It's back to basics for many businesses struggling to manage their way through today's economic recession. Real estate management firms are no exception. They understand that in order to survive the current downturn they must master the essentials of basic business acumen including financial fundamentals.
Measuring investment performance is one such critical business skill for today's real estate managers. Understanding how to accurately calculate net present value (NPV) and the internal rate of return (IRR) is essential to developing effective decision-making criteria. Typically, the management of income-producing properties involves three phases of real estate investment.
Part 1: The "Going In" Phase
In this phase, the investor acquires the property for which a price is paid. Although there are some investors who may pay cash for the property, the majority of investors acquire properties with the use of two types of funds-mortgage funds and the investor's cash equity portion. The mortgage portion is typically based on a Loan to Value Ratio (LTV) imposed by the lender. This LTV ratio is applied against the total purchase price or the appraised value, which ever is least, in many cases. (Example: 75% LTV or 80% LTV.) The investor would need to provide the balance in the form of cash equity. This is generally referred to as "Investment Base." (See Chart A.)
In addition to the traditional terms of lending (i.e., interest rate, LTV ratio, the amortization term, payment periods), the lender most often will use another judgement criteria called the debt coverage ratio (DCR). This is the ratio of net operating income to the annual debt service. It measures the ability of a property to meet its debt service out of net operating income. It is also referred to as the debt service coverage ratio (DSCR). Thus, for a property with a net operating income of $60,000 and annual debt service of $49,275, the debt coverage ratio is calculated as: NOI $60,000 / ADS $49,275 = DCR 1.22 (rounded). The .22 represents the cash flow position as well as the lender's margin of safety.
After considering the mortgage position, the balance of the purchase price must be paid by the borrower in the form of cash equity. In order to place these equity funds (investment base) into an income-- producing property, investors want to receive an adequate return on their invested capital. This is called a "cash-on-cash return to equity", an cl equity dividend rate", or even a "cash flow" rate. It might also be referred to as a "reinvestment rate", if used in conjunction with a FMRR "Financial Management Rate of Return" calculation.
The selection of the appropriate annual cash-on-cash return may come from various sources. First, the investor either may have owned a similar investment at one time, and received a certain annual return. This may become the benchmark for this new investment.
Second, national economic indicators, such as those from the American Council of Life Insurance Companies, Korpacz Real Estate Investor Survey, Pricewaterhouse-- Coopers, LLP, or the Valuation Insight er Perspectives, published by the Appraisal Institute, might indicate that the range of cash-on-cash returns for this property type might, hypothetically, be from 10 percent to 12 percent. Thus, the investor might select a rate that is commensurate with these indicators.
Third, the investor might select a rate based on the "build up" method. Consider, for example, that prior to the acquisition, the $1,250,000, which will be used for the down payment, lies in an interest bearing account, drawing 4.5 percent per annum. This is considered a "safe rate" or return on capital. (See Chart B.)
Whether the owner's funds are currently deposited into a 90-day Certificate of Deposit or Corporate Aaa Bond, consideration must be given to the anticipated holding period should the owner acquire this particular property. For example: If the anticipated holding period is five years, the "safe rate" should be commensurate with a return on capital received from a similar holding period. …