A single entry system with profit based
on cash received less money expended in the
same period. The Income Tax Act permits cash
accounting in the case of farmers,
fishermen, and commission salespeople. A
real estate brokerage must use accrual
accounting, also referred to as double entry
or accounts payable/accounts receivable
system.
The budget provides an overall estimate
of financial performance that must be
converted into cash flow projections. This
task, broadly described as cash flow
analysis, is normally completed based on
historical operating data from the
brokerage. In such instances, the exercise
becomes largely one of refining prior year
budget estimates in light of actuals and
forecasted performance levels. In the case
of income projections, if year-to-year
comparisons are unavailable (e.g., a new
brokerage), previous MLS statistics provide
a starting point, assuming that 80–90% of
all transactions occur on MLS.
Unfortunately, trend analysis for commercial
brokerages is more difficult as MLS
transactions may not constitute a large
portion of market information.
Cash flow analysis begins with
estimating a gross commission income for the
upcoming year and then slotting this income
in relation to typical MLS activity.
Expense calculations are also based on
historical data. Selected organizations and
larger brokerages provide guidelines for
predetermined expense categories. Expense
categories and selected budget amounts are
for illustration only. Wide variations exist
based on accounting systems used by
individual brokerages, compensation plans
for salespeople, and specific brokerage
circumstances, e.g., a new brokerage would
undoubtedly budget more dollars on premises,
advertising, and communication than a
well-established operation.
A relatively generic term that has
traditionally eluded precise definition.
From an historical perspective, cash flow
referred to the profit arising from a
business and provided an indication of
internal funds available for capital
acquisitions and payment of dividends. In
real estate, the buying and selling public
typically view cash flow as any income
generated by an investment. Differing
terminologies have often made comparisons
difficult. Consumers and practitioners often
reference gross operating, gross rental,
effective gross, and adjusted gross incomes
to mention a few. To compound matters in
real estate, no standard cash flow reporting
formats are universally used in the real
estate profession.
Commercial practitioners and appraisers
have sought to more accurately define cash
flow as the net operating income generated
by an investment property less debt service
(more technically called cash flow before
taxes (CFBT) or, before tax cash flow).
During the past three decades, more precise
terminology concerning cash flow has entered
the marketplace. This is due, in no small
way, to recent attention given real estate
by financial analysts. Precision was
inevitable as the convergence of commercial
real estate with other capital markets
occurred. Now, properties are screened,
valued, and selected with tools commonly
associated with the bond and equity
financial markets. Institutional investors,
familiar with capital budgeting and asset
selection techniques, now routinely dissect
real estate cash flows in their search to
maximize returns.
The more or less widely accepted
categorization of cash flow involves two
parts: operations cash flow and sale
proceeds cash flow.
The ongoing activities of an investment
and the positive or negative cash generated.
Appraisers and real estate practitioners
calculate a single year’s cash flow based on
income and expense analysis to arrive at 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,
practitioners work in two worlds:
The objective development and
analysis of reconstructed operating
statements and cash flows based on
appraisal criteria to arrive at market
value; and
The more subjective, individual,
investor-oriented forecasting of cash
flows based on specific investor goals
leading to investment value.
Capital budgeting techniques have
introduced a differing perspective on
revenue generated at the point of sale. As
with operations cash flow, sale proceeds can
be viewed under sale proceeds before tax or
sale proceeds after tax.
Asset managers typically review
operations cash flow and reversionary funds
(sale proceeds) within the overall analysis
of any capital project. Consequently, real
estate followed suit. This perspective on
cash flow is particularly important when
applying discounted cash flow (DCF)
techniques in the analysis and valuation of
investment-grade properties. DCF takes into
account the initial equity, a specified
holding period, the operations cash flow
over a specified period, and the proceeds at
the point of sale (reversion). The discount
rate relates to individual investor
expectations and/or marketplace trends
relating to either before tax or after tax
analysis.
Practitioners widely accept the DCF
method as a valuable measure in accurately
assessing the future benefits (cash flow) of
a real estate investment. Appraisers group
the DCF technique under yield
capitalization, one of two methods used
under the income approach to value.
Cash flow (periodic dollar amounts),
relating to the operation of an investment
property after all expenses are deducted
including annual debt service and tax
liability. CFAT refers to operations cash
flow only and should not be confused with
sale proceeds after tax. The latter involves
cash flow resulting from disposition
(reversion) of the property. The terms after
tax cash flow and cash flow after taxes are
synonymous for purposes of real estate
investment analysis.
CFAT is one component within the overall
cash flow model in providing real estate
valuation and investment comparisons. In
particular, CFAT is most commonly associated
with the analysis of real estate investments
and the establishment of investment value
(value to a specific investor), using the
discounted cash flow model. The cash flow
model provides a template for the analysis
of CFAT derived from both operations and
sale proceeds over a specified holding
period.
Cash flow (periodic dollar amounts),
received from the operation of an investment
property after all expenses are deducted
excluding a deduction for any tax liability.
Operations CFBT is calculated by subtracting
annual debt service from net operating
income.
CFBT is most commonly associated with
the analysis of real estate investments
based on the discounted cash flow model. The
cash flow model provides a template for the
analysis of cash flows before tax derived
from both operations and sale proceeds over
a specified holding period. CFBT is
frequently used by appraisers in
establishing market value based on
discounted cash flows; however, its role
extends to investment analysis and
estimating of investment value depending on
assumptions made in the analysis process.
A term
used in commercial real estate
denoting an analytical structure for
estimating cash flows derived both
from the operations of investment
property (operations cash flow), and
the cash flow arising from the sale
proceeds of property (sale proceeds
cash flow).
Real estate practitioners can
provide investment comparisons and
estimate either market values or
investment values through detailed
analysis of operations and sale
proceeds cash flows, either before
or after taxes. The model contains
four elements:
Initial Investment
Amount invested by the investor
not including borrowed funds.
Consequently, other non-investor
capital would also be excluded,
e.g., equity participation and joint
venture capital from others.
Estimated Investment
Holding Period
A forecasted time for both
operations and sale proceeds cash
flows, often for a period of three
to five years. Cash flows within
periods may vary and also be
positive or negative.
Periodic Cash Flows
Cash flows must be consistent;
that is, either before tax or after
tax dollars and typically end of
year (EOY). Periodic cash flows are
referred to as operations cash
flows.
Sale Proceeds Cash Flow
Cash flow realized from the
reversion (sale) of property,
expressed as sale proceeds before
taxes or sale proceeds after taxes.
Consistent cash flows are
required in investment analysis. If
periodic cash flows are after tax,
sale proceeds must also be after
tax. The cash flow model applies to
either before or after tax cash flow
basis to arrive at investment
analyses and value estimates.
Commercial practitioners typically
forecast cash flows after tax, to
reflect a truer, more accurate
measure of yield from an individual
investor’s perspective. Market value
estimates are commonly associated
with before tax perspectives.
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