Notes

Outline

Income Analysis Software Understanding and Explaining

Introduction Prerequisite - Basic knowledge of Income Analysis as applied to income producing real estate Seminar objective Your objectives

Agenda – Morning Session 8:00 am to 8:50 am Definitions, Capitalization, Income Analysis 9:00 am to 9:50 am Income Analysis and the Capitalization Process 10:00 am to 10:50 am Income Analysis Software can greatly improve your analyses An Accounting Analogy Know Where the Numbers Come From 11:00 am to 11:30 am Review, Class discussion

Agenda – Afternoon Session 1:00 pm to 1:50 pm Income Analysis – Defining the problem; criteria 2:00 pm to 2:50 pm A Case Study – Using Income Analysis Software 3:00 pm to 3:50 pm Important Reports, Ratios, numbers to verify Benchmarks 4:00 pm to 4:30 pm Review of subject. Class discussion

Math is Easy Value = Cash Flow / Caprate

What is Present Value?

Cash Flow or Net Income?

A Rose by Any Name Capitalization Rate Discount Rate Rate of Return IRR Yield Rate

Simple Algebra

Definitions - Terms   Value   Capitalization Process   Capitalization Techniques   Analysis Types

Value Value is a concept that has been pondered by philosophers, politicians, and religious leaders for centuries.  In recent modern history, economists, financiers and appraisers have defined and redefined Value many times.

Value The Society of Residential Appraisers, in their Appraisal Guide, published in 1956, defined value as "the present worth of future benefits to typical buyers." Another definition from The Dictionary of Real Estate is:  "the present worth of future benefits that accrue to real property ownership."

Many Values There are definitions for Market Value, Investment Value, Use Value, Fair Value, Leased Fee Value, Assessed Value, and Insurable Value . . . These definitions tend to change over time as they are influenced by the prevailing economic, social and political climate.

What is Your Value?    When performing an income analysis, the inputs that you enter will determine whether the value conclusion is   Market oriented   Specific to a single investor   Limited to specific criteria.

The Capitalization Process The capitalization process is used to estimate the value of income producing property. Most reference sources define the capitalization process similarly and the basic definition has not changed much over the years.

The Capitalization Process Capitalization was defined this way in Real Estate Appraisal Principles and Terminology, published by the Society of Residential Appraisers in 1960. Appraisal by Capitalization The processing of an indication of market value through the discounting of anticipated future net income.  The validity of the value indication so produced depends upon the amount and probable duration of the anticipated net income, and the market support for the rate at which it is discounted.

The Capitalization Process Other Definitions Capitalization is the process of converting an income stream to a lump-sum capital value.  In real estate appraising, it usually takes the form of discounting. The conversion of income into value.

Direct Capitalization The capitalization method used to convert an estimate of a single year's income expectancy or an annual average of several years' income expectancies into an indication of value in one step, either by dividing the income estimate by an appropriate rate or by multiplying the income estimate by an appropriate factor.

Yield Capitalization A capitalization method used to convert future benefits to present value by discounting each future benefit at an appropriate yield rate or by developing an overall rate that reflects the investment's income pattern, value change, and yield rate.

The Capitalization Process The Income Capitalization Process is not a new concept.  Thousands of pages have been devoted to explaining it and its various components since the beginning of 20th century. We strongly recommend that the reader do some reading about the history of the capitalization process. An understanding of how the method has been applied over the years as capitalization techniques have evolved will place the techniques discussed in this seminar in perspective.

Lets Take A 10 minute Break

Income Analysis and the Capitalization Process All of capitalization techniques convert an income stream into value. The capitalization process is the basis for the techniques that are used in Income Analysis Software. In this seminar we will be discussing two methods of Yield Capitalization.

Yield Capitalization Two Categories Yield Capitalization methods fall into one of two general categories; Development of an Overall Capitalization Rate  (OAR) Discounted Cash Flow Analysis  (DCF)

Income Analysis and the Capitalization Process Many techniques have been employed over the years to develop an OAR.  These include: Capitalization in Perpetuity The Band of Investment The Ellwood Method The Mortgage Equity Technique

Income Analysis and the Capitalization Process The goal of each technique is to develop a capitalization rate that reflects the pattern and timing of the future benefits produced by an investment. This rate is then applied to (divided into) the current income estimate to produce a present value indication for the investment. As such, each of these techniques is a form of Yield Capitalization.

Income Analysis and the Capitalization Process Discounted Cash Flow Analysis (DCF) explicitly discounts each individual cash flow that is produced by an investment. Two variations of the Present Value Theory will be discussed. Present value discounting Calculation of the IRR

Income Analysis and the Capitalization Process This technique discounts to present value the future benefits that are produced by an investment at an appropriate yield rate.

Income Analysis and the Capitalization Process This technique calculates the Internal Rate of Return of the series of cash flows.  The IRR is calculated in order to provide a separate, independent check that insures that the Present Value Discounting was performed correctly.

Income Analysis and the Capitalization Process When the income stream produced by an investment is level or when it changes at a constant rate, the value produced by using an OAR that was developed by the Mortgage Technique is identical to that produced by a DCF. The techniques are mathematically equivalent under these conditions.  The advantage of using both techniques in a single analysis is the additional proof provided when the same result is achieved using two separate techniques.

Same Assumptions Same Results When these methods use the same assumptions, both methods will produce the same results.

OAR and DCF COMPARED

Income Analysis Software

Points to Consider How comprehensive are the models? Is it easy to enter data and check data entry? Do the reports produce sufficient documentation? Both Capitalization Rate and a DCF analysis? Sufficient Checks Built into Software?

Review   Value   Yield Capitalization   Income Analysis   Income Analysis Software

Different Income Streams Require Different Techniques

Types of Income Streams   Stable   Uneven     Rent-up     Lease

Stable Income Stream    The word stabilized is one of the most overworked and under-defined words in the analyst's vocabulary.  This word has been used synonymously with level, typical, reasonable, average, and according to market standards.  There is no single definition of the term, yet every appraiser we talk to seems to understand its meaning intuitively.    Stabilized is a judgment call.  We will not attempt to define the term here.  Instead, we will expand upon the adjectives associated with the word stabilized so that the student might refine his own understanding of the term.

Descriptions of Stable Income Income should not fluctuate from year to year, but may grow or decrease at a constant rate. The income estimate should be typical for the type of property being analyzed and the income estimate should be representative of a typical year. The income estimate should meet the tests of reasonableness as they might be applied by a person knowledgeable with similar property types. Usually used in reference to expenses.  An expense like building maintenance might fluctuate from year to year.  The best stabilized estimate of this expense might be an average of several previous years. Most probable income as ascertained by a review of the amount paid for similar space that is rented and the amount asked for similar space which is currently being offered for rent.

Stable Income Stream    When an appraiser refers to an item as stabilized, he is implying that he has considered the above descriptive terms as they relate to the item.  He then adjusts the item as necessary.   A Stable Analysis assumes that the individual factors that affect the value calculation are stabilized.  This means that income, vacancy and expenses should be adjusted to stabilized.  So too should the growth rate in value, the growth rate of net income, and the loan interest rate.

The “Perfect Property”   There are no leases to restrict your estimate of income.  You are free to estimate market rentals.   The property could be rented immediately.  There is no rent-up period to evaluate.   No unusual expenses exist and the expenses are consistent and predictable.   Because no leases exist, you are free to project income to grow at a stabilized rate.   The growth in value can also be reasonably projected.   Fill in the blanks and you have a stabilized analysis.  Of course, it is seldom easy to fill in the blanks.  However, it is important to stabilize all factors that influence the value calculation.

The “Perfect Property”  . . . proper judgment takes place only when it is brought into relation with some other judgment which has already been tested, and which has found a place in our body of general knowledge.  That is, every property is in effect checked against a hypothetically perfect property - an engineer would call it a "bench mark." Ivan A. Thorson, M.A.I.

The “Perfect Property”  When care is taken in developing the Stable Analysis, it becomes our benchmark.  For many properties, it will only be necessary to perform a Stable analysis.  This is true when income and expenses are currently at or near market and no long term contracts exist which will cause the net income to deviate significantly from our stabilized projections.

Uneven Income Streams Not all income streams produced by real property are Stable.

Uneven Income Streams New projects and properties that are not fully rented at the time of the analysis will often not reach stabilized operation for several years. This results in an uneven cash flow pattern.

Uneven Income Streams It is sometimes necessary to analyze the specific lease terms that are in effect for a property. There are also times when expenses grow at a different rate than income or when the growth rates of individual expenses vary.

Which Income Analysis Method is Appropriate?   Capitalization Rate Method   Income and Expenses are “Stabilized.”   Discounted Cash Flow Method   Income and Expenses are “Stabilized.”   Cash flows are UNEVEN because there is a RENT-UP period   Cash flows are UNEVEN because property is encumbered by long-term leases

Characteristics of an UNEVEN Income Stream   Long-term leases encumber the property   An extended rent-up period is anticipated to bring the property up to stable occupancy   Large capital expenditures are anticipated during the projected holding period

Characteristics of an UNEVEN Income Stream   Expenses are not stabilized or are anticipated to change at a different rate than income during the projected holding period   The leases that are in effect are not at or near market terms

Lets Take A 10 minute Break

Income Analysis Software   We have discussed various terms, capitalization techniques, and the characteristics of income streams.   A basic understanding of these concepts is required to properly use Income Analysis Software.

Income Analysis Software Will Improve Your Income Analyses  IF you know what the software can and cannot do  IF you use the software properly, and  IF you UNDERSTAND and can EXPLAIN the results.

Accuracy and the ILLUSION of Accuracy

Income Analysis Software  is only a Tool ALL OF THESE VEHICLES RUN. SOME WILL GET YOU TO YOUR DESTINATION. SOME WILL NOT.

Income Analysis Software  is only a Tool

Thousands of Numbers

Thousands of Numbers

YOU HAVE TO KNOW WHERE THE NUMBERS COME FROM   The implication is that if you did your analysis on a computer, and cannot replicate each calculation by hand, then the analysis is somehow flawed.   On the other hand, if you can do the math, then the analysis is valid; even if you use the Band of Investment - a technique that is rudimentary, incomplete and does not consider all of the factors that influence the income value of a property.

YOU HAVE TO KNOW WHERE THE NUMBERS COME FROM Reports produced by income analysis software can be overwhelming.  Suppose that you have a small office building with 20 tenants.  You have itemized 12 expenses. And you decide to print every report offered in a software package.  When the printing is complete, you will have over 60 pages of numbers.  If you have a large building with 200 hundred tenants and 50 itemized expenses, look for nearly 300 printed pages of output!

YOU HAVE TO KNOW WHERE THE NUMBERS COME FROM   So which numbers are important?   Which numbers should you check?   Which reports should you study?   How can you possibly know where all of those numbers come from?   And even if you grind out every number again by hand, would you have a better analysis?   Would you know any more about the property?   Would you have a more reliable estimate of value?   Would it prove that you know where the numbers come from?

The Accounting System Analogy   Every business faces numbers problems every day. Checks come in. Expenses are paid. Debts are incurred. Sales are made. Bills come in.   Hundreds of numbers documented on invoices, receipts, check stubs, napkins...

Two Critical Reports Accounting systems have evolved to handle these masses of paper and numbers. Whether the information is entered in a daily ledger by hand or into an automated computer system, the goal is the same:  to organize the information and condense it into two clearly defined reports - the Income Statement and the Balance Sheet.

Income Statement Balance Sheet Many ancillary reports are prepared as supporting documents. But give an accountant the Income Statement and Balance Sheet and he will have a snapshot of the company. One report is not sufficient.  He needs both.

Income Statement Balance Sheet An accountant who is analyzing the financial statements of a company needs to know two things about the statements before he can rely upon them.   First, he must know that the math is correct - that the books balance.   Second, he must know that the cash in and out is properly allocated; i.e., that an expense is charged as an expense and not as a loan payment.  That an investment of cash by the owner was not credited as a sale.

Income Statement Balance Sheet Does this mean that the accountant knows where the numbers came from?      Yes and No.   The accountant does know where each number on the financial statement comes from.   He knows that a sale goes on the Income Statement and is reflected on the Balance Sheet as a deposit to the checking account.   He knows that an expense will be deducted from gross profit and will reduce the checking account balance.

Income Statement Balance Sheet Does this mean that the accountant knows where the numbers came from?      YES AND NO.   He only has to verify a few key numbers to know that the books balance.   However, unless the accountant reviews the supporting invoices, checks, napkins, etc., he cannot say, just by reviewing the financial statements, that he knows where the numbers came from.

Income Statement Balance Sheet Does this mean that the accountant cannot have confidence in the numbers?   NOT NECESSARILY.   He can look at a few key numbers on the Income Statement and the Balance Sheet and determine whether the financial statements balance.  He can verify the beginning and ending checking account balances and have confidence that all cash in and cash out has been accounted for.   Unless the statements are audited, he cannot have complete confidence in the allocation of the numbers on the financial statements.

Income Statement Balance Sheet But he can gain a high level of confidence in the financial statements by checking certain key numbers   He will study important ancillary reports: Source and Use of Funds, bank statements, Accounts Receivable, etc.  And he will look for familiar ratios.   In any case, you can be sure that the accountant does not add up all of the sales, invoices, bills, checks, bank statements and napkins.  That is why we have computers.

Where the Number Come From “Knowing where the numbers come” from means understanding:  Which numbers make the books balance  Which reports are important and must be verified  Which ratios must be studied.  “Knowing where the numbers come from” should NOT mean re-calculating each number.  It should not mean re-verifying every number on every report.  It should not mean having every formula indelibly etched in memory.

Double Entry Bookkeeping The accounting profession has the double entry accounting system.  The system provides the foundation for verifying financial statements.  The books balance because the system ensures that they balance. There is a consensus of what it means to balance the books.  In fact, it is more than a consensus.  Two plus two is always four.  The double entry accounting system is mathematically provable.

How Do You Prove an Income Analysis?   An Income Analysis has many of the same characteristics as an accounting system.   ONE MAJOR DIFFERENCE. There is no consensus on what it means to balance the books.   So the appraiser is reminded that he MUST KNOW WHERE THE NUMBERS COME FROM.

Lets Take A 10 minute Break

Review Definition of Terms-Overview   The Capitalization Process   Income Analysis   Capitalization Rate Method   Discounted Cash Flow Method

Review Income Analysis and the Capitalization Process   Types of Income Streams   The Perfect Property   Different Income Streams Require   Different Capitalization Techniques   Capitalization Rate Method   Discounted Cash Flow Method

Review Income Analysis Software   Income Analysis Software is a Tool   Thousands of Numbers   Know Where the Numbers Come From   Income Statement / Balance Sheet   This Afternoon

Income Analysis Software  is only a Tool ALL OF THESE VEHICLES RUN. SOME WILL GET YOU TO YOUR DESTINATION. SOME WILL NOT.

Thousands of Numbers

Thousands of Numbers

Review Income Analysis Software   Income Analysis Software is a Tool   Thousands of Numbers   Know Where the Numbers Come From   Income Statement / Balance Sheet   This Afternoon

Lunch Time Instructor: Bob Halko Company: Financial Masterplan, Inc. Telephone: 412-606-9000 Web Site: IncomeAnalysis.com Email: fmi@dcfsoftware.com

Review of Morning Session   Definitions and Terms   Income Analysis and the Capitalization Process   Income Analysis Software

This Afternoon   How do you prove an Income Analysis   Income Analysis – Defining the problem; criteria   A Case Study – Using Income Analysis Software   Important Reports, Ratios, numbers to verify   Benchmarks

How Do You Prove and Income Analysis   An Income Analysis has many of the same characteristics as an accounting system.  However, there is one major difference.   There is no consensus on what it means to balance the books.   So the appraiser is reminded that he MUST KNOW WHERE THE NUMBERS COME FROM.

Preparing an Income Analysis   Selecting the proper technique   Estimating and entering Income/Expenses   Estimating mortgage terms, growth rates, etc.   Selecting Rate of Return, Holding Period   Applying the math and calculating a Value

Proposition: You Cannot Prove that Your Value is Correct An Income Analysis is Based upon Projections and Assumptions

You can prove that, given the projections and assumptions that you have made, there is only one mathematically correct calculation of value 2  + 2 = 4

Five Criteria that are Central to a Good Income Analysis  The Correct Method Must be Applied   The Correct Data Must be Entered   The Proper Assumptions Must be Made   The Calculations Must be Checked   The Cash Flows and Value must be     Compared to a Standard

Yield Capitalization  A capitalization method used to convert future benefits to present value by discounting each future benefit at an appropriate yield rate or by developing an overall rate that reflects the investment's income pattern, value change, and yield rate

The Correct Method Must be Applied At least three mathematical techniques can be applied

The Correct Data Must be Entered Entering the Correct Data is Critical

The Proper Assumptions You are Projecting into the Future

Calculations MUST be Checked

The Cash Flows and Value Must be Compared to a STANDARD

You Need A Benchmark

Lets Take A 10 minute Break

"How Income Analysis Software processes..." How Income Analysis Software processes data

An Income Analysis Case Study We will be using  an Income Analysis software product called Investment Analyst to do our case study this afternoon.  The points we make, though, apply to any Income Analysis Software.   Investment Analyst produces 30 basic reports   Referring again to the accounting analogy, an accountant considers two reports essential - the Income Statement and the Balance Sheet.   All of the other reports produced by an accounting system are supporting documents.   Without these two essential reports, no financial judgments can be made about the company.

An Income Analysis – Two Reports For each Income Analysis there are two reports that stand out above all others  Multi-year Income Statement  Projected Cash Flow Analysis If you understand the numbers on these two reports and can explain them, then YOU KNOW WHERE THE NUMBERS COME FROM.

Multi-year Income Statement Projected Cash Flow Analysis   Like an accounting system, the purpose of Income Analysis Software is to organize the information.   The accounting system’s Income Statement and Balance Sheet will give a knowledgeable reader a clear picture of the financial health of a company.   These two Income Analysis reports will give the knowledgeable reader a clear picture of the Income analysis.

Proper Assumptions Proper Assumptions

Entering Income

Entering Income

Entering Expenses

Lets Take A 10 minute Break

Reports, Ratios, Numbers   An Income Analysis has many of the same characteristics as an accounting system.  However, there is one major difference.   There is no consensus on what it means to balance the books.   So the appraiser is reminded that he MUST KNOW WHERE THE NUMBERS COME FROM.

Two Essential Reports Multi-year Income Statement

Multi-year Income Statement Eight Income Statements  Each Year of Holding Period  Terminal Year

Multi-year Income Statement Scan Income

Multi-year Income Statement Scan Expenses

Multi-year Income Statement STUDY RATIOS

Multi-year Income Statement You must study the Multi-Year Income Statement until you are satisfied that it reflects the income, expenses and net income that you intend for the type of analysis you are performing.

Projected Cash Flow Analysis Multi-year Income Statement

Projected Cash Flow Analysis If you have determined that the yield capitalization method is the proper method to use for your analysis (i.e., that you will use Income Analysis software); if you have entered the correct income and expense data; and if you have made the correct assumptions; then there can be only one indicated value. AND YOU CAN PROVE IT.

Projected Cash Flow Analysis The Projected Cash Flow Analysis report contains the information that documents the value calculation.  Once you have verified that the net income used in the analysis is correct (Multi-year Income Statement and other supporting reports as necessary), you can calculate and verify the indicated value and every other number on the Projected Cash Flow Analysis report.  You can grind out each number by hand or with a calculator.  And you should try it.  When you can do it, YOU KNOW WHERE THE NUMBERS COME FROM.

Projected Cash Flow Analysis We said you could prove it.  You can demonstrate that there is only one value that will produce the cash flows and yield rate that conform to the assumptions that have been specified for the analysis. The Projected Cash Flow Analysis is divided into five sections.

Projected Cash Flow Analysis How does Analyst find this value?  It seems like a circular argument.  If you are trying to determine the value of a series of cash flows, you cannot know the value before hand.

Projected Cash Flow Analysis When a value is selected, many other numbers are affected.

Projected Cash Flow Analysis Cash Flows

Projected Cash Flow Analysis Reversion

Projected Cash Flow Analysis Internal Rate of Return

Projected Cash Flow Analysis Initial Investment = Indicated Value - Loans + Soft Costs We must find the rate that equates the present value of these future cash flows to the Initial Investment.

Projected Cash Flow Analysis The equation for calculating the IRR is:  Hp ð       CFN      - I = 0  N=1  (1+R)N

Projected Cash Flow Analysis If you have your financial calculator handy, you can use it to verify the IRR calculation.  Enter the Total Investment as the Present Value and the series of annual cash flows.  Then have the calculator calculate the IRR.

Projected Cash Flow Analysis Present Value

Projected Cash Flow Analysis The Present Value Discount factor is derived according the following formula: PVfactor =    1                  (1+R)N

Discount Factor The Present Value Discount factor is derived according the following formula: PVfactor =     1                      (1+R)N

Two Essential Reports Multi-year Income Statement

How Much Confidence  do you have in the Numbers?

Accounting Analogy Financial Statements

Stable Analysis

Lease by Lease Software

Benchmark . . . proper judgment takes place only when it is brought into relation with some other judgment which has already been tested, and which has found a place in our body of general knowledge.  That is, every property is in effect checked against a hypothetically perfect property - an engineer would call it a "bench mark.

Check Against a Standard

Most Important

Advanced Mortgage Equity Technique If your software can build a Caprate, using the same assumptions that you used in the DCF, then this is your final proof that the numbers are correct. WHEN YOU ARE PER-FORMING A STABLE ANALYSIS, THIS ELIMINATES THE NEED TO VERIFY THE PRESENT VALUE DISCOUNTING CALCULATIONS.

Advanced Mortgage Equity Technique Simple Mortgage Equity Holding Period Loan Terms Required Yield (IRR) Advanced Mortgage Equity Growth Rate – Value Growth Rate – Net Income Soft Costs Selling Expenses

Mortgage Equity and DCF

CONFIDENCE

Lets Take A 10 minute Break

Accuracy and the ILLUSION of Accuracy

YOU KNOW WHERE THE NUMBERS COME FROM

Discussion - Questions

Thank You