What Every Real Estate Investor Needs to Know about Cash Flow... And 36 Other Key Financial Measures
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|Released||November 25, 2003|
In the midst of one of the most protracted and dynamic real estate bubbles in recent memory, many amateur investors have turned to property investments as a unique, collateral-based means of growing their personal wealth. However, while real estate investment may appear to be something that anyone can do correctly in the right market environment, renowned author Frank Gallinelli argues that the application of a few relatively uncomplicated financial calculations prior to purchase can greatly increase the likelihood of making a beneficial, lucrative property-buying decision. He intends this book to function as a decision-making toolkit for investors who may be intimidated by or unfamiliar with some of the key concepts and terminology in the field.
The first five chapters offer brief narrative explanations of some of the basic concepts that are used in the book. Then, the remaining 37 chapters each present a mathematical calculation related to the assessment of cash flow and other values and measurements crucial to success in real estate investment. The author also offers tips for supplementary resources, including many Excel templates that can be downloaded from the book’s web site to help expedite the computation of some of the more complex calculations discussed in the text. After reading What Every Real Estate Investor Needs to Know About Cash Flow…And 36 Other Key Financial Measures, even the most inexperienced investor will be prepared to make a foray into this potentially lucrative field.
In this book, Gallinelli presents a number of indispensable rules about the correct management of cash flow in real estate investment, along with 37 calculations that can return precise data that will enhance the accuracy of your real estate decisions both before and after purchase. His chief assertion is that beneficial real estate investments provide four major benefits to property owners: cash flow, appreciation, loan amortization, and tax shelter. This book, Gallinelli explains, undertakes an in-depth examination of cash flow and a number of other key real estate concepts for the property investor.
Chapter 1: Do Your Homework: How to Gather the Data Needed to Make an Investment Decision
Gallinelli asserts that the key to ensuring a profitable cash flow in real estate investment is predicated first and foremost upon buyers’ ability to select lucrative properties for purchase. Before making the decision to buy, he suggests gathering data from as many sources as possible, including current leases, recent property tax bills, recent utilities bills, and even pertinent sections of the seller’s tax returns. He also suggests doing some market analysis by looking at comparable sales in the area, estimating operating costs in the neighborhood, and researching local capitalization rates.
Chapter 2: Financial Detective Work Before You Buy: Finding the Truth Behind What the Seller Tells You
Gallinelli cautions that even the seemingly straightforward offered by the seller may conceal some information that could impact the decision-making process. As such, he sets forth several important investigative procedures that should precede any real estate investment. Most importantly, the author recommends undertaking an in-depth analysis and comparison of the income and appreciation value of each property that is under consideration. The calculations that are suggested for this process include gross scheduled income, vacancy allowance, gross operating income, operating expenses, net operating income, and annual property operating data.
Chapter 3: How the “Time Value of Money” Should Influence Your Real Estate Investing Decisions
Gallinelli contends that many potential real estate investors overlook one of the most significant sources of potential profit in gauging the efficacy of potential property purchases, namely, the “time value” of money. The power of compound interest can help real estate investors grow their wealth in a way that may not be immediately apparent to amateur investors. The author demonstrates several calculations that can be used to estimate the financial impact of compound interest on long-term assessments of value in real estate deals. Examples are offered for calculating the property’s present value, evaluating leases, and calculating mortgages. Gallinelli recommends the use of Excel software to expedite these calculations.
Chapter 4: How to Estimate What an Income Property is Really Worth
Gallinelli acknowledges that there are myriad factors and variables that can play a role in determining the “worth” of a particular property. However, for real estate investors seeking to use property investment to grow wealth, the author contends that there are a few calculations that are of particular significance. These include gross operating income, operating expenses, and net operating income. Based on the data obtained through these calculations, the potential investor can make more detailed, accurate assessments of cash flow, taxable income, and appreciation, three factors that should be the primary considerations of the pre-purchase decision-making process.
Chapter 5: Measuring the Return on a Real Estate Investment
There are many methods that can be employed to evaluate the success of a real estate investment. The best approach to use depends on each investor’s goals and aims. Gallinelli recommends using multiple investment return metrics in order to develop a multi-dimensional picture of each property’s performance. Calculations that he demonstrates include payback period, cash-on-cash return, gross rent multiplier, debt coverage ratio, capitalization rate, discounted cash flow, and internal rate of return.
Chapter 6: Calculation 1: Simple Interest
To compute interest in a manner that applies the interest rate only to the original principal amount, Gallinelli recommends the following formula:
- Interest = Principal x Rate x Time
Chapter 7: Calculation 2: Compound Interest
This calculation allows you to apply the aggregation of interest to not only the principal, but also the interest that has already accumulated over time:
- Amount (Future Value) = Principal x (1 + Periodic Rate) ^ Number of Periods
Chapter 8: Calculation 3: Rule of 72s
This calculation can help determine the amount of time it will take for a real estate investment to double in value.
- Number of Years to Double in Value (approximate) = 72 / Rate of Growth
Chapter 9: Calculation 4: Present Value of a Future Cash Flow
This calculation offers real estate investors a simplified, but accurate approach to discounted cash flow analysis.
- Present Value = Future Value / [(1 + i)n]
Chapter 10: Calculation 5: Gross Rent Multiplier
This calculation offers a method to estimate the market value of an income property.
- Gross Rent Multiplier = Market Value / Gross Scheduled Income (annual)
Chapter 11: Gross Scheduled Income (Potential Gross Income)
This calculation helps potential investors determine the maximum potential income stream under ideal circumstances, with all units rented and all rent collected.
Gross Scheduled Income (for a given year) = Total rent payable for that year under existing contracts for occupied space + Total potential rent (at market rates) for vacant space
Chapter 12: Calculation 7: Vacancy and Credit Loss
This calculation can estimate the amount of future loss that may occur due to unoccupied units and non-payment of rent by tenants.
Vacancy and Credit Loss (in dollars) = Gross Scheduled Income x estimated % Vacancy and Credit Loss
Chapter 13: Calculation 8: Gross Operating Income (Effective Gross Income)
This calculation helps investors gauge a realistic estimate of the total amount of income that will be collected annually.
- Gross Operating Income = Gross Scheduled Income less Vacancy and Credit Loss
Chapter 14: Calculation 9: Net Operating Income
This calculation estimates a property’s income after operating expenses and all loss.
- Net Operating Income = Gross Operating Income less Operating Expenses
Chapter 15: Calculation 10: Capitalization Rate
This calculation allows you to translate future income into the terms of its present value.
- Capitalization Rate = Net Operating Income / Value
Chapter 16: Calculation 11: Net Income Multiplier
This calculation is a reverse expression of the capitalization rate of property. It provides investors with a means to express the per-dollar value of a property’s net operating income.
- Net Income Multiplier = 1 / Capitalization Rate
To use the Net Income Multiplier to estimate a property’s value, you would multiply this figure by the Net Operating Income thusly:
- Present Value = Net Income Multiplier x Net Operating Income
Chapter 17: Calculation 12: Taxable Income
This calculation allows investors to estimate the amount of the property’s value upon which you will likely be liable for federal income tax.
Net Operating Income less Mortgage Interest less Depreciation, Real property less Depreciation, Capital Additions less Amortization, Points and Closing Costs plus Interest Earned = Taxable Income
Chapter 18: Calculation 13: Cash Flow
This calculation is the primary method that investors will use to determine all of the cash inflows less all cash outflows. It is central to many of the other calculations that Gallinelli recommends.
Net Operating Income less Debt Service less Capital Additions plus Loan Proceeds plus Interest Earned =Cash Flow Before Taxes
Gallinelli also offers this corollary calculation:
Cash Flow Before Taxes less Income Tax Liability = Cash Flow After Taxes
Chapter 19: Calculation 14: Cash-on-Cash Return
This calculation allows investors to gauge the relationship between the property’s cash flow and the amount of the initial capital investment.
- Cash-on-Cash Return = Annual Cash Flow / Cash Invested
Chapter 20: Calculation 15: Sale Proceeds
This calculation offers an estimate of the before-tax sale proceeds on a real estate property.
Selling Price less Costs of Sale less Mortgage Payoff = Sale Proceeds Before Taxes
To determine the after-tax sale proceeds, simply subtract the tax on the sale from the final figure.
Chapter 21: Calculation 16: Discounted Cash Flow
This calculation offers investors a means of determining the present value of an aggregate income stream. To complete it, you add up the cash flows achieved using the “Annual Present Value Factors” discussed in chapter for a particular property over a length of time, such as five or ten years. This total will represent your discounted cash flow.
Chapter 22: Calculation 17: Net Present Value
Net Present Value is defined as the difference between the present value of all future cash flows and the amount of cash you invest to purchase those cash flows.
Net Present Value = Present Value of all Future Cash Flows less Initial Cash Investment
Chapter 23: Calculation 18: Profitability Index
Gallinelli offers the Profitability Index calculation as an alternate means of assessing investment return. It is closely related to Net Present Value, although it is expressed in a ratio format.
Profitability Index = Present Value of all Future Cash Flows / Initial Cash Investment
Chapter 24: Calculation 19: Internal Rate of Return
The author asserts that the calculation used to estimate internal rate of return is one of the most widely credited estimates of cash flow in the real estate industry. It measures not only the dollar worth of investment, but also the scale and impact of property value over time.
Because this calculation is complex, Gallinelli recommends that readers employ the Excel template proffered at <a href="http://www.realdata.com/book">www.realdata.com/book</a>, rather than trying to complete the calculation manually.
Chapter 25: Calculation 20: Price, Income, and Expenses Per Unit
These calculations are geared to assess the estimated cash inflows and outflows associated with residential rental properties.
- Price per Unit = Price / number of rental units
- Income per Unit = Gross Scheduled Income / number of rental units
- Expenses per Unit = Operating Expenses / number of rental units
Chapter 26: Calculation 21: Price, Income, and Expenses per Square Foot
Gallinelli offers this calculation as an alternate means of assessing cash inflows and outflows associated with rental properties. He asserts that this approach is likely to be more applicable for commercial rental properties.
Price per square foot = Price / Gross Building Area or Net Rentable Area Income per square foot = Gross Scheduled Income / Gross Building Area or Net Rentable Area Expenses per square foot = Operating Expenses / Gross Building Area or Net Rentable Area
Chapter 27: Calculation 22: Operating Expense Ratio
This calculation measures the relationship between the operating expenses of a property and its gross operating income.
- Operating Expense Ratio = Operating Expense / Gross Operating Income
Chapter 28: Calculation 23: Debt Coverage Ratio
This calculation allows investors to achieve a clear statement of the relationship between a property’s net operating income and the annual debt service required on the property.
- Debt Coverage Ratio = Annual Net Operating Income / Annual Debt Service
Chapter 29: Calculation 24: Break-Even Ratio
This calculation results in an expression of the comparative relationship between your cash inflows and expenses. It is significant because it is commonly employed by mortgage underwriters to assess your risk of defaulting on a loan.
Break-Even Ratio = (Debt Service + Operating Expenses) / Gross Operating Income
Chapter 30: Calculation 25: Return on Equity
This calculation is one way of measuring the relationship between your accumulated equity holdings in your property and your after-tax cash flow. The author offers two methods of making this calculation.
Return on Equity = Cash Flow after Taxes / Initial Cash Investment Second Method:
Return on Equity = Cash Flow after Taxes / (Resale Value less Mortgage Balance)
Chapter 31: Calculation 26: Loan-to-Value Ratio
This calculation helps investors estimate the relationship between the amount of mortgage financing for a property and the property’s appraised value or selling price.
Loan-to-Value Ratio = Loan Amount / Lesser of Property’s Appraised Value or Actual Selling Price
Chapter 32: Calculation 27: Points
Points are defined as a fee that is often required by the lender in return for the approval of a mortgage note. This calculation allows investors to estimate the value of points for a particular loan.
1 Point (in dollars) = Mortgage Loan Amount / 100
Chapter 33: Calculation 28: Mortgage Payment / Mortgage Constant
This calculation helps calculate an estimated loan payment based on the amortization of a mortgage.
Payment = PV x (I / [1 + l) ^ x n]) where PV is the amount of the loan, I is the interest rate per period, and n is the number of periods
Chapter 34: Calculation 29: Principal Balance / Balloon Payment
This calculation helps determine the remaining balance of a mortgage loan at any given time.
PV of an annuity = A x (1 + i)^n - (Pmt/i) x [(1 + i)^n - 1]) Where A is the original amount of the loan and n is the number of payments made
Chapter 35: Calculation 30: Principal and Interest per Period
These calculations help property owners determine the ratio of principal to interest in each mortgage payment.
Interest Portion of a Payment = Outstanding Principal Balance x Periodic Rate
Principal Portion of a Payment = Payment amount less Interest portion
Chapter 36: Calculation 31: Maximum Loan Amount
This calculation helps property owners applying for a mortgage estimate what the maximum loan amount they are likely to be approved for will be.
Maximum Loan Amount = Net Operating Income / Debt Coverage Ratio / (Monthly Mortgage Constant x 12)
Chapter 37: Calculation 32: Assessed Value, Property Taxes, and Value Indicated by Assessment
These calculations help property owners arrive at a rough estimate of their property tax liability.
Property Taxes = Assessed Value x Tax Rate
Appraised Value = Assessed Value / Assessment Ratio
Chapter 38: Calculation 33: Adjusted Basis
This calculation helps property owners selling their properties to estimate the gain on sale, a figure that is necessary to calculate the taxable profit of the transaction.
Original Basis (Purchase Price) plus Capital Additions plus Costs of Sale less Cumulative Depreciation, Real Estate less Cumulative Depreciation, Capital Additions = Adjusted Basis
Chapter 39: Calculation 34: Depreciation
This calculation estimates the amount of annual tax deduction that can be claimed for the depreciation of real property. Depreciation Allowance (annual) = Depreciable Basis / Useful life (determined according to standards set forth in the current tax code)
Chapter 40: Calculation 35: Gain on Sale
This calculation is used to determine the amount of taxable profit you can claim after the sale of a real estate investment property.
Selling Price less Adjusted Basis = Gain on Sale
Chapter 41: Calculation 36: Land Measurements
In real estate, many different units of land measurement are employed in different contexts. The author offers a number of conversion factors to allow these measurements to be conveyed into a more readily understandable format.
Acres to Square Feet -- multiply by 43,560 Square Feet to Acres -- multiply by .000023 (or divide by 43,560) Acres to Hectares -- multiply by .4046856 Hectares to Acres -- multiply by 2.471054 Acres to Square Meters -- multiply by 4046.86 Square Meters to Acres -- multiply by .000247
Chapter 42: Calculation 37: Building Measurements
These calculations offer an array of measurements for real property.
Gross' Building' Area = Total area of all floors, including basement Usable Square' Footage = Actual space occupied by a tenant; for an entire building, Gross Building Area less Common Area Rentable Square Feet = Defined by lease, but often USF + an allocated portion of Common Area Loss Ratio = Common Area / Gross Building Area