Value Added Transactions Mastery Lesson 08

Lesson Eight: The Key Metrics for Good Decisions

There are several simple metrics that the value added investor should review and understand while making an investment decision. This lesson will review the following key metrics:

  • Cash-on-cash return
  • Leveraged cash-on-cash return
  • Debt service coverage (DSC) ratio
  • Loan-to-Value (LTV)
  • Price-per-pound
  • Gross profit
  • Profit multiple
  • Capitalization (cap) rate-to-loan basis (aka debt yield)
8.1 Cash-on-Cash Return

Real estate investments are similar to bonds in that they produce yield to the investor. In real estate, the project or investment yield is known as the cash-on-cash return. This return equates the yield to the investor if he or she was to purchase the property on an all-cash basis (i.e. without debt). Simply put, this is the initial net operating income (NOI) divided by cost (acquisition), compared to the stabilized NOI divided by total cost (total capital stack).

It is important to always analyze the difference between the initial (day one) and the stabilized cash-on-cash returns. The more value-created opportunity, the greater the delta should be. Look for at least 200-basis point increase on most value added transactions.

8.2 Leveraged Cash-on-Cash Return

The leveraged cash-on-cash return is the same as the cash-on-cash return, except that it is calculated on cash flow to the investor after debt service, relative to the investor’s equity investment. This is a key metric in commercial real estate investment.

Good investors understand when leverage enhances return (i.e. makes a good project better) and when leveraged creates the return (i.e. make a mediocre transaction acceptable). Thus, the good investor always looks at the leveraged and unleveraged returns. The unleveraged returns should be reasonable. Good investors stay away from using leverage to make mediocre transactions acceptable.

8.3 The Debt Service Coverage Ratio

The DSC is traditionally a measure of a loan’s safety. Bridge loans are typically interest only, meaning that no principal amortization is required. If the DSC exceeds 1.00x, then at minimum, monthly interest payments are covered by the property. Yet because the property is still being improved, it is not unusual for the loan to have an initially low DSC of 1.00x to 1.10x. In some cases, the DSC might be less than 1.00x, which would mean that an interest reserve would be required. Permanent lenders typically look for a 1.20x to 1.25x DSC as the benchmark for a safe loan.

DSC’s are evaluated as follows:

  • 1.00x to 1.05x: Poor
  • 1.06x to 1.10x: Weak
  • 1.11x to 1.15x: Fair
  • 1.16x to 1.24x: Good, but unacceptable for permanent financing
  • 1.25x and above: Acceptable for permanent lenders

Always analyze the difference between the beginning and stabilized DSCs (using the same constant). The wider the gap, the more value that is added and the more risk that is taken.

8.4 Loan-To-Value

The value-added investment business is all about increasing value. The loan-to-value test measures the increase in value.

The value of the property must increase to have a successful value projection. Do not be fooled by properties that have extensive rehab and little to no NOI improvement.

8.5 Price-Per-Pound

When the NOI is not a meaningful number (e.g. when there is little or no cash flow), value is best determined by the price-per-pound test.

There should be a significant difference between the initial (i.e. day one) value and stabilized value on a per-pound basis. These numbers should be compared to the following:

  • Market sales per square foot: Sales per square foot of stabilized and unstabilized property.
  • Replacement cost: A good measure of value; how the investor basis compares to replacement costs.
8.6 Gross Profit (Whole Dollar)

At the end of the day, the business is about making money, not yield or the internal rate or return (IRR). The gross profit test measures how much money is made on the transaction.

8.7 Gross Profit Multiple

The gross profit multiple is the amount of money the investor receives back in total, including principal, interest, and profit. Thus, a 2x multiple means that all principal is returned, along with interest and profit equal to 100 percent of the original principal. A 1.5x multiple means that all principal is returned, plus interest and profit that is equal to 50 percent of the original principal investment.

8.8 Cap Rate to Loan Basis (AKA Debt Yield)

Most lenders look at the loan compared to the NOI rather than the total capital stack. This is known as debt yield or cap rate-to-loan basis. This test should be performed on both initial NOI and stabilized NOI.

Each transaction should be evaluated by using these tests:

  • Gross profit
  • IRR
  • Profit multiple

Are you ready?

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