preparing_the_pro_forma_real estate.pdf

8/10/2019 preparing_the_pro_forma_real estate.pdf

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Preparing, Evaluating, & Analyzing

the Real Estate Pro Forma


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G.R.e.A.T., LLc 2012Cash Flow Pro forma Page

Contents

Introduction ........................................................................................................................................................ 1

What is the Financial Analysis .............................................................................................................................. 1

Risk ................................................................................................................................................................ 2

Discounted Cash Flow .................................................................................................................................... 2

How do you prepare the Financial Analysis and how to start ............................................................................. 3

Stage 1 Initial Analysis .................................................................................................................................. 5

Stage 2 Refinement of Assumptions & DCF Analysis ..................................................................................... 5

Stage 3 Final Refinement and Cash Flow Distributions ................................................................................. 6

What are the components of the Financial Analysis ............................................................................................ 6

How should the Financial Analysis be organized ................................................................................................ 6

How do Financial Analyses change based on the asset type? ............................................................................... 7

Types of Investment Analyses ............................................................................................................................. 8

Land Development Analysis ............................................................................................................................ 8

Land Development Case Study .................................................................................................................... 9

Back of Envelope Analysis for Land Development .................................................................................... 9

Land Development Discounted Cash Flow .............................................................................................. 12

Assumptions ........................................................................................................................................ 13

Summary of Project Returns ................................................................................................................ 14

Project Schedule .................................................................................................................................. 15

Construction Budget ........................................................................................................................... 16

Hard Cost Construction Detail & Lot Release Pricing ........................................................................... 17

Before Tax Pro Forma Cash Flow Analysis...........................................................................................18

Cash Flow Distribution ........................................................................................................................ 19New Development Analysis .......................................................................................................................... 20

Office ........................................................................................................................................................ 20

Preliminary Analysis ............................................................................................................................... 20

New Development Discounted Cash Flow Analysis ................................................................................. 21


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The Assumptions Page ......................................................................................................................... 21

Assumptions, Facts, & General Information ......................................................................................... 21

Sources & Uses ................................................................................................................................ 22

Sources ........................................................................................................................................ 22

Uses ............................................................................................................................................ 22

Summary of Income & Expense .......................................................................................................... 23

Rent Assumptions ............................................................................................................................... 24

Project Schedule ................................................................................................................................. 25

Development Costs ............................................................................................................................ 26

Hard Costs ......................................................................................................................................... 27

Soft Costs ........................................................................................................................................... 28

Operational & Holding Period Costs .................................................................................................. 29

Operating Costs .............................................................................................................................. 29

Holding Period Costs ...................................................................................................................... 29

Financing Costs ............................................................................................................................... 29

Cash Flow .......................................................................................................................................... 30

Capitalized Interest ............................................................................................................................. 31

Owners Equity .................................................................................................................................. 32

Operating Pro Forma ......................................................................................................................... 33

Debt Service Schedule......................................................................................................................... 34

Existing Operated Asset Analysis ................................................................................................................... 35

Reconstructing the Operating Statements ................................................................................................... 35

Operating (Income) Statement Example ................................................................................................. 36

Forecasting Income & Expenses ................................................................................................................. 37

Revenue Projections .............................................................................................................................. 37

Building the Analysis ................................................................................................................................. 38

Detailed Research & Financial Analysis ...................................................................................................... 38

Assumptions Sheet ................................................................................................................................. 38


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Rent Roll & Stacking Plan (if the project is a multi-tenant office building and occupied) ......................... 39

Operating Expense Summary ................................................................................................................. 40

Lease Expiration & Market Rent Analysis ................................................................................................ 40

Income In-place & Projected NOI Summary ............................................................................................ 41

Replacement Cost Analysis ..................................................................................................................... 42

Cash Flow Projections ........................................................................................................................... 43

Estimated Project Cash Flows ............................................................................................................. 44

Valuing the Real Estate Asset .................................................................................................................. 45

Estimating the Cash Flows to Equity ....................................................................................................... 45

Sensitivity Analysis ............................................................................................................................................ 45

What are the important metrics and how should project be evaluated? ............................................................ 47

Financial Ratios ................................................................................................................................................ 47

Categories of Financial Ratios ........................................................................................................................... 48

Liquidity Ratios ............................................................................................................................................. 48

Operating Expense Ratio ........................................................................................................................... 48

Payback Period ......................................................................................................................................... 48

Breakeven Ratio ........................................................................................................................................ 48

Debt Ratios ................................................................................................................................................... 49

Loan to Cost Ratio .................................................................................................................................... 49

Loan to Value Ratio .................................................................................................................................. 49

Debt Coverage Ratio ................................................................................................................................. 49

Debt Constant ........................................................................................................................................... 49

Profitability Ratios ........................................................................................................................................ 50

Holding-Period Returns ............................................................................................................................. 50

Periodic Return ......................................................................................................................................... 50

Before-Tax Return ..................................................................................................................................... 50

After-Tax Return ....................................................................................................................................... 50

Leveraged Return ...................................................................................................................................... 50


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G.R.e.A.T., LLc 2012Cash Flow Pro forma Page iv

Unleveraged Return ................................................................................................................................... 51

Positive & Negative Leverage ..................................................................................................................... 51

Total Return.............................................................................................................................................. 52

Income Return .......................................................................................................................................... 52

Appreciation Return .................................................................................................................................. 52

Return on Equity ....................................................................................................................................... 53

Cash on Cash Return ................................................................................................................................. 53

Equity Multiple ......................................................................................................................................... 53

Internal Rate of Return .............................................................................................................................. 54

Net Present Value ..................................................................................................................................... 54

Profitability Index ..................................................................................................................................... 55

Market Ratios ............................................................................................................................................... 56

Capitalization Rates. .................................................................................................................................. 56

Gross Income Multiplier ............................................................................................................................ 56

Net Income Multiplier ............................................................................................................................... 57

Conclusion ....................................................................................................................................................... 57


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Introduction

The financial analysis of any real estate project is generally the meat of the story. Like most books, you have

one chance to grip your reader. The structure is the backbone of the analysis beneath the surface, it holds

everything together and imposes order on the flow. Without a coherent and logical structure, the analysis is

unclear.

Like writing a novel, you may need to play around with the structure before you feel the analysis is ready to

publish. Experiment. The process of experimentation and iteration allows you to refine your thoughts, the

facts, the assumptions, format, and other aspects to ensure the results support the story. Ask yourself questions.

Seek input from your team or other professionals.

Are the assumptions correct?

Does the analysis support the idea?

Does the analysis flow?

Is it easy to read?

Are the individual parts linked (properly)?

Is the math correct?

Can you sum up the story in a simple chart?

Does the story start in the right place and reach a conclusion?

Will someone want to invest in the project?

The financial analysis is a report forecasting income, expenses and expected returns associated with a real estate

project. The cash flows are projected for a period of time through study, research, analysis, and experience

although there is sometimes looking through a crystal ball. The analysis is prepared for a variety of purposes but

mostly to attract capital (debt and equity) to a specific project. The pro forma will be evaluated by potential

equity partners and lenders. As a result, the information included in the pro forma is required to be verifiable

and reliable. Most importantly, the mathematics must be correct.

In most cases, it is best to keep the analysis simple. It is important that the reader, without explanation, can

make sense of the assumptions, analysis, and results. The format and the results should make it easy to

understand the time without knowing how you built the watch.

What is the Financial Analysis

The analysis of real estate, like other cash flow producing assets, it to determine the value based on the present

value of the expected cash flows. The financial analysis is a tool used to estimate the expected cash flows on the

real estate investment for the life of the investment as well as to measure the risk of the real estate investment.


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Risk

The risk of the investment extends to diversifiable and non-diversifiable risk (sometimes referred to as systematic

and unsystematic risk).

Diversifiable risk (also known as unsystematic risk) represents the portion of an assets risk that is associated with

random causes that can be eliminated through diversification. It is attributable to firm-specific events, such as

strikes, lawsuit, regulatory actions, and loss of a key account. Unsystematic risk is due to factors specific to an

industry or a company like labor unions, product category, research and development, pricing, and marketing

strategy. Factors such as estimation errors, legal and tax changes, and volatility in specific real estate markets fall

into this category.

While the non-diversifiable risk (also known as systematic risk) is the relevant portion of an assets risk

attributable to market factors that affect all firms such as war, inflation, international incidents, and political

events. It cannot be eliminated through diversification and the combination of a securitys non-diversifiable risk

and diversifiable risk is called total risk.

Discounted Cash Flow

The Discounted Cash Flow analysis (DCF) is a valuation method used to estimate the investment opportunity

using future free cash flow projections and discounts the future income to derive the present value. If the value

arrived through the DCF analysis is higher than the current cost of the investment, the opportunity may be

worth pursuing. DCF can be summarized by:

1.

Forecasting the expected future cash flows

2.

Assessing the required total return (Appreciation return + income return = Total Return)

3.

Discounting the cash flows to present values at the required rate of return.

The result returns the present value. This amount should equal the maximum amount that could be paid so the

expected return will equal the required return.

Discounted cash flow analysis is used to make investment forecasts in the real estate market by estimating the

quantity, variability, timing, and duration of cash flows. The data is generated by pro forma or from financial

statements. Discounted cash flow analysis is used to solve for present value given the rate of return or for therate of return given the purchase price. DCF accounts for all cash flowing into and out of the real property

interest over time, so the time value of money is recognized.

The data required to perform the DCF analysis includes:

Estimates of property income


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the present time using a discount rate. The discount rate can be defined as the required rate of return by the

investor.

Each real estate project is unique due to its location, the timing, the capital requirements, and type of project.

Most projects include several worksheets that provide information and detail about the project. What is similar

between projects is the multi-period discounted cash flows. This process is an application of the capital asset

pricing model (CAPM) to real estate. The cash flow analysis assigns revenues and expenses to periods of time

(annual, semi-annual, quarterly, or monthly). The purpose of the analysis is to compute returns for the project,

evaluate the loan requirements, and returns to the venture participants.

The benefit of this type of analysis is that if there is relative certainty of the future cash flows and the true cost of

capital is correct, the value of the asset and a fair market price established for the asset. The challenge is the

prediction of future cash flows (income and expenses) for extended periods and the sensitivities of pricing

relative to the prediction of the cash flows.

There are numerous programs available to prepare the financial analysis however many analyses are prepared

using Microsoft Excel based template since it is widely available, inexpensive, and easy to learn. The analysis

can be static or dynamic, simple or complex. The type of analysis is dependent on the type of project, the

requirement to attract capital, and complexity (multiple buildings, phased construction, or mixed-uses) of the

project. To create a dynamic pro forma, cells and sheets are linked through named and cell references allowing

the user or users to quickly change assumptions without manually adjusting information. Further the use of =IF

formula will allow the analyst to make changes to input assumptions without adjusting each individual

worksheet.

Regardless of the perspective of the user (lender, rating agency, securities analyst, and other capital market

investors) the forecasting and discounting of cash flows must begin with market evidence for the baseline

assumptions. Discounted cash flow analysis is extremely sensitive to the precision of these inputs. A small

change in any of the input variables such as income, cost, yield, interest rate, or time, can disproportionately

affect the value or profit. Therefore, thorough market research, a careful analysis of cost, and the assumptions

and projection of future cash flows will enhance the investment analysis.


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The financial analysis is an iterative process that is refined during the feasibility, pre-construction and

development process. The analysis uses the information that is collected, vetted, and refined throughout the

process.

The analysis evolves over the stages of the process beginning with a simple capitalization of net operating

income (back of envelope analysis), to a more complex monthly cash flow where the level of analysis

correspond to major hurdles in the course of financing the project. Real estate investment requires specific

information about specific conditions of the real estate. This information takes time to research, assemble, and

can be costly to obtain.

Stage 1 Initial Analysis. During the idea inception phase, the initial feasibility analysis is based on simple proforma income and cost estimates. The analysis estimates value through direct capitalization using approximate

values for rents and expenses for the stabilized development. Inputs for this back of envelope analysis include

determining the type and size of the units (apartments, office space, retail spaces, or other units), vacancies, and

operating expenses. Historical data and analysis of local conditions provide the basis for the estimates. The

results of the analysis should point to go, no-go decision points based on investor criteria.

Stage 2 Refinement of Assumptions & DCF Analysis. Assuming the initial analysis points to a feasible project,

the input information regarding revenues and expenses is refined. This stage of analysis justifies the value of theinvestment as an operating real estate venture and is typically used for attracting debt and equity. The analysis

is typically made numerous times as detailed and accurate information regarding development costs and

anticipated revenues become available.

The analysis during this stage defines returns based on yield capitalization. The net present value and internal

rates of return are calculated for the annual unleveraged returns for the project on the total project costs. The


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returns represent the relationship between the present value of the cash flow and the capital invested. The

unleveraged return focuses on the returns as single, undivided investment where all of the capital requirements

and all of the returns are to a single entity.

During the later parts of this stage, prior to commitments on earnest deposits or land purchase, the cash flows

are converted to monthly amounts during the development and operating period. The monthly cash flow

model shows when equity and debt funds will be needed and how long they will accrue interest before theprojects cash flow can support the debt service payments.

Stage 3 Final Refinement and Cash Flow Distributions.The final stage of the analysis is to further refine the

input assumptions based on contract pricing, and divide the cash flows into the investor and developers shares.

This is the joint venture/syndication analysis. This analysis is used to structure the deal between the developer

and the equity investor. The analysis typically focuses on the before tax cash flows.

What are the components of the Financial Analysis

The specific components of the financial analysis will vary based on the asset type however the basis of any

analysis includes income estimates, vacancy (in the case of operating assets) or the velocity of sales (as the case in

land development, expense and capital improvements, development schedule or investment holding period and

yield analysis.

Most financial analyses include information regarding the project revenues, expenses, and the timing of cash

flows. Since each real estate asset is as unique each analysis will be unique in the information that each analysis

will include. The process requires number crunching and accounting of all potential costs and revenues over a

holding period. Projecting revenues, expenses, and other costs related to the development or operation of the

real estate is not an easy task. The reliability of the results is dependent on the basis for revenues, costs, and

expenses as well as projections for changes in demand, supply, and other forecasts for inflation.

How should the Financial Analysis be organized

Whether the financial analysis is prepared for an operating asset, a new development, or land development, the

analysis should have a clear sense of organization and support the story of the project. Some analyses may

require more information than others but generally each analysis should include:

Cover Sheet. The cover sheet should provide the reader with information about the project including:

o Name of the project and the address of the project

o Name of Developer

o

Who prepared the analysis

o When the analysis was prepared

o Table of Contents to use for navigation

o General Project Information


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o An illustration of the project

Assumptions & Facts. Many analysts use a single page to place all of their key assumptions and known

facts. Depending on the quantity of information, this may require more than a single page. For

example, soft costs and construction costs will generally have their own individual sheet but the

summary information can be shown on this page.

o

Property Information such as areas, location,

o Key Dates

o

Sales (Revenue & Absorption) Information (Can be provided on a separate page if necessary)o Other information such as holding period costs, financing assumptions, or equity distributions

Summary of ProjectReturns

o Summary of Sources and Uses

o Investment summary

o Project Returns

Project DevelopmentScheduleidentifying the major tasks

Loan Summaryillustrating the loan allocation and release amounts if applicable

Cash Flow Analysissummarizing annual costs based on monthly draws.

Added detail may be necessary to substantiate the expenses. The detail may include:

Residual Land Value calculations for each land use

Construction Budget including hard costs and soft costs

Loan Summary illustrating the loan allocation and release amounts if applicable

How do Financial Analyses change based on the asset type?

Financial analysis of real estate development and investment is a quantification of future expectations. The

analysis relies on the developer having an understanding of the future including the marketability of the project,

operational expenses, and capital costs for the development. For operated assets, projection of revenues and

costs can be found by analyzing the historical income statement describing the revenues, expenses, profits, andlosses.

Unlike operated assets that have monthly cash flow from rental income, revenues from new development

projects and land development projects are derived from rents or from the sale of the property. Further, future

expenses will be predicted from plans and reports and are at best estimates (depending on the completion of

the plans, bids, and contracts for construction).

Therefore, the type of analysis will vary based on the asset type, particularly with respect to income and

expenses. For commercial buildings, the cash flow is determined by rental or lease income and affected by

changes in rents and vacancies, expenses for operations, taxes, tenant improvements, and mortgage payments.

The reversion price becomes a critical factor and subject to sensitivity in calculating the property value. For land

development projects, the cash flow is determined by the sale of properties. This is non-recurring income.


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The input assumptions and variables may change based on the specific project however as with other financial

analysis, the focus is on revenue, expenses, and the schedule of cash flows. The result of any financial model is

dependent on the inputs provided. Costs, revenues, operating expenses, reserves for replacements, repairs, and

interest, turnover costs, the reversion price, and the timing of the cash flows (schedule) take careful

consideration.

Land Development Case Study

To illustrate the format of the financial analysis consider a 90 acre parcel of land that has the potential for a

mixed use land development with office, hotel, and retail uses. The property is well located near the

intersection of two freeways, existing housing, and other industry. The benefit of the property is the city has

designated the property for office/employment uses that are not restricted similar to properties south that

require a minimum of forty acres. The owner is asking a price of $6.50 per square foot. Based on the current

market conditions and forward commitments by third-party developers, a 36 month development (very

aggressive) and hold period is estimated.

Back of Envelope Analysis for Land Development

The initial analysis for land development estimates the revenues and expenses to calculate the profit margin.

Based on debt and equity investment criteria, interest reserves and the return on equity can be calculated to

assess feasibility. The back of envelopment analysis begins with the initial sketch showing the possible land

division and the infrastructure required to serve the divided properties. This initial sketch serves as the basis for

the revenues and expenses.


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This case study assumes forward

commitments for the property based on

market pricing. The expense estimates are

based on information from consultants,

contractors, and historical information

from prior projects. Note that with the

exception of the revenues, expenses are

rounded to the nearest $1,000.


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Gross Lot Sales Acres Price per SF Gross Sales

Lot 1 23.76 $13.50 $13,972,527

Lot 2 8.00 $15.00 $5,228,460

Lot 3 4.01 $12.83 $2,243,351

Lot 4 9.40 $12.83 $5,254,488

Lot 5 6.07 $12.83 $3,394,125

Lot 6 6.04 $12.83 $3,376,946

Lot 7 6.14 $12.83 $3,428,920Lot 8 6.17 $12.83 $3,447,459

Lot 9 20.41 $14.50 $12,894,328

90.01 53,240,605

REVENUES

Gross Lot Sales $53,240,605

Less Commissions $3,726,842 Assumes 7% Cost of Sales

Net Lot Sales 49,513,763

CQUISITION & DEVELOPMENT BUDGET /Acre /SF

Land Acquisition Price $25,500,000 $283,294 $6.50

Incentive Sales Fee Advance $250,000

Closing & Formation Costs @ 1% $270,000

SUBTOTAL 26,020,000 289,071 6.64

OFT COSTS % of Total % of HC

Due Diligence, Loan Commitment $45,000 3.14%

Design - Master Plan $125,000 8.71%

Engineering - Master Plan $80,000 5.57%

Other Consultant Fees $75,000 5.23%

Miscellaneous Expenses $50,000 3.48%

Legal Expenses $150,000 10.45%

Outside Accounting Fees $45,000 3.14%

Liability Insurance $60,000 4.18%

Environmental Insurance $150,000 10.45%

Travel & Marketing $75,000 5.23%

Project Management $180,000 12.54%

Development Fees $300,000 20.91%

Contingency @ 7.5% $100,000 6.97%

UBTOTAL 1,435,000 29.7%

ONSTRUCTION HARD COSTS % of Total CostWest Road $900,000

North Road $1,200,000

Center Street $2,500,000

Contingency @ 5% $230,000

UBTOTAL 4,830,000 14.96%

re-Financing Total Project Costs 32,285,000


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re-Financing Profit 17,228,763

Profit on Cost 53%

Loan to Value @ 65% 20,985,250

Interest Reserve @ 6% $1,259,115

Equity Investment 12,558,865Estimated Profit 4,669,898

Cash on Cash multiple 1.37

The results of the analysis illustrate the profit of approximately $4,670,000 on an initial investment of

$12,102,000. The cash multiple is approximately $0.37 for every dollar invested. Depending on the capital

partner, the risk of development would need to be further assessed.

Land Development Discounted Cash Flow

As the design is refined, the revenues and expenses are also refined. The discounted cash flow analysis beginswith preparing a project schedule to establish the timing of the cash flows. While this project establishes a thirty

six month development and hold period, based on the forward commitments and a careful consideration of the

jurisdictional processes, the revenues and expenses are continuously refined to reflect contracts, bids, and

address unforeseen conditions.

As the project cash flows are refined and programmed over time, the result of the analysis indicates the

unlevered cash on cash return is 1.46 and the levered return is 1.86. The project returns equal 33.24% on an

unlevered basis and 46.51% on a levered basis. Based on the results of the analysis, the project seemingly meets

the requirements of the investor returns. Once the analysis is prepared and the results returned, sensitivity to

input assumptions can be made to test probabilities that may increase or decrease returns. For example, what if

one of the purchase contracts is not completed or the time to complete the entitlements or construction of

improvements takes longer than expected.


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ash flow is calculated on a monthly basis but is illustrated annually.


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Cash Flow Distribution


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New Development Analysis

Office

The office development case study analyzes a project where the land was purchased well in advance of

development. Due to a downturn in the economy, the development was delayed from the initial timeframe for

development until a recovery took place. The land was originally purchased at $14.00 per square foot. THe

current value of the property was fifty (50%) percent of the original purchase price.

The initial analysis solves for land value based on a contribution of land value and the expected cost of the

improvements. Concept plans were prepared and cost estimates were provided by a local contractor.

Preliminary Analysis

The preliminary analysis solves for land value using a direct capitalization of income and subtracting the cost

from the exit value. The land was contributed at a value of $7.00 per square foot with an exit value

SITE AREA Acres Square Feet

Gross Area 20.41 889,264

Net Area 20.41 889,264

BUILDING AREA CALCULATIONS

Allowable FAR 0.31

Allowable Gross SF 280,000.00 Square Feet

Building Efficiency % 0.88 Estimate

Total Leasable 246,400.00 Square Feet

HARD & SOFT COSTS

Shell costs 55.00 Estimate - steel frame

Site Development 12.00 Estimate - surface parking

Tenant Improvements 40.00 Estimate Allowance

Total Hard Costs 107.00 per square foot

Total Soft Costs 32.10 Estimate at 30% of Hard Cost

Total Cost/SF 139.10 per square foot

Total Hard & Soft Cost 38,948,000.00

VALUATION ESTIMATE

Land Cost per SF 7.00 per square foot

Estimated Land Cost 6,224,848.00

Total Project Cost 45,172,848.00 161.33

NOI 3,839,692.08 Project Cost capped at 8.5%

NOI/Gross SF 13.71 per square footExit Valuation at 7% Cap (NOI /

Exit Cap) 54,852,744.00 195.90Profit (Difference between Value &

Cost) 9,679,896.00

Exit Value per SF land cost 10.89 per square foot land

Exit Value per SF plus land 17.89 per square foot land


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New Development Discounted Cash Flow Analysis

Similar to the land development analysis, the discounted cash flow analysis begins with preparing a project

schedule to establish the timing of the cash flows, refinement of the assumptions, and detail required to develop

the project. Initial analysis may use estimates but the final analysis requires bids, contract pricing, and other

detailed information to provide reliable results.

The Assumptions Page

Some analysts will try and create one page listing all of the inputs. This may work well for simple projects

however most projects are generally complex. As with any analysis, the greater the detail, the more reliable the

results. The Assumptions Page should provide information regarding the site, such as location, size of the

property, required dedications of roads, tracts, or open space, identification of how the parcel will be

subdivided, and other information such as holding period costs and the types of land uses.

The development analysis begins with the development schedule. The development schedule provides an

outline of the major tasks and milestones for the project. Categories include Business Planning & Due Diligence,Pre-construction activities such as zoning and other entitlements required before the project can be constructed,

Construction of the infrastructure, and unit sales. If the schedule is prepared in Excel, the information can be

integrated with the cash flow.

Assumptions,

Facts, &

General

Information

General

information

such as the

size, location,

use, and

analysis date

should be

included on

one sheet.


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This sheet should identify each project assumption and clearly organized. Items that may be subject to

sensitivity should be prepared using DATA VALIDATION allowing for changes to information quickly and

efficiently. Specific information should be provided a NAMED REFERENCE for use in formula.

The information should be organized showing General Information regarding the project such as site area,

building area, FAR, parking requirements, Source & Usesshowing equity contributions and loans, Financing

Terms, Leasing information, Operating Costs, and Performance Measures.

Sources & Uses

A Source describes the capital received or is needed in connection with the project. The sources of capital can

be income, equity, or debt. Uses describe the expenses made in connection with the project. The expenses can

include hard costs, soft costs, operational costs, and holding period costs.

Sources

The sources of capital include equity, debt, and income. Each source should be clearly identified along with a

schedule showing contributions, interest accrual or payment, the return of capital, and the return on capital. As

an example, if the project costs total $1,000,000 and the lender has agreed to a 60% loan to value (LTV), the

equity required would be $1,000,000 x 40% = $400,000 and the debt source is $1,000,000 x 60% =

$600,000. A schedule should be prepared showing the distribution of the money as well as the return of the

money including interest.

Income is also a source. If the project is a land development project where lots, homes, or buildings are sold,

the sales schedule will reflect the individual sales projections. If a commercial building, the rents (minus the

operating costs) are reflected.

Uses

Uses include all of the expenses made in connection with the project. The expenses can include development

expenses, management fees, operating costs, holding period costs, and financing costs. Schedules should be

included articulating the individual uses.


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Summary of Income & Expense

This sheet provides a snapshot summary of the income for the building and the operating budget before sale.

The cash flow analysis for this project was extended for 20 years covering the first lease through the last lease.

This project is intended to be sold upon stabilization of occupancy. The schedule identifies the tenant (rent roll)

area of the tenant space, first year rental rate, and the annual escalation (inflation) of the rental payments.


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Rent Assumptions

This sheet schedules the income and operating expenses for the building calculating the Net Operating Income

(NOI). The lease for this building is a triple net lease (NNN). Triple net leases require the tenant to pay their

pro-rata share of the operating expenses. Upon full occupancy, the building owner does not pay any of the

operating expenses.


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Project Schedule

The project schedule was prepared using Excel to be interactive and dynamic with the cash flow model. As

dates are changed in the schedule, cash flow is recalculated based on the change. An independent schedule was

prepared for each Project Phase. The schedule identifies the major tasks and sub-tasks along with the start date,

number of months required for the work, and the end date. The schedule is used to help time cash flows for

each major task.


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Development Costs

The development costs identify those costs required for the development of the project including construction

costs (hard costs), indirect costs (soft costs), developer fees, and financing costs (interest during construction).

The costs are organized by description, phase of the work and summarized.


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Hard Costs

Hard costs represent the costs associated with the construction of project, including material, labor, and

equipment. The general contractor will prepare an itemized budget based on the contract documents (or

whatever design level is available). The materials, labor, and equipment required to construct the project is

referred to as Direct Costs. The Direct Costs include specific construction disciplines such as site work, landscape,

concrete, masonry, and structural steel. The costs are summarized into a summary page identifying the square

footage cost and total cost by description.


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Soft Costs

Soft costs are another form of indirect costs. The Soft Cost budget should include the costs for engineering,

architecture, other design consultants, The Soft Cost budget or indirect cost budget should also include the costs

for entitlement, jurisdictional review and permit fees, construction administration, utility permit fees, legal fees,

material testing, special inspections, and security costs (during construction).

Rather than estimating the soft costs for the project as a percentage of hard costs, individual soft costs were

researched and described.

For this example, the costs were categorized by preconstruction, city review and permit, and construction

related items. For this project, the soft cost budget (not including financing costs) was approximately 9% of the

cost of construction or $8.17 per gross square foot (building area).


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Operational & Holding Period Costs

Operating Costs

Operating expenses (OpEx) include expenses common to the operation of the real estate. The list of expenses

may vary based on property type and region however the expenses generally include the following:

o Administration

o Cleaning

o

Insurance

o Landscaping

o Maintenance and Repairs

o Management Fee

o Marketing

o

Property Taxes

o Salaries

o Security

o Snow removal

o

Supplies

o Trash removal

o Utilities

The costs should be determined and analyzed carefully including those specific to the project. The timing of the

expenses should also be determined (for example Property Taxes are paid twice annually).

Holding Period Costs

There may be projects where there is a period of time between acquisition, development and/or operation.

The costs associated with holding the property should be properly accounted. The expenses may include

Developer Management Fees, Property Taxes, Insurance, Accounting Fees, Interest Expense, Legal Fees,

Association Management Fees, Assessments, and other costs required to maintain the property during the

Holding Period.

Financing Costs

Financing costs (interest payments or accrual) should be scheduled based on the distribution of the debt.


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Capitalized Interest

This worksheet provides the month by month accounting of equity or debt. When equity is contributed, the

amount accrues interest at the prescribed preferred rate. In this example, the amount of preferred return is 10%

When the maximum amount of equity is contributed, debt is contributed and interest calculated on the

outstanding balance. This schedule is prepared on a monthly basis through the completion of the project

including the loan payoff.


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Operating Pro Forma

As a development project, an Operating Pro Forma was prepared to illustrate to a potential investor, the before

tax cash flow for a stabilized building. For a project that is purchased for investment, this may be one of the

few schedules that is prepared. The operating pro forma was prepared showing a ten year operating plan with

a sale in the final year based on capitalizing the NOI.

Performance measures (shown in green) are provided on the report for easy evaluation.


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Debt Service Schedule

As a support to the Operating Pro Forma, a Debt Service Schedule showing the amortization of the loan was

prepared. This schedule identifies the total project value at purchase, equity requirement, and loan amount.


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Existing Operated Asset Analysis

Evaluating and analyzing operated assets (existing buildings) and the returns is based on the principle of

maintaining or increasing the cash flow. Since the formula for total return involves income returns and

appreciation returns, the analysis of cash flow from operations and the eventual sale of the property require

careful consideration ( =+). Most investment purchases ofoperated assets capitalize the current cash flow from operations (

=

/

)and approximate the

future sale of the asset at a point in the future at a lower cap rate considering improvements to the project and

improvements to the cash flow (cap rate compression). The challenge for the investor is to estimate the cash

flows. Too often, investors assume rent and income growth follow inflation. Usually, rents and income within

a given building do not keep pace with inflation over the long term due to the term of the leases. Secondly,

capital improvements can erode cash flow from operations if not projected and estimated appropriately.

Capital improvements for new building equipment or tenant improvements will have an adverse effect on the

cash flows from operations. Many investors over-estimate the terminal cap rate projection including lower rates

than the going-inn cap rate. Unless the project is unique in its location and market, older properties have morerisk and less growth potential thus the going-out rate should be at least as high as the going-in cap rate. Lastly,

since the process involves calculating the present value of the investment

Reconstructing the Operating Statements

Real estate income statements or operating statements report cash receipts and disbursements whereas

traditional income statements show revenues and expenses when earned or incurred. Analyzing the income

statement is the starting point for forecasting income and expenses by looking into the operating history of the

property.

The typical operating statement will provide sufficient detail that is verifiable. The statement should include

information from not less than the current year. Rental income and revenues should be compared with the

current leases. A rent roll, a listing of the building tenants and other information regarding the lease, should be

evaluated and verified. The rent roll should include the tenant, the area of the lease, the type of lease (gross

lease or net lease), term including start and expiration, and the rental income including any abatements and

other information such as renewal options. The operating statement should be analyzed with the gross

potential rent, total base rent amounts subtracting vacancy and rent abatements, and adding back expense

reimbursements and other revenues.


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Operating (Income) Statement Example

Revenues

Scheduled Base Rent

Gross Potential Rent

Absorption & Turnover Vacancy

Base Rent Abatements

Total Scheduled Base Rent

Expense Reimbursements

Parking Revenues

Other Rents

Total Gross Revenue

General Vacancy Loss

Effective Gross Revenue

perating Expenses

Cleaning

Repair & Maintenance

Utilities

Roads & Grounds

Security

General Administrative

Management Fees

Real Estate Taxes

Insurance

Non-recoverable cleaning

Total Operating Expenses

et Operating Income

Capital Costs

Tenant Improvements

Leasing Commissions

Capital Reserves

Other Costs

Total Capital Costs

perating Cash Flow


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Forecasting Income & Expenses

Market supported forecasting is the basis of valuation of income properties. Therefore, diligent and careful

analysis and verification is required. As a guide, the following categories should be determined during the

analysis:

Current rental rates and expected changes in the rents

Analysis of the existing base rents, contractual rent adjustments, and renewal options

Escalation provisions and expense recovery

Turnover of tenants

Re-leasing assumptions

Operating expenses

Capital improvements

Debt service costs and adjustments including refinancing

Net Reversion (sale of the property)

After-tax adjustments (including effects of depreciation)

Appropriate discount rate used to determine present value.

The challenge for the investor is to accumulate the market data and exercise appropriate judgment to determine

changes that will affect the valuation of the project. Forecasting is used to determine the future income and

expenses based on historical trends with some judgment applied. An industry of economists and analysts

forecast and create projections based on economic and real estate indicators. Since there is reliance on

judgment, it is important to assess the quality of the information and assumptions used in the forecasts and

projections.

Revenue Projections

The revenues projections should be assessed from the current lease agreements showing escalations or changes

to the lease rate. Forecasting changes based on the market are important to determine in the event a tenant

vacates the space or is looking to renegotiate. Market lease assumptions (MLA) are used to control what

happens to a contract lease after it expires and goes to market. Inputs into the market lease assumption include:

Probability of Renewal. This is the percentage that the expiring tenant will renew the lease

Market Rent at Renewal

Number of months the space is vacant (to determine lost revenue)

Tenant Improvements

Rent Abatements


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The MLA should also address what happens to a rented space upon expiration of the lease term. The options

typically include:

Changes in rent amount

Renewal under the current lease terms

Vacating the space

Building the Analysis

Whether the analysis is prepared using and Excel-based template or a commercial software program, the

information should be verifiable and reliable. Similar to a real estate development project, the analysis can be

divided into an initial analysis and more detailed analysis. The initial analysis may include reviewing the

operating statement and projecting the cash flow over a specific hold period. The net reversion may be

estimated based on general market data and the cap rate you may use when purchasing the property. The

levered and unlevered net present value and rate of return can be easily calculated providing a decision point

whether to proceed or pass on the investment.

Detailed Research & Financial Analysis

If the decision is to proceed with the investment, the analysis requires refinement and detail. Learning, using,

and becoming more comfortable with Excel or Argus will allow the real estate investor more tools to use in

sorting through and using available data. Becoming proficient using Excel allow the user to turn data into

answers and structure the presentation in a clear and understandable format. Sensitivity analyses can be

developed to account for probability of occurrences, changes in the market, and other variables that allow the

user to address the risk of investment. While beyond the scope of this writing, learning how to write and

combine formulas such as SUMIF, SUMPRODUCT, VLOOKUP, INDEX+MATCH, CHOOSE, and TABLE

functions.

If preparing an Excel based template, a workbook is prepared summarizing the detailed research. Typical of an

analysis, the following sheets would be prepared.

Assumptions Sheet

This sheet will provide information regarding the building and analysis period. The assumptions/data will

include:

General information including project name, location, address, analysis period and investment holding

period, area of the building (net leasable square feet

Income Assumptions including market rents and annual growth percentages, other income such as

parking revenues and antenna revenues, annual escalation, credit loss, and general vacancy loss

percentage


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Vacant Space Lease-up including total vacant space, absorption period, lease terms, tenant

improvements, leasing fees, initial market rent per square foot, annual rent adjustment, and rent

abatements

Second Generation Space assumptions including initial market rents per square foot, annual rent

adjustments, recoveries, retention percentage, lease term, rent abatements, tenant improvements, leasing

commissions, and months spaces are not leased (Market Lease Assumptions can be prepared for the

building as a whole or multiple MLAs used for leased areas. For example, for spaces less 5,000 square

feet, for spaces between 5,000 and 15,000 square feet, and spaces greater than 15,000 square feet).

Operating Expense including initial year expenses per square foot, management fees, property taxes,

capital reserves per square foot and the capital reserve annual escalator

Rent Roll & Stacking Plan (if the project is a multi-tenant office building and occupied)

The rent roll is a chart identifying the building tenants. The rent roll may also identify the market lease

assumptions for the tenant.

The stacking plan is a representation of the tenant spaces in the building graphically illustrating the spaces

occupied.


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Operating Expense Summary

The operating expense summary provides the detail of building operating costs. The summary is commonly used

to calculate the expense reimbursement. The expenses will vary by product type however the general categories

of operating expenses is similar and include

personnel, cleaning, supplies, repairs &

maintenance, contract services (landscape,

window cleaning, parking lot sweeping),

utilities, administrative, management fees,

property taxes, and insurance. Operating

expenses can be considered fixed, that is they

do not change with occupancy, or variable,

meaning they do change with occupancy.

Fixed expenses include insurance and property

taxes whereas management fees, utilities, andsome maintenance may vary based on occupancy.

Lease Expiration & Market Rent Analysis

The lease expiration combined with market rent analysis provides a tool for forecasting and projecting the

number of tenants leaving the building and market rent assumptions.

Operating Expenses Cost/SF

FY 1

Actual

FY 2

Budget

Cleaning 0.98 $47,732 $47,732

Repair & Maintenance 1.03 $50,167 $51,171Utilities 0.93 $45,297 $46,203

Roads & Grounds 0.71 $34,581 $35,273

Security 0.51 $24,840 $25,337

General Administrative 0.26 $12,664 $12,917

Personnel 1.12 $54,551 $60,006

Supplies 0.16 $7,793 $7,403

Management Fees 0.33 $16,073 $16,073

Real Estate Taxes 3.84 $187,031 $194,512

Insurance 0.17 $8,280 $8,446

Total Operating Expenses 10.04 $489,008 $505,071


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Income In-place & Projected NOI Summary

The income in-place summary provides an illustration of the income, expenses, and operating cash flow of the

project. The summary can show per square foot, annualized, and monthly amounts. Consider our example

with added information.

The base rents are calculated using the weighted

average of the leases. Rent Abatements arecredits provided to tenants for signing or

renewing leases. Lag vacancy is the period of time

between consecutive leases. The lag vacancy (or

gross-up) will vary based on market conditions

and other factors such as location, type of

building, age of the building, and functional

efficiency of the building.

Income In Place

Building Area (NLA)

48,706

SF

Income Per SF Annualized Monthly

Base Rent $25.63 $1,248,334.78 $104,027.90

Less Rent Abatements ($0.54) ($26,301.24) ($2,191.77)

Less Lag Vacancy ($5.62) ($273,727.72) ($22,810.64

Total Minimum Rents $19.47 $948,305.82 $79,025.49

Recoveries $0.72 $35,068.32 $2,922.36

Total Parking Income $1.82 $15,000.00 $1,250.00

Parking Expenses ($0.03) ($1,461.18) ($121.77)

Antenna Income $0.23 $11,202.38 $933.53

Storage & Other

Income $0.10 $4,870.60 $405.88

Gross Rental Income $22.31 $1,012,985.94 $84,415.50

Credit Loss ($0.18) ($8,767.08) ($730.59)

Vacancy Loss $0.00 $1,004,218.86 $83,684.91

Total Net Effective

Income $22.13 $2,008,437.72 $167,369.81

Expenses

Operating Expenses $5.70 $277,624.20 $23,135.35

Management Fees $0.33 $16,072.98 $1,339.42

Property Taxes $3.84 $187,031.04 $15,585.92

Insurance $0.17 $8,280.02 $690.00

Total Expenses $10.04 $489,008.24 $40,750.69

Net Operating Income $12.09 $1,519,429.48 $126,619.12

Capital Costs

Tenant Improvements $0.00 $0.00 $0.00

Leasing Commissions $0.00 $0.00 $0.00

Capital Reserves $0.20 $9,741.20 $811.77

Total Capital Costs $0.20 $9,741.20 $811.77

Operating Cash Flow $11.89 $1,509,688.28 $125,807.36


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Replacement Cost Analysis

The replacement cost analysis is

prepared as a comparison of

value. The replacement cost for

direct, indirect costs, and soft

costs are calculated based on

current market pricing. The land

cost can be estimated using the

residual land value analysis

and/or the land value can be

established by comparable

analysis.

For the example above, the

building has a net leasable area

of 48,706 square feet. The

building has an efficiency of

approximately 90% so the gross

square foot of the building is

54,064 (48,706 x 1.10). Your

contractor has looked at the

building and estimated the shell

cost including site improvements

and contingency at $100 per

square foot. Tenant

improvements are estimated at

$40 per square foot. The soft

costs are estimated at 25% of the construction costs.

The weighted average rent is calculated with an estimate for expenses (assumed as a full gross lease with a $7.00

per square foot expense). Therefore, the Net Operating Income is approximately $816,654. Using a cap rate of

8% for this class of office, the total replacement cost is approximately $10,208,000 including land.

Residual Land Value Analysis

Property Information Acres Notes

Gross Area 4.11 179,031.60

Net Area 4.11 179,031.60

Building Information Values NotesAllowable FAR 0.30

Allowable SF 54,064 SF

Bldg Efficiency % 0.90

Total Leasable 48,706 SF

Construction Cost Information Cost Notes

Shell costs $95.00 Estimate per square foot

Site Development $5.00 Estimate per square foot

Tenant Improvements $40.00 Estimate per square foot

Total Hard Costs $140.00

Total Soft Costs $35.00 Estimate at 25% of Hard Cost

Total Cost/SF $175.00Total Hard & Soft Cost $9,461,200.00

Income Information/Estimates Values Notes

Stabilized Occupancy 0.90 Estimate

Gross Rent Stabilized $25.63 From average rent

Rental Concessions $0.00

Effective Gross Rent $25.63

Expense Stop $7.00

Net Effective Rent $18.63

Net Effective Adjusted $16.77

Net Operating Income $816,653.50

Value Estimate Values Notes

Rate of Return 8.00% Cap rate

TOTAL REPLACEMENT COST $10,208,168.78 V=NOI/r (Land+HC+SC)

Residual Land Value $746,968.78

Residual Land Value /SF Net Site Area $4.17

Residual Land Value /SF Leasable Area $26.69


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Cash Flow Projections

Once the cash flows are verified and projected or forecasted for future years, the value of the income property

by discounting the cash flows. The cash flows prior to debt payments are calculated for the proposed holding

period of the investment. Revenues and expenses are summarized into a table identifying the gross rental

income, total income when accounting for credit and vacancy loss, expenses, net operating income, and total

operating cash flow.

The example shown on the following page provides an example of the cash flows, before and after debt

payments, and before and after tax to the investor.


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Valuing the Real Estate Asset

Whether preparing the materials for analysis or analyzing the information provided, a purchase or sales price for

the asset needs to be established and agreed between buyer and seller. As reviewed, the value of real estate

assets should be the present value of the expected cash flows. The challenge for the investor is to determine the

uncertainty associated with the cash flows and the expected growth in the cash flows. The higher the level and

growth in the cash flows, and the lower the risk associated with the cash flows, the greater the value of the

asset.

Beyond the revenues and expenses, the terminal value is a key input to value the property. The terminal value

can be derived from the terminal cap rate should be close to the going-in cap rate to avoid over estimating the

growth rate or appreciation value of the asset. A second method to establish the terminal value is to increase

the value of the property at the expected inflation rate.

Choosing the discount rate is dependent on the cost of capital to the firm. This is why some companies can

afford to pay more, or less, than others. Once the discount rate is determined and the cash flows are estimated,the value of the asset is estimated by discounting the cash flows by the cost of capital and discounting the cash

flows to equity at the cost of equity. The cost of equity is sometimes referred to as the hurdle rate quoted as the

minimum investment return required by the investors. The true cost of capital can be calculated using the

weighted cost of capital formula, estimating levered and unlevered beta and risk premiums, but most times, this

amount is a stated amount by the investor.

Estimating the Cash Flows to Equity

The estimated cash flows to equity are estimated each year by netting out the debt payments from income. At

the end of the investment holding period, the terminal value of the equity is calculated by subtracting the

remaining principal payment from the terminal value. The present value of the equity can be calculated for

each year of the investment, discounting the present value or using the net present value formula for the entire

period of the investment. The cash flows can be calculated before and after tax.

The reason cash flows are calculated before taxes is they can be more easily compared to other competitive

investments whereas cash flows and returns after taxes provide the real returns to the investors.

Sensitivity Analysis

Financial analysis of real estate development and investment is a quantification of future expectations. The

analysis relies on the developer having an understanding of the future including the marketability and cost of the

development. In few cases does the developer have the control over all of the possible variations of variables

involved during the development or investment period. Most sensitivity analyses focus on best and worst

scenarios but not always the uncertainty and range of outcomes that may occur.


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Among other factors, sensitivity analysis provides the opportunity to assess the risk involved in the layers of

development. There are various methodologies of sensitivity including the use of Monte Carlo analysis. It is

important to recognize and assess the sensitivity of the returns relative to changes in the assumptions. The

assumptions can include the property use, density, expenses, schedule/cash flow, and revenue sources.

Depending on the capital structure, the project could be subject to sensitivity in rising interest rates. In the event

the schedule suffers delays, the effects could erode returns quickly.

Sensitivity analysis consists of studying the effects of changes in variables on the outcomes of a mathematical

model. A model may consist of numerous input variables and one or more output variables. By changing an

input variable, and measuring how the outcomes are affected by that change, the analyst can gauge how

sensitive the model is to the individual input variable.

Sensitivity Analysis in Business Decision-Making

Sensitivity analysis can be used in business decision-making. It is a way of measuring and quantifying uncertainty.

The analyst can create a model based on the relationships between inputs and outputs. Once the model is set

up, the analyst can tweak the inputs to see how the outputs are affected. For example, an analyst might use

sensitivity analysis to measure a projects net present value (NPV) for various expectations of costs, revenues,

capital investment, macroeconomic factors, and other relevant variables. The analyst can also alter the model to

create hypothetical scenarios such as a best case scenario, a worst case scenario, and a most likely scenario.

There are several tools in Microsoft Excel that can be used for sensitivity. For example, Data Validation can be

used to create drop-down menus allowing variables and assumptions to be changed easily. The What-if Analysis

tool allows the user to perform a sensitivity analysis by selecting specific assumptions to test the results andprovide a report of the findings. The Goal Seek function allows the user to solve for a specific amount based on

fixing certain data. These functions are found on the Data Tab. As the user becomes more comfortable with

writing formula and creating data tables, formulas using CHOOSE and VLOOKUP commands.

Problems with Sensitivity Analysis

First, the accuracy of the sensitivity analysis depends on the quality of the assumptions built into the model. If

the model contains erroneous assumptions, the output of the sensitivity analysis will be inaccurate. Second,

sensitivity analysis may not account for interdependencies among input variables. Third, the assumptions built

into the model may be based on historical data which cannot necessarily be relied upon to predict future results.

Also, subjectivity may taint the analysis.


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What are the important metrics and how should project be evaluated?

Most new development projects compute the ex ante return distributions; that is, the expected or anticipated

return of an investment. Ex ante returns are always projections and cannot be known with certainty. The

analysis of the results will vary based on the asset and whether the project is a development project or an

investment in an operated asset. Real estate development financial analysis is extremely sensitive to the

precision of the inputs. A small change in any of the input variables such as income, cost, yield, interest rate, ortime, can disproportionately affect the value or profit.

The analysis of returns may require the separation of development and operation and decisions such as Build

and Hold or Build and Sell. Evaluation of the performance of a project is like art; that is, in the eye of the

beholder. The performance is dependent on whether you are a lender, investor, or developer. Lenders have

specific measures that will identify risk whereas investors will look to maximize yield.

Real estate return measures are very valuable tools for property investors in terms of evaluating the viability and

profitability of potential real estate investment opportunities, and comparing them against their financial

objectives. Besides return, investors are also interested in the risk that is associated with the opportunity

evaluated in order to assess whether the expected return is in line with the risk that is being undertaken.

Once the DCF model is complete, there are numerous metrics that can be calculated for evaluation. Each of the

metrics provides perspective and information for managers and decision makers.

When analyzing and making decisions regarding new development or property investments, there are several

real estate return measures that can be used to help with decision making.

Financial Ratios

Financial Ratios are used to measure financial performance against standards. Analysts compare financial ratios

to:

1. Industry averages (benchmarking),

2.

Industry standards or rules of thumbs and

3.

Internal trends (trends analysis).

The most useful comparison when performing financial ratio analysis is trend analysis. Financial ratios are

derived from the three financial statements;

1.

Balance Sheet,

2.

Income Statement, and

3.

Statement of Cash Flows.


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Categories of Financial Ratios

There are generally five (5) categories of financial ratios:

1.

Liquidity Ratios. Liquidity ratios measure whether there will be enough cash to pay vendors and

creditors of the company.

2.

Activity Ratios. Activity ratios measure how long it will take the company to turn assets into cash.

3.

Debt Ratios. Debt ratios measure the ability of the company to pay their long term debt.4.

Profitability Ratios. The profitability ratios measure the profitability and efficiency in how the company

deploys assets to generate a profit.

5. Market Ratios. The market ratios measure the comparative value of the company in the marketplace.

Liquidity Ratios

Liquidity ratios measure whether there will be enough cash to pay vendors and creditors of the project.

Operating Expense Ratio

Operating Expense Ratio (OER) is a ratio of property performance. OER measures the relationship between the

income of the property (which is primarily derived from rents) and a basic recurring cost element, the operating

expenses.The OER can be calculated on potential gross income (PGI) or effective gross income (EGI). These

ratios are usually below 1. If greater than one, it means that the operating expenses are greater than the income

the property is expected to produce or is producing.

=

Payback Period

The Payback Period measure provides the number of years required to recoup the initial cash investment in a

project or property. Where,

=

The limitations of this calculation is that annual cash flows are rarely constant. Secondly, the metric ignores cash

flows to the investor after the payback period. Lastly, this measure ignores potential appreciation gains.

Breakeven Ratio

The property breakeven ratio is a ratio measuring the risk of negative cash flow of a property investment. This

metricexpresses the operating cash outflows of the property, including debt service, as a percent of the

propertys gross effective income. The formula for calculating the property breakeven ratio is the following:


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= (+) The closer the ratio is to 100% the higher the risk of negative cash flow. If the ratio is greater than 100%, it

indicates that the property is experiencing a negative cash flow. If the ratio is below 100%, the lower the risk

the property cash flow will turn negative.

Debt Ratios

Debt ratios measure the ability of the company to pay their long term debt. Common metrics include:

Loan to Cost Ratio

The amount of money borrowed in relation to the development costs (loan amount divided by the

development costs including hard costs and soft costs).

Loan to Value Ratio

The amount of money borrowed in relation to the market value of the property (loan amount divided by the

property value or sales price).

Debt Coverage Ratio

Debt Coverage Ratio (DCR) or Debt Service Coverage Ratio (DSCR) is the ratio of net operating income (NOI)

and its annual debt service (ADS).

=

If the calculation produces a result of greater than 1.0, the implication is the property net operating income is

higher than the annual payment required to service thedebt payments. If the debt coverage ratio is less than 1, it

indicates that the property produces insufficient income to cover both operating expenses and the mortgage

payment. While lending requirements fluctuate with market cycles, lenders are usually requiring a DCR of at

least 1.2, which means that property net operating income needs to be at least 1.2 times higher than the

mortgage payment.If the property has more than one loan, then the debt service used to calculate this ratio will

be the sum of the annual payments due for all loans.

Debt Constant

This represents the total cost of debt service as a percentage of the loan amount. This is of interest to investors

because it is the total cash cost of debt service to the project. The higher the debt constant is, the greater the

relation of debt to equity


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Profitability Ratios

The profitability ratios measure the profitability and efficiency in how the company deploys assets to generate a

profit. The ratios can be calculated on a periodic or over the holding period. The returns can be calculated

before tax or after tax and as either leveraged (with debt) or unleveraged (without debt).

Holding-Period Returns

Holding-period real estate return measures calculate the return of a property investment over the investment

horizon. Holding-period return calculations contemplate an expected resale (reversion) price of the property at

the end of the investment horizon. Capital gains or losses that are realized upon the termination of the

investment are therefore included in the return calculations. This metric takes into account any potential

fluctuations in the net income of the property.

Periodic Return

Periodic return is the expected return of an investment over a given period internal, which does not necessarily

reflect the planned holding period of the investment. Typical real estate returns measures refer to one-year orone-quarter intervals. Periodic returns are rarely quoted in one-month time periods. The National Council of

Real Estate Investment Fiduciaries (NCREIF), is a good source to research return measures for comparable

commercial properties throughout the United States.

Before-Tax Return

Real estate return measures may differ in terms of whether income and/or corporate taxes are taken into

account. Before-tax real estate return measures are estimated without taking into account any income and/or

corporate taxes that the owner may have to pay in connection with income earned by the property (propertytaxes are generally considered an operational cost rather than a specific tax to the owner). The most common

before-tax measure is the income return, calculated using the propertys net operating income.

After-Tax Return

After-tax real estate return measures calculate investment return using the after-tax and net of debt-service (if

there is a loan involved) cash flows of the property. The after tax cash flows are calculated taking into account

any income taxes (and deductions) in association with income earned by the property, as well as any payments

to service any loansassociated with the property.

Leveraged Return

Leveraged return is the return of a property investment when debt is used to finance the acquisition of the

property or any other capital needs in association with the operation, renovation or modification of the

property. The leveraged return represents the Return On Equity capital contributed by the investor.


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Unleveraged Return

Unleveraged return is the return of a property investment assuming the investor uses its own capital without

debt to finance any capital needs for the acquisition of the property as well as during the holding period of the

investment.

Positive & Negative Leverage

Positive leverage is the term used to describe the case in which the use of borrowing contributes to a higher

return on capital compared to the return that would be obtained without borrowing, while negative leverage

refers to the case that the effect of borrowing reduces the return on capital.

Profitability ratios include:

Total Return

Appreciation Return

Income Return

Gross Profit Margin

Operating Profit Margin Ratio

Net Profit Margin

Return on Equity Ratio (ROE Ratio)

Return on Investment Ratio (ROI Ratio)

While there are no specific measures or ratios in commercial real estate that are called Return on Investment

(ROI), there are many that can be described as Return on Investment (ROI) type ratios. All the ROI ratios are

preparing_the_pro_forma_real estate.pdf

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