On the Road to Cash Flow

This article is adapted from the newly released second edition of Investment Real Estate: Finance and Asset Management

For investment real estate, the endgame is net operating income (NOI), which represents a property’s earning power and is a determinant of a property’s market value. However, cash flow is often viewed by investors as a better ongoing measure of a property’s financial health, economic success and management performance. The stream of money coming into and out of an investment, cash flow represents the amount of cash available after all operating expenses and debts have been paid. In a pro forma statement, it is the estimated amount of cash inflows and outflows expected in one or more future periods.

Sounds simple enough. But the issue can become slightly complicated when taking into consideration that not everyone uses the same formula for determining cash flow, makes the same assumptions in calculating it, or employs the same definitions—and these differences start with the calculation of net rent revenue. Property managers encounter financial statements from many different sources, including those from potential future clients who often take different approaches. It’s important for managers to be able to identify the methodology and, where appropriate, convert to that system.

Based on the IREM cash flow model, the first step in the calculation is gross potential income (GPI), sometimes known as potential gross income or potential rental income. GPI is the maximum rent that can be derived from 100 percent occupancy at market rent over the course of a financial period (normally, a year). To determine GPI, assume that all space/units are occupied and all rents are at market value and are paid in full and on time. The result is an indication of what could be achieved if all of the space were generating revenues based on full market rent.

Of course, this number is seldom realized, because 100 percent occupancy at full market rent is seldom achieved. For one thing, there is nearly always some amount of the space subject to existing leases. For example, an office building may have several leases with, say, five years to maturity that were negotiated when rents were lower. Even though the owner will not likely receive market rent for this space for five years, in the calculation for GPI, the figure is reported at market rent and then modified by a deduction known as loss to lease (more on this later).

Commercial leases are often analyzed in detail in the process of calculating cash flow. Part of this leasing process includes preparation of an abstract of the key lease provisions for each tenant to help the real estate management company be aware of key obligations of both parties. Residential leases typically pose less concern than commercial leases because they are short-term in nature (seldom more than one year) and because the landlord dictates the lease format and its key provisions. Properties that use revenue management software must determine how they will report GPI, which could cause the number to vary from day to day. Some owners wish to see the fluctuation in monthly or a stabilized GPI with differences reported in loss to lease.

Loss to Lease

Loss to lease is the income that is lost as a result of contract (actual) rents being less than maximum market rents. This figure is especially important when evaluating a property in a rising market and projecting future rent increases.

A loss to lease can occur in any type of property. For example, in multifamily properties, rents can be raised more easily, but a loss to lease may occur due to a site manager’s unwillingness to raise rents for long-time tenants. Analysts sometimes calculate loss to lease to monitor lost market potential and, in the case of office or retail tenants, to terminate leases if possible when the loss is considered too great.

Loss to lease is an important factor for consideration by property managers for several reasons, one of which is as a measure of management performance. A property without the constraints of long-term leases, such as a multifamily property, needs to keep rents at market, especially in an upward trending market. While there is likely to always be some loss, revealing this amount on the pro-forma statement and clearly stating market rents as GPI indicates the manager is analyzing the market regularly and can plan for rent increases as appropriate.

The loss to lease figure may also be meaningful where the manager has space with long-term leases. While the manager likely cannot raise rents for these tenants, a high loss to lease could alert the manager to re-examine the terms of that tenant’s lease. Perhaps a certain tenant has not been performing on some element of the lease, which could re-open it for negotiation, or there may be a buyout clause that is favorable to the landlord, in which case management may want to consider opening the space for rental at market rates.

In a rising market, knowing the value lost on space leased earlier can help in planning for future leasing activities. In a declining market, where existing leases are higher than current market rents, the pro forma may reveal a gain to lease. This figure may also be used to plan future leasing and operational activities, with a planned reduction of revenue. In a declining market, the manager should be prepared to negotiate rent reductions when leases are renewed, or even earlier than the renewal date, in an attempt to keep tenants who might be tempted to move to a building with more attractive rent.

Vacancy and Collection Loss

In the real world, seldom if ever is all space in a commercial property or are all units in an apartment community rented all of the time. GPI has to be adjusted down to reflect market conditions. Coming up with an accurate adjustment due to vacancy and collection loss will depend in part on the real estate manager’s attention to these figures (i.e., good record keeping).

• There are two types of vacancies that result in a loss of rental income:
• Physical vacancy, which consists of any space that is unoccupied.

Economic vacancy, which reflects any physical vacancies plus space that is leased but not producing rent. This includes space that cannot be rented as is; space used as offices, models or for storage; and space (typically apartments) provided to staff as part of their compensation and thus does not produce rent.

Collection loss stems from bad debts resulting in rents that may not be collected, and concessions or other rent reductions given to attract tenants. Some owners want concessions separated on a line item so they can be monitored or included in loss to lease. Owner goals will dictate how this is reported.

Net Rent Revenue

The difference between GPI and losses due to below-market rents, vacancy and collection loss is net rent revenue. This adjustment is the first part of the equation for calculating NOI and determining cash flow.

The methodology outlined here follows the IREM model and is reflected as Approach A in the chart below. Keep in mind that the perspective of the analyst may influence the approach used for forecasting and reporting net rent revenue. While the end result may be the same, it may not always be desirable or efficient to regularly calculate market rents and loss to lease.

A real estate appraiser, for example, may calculate GPI as the total of all rents under existing leases at the contract rent, plus all vacant space at the market rent for that type of space. This method is based on the concept that in the current year the maximum revenue the property could produce is limited by the leases in place on the property. Vacant space has the potential of being rented at market rates. Sometimes GPI when calculated in this manner is referred to as gross possible income.

The other popular model, shown in the chart as Approach B, is to define gross potential income as the expected income of all occupied units at existing lease rates (contract rent) and vacant units at current market rates. This approach to GPI has been adopted by the National Apartment Association (NAA). It is especially popular with apartment owners who favor it because it places the focus on the degree of leasing activity needed to reach the property’s true potential at any given point in time. While loss to lease can be calculated, it is not emphasized in this approach because, in the short term, contract rents will not change until leases expire and are renewed at market rents.

In the multifamily space, owners and managers who use revenue management platforms often prefer this method because these platforms are highly revenue-driven based on constant fluctuations in the market. Using these platforms, market rents—instead of being solely based on a property manager’s observations of competing units—aggregate demand, supply, renewal trends, competitive rents and more than 500 submarket data points instantaneously. Under these models, GPI can change on a weekly or even more frequent basis, depending on the user’s marketing philosophy.

The chart on this page shows how net rent revenue is calculated and displayed under different approaches to analysis of revenue. Approach A is suggested for property managers when performing cash flow analysis, as it clearly identifies inefficiencies either in management or market forces and points to opportunities for performance improvement.