HomeMy WebLinkAboutKey elements to the financial analysisKey Elements to the financial analysis, p.1
Key elements to the
financial analysis
1) A Project Cost Summary - shows what it costs to get the
building out of the ground (Project Cost Summary
Worksheet)
Acquisition Cost
+ Renovation/Construction Cost
+ Fees
= Project Cost
2) An Operating Pro forma - shows income stream from project, in particular, the stabilized
NOI , which is critical in determining its value. See below how NOI is used to compute fair
market value.
Gross Rent
+ Tenant Contributions
= Gross Income
- Vacancy Contingency
= Effective Gross Rent (EGR)
- Operating Expenses
= Net Operating Income (NOI)
- Debt Service #1
- Debt Service #2
= Cash Flow
3) Determination of Fair Market Value (FMV) of the Completed Project
FMV = Net Operating Income (NOI)
Capitalization Rate
Solving for Fair Market Value -- a property with an annual NOI of $20,000 where the desired
cap rate is 10.5% puts the value at $190,500. The higher the cap rate, the lower the value.
Fair Market Value = NOI = $20,000 = $190,500
Cap Rate .105
Conversely, you can solve for a cap rate, by flipping the equation.
Cap. Rate = NOI
FMV or Sale Price (sale price of comps if solving for market cap rate)
Cap expresses “for X flow of income (NOI), at Y price, I expect this rate of return.”
Key Elements to the financial analysis, p.2
4) Determination of maximum loan size by each of two methods, to ensure maximum loan
capacity is taken on by developers; also referred to as debt that can be attracted to the
project.
a) Banks require a certain Debt Coverage Ratio (DCR). A common DCR is 1.2 to 1.35
which means for every $1 in debt, you must have $1.20 to $1.35 of net operating
income.
Loan Size By DCR = NOI
Debt Service (D/S)
To solve for a loan size based on DCR, use 2 step process:
1. D/S = NOI
DCR
2. Loan = D/S
“c” (terms of the loan: duration and interest rate)
b) Banks also require a certain Loan to Value (LTV) ratio, which measures a 2nd way out
of the deal. Common local Loan to Value ratios are .75 - .8, which requires that for every
75 or 80 cents of loan, there must be at least $1 in fair market value.
Loan Size By LTV = Loan Size
Fair Market Value (FMV)
To solve for a loan size based on LTV, use 2 step process:
1. FMV = NOI
Cap Rate required
2. Loan = FMV x LTV
5) Measuring reasonable returns to the developer is a critical part of the financial analysis
process. Here are 2 common ways to measure returns.
Cash on Cash Return
Cash Flow = Money out of a deal = CF (out)
Equity Invested Money in the deal EQ (in)
While cash on cash returns in the mid- to high-teens are desirable for privately owned
investments, this level of return is high. A 10% return would be considered more
acceptable for City participation in financing a project. Reducing costs and/or increasing
equity are the primary ways to effect change in this number. Cash on cash measures a
developer’s cash flow as a percent of their equity investment.
Internal Rate of Return (IRR)
The all-important IRR measure combines all benefits, of owning real estate, after taxes,
and converts them to a single rate of return. IRR is the discount rate at which the
present value (PV) of a stream of income equals the equity investment. Specifically it
Key Elements to the financial analysis, p.3
measures the owner’s return on equity invested and provides City staff one of the
standards for evaluating whether a developer’s return is fair when City financing is
included among funding sources.
An IRR in the teens is great for privately owned investments but is too high to justify City
participation unless there are extenuating circumstances. A more modest 7% - 8% IRR
might be considered.
Perhaps a good way to illustrate IRR is to show and illustration of 2 ten-year equity
investments of $1,000 – each with different annual cash flows, yet each resulting in a
10% IRR:
Year
Present
Value
(PV) of
$1.00 @
10%
return
Returns on
Scenario A
Present
Value of
Scenario A
returns
Returns on
Scenario B
Present
Value of
Scenario B
returns
1 $0.9091 $10 $9.09 $500 $454.55
2 $0.8264 20 $16.53 500 $413.20
3 $0.7513 30 $22.54 300 $225.39
4 $0.6830 100 $68.30 300 $204.90
5 $0.6209 200 $124.18 200 $124.18
6 $0.5645 300 $169.35 200 $112.90
7 $0.5132 400 $205.28 250 $128.30
8 $0.4665 600 $279.90 247 $115.23
9 $0.4241 600 $254.46 200 $84.82
10 $0.3855 2,250 $867.38 400 $154.20
$2,017.00 $2,017.67
Note that that the present value of Scenario A and Scenario B returns are nearly equal
due to the time value of money, even though the returns to the investor are so vastly
different in the initial years.