Book: What Every Real Estate Investor Needs To Know About Cash Flow

What_Every_Real_Estate_Investor_Needs_To_Know_About_Cash_Flow“What Every Real Estate Investor Needs To Know About Cash Flow … And 36 Other Key Financial Measures” By Frank Gallinelli
  • “Amortization is the liquidation of this debt by the application of installment payments over time.”
  • Tax deductions:
    • “The first of these deductions is for mortgage interest.”
    • “The second source of tax shelter is through the depreciation deduction, which is now called cost recovery in the tax code as of this writing, but is still usually called depreciation by real flesh-and-blood investors.”
  • “Income less Operating Expenses = Net Operating Income”
  • “Net Operating Income less Mortgage Interest less Depreciation (Cost Recovery) = Taxable Income”
  • Leases: “Do the leases agree with the seller’s representations? How long does each lease run? Do tenants have options to renew and at what rates?”
  • Property Tax Bill:
    • “That’s one way to confirm the accuracy of this expense; but also look to see if the current owner has received some sort of tax abatement (perhaps a development incentive) that may expire or may not apply at all to a new owner.”
    • “Some cities, in order to mitigate the impact that the periodic reassessment of property values can cause, will choose to implement a new assessment in phases. This can mean that the current taxes are accurate but that there is also the certainty of higher tax bills as the new assessment comes online.”
  • “Spot-Check Utility Bills”
  • “Ask to See the Appropriate Sections of the Seller’s Tax Return”
    • “point out that you don’t need to see anything related to the property. If the owner holds the property as an individual, then the income and expense information probably appears on Schedule E, and he or she can show you just that form.”
    • “The owner may own the property as a limited liability company (LLC) or some other form of partnership, in which case the property has its own tax return.”
  • “Check with an attorney about the proper language, but put into the offer to purchase something along the lines of ‘The Seller warrants and represents that as of the date of  this agreement, the leases are for [such and such amounts] and the expiration dates and renewal options are[whatever].’ Then ask the lawyer about adding, ‘and that these warranties will survive the delivery of the deed.’ The first part means the seller swears to tell nothing but the truth, and the second part means that he or she is not off the hook if you discover the lie after you complete the purchase.”
  • ” Also, check the websites of trade organizations like the Appraisal Institute (http://www.appraisalinstitute.org); they will almost certainly direct you to the sources of data.”
  • “Gross scheduled income is the total annual rent value of all units in the property. This amount includes the actual rent generated by occupied units, as well as the potential rent from vacant units.”
  • “Vacancy allowance is usually expressed as a percentage of the gross scheduled income. As its name suggests, it is an estimate of amount of potential income that will be lost due to vacancy.”
  • “Gross operating income (GOI) is the gross scheduled income less the vacancy allowance. It is also known as effective gross income.”
  • “Operating expenses are items such as property insurance and taxes, repairs, utilities, and management fees.”
  • “Net operating income (NOI) is the gross operating income less the operating expenses. In other words, it is what is left of your total potential income after all vacancy and expense items have been subtracted.”
  • “Annual Property Operating Data is the real estate equivalent of an income-and-expense statement. You’ll use the terms APOD and income and expense interchangeably.”
  • “In the absence of usable market data, many investors like to use a vacancy allowance in the range of 3 to 6%. An exception to this rule of thumb usually occurs in the case of a newly built project that is being leased for the first time. Vacancy during the initial lease-up period can be much higher.”
  • “Conventional wisdom also has it that a property whose actual vacancy history is close to zero has probably been rented at less than market rate.”
  • “It’s always a good practice for you to get a quote on insurance from your own agent rather than relying on the current cost.”
  • “Also, you should always verify heating and other utility costs by contacting the utility suppliers directly.”
  • Property tax: “a quick telephone call to the assessor’s office will determine whether any change can be expected soon.”
  • “You should count on something more realistic for repairs and maintenance for next year, perhaps 6%, which would be the low end of your typical range.”
  • “Gross Schedule Income less Vacancy & Credit Loss = Gross Operating Income”
  • “To be considered a real estate operating expense, an item must be necessary to maintain a piece of a property and to ensure its ability to continue to produce income.”
  • “For example, utilities, supplies, snow removal, and property management are all operating expenses. Repairs and maintenance are operating expenses, but improvements and additions are not-they are capital expenditures. Property tax is an operating expense, but your personal income tax liability generated by owning the property is not. Your mortgage interest maybe a deductible expense, but it is not an operating expense. You may need a mortgage to afford the property, but not to operate it.”
  • “Gross Operating Income less Operating Expenses = Net Operating Income”
  • “The NOI represents a return on the purchase price of the property, and the cap rate is the rate of that return. Hence, a property with a $1,000,000 purchase price and a $100,000 NOI has a 10% capitalization rate.”
  • Taxable Income or Loss = NOI – Interest Paid – Depreciation and Amortization + Interest Earned
  • Cash Flow Before Taxes = NOI – Debt Service – Capital Expenditures + Interest Earned
  • “As of this writing, you can depreciate a residential income property over 27.5 years and nonresidential property over 39 years.”
  • Taxable income amortization: “It is important to understand that the term, as used here, does not refer to the principal portion of a loan payment. Instead, it refers to the process of taking a partial annual tax deduction for an item you are not allowed to expense in a single year.”
  • Income Tax = Taxable Income or Loss x Tax Bracket
  • Cash Flow After Taxes = Cash Flow Before Taxes – Income Tax
  • See also realdata.com
  • “If it’s not worth selling, then it’s not worth buying.”
  • “”If you’re the buyer, you generally prefer to capitalize the current year’s NOI when you estimate what a property is worth. If you’re the seller, you typically prefer to capitalize your estimate of the coming year’s NOI. The buyer prefers the current year because the NOI is likely to be lower and will justify a lower selling price. Similarly, the seller is inclined to predict that next year’s income will be higher and thus will justify a higher selling price.”
  • “A higher cap rate yields a lower estimate of value. A lower cap rate yields a higher estimate of value.”
  • “Cap Rate = NOI / Value”
  • “An estimated of 7% of the selling price for cost of sale has traditionally been popular among income property investors.”
  • Adjusted basis at sale =  Original basis, purchase price of real estate + Cumulative Capital Improvements + Cost of Sale – Cumulative Depreciation, Real Estate – Cumulative Depreciation, Capital Improvements
  • “Keep in mind hat under the current tax code, you can take only one-half month of depreciation deduction in the month that you dispose of the property.”
  • Gain or (Loss) = Projected selling price – Adjusted Basis
  • “Gross Rent Multiplier = Market Value / Gross Scheduled Income (annual)”
  • “Market Value = Gross Rent Multiplier x Gross Scheduled Income (annual)”
  • “Debt Coverage Ratio = Net Operating Income / Annual Debt Service”
  • “Most lenders require a debt coverage ratio of at least 1.20 in order to finance an income property, and since the Great Recession, 1.25 or higher is not uncommon.”
  • “Gross Scheduled Rent Income less Vacancy & Credit Loss less Operating Expenses = Net Operating Income”
  • “If the IRR peaks, it is identifying an optimum holding period.”
  • “Safe rate (sometimes called the finance rate). This is the interest rate at which you put money aside, in a secure and reasonably liquid form, so that it can grow to meet the amount or amounts needed to cover future negative cash flows.”
  • “Reinvestment rate (sometimes called the risk rate). This is the rate at which you assume you can reinvest all positive cash flows.”
  • financial management rate of return (FMRR): “FMRR eliminates negatives by first discounting them back at the safe rate to the nearest previous positive cash flow, then adding that discounted negative amount to the positive cash. If there are any negative amounts left over after doing this, those are discounted back to the time you make your initial investment (i.e., year 0), also at the safe rate, and added to the initial investment. The procedure then compounds the remaining positive cash flows toward to the end of the holding period at a rate that is realistic for those cash flows.”
  • modified internal rate of return (MIRR): “The difference with MIRR is that it discounts all negative cash flows to year 0 rather than trying to mix and match individual negatives with offsetting positives.”
  • “An expense stop is an amount at which the parties have agreed that the landlord’s obligation to pay a particular expense will stop and the tenants’ obligation to reimburse will begin.”
  • Expense recoveries: “The industry standard is to treat them as income.”
  • triple-net lease: “It is a lease where the tenant agrees to pay (in addition to its base rent) the net taxes, insurance, and maintenance costs.”
  • “Number of Years to Double in Value (approximate) = 72 / Rate of Growth”
  • Note: Rate of growth is in percent, i.e. if it’s 8%, then use 8
  • “The gross rent multiplier (GRM) is a simple method by which you can estimate the market value of an income property.”
  • “Gross Rent Multiplier = Market Value / Gross Scheduled Income (annual)”
  • “Market Value = Gross Rent Multiplier x Gross Scheduled Income (annual)”
  • “Realistically, you would probably be surprised (and suspicious) to see a GRM below 4 and aghast to see one higher than 10.”
  • “Vacancy and Credit Loss (in dollars) = Gross Scheduled Income x estimated % Vacancy and Credit Loss”
  • “Net Income Multiplier = 1 / Capitalization Rate”
  • “NIM represents the amount that typical investor would pay for each dollar of NOI”
  • “Net Operating Income
    less Mortgage Interest
    less Depreciation, Real Property
    less Depreciation, Capital Additions
    less Amortization, Points and Closing Costs
    plus Interest Earned
    = Taxable Income”
  • “The cash-on-cash return (also called the equity dividend rate) is the ratio between the property’s cash flow in a particular year (usually before taxes) and the amount of the initial capital investment. It is expressed as a percentage.”
  • “Cash-on-Cash Return = Annual Cash Flow / Cash Invested”
  • “Profitability Index = Present Value of all Future Cash Flows / Initial Cash Investment”
  • “A profitability index of 1.0 means you have exactly achieved your rate-of-return goal. An index greater than 1.0 means you’ve exceeded that goal. An index less than 1.0 means you failed to reach the goal.”
  • “Net present Value = Present Value of all Future Cash Flows less initial Cash Investment”
  • “Income per square foot = Gross Scheduled Income / Gross Building Area or Net Rentable Area”
  • “Expenses per square foot = Operating Expenses / Gross Building Area or Net Rentable Area”
  • “Operating Expense Ratio = Operating Expense / Gross Operating Income”
  • “Break-Even Ratio = (Debt Service + Operating Expenses) / Gross Operating Income”
  • “Most lenders look for a BER of 85% or less. If occupancy rates in a particular market are exceptionally low (meaning that the certainty of your revenue stream is especially dicey), lenders may require a BER that is several percentage points less than the average occupancy rate.”
  • “Return on Equity = Cash Flow after Taxes / Initial Cash Investment”
  • “Return on Equity = Cash Flow after Taxes / (Resale Value less Mortgage Balance)”
  • Loan-to-Value Ratio: “If you were to purchase a home as a personal residence, the maximum LTV (i.e., the most the bank would lend you) would typically be 80% for a conventional mortgage.”
  • “Loan-to-Value Ratio = Loan Amount / Lesser of Property’s Appraised Value or Actual Selling Price”
  • “Unless you feel quite certain that you will not sell or refinance the property any time soon, you should keep loan points to the lowest possible amount.”
  • “Maximum Loan Amount = Net Operating Income / Minimum Debt Coverage Ratio / Mortgage Constant (annual)”
  • “A table of monthly mortgage constants is available at http://www.realdata.com/book”
  • Annual formula: “Maximum Loan Amount = Net Operating Income / Minimum Debt Coverage Ratio / (Mortgage Constant  x 12”
  • “Tax rate. The rate applied to the assessed value to determine the actual number of dollars of property tax. Often this is called the ‘mill rate’ (sometimes written ‘mil rate’) because it is expressed as the tax rate per thousand dollars of assessed value.”
  • “In order to determine the gain on sale, you first calculate the adjusted basis and then find the difference between that amount and the selling price.”
  • “Original Basis (Purchase Price)
    plus Capital Additions
    plus Costs of Sale
    less Cumulative Depreciation, Real Estate
    less Cumulative Depreciation, Capital Additions
    =Adjusted Basis”
  • “Depreciation (also called cost recovery) is the amount of the tax deduction that a property owner may take each year until he or she has written off the entire appreciable asset.”
  • “The exact amount of your depreciation deduction each year is determined by the asset’s useful life as specified in the tax code.”
  • “As of this writing, the useful life for residential property is 27.5 years, and for nonresidential, it is 39 years.”
  • “If you make additions or capital improvements to the property, you depreciate these according to the same useful life and begin doing so at the time you place the additions or improvements in service.”
  • “The current tax code also provides for what is called the half-month convention. In whatever month you place an asset in service and whatever month you dispose of it, you’re allowed to take only one-half of the depreciation normally allowed.”
  • To calculate depreciation: “1. Determine the depreciable basis by separating the value of the improvements from the value of the land. 2.  Determine the useful life according to the current tax code. 3. Apply the formula: Depreciation Allowance (annual) = Deprecialbe Basis / Useful Life”
  • “Under the current tax code, if you hold for 12 months and then sell, you qualify for the lower long-term capital gain tax rate.”
  • Gross building area: “GBA represents a building’s total floor area, as measured from the outer surface of exterior walls and windows, and includes elevator shafts, utility rooms, and basement space.”
  • “Usable square footage (USF) is the actual space contained within a tenant’s (or all tenants’) premises.”
  • “Rentable square footage (RSF) is the number of square feet on which the tenant’s rent is based.”
  • “The owner will typically take a percentage of the square footage that makes up the common area and add that to the USF to make what is called the net rentable area (NRA).”
  • “Loss Ratio = Common Area / Gross Building Area”
  • “How much higher is RSF than USF? The difference will obviously depend on the building’s proportions, but 15 to 20% is not uncommon.”

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