When analyzing a real estate investment, many financial projections must be made. The assumptions in these calculations often mean the difference between an enduring career in this industry or a gut-wrenching loss. Nearly every assumption matters to some degree, and the accuracy of these numbers, based on market statistics, is critical, so don’t gloss over any assumption. If there are one or many unknowns, then stress testing your return performance for these variables is a must.
Over the years, I have come to focus first on three primary figures that are of the utmost importance in my property financial analysis. Before getting excited about an Internal Rate of Return (IRR) that looks acceptable, you should review the Debt Service Coverage Ratio (DSCR), defined as the ratio by which the Net Operating Income exceeds the total Debt Service payment. NOI / DS = DSCR. For example, $120k NOI / $80k DS = 1.5 DSCR. To properly evaluate this, you must know what DSCR is required for the different types of loans you may be eligible for in the current lending environment. Since real estate investors seek cash flow over at least a portion of the holding period, a 1 DSCR is quickly a red flag of high risk for further review. It can show that the investment's potential upside hinges on loan markets loosening, the revenue increase, operating expense savings surpassing your projection (light value-add), and likely a combination of these. At a minimum, it highlights the need to raise enough upfront capital for operations or a higher capital reserve over a specified period, such as a lease-up or a renovation timeframe. Often loans require a 1.2 to 1.35 DSCR. Failing to meet this number can have severe repercussions, such as a springing guarantee by the borrower or increased cash reserve requirements. If your projected DSCR is equal to the loan requirement, there is little room for your other assumptions to be incorrect before some of these negative loan terms are triggered. Also, remember that an elevated debt coverage ratio brings the bank's allowable loan value down on the property. For example, in the current market of January 2023, Freddie Mac and Fannie Mae are requiring between 1.25x to 1.35x DSCR. Because of the elevated interest cost, the maximum allowed loan cost can reduce to 55% to 60% of the property value.
Following a first glance at the after-debt IRR and debt coverage, I look at the Cash-on-Cash return (CoC). This ratio considers the leverage on the property and the equity investment. This ongoing cash flow is often a driver for investing in commercial real estate; therefore, it must meet your investors' expectations. A good annual return often makes the investor timeframe more flexible to holding through adverse market conditions. If this number is below the required return, further investigation is required of the assumptions of all income, debt, and expenses. Every line item will affect the CoC Return. If this figure greatly exceeds expectations, it also cautions that you may be overly ambitious in your assumptions of revenue, expenses, and timeframes. The return sought will differ based on different investors, property types, risk levels, and alternative investment returns. The Cap Rates acceptable to Institutional investors in Class A properties hit record lows during the post-pandemic boom, sub 3.5%. And with this drastic move lower in Cap Rates, the CoC moved in lockstep along with it. Whether a 6% or a 12%+ CoC is needed to get investors interested in the deal depends on their specific situation and the current market. Today the five-year Treasury is approximately 3.61%, and index funds are mostly in the .75% - 1.75% range.
With the DSCR and the CoC meeting the investment requirements, I focus on the Internal Rate of Return for this investment. Distributions often happen monthly or quarterly; therefore, the timing of these must be considered in IRR calculation. The excel formula for this is XIRR which needs dates for the timing of the cash flow. A significant factor for the IRR comes from the projected disposition cap rate. This may be the greatest variable in your analysis because your holding period may change as disposition decisions adjust to market selling conditions. Any changes in duration can greatly affect the IRR. This means that you may hold the property for longer than originally projected in expectation of future lower cap rates, further emphasizing the need for strong DSCR and CoC. If you achieve the desired disposition cap rate in a shorter-than-projected hold period, the IRR will drastically improve, showing the power of the Time Value of Money. In addition, an Internal Rate of Return can be calculated on unleveraged and leveraged, considering debt. In a development analysis, I aim for a proforma with a leveraged IRR of 16%+ to proceed with the required work and risk of developing a project. For an investment purchase that is cash-flowing from the acquisition date, a lower IRR may be acceptable. But the critical thing to remember is to perform risk and sensitivity analysis for different income, expense, and time assumptions.
There are, of course, many more aspects of a proforma financial analysis to consider for every investment, and I will attempt to cover these in articles to come.