Commercial Investment Real Estate Winter 2020 | Page 43

5-Year Equity and Effective Loan Rate Unleveraged Investment Cash Flow and 5-Year Yield outlines the deal without financing, in- cluding an upfront investment of $6.63 million. The cash flow meets your in- Equity Investment vestor’s requirements, while the prop- Cash Flow & 5-Year Yield erty IRR remains the same regardless of financing. The second represents the N $ annual financing cash flow, which in- 0 ($1,482,000) cludes the initial loan proceeds, annual 1 $135,616 debt service, and the final loan balance 2 $151,054 repayment in Year 5 of $4.97 million. = The last column shows the investment 3 $166,955 with the 80 percent loan — this rep- 4 $183,332 resents your money. 5 $3,160,780 As you can see, using financing more than doubled the property IRR/ Equity IRR/Yield = 23.39% yield for an equity return of 23.39 per- cent annually, an increase of 13.11 percent from the 10.28 percent property IRR. By making the most of available financing, you’ve positioned your client to more than surpass the initial goals for this multifamily development, while re- ducing the necessary upfront investment. As an experienced, knowledgeable com- mercial real estate professional, you want to be able to deliver this kind of value add to your clients. In this case, you have a cash buyer with the funds to cover With positive the $6 million-plus investment. But with positive leverage, you leverage, you can boost the equity yield, literally dou- bling the returns for your client. Financing Cash Flow and Effective Rate N $ N $ 0 ($6,630,000) 0 $5,148,000 1 $500,000 1 ($364,784) 2 ($364,784) 2 $515,838 3 $531,173 3 ($364,784) 4 $548,116 4 ($364,784) 5 $8,131,734 5 ($4,970,954) + Property IRR/Yield = 10.28% Effective Loan Rate = 5.19% does this mean for your investor? Projecting out five years in the chart below, you can see that cash flow before taxes steadily rises from $500,400 in the first year to $564,984 in Year 5. That’s a nice chunk of change, but your investor was looking for 10 percent annual return. In Year 5, when income is at its high- est, the cash-on-cash return is only 8.52 percent. EXPLORING OTHER OPTIONS But once your investor sells the property after five years, he will bring in another $936,750 above the purchase price. With this, along with the cash flow, the annual property yield (IRR) of the invest- ment reaches 10.28 percent. Let’s look at other options for this investment — namely how a loan could turbocharge returns. Let’s say the investor could get a loan for 80 percent of the apartment complex at 5 percent. (Based on the current 10-year Treasury rate, this is on the high side.) The bank will get 1 percent with 25-year amor- tization and a 10-year term. The initial investment drops considerably, from $6.63 million to $1.482 million. But the overall return more than doubles, to 23.39 percent. The chart above has three columns showing how a proposed deal changes with a loan. The first can boost the equity yield, literally doubling the returns for your client. Todd Kuhlmann, CCIM President/founder of TheAnalystPRO, a CRE Tech Inc. company in Austin, Texas and a senior instructor at CCIM Institute Contact him at [email protected]. Editor’s note: This article was adapted from “Cap Rate and Rent Setting: Analyzing a Proposed Development,” Kuhlmann’s presentation at the 2019 CCIM Global Conference in San Diego, presented with Karl Landreneau, CCIM. 5-Year Cash Flow For the Year Ending Year 1 Aug 2020 Year 2 Aug 2021 Year 3 Aug 2022 Year 4 Aug 2023 Year 5 Aug 2024 POTENTIAL RENTAL INCOME (PRI) $1,012,958 $900,000 $927,000 $954,810 $983,454 - Vacancy / Credit Loss $45,000 $46,350 $47,741 $49,173 $50,648 EFECTIVE RENTAL INCOME $855,00 $880,650 $907,069 $934,281 $962,310 $4,000 $4,080 $4,162 $4,245 $4,330 GROSS OPERATING INCOME (GOI) $859,000 $884,730 $911,231 $938,526 $966,640 - Operating Expenses $343,600 $353,892 $364,493 $375,410 $386,656 NET OPERATING INCOME (NOI) $515,400 $530,838 $546,738 $563,116 $579,984 - Capital Express / Replacement Reserves $15,000 $15,000 $15,000 $15,000 $15,000 $0 $0 $0 $0 $0 $500,400 $515,838 $531,738 $548,116 $564,984 + Other Income - Annual Debt Service 1st Lien CASH FLOW BEFORE TAXES CIREMAGAZINE.COM COMMERCIAL INVESTMENT REAL ESTATE MAGAZINE 41