Proper Investing

Cash-on-Cash Return: Beyond Pro Formas & Cap Rates

The adversity most investors in commercial real estate are going through right now is leading to a new industry paradigm when it comes to analyzing investment properties. Not only are investors themselves looking for new, more practical ways to analyze these properties, underwriters are as well.

Cash flow is king!

To make successful deals in today’s market, capitalization rates and pro forma numbers take a back seat to cash-on-cash returns and accurate pricing. Financing is the biggest stumbling block in the market today. Capital is scarce, scared or patient. As a result, property owners who used to quote cap rates are now paying much more attention to cash flows. Cash flow is king! Equity and appreciation are secondary at best.

The questions for distressed property investors are whether the property has positive cash flows and the prospects of maintaining current tenancy levels. Prospective buyers and sellers are also paying more attention to the quality of the tenants than they were 18 months ago. Back then, vacancies were viewed as opportunities by the landlord to add value. Now they are a major liability.

Cap rates can only tell you so much about a property. For example, let’s say you have two retail properties with the same cap rate. One is a NNN, single-tenant space with a creditworthy lessee and a long-term lease in place. The other contains three tenants, one or more of which may be of questionable creditworthiness with shorter-term leases in place. All things being equal, it wouldn’t take a rocket scientist to figure out which of these is the better investment in today’s market. That’s why investors, like banks, are looking more and more at cash-on-cash return.

Cash-on cash is the ratio of annual before-tax cash flow to the total amount of cash invested, expressed
as a percentage.

                                         Annual Before-Tax Cash Flow
Cash-On-Cash Return = -----------------------------------------
                                               Total Cash Invested

For example, suppose an investor purchases a $1,200,000 apartment complex with a $300,000 down payment. Each month, the cash flow from rentals, less expenses, is $5,000. Over the course of a year, the before-tax income would be $5,000 x 12 = $60,000, so the cash-on-cash return would be 20% ($60,000 / $300,000 = .20).

However, it’s important to note that although cash-on-cash return is a better determinant of cash flow than cap rates are, it is still not perfect and should be used as just one tool in an arsenal for analyzing investment  properties. Because this calculation is based solely on before tax cash flow relative to the amount of cash invested, it cannot take into account an investor’s tax situation, the particulars of which may influence the desirability of an investment.

Washington DC Commercial Real Estate Insight.

Lenders Postpone the Pain (Troubled Loans)

Two new phrases have entered the commercial real estate industry lexicon in recent months: "Pretend and extend" and "A rolling loan gathers no loss." Both witticisms describe an ongoing phenomenon in commercial real estate
finance: as the level of distress mounts, lenders have been loath to seize properties from troubled borrowers. Instead, in many cases banks are generously granting extensions or other modifications even in situations where it appears unlikely that borrowers will be able to pay back the loans.

From January through April of this year, the 20 largest banks in the country reported that modifications of existing loans outnumbered new commitments by approximately two to one. What's at work is that lenders are attempting to avoid recognizing write downs and losses on their commercial real estate loan books. Loans originated at the height of the market were done at near 100 percent loan-to-value ratios and underwritten with generous assumptions on increasing occupancies and rents. But in the past two years commercial real estate values have dropped considerably and fundamentals have weakened. Rents and occupancies are now dropping quickly, not rising. On top of everything, a major source of financing, the commercial mortgage-backed securities (CMBS) market, remains locked down.

Many banks hope that if they stave off foreclosure for a year or two, even if a distressed sale becomes inevitable, they will be able to recover more of their investment than they would if they sold right now. So lenders are playing a waiting game. Foreclosing on assets today means they would have to manage properties in a treacherous economic climate. The alternative would be to sell. But the investment sales scene is not encouraging. Distressed assets are trading at steep discounts to peak market prices.

If banks were to take back these assets now and try to sell them, they would fetch prices as much as 35 percent off pricing peaks. In May, the most recent month for which data are available, only $418 million in retail properties changed hands, representing a 12 percent decline in sales activity compared to April and a decline of 89 percent compared to May of 2007, the peak period for the investment sales market.

When a borrower does go into default and the bank takes over the property, the servicers are increasingly turning to receivers to take over the management of such properties and eventually attempt to sell them (a sale outside foreclosure also allows the lender to provide seller financing, rather than looking for an all-cash buyer) Meanwhile, banks and other traditional lenders want time to develop a long-term strategy for their real estate portfolios, as well as being reluctant to sell at the bottom of the market.

Lenders are not treating all borrowers equally, however. They are making distinctions based on the quality of borrowers and assets. In cases where properties boast healthy cash flows and owners with proven track records, lenders see little reason to foreclose. Why go through the tumult of a foreclosure and changing over day-to-day property management if the current management team is doing a good job? In these cases, the delinquencies are more the result of the poor financial climate than they are of mismanagement.

Market observers hope the current logjam will start to un-wind by the first quarter of 2010. If their predictions are on target, it will be another three to five years before all the bad commercial loans out there get resolved. But if lenders continue to postpone dealing with troubled assets, the resolution of this crisis might take as long as 10 years.

The good news is that in many cases, lenders are not simply extending the loans, they are trying to rework the terms in such a way that they don’t have to come back to the negotiating table six months or a year down the road. They are factoring in falling cash flows and the possibility of higher vacancies and lower rents. The bad news is that in a number of instances, banks may not be lowering those assumptions enough. Meanwhile, with banks unwilling to take
troubled assets to market, opportunistic investors continue to stay away from acquisitions and the process of price discovery in commercial real estate continues to be arduous.

DC Top Student Destination

Washington DC has always been labeled as a highly educated city, now there's more proof to back it up.  This is good news for property owners focusing on student housing, since demand will remain strong for housing near campuses in the district. 

The opportunity and hope radiating from our nation's capitol has drawn droves of students to colleges in the DC area for their education and subsequent employment opportunities. The top reasons are obvious: 1) Low unemployment: 5.6% 2) Second Highest per-capita income in the US ($54,971)

All this news is good news to help aid the local economic recovery. As a talent magnet for the educated masses, DC will have the intellectual capital to grow its employment base. 

D.C. Ranks Fourth in Report on College Destinations - washingtonpost.com