGURE 7-1

CASH FLOW RATIOS

Vacancy Rate = Vacancies/PGI

Operating Expense Ratio = OE/EGI

Debt Service Coverage Ratio = NOI/ADS

Equity Dividend Rate = BTCF/Equity

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The next ratio of interest is the debt service coverage ratio (DSCR). The DSCR is the estimated net operating income of the property divided by the annual debt service associated with financing. The DSCR is one measure of the potential for default. DSCRs less than one imply that there is not enough net operating income to meet the annual debt service requirement. Generally lenders require DSCRs that yield a sufficient cushion should the property suffer from increases in vacancy and/or operating expenses or declines in potential gross income. These minimum DSCRs usually begin at about 120% of the annual debt service (i.e., (a ratio of 1.20) and up to 1.30 or so. The higher the DSCR, the less likely the investor is to default on the mortgage loan and the more likely they will be able to borrow additional funds.

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