I have been talking to a seller about his park and his pro forma adds a figure for loan principal reduction to the NOI. This effectively increases the cash on cash return by nearly double. Is this a true reflection of the property’s performance or an accounting gimmick? Based on his asking price, the cash on cash return is about 5.5% without pricncipal reduction added in and over 12% including the principal reduction amount. Since the principla reduction is not spendable cash for me, I don’t think it is apprpriate to include in the pro forma to a prospective buyer. Please comment.
The “property’s performance” and the cash on cash return for a specific year are not necessarily synonymous. Technically it is a true reflection of the property’s performance but it is NOT a true reflection of the cash on cash.
Usually the principal reduction is separated out from the net cash flow when listing returns. In other words, the cash on cash is listed as net cash flow after debt service / total amount invested. Below that, the total return(or something similarly worded) is listed as (cash flow after debt + principal reduction) / total amt invested.
From an ethical standpoint, they should be separated. Does that mean you’ll never come across a seller trying to pull a fast one in hopes of making the deal look more attractive? Of course not.
Your seller is loosely talking about IRR and not about Cash on Cash here. IRR and CoC are very different. As an aside, a 5.5% COC or a 12% IRR are not compelling numbers in our industry.
If your target is “X” COC, then your IRR will usually be “X+principal reduction and appreciation” IRR. He’s pulling an accounting trick of sorts on you it appears. If you are looking for “x” CoC (spendable cash) and this deal does’t provide that, toss it in the trash can and move forward to the next deal. There’s always another one to look at.