Managing the Financial Aspects of a Real Property Asset
A property owner has need of market and financial analyses both before and during the term of ownership. Before making a decision on buying the property, the investor needs to know the market potential of the property as well as the potential for financial return on the investment. Later, the property owner will need analyses to help him or her decide whether to refinance the property; whether to rehabilitate, renovate, or redevelop the property; and/or whether to hold or to sell the property. The owner may look to the property manager for assistance with any or all these important analyses. The property manager’s ability to help will depend upon his or her ability to understand the nature and substance of these analyses and how to perform a specific analysis. The purpose of this chapter is to explain these financial analyses briefly. The property manager may wish to get more detailed training in each of the subject areas in this chapter.
EVALUATING THE MARKET POTENTIAL OF THE PROPERTY
Information about the market potential of the property comes from a market analysis technique called a survey of the competition. The analysis starts with a detailed inspection of the subject property to learn its financial, physical and locational characteristics. Financial characteristics of the subject property include:
|(a)||the asking or listed rent rate; Historical operating expenses and projected capital expenses; any deferred maintenance items; levels of property taxes;|
|(b)||the costs of tenant concessions that convert the asking rate to an effective rent rate;|
|(c)||the vacancy rate; and|
|(d)||rent collection losses.|
Physical characteristics of the subject property are the structural characteristics and the site characteristics. Structural characteristics include:
|(a)||the type of space available for rent;|
|(b)||the amount of available space including its dimensions and square footage;|
|(c)||the condition of the space; and the structural integrity of the entire building|
|(d)||the attractiveness or appeal of the structure; and|
|(f)||compliance with all applicable codes and regulations|
The site characteristics include:
|(a)||the amount and the qualitative features of the available parking;|
|(b)||the visibility characteristics of the property, especially if it is a retail site;|
|(c)||the landscaping features;|
|(d)||the land use restrictions and easements affecting the site;|
|(e)||the ingress and egress onto the site from the street; and|
|(f)||the site amenities.|
Location amenities and features include estimates or judgments of:
|(a)||neighborhood or area prestige;|
|(b)||the availability and quality of public services such as schools, fire and police protection;|
|(c)||the cost of the public services;|
|(d)||the accessibility of the property to employment opportunities, shopping, entertainment facilities, recreation areas and other land uses desired by tenants;|
|(e)||proximity to major transportation systems such as highways, public transportation, and airports. and|
|(f)||uses and conditions of neighboring properties.|
The specific list of these financial, physical and locational characteristics will depend on the type of property being analyzed. For example, the analysis of an apartment community would include the type of units identified by the number of bedrooms as well as square footage; structural amenities such as balconies, a laundry room and a vending/game room; site amenities such as a swimming pool, tennis courts, and jogging/walking paths. For a retail property, a list of characteristics would include the square footage of total gross leasable area and the size configurations of the retail space units. Structural amenities include atriums, escalators, elevators, landscaping and fountains. The site amenities are the landscaping. For an office building the analysis includes the amount of rentable area and the configuration of the rentable area. Structural amenities would include convenience retail establishments, covered parking and ascetically pleasing entrances and lobbies. Site amenities would be recreational facilities, picnic areas, jogging and walking trails.
Once the analyst or property manager identifies the important or major characteristics of the subject property, then he or she identifies properties close to the subject property having the same use as well as general physical and locational characteristics. The analyst inspects each of these competitive properties for information about the characteristics identified as important to prospective tenants or for property uses similar to the subject property. In addition, he or she would analyze each of the competitive properties for other characteristics that the comparable properties may have that are absent from the subject property. As part of the analysis of the competitive properties, the analyst gathers specific information about their effective rent rates and their vacancy levels.
The analyst displays all of this information in a table that allows him or her to compare each competitive property to the subject property to determine whether the subject property is comparable to the competitive property, superior to it, or inferior to it. The analyst can assign values to calculate whether the subject property is inferior or superior to the competitive property. For example, the weight of zero may mean that the subject and the competitive property are similar or identical, while a weight of +1 applied to the competitive property implies it is slightly superior to the subject, +2 implies it is moderately superior and +3 implies it is highly superior to the subject property. Similarly, -1, -2 and -3 would imply the degrees to which the competitive property is inferior to the subject property. As a second example, a manager would use a comparison grid with a minimum of three competitive properties. He would then assign values in $/unit/mo for residential or $/sf/yr for office or retail to each rating factor with location being given the highest weight. Should a concession be given by a competitor, it also factored into the adjustments.
When the property manager performs the field work and creates this table or grid, he or she can make judgments about the ability of the subject property to compete with the market. For example, if the subject property is superior to all of its competitors but receives rents that are the same as the competitors, the property manager has evidence that the rents in the subject property can be increased to reflect its superior nature. On the other hand, if the subject property is only comparable or inferior to the competitive properties, the property manager will be able to identify the specific characteristics that make the subject property inferior. For example, the competition may have Olympic size swimming pools and many tennis courts while the subject property has a small pool and only two courts. If the site contains room for expansion, upgrading the on-site amenities could lead to higher rents and lower vacancies in the future.
The property manager will also include in the analysis those competitive properties under construction and properties in the planning stage. These potentially competitive properties are not currently competing with the subject property but will be major competitors in the very near future and could have a great impact on the financial performance of the subject property.
In conclusion, the survey of competition is the analytical technique to evaluate the subject property, its market potential, and establish appropriate market rents. The analysis requires extensive field research of the competition and the ability to organize and synthesize the information gathered about the competition. Once the analyst gathers, organizes, and synthesizes the information, he or she can judge the relative position of the subject property in the market as well as set or recommend appropriate rents.
ESTIMATING THE FINANCIAL RETURN
The income and operating expense statements discussed in the previous chapter provide the basic data for the analysis of the property’s financial return. Analysts who perform this type of study typically begin with an analysis of performance and profitability ratios. The performance ratios are the operating expense ratio, the debt service coverage ratio, and the break-even or default ratio. The profitability ratios are the equity dividend rate, and the return on total investment. The financial data in the operating statement provide the information to calculate each of these ratios.
|(a)||PERFORMANCE RATIOS – Performance fall into three categories.|
|(1)||OPERATING EXPENSE RATIO – The operating expense ratio is total operating expenses divided by effective gross income. The value of the ratio lies in the range between zero and one. Typically its value is between 40% and 60% depending on the type of property being analyzed. The significance for the operating expense ratio rests on its relationship to the operating expense ratio for similar or comparable properties. For example, if the operating expense ratio for the subject property is 50% while the operating expense ratio for similar properties is 40%, the analyst receives a signal that the subject property is performing worse than the competition. The subject property’s operating expenses are much higher than the operating expenses of similar properties. This signal alerts the analyst to check the operating expenses of the subject property for problems. The analyst may discover that the utility bills for the subject property are out of line with the utility bills in competitive properties. The cause might be faulty HVAC equipment or improper insulation.|
|(2)||DEBT SERVICE COVERAGE RATIO – The debt service coverage ratio, or DCR, is net operating income divided by the total annual mortgage payments (also known as the annual debt service or the acronym ADS). Most lenders insist upon an absolute minimum of 1.1 and more commonly 1.25. This is the initial DCR used by lenders as one of the two tests (Loan-to-value, LTV, being the other) to determine a maximum loan amount. As years go by, this number can change dramatically. When the debt service coverage ratio equals one, the net operating income is sufficiently large to cover the debt service. This situation means that the property is paying all of its operating expenses as well as its financial expenses leaving zero dollars as before-tax cash flow. If the debt service coverage ratio is less than one, the debt service exceeds net operating income and the property generates a negative before-tax cash flow. The property owner in this instance will have to use money from other sources to meet the total obligations of the property. On the other hand, if the debt service coverage ratio is greater than one the net operating income is large enough to pay the debt service and provide a positive before-tax cash flow.|
|(3)||THE BREAK-EVEN OR DEFAULT RATIO – The break-even ratio is the sum of total annual operating expenses plus the debt service for a year divided by the annual effective gross income. The typical range for this ratio is between 50% and 90% If the ratio equals one, then the total of operating expense plus financial costs associated with the property are equal to the effective gross income, leaving no before-tax cash flow to the owner. When the ratio is 0.9, 90 percent of the effective gross income goes to meet the operating expenses and the financial costs of the property and 10 percent of the effective gross income remains as before-tax cash flow.
The purpose of this measurement is to determine at what percentage occupancy the property will break even on a cash-flow basis. If the market occupancy is 90% and the subject’s break-even point is 72%, it is a relatively secure investment.
|(b)||BASIC INVESTMENT TESTS-There are two commonly used measures of return. It should be understood that these are simple measures based on first year results only, and more sophisticated measures using longer time periods are available.|
|(1)||EQUITY DIVIDEND RATE – The equity dividend rate is before-tax equity cash flow divided by the initial equity that the property owner invested in the property. It is also referred to as Return on Equity, or ROE, or the Cash-on-Cash return. The calculation is a measure of one year’s before-tax cash flow (also referred to as BTCF) divided by the initial investment. For example, if before-tax cash flow is $5,000 and the property owner invested $50,000 of equity capital into the purchase of the property, then the equity dividend rate is $5,000 divided by $50,000 which is 10 percent.|
|(2)||THE RATE OF RETURN ON THE TOTAL INVESTMENT – The rate of return on the investment, or ROI, is net operating income divided by the total acquisition price of the property. For example, if the net operating income is $50,000 and the property’s acquisition price is $500,000, the rate of return on the total investment is $50,000 divided by $500,000, which is 10 percent. Students of corporate finance know this as Return on Assets, or ROA.
This relationship (NOI/purchase price) is also referred to as the Free-and-Clear Return (F&C) because it assumes the property is free of debt. Appraisers call it a Capitalization rate.
The property manager must understand the nature and the significance of these performance and profitability measures to assist the owner in making decisions about the property’s operation as well as future direction. A more extensive discussion of these ratios is provided in college courses and textbooks that discuss the topic of “Real Estate Equity Investment.” Also, “Real Estate Equity Investment” is the subject of courses offered by several professional real estate organizations. The property manager can assist the owner by analyzing the cash flow on the property using widely recognized techniques.
ADDITIONAL PERFORMANCE ANALYSIS
While the ratios described above are based on a single year of performance data, it is possible to view the property over several years. This is supported by the use of computers and multi-year cash flow analysis frequently using spreadsheets such as Excel. Examples follow.
|(a)||BREAK-EVEN ANALYSIS – Break-even analysis uses the information from the operating statement, including the debt service component, to evaluate the size of before-tax cash flow. See the break-even ratio above. The break-even point occurs when before-tax cash flow is equal to zero. If before-tax cash flow is greater than zero, then the property owner receives a positive financial gain from the real property investment in that year. This financial gain is “profit.” If before-tax cash flow is less than zero, the property owner faces a negative cash flow situation that requires money from other sources to meet the expenses of the property. This situation constitutes a “loss.” The primary purpose of such an analysis is to measure the break-even occupancy for comparison to typical market occupancy. Thus, this provides a measurement of investment risk.|
|(b)||DISCOUNTED CASH FLOW ANALYSIS (DCF) – Discounted cash flow (DCF) analysis is another financial analysis technique that uses information in the operating statement projected into the future for a period of several years. Most often, it uses projected cash flows before taxes plus net re-sale proceeds.|
DCF is a multi-year analysis of the cash flows that appear in the income and total operating expense projections for future years. The analyst gathers and evaluates a historical record of the operating expenses and the revenue generating capabilities of the property. From this historic information, the analyst constructs the most likely scenario for the property’s operation in future years. Then, the analyst uses his or her judgment to make changes in effective gross income and the various major components of total operating expenses into the future to improve the reliability of the forecasts. Based on the available information, the line items for income and operating expenses can remain constant over time, increase over time or even decrease over time. When this portion of DCF analysis is complete, the analyst has a multi-year pro forma budget that projects a stream of before-tax cash flows into the future and facilitates prospective investment and risk analysis.
As part of the financial analysis, the analyst should state a period over which the property owner intends to own the property. This period, usually stated in years, is the holding period. The length of the holding period results from the analyst’s judgment about the property owner’s financial objectives. For one property owner considering a specific investment property, the appropriate holding period could be five years. For a second property owner considering the same property, the holding period could be ten years. Therefore, the holding period is an important part of the DCF analysis. Holding period analysis is also a specific aspect of the DCF analytical technique. For a specific investor or owner, the analyst might perform the financial analysis for several relevant holding periods. For example, the investor might reach the conclusion that he or she should own the property for ten years. Using computer spreadsheet software, the analyst could make the analysis for nine, ten and eleven years to see which holding period provides the most favorable financial return.
When the discounted cash flow statement is complete, the analyst calculates the present value of the future before-tax cash flows and the present value of the owner’s equity at the end of the holding period. This analysis requires the use of a financial concept called present value. The concepts of present value and future value are also the subject matter of college textbooks and courses on real estate investment and are important elements in such courses offered by professional organizations. Related topics for further study are Net Present Value, or NPV and Internal Rate of Return, or IRR.
DCF is a somewhat complex financial analysis technique most commonly using computerized programs for the calculations. A full discussion of its complexities is not appropriate for this reference guide. The property manager who wishes to assist the property owner in his or her financial analysis will want to seek specialized training in this subject.
ANALYZING BENEFITS AND COSTS OF REFINANCING
The decision to refinance the mortgage on the property rests on an analysis of the financial benefits generated by the refinancing and the costs of undertaking the refinancing. The financial analysis underlying the refinancing decision starts when the current or market mortgage interest rate drops below the mortgage interest rate on the existing mortgage. The analyst starts by calculating the difference between the mortgage payment at the contract interest rate and the mortgage payment at the currently prevailing market interest rate. The difference in the current mortgage payment and a payment at the current interest rate is usually positive, and the advantage of the lower payment is easy to grasp. However, under certain circumstances, a negative difference brought about by higher mortgage payments after refinancing with a loan having a lower interest rate, makes financial sense. For example, a higher monthly payment for a substantially reduced period can be a financially sound decision because the owner will realize savings in interest payments over the life of the loan or to the end of the property owner’s holding period, whichever is less.
The financial analysis consists of calculating an interest rate that equates the present value of the benefits to the present value of the costs of the refinancing. For example, an initial outlay of $9,000 could generate a reduction in the mortgage payment of $110 a month for the next fifteen years. This situation in which $9,000 is the cost to get an income stream of $110 per month for 180 months leads to an annual rate of return of 12.34 percent using monthly compounding. The calculation requires the analyst to use present value concepts and a financial calculator or computer.
The owner makes the refinancing decision by comparing his or her alternate uses for the $9,000. Using the money to refinance the property yields a 12.34 percent per year return on that $9,000 investment for fifteen years. The property owner may discover that none of his or her alternate investment opportunities in other properties, the stock market, the bond market or certificates of deposit will yield 12.34 percent per year for 15 years. In this case, the $9,000 should go to refinance the loan on the property. However, if the property owner discovers that the use of the $9,000 in an alternate investment would yield a rate of return greater than 12.34 percent, then the funds should go to the alternate investment opportunity and not into the refinancing.
RENOVATION AND REHABILITATION FEASIBILITY ANALYSIS
The decision to renovate or rehabilitate the property rests on the comparison of the financial returns from operating the property “as is” to operating the property after the expenditure of funds for the renovation or rehabilitation. This is accomplished by conducting a cost-benefit analysis. Using discounted cash flow analysis, the analyst calculates the financial returns to the property “as is” and after the renovation. Renovation will have two major impacts on the financial position of the property. First, the costs to undertake the renovation are a financial outlay. The costs are covered by either a cash payment by the property owner, a loan to cover the costs of the renovation (typically a second mortgage,) or a combination of the two. Second, the renovation should have substantial measurable positive monetary benefits that appear in the operating statement. For example, the renovation could generate higher contract rents and lower vacancies, thereby increasing effective gross income. In addition, the renovation could reduce operating expenses such as utility payments, maintenance and repair.
If the measure of the financial return to the property after the costs and benefits of renovation exceed the rate of return for the property “as is,” then renovation is a sound financial decision for the property owner. On the other hand, if the renovation generates a lower financial return because the costs of renovation are not adequately counter-balanced by an increase in effective gross income and/or a reduction in operating expenses, then the property should not be renovated at this time. The renovation may have to wait until changes in market conditions generate the necessary increase in rent and/or vacancy reduction to increase effective gross income and make the renovation financially feasible. Based on the property itself and the market in which it operates, the proper timing might occur in the near future or never.
THE DECISION TO HOLD THE PROPERTY OR TO SELL IT
The property owner’s decision to continue owning the property into the future as opposed to selling it now rests on a comparison of the relevant alternate rates of return. The property owner should compare the rate of return from continued ownership with the rate of return on the net proceeds he or she will receive from the sale of the property. Using the discounted cash flow analysis, the analyst estimates a rate of return from holding the property. If this anticipated rate of return exceeds the rate of return from another parcel of real property or other financial asset, then the property owner should continue to hold the property. If, on the other hand, the property owner or the analyst discovers that placing the net proceeds from the sale of the property in another investment will yield a greater rate of return, then the property owner should sell the property and use the funds for the alternate investment. Of course, tax considerations should be factored into such decisions.
COMPARING THE MARKET VALUE AND ASSESSED VALUE OF THE PROPERTY
The owner might ask the property manager to analyze whether the real property tax assessment for the subject property is higher than it should be based on the current market value of the property. This situation occurs when the economic performance of the property declines over several years causing its market value to diminish, while the assessed value remains the same or even increases.
The property manager might advise the property owner about a need to have the property appraised. By keeping track of the competitive properties in the public records, the property manager can discover sales prices for competing properties and can obtain the assessed value of those properties. Making assumptions about the possible sales price of the managed property, the property manager can determine if the ratio of the assessed value to the sales price is consistent between the subject property and the recently sold comparable properties. If the property manager discovers that the ratio of assessed value to possible sales price for the subject property is substantially greater than that for recently sold comparable properties, he or she can inform the property owner of this fact and recommend that the owner file a property tax assessment appeal. This appeal would probably require an appraisal. The property manager in this situation can serve as a source of information to an independent fee appraiser who performs an income property valuation for the property owner. Serving the property owner in this capacity, the property manager needs to understand the nature of the sales comparison valuation technique and discounted cash flow analysis as valuation techniques.
If the property manager realizes that the property’s performance has deteriorated over recent years, he or she can report this situation to the property owner and recommend an appraisal. If effective gross income is declining because market rents have declined and/or vacancies have increased, or if total operating expenses have increased while effective gross income remains stable or declines, then net operating income and before-tax cash flow will also decline. The decline in net operating income and before-tax cash flow signal a reduction in the financial rate of return on the property as well as a reduction in the property’s value.
BEFORE-TAX AND AFTER-TAX FINANCIAL ANALYSIS
The foregoing discussion of financial matters deals with before-income-tax income. To evaluate completely or estimate the financial rate of return to a property of the refinancing decision, the renovation decision, and the hold or sell decision, the analyst and the property owner must consider the effects of federal and state income taxes. The income tax effects occur both during the ownership period and upon the sale of the property. During the ownership period, taxable income is the basis of the tax consequences. Upon the sale of the property the capital gain or loss is the basis of the principal income tax effect. An effective property manager is aware of the income tax consequences to real estate equity investors such as ways in which, the income tax code allows the property owner to defer the payment of capital gain tax by using a capital gains tax deferral technique such as a Section 1031 exchange of like kind assets.
A discussion of the income tax code and its consequences is beyond the scope of this reference guide. However, the college courses and college texts as well as the courses offered by professional associations dealing with real estate equity investment discuss the necessary income tax considerations.
ESTIMATING THE INSURANCE NEEDS FOR THE PROPERTY
The property owner needs to protect the property from three possible losses.
|(a)||Casualty losses are property damage from fire, wind, lightening, hail, explosion, smoke, and water from broken pipes and fire hoses. Other casualty losses are those due to earthquakes and riots. Protection against these latter perils may require extended coverage.|
|(b)||Liability losses arise from personal injury to tenants and third parties who use the property.|
|(c)||Other losses result from theft and vandalism.|
Casualty insurance does not protect the land component of the property against casualty loss because the protection is not necessary, and only the value of the property’s improvements should be used in determination of the insurable value for casualty insurance premium purposes. Therefore, the property owner may ask the property manager to keep records showing the allocation of the total value of the property between the land component and the improvements. This allocation can change over time as land becomes more valuable and the improvements age. The property owner may ask the property manager to monitor the change in the value of the improvements on the property and to keep records in the event of damage or destruction. In this event, the owner may request the property manager to make sure that the premium for casualty insurance reflects only the value of the improvement and not the total value of the property.
The property manager must also monitor the level of insurance coverage that protects the property owner against lawsuits arising from liability claims. In this capacity the property manager will find the advice and counsel of a qualified insurance agent to be the best source of current information on the nature and magnitude for liability coverage as well as the coverage for losses due to thefts, vandalism and malicious mischief.