Analyzing Real Estate Like the Pros
By Jeff Greenspan, Managing Director, Financial Modeling Services
Educated investors know that you can’t put all your eggs in one basket. Real estate is an asset class that provides some very specific time-based and tax-based advantages to an investor (see Table 1), though it is not without its headaches! Unlike investments in the stock market, you can often estimate the future cash flows of a real estate investment with some precision. This, of course, requires financial modeling. So let’s GET STARTED1.
1. Advantages and Disadvantages of Real Estate as an Asset Class.
|Time Value of Money: money spent on loan payments in the future is worth less than money spent today.||Because it is considered less risky than stocks, the overall returns may be less than investing in the stock market.|
|Leverage: 70-80% leverage is commonly available. Leverage increases your return on investment when used properly.||Illiquidity|
|Tax Advantages: almost every form of real estate has tax advantages, with the tax treatment of depreciation being the most commonly cited.||Location specific|
|Passive Income Generation||Requires some level of management, even if you are not the person doing it.|
|Stability of Cash Flows||Tenants: you have to deal with people.|
|Diversification||Toilets: you have to deal with maintenance.|
|Inflation Hedge||Shifting demographics and preferences can affect your returns|
All real estate models are designed to estimate future cash flows. Simple models exclude the impact of taxes and are typically used for single-family investments like homes and condos. The most complex models consider the multi-year lifecycle of a property and reflect the cash flows to different levels of investors (general partners vs. limited partners), including those cash flows that are generated when the property is sold. We’ll start by considering a few definitions:
- Potential Gross Income (PGI): the total annual income that a property can generate if fully rented.
- Vacancy Loss (VL): Income lost due to vacancy and collections. It is common to estimate this as a percentage of PGI.
- Effective Gross Income (EGI): A realistic estimate of the total income that a property will actually generate.
- Miscellaneous Income (MI): Any non-rental income generated by the property (pet fees, laundry rooms, snack machines, etc.).
- Operating Expenses (OE): The set of expenses required to run the property as a business. It includes both fixed expenses, like real estate taxes and insurance, and variable expenses, like banking fees, management fees, repairs, marketing, legal and accounting fees, garbage collection, landscaping, and potentially many others.
- Net Operating Income (NOI): The income left over after all operating expenses have been paid.
- Capital Expenditures2 (CapEx) : Any cash required to improve the property. CapEx is distinguished from repairs in its tax treatment, and thus requires a separate line in the model. CapEx is often referred to as a “below-the-line” expense because it is not included in NOI. Unless an improvement is significant, owners prefer to treat most expenses of this type as an expense when allowable.
- Capitalization Rate (Cap Rate): All real properties are unique. In order to make some reasonable comparisons between properties, investors consider the ratio of the property’s first year NOI to Purchase Price. For example, a property that costs $1m to buy and generates $80k of NOI in its first full year of operation has a Cap Rate of 8%. Higher NOIs indicate properties that generate relatively more cash, but note that they also indicate properties with less stable cash flows because investors demand higher returns when volatility is higher!
The basic annual analysis looks like this:
PGI - VL + MI = EGI and EGI - OE = NOI
The astute reader will notice that we haven’t said anything about loans or loan payments yet. Most loans come with an amortization schedule that specifies the amount of each monthly payment that goes to pay interest (money to the bank) and the amount that goes to pay principal (additional equity in the property). The entire mortgage payment is an outgoing cash flow, but only the interest payment portion is considered a taxable expense. Now we need two calculations, one for tax purposes and another tracking cash flows:
NOI - Interest Paid = Taxable Income and Taxable Income * Tax Rate = Tax Expense
NOI - CapEx - Debt Service - Tax Expense + Depr = Property Cash Flow
You now have the basic knowledge needed to model the property’s first year cash flow. To model subsequent years, we need to make some basic assumptions about how our revenues (rents) and expenses will change over time. Most models assume a modest increase in rents of 2-3% per year and an equally small increase in expenses, but be careful here, as some expenses change significantly from year to year. Real estate taxes often increase substantially one to two years after a sale because most jurisdictions use the sale price to reset the basis on which you are taxed. It is 100% up to you to research the tax rules in the county in which you are purchasing to understand how much your real estate taxes will increase over time. Management expenses are also likely to change under new ownership.
To model the cash flow in the final year of property ownership, we must add any cash flows from the sale to our last year’s Property Cash Flow. We first calculate the NOI for year n+1. This will seem strange until you recognize the importance of Cap Rates in comparing properties. Go back and look at the definition of NOI and Cap Rate. Most owners assume that the terminal Cap Rate when they sell will be 0.5-1.5% higher than when they purchased: to calculate the expected sales price in year n, we divide the terminal Cap Rate into the NOI from year n+1. Updating the example we used above, if we assume an NOI in year 6 of $95,331 and a cap rate of 10.5%, our expected sales price at the end of year 5 is $1,121,543.
Sales Price - Sales Costs (commissions et al) = Net Sales Proceeds
Net Sales Proceeds - Adjusted Basis (Original Cost – Depr) = Taxable Gain
Taxable Gain - Depreciation Recapture = Capital Gain
We calculate Taxes Due from the property sale by adding Depreciation Recapture taxes (Depreciation Recapture x 25%) to Capital Gains taxes (Capital Gain x Your Capital Gains Tax Rate is between 0% and 20%). Finally, we calculate the Cash Flows from Sale:
Net Sales Proceeds - Loan Balance - Taxes Due from Sale = Cash Flow from Sale
The last piece of information we need is our personal discount rate (see my discussion here), which we use to discount the series of cash flows in order to calculate our Net Present Value (NPV) for this property. We may also want to calculate our Internal Rate of Return (IRR), which we recall is a special case where the NPV equals $0.
It is important to remember that the ability to analyze real estate like a pro does not make you a pro! Only experience can do that. IMHO, real estate can play a critical role in Amassing Long-Term Wealth, but you must be prepared for and able to manage the hassles that come with it.
Finally, Financial Modeling Service can assist you in modeling your real estate project. In addition to analyses like this one, we can perform Loan Analysis and Sell vs. Hold vs. Hold & Refinance analysis. Please contact us and let us know how we can help.
Greer, R. J. (1997). What is an asset class, anyway? Journal of Portfolio Management, 23(2), 86.
Real Estate Principles: A Value Approach, 5th Edition, McGraw-Hill Irwin, 2018. Professors David Ling and Wayne Archer at the University of Florida provide a comprehensive overview of the real estate industry.
Real Estate Development: Principals and Process (5th edition, 2015) by Mike E. Miles, Laurence M. Netherton, and Adrienne Schmitz, ULI – The Urban Land Institute: Washington, D.C. ISBN 978-0-87420-343-1. For those interested in real estate development, this textbook has numerous invaluable checklists.
YouTube has a plethora of videos on this topic, but BEWARE of videos that do not use academically verified principles.
1 Sometimes a picture is worth a thousand words. This is probably one of those times! Click HERE for our video on this complex topic.
2 Both CapEx and repairs are outgoing cash flows, but distinguishing between them can be tricky. Your accountant will tell you when money poured into your property is CapEx or a repair.