# cash flow and 36 other financial metrics: chapter 4

**How to Estimate What an Income Property Is Really Worth**

Whether you’re a buyer, a seller, or a mortgage lender, one of the most important questions you need to answer is, “What is this property really worth?” It may be argued that value, like beauty, is in the eye of the beholder. This argument tends to ring true in regard to single-family homes, where conventional wisdom has always held that a house is worth what someone is willing to pay for it. Income-producing property, however, is different. Value is determined by the numbers. The owner of the Yankees may admire a batter’s graceful swing, but he pays for that player’s batting average. Let’s begin this discussion with a subject that always warms your heart: income. Everyone in business or finance has encountered the term “net income” and understands its general meaning (i.e., what is left over after expenses are deducted from revenue). With regard to investment real estate, however, the term “net operating income” (NOI) represents a minor variation on this theme and has a very specific meaning. You might think of NOI as the number of rands a property returns in a given year if the property is purchased for all cash and if there is no consideration of income taxes or depreciation. By more formal definition, it is a property’s gross operating income less the sum of all operating expenses. You saw these terms in Chapter 2, but they’re critical to your understanding of virtually everything that follows. Let’s review them briefly:

- Gross operating income. Definitions are like artichokes. You need to peel the layers off one at a time. In this case, start with the gross scheduled income, which is the property’s annual income if all space were in fact rented and all the rent actually collected. Subtract from this amount an allowance for vacancy and credit loss. The result is the gross operating income. Gross Scheduled Income−Vacancy & Credit Loss=Gross Operating IncomeGross Scheduled Income−Vacancy & Credit Loss=Gross Operating Income
- Operating expenses. This is the term that causes the greatest mischief. Many people say, “If I have to pay it, then it’s an operating expense.” That is not always true. To be considered a real estate operating expense, an item must be necessary to maintain a piece of a property and to ensure its ability to continue to produce income. Loan payments, depreciation, and capital expenditures are not considered operating expenses. For example, utilities, supplies, snow removal, and property management are all operating expenses. Repairs and maintenance are operating expenses, but improvements and additions are not—they are capital expenditures. Property tax is an operating expense, but your personal income tax liability generated by owning the property is not. Your mortgage interest may be a deductible expense, but it is not an operating expense. You may need a mortgage to afford the property, but not to operate it. Subtract the operating expenses from the gross operating income, and you have the NOI. Gross Operating Income−Operating Expenses=Net Operating IncomeGross Operating Income−Operating Expenses=Net Operating Income

Why all the nitpicking? Because NOI is essential to your understanding the market value of a piece of income-producing real estate. That market value is a function of the property’s “income stream,” and NOI is at the core of that income stream. As unfeeling as it may sound, a real estate investment is not a handsome assemblage of bricks, boards, bx cables, and bathroom fixtures. It is an income stream generated by the operation of the property, independent of external factors such as financing and income taxes. Investors don’t decide to buy properties; they decide to buy the income streams of the properties. This is not such a radical notion. When was the last time you chose a stock based on the aesthetics of the stock certificate? (“Broker, what do you have with a nice mauve filigree border?”) Never. You buy the anticipated economic benefits. The same is true of investors in income-producing real estate. Those readers who have not yet been lulled to sleep by this discussion will alertly point out that they have in fact observed changes in the value of income property brought about by changes in mortgage interest rates and in tax laws. Doesn’t that observation contradict our assertion about external factors? If you’re familiar with the concept of capitalization rate (which we’ll discuss again below), you recognize that there are two elements to a property’s value equation: the NOI and the cap rate (universal shorthand for capitalization rate). The NOI represents a return on the purchase price of the property, and the cap rate is the rate of that return. Hence, a property with a R1,000,000 purchase price and a R100,000 NOI has a 10% capitalization rate. However, the investor will purchase that property for R1,000,000 only if he or she judges 10% to be a satisfactory rate of return. What happens if interest rates go up? In that case, there may be other opportunities competing for the investor’s capital—bonds, for example—and that investor may now be interested in this same piece of real property only if its return is higher, say 12%. Apply the 12% cap rate (PV = NOI / Cap Rate), and now the investor is willing to pay about R833,000. External circumstances have not affected the operation of the property or the NOI. They have affected the rate of return—the so-called market cap rate—that the buyer will demand, and it is that change that impacts the market value of the property. In short, the NOI expresses an objective measure of a property’s income stream, while the required capitalization rate is the investor’s subjective estimate of how well his or her capital must perform. The former is mostly science, subject to definition and formula, while the latter is largely art, affected by factors outside the property, such as market conditions and federal tax policies. The two work together to give you your estimate of market value.

**Cash Flow and Taxable Income**

So far, our discussion has focused on the meaning of NOI—what it includes, what it does not include, and what significance it has to your understanding of the worth of an income property. As Figure 4.1 shows, the topics of cash flow and taxable income are natural extensions of NOI.

When you look back at a year of operating your property, a reasonable question for you to ask is, “How much did I make this year?” The answer lies in a review of the property’s cash flow and taxable income.

NOI is the starting point of our discussion here. Once you know the property’s NOI, you branch off in one direction to figure its taxable income and in another to figure its cash flow.

As you’ll see shortly, these two branches eventually reconnect to give you your true bottom line. First, let’s look at these two branches to see how they differ.

**Taxable Income or Loss**

Both branches start with NOI. Remember that mortgage payments play no part in the NOI calculation, so it is now, below the NOI line, that you will at last take financing into account.

When you make your taxable income calculation, you can deduct only the interest portion of the loan payments. Likewise, if you earn interest (on your escrow account, for example), you must add that back into your income.

You also make deductions for depreciation and amortization. When you purchase a piece of investment real estate, you can’t just deduct its full cost immediately as an investment expense. Instead, you can deduct each year a portion of the value of the depreciable asset, until finally you have written off the entire amount. With real estate, you are allowed to treat the physical structures (i.e., the buildings) as the depreciable asset for tax purposes, but not the land.

(An editorial aside: The author, having learned the commercial real estate business in the Pleistocene Age, still uses the traditional term “depreciation.” In the Modern Age of unrelenting political correctness, you will frequently find this same concept referred to as “cost recovery.” Congress, ever the subtle wit, no doubt became uncomfortable with an economic term that conveyed the notion of unremitting decay and collapse and chose to replace it with one that conveyed a sense of a rise-from-the-ashes return to health and well-being. No political agenda here, of course. It is interesting to note that Congress could not let go of the term “depreciation recapture,” which seems to conjure up subliminal images of the taxpayer as escaped convict, once again ensnared.)

At this writing, you can depreciate a residential income property over 27.5 years and a nonresidential property over 39 years. Since not everyone buys or sells on the first of the month, the tax code tries to even matters out with a so-called half-month convention, which allows the taxpayer to claim only half the normal amount of depreciation in the month that the property is placed in service and half in the month when it is sold. Of course, the authors of the tax code could have made matters more precise by simply asking you to prorate your partial month of depreciation, just as your bank does with per diem mortgage interest when you buy or sell. But they didn’t.

Another item that affects your taxable income is amortization. It is important to understand that the term, as used here, does not refer to the principal portion of a loan payment. Instead, it refers to the process of taking a partial annual tax deduction for an item you are not allowed to expense in a single year. A good example of a cost that must be amortized is the premium you pay for securing a loan, commonly called “points.” You typically pay this premium in one lump sum on the day you close the loan, but you must amortize it over the life of the loan. So, if you take out a 240-month investment-property loan for R720,000 that requires payment of 2 points (2%, or R14,400), you can deduct R60 per month, or R720 for each full tax year. You may also earn some interest income on your property bank accounts or on an escrow account that your lender may require for real estate taxes and insurance.

To review, your taxable income is your NOI less interest payments, less your allowable write-offs for depreciation and amortization, plus any interest earned (Figure 4.2).

**Cash Flow Before Taxes**

Cash flow is even more straightforward. As we suggested in the Introduction, think of it as your property’s checkbook. It is everything that comes in less everything that goes out. By starting with NOI, you have already accounted for all the rent revenue, credit losses, and operating expenses. Where else do you spend or receive money?

You make mortgage payments, and now you can count the entire payment amount. You may also make capital improvements to a property. An improvement prolongs the life of a property. It’s different from a repair, which maintains, rather than increases, that life expectancy. The cost of the improvement affects your cash flow as soon as you spend the money, even though you may typically have to write it off over 27.5 or 39 years.

Again, here you may earn interest income on your property bank accounts, which also adds to your cash inflows.

The short version of our discussion now boils down to this (Figure 4.3): To derive your property’s taxable income, you take its NOI, subtract everything that is properly tax deductible, and add any nonrental income such as interest. To calculate its cash flow, you take its NOI and subtract everything that was actually spent but not already accounted for in the NOI computation itself. Again, add any nonrental receipts.

**FIGURE 4.3 Cash flow before taxes.**

Cash flow and taxable income are closely related but still have important differences. Cash flow is real. Money comes in; money goes out. You earnestly hope the difference will always be a positive number, and if it is, you can take it with you; you can even spend it.

With all due respect to the considerable industry that is built around tax planning and preparation, taxable income is not quite so real. It’s whatever the tax code du jour says it is.

If tomorrow the House of Representatives should decide that the useful life of commercial real estate ought to be 100 years instead of 39, then your property’s taxable income will rise without your experiencing a single additional dollar in rental income. Why? Because the longer write-off period would mean smaller annual deductions for depreciation, and fewer deductions mean higher taxable income—despite the fact that your gross and net incomes remain unchanged.

Likewise, if mortgage interest were no longer deductible, the effect of the mortgage payment on your cash flow would remain unchanged, but the effect of the lost deduction would be to increase your taxable income and hence your taxes.

**Cash Flow After Taxes**

All this talk of deductions brings you to the fulfillment of an earlier promise, to reconnect the two branches of our diagram. Up until now, we have been discussing cash flow before taxes (CFBT), but a more meaningful bottom line to you as an investor may be cash flow after taxes (CFAT, Figure 4.4).

While taxable income is a somewhat artificial notion, the tax liability it provokes feels very real indeed. Taxable income creates one last cash flow item: income tax, which must be subtracted from your CFBT to give you your bottom line, CFAT.

Again, recall our discussion in the Introduction of the four ways to make money in real estate. Your taxable income may be negative as well as positive. If it is negative, then it may actually result in a negative tax liability and can increase your CFAT by sheltering other earnings.

**A Case Study**

A comprehensive example will demonstrate how all these numbers interact. For readability, let’s make projections that go out just five years. If you would like to work out any of the calculations in longhand, you’ll find forms for taxable income and cash flow in their respective chapters in Part II.

In this analysis, you plan to acquire a small strip shopping center for R1,250,000. Your cavalier attitude toward debt leads you to take on three mortgages. The first mortgage is for R720,000 with an interest rate of 8% for 20 years. You must pay 2 points (R14,400) to secure the loan. The second mortgage is a 10-year note for R100,000 at a fixed interest rate of 9%. It also requires 2 points (in this case, R2,000). The third loan is from the seller for R10,000, interest only, at 10% fixed and due to mature in 10 years. It requires a single interest-only payment annually until then.

For purposes of calculating depreciation, you look at the municipal tax assessments for the land and the building and conclude that 72% of the property’s value lies in the building and the remainder in the land. Therefore, you judge, reasonably enough, that the amount that can be depreciated is 72% of the R1,250,000 purchase price, or R900,000.

The property has an annual gross scheduled income of R208,200 and annual operating expenses of R40,900 for the first year of your projections. You expect both income and the expenses to increase at a rate of 2% per year. You leave an allowance of 3% for possible vacancy and credit loss.

Sorry to get personal, but we also need to know your marginal tax bracket (that is, the rate at which your next dollar of income will be taxed). You whisper it to us discreetly, but we publish it here for the world to see: 28%.

Now you can begin to sort out all this information. What is the NOI for years 1 through 5?

In the first year, your property’s gross scheduled income is R208,200. From that amount you subtract a 3% allowance for vacancy and credit loss to get the gross operating income. Next, you subtract R40,900 in operating expenses to find a first-year NOI of R161,054.

To calculate the NOI for the next four years, you’ll first need to increase the gross scheduled income by 2% for each year. Once you have done so, you can then compute the vacancy and credit allowance, which is 3% of each year’s scheduled gross. After that, figure out the operating expenses by taking the first-year amount of R40,900 and increasing it 2% per year (it’s that old compound interest again). Finally, subtract the expenses from the gross operating income to get your NOI.

All that was easier to do than to say. Now, from the NOI, you can follow the first branch of our diagram, which calculates the taxable income. Before you do the math, look at a more detailed representation of that branch:

**NET OPERATING INCOME** – Interest, 1st Mortgage – Interest, 2nd Mortgage – Interest, 3rd Mortgage – Depreciation, Real Property – Amortization of Points, 1st Mortgage – Amortization of Points, 2nd Mortgage – Amortization of Points, 3rd Mortgage

- Interest Earned
**TAXABLE INCOME**

From your NOI, you subtract anything that is tax deductible. Mortgage interest falls into that category, so you subtract the interest from each of the three mortgages. Depreciation, even though it is not cash out of pocket, is also deductible. Similarly, you can deduct a portion of the points you paid to obtain each mortgage. If you had income that was not from rent—typically, interest earned on the property’s bank or escrow accounts—that interest needs to be added in as additional income.

(A shameless self-promotion: If you go to realdata.com, you can purchase software that performs calculations like these and produces elegant presentations. This fact absolutely does not excuse you from reading the rest of this book, however. No amount of automation will benefit you if you don’t first get a grip on the basic formulas and techniques presented here.)

Now let’s look at this same list with the amounts calculated and filled in:

In regard to the mortgage interest paid out each year, there are several ways to calculate the amount manually or with Microsoft Excel (see Part I, Chapter 3, and Part II, Calculations 28 through 30). You can also download a loan amortization schedule to create a table that will show monthly and annual principal and interest (see http://www.realdata.com/book).

Note, however, that one of the mortgages is not amortized. The third mortgage in this transaction is interest only, paid annually

cash **Flow will increase every year.**

To arrive at your final result, you must estimate your income tax liability to determine your CFAT. Although the calculation of potential income tax liability can involve complexities such as passive loss limitations and suspended losses, this case study maintains a straightforward approach. As demonstrated in Figure 4.4, refer back to the taxable income calculation in the previous table to retrieve the year 1 taxable income of R71,231. From this figure, calculate the income tax liability attributed to your ownership of the property. Multiply the taxable income of R71,231 by your marginal tax bracket of 28% for an estimated tax liability of R19,945.

In summary, achieving your projected year 1 CFBT of R72,585 would result in a tax liability of R19,945, leaving you with a CFAT of R52,640.

It’s noteworthy that you anticipate paying more tax each year as the property earns more taxable income annually. However, since your CFBT is growing at a faster rate than your tax liability, your bottom line—the CFAT—increases each year.

Without positive cash flow, your property becomes akin to the plant in Little Shop of Horrors, constantly demanding, “Feed me” at every turn. Positive cash flow is crucial for all investors and indispensable for some. Does CFAT mark the conclusion of your ongoing investment analysis saga? Not at all. Next, delve into the ultimate resale of your property and how its value impacts your overall investment quality.

**Resale—How to Forecast the Appreciation Potential for a Property**

While net operating income, taxable income, and cash flow have been discussed, resale is a topic that sometimes receives less attention from novice real estate investors. Some may dismiss resale as speculation, while others find it challenging to seriously consider selling a property they haven’t yet purchased. Incorporating a contemplation of resale into your investment mindset may require extra discipline, but such discipline often distinguishes successful investors from others. Evaluating your property’s future worth is just as crucial as assessing its value on the day of purchase.

You care about potential cash flow, financing, operating costs, and tax benefits. Equally important is whether the property will be sellable after acquisition. Recite this mantra when considering an income property: “If it’s not worth selling, then it’s not worth buying.” While the world may not be perfect, assuming a level playing field is reasonable. If you would scrutinize a property’s income, expenses, financing, and returns before buying, expect future investors to do the same when you decide to sell. It pays to forecast future numbers today and understand how this investment will appeal to a future buyer.

What are the numbers that should concern you when analyzing the potential resale of an income property? The most obvious and crucial is the selling price. You can estimate the property’s value in the future by applying a reasonable capitalization rate to the net operating income. To do this, estimate the property’s NOI in the year of sale and the capitalization rate (rate of return) that a buyer would expect. The NOI is the return amount, and the cap rate is the rate of return. For instance, if the market expects a 10% return and your property has an NOI of $12,000, the estimated selling price would be $120,000.

Buyers and sellers may interpret the same information differently, making the process akin to poetry in commercial real estate. Sellers may estimate the value based on next year’s expected NOI, while buyers may capitalize on the current year’s income stream. Understanding this difference in perspective is crucial.

Once you estimate the resale price, the rest of the analysis is relatively straightforward. Calculate the estimated tax liability at the time of sale, and with that number, forecast the sale proceeds and the overall rate of return for the holding period. Revisit the property in the case study to estimate its value to a new buyer and the cash proceeds you might expect from a sale to that buyer. Assuming you sell the property at the end of five years, start with an estimate of its selling price by capitalizing its NOI. Be conservative and assume investors will expect a higher cap rate that year.

Given an NOI of R174,330 in year 5, if investors expect a 12% cap rate, estimate the property’s selling price as follows: Value=NOICap Rate=R174,3300.12=R1,452,750Value=Cap RateNOI=0.12R174,330=R1,452,750

After estimating the selling price, deduct costs of sale, mortgage payoffs, and other expenses to calculate the before-tax sale proceeds. Subtract these from the projected selling price to determine the cash you might receive from the closing.

**Projected Selling Price** −Costs of Sale−Costs of Sale −1st Mortgage Payoff−1st Mortgage Payoff −2nd Mortgage Payoff−2nd Mortgage Payoff −3rd Mortgage Payoff−3rd Mortgage Payoff Before-Tax Sale ProceedsBefore-Tax Sale Proceeds

Typically, a cost of sale estimate is 7% of the selling price, covering legal and brokerage costs. Fill in the numbers to determine the cash remaining after paying off debts and expenses.

Finally, compare this amount with your initial cash investment, considering the property purchase, loan points, and the balance as your cash investment. With an initial investment of R436,400, positive cash flows, and a closing check for over R650,000 before taxes, the investment appears promising.

When it comes to taxes, the rules for real estate sales are moderately complex and subject to change. For a general understanding, calculate the gain on the sale by subtracting the adjusted basis from the selling price. The adjusted basis is the property’s original cost, plus capital improvements, plus closing costs and other sale-related expenses, less accumulated depreciation.

For the property in the case study, assume that you can only take one-half

This aspect of the computation has weathered numerous alterations in the tax code, indicating its likely persistence for the foreseeable future. Nevertheless, one should refrain from relying on the permanence of tax regulations. Please note that the calculations in the following section are presented more for illustrative purposes than explicit guidance.

When determining your tax liability upon the property’s sale, specific deductions may come into play. For instance, if you experienced operating losses in previous years that surpassed your “passive loss allowance,” which prevented their deduction earlier, you can now deduct them during the sale. Additionally, if you’ve been amortizing loan points and leasing commissions, and there’s an unamortized balance on these items, you can deduct it upon selling.

In the case of your sample property, there are outstanding points yet to be fully written off. Recall the R16,400 paid for points to secure the first and second mortgages. You’ve been amortizing R720 of the first mortgage points and R200 of the second mortgage points annually. Over five years, you’ve deducted a total of R920 each year, amounting to R4,600. With the full points value at R16,400 and R4,600 already amortized, there’s R11,800 left to deduct. This amount can be added to your deduction for the fifth year, considering the property’s sale is retiring the loan.

With this information, you can now calculate the tax liability due upon sale. Under current rules, as a taxpayer in the 28% bracket, you would split your R214,752 gain into two parts: an amount equivalent to the total depreciation taken (subject to recapture at an ordinary income rate, capped at 25%) and the remainder. The gain is divided into R113,462 taxed at 25% and R101,290 taxed at the capital gains rate (15% or 20%, potentially more based on the current tax code, influenced by modified adjusted gross income, tax bracket, holding period, and year of sale). Don’t forget that you still have the amortized points (R11,800), which you can deduct at your ordinary income rate.

If this seems intricate, you’re not alone. Follow our earlier suggestion and consult your accountant when the complexity increases. The inclusion of this information here aims to complete the circle and reveal your ultimate bottom line at the time of sale—the after-tax sale proceeds.

In this chapter, you’ve gained a comprehensive understanding of a property’s true value in terms of cash flow and eventual sale proceeds. Now, it’s time to wield your yardstick and learn how to gauge the quality of a real estate investment.