Every thing we need to calculate these three items is contained within the nine lines of the before-tax cash flow model. Of particular interest are Gross Scheduled Income (line 1), Net Operating Income (line 7), Annual Debt Service (line 8), and Before-Tax Cash Flow (line 9).

 

Before-Tax Cash Flow

1. GROSS SCHEDULED INCOME $

2. – Vacancy & Uncollected Rents – $ ___________

3. = EFFECTIVE RENTAL INCOME = $   

4. + Other Income                              + $___________

5. = GROSS OPERATING INCOME = $

6. – Annual Operating Expenses      – $___________

7. = NET OPERATING INCOME = $  

8. – Annual Debt Service                  – $___________

9. = BEFORE-TAX CASH FLOW  = $ 

Determining the Value of Investment Property

Two commonly used methods of determining the value of an investment property are the Gross Rent Multiplier (GRM) method and the Income Capitalization or Cap Rate method.

Gross Rent Multiplier (GRM)
The investment value of a property can be calculated using the estimated Gross Scheduled Income (GSI) for year one, multiplied by a factor known as the Gross Rent Multiplier (GRM). ("Gross Rents" is just another way of saying Gross Scheduled Income.)

First-year GSI x GRM = Investment value of property
The gross rent multiplier used in evaluating investment property is typically derived from comparable properties in the marketplace and may be adjusted by the investor to reflect his or her specific requirements.

Using the Gross Rent Multiplier to Determine Investment Value
Example:
Suppose a potential buyer's gross rent multiplier (GRM) requirement is 8. (This means the investor will pay no more than 8 times the gross scheduled rent to purchase an investment property.) The property the buyer is considering has an estimated first-year gross scheduled income of $24,000. The investment value, or the amount this investor would be willing to pay for this property, is:

 $24,000 x 8 = $192,000

Pros and Cons in Using a Gross Rent Multiplier:
Pros: The gross rent multiplier is a convenient tool because of its simplicity.

Cons: The usefulness of the gross rent multiplier is limited by the fact that it does not take into account vacancy and uncollected rent, operating expenses, debt service, tax impact, or income past the first year.

Capitalization Rate (Cap Rate)
The value of an investment property can be determined by its ability to produce cash returns. After paying all expenses, except principal and interest payments, the remaining cash flow is called the Net Operating Income (NOI). NOI is most commonly used in conjunction with a cap rate to determine property value.

Cap Rate
The cap rate is the ratio (expressed as a percentage) between purchase price and the first-year net operating income (NOI) of the property.

Determining the Cap Rate of an Investment
Investors use cap rates to measure investment performance:

Net Operating Income (NOI) = Cap Rate
         Purchase Price

Example:
An investment property selling for $200,000 with an estimated first-year NOI of $20,000 would have a capitalization rate of 10%.

       $20,000                     =  0.10  or 10%

          $200,000

Example
Suppose a potential buyer is looking at a property listed for $200,000 with an estimated first-year NOI of $18,400. After looking at the cap rates of similar properties, the buyer has decided on a cap rate requirement of 9.5%. We can use the formula below to determine the purchase price he would be willing to pay.

Cons: The reliability of using a cap rate is limited because it only looks at a one-year forecast and does not take into consideration any financing or tax implications.

Before-tax cash flow =  % Return Initial investment

 

$4,972  (cash)   =  .11  or 11%
                $45,000                         (on cash)

Cons: Cash on Cash does not take into consideration anything past a first-year forecast. It does not take into account tax considerations or any increase or decrease in equity

 Formula: Debt Coverage Ratio (DCR) is determined by dividing net operating income (NOI) by the annual debt service (ADS). Remember, annual debt service is the total principal and interest for all mortgages.

      Net Operating Income     = Debt Coverage Ratio  or NOI =   DCR
    Annual Debt Service ADS

Example: Observe the following cash flow model for Before-Tax Cash Flow.

 

Debt Coverage Ratio   = Net Operating Income                  $18,400 (NOI)    = 1.37 DCR

                 Annual Debt Service                   $13,428 (ADS

What is the before-tax cash flow? ________________

(Bottom line of the before-tax cash flow model)

 What is the gross rent multiplier for this investment? __________
(Purchase price divided by gross scheduled income)

 What is the capitalization rate for this investment? ___________
Net Operating Income (NOI) = Cap Rate
     Purchase Price

 What is the cash on cash return on this investment? ____________
Before-tax cash flow    =  % Return
   Initial investment

What is the debt coverage ratio for this investment? ____________
Net Operating Income     =  Debt Coverage Ratio
 Annual Debt Service

Important Questions to Ask
Gross Scheduled Income

Vacancy & Uncollected Rents

Other Income

 

Annual Operating Expenses
Annual expenses should be broken down into categories. This will assist a buyer and his or her tax professional to properly analyze the property. In addition it makes it easy to enter the expenses on a Schedule E at tax time. The following is a typical breakdown of annual expenses:

· Advertising
· Cleaning and maintenance
· Leasing commissions
· Property insurance
· Legal and other professional fees
· Management fees
· Repairs
· Services (garbage, gardening, pest, pool, landscaping, etc.)
· Supplies
· Taxes
· Utilities
· Other

Annual Debt Service
Remember to include only principal and interest payments; taxes and insurance have already been accounted for under operating expenses.

Review
To reinforce what we have learned so far, we will use the entire cash flow model to answer the following questions: 

Case Study
A ten-unit property is listed for $465,000. It has five 1bd/1ba units rented at $500/month and five 2bd/1ba units rented for $600/month. 

The average vacancy in the area is reported to be 5%. $1,100 per year in other income is expected. Property taxes will be 1.2% of sales price/year. Insurance will cost $1,800/year. Maintenance averages $2,500/year. Total utilities will cost $2,600/year. Total services will cost $5,000/year. Property management will cost 7% of Gross Operating Income. Buyer will pay one point for 80% financing at 7.5% fixed rate amortized over 30 years with annual P&I payments totaling $31,213. Closing costs will be 1.5% of sales price. Mortgage interest for year one will be $27,784. Cost recovery will be $13,158. Annual points amortization will be $124.00. Use 28% as the investor's tax bracket.

1. GROSS SCHEDULED INCOME $

2. – Vacancy & Uncollected Rents – $ ___________

3. = EFFECTIVE RENTAL INCOME = $   

4. + Other Income                              + $___________

5. = GROSS OPERATING INCOME = $

6. – Annual Operating Expenses      – $___________

7. = NET OPERATING INCOME = $   

8. – Annual Debt Service                  – $___________

9. = BEFORE-TAX CASH FLOW  = $ 

Tax Aspects of Cash Flow

10. NET OPERATING INCOME (LINE 7) $

11. - Interest (Mortgage 1) - $

12. - Interest (Mortgage 2) - $

13. - Points Amortization - $

14. - Cost Recovery (Depreciation) - $____________

15. = REAL ESTATE TAXABLE INCOME = $

16. x Investor's Tax Bracket x %___________

17. = TAX LIABILITY OR (SAVINGS) = $

After-Tax Cash Flow

18. BEFORE-TAX CASH FLOW   (LINE 9) $

19. - Tax Liability or (Savings)   (line 17) - $____________       + or (-)

20. = AFTER-TAX CASH FLOW = $

What is the total initial investment?________________
(Down payment plus closing costs plus points.)

What is the before-tax cash flow? ________________
(Line 9 of the cash flow model)

 What is the gross rent multiplier for this investment? __________
(Purchase price divided by gross scheduled income)

What is the capitalization rate for this investment? ___________

Net Operating Income (NOI) = Cap Rate
       Purchase Price

What is the cash on cash return on this investment? ____________

Before-tax cash flow =  % Return
   Initial investment

What is the debt coverage ratio for this investment? ____________

Net Operating Income     =  Debt Coverage Ratio
  Annual Debt Service

What is the after-tax cash flow for this investment? _____________
(Bottom line of the after-tax cash flow model.)

Information contained on this page provided by  Wandering Star, with permission.