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 pretax or in
terms of its aftertax 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 aftertax 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 "Semiannual
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.
