Maximizing Return - Part 1
Investors seek to maximize returns through revenue generated from income property. Three concepts directly impact the yield realized. • Cash flow • Leverage • Taxation CASH FLOW Cash flow represents all monies flowing from an investment. Cash flow is fundamental to building wealth from an investment perspective. Cash flow is derived from two sources; ongoing rental income (operations cash flow) and appreciation in the value of the building at point of disposition (sale proceeds cash flow). Operations Cash Flow – Operations cash flow represents periodic monies received from the operation of the investment. Cash flow can be positive or negative. Appraisers and real estate registrants calculate a single year’s cash flow based on income and expense analysis to arrive at a net operating income (NOI). Annual debt service is then deducted from NOI to arrive at cash flow before taxes (CFBT). Cash flow can be further analyzed from an after tax perspective. Cash flow before taxes is frequently used in market value estimates, while cash flow after taxes is applied with investment value estimates, although this distinction should not be overemphasized as the lines are often blurred. In reality, registrant work in both worlds. Sales Proceeds Cash Flow – Sales proceeds cash flow represents the sale proceeds of the investment (reversion). Traditionally, sales proceeds have been viewed separately and treated as capital appreciation. This approach was particularly popular in inflationary periods when operations cash flows were either small or negative and investment decisions were made solely on anticipated sale gains. However, stable economic periods require a more all encompassing perspective on investment return. Real estate investment analysis analyzes the interplay of both operations cash flow and sales proceeds cash flow when determining yield on investment property. Capital appreciation, while valid, is only one dimension within a larger picture. Cash Flow Rules Over the years, investors have discovered three important rules when analyzing cash flow for investment purposes. 1. Larger Cash flow is better than smaller cash flow 2. Today cash flow is better than tomorrow cash flow • It is not only what is received, but when it is received. • Time is an important consideration in analyzing cash flows • Often referenced as Time Value of Money 3. After tax cash flow is better than before tax cash flow • The best measure of true cash flow realized by the investor • The most accurate comparison between carious investment properties being considered. Cash Flow and Liquidity Liquidity involves the ease by which assets can be readily converted into cash. Funds helped in chequing accounts, savings accounts and short-term guaranteed investment certificates are generally viewed as highly liquid, as opposed to holdings in long term bonds, mortgages and ownership of real estate. Liquidation is often referenced in the retail sector and in the ability to convert assets into cash. For real estate purposes, liquidity in operations cash flows is important to ensure the continuance of an investment. The investor must be able to meet the cash demands of the enterprise in terms of current and future operating expenses. Further, the marketability of the property plays into the equation. At some future point, the investor will seek to sell the investment. Sale proceeds cash flows can be a significant portion of overall return. Registrants concentrate on analyzing cash flows and discounted cash flows to evaluate the attractiveness of investment properties. While the ownership of real estate is viewed as a non-liquid asset, care in the selection process and prudent forecasting of cash flows generated can address both liquidity and returns.