Structuring a commercial real estate investment

As a commercial real estate lawyer, I understand that my clients often rely on their financial analysts and their projections, forecasts and assumptions to determine whether to invest in a real estate venture. Whether a lawyer or a nonlawyer, it is helpful to understand what real estate investors may look at when evaluating and structuring potential investments and correlating strategies.

One of the first things investors may look at is the net operating income (NOI) of their proposed purchase. NOI is the annual income generated by an income-producing property after collecting all income from operations and deducting all expenses required to operate the property.

NOI calculation formula:

Potential rental income (sum of rents) – vacancy (rent loss due to empty units) and credit losses = effective rental income + other income (collectible) = gross operating income -operating expenses (e.g., taxes, utilities, management, maintenance, insurance) = net operating income

The NOI helps investors identify if a property will produce an income stream from its operations. NOI is an important financial metric that investors consider and analyze when deciding whether to invest in a particular property versus another.

However, more information is needed to analyze a commercial real estate investment. It is also helpful to look at the capitalization rate.

The cap rate is a metric that is most valuable when used to compare similarly located properties, of the same asset types and classes, and valued at the same points in time. In general, a lower cap rate indicates less risk associated with an investment, which means the investment’s valuation is higher. Once a good market cap rate is determined, one can divide the NOI by that cap rate to determine an estimated property valuation.

In addition to the NOI and cap rate, the investor will often borrow money to purchase the investment. When evaluating whether to borrow, investors will want to determine if that leverage would be best spent on the targeted real estate or elsewhere.

To help make this determination and create an analysis of potential investment yields, investors will typically evaluate other financial metrics, including the gross rent multiplier, cash on cash returns, the internal rate of return, and equity multiples.

To analyze the gross rent multiplier, an investor calculates a property’s investment value using the gross rents the investor anticipates the property will produce, multiplied by a given factor or the gross rent multiplier, which is derived from an analysis of comparable property sales. The gross rent multiplier measures investment performance, assuming a given price. In other words, the gross rent multiplier = property price or value / gross rental income.

Generally, many investors use the following rule of thumb: the lower the GRM is compared to similar properties in the same market, the more attractive the investment.

In addition to the gross rent multiplier valuation method, there is the more thorough cash on cash method.

Cash on cash is calculated using the first-year cash flow before taxes as: first-year cash flow (after financing) and before tax/cash investment (down payment) = cash-on-cash return (yield).

The investor’s cash-on-cash requirement is derived from comparable properties in the market and/or the investor’s objectives. This allows the investor to determine how long it would take for the down payment, or the actual amount invested, to return to the investor.

However, a cash-on-cash ratio is limited because it does not consider the tax impact and typically only looks at a one-year forecast. Therefore, the internal rate of return is helpful and commonly used.

The internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested. IRR is another term for interest, or, more appropriately, when adding up all future cash flows, the discount rate is reduced to present value, where the total equals the initial capital investment. The IRR allows investors to compare alternative investments based on this yield.

IRR isolates the return on the portion of the total amount of money received from the investment over the holding period. To have a return on investment, dollars received must exceed dollars invested. IRR is a straightforward measure of annualized yield on each dollar invested for as long as it remains there. IRR accurately shows exactly what return may be expected from an investment over a specific holding period but can be easily subject to manipulation by sellers and brokers with respect to its assumptions. IRR analysis is often a cornerstone for investment selection and performance measurement. However, an IRR analysis is incomplete without examining the equity multiple.

Equity multiples are used primarily to measure the total return to an investor. The equity multiple is found by dividing the cumulative distributions from a project by the paid-in capital. The equity multiple differs from the IRR in that it does not consider the length of the investment period or the time value of money.

The formula for the equity multiple is: equity multiple = total cash distributions / total equity invested.

The equity multiple is static, while the IRR is variable. That is why looking at IRRs in conjunction with equity multiples is a key measure of total returns. It is important to closely check the assumptions used to derive the IRR and equity multiple, and investors should run their own numbers before purchasing a property based on a proposed or advertised yield.

While IRRs and multiples are used widely in the real estate investment world and the equities marketplace, relying on them as the exclusive criterion for selecting between two or more investment alternatives brings potential problems beyond this article’s scope. However, it is important to consider all metrics, including net present value.

Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV compares the value of a dollar today to the value of it in the future, taking inflation and returns into account. Generally, if the NPV of a prospective project is positive with a large enough delta, the investment may be acceptable. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative.

Analyzing a commercial real estate investment can be complex and involves the analysis of multiple financial metrics and projections. The aforementioned factors are among those that may be considered.

Dave Hailey is an attorney at Schwabe, Williamson & Wyatt. This column is intended to provide readers with general information and not legal advice. Consult professional counsel for help regarding specific situations.