Property Indebtedness - Apartment Buildings

The following excerpt is from IREM’s publication, Practical Apartment Management, Sixth Edition (IREM © 2009):

Property values are basically determined assuming there is no debt. This helps simplify and equalize the analysis process. But, for the most part, most rental properties have one or more levels of financing that must be accounted for. The payments on these encumbrances are referred to as debt service. 

The investment property’s ability to produce income is one thing, but its ability to service debt is a variable and an independent calculation. Some call property financing a personal undertaking. The owner chooses to finance the property to make up the difference between available cash and the purchase price. Or, by financing a portion of the property, the investor can spread available funds to purchase additional properties. 

While not very likely today, there used to be situations where properties would yield more than the mortgage rate, thus producing what is called a positive leverage. More likely now, investors will experience negative leverage, meaning that the rate of interest will exceed the property’s yield rate. Hopefully, the big payoff will come at the time of sale with an increase in value and without the need to share a portion of it with the mortgage partner. You might say, “Whoa! How did the lender become a partner?” That occurred when the buyer signed the deed of trust (mortgage document). Actually, the lender holds a warranty deed to the property, and the borrower simply has the right to “redeem” ownership. 

Owners who are aggressive, or even unrealistic, in acquiring one or more levels of debt can effectively destroy the proper operation of the investment. The ability of an owner to acquire debt is not an automatic indicator that a property’s income can support the accompanying payments. This problem often influences the property’s operation because there is the practical tendency to follow a system of payment priority. It goes something like this: Pay the mortgage first, or there won’t be any property to manage; pay the employees next, or they won’t come to work; then pay the utilities so that you have light, heat, and water; and finally, pay the insurance and real estate taxes so the lender doesn’t take the property back. These are must-pay items, and they also represent the most significant portion of money outflows. If there is going to be a cash shortfall, the resulting adjustments will almost certainly be deducted from the maintenance, upkeep, and repair expense categories. 

On mortgaged funds, the debt service (the principal and interest payments) is deducted from the NOI; any money remaining is termed cash flow. This money will form the owner’s return on the actual cash invested, also referred to as equity. This cash surplus represents pre-tax, spendable income. While cash flow is tracked and can be distributed monthly, it is usually expressed as an annualized amount. The annual cash return divided by the invested cash equity indicates the property’s cash-on-cash return, or its yield. 

Annual Cash Flow (CF) = Cash-on-Cash Return
     Cash Equity 

As an example, if an owner’s equity amounted to $1 million and the amount of cash generated (CF) in a year was $65,000, the owner’s return would be 6.5 percent

$65,000 Cash Flow = 6.5% Cash-on-Cash Return
$1,000,000 Equity 

Many owners look to cash-on-cash return as their primary concern, and therefore they use this method when measuring investment performance. Be aware, however, that the investment real estate industry has devised a myriad of other methods and formulas to arrive at values and returns. Many deal with after-tax consequences and the property’s appreciation at the point of sale. The accompanying “Cash Flow Projection Example” exhibit illustrates how a property’s financial picture might be presented.