Whether you are planning to manage a property yourself, or invest passively in real estate, examining a full budget and pro forma to evaluate the overall profitability of a project is a necessary prerequisite to understanding an asset and the potential success of an investment.
There are a variety of types of real estate investing, each marked by different phases of development, so it is important to understand the timeline of the potential project, its development stage, and how that will affect your investment.
Identifying Your Risk Tolerance and Goals
Identify your goals first. Are you a risk-averse investor interested in collecting a monthly, quarterly, or semi-annual payment? Do you need a steady stream of cash flow, or can you afford to have your money locked up without current payments at the beginning of a project?
If you are risk tolerant and can have your funds tied up without current distributions, ground-up construction might be the right fit for you. As you would expect, there is no incoming rent at this stage of development (there isn’t even a building yet!), so investing in this type of asset could mean several quarters without current cash flow. As a result, ground-up projects are often deemed more risky.
If you are searching for yield with more regular payments, stabilized cash-flowing properties may be a better match. This type of investment is often called “cash flow investing,” and, all things being equal, is generally seen as less risky with a potentially lower overall yield than a successful ground-up project.
Since investors can expect current payments, they will rarely wait more than a quarter to begin to see distributions. The cash flow they receive is the amount of money the property brings in after taxes, financing, and operating expenses. Underlying tenants could be stores (retail), individuals or families (multifamily), companies (office), or industrial tenants.
If you look at a pro forma and see a line item for a bulldozer, you are very likely not looking at a cash flowing property!
The Importance of Cash Flow
While there are a variety of important factors to consider when evaluating a potential real estate investment, banks usually focus on cash flow. Why? Incoming cash pays down loans and outstanding liabilities owed to the bank. If cash flow doesn’t meet projections, the bank likely won’t get paid back in full or as soon as they want.
Capitalization (cap) rates are highly sensitive to income streams because they are calculated by dividing the Net Operating Income (NOI) by the cost, or purchase price, of the property. You can imagine what even a small change in the numerator does to impact the rate.
The debt service coverage ratio (DSCR) calculates the amount of cash flow available to pay back current debt. It is calculated as the Net Operating Income (NOI) divided by the Total Debt Service, or the debt payments on loan. If the ratio is less than 1 there is not enough income to cover the debt payments. Banks typically will not lend at less than 1.2 or 1.3x DSCR.
Evaluating the Pro Forma
An important step in making an informed investment decision is to evaluate a pro forma to see if the projections seem reasonable. A pro forma for a stabilized building typically includes the purchase price, monthly income, cost of debt, insurance, operating expenses, and taxes for a given property.
As you evaluate the line items, ask yourself if the projections seem overly optimistic. Do they project 100% occupancy, or do they take into account that there may be vacancies? If more vacancies occur than are projected, are expenses low enough that cash flow will continue to be positive? Are rent increases in line with historical data?
Lessons for the Online Investor
As with any investment, it’s important to assess how it fits within your broader investing goals. If cash flow is a priority, understand where it comes from and how you will get paid back. Cash flow investing in stabilized real estate can be a lucrative addition to a balanced portfolio and can bring yield without compromising liquidity.