Equity Based Services, Inc

EBS has acquired two new Self Storage facilities. The properties were acquired as two stand-alone facilities with one located in Colorado Springs, CO and the second located in Missouri City, TX.

Access Self Storage located at 6604 Murphy Road, Missouri City (Houston Area), TX, is a single-structure climate-controlled facility with 560 rental units and 55,472 Net Rentable Square Feet of self storage space. EBS now owns 26 Self Storage facilities in the state of Texas.

Access Self Storage located at 3150 Boychuck Avenue, Colorado Springs, CO consists of 487 climate controlled units (31 of them are office warehouse units) and 36 RV parking spaces. This property has a total of 77,720 Net Rentable Square Feet. This acquisition represents the second facility in Colorado Springs acquired by EBS.

Both facilities will be re-branded as American Mini Storage and managed by All American Property Management, Inc. (“AAPMI”) under the direction of Eric Kaplan.

The equity financing for these acquisitions came from the fully subscribed and closed EBS Income Fund III, LP and from the pool of EBS private client investors.

“These acquisitions should complete the portfolio for the EBS Income Fund III”, states Troy Downing, Principal, Equity Based Services, Inc.. Downing continues, “These two Access Self Storage facilities are strong class-A properties. The debt financing we were able to facilitate for these deals has allowed EBS to wrap up its year on a very positive note”.

The debt financing for these acquisitions came from a life insurance company and was arranged by Tavernier Capital Partners. The general terms included non-recourse, 7% interest, and a 10 year term with a 25-year amortization.

“In these days of short, 1-3 year loan terms, we were very happy to be able to secure 10-year notes for these projects”, states Downing.

“These transactions are further evidence that life insurance companies are a viable alternative to commercial banks for longer term fixed rate non-recourse debt”, states Saul Hoppenstein, Principal, Tavernier Capital Partners. Tavernier secured the financing through one of its life company correspondent lenders. The loans accounted for 62% of the purchase price at a fixed rate of 7% for 10 years with a 25 year amortization schedule. Hoppenstein further comments, “Due to low delinquency rates in the self storage sector lenders are actively looking to finance cash flowing well located facilities with established operators such as Equity Based Services.”

These acquisitions represent the final 2 closings for a busy acquisition year. EBS has acquired more than 508,000 NRSF of new Self Storage units, successfully refinanced maturing debt, and closed on their fourth private equity fund.

“These two final acquisitions of 2009 cap off a phenomenal year for EBS.” states Stephen Kaplan, CEO. Mr. Kaplan continues, “These facilities are strategically located in strong growth markets that EBS has been actively targeting. 2009 will be remembered as the year cash flow went on sale and EBS was able to acquire strong performing assets at discounted prices in first tier growth markets.”

EBS now owns 66 Self Storage properties in 11 states with nearly 37 thousand storage units and nearly 4.6 million Net Rentable Square Feet.About Equity Based Services, Inc

This article is for informational purposes only and does not, in any way, constitute an offering to buy or sell securities.

Equity Based Services, Inc. and principals Stephen Kaplan and Troy Downing spent an evening with the Cystic Fibrosis Foundation to help raise money to fund research to find a cure for this debilitating disease.

Mr. Kaplan was a table sponsor and competed in the pro/am tennis match that followed the event. Donors sponsored teams by bidding for their favorite pair. All proceeds went to the CF Foundation to help fund further research. Mr. Downing also donated an auction item and volunteered time to help make the event a success.

L-R Kurt Ambrosius-Inv. Relations, David Gill- Investor, Gregg Caledonia- Partner, Troy Downing- Principal, Stephen Kaplan- Principal

The Event was a success and will hopefully bring us closer to finding a cure for CF. 

For information about the CF Foundation, or to donate time, money or services, please contact the foundation directly:

Cystic Fibrosis Foundation, San Diego Chapter

If you build it, they will come. In the heady, cash flowing, free lending days of the first half of the decade that may have been the case, but, as we’ve all seen, the times they are a changing.So where are the opportunities today? We keep hearing the mantra “self-storage is recession proof.” Is this true? Absolutely not! Self-storage has proven recession resistant, but, a recession definitely affects the self-storage industry, especially a recession as long and drawn out as the current one. Resistance is all we need to maintain a strong asset in a down economy. Add the fact that self-storage is inflation neutral and you have a recipe for success independent of the whims of the economy.

“The best days for self-storage are ahead of us,” said Spencer Kirk, CEO Extra Space, at a recent California Self Storage Association (CSSA) meeting. I couldn’t agree more.

Let’s think about the mechanics of this. As the economy recedes, people and businesses downsize (or close down). This is an obvious perk for self-storage as storage needs are created with both of these situations. Recessions can also cause people to move in search of new jobs. Relocating can create a need, especially if people are moving with the intention of returning at some point. Businesses may also close down temporarily, or downsize, with the intention of reorganizing or expanding upon a macro-economic recovery.

But, what happens with an extensive and prolonged recession? What happens with double-digit unemployment numbers and a massive exodus of people, jobs, and businesses with no intention of returning? There is a tipping point. There is a point at which even the $50 a month for a small storage unit is just too much. Fortunately, we are nowhere near this point, but we are close enough to see weakness in rents and occupancies in certain markets.

These weaknesses are nowhere near catastrophic, as even in a weakened state self-storage investments are some of the strongest performers, certainly in terms of cash flow Real Estate, which we have seen in recent years.I hesitate calling this a weakness because the cash flow part of the business is still very strong and will continue to be strong, but it’s just not as strong as it was a year or two ago in certain markets; “certain markets” being the key operative phrase. If you are operating in established neighborhoods, infill locations, with little to no competition, you are probably doing pretty well. If you took the “if you build it, they will come” attitude and built in a new neighborhood, you are probably feeling the crunch of a slow absorption of new houses and slow lease-up schedules. Some of these markets can take four years or longer to stabilize from Certificate of Occupancy compared to 30 to 36 months in a well-established market. This can be a long and painful period of feeding carry costs and debt service.

Understanding The Issues

What this means to the developer is a higher and longer carry cost until the facility is paying for itself. This is also a very tough market to sell these facilities in because the actual value of an unstabilized asset may be below the replacement cost or cost of construction. Very few buyers want to take on the burden of an unstabilized product in this market. Does that mean opportunity? Of course it does! Personally, I wouldn’t build myself, but I would love to make a deal on the right new project by buying it from a developer who is “compelled” to sell. 

There are a couple of issues to address with the “value-add” deal. First of all, it has to be priced right. Since a cap rate doesn’t make sense on actual numbers, I’d value it on proforma numbers, but at a high cap rate, definitely in the double digits. It doesn’t make a lot of sense to value based entirely on replacement cost since there is a certain amount of risk involved in lease up that has to be accounted for in the current market. Hopefully, the phantom cap rate and the cost of construction come together and it’s a win, win situation for everyone, but this is a business opportunity and must be scrutinized as such.

The second problem is financing. Financing has a lot of people and businesses in trouble over the last few years and we will continue to see the fallout for a few years to come. Leverage is a valuable tool, but must be carefully considered. Relatively low leverage is fine on an unstabilized asset, but difficult for most operators to obtain as lenders are still a little gun shy about making these types of speculative loans. If you are well capitalized, it may make sense to just pay all cash for a lease-up deal. By doing this, you’re not under the gun to rapidly stabilize the facility to make debt service or coverage ratios. This is in addition to the fact that you will most likely be paying a higher interest rate on the note because of the increase in lending risk.

According to Kirk, Extra Space approached 250 banks and was only able to secure one loan. This is with a $1 billion balance sheet. Personally, I don’t believe the lending markets are quite that bleak, but you definitely have to turn over a lot of rocks to find a lender that meets reasonable lending criteria.

Depending on the market, you should assume a 36 to 48 month lease-up period and either sell or refinance after that to maximize your return. If you are able to stabilize the property to at least 85 percent economic occupancy, it should be easy to sell at a reasonable stabilized cap rate (seven to nine percent depending on the market) on real numbers. It should also be easier to leverage as the lenders will put value and safety into the fact that the property has exhibited stable and predictable cash flow.

So, what’s the opportunity here? The opportunity is to acquire unstabilized, newer facilities at bargain prices. Eventually, we will see a huge amount of value created in these properties, but this is a speculative play and not a cash flow play. So, it must be given its due scrutiny when establishing pricing and value.

Slow Down In New Construction

The difficulty in developing new projects, the main hurdle being access to reasonable financing, will create a tremendous amount of value in existing facilities. This is a necessary and welcome correction. The industry was just plain overbuilding. Even projects that have made it past the permitting and entitlement stage will most likely remain stagnant for some time if not forever. Even large operators such as Extra Space have halted new construction projects citing lack of appropriate financing. Obviously, the large public operators have to answer to their analysts and shareholders that very carefully scrutinize maturing debt and liquidity, so it makes sense that they would put a hold on new developments. For the rest of us, we are enjoying the benefits of uncorrelated assets that aren’t subject to the whims of stock analysts and stock markets.

 Obviously, with less inventory on the market, existing inventory should remain strong and grow stronger. I usually subscribe to contrarian thinking. In other words, if everyone’s getting rich buying widgets, it’s probably too late to get into the widget market. With this in mind, I have to contradict my contrarianism. I don’t see a lot of interest in developing new product. There are a few out there, but the general thinking is that it’s not a good time to be developing. The contrarian argument would be that this is the best time to jump into that market as there would be little, if any, competition. But given the overall state of the lending and real estate markets, I think we should hold off a little longer before jumping into speculation on new product. There will be a tremendous opportunity in this space once we see stronger growth in absorption, occupancy, and rents in existing facilities.

Stabilized Product

Here is where I see the biggest opportunity: Cash flow is on sale. This is a great time to own and operate cash flow real estate. It is one of the few predictable performers out there in terms of investment dollars. As of this writing, the DOW is slowly creeping upward, but it is a fickle and unpredictable beast. By year end, I wouldn’t be surprised to see it soar to 11,000 or drop to 6,000. However, here is the problem. All you need is a report on job weakness, institutional failure, or some missed target in an economic indicator to cause a precipitous fall, whereas raw exuberance about a positive indicator can cause it to soar. In other words, it is a great vehicle to make a lot of money or lose a lot of money.

We just don’t see that in self-storage. The returns are predictable. If you buy right and operate professionally, it is very difficult to make it worth zero. At a recent storage convention in Huntington Beach, Spencer Kirk posed the following question: “How many self-storage Assets have ever gone dark? I’ve seen one. Self-storage is not a distressed asset.” This is an important point. The asset class wants to perform. Very few have ever actually failed, and this is not considered a distressed asset class. There’s a lot of security in that. This is not a speculative play.

 According to Kent Christiensen, CFO of Extra Space Storage, who also spoke at the recent CSSA meeting, “The product is doing very well. We are still issuing rent increases on existing customers.” This reality gives credit to the general thought that self-storage continues to be a safe, predictable, and recession resistant asset. There is obviously a huge amount of opportunity here. 

Here’s the quandary. Well-capitalized and strong operators are hanging on to their stabilized product. The opportunity lies in the fact that very few of them are actually in the market to buy. There are deals out there where you can buy stabilized cash flowing class-A product at reasonable cap rates (expect anywhere from eight to 9.5 percent on actual numbers). I’d argue that the values of many of the stronger facilities lie in the seven percent range, but these are simply not trading.

What you need to look for is a seller who is compelled to sell. The seller must be either distressed or experiencing some other compelling reason to get out of the market or raise capital. Examples that we’ve seen include sellers with maturing debt that are unable to extend or modify their loans, cross-collateralized loans with underperforming assets are forcing operators to sell their performing assets problems in other parts of their portfolios that require cash to carry, and public companies that need to increase their cash position to satisfy analysts and shareholders.

For the most part, these sellers realize that it is very difficult to find a seven cap buyer in the current market. There are a few delusions of grandeur out there and these delusions have soured many deals. Time will correct all of these issues. But for now, it simply doesn’t make sense to buy a facility that won’t produce more than eight percent net cash flow out of the box. The main lever you have for adjusting the cash flow is, of course, the purchase price.

All things considered, a stabilized cash flow deal, bought right, should yield at least eight percent NOI after debt service year one and should have an all-in return with appreciation in the 20 percent range with a five- to seven-year hold. Where do you find these deals? In general, once they reach loopNet, it’s too late. The seller’s have been out in the market, their brokers have already approached the “usual suspects” trying to find a buyer, and the property is burdened with marketing and broker’s fees.

Finding an “off market” deal is usually your best bet, but it requires legwork. Sourcing deals from lenders is one approach. Often lenders are the first to know about distressed sellers and are more than willing to match buyers with sellers. Another approach is to simply approach operators in markets in which you are interested. Leave your card and tell them that you’re a motivated buyer. Eventually, you will start getting calls.

Enlist the help of your existing facility managers. If you have facilities in markets that you like, your managers should be conducting periodic market surveys as part of their normal duties. Have them approach other managers in the markets you like and get a read on whether there may be interest in selling. You never know what you might dig up. These managers are “locals” who should have a pretty good read on what’s performing and where the opportunities lie. 

Finally, don’t underestimate the breadth and reach of the brokerage community. Develop relationships and make sure the brokers know that you are a motivated and effective buyer looking for off market deals. They all have pocket deals and are more than happy to find a bona fide buyer. We all need to take care of each other, and of course, the broker needs to be paid a commission for his or her service. But, finding these off market deals will limit the costs the broker incurs marketing a deal and will often lead to a lower commission which is a cost to the buyer whether the seller pays it or not.

Going Forward

I have no idea if we are at the bottom, in the middle, or at a plateau in the economy. My gut feeling tells me that it is still not stable and that it will not be stable for some time. Once we begin the recovery process, it will be a long and slow road. First we will see unemployment peak and stabilize. After this, lenders will start getting their feet wet in this brave new world. Once financial liquidity starts to increase, jobs will increase, consumer confidence will increase, prices will stabilize, and the economy will warm up.

Then the stimulus hits. If it hits hard, we will see inflation and every one of us will be glad that we have investments in self-storage real estate.

EBS has been in the press this week. Two interesting articles to note. The First was an article that was featured in today’s (Oct 5, 2009) edition of the San Diego Business Journal. The article was titled “Recession Good for Self-Storage Sector?” with a subtible of “Equity Based Services Sees Sales Rise, Others Don’t”.

The SDBJ article was written by Mike Allen who interviewed EBS Principal Troy Downing as well as other local San Diego storage operators.

The article basically pointed out that EBS was reporting strong gross income and occupancy numbers as other operators were not. The main discrepancy in these reportings can be attributed to location. EBS has been very diligent about locating markets that are conducive to the operation of Self Storage Facilities. Targeting micro economies, infill locations, and stabilized product has allowed EBS to maximize the performance of these properties fully leveraging their operations with EBS’ inhouse management company, AAPMI.

EBS has more than a third of its portfolio in Texas, which has continued to be a strong growth economy. The rest of EBS’ portfolio is in targeted, sun belt areas that have also, for the most part, shown strong rental numbers in spite of a downward trend in the macro economy. There are definately a few spots that are flat, but, overall, EBS has enjoyed upward trends even in the first quarter of 2009. EBS’ overall growth in gross collections from rent has increased by 13.1% over the last 12 months and this is not including ancilliary income from truck rentals, retail sales, cell towers, or billboards.

EBS still sees opportunity in stabilized, class-A product in established markets and will continue to capitalize on these opportunities in the forseeable future.

The other article of note is in this month’s Mini-Storage Messenger published by Minico, Inc.

In the October issue, there is an article by Yours Truly, Troy Downing regarding opportunities in Self-Storage. The article is an attempt to make sense of the Commercial Real Estate Markets as they relate to the Self Storage Industry, as well as the lending and development markets. In this article, I discuss what I see as the opportunities for successful acquisitions and investments in the Self Storage Commercial Real Estate Space.

The Mini-Storage Messenger article can be found in the October issue of their glossy Trade Magazine, or, online at: Opportunities In Self-Storage

Dear Friends and Partners;

Stephen Kaplan and I share a vision of giving back to the community where possible and supporting the efforts of others who are, in our opinion, striving to make the world a better place, performing admirable work in finding cures for debilitating diseases, and/or create opportunities where there is need.

Stephen and I, as well as Equity Based Services, Inc. would like to take this opportunity to introduce you to one of these organizations.

Youth Tennis San Diego is an organization devoted to creating positive opportunities to underprivileged and at risk youth in San Diego County.

For the past 20 years, at over 100 park and recreation sites, the Youth Tennis San Diego After School Tennis Program has given positive opportunities to over 10,000 young people in the critical after school hours where positive activity is most needed. 93% of the children involved are enrolled in “free lunch” programs at their schools.

This organization helps our community by giving positive activities, mentoring, scholarships, and friendly competition to children in need. These are often children who would otherwise be left on their own.

Stephen and I, as well as Equity Based Services, Inc. and our partner Gregg Caledonia encourage you to consider supporting this worthy cause.

YTSD is planning a fundraiser “MatchPoint Ball” on Friday, November 13^, 2009. Information on their Gala is attached, or, you can find them online at: http://www.barnestenniscenter.com/ytsd

You can also get more information by contacting Linn Walker at 619-221-9000.

Sincerely,

 Troy Downing

ENC:

Gala Invitation

YTSD Information Sheet

Gala Wish List

It’s been a great week at EBS with the successful refinincing of a construction project in Arizona, and the acquisistion of Advantage Storage in Rockwall, Texas.

Rockwall has great demographics (one of the fastest growing and wealthiest counties in the country) and is a stabilized Class-A facility in a city with a moratorium on any new Self Storage construction. Quality of the location, quality of the facility, and the huge barrier to entry for any competition create the perfect storm of opportunity to successfully operate this facility.

It’s a welcome addition to the EBS portfolio which can be found here: American Mini Storage.

A complete press release announcing the acquisition can be found here: EBS Acquires Class-A Facility in Texas

According to the 2009 Top Operators list published annually by the Mini Storage Messenger, Equity Based Services, Inc. is number 12 in the Private Sector with more than 4.3 Million Net Rentable Square Feet of Self Storage owned and operated. If you include the 5 public REITS, EBS is number 17 in the Nation. All EBS properties are owned by EBS and not third party management arrangements.

EBS is continuing to grow with several new properties in the pipeline including at least one scheduled to close in the next few weeks.

We look forward to growing our successful business model and continuing to be a fast mover and successful operator devoted to the Self Storage Industry.

by Troy Downing 

Generally, when we talk about Self Storage Real Estate Investments, the topic of tax sheltered income comes up. This is a great way of deferring taxes on a large portion of the income that a real estate investment makes. But what about growing and accumulating this income tax free?

Real Estate belongs in your retirement portfolio. This is a great asset that can balance your portfolio of stocks, bonds, and other asset types.

I am not a tax professional. I have to throw that caveat out. So, please discuss this with your tax professional before making any decisions.

Here are the general issues with holding real estate in your self-directed IRA or Defined Benefit Pension Plan.

First of all, the IRA has to be held by a trustee. There can be no co-mingling of funds or assets. There are a number of companies that offer these services such as IRA Resources in La Jolla, CA. The trustee will hold all of the cash and investments for you and make investments based on your direction.

In order to hold real estate in your IRA, the trustee must purchase the property within the IRA. In other words, you cannot transfer property that you already own into your retirement account. It is also a non qualifying transaction for you to sell property that you own into your retirement account. A retirement account can only be funded with cash or a rollover from another IRA.

Once you have set up an account with an administrator, they will handle all of the cash issues. They will pay for the purchase and will take possession of all of the cash generated from the real estate investment. The cash generated is not taxable and as it accumulates can be used to make other real estate or non real estate investments.

As per current IRS rules, the cash flow and appreciation that you accumulate in your IRA won’t be taxed until you reach retirement age and start to take distributions.

A couple of other things to think about with holding real estate in a retirement account. It really is best to have a third party management company run the real estate business for you. They should market, rent, pay the bills, and distribute the net cash flow to the trustee that is administrating your retirement account. There are a number of things that can cause problems if you don’t follow this route.

First of all, co-mingling of funds can cause problems with your retirement account. You don’t want to take personal possession of the income but rather keep all of the cash in a separate entity for the real estate investment and the net should flow directly to the IRA administrator or trustee.

You also have to be careful about paying for expenses and repairs out of your own funds as this may be considered a contribution to your IRA and is subject to penalties if the amount if over the IRS maximum yearly contribution.

Another advantage to using a third party acquisitions/management company for buying and running the property is that these companies will generally syndicate the ownership interests. In other words, you can own a portion of a larger property that you may not have been able to participate in otherwise. So, if you have $50,000 to invest from your IRA, a Tenant in Common syndication will allow you to participate in a much larger transaction, such as a 1% interest in a $5 million Self Storage facility.

To simplify all of this it’s usually best to put your trust in a third party to handle the acquisition, management, and disposition of the property.

To simplify, here are the basic steps for holding real estate in your retirement account:

1. Set up an account with a facilitator, such as IRA resources.
2. Fund your account with cash or rollovers from another IRA
3. Find an acquisitions/management company that will acquire and manage the real estate investment that you are interested in.
4. Direct your IRA trustee to allocate funds to the real estate investment and close the transaction
5. Relax until retirement.

Once again- I believe that this is a great way to balance a retirement portfolio, but please discuss the intricacies with your tax and investment professionals before making any decisions.

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Here are a few highlights for operations for the month of June, 2009.

Storage Inn of Las Vegas, NV

• Occupancy remains 88%+/-. 
• Year to date we have been able to decrease expenses by approximately 5% compared to last year.

Pro-Storage Chattanooga, TN

• Occupancy remains 90% +/-.
• Year to date through June 30, 2009 we have been able to decrease expenses by 7.6% compared to last year.

Ashley Road Charleston, SC

• The current occupancy at Ashley Road is 87% and is in great position as we move into the prime leasing months.

Storage Plus Tyler, TX

·         Occupancy remains at approximately 90%.

·         Gross profit for the 2^nd Quarter 2009 has increased over 5.5% compared to the same quarter last year.

AMS 1 Austin, TX

•  AMS 1 Austin remains approximately 88%.
• The property is running at a 32% expense ratio, demonstrating efficient management and strong performance. 

AMS I San Antonio (Fredricksburg), TX

·         As of June 30, 2009 occupancy increased to 84% at the site. 

·         As of July 24th occupancy has further increased to 85.8%.

·         Gross income for the month of June 2009 was 4.8% higher than in June 2008.

·         Year to date through June 2009, gross income has increased 2.9% compared to the same time period in 2008.  

·         Receivables for tenants over thirty days late remain under $1,900, which is very low.

AMS 1 Converse, TX

·                Gross collected income increased 5.4% in June 2009 versus June 2008.

·                Gross collected income year to date through June 2009 increased 5% versus the same time period in 2008.

·                Occupancy remains in the 95% range.

·                Receivables remain low, under $3,000 for tenants over thirty days late.

·                A new digital camera system is being installed at the property.

AMS III Memphis, TN (LocknLatch)

·         The storage units have maintained 90%+/- occupancy

·         The RV parking has increased to 88% in occupancy.

·         Receivables remain extremely low, under $1,000 for tenants over thirty days late

·         Gross income increased 6.9% in June 2009 when compared to June 2008.

·         Year to date through June 2009, net operating income has increased 6.3% vs the same time period in the previous year. 

AMS 1 Colorado Springs, CO (Grinnell)

·         Occupancy has remains at approximately 99% despite the aggressive rent increases to current tenants.

·         Gross income increased 6.7% in the month of June 2009 when compared to June 2008

·         Year to date through June 2009 income has increased 4.8% when compared to the same time period in the prior year.

·         Net operating income has also increased 4.8% year over year in the same time period despite the recession that has crippled other classes of commercial real estate.

by Troy Downing

I’ve been asked a few times lately about the differences between cash flow, cash on cash returns, and total returns in Commercial Real Estate transactions. In other words, there seems to be confusion about what the difference on a pro forma is between a 9%/year cash flow distribution and a 25%/year total cash on cash return. There also seems to be some confusion on what the basis is that these are calculated on.

“Cash on Cash” return is a metric that I personally prefer using because it is a simple way of describing the actual return on investment received without weighting the return as principal is returned. This would be much more complicated and would be represented as an Internal Rate of Return (IRR) calculation. An IRR calculation takes into account the time/value of money. I will discuss IRR calculations later, but, for now, it is beyond the scope of this article.

Annual Cash Flow

The Annual Cash Flow is the Net Operating Income (NOI) that is generated and distributed in a year. This does not directly correlate to an investor’s pro rata share of the profit and loss from running the business but rather the amount of cash that is distributed- the free cash flow. The reason that there isn’t a direct correlation between the cash flow and the profits of the business is due to the tax deductible expenses of running the business such as interest expense and depreciation. The basis that the return is based on is the number of dollars that were actually invested into the project.
For example, an investment of $100,000 that pays 9% in cash flow will obviously pay $9,000 over the course of a year. Depending on the project, the investor’s share of profit and loss of the business may only be $2,000 if adequate expenses and depreciation exist to shelter the bulk of the income. So, in our hypothetical situation, the investor receives $9,000 in cash flow distributions but is only required to report the unsheltered amount of $2,000 on their taxes.

If there is no appreciation in the value of the underlying asset or it is never sold at a profit, the annual cash flow and the total return is the same. In other words, if the project is bought for $100,000, it produces $9,000 per year for 5 years and is then sold for $100,000 the total return is 9%/year.

Total Returns with Appreciation

Here’s where the confusion normally sets in. If there is a project that has a pro forma expectation of 9%/year in cash flow and a total return or “all-in” return of 23%/year, what does that mean?

Let’s go back to our earlier example. We will assume that there was a $100,000 investment, it distributes net cash flow of $9,000/year, and it is held for 5 years. With these assumptions, there must be appreciation in the underlying asset. More specifically, it must appreciate by an average of $14,000 per year. (This appreciation is not necessarily linear and may increase more toward the end of the investment cycle than it does toward the beginning.) So, in this example the property must be sold for $170,000 at the end of the 5 year hold.

To calculate the total return, we first add the cash flow received over the 5 year term of the investment. Since we had a simple return of $9,000, we come up with total cash flow of $45,000 distributed over 5 years. Now we add in the appreciation. If we bought in for $100,000 and sold for $170,000 our appreciation is $70,000. Add the total cash flow to the total appreciation and we come up with $115,000. That was the total dollar amount of the return on investment. If we divide this number by the number of dollars invested ($115k/$100k) we end up with a return of 115%. Not a bad return. Now divide the 115% by the number of years held, or 5 in this case, and we end up with a total return of 23%/year.

In other words: total return = ((cash flow + appreciation)/dollars invested) / years held

Total Returns with Return of Principal

Here’s a slightly more complicated model. Some times during the investment cycle, part of the invested capital is returned. Since this is a return of capital, it is not a taxable distribution. But, it does reduce the amount of capital that is “working” in the investment. These returns are normally the result of refinancing that lever properties as they mature. This is a pretty powerful tool that allows the investor to re-invest capital that is freed up from the refinancing and potentially achieve compounded returns as the capital returned is invested.

In this case, the annual returns need to be based on the actual capital in the deal. This is normally represented as a weighted average. An example of a weighted average can be as simple as this: Assume $100,000 is invested for 6 years. At the end of 3 years, $50,000 is returned to the investor as the result of a refinancing. At the end of the term, the remaining $50k is returned. In this example, there was $100k working for 3 years and then $50k working for 3 years. If you add the amount of capital working each year together and divide it by the number of years, you get the average. So, 3 years at $100k = $300k. Three years at $50k = $150k. If you add these together, you get $450k. Divide this by 6 years and you get $75,000 as the average. (100 +100 + 100 + 50 + 50 + 50 = 450; 450 / 6 = 75)

In calculating cash flow rates for an investment like this, the cash flow will always be in relation to the amount invested at a given time. So, if we receive $9,000/year through the 6 years of this hypothetical investment, the return will be 9% for the first 3 years ($9k/$100k) and will be 18% for the second 3 years ($9k/$50k).

It is because of this change in actual equity in the project that you will normally see cash flow percentage numbers move up after a refinancing.

For calculating the total return for a project that returns interim capital, we use the same formula as we did for calculating the simple “all-in” example above, but, we divide the total return dollars by the average equity in the deal rather than the initial investment.

Let’s assume $100,000 is invested for 6 years now. We’ll assume that the investment pays $9,000/year and is sold for $150,000. After 3 years, $50,000 of principal is returned to the investor, so, the average equity invested over 6 years is $75k ((3 * 100k + 3 * 50k) / 6). If we add the cash flow to the appreciation we come up with $104k ($50k appreciation + $54k cash flow). If we divide the $104k by the average principal in the deal ($104k / $75k) we come up with a ratio of 1.38. If we divide this ratio by the number of years held, we come up with a total return of 23%/year. Another way to think of this is that you made 9%/year on the original $100k before the return of capital and you made 34%/year on the remaining $50k. Normally this is simply stated as a 23%/year total cash on cash return. But in any case, you invested $100k and you increased it to $204k over a 6 year period. This is not accounting for the compound returns that you may have generated by investing the $50k return of capital at the midterm of this investment.

In Summary

Annual Cash flow is exactly that. It us usually represented as an annual percentage that an investor receives based on the dollars invested. Total cash on cash return is the total amount of cash flow, plus the total amount of appreciation divided by the amount invested, and then divided by the number of years that the investment lasted. Finally, total cash on cash return with a return of capital is represented by the total cash flow added to the appreciation then divided by the average amount of equity in the deal and then divided by the number of years held.