2. 2
Agenda
• Model Setup and Proforma
• Assumptions of Modeling
• Financial Rates of Return
• Completeness and Reasonableness
3. 3
Learning Objectives
At the end of this program, you will be able to:
• Describe the key users, uses, and components of a proforma cash
flow
• Understand the relationship between the various components that
make up a proforma cash flow
• Understand the next steps of how to model the components to vary
in future cash flow years
• Recognize and understand the different categories in which to
make assumptions
• Identify key financial rates of return used to assess cash flows
• Verify cash flow analysis mechanics and assumptions for
completeness and reasonableness
• Discuss how to test DCF via logic and a variety of ratios
4. 4
Cash Flow Overview
What are cash flow models?
• Cash flow models are used to convert future income into a
value estimate based upon current facts and future
assumptions
What are cash flow models used for?
• Budgeting
• Valuation
• Investment
• Finance
• Accounting/Auditing
5. 5
Cash Flow Overview (Cont.)
Who uses cash flow models?
Audience Possible Uses
• Buyers/Sellers ?
• Developers ?
• Lenders ?
• Landlords ?
• Regulators or Public Agencies ?
6. 6
Cash Flow Overview (Cont.)
Direct capitalization
– Relationship between one year’s income and value is reflected in
either a capitalization rate or an income multiplier
– Capitalized by applying appropriate rate or factor
ü Discounted cash flow (DCF)
– Relationship between several years of cash flows and reversionary
value in either a capitalization rate or an income multiplier
– Converted into present value through discounting
Which methods are typically used?
q
q
7. 7
Cash Flow Overview (Cont.)
Direct Capitalization
• Single-tenant properties
• Apartment buildings
Discounted Cash Flow
• Multi-tenanted properties
• Office
• Retail
• Hotel
• Land development
• Mixed-use projects
8. 8
Cash Flow Overview (Cont.)
How does an analyst build a cash flow model?
• Set up the analysis and develop a proforma
• Apply future assumptions
• Select and apply the proper financial rates of return
to conclude a value estimate
• Review the model for reasonableness and
completeness
9. 9
Elements of a Cash Flow Model
Model Setup
and Proforma
Completeness
and
Reasonableness
Assumptions of
Modeling
Financial Rates of Return
11. 11
Model Setup
• Determine the computer model
– Argus, Dyna-Lease, Pro-Ject, Excel, etc.
• Set up the analysis
– Effective start date and frequency of cash flows
(monthly, quarterly, yearly)
– Property size (square feet)
– Holding or projection period (length)
– Base rent
– Concessions
– Rent steps
– Base year
12. 12
What Is a Proforma?
• A real estate proforma is a forecast of the income
and expenses that are associated with a subject
property.
• A proforma is usually accompanied by financial
ratios that help indicate the financial soundness of
the property.
13. 13
Key Components of a Proforma
Potential Gross Income (PGI)
Vacancy / Collection Loss (VC)
Miscellaneous Income (MI)
Effective Gross Income (EGI)
Fixed Operating Expenses (FOE)
Variable Operating Expenses (VOE)
Net Operating Income (NOI)
Capital Expenditures (CAPEX)
Debt Service (DS)
Before Tax Net Cash Flow (BTNCF)
(-)
=
(-)
=
(-)
(-)
=
+
(-)
14. 14
Review: Where Do These Items Fit?
1. Base rent
2. Real estate taxes
3. Bad debt
4. Tenant improvements
5. Trash removal
6. Percentage rent
7. Depreciation
8. Mortgage interest
PGI
VC
MI
EGI
FOE
VOE
NOI
CAP EX
DS
BTNCF
(-)
=
(-)
=
(-)
(-)
=
+
(-)
15. 15
Exercise 1: Effective Rents Analysis
Stay in place
Scenario 1 Scenario 2 Scenario 3
Scenario:
You and your team need to evaluate three different
leasing options (from the tenant’s point of view) and
recommend the best option to the client.
Move to Bldg. A Move to Bldg. B
17. 17
Key Concepts
• Anticipation and change – The need to develop
procedures to attempt to consider the anticipated future
benefits of an asset and estimate it into a present value
• Supply and demand – The need to analyze the present
and future demand for a property and how its demand relates
to current and proposed supply
• Time value of money - Investors are concerned with the
amount and timing of the expected cash flows
• Risk – The possibility of suffering adverse consequences
resulting from an investment
18. 18
Current Information to Collect and Analyze
• Leases in place – current rents and reimbursed expenses,
escalations, concessions
• Market rents, renewal probabilities, downtime between
leases, vacancy and credit loss estimates, etc.
• Operating expenses
• Leasing costs – broker’s commissions, tenant
improvements (TIs), etc.
19. 19
Future Assumptions to Apply
• Growth rates – rent, expenses, overage rents
• Turnover scenarios – amount and length of lag
vacancy, TIs, leasing commissions, etc.
• Expense – estimates considered for fixed, variable, and
capital expenditures
• Capital expenditures – when, how much
• Investment rates – capitalization, discount rates
• Sale of property – when, how much, associated sales
costs
• Debt or leverage – impact on the investment
20. 20
Growth Rates
Market Rent
• Rate at which market rent is expected to increase or
decrease over the projection period
• Depends largely on factors of supply and demand, not simply
inflation
Expenses
• Rate at which operating expenses and real estate taxes are
expected to grow over the projection period
• Operating expense growth rates may correlate to inflation
rates
• Real estate tax growth rates vary by local municipalities
21. 21
Goals of Financial Projections
To provide an analytical basis for decision making
regarding real estate investment and finance
through the use of such tools as DCF models.
Examples
• Determine how much to pay for a particular property given its
underlying income and overall market conditions/trends.
• Test and establish the highest and best use of a particular site.
• Compute the rate of return on an investment.
• Assess the sensitivity of the DCF to changes in investment
assumptions.
• Consider the impact of debt leverage and/or taxation.
22. 22
Exercise 2: Review a Cash Flow Model
Review the “Cash Flow – Sample
A” Excel file and discuss the
following:
– How effective is the model?
– What is ineffective about the
model? Is anything missing?
– What would you change about
the model?
24. 24
Going In Capitalization Rate - Ro
• First-year net operating income (NOI1) divided by
the present value (or purchase price) of the asset
• Commonly used as a measure of risk in real
estate—the higher the cap rate, the higher the
perceived risk to the investor/lender. Cap rates
represent required returns by investors.
• Cap rates can vary because of a variety of
factors.
NOI1
Stabilized Value
= Going-In Cap Rate
25. 25
Build-up of Going-In Cap Rate - Example
3.12
2.12
4.27
Real Rate
Risk
Premium
Inflation
Rate
9.51%
2.12 + 3.12 = 5.24% (Treasury Bond Rate)
5.24%
Treasury
Bond
Rate
26. 26
Going In Cap Rate: Direct Capitalization Example
Scenario:
A property has a stable NOI of $27,500. Several
comparable sales have been investigated, and the going-in
capitalization rates show a range of 9.78% to 10.39%, with
a median of 10.13%.
Task:
• Develop a range of prices given the extracted market
capitalization rates.
Answer:
• At 9.78% = $281,186 ($27,500 / 9.78%)
• At 10.39% = 264,678 ($27,500 / 10.39%)
27. 27
Exercise 3: Direct Capitalization
Review the scenario facts and
calculate a value range for the
subject property.
• Individual exercise
• Five minutes
28. 28
Terminal Capitalization Rate – Rt
• The rate applied to convert future cash flows into an
estimate of value in the last year of a cash flow
projection
• The Net Operating Income (NOI11) of the year following
the end of the holding/projection period is capitalized
into value
• Reflects the resale of the property and a lump-sum
benefit that an investor receives at the termination of an
investment less any sales costs
NOI11
Terminal Cap Rate
= Terminal Value10
29. 29
Discount Rate - Yo
• The rate that reflects compensation necessary to attract
an investor to give up liquidity, to defer consumption,
and to assume the risk of investing
• It is the rate used to calculate the net present value
(NPV) and is typically the rate of return offered by
comparable investment alternatives
• Also called the hurdle rate or opportunity cost of capital
30. 30
Build-up of Discount Rate - Example
3.12
2.12
4.27
3
Real Rate
Risk
Premium
Inflation
Rate
Growth
Rate
2.12 +3.12 = 5.24 (Treasury Bond
Rate)
12.51%
5.24%
Treasury
Bond
Rate
31. 31
Discount Rate - Example
Task:
• What is the present value of a property that can
command a net annual rental of $10,000 for five years
and can be resold for $100,000 at the end of the fifth
year, assuming a discount rate of 12 percent?
Answer:
• Total present value = $92,790
32. 32
Exercise 4: Discount Rate
Review the scenario facts and
calculate the discount rate for the
subject property.
• Individual exercise
• Five minutes
33. 33
Internal Rate of Return (IRR)
• The discount rate that makes the NPV of the investment
series of cash flows equal to zero
• The true annual rate of return on an investment
• A profitability measure which depends on the amount
and timing of the project cash flows
34. 34
Financial Ratios and Multipliers
• Operating Expense Ratio (OER) = Operating Expenses / EGI
• Debt Coverage Ratio (DCR) = NOI / Debt Service
• Breakeven Ratio (BER) = Operating Expenses + Debt Service / EGI
• Gross Income Multiplier (GIM) = Market Value / PGI
• Net Income Multiplier (NIM) = Market Value / NOI
35. 35
Interrelationship of Rates
• NOI / Ro = Value
• Loan amount (M) x Rm = Debt service
• NOI / DCR = Debt service
• Ro = (M x Rm) + ((1-M) x Re)
• Ro = DCR x Rm x M
• Ro = (1 – OER) / EGIM
• Ro = Yo – NOI Δ
36. 36
Financial Rates of Return - Example
Task:
• Review the “Cash Flow – Sample B” Excel worksheet.
• If you assume a 10 percent going-in capitalization rate,
what is the value estimate for the property?
Answer:
• $12,509,750, rounded to $12.5 million
(first-year NOI of $1,250,975 / cap of 10%)
37. 37
Exercise 5: Financial Rates of Return
• Review the “Cash Flow – Sample
B” Excel worksheet.
• Calculate the maximum amount of
debt service the property can
support.
• Determine the annual debt service
payment.
• Individual exercise
• Five minutes
39. 39
• Revenue and expenses
• Space absorption
• Market lease terms
• Concessions/abatements
• Vacancy and collection loss
• Building area, calculations for reimbursements
• Debt service
• TIs, leasing commissions, replacement reserves
• Growth rates
• Rates of returns (capitalization rates, discount rates, etc.)
Projected DCF Model Considerations
40. 40
Assumption Testing
Support for Projections
• Market vs. contract rents
• Vacancy or absorption of space
• Concessions
• Timing of the cash flow stream
• Financial rate of return assumptions and
interrelationships
41. 41
Assumption Testing (Cont.)
Relationship Congruency
• Are mechanics auditable?
• Is the model flexible?
• Can the differences between the contract vs. market rents be
reconciled?
• Is the rationale for the growth assumptions supportable?
• Do the income, variable expense, and capital expense
figures correlate to the changes in occupancy over the
holding period?
• Are the financial rate interrelationships logical?
42. 42
Exercise 6: Completeness & Reasonableness
• Review the “Cash Flow –
Sample B” Excel worksheet.
• Answer the questions on the
“Exercise 6: Completeness and
Reasonableness” document.
• Individual exercise
• Twenty-five minutes
44. 44
Program Debrief
• What lessons did you learn by reviewing the “Sample
A and Sample B” Excel worksheets?
• Which cash flow concepts and/or procedures did you
find most helpful?
• What was the most challenging aspect of today’s
session? Why?
• As a result of the skills/knowledge gained during this
training, what will you do differently in the future?
45. 45
Summary
• Cash flows are use to convert future income into an
estimate of value.
• The discounted cash flow (DCF) technique provides
greater flexibility to incorporate more precisely the
expectations of market forces, vacancy periods, and
varying income/expense growth rates.
• Assumptions are the rationale upon which data, input into
a proforma, is based.
• Financial rates of return help express the relationship
between income and value.
• Testing or “auditing” a cash flow model is critical to making
certain the model is logical, sound, and complete.
46. 46
Course Evaluations
• Please complete
your course
evaluation before
you leave
• Give the
evaluations to
your instructor
Real Estate Advisory Services All- Hands Meeting Evaluation
July 10–12, 2003; Colorado Springs, Colorado
Solution Team:rCRE rConstructionrEnergy rTransactionrBPI/Transformation
rGov’t rHospitality rOther
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Agree
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Applicable
I clearly understood the program objectives. 5 4 3 2 1 N/A
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program are directly applicable to my job.
5 4 3 2 1 N/A
This program was appropriate for me given my
knowledge,
level, and experience.
5 4 3 2 1 N/A
The knowledge gained through this program has
increased my confidence in my ability to perform.
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Program Design
The program content was logically organized. 5 4 3 2 1 N/A
The delivery method(s) used in this program was an
effective way for me to learn the subject.
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The length of the program was … Too long
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Presentations
Overall, the … segment was an effective learning experience.
Opening General Session July 10 5 4 3 2 1 N/A
Team Building July 10 5 4 3 2 1 N/A
Product Fair July 11 5 4 3 2 1 N/A
Closing General Session July 12 5 4 3 2 1 N/A
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