Q and A

Here are answers to frequently asked questions about The Real Estate Skinny.

What can a Sensitivity Analysis do for me?
A Sensitivity Analysis  is a method of evaluating the riskiness of a real estate investment.  It produces a "what if" comparison showing the effects different down payments, mortgage interest rates and occupancy rates would have on the cash flow produced by your property.  It also projects the impact of these changes on the future resale of the rental property. 

A sensitivity analysis helps answer these questions:

• How much net operating income is the property able to deliver?
• How much vacancy can the property stand before the debt service coverage is no longer enough to satisfy the lender?
• What effect does increasing the down payment have on first year breakeven occupancy rates?
• What effect does increasing the down payment have on first year cash flow rates?
• What is the minimum first year breakeven occupancy before the property becomes a losing proposition?

Changing the occupancy rates in the projections allows you to compare "what if?" cases and by trial and error you can get breakeven.

What can a Cash Flow Analysis do for me?
The discounted cash flow (or DCF) analysis describes one method to value your property based on its income potential now and in the future.  Using the concept of the time value of money, all future cash flows (e.g. rent payments) are estimated and discounted to give them a present value. The discount rate used is generally the cost of capital or interest rate.  Cash flows should be adjusted to incorporate factors that put future cash flows at risk, such as vacancies.

A cash flow analysis helps answer these questions:

• How much value does a rent roll add to the property?
• Which property provides the most income over its lifetime?
• How sensitive is the cash flow's net present value (NPV) to income timing and frequency?
• What effect does compounding have on the cash flow's NPV?

A stepped cash flow analysis produces the present worth of cash flows when the base rental amount changes by periodic dollar amounts and/or a compound percentage.  A variable cash flow analysis produces the present value of a series of irregular cash flows at a specified discount rate.

What can an Ellwood Analysis do for me?
The Ellwood Analysis is also known as the Mortgage Equity Analysis.  The Ellwood Analysis describes one method to value the equity portion of your real estate investment.  This analysis puts the emphasis on maximizing the return on your investment and secondarily on maximizing the value of the entire property.

An Ellwood analysis helps answer these questions:

• How do changes in the holding period affect the equity value of the property?
• What is the financial impact of mortgage principal reduction on the equity value?
• What is the required growth in property value or income necessary for the mortgage cost and equity to break even?

What can a Pro Forma Projection do for me?
A "pro forma," or financial statement, is a tool that is used to communicate relevant financial information about your property. It balances the costs of your property against the flow of income which your property will produce.

Pro Forma Projections forecast the income and expenses that are associated your property. It produces a projection of after tax cash flow based on changing net operating income and property value.  It takes into account tax adjustments from mortgage interest and depreciation.  The pro forma is usually accompanied by one or more "feasibility ratios," or indices of financial soundness of the property.

A property can be analyzed in terms of its pre-tax or in terms of its after-tax return. The 1986 Tax Reform Act has eliminated many of the tax advantages of real estate investment.  Depreciation does still provide some tax advantage, however, and in some cases the after-tax return from a project may be greater than the cash flow generated by the project itself.  Of course, the tax advantage is a benefit only for investors who pay income tax (local governments do not).

A Pro Forma Projection is divided into several sections. Expenses are divided into capital costs (the expenses associated with acquiring and improving a property) and operating costs (interest on the mortgage, costs of operating the project, and taxes).  Income is divided into potential income and effective income (potential income less vacancies and associated losses).  The relation between income and expenses is used to develop the "feasibility ratios," which are used to judge the soundness of the investment.

A Pro Forma projection helps answer these questions:

• How much profit will there be after expenses and mortgage payments?
• How much profit will there be after taxes?
• What will be the return on investment before and after taxes?
• What is the ratio of annual net operating income to annual debt service (debt coverage ratio)?
• What is the ratio between operating expenses including debt service and operating income (default ratio)

How can I analyze an Adjustable Rate Mortgage?
By their nature, Adjustable Rate Mortgages (ARMs) are unpredictable as to when rates will change.  To simulate ARM mortgages, run the 'Mortgage Amortization' tool then look at the last line before the period you expect rates to change.  Input this value in  'Mortgage Amount'.  Change the 'Mortgage Term' to the balance of the original mortgage term.  For example, if you expect rates to change after 5 years on a 30 year mortgage, then enter 25 years for the new mortgage term.  Finally, change the 'Regular Payment Amount' to zero.  Click 'Results' to see the new regular payment amount and the mortgage amortization schedule for the balance of the ARM.

I own my rental property outright. How can I account for the effect of property taxes on my rental's annual cash flow?
Many counties require that property tax installments be paid at unequal intervals such as the beginning and end of summer.  Even though it is primarily a cash flow tool, the 'Stepped Cash Flow Analysis' tool can be used effectively to model property tax expenses.  In the 'Base Rental Amount', enter the first installment amount from your annual property tax bill.  Set the 'Dollar Amount of Variation' to zero.  Set the 'Percent Variation' to the expected annual rate of change of your property taxes, e.g. 2% annual increase.  Set the 'Number of Payment Periods' to the desired number of months in your projection.  Set the 'Frequency of Payments' to the number of property tax installments per year.  In the case where installments are due at the beginning and end of summer, the correct selection would be "Semi-annual Payments".  The fact that the installments are not due at exact 6 month intervals will have no effect on the result.  Set the 'Periods Between Income Variations' to the number of property tax installments per year, e.g. 2 in this example.  This will ensure that installment amounts are equal during the year.  The other input fields are irrelevant to the result.  Click the 'Results' button.  Your property tax installments are listed in the 'Payment' column.  These results can be used with the 'Variable Cash Flow Analysis' tool to model the the effect of property taxes on rental income.  In the 'Variable Cash Flow Analysis' tool, set the 'Number of Payments/Yr' to 12.  Then, use the calculator ('Calc' button) to subtract the property tax installment from the month in which it is due. For example, if taxes are due Jun 1 and Sep 1, subtract the installments from "Period 5" and "Period 8" of each row.

Is there a way to enter more than 10 expenses in the 'Net Operating Income' and 'Pro Forma Projection' tools?
The current screen design permits a maximum of 10 line items.  To work around the 10 line limit, you might consider consolidating similar expenses such as electricity, water, and gas into a "Utilities" line item.

How can I compare the property's rate of return to a fixed income security rate of return?
A fixed income security such as a CD provides an annual rate of return in percent.  A stock's rate of return is the value of the stock at the end of the year including dividends minus the value at the beginning of the year.  Divide that value by the beginning value and then multiply by 100.  There are a number of tools in The Real Estate Skinny that can provide a picture of your property's future rate of return.  The 'Appreciation or Depreciation' tool is a good way to get a total picture of the property's rate of return.  It includes property value as well as annual income such as rent in the results.  If you want to focus on just the property's income as an investment, use the 'Rates of Return' or 'Variable Cash Flow Analysis' tools.