REAL ESTATE FINANCIAL ANALYSIS

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NET OPERATING INCOME (NOI)

• Net Operating Income (NOI) is a measure of cash flow after expenses.

• NOI is the starting point for all investment real estate valuations.

• NOI = Gross Operating Income - Total Expenses

CAP RATES

• Cap rates are a measure of current, annual yield and when underwriting a deal, are generally measured off first year Net Operating Income (NOI).

• For those of you who follow the stock market and are familiar with P/E ratios, cap rates are in the inverse of P/E ratios and are basically a E/P ratio.

• For example, a property has $100,000 NOI. If you were going to pay $1,000,000 for the asset, you would have a cap rate of 10%.– NOI / Price = Cap Rate– $100,0000 / $1,000,000 = 10%

CAP RATES

• When price goes up, cap rates go down.• When price goes down, cap rates go up.

Cap Rate = 100,000.00$ 1,000,000.00$ 10.00%

100,000.00$ 1,200,000.00$ 8.33%

100,000.00$ 800,000.00$ 12.50%

CAP RATES

• Generally, cap rates will vary from time to time, depending primarily upon four factors:

1. Current Interest Rates2. Market Efficiency/Conditions3. Property Conditions4. Creditworthiness of the Tenants5. Length of Leases

CAP RATE SPECTRUM (STABLE MKT)

Core (-

7.0%)*• Long term

tenancy • Creditworthy

Tenants• Newer

Construction• Well located

Value Add (7.0% - 8.5%)*

• Less stable tenancy and credit

• Older assets• Less

centralized location

Opportunistic (8.5%+)*

• Unstable or short term tenancy

• More difficult to finance

• Older construction

• Tertiary markets or challenged locations.

* Please note that these ranges are merely for illustration and do not represent bright line distinctions.

INTERNAL RATE OF RETURN

• Internal Rate of Return (“IRR”), along with Equity Multiple, is the baseline for which most institutional real estate investments are made.

• IRR is defined as the return rate which can be earned on the invested capital, i.e. the yield on the investment.

• LTV has a significant impact on IRR.

INTERNAL RATE OF RETURN

• A project is a good investment proposition if its IRR is greater than the rate of interest that could be earned by alternative investments (investing in other projects, buying bonds, even putting the money in a bank account). The IRR should include an appropriate risk premium.

• Mathematically the IRR is defined as any discount rate that results in a net present value of zero of a series of cashflows.

• In general, if the IRR is greater than the project's cost of capital, or hurdle rate, the project will add value for the company.

• IRR is also used to determine which investment has higher returns, if capital is limited. For example, you can earn 3% by investing in government bonds or X% IRR by investing in this real estate transaction.

IRR VERSUS CAP RATE

• Cap rates, again, are the annual, current yield on an investment.

• IRR looks back, post disposition, at what the annual returns are over the life of the investment.

SENIOR FINANCING

• In any real estate acquisition, the terms of the senior financing are going to significantly impact your valuation.

• The financing will dictate your cash flow and IRR.• Factors to consider when examining financing are:

– LTV– Recourse versus non-recourse– Spread over the rate– Amortization and Interest Only Periods– Reserves

• All of the above factors will reduce your cash flow and help dictate the LTV available on that acquisition.

OTHER COMMON VALUATION METHODS

• Cash Flow• Cash on Cash Return• Whole Dollar Profit• Equity Multiple

CASH FLOW

• The cash flow from any asset is a function of the going-in cap rate as well as the LTV.– The higher the cap rate, the more cash flow.– The lower the LTV, the more cash flow.

• Cash flow will be reduced by required debt payments and reserves.

CASH ON CASH RETURN

• The cash-on-cash return is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed as a percentage.

• For example, if you buy the same $1 million dollar asset, with 70% loan to value (“LTV”) (meaning $700,000 of debt and $300,000 of cash) and you have the same $100,000 in net rents, your cash on cash return is 33%

CASH ON CASH RETURN

Cash on Cash Return is generally used simply as a litmus test to see if the deal warrants further investigation and underwriting.

Annual Before Tax Cash FlowTotal Cash Invested

100,000.00$ 300,000.00$ 33.33%

Cash on Cash Return =

WHOLE DOLLAR PROFIT

• While IRR is a mathematical equation, real estate investors also examine the Whole Dollar Profit on any given acquisition opportunity.

• It is possible for deals to have a high IRR but the Whole Dollar Profit is low, or not high enough to justify the risk of investment.

• Whole Dollar Profit is calculated either with or without regard to distributions of current income.

EQUITY MULTIPLE

• Equity Multiple is amount of equity received as compared to that invested upon asset disposition.

• Equity Multiple is frequently evaluated side by side with IRR and is sometimes deemed a more pure result of project profitability. There is an expression “You cannot eat IRR.”

• For example, if you invested $300,000 in an asset, and after disposition had $600,000 in equity, you would have a 2.0x equity multiple.– Obviously, deals with equity multiples under

1.0x do not justify investment.• Equity Multiple, unlike IRR, is decreased when

the equity is returned early.

EQUITY MULTIPLE

Equity Multiple Equals =

(Cash Invested + Distributions + Capital Events)Cash Invested

PeerRealty

PeerRealty.comJordan.Fishfeld@PeerRealty.com

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