Evaluating Currently Owned Property Performance Question

[Brian S.]

This is my first post here after reading for some time. I a have a few somewhat specific questions regarding analyzing the performance of currently owned properties that range from 90+ unit complexes to 5-6 unit mfd's I'm hoping someone can assist me with:

1. If I wanted to calculate a hybrid what-if internal rate of return for a currently owned property that has a balloon mortgage maturing in the next 4-5 years would it be appropriate to set up a model to do the following:

- Utilize actual/realized cash flows from the time of purchase to present. Should these prior cash flows be left as-is or discounted to the acquisition year? I'm thinking left as-is as they've already been realized.

- Factor in actual gains/losses on re-investments of past positive cash flows while projecting/discounting the future cash flows of those already held reinvestments (let's assume they're reinvested in fixed % cd's or savings accounts for simplicity).

- Projects future cash flows for the remaining term based on historical data/performance expectations, discounting these projected cash flows to the present day rather than the acquisition year (or am I wrong? If these were discounted to the acquisition year I assume the past cash flows would need to be as well). Future excess cash flows would be reinvested in the same reinvestment assets as previously, then discounted to the present day.

- Project various terminal year cash flows based on various potential sales prices to set up a "if the property sells for ___, then we'll return ___ " type of situation / table.

Would this be appropriate / logical?

[Bryan Hancock]

Welcome to BP Brian.

Originally posted by Brian S.:

1. If I wanted to calculate a hybrid what-if internal rate of return for a currently owned property that has a balloon mortgage maturing in the next 4-5 years would it be appropriate to set up a model to do the following:

An IRR calculation is going to reinvest the interim cash flows at the project's yield. If you want to select non-project reinvestments for the realized cash flows use the MIRR function in Excel.

Originally posted by Brian S.:

- Utilize actual/realized cash flows from the time of purchase to present. Should these prior cash flows be left as-is or discounted to the acquisition year? I'm thinking left as-is as they've already been realized.

What are you trying to value? If you are trying to value the project overall you would want to include the realized cash flows.

Originally posted by Brian S.:

- Factor in actual gains/losses on re-investments of past positive cash flows while projecting/discounting the future cash flows of those already held reinvestments (let's assume they're reinvested in fixed % cd's or savings accounts for simplicity).

This is very easy to do with the MIRR function in Excel. In the resources section of this site Phil C. has modified a model I used to use for multi-familiy product that bakes in stuff like this so you don't have to use your own model.

Originally posted by Brian S.:

- Projects future cash flows for the remaining term based on historical data/performance expectations, discounting these projected cash flows to the present day rather than the acquisition year (or am I wrong? If these were discounted to the acquisition year I assume the past cash flows would need to be as well). Future excess cash flows would be reinvested in the same reinvestment assets as previously, then discounted to the present day.

Again...it depends on what you are trying to value. If you are valuing the whole project you need to include the past cash flows.

Originally posted by Brian S.:

- Project various terminal year cash flows based on various potential sales prices to set up a "if the property sells for ___, then we'll return ___ " type of situation / table.

This type of what-if scenario makes a lot of sense. The terminal cash flow will make less impact on your overall project-level returns if it is distant. For shorter projects it drives the variance in returns greatly. The rent and vacancy (sales) assumptions drive your returns big-time too. You may want to consider doing a what-if analysis that varies all three of these data points. I think v7 of the model Phil wrote does this in the spot referenced above.

Originally posted by Brian S.:

Would this be appropriate / logical?

You just need to know what assumptions you are making. If you are trying to value the project overall I would include all of the data for the project. If you are trying to blend one project with the next I would use the same discount rates and weight the projects by their overall value to come up with an overall return for the rental portfolio.

[Bryan Hancock]

Welcome to BP Brian.

Originally posted by Brian S.:

1. If I wanted to calculate a hybrid what-if internal rate of return for a currently owned property that has a balloon mortgage maturing in the next 4-5 years would it be appropriate to set up a model to do the following:

An IRR calculation is going to reinvest the interim cash flows at the project's yield. If you want to select non-project reinvestments for the realized cash flows use the MIRR function in Excel.

Originally posted by Brian S.:

- Utilize actual/realized cash flows from the time of purchase to present. Should these prior cash flows be left as-is or discounted to the acquisition year? I'm thinking left as-is as they've already been realized.

What are you trying to value? If you are trying to value the project overall you would want to include the realized cash flows.

Originally posted by Brian S.:

- Factor in actual gains/losses on re-investments of past positive cash flows while projecting/discounting the future cash flows of those already held reinvestments (let's assume they're reinvested in fixed % cd's or savings accounts for simplicity).

This is very easy to do with the MIRR function in Excel. In the resources section of this site Phil C. has modified a model I used to use for multi-familiy product that bakes in stuff like this so you don't have to use your own model.

Originally posted by Brian S.:

- Projects future cash flows for the remaining term based on historical data/performance expectations, discounting these projected cash flows to the present day rather than the acquisition year (or am I wrong? If these were discounted to the acquisition year I assume the past cash flows would need to be as well). Future excess cash flows would be reinvested in the same reinvestment assets as previously, then discounted to the present day.

Again...it depends on what you are trying to value. If you are valuing the whole project you need to include the past cash flows.

Originally posted by Brian S.:

- Project various terminal year cash flows based on various potential sales prices to set up a "if the property sells for ___, then we'll return ___ " type of situation / table.

This type of what-if scenario makes a lot of sense. The terminal cash flow will make less impact on your overall project-level returns if it is distant. For shorter projects it drives the variance in returns greatly. The rent and vacancy (sales) assumptions drive your returns big-time too. You may want to consider doing a what-if analysis that varies all three of these data points. I think v7 of the model Phil wrote does this in the spot referenced above.

Originally posted by Brian S.:

Would this be appropriate / logical?

You just need to know what assumptions you are making. If you are trying to value the project overall I would include all of the data for the project. If you are trying to blend one project with the next I would use the same discount rates and weight the projects by their overall value to come up with an overall return for the rental portfolio.

[Brian S.]

First I'd like to thank you for your concise and extremely helpful response, and also wish you a happy new year.

Originally posted by Bryan Hancock:

An IRR calculation is going to reinvest the interim cash flows at the project's yield. If you want to select non-project reinvestments for the realized cash flows use the MIRR function in Excel.

I realized it wasn't an actual IRR, and this was what I was thinking, I just didn't know how to describe it and with mirr being a defined metric I decided to go with 'hybrid'.

Originally posted by Bryan Hancock:

What are you trying to value? If you are trying to value the project overall you would want to include the realized cash flows.

Single projects overall

Originally posted by Bryan Hancock:

This is very easy to do with the MIRR function in Excel. In the resources section of this site Phil C. has modified a model I used to use for multi-familiy product that bakes in stuff like this so you don't have to use your own model.

Thanks for the tip, I'll be sure to check it out.

Originally posted by Bryan Hancock:

This type of what-if scenario makes a lot of sense. The terminal cash flow will make less impact on your overall project-level returns if it is distant. For shorter projects it drives the variance in returns greatly. The rent and vacancy (sales) assumptions drive your returns big-time too. You may want to consider doing a what-if analysis that varies all three of these data points. I think v7 of the model Phil wrote does this in the spot referenced above.

The terminal years for these projects range from 4-6 years away, with partially amortizing balloon mortgages, so terminal year flows will have a significant impact.

The idea of doing a what-if on rent and vacancies ran through my mind, thanks for confirming I'm not thinking 'too outside-the-box'. This model you referenced is sounding better and better, I'm about to try it out.

Originally posted by Bryan Hancock:

Would this be appropriate / logical?

You just need to know what assumptions you are making. If you are trying to value the project overall I would include all of the data for the project. If you are trying to blend one project with the next I would use the same discount rates and weight the projects by their overall value to come up with an overall return for the rental portfolio.

Thanks for the tip, would the discount rate I'd use be the average rate of the entire portfolio's loans? Or would I need to calculate a weighted discount rate based on the percentages of debt each property holds in the portfolio?

Thanks again,
Brian

[Brian S.]

*update*

Would someone please re-upload Phil's model v7? The download link through his profile/the resource section isn't working - http://www.biggerpockets.com/files/112/download

[Bryan Hancock]

Originally posted by Brian S.:

Thanks for the tip, would the discount rate I'd use be the average rate of the entire portfolio's loans? Or would I need to calculate a weighted discount rate based on the percentages of debt each property holds in the portfolio?

You need to include the equity cost in your WACC calculation to determine an appropriate discount rate. If you blend your equity return requirements with the loan constants (lender's yield requirement) you can come up with a WACC calculation. I would choose a discount rate for each project independently so you are pricing risk properly. This risk is likely to largely be baked into your lender's constant anyway since it likely represents the bulk of the individual project's capitalization. This may not be the case if you are highly leveraged though. What are your leverage ratios for each project?

Here is a primer if you need one:

Choice of Discount Rate

Ray Alcorn's article will help a lot too:

Google search for Alcorn's article

Make sure you weight your debt for taxes. Note that this is pretty complicated for real estate investors. I would use your realized tax rate from last year instead of your marginal rate. This will be wrong...but it is close enough.