The good news – real estate cash flows are easier and much more intuitive than traditional financial statement construction and analysis. But, just because it is simple does not mean it is unimportant. Setting up your real estate cash flow is the first step to much more complicated real estate analysis and to more sophisticated performance measurement and asset management techniques. Let us look at what a real estate cash flow is, how to utilize it in your analysis and some potential pitfalls and concerns.
What is a RE Cash Flow? The Formula
At its most basic, a real estate cash flow simply shows the cash inflow and cash outflow generated by your investment. A real estate cash flow statement for real estate can be thought of as similar to the three main financial statements used in traditional financial analysis (i.e. Balance Sheet, Income Statement, Cash Flow Statement) but there are some differences. Most notable, the three main financial statements are often constructed with a set of rules determined by applicable accounting standards – GAAP or IFRS. Real Estate cash flow statements are less stringent. Here are the typical components for a real estate cash flow:
Operating Revenue – Operating Expenses = NOI – Capital Expenses = Before Tax Cash Flow (unlevered) – Debt Service = Before Tax Cash Flow (levered)
Depending on the analysis and purpose, you will often see the cash flows associated Purchase and Sale to get the full picture. Thusly:
Operating Revenue – Operating Expenses = NOI – Capital Expenses – (Purchase Price + Sale Price) = Before Tax Cash Flow (unlevered) – Debt Service + (Debt Proceeds At Purchase – Principal Repayment At Sale) = Before Tax Cash Flow (levered)
Now that you have a formula to use, I suggest we simplify it. One of the benefits of real estate analysis is that it is (typically) simpler than many other financial disciplines. Let us not lose that. Below is the above formula but stated in less “formulaic” terms:
Real Estate Has Six Basic Components That Impact Your Cash Flow:
Rent, Expenses, Capital Costs, Debt, Purchase, Sale.
That is it. All your estimations, assumptions, guess, and tea leaves can be summed up into one of those components. For more about each component, check out this article.
If that is all you need to buttress your understanding…then, by all means, stop reading. For those that would like additional color, we can keep exploring.
Cash Is King (excluding non-cash items)
In real estate, cash is king. This is what we care about. Now, in a more academic setting you may hear that “capital investment decisions should be made on a cash basis” but basically that just means we care about cash.
Depreciation is not cash. It is a non-cash item used amortize the value of an asset over its useful life. Let the accountants and CPA’s concern themselves with depreciation (more so, because despite accounting treatment, the value of your investment will hopefully appreciate, not depreciate).
For real estate cash flow analysis, do not include or concern yourselves with non-cash items. Also, our concern is when that cash impacts our bank accounts. In accounting terms, we are concerned about cash (and not accrual) -accounting.
Above The Line and Below The Line
Above the line and below the line are concepts that refer to components or “line items” in the cash flow. So, that begs the question – “where is the LINE”. The Line refers to NOI, the Net Operating Income. The Net Operating Income is a key component in real estate for various performance metrics and benchmarking. It is “unsullied” by debt or capital decisions and one-time fees or expenses and thus seen as a good indicator of operating performance. As such, items are often referred to relative to NOI. Items above-the-line would impact NOI. Items below the line are AFTER the NOI calculation. So, “Is that above the line or below the line?” = “Does that impact NOI or not?”.
What About Taxes?
Ahhh, the CPA’s have entered the discussion again. In one school of thought – tax treatment (here we are referring to income and capital gains tax and not real estate property taxes which are usually an expense treated above-the-line) is particular to the individual/ownership entity and related structures and thus not necessarily a consideration when analyzing the relative risk and potential returns of the real estate asset, itself.
I have always seen that as a bit of a “cop out” and will contribute the following:
- Remember to keep it simple. Keep tax analysis and treatment away from the initial assessment of real estate investments and when looking at relative performance. (Typically, and most conservatively) If deal does not work before tax implications, it likely won’t after tax. If the deal is only a go because of your particular tax treatment, then you are not focused on real estate investment but other mechanics.
- However, a thorough tax analysis and assessment of your situation should be made and known to you prior to undertaking any considerable financial investment. A proper investment memo should address tax considerations somewhere in the document.
- There are always exceptions to the rule #1. Tax implications of real estate to the small investor, indeed, is one of the big advantages. You SHOULD understand basic treatment of long-term capital gains, recapture, 1031’s Exchanges, interest expense tax deductibility and the like. More sophisticated investors who utilize low-income-housing-tax-credits (“LIHTC”) or other such strategies, should be aware of the mechanics. But, even under these scenarios, it should be said that your priority is to understand the cash flow being generated from the real estate asset. Full stop. That is the first hurdle.
What Can I do With A Real Estate Cash Flow?
At this point, you should have a solid understanding of real estate cash flow construction in real estate analysis. You also know that cash is king in real estate and to risk saying the obvious…you care how much cash your real estate asset generates.
A real estate cash flow is central to real estate analysis. Real estate cash flows are created to generate a complete picture of your real estate asset. Most of your performance metrics or key performance indicators (“KPI”s) are derived from your cash flow. As you progress with your due diligence, your cash flow is updated with the latest assumptions and the impact to your cash flow is observed and analyzed. Real estate assets are benchmarked and compared to each other via these various KPI’s. Your real estate cash flow tells a story about all of the inputs that contribute to (or take away) from that all-important bottom line – cash to the investor. It is the complete picture…or at least your well-researched opinion of what may be the complete picture.
Consider taking it a step further by using tools like Money Weighted to create accurate cash flow models in just a few minutes.