Four (4) Factors in Investment Definition: Investment

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1 Introductions Your name Where you work Your job responsibilities How long you have been in the industry What you hope to get from this class Chapter 1: Investments Agenda 2 Investments Adding Value to the Investment Economic Analysis of a Property Budgets Property Valuation 3 4 Four (4) Factors in Investment Definition: Investment An investment is the use of funds to earn a profit. We will discuss: - What are investments and whether to make them - Advantages and disadvantages of investing in multifamily housing - Different types of ownership and methods of financing 5 Risk low risk = low return high risk = high return Income may depend on risk involved Growth means a potential to increase in value >NOI = greater value Liquidity - ability to convert to cash 6 1

2 Owner s Objectives Why is it important to know the owner s investment objectives for the property you manage? Activity #1: How the Four Factors Affect Investments How do general economic and market conditions affect investments? Why is it important to know the owner s objectives for the property you manage? 7 8 Performance Measures Rate of return on investment (ROI) Cash-on-cash return Capitalization rate Internal rate of return (IRR) ROI Rate of return on investment = performance measure used to evaluate the efficiency of an investment Return can be cash, cost to manufacture vs. price, appreciation growth or some other benefit compared to cost Benefit/Cost = Return 9 10 Capitalization Rate NOI/Purchase Price = Cap Rate NOI/Cap Rate = Value Exercise We paid $7,000,000 for a property and the NOI is $500,000. What is the cap rate? Divide NOI by 6%

3 Remember Lower cap rate = higher value Higher cap rate = lower value Advantages of Investments Advantages include: Periodic cash payments Potential for increase in value Reduction in income taxes due to depreciation Ability to invest using borrowed funds Disadvantages of Investments Disadvantages include: Real estate is not a liquid asset Active participation is often required Potential for risk (natural disasters, changes in market conditions) Forms of Ownership Direct ownership/sole proprietor Limited liability partnership Limited liability corporation S corporation Joint venture Real Estate Investment Trusts (REITs) Tenants in Common (TICs) Types of mortgages Fixed rate Variable rate Balloon Bullet loan Where to obtain a mortgage Commercial banks Finance companies Savings and loan institutions Insurance companies Pension funds Mutual funds Federal government (Freddie Mac, Fannie Mae)

4 Skill Check #1 Chapter 2 Chapter 1- Investments Adding Value to the Investment Adding Value: CAM Responsibilities 1. Generating and collecting as much income as possible 2. Controlling expenses 3. Meeting the financial goals of the investment Additional ways to add value: Reduced staff turnover and lower personnel costs Reduced resident turnover with better customer service Aggressive rental rates set by unit type New income sources through resident services Better collection of resident charges Sources of Income Rent Administrative Fees Parking/Garage fees Pet fees Laundry room/ Vending Late fees/collection fees Clubhouse rental/ video rental Car wash Cable/Internet/ Phone Types of Expenses Maintenance Administrative Salaries/Personnel Taxes Insurance Utilities Contract services Advertising and Marketing

5 Three Factors That Affect Rental Income Competitive rental rents Physical occupancy Collection percent or economic occupancy Concession Impact Market rent = $700 Concession = one month rent What is the Effective Rent? Law of Supply and Demand If the demand is high and the supply is low, higher prices can be obtained. If demand is low and the supply is high, rents must be made competitive to attract residents. Economic Conditions Population growth Household formation Job creation Balancing Rental Rates and Vacancies The goal is to maximize income, not occupancy Pricing too high may cause longer vacancy Pricing too low means you are losing money while the unit is occupied Increasing Rental Rate Market value = $800 Raise rent 10% = $880 Vacancy = 15 days What is the cost of the vacancy? At the new rate, how long before you recover the vacancy loss?

6 Lowering Rental Rate Market value = $800 Lower rent 10% = $720 Loss per month = $80 Loss per year = $960 What would you lose if you did not lower the price and the apartment sat vacant for a month? Before adjusting rent, analyze the four P s: People Product Promotion Price Determining Pricing Conduct a market analysis Use an automated revenue management system When to Consider a Rent Increase When any floor plan remains 95% or more occupied or that remains full even when the community turnover ratio averages below 55% When rents fall below levels indicated by a comparative rent analysis Anytime a community is full Upon owner request Rental Increases: Current residents Increase rent as leases expire, OR Increase rent selectively on expired leases using a quantifiable, non-discriminatory standard (years of residence or number of previous renewals) Consider a renewal rate that is slightly lower than the new market rate as an incentive to stay Provide 60 days notice prior to the effective date of the increase Managing Occupancy: Reports Occupancy reports Rent roll Delinquency report Deposit/Income reports Concession report Demographics report

7 Managing Occupancy: Methods Calculate occupancy trend Manage lease expirations Calculate turnover ratio Activity #2: Adding Value Expenses Fixed property taxes, insurance Variable utilities, turnover costs, etc. Capital- appliances, HVAC, etc. Replacement Reserve Account Debt service Cost Benefit Analysis Potential Expense Dollars Time Image Potential Benefit Income Time Employee satisfaction Market position Image Accounting Practices Budget control log Invoices Purchase discounts Check request or payment vouchers Petty cash Resident records Resident security deposit Collection of former resident accounts Skill Check #2 Chapter 2: Adding Value to the Investment

8 Chapter 3 Economic Analysis Economic Analysis of a Property Balance Sheet When analyzing a property, ask - How well has a property performed over a specific time period? - Where does a property stand at a given date in time? May 31, 2010 ASSETS Petty Cash Cash Cash Fund Prepaid Insurance Building 16,350,000 Less Depreciation 885,000 Building Net Land Furniture & Equip 400,000 Less Depreciation 100,000 Furniture & Equipment Net Escrow Total Assets LIABILITIES Accounts Payable Notes Payable Accrued Interest Payable Accrued Property Tax Security Deposit Liability EQUITY Partners Equity Distributions to Partners Prior Period Earnings Current Earnings Total Equity Rental Income Other Income (Fees, Vending, Utilities) Vacancy & Collection Loss Effective Gross Income ,055 7,700 Operating Expenses Fixed Expenses Real Estate Taxes Insurance Variable Expenses Payroll Repair & Maintenance Utilities Contract Services Administrative & General Management Fee Advertising & Leasing 15,465,000 3,750, , ,000 19,534,055 55,000 12,275, , ,000 96,000 13,485,700 9,010, ,500-2,544,500 15,000 6,048,355 Total Operating Expenses Net Operating Income Other Expenses Interest Replacement Reserves Total Expenses Cash Flow 45 $19,450,000 1,815,000-97,500 $21,362,500 $1,268,000 97, , ,800 1,636, , , , ,000 $4,737,500 $16,625, , ,000 1,112,000 5,849,500 15,513, ,534,055 Accounting Methods Cash Flow Accrual- records all income and expenses in period they were earned or incurred, regardless of when received or paid Cash- records all income and expenses when they are actually received or paid The amount of money left after all sources of income are collected and operating expenses, capital expenses and debt service have been paid Often referred to as the operating statement

9 Gross Potential Rent (GPR) Current rent charged at 100% occupancycombines the sum of occupied units at current lease rents plus vacant units at market rents 100% of possible income All other income and expenses measured and evaluated as % of GPR Market Rent Total annual income received if 100% of all units were occupied and paying market rents Loss to Lease Variance between market rent and lease rent Market rent that is lost due to lease rents at rates lower than the market rate For many companies it is a separate line item on the operating statement Loss to Lease Example Annual market rent of $1,375,025 with a loss to lease of $125,700 has a loss to lease of 9.1% 125,700/ 1,375,025=.0914 or 9.1% GPR of $1,249,325; market rent of $1,375,025 less loss of $125, Vacancy, Concession, and Collection Loss (VAC) Total value of rent loss from vacant units, concessions given, collection losses from bad debt write-off, rent loss from nonrevenue units Standard for uncollectible/bad debt- 2% of GPR VAC can be higher than10% of GPR Effective Gross Income (EGI) GPR less vacancy, concessions, and collection loss. Also called net rental revenue or total rental income Represents all rent and only the rent income at the property GPR-VAC= EGI

10 Other Income (OI) Income from items other than rent Laundry, cable, parking, amenity charges, pet fees, application fees, administrative fees, lease premium fees, late fees Fee policies established by owner or manager Up to 10% of GPR- NAA survey in % of GPR or $753 per unit Gross Operating Income (GOI) EGI + OI = GOI Property s total revenue Available to pay property s operating expenses, capital improvements, and debt service Operating Expenses (OE) All expenses fixed and variable incurred in the course of managing the property Controllable and uncontrollable expenses Capital expenses and reserve for replacement costs are not typically considered operating expenses Net Operating Income (NOI) GOI-OE=NOI Applying cap rate to NOI allows you to determine property value using the income approach Operating Expense Ratio Expense to income ratio Evaluation tool to measure property performance and expense control % of GPR used to pay operating expenses Ratio depends on age, location, property type, and expense classification OE/GPR= operating expense ratio 2010 NAA survey showed national OE ratio of 40% Capital Expenses (CE) Also called capital improvements Includes non-recurring expenditures like appliances, roofing, carpet replacement, etc. intended to add to the life of the property and its fixtures Offer ability to depreciate over time

11 Debt Service Mortgage or loan payment- principal and interest payment Fixed rate mortgages usually have level monthly payments that amortize the loan Break-even Occupancy Ratio (OE + DS) GOI 1,803,800 +1,278,000= 3,081,800 3,081,800 4,359,000 = 71% Break-even Rent Per Sq. Ft. (OE + DS) total square feet $1,803,800 + $1,278,000= $3,081,800 $3,081, ,000 = $4.05 Cash Flow Calculation Gross Potential Rent (GPR) -Vacancy, Concessions, collection losses (VAC) = Effective Gross Income (EGI) + Other Income (OI) = Gross Operating Income (GOI) - Operating Expenses (OE) = Net Operating Income (NOI) - Capital Expenses (CE), Reserve Payments (RR), and Debt Service (DS) = CASH FLOW Activity #3: Cash Flow Calculate the cash flow of the NAA Apartments The General Ledger Provides more detail of major financial statements Chart of Accounts Know cut-off date for invoices to be submitted

12 Skill Check #3 Chapter 3: Economic Analysis of a Property Chapter 4 Budgets Purpose of a Budget To estimate expected income and expenses to determine what occupancy levels will be needed to cover expenses and provide a return on investment To monitor the property s performance To evaluate performance of personnel Lease-up Budget Special attention paid to activities and costs associated with attracting residents, signing leases and generating income Information used for projecting expenses depends on your and your supervisor s previous experience Modernization Budget Reflects larger allocations for capital expenses and labor Must be flexible if the work is dependent on contractors schedules and vendors supplies May include periods of no rental income while work is being done in part or all of the building May be prepared separately from the operating budget of a property and be for a short time only Stabilized Operating Budget Reflects varying expenses from month to month Examples: Utilities for heating would be higher in winter months Utilities for cooling would be higher in summer months Snow removal would be posted only for winter months

13 Tips for Developing Budgets Use round numbers Use current figures Prepare early Seek input Extrapolation/Annualization CAM Responsibilities Managing the budget Analyzing variances Explaining variances Recommending action Activity #4: Review a Budget Identify figures that may point to extraordinary conditions or needs. Skill Check #4 Chapter 4: Budgets Chapter 5 Property Valuation Property Valuation The process of determining the value of a property in order to make financial decisions regarding the property

14 The Cost Approach Estimates the current cost of reproducing or replacing the improvements, minus the loss in value from depreciation due to age, condition or obsolescence, plus land value Important when there is no market activity and a sales approach cannot be used to value a property The Sales Comparison Approach In this approach, the market value of a property is directly related to the prices of comparable competitive properties Most useful when there are several similar properties in the local market that have been recently sold or are currently for sale The Income Capitalization Approach This approach uses methods, techniques and math procedures to analyze a property s ability to generate income and convert future earnings to present-day dollars Capitalization Value = NOI/Overall capitalization rate Skill Check #5 Chapter 5: Property Valuation 83 14