When acquisitions team members evaluate a potential real estate investment, they consider a wide range of key metrics to determine if a property is a match for a fund. A critical data set in the evaluation process is the existing and projected cash flow that can be generated from a property. Cash flow is not the only consideration informing decision-making in the acquisitions process, but it is inextricably linked to the strategic business plan of the property. Next, we’ll explain what cash flow means and how we evaluate it.
How We Calculate Cash Flow
At a high level, real estate cash flow is made up of four financial components: revenue, operating expenses, capital expenditures, and debt service. A tenant pays rent, which generates revenue to the property, and a property incurs operating expenses for items such as utilities, real estate taxes, and insurance. When operating expenses are subtracted from a property’s revenue, the net operating income, or NOI, is established. Oftentimes, a landlord reinvests in the property to maintain and improve its physical appearance and structure. Those projects are known as capital expenditures, or CapEx. CapEx also includes any leasing costs a landlord incurs, such as leasing commissions and tenant improvement allowance. The cash flow of each property is calculated by subtracting operating expenses and CapEx from the property’s revenue. For properties financed with mortgage debt, debt service payments will be further subtracted from the property’s cash flow and the remaining value is called cash flow after debt service.
Revenue is the sum of the total rent and other income that is paid to the landlord. Total rent may include base rent, percentage rent, and recovery income (e.g. CAM or maintenance charges). Other income could include items such as parking fees or storage rentals, for example. When estimating a property’s cash flow over the expected ownership period, one must account for both contractual and speculative rent.
When a company evaluates a property’s suitability for investment, it reviews the property rent roll. The rent roll details key metrics on existing tenants and their lease terms, including the rent amount a tenant pays, how many square feet that tenant occupies, and the lease length. The contractual rent (also known as in-place rent) is the sum of all the rental revenue from tenants that lease space in the property at the time it is acquired.
Properties may have some existing vacancies or projected vacancies as existing tenants leave the property. If that is the case, the company evaluating the investment will make assumptions, which are called Marketing Leasing Assumptions (“MLAs”), about when and for how much those spaces will be leased. The MLAs include the projected rent the tenants will pay, the lease start date, the lease end date, and any expenses incurred by the landlord. MLAs are based on market trends and an analysis of comparable leases in competitive buildings. MLAs are also used to project future rent when existing tenants’ leases expire.
When you pair contractual rent and speculative rent, the two pieces function as different parts of the total revenue stream. As time goes on, more and more leases expire and therefore speculative rent becomes an increasing percent of the total revenue.
The operating expenses at the property are divided into two categories: variable and non-variable expenses. Non-variable expenses are costs that won’t change at the property if the occupancy changes, for instance real estate taxes or property insurance. Variable expenses are costs that change with occupancy at the property. These expenses include utilities, cleaning, and many others. It’s very similar to how you think about expenses within your own home. If you aren’t living there, your electricity and water bill will decrease but your real estate taxes stay the same. The same happens at a commercial property.
Capital Expenditures and Leasing Costs
The next component of a property’s cash flow are the capital expenditures and leasing costs. Capital expenditures are also divided into two categories: discretionary and non-discretionary. Non-discretionary capital expenditures are required building improvements like roof replacements, elevator repairs, or heating and cooling system upgrades. Discretionary capital expenses are items that aren’t needed to keep the property operational, but make it more appealing and inviting to tenants. These can include painting, landscaping, a lobby renovation, or creating a new common area for tenants. These new projects can help improve leasing and increase rent at the property. Leasing costs are also considered a component of CapEx, which include commissions paid to leasing brokers, as well as any improvement allowance provided to a tenant in order to renovate or customize a space.
Real estate buyers will commonly use debt, such as mortgage debt, to purchase a property. The use of loan proceeds (also referred to as “leverage”) allows the buyer to invest less cash in the asset, which may enhance its return on invested capital. The buyer will repay the borrowed funds at loan maturity, and will compensate the lender throughout the term of the loan through making interest and/or principal payments. These interest and principal payments are collectively called “debt service.”
Whereas the property’s cash flow before debt service is “unleveraged cash flow,” the “leveraged cash flow” is after deduction of debt service. As debt service is usually the last expense to be reflected on a property’s income statement, the leveraged cash flow is the property’s “bottom line,” which reflects the total net cash flow that is available for distribution.
Net Operating Income vs. Cash Flow
Net Operating Income, or NOI, is calculated by subtracting operating expenses from a property’s revenue. NOI less capital expenditures is the cash flow available to repay lenders or investors.
Why does cash flow matter?
Cash Flow and Property Valuations:
Typically, investors project ten years of cash flow when accounting MLAs and capital expenditures over the foreseeable future. These cash flows are then valued using a discounted cash flow model (“DCF model”) to determine the value today. The construction of a DCF model is beyond the scope of this article, however, an investment property’s value can be quickly estimated using a capitalization rate (“cap rate”). A cap rate is similar to a P/E ratio (or a price-to-earnings ratio) in the stock market except that a cap rate is stated as a percentage (the inverse of a multiple) and it is applied to NOI instead of a company’s earnings. The cap rate is a function of the rate of return required to compensate for the risk of an investment as well as the potential for growth in NOI. While each investor decides what his or her required returns are, the investor with the lowest required return or an investor who believes in the highest growth in NOI will often be able to pay the most for a property.
As mentioned above, the required return is related to the perceived riskiness of the investment. Most investments across asset classes in the United States are measured against the annual rate of return of the safest investment, US Treasury Bonds. If a ten-year US Treasury Bond is yielding a 2% annual return, real estate must achieve something greater as it is considered a riskier investment. As an example, let’s say that the spread between well-located industrial real estate and US Treasury Bonds is 3%. This 3% is considered the risk premium. However, the NOI of an industrial property will usually grow and Treasury interest payments do not, thus this risk premium needs to be reduced by the expected averaged annual growth in NOI for industrial properties. Once the cap rate is established, the NOI is divided by the cap rate, establishing an estimated value for the property.
The required risk premium varies widely and is determined by a large range of factors, some of which include location (urban versus suburban or from city to city), property type (industrial versus office), risk profile, and occupancy.
Cash Flow and Fund Suitability:
The current and projected cash flow at a property are a crucial component of deciding if a property is a suitable investment within a private fund or on a standalone basis. Over the lifecycle of an investment, investors in a private fund will typically receive distributions as determined by the fund management team if the fund investment strategy is successful. The distributions are the result of cash flow from the property as calculated above, less any amounts owed to lenders or to the fund manager in the form of fees.
As you can see, a great deal of calculation and judgement is required to successfully invest in real estate, and as a passive investor in a fund, one way to achieve positive results is to invest alongside an experienced investor with a strong track record.
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