Bay Area Wealth Builders

Tue, 15 Jun 2010 05:16:23 GMT

Test Club

Tue, 15 Jun 2010 05:16:23 GMT

Four Investment Analyses

Tue, 04 May 2010 20:04:23 GMT

This is post #1 of this blog. I want to present some useful information to you immediately rather than burden you with information about this blog. Consequently, I will write about the nature of this blog and what to expect, not in this post but in post #2. Yes, you may want to know what we’re going to cover, but first let’s get off to a quick start.

This post covers the basic ideas of real estate investment analysis. Many of the topics we will cover in the future will require understanding of these ideas, and indeed, in future posts I will go into greater detail on each of these analyses.

Who is this for? Novice real estate investors will find this information very enlightening. Experienced real estate professionals will find this post a good review and may pick up some new points of view about the standard process of analysis.

Real estate professionals use four different analyses to evaluate income property. Taken individually these analyses are easy to understand. Often, however, they are printed together on one page making understanding more difficult for those who have not considered the ideas separately. By reviewing these ideas individually, you can better understand what they mean and how they contribute to the overall understanding of a real estate investment.

Now the following will surprise some people but is self-evident after you consider it. These analyses do not summarize past performance. They estimate the future performance of the property and the investment. And you create them according to customary form (i.e., pro forma).

Specifically, these analyses are an estimate of the next year's operation of the property and the next year's investment performance. Of course, you may take into account the past information regarding the operation of the property when you create these pro forma analyses. But pro forma analysis is not about what happened yesterday. It’s about what’s going to happen tomorrow.

The first analysis format is the income and expense statement, which indicates how the property itself will perform.

Income and Expense Statement

First, you adjust rental income for vacancy & credit loss. Add other income, if any, that’s related to the operation of the real estate. Then you subtract operating expenses. The "bottom line" is net operating income.

Because net operating income is discussed so much in real estate analysis, it is abbreviated to "NOI." What follows is a more precise statement of the income and expense analysis using the appropriate real estate terminology:

Potential Rental Income
- Vacancy & Credit Loss
= Effective Rental Income
+ Other Income
= Gross Operating Income
- Operating Expenses
= Net Operating Income (NOI)

Do not include interest and depreciation (cost recovery) in operating expenses. Although they are legitimate expenses for the taxable income analysis, you do not include them in the income and expense statement because they are subjective expenses. For example, not every buyer gets a real estate loan, thus the interest expense depends on the buyer, not the property. Regarding cost recovery, there choices to be made under the Tax Code, and not every owner makes the same choices.

The income and expense statement shows how the property performs, not how an investor's investment performs. The property generates the same NOI regardless of who the owner is (more on this in a later post). This is an objective analysis because it does not take into account the investor.

Do you have the freedom to treat this as something besides an objective evaluation of the property’s performance? Absolutely not! More on that in a later post.

The relationship between the NOI and the value is a ratio known as the capitalization rate (cap rate). The cap rate is the rate of return generated by the property for the next year assuming an all-cash purchase.

Taxable Income Analysis

You cannot use the income and expense statement to estimate the taxable income from the property because interest, cost recovery, and other non-operating expenses are not included in the expenses subtracted from rental income. Thus, you need to do a separate analysis to incorporate these expense items. The bottom line of this analysis is the taxable income generated by the property. But properties don't pay income taxes. People do. Therefore, this analysis can only be done with a specific investor in mind. The format is as follows:

Net Operating Income
- Interest Expense
- Cost Recovery
- Non-Operating Expenses
= Taxable Income

The expenses above require a specific investor who borrows a specific amount of money, who elects a specific cost-recovery schedule, and who pays specific non-operating expenses. This analysis indicates how the investor's investment is operating in regard to the Tax Code. It does not indicate how the property is operating. It is a subjective analysis.

Cash Flow Analysis

Like the taxable income analysis, the starting point for the cash flow analysis is NOI. The objective of this analysis is to show how much money is flowing into (or out of) the investor's pocket.

You subtract he annual debt service (interest plus principal) from NOI. Subtract also any non-operating expenses (outlays) not included in operating expenses. If capital additions or replacements are to be made in the next year, you also subtract them. If reserves are to be funded for capital additions, you subtract the reserves too. Apply any reserves currently or previously placed in a reserve fund to capital additions, if any. The bottom line is the cash flow before taxes. The format follows:

Net Operating Income
- Debt Service
- Non-Operating Outlays
- Capital Additions
- Reserves
+ Reserves To Additions
= Cash Flow Before Tax (CFBT)
- Tax Liability
= Cash Flow After Tax (CFAT)

To determine the tax liability, use the taxable income from the taxable income analysis and apply the investor's marginal tax rate. You subtract the tax liability from the cash flow before tax (CFBT) to the calculate cash flow after tax (CFAT). The cash flow analysis shows the flow of cash into the investor's pocket from the investment, all things considered.

Sometimes, the cash flow may be negative indicating that cash flows out of the investor's pocket. In other words, sometimes the investor may have to invest more money in the property.

This is a subjective analysis. It focuses on the investor, not the property. Nonetheless—and hard to believe—you will find people who promote the sale of a property by providing cash flow figures as part of their marketing package. To do so, they must have a hypothetical investor in mind. If that hypothetical investor is disclosed (e.g., one who borrows 65% of the purchase price), at least you have an idea how the cash flow may have been calculated. If not disclosed, the information is utterly useless.

Sale Proceeds Analysis

The sale proceeds analysis is similar to the cash flow analysis except it shows the cash flow for the sale of the property rather than for a year's operation. The format is as follows:

Sale Price
+ Reserve Fund
- Loan Balances
- Cost of Sale
= Sale Proceeds Before Tax
- Tax Liability on Sale
= Sale Proceeds After Tax

Add any unspent funds in the reserve account to the sale price. Subtract the unpaid balances on the loans. Subtract also the broker's commissions and other anticipated sale and closing costs. The result is the sale proceeds before tax.

Calculating the tax liability on the sale is complicated and is done in a separate format (beyond the scope of this post). Subtract the resulting tax liability from the sale proceeds before tax to compute the sale proceeds after tax.

Again, this analysis is for a specific investor and shows how the investor's investment does as a result of the sale. You use the sale proceeds combined with the annual cash flows (over a number of years) to measure an investor's rate of return from the real estate investment.

Keep in mind again that this is a subjective analysis because you calculate it for a specific investor, not for the property.

Forecast

A forecast is simply the combination of the above analyses into one format, usually on just one page. Once you become accustomed to reading the format, it enables you to develop a good idea at one glance of how the investment will perform. The forecast can be for just one year, but usually it is for a multi-year holding period.

At One Glance?
Yes, at one glance (in second) you can understand a lot about an income property assuming that the analyses are done accurately and in the standard format.

Standard Format

This is the standard format for analyzing income real estate and used almost exclusively in the US as well as being widely used around the world. The format is well over 100 years old and doesn’t change except to adopt to the current tax laws.

There are minor variations to this format usually used for specific properties (e.g., shopping centers). But such minor variations do not make the alternative analyses unrecognizable.

Epilogue

Future posts will explore these analyses individually in greater detail. Real Numbers New Edition, available at the URL below, also covers these analyses in great detail.

Visit my website for a substantially large volume of information relevant to investment real estate:

RealEstateInvestmentCenter.com

In the next post, post #2, look for my introduction to this blog and what kinds of information I will cover in future posts.

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Arlington (1)

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Virginia Chesapeake

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National Average

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Irvine

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Rochester

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North Las vegas

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Garland

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Winston-Salem

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Chesapeake

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Chula Vista