Running the Numbers: Structuring a Commercial Real Estate Investment

As a commercial real estate attorney, I realize that my clients often rely on their financial analysts, forecasts, predictions, and assumptions to determine whether or not to invest in a real estate project. Whether you are a lawyer or a non-lawyer, it is helpful to understand what real estate investors may look at when evaluating and structuring potential investments and associated strategies.

One of the first things investors might look at is the net operating income, or NOI, of the proposed purchase. NOI is the annual income generated by an income-producing property after adding all income from operations and deducting all expenses necessary to operate the property.

NOI calculation formula:

Potential rental income (total rents)

? Vacancy (rent loss due to empty units) and credit losses

= Actual rental income

+ Other income (collectible)

= Total operating income

? Operating expenses (such as taxes, utilities, administration, maintenance, and insurance)

= Net operating income

NOI helps investors determine whether a property will produce an income stream and how much income will come from their operations. NOI is an important financial metric that investors consider and analyze when deciding whether to invest in one property versus another.

However, more information is needed to analyze a commercial real estate investment. It is also useful to look at the capitalization rate.

Cap rate is the most valuable metric when used to compare properties in similar locations, from the same asset types and categories, and valued at the same points in time. In general, a floor rate indicates lower risks associated with the investment, which means the investment valuation is higher. Once a good market value rate is determined, one can divide the NOI by this cap rate to determine the property’s estimated valuation.

In addition to the NOI and cap rate, the investor often borrows money to purchase the investment. When evaluating whether to borrow, investors will want to determine whether this leverage would be better spent on the target properties or elsewhere.

To help make this decision and analyze potential investment returns, investors will typically evaluate other financial metrics, including the gross rental multiple, cash on cash returns, internal rate of return and equity multiples.

To analyze the gross rent multiple, an investor calculates the investment value of a property using the total rents that the investor expects the property to generate, multiplied by a certain factor, or gross rent multiplier, derived from an analysis of sales of comparable properties. The gross rental multiplier measures the performance of an investment, assuming a certain price. In other words, gross rental multiplier = property price or value / gross rental income.

In general, many investors use the following rule of thumb: the lower the RRP compared to similar properties in the same market, the more attractive the investment is. In addition to the gross rent multiple valuation method, there is a more comprehensive cash-on-cash method.

Cash on cash is calculated using the first year’s cash flow before taxes as follows: First year’s cash flow (after financing) and before tax/cash investment (down payment) = cash return on cash (yield).

The investor’s cash requirements are derived from similar properties in the market and/or the investor’s objectives. This allows the investor to determine how long it will take for the down payment, or the actual amount invested, to return to the investor.

However, the cash-to-cash ratio is limited because it does not take into account the tax impact and usually only looks at one-year forecasts. Therefore, the internal rate of return is useful and commonly used.

The internal rate of return, or IRR, for an investment is the percentage earned on each dollar invested for each period that it is invested. Internal rate of return is another term for interest, or, more appropriately, when all future cash flows are added up, the discount rate is reduced to present value, where the total equals the initial capital investment. The internal rate of return allows investors to compare alternative investments based on this return.

IRR isolates the return on a portion of the total amount of money received from the investment during the holding period. To get a return on investment, dollars received must exceed dollars invested. The internal rate of return (IRR) is a direct measure of the annual return on each dollar invested as long as it stays there. The internal rate of return (IRR) accurately shows the return that can be expected from an investment over a specific holding period but can easily be subject to manipulation by sellers and brokers regarding its assumptions. Internal rate of return (IRR) analysis is often the cornerstone of investment selection and performance measurement. However, an IRR analysis is incomplete without examining equity multipliers.

Equity multiples are primarily used to measure total return to an investor. The equity multiplier is found by dividing the cumulative dividends from the project by the paid-up capital. The equity multiplier differs from the internal rate of return (IRR) in that it does not take into account the length of the investment period or the time value of money.

The formula for the equity multiplier is: Equity Multiplier = Total Dividends / Total Equity Invested.

The equity multiplier is fixed, while the internal rate of return is variable. That’s why looking at internal rates of return (IRR) in conjunction with stock multiples is a key measure of total returns. It is important to closely check the assumptions used to derive the internal rate of return and equity multiples, and investors should run their own numbers before purchasing a property based on the proposed or advertised return.

While internal rates of return and multiples are widely used in the world of real estate investing and the stock market, relying on them as the exclusive criterion for choosing between two or more investment alternatives brings potential problems beyond the scope of this article. However, it is important to consider all metrics, including net present value.

Net present value, or NPV, is the difference between the present value of cash inflows and the present value of cash outflows. Net Present Value compares the value of a dollar today with its value in the future, taking inflation and returns into account. In general, if the present value of a potential project is positive with a large enough delta, the investment may be acceptable. However, if the NPV is negative, the project will likely be rejected because the cash flows will also be negative.

Commercial real estate investment analysis can be complex and involve analyzing multiple financial metrics and projections. The above factors are among the factors that can be taken into consideration.

Dave Healey is an attorney with Schwabe, Williamson & Wyatt. Call him at 206-407-1594 or (email protected).

You may also like...

Leave a Reply

Your email address will not be published. Required fields are marked *