The German Real Estate Market: Analysing Balance Sheets is the Key to Rate of Return
In Germany, when working in the dynamic framework, external accounting is extremely helpful for investigating possible return if you are dealing with investments in real estate or companies that are active on the real estate market. In the previous article we therefore acquainted ourselves with how balance sheets, profit and loss accounts with associated notes, and the cash flow statement are prepared. In this article we will direct our attention to the tools available for analysing a balance sheet in order to help ascertain investment strategies as well as the risk and opportunities profile.
Balance sheets analysis summarizes financial information. This makes it possible to analyse the key performance indicators for the economic situation of a real estate company and to predict its development. There are a number of different theories concerning just how to analyse a balance sheet. The difference generally lies in the treatment of certain items and how success is defined in terms of a given period of time.
In Germany discussion generally centres on the third book of the Commercial Code. A schematic method consisting of six steps for analysing balance sheets has prevailed in the literature on this topic:
1. Data collection for the economic aspects of the legal framework
2. Preparation of the annual financial statement and the material associated with it
3. Creative formulation of indicators and hypotheses in regard to key figures
4. The selection and weighting of key figures
5. Comparison of key figures and target-setting
6. Interpretation of the results of analysis and overall assessment
The key performance indicators of a balance sheet thereby provide information about the success of investments on various levels. This is crucial, because the absolute figures of a company or an investment are only of limited informational value in regard to the actual revenue and earnings situation. It is only when the decisive factors have been put in relation to one another that the dynamic of the investment can be arrived at. The special feature of an analysis of key performance indicators is not just that they provide information on business matters. It also makes clear the “financial engineering” that is at the root of every real estate investment and highlights the various strategies that can be chosen in terms of an investment cycle.
The analysis of financial reporting therefore indicates precisely what return you will get when buying property at a certain time at a certain price, after its price increases and you realize it upon exit. Three approaches should be explained, each of which uses different key performance indicators: the return on investment, the internal rate of return, and the cash on cash return.
The first option for investigating an investment based on balance sheet analysis is offered by the return on investment (Rol) approach. This factor views the return on investment as the ratio of the annual earnings to the capital employed. The RoI can be broken down into several key figures and offers the opportunity to determine the strategic alignment of an investment between “money earned” and “secure source of income.” Mathematically, the RoI can be equated with the product of the return on equity and the equity ratio. Each of these key figures provides information on strategic direction.
Return on Equity (RoE) constitutes an important indicator in determining whether a company primarily serves the investment objective of “earning money.” It shows the return on the equity provided and thereby the profitability of a company. The equity ratio is an important indicator of the stability of a company. When investing a high equity ratio is required in order to increase the safety of risky investment projects. The greater the risk classification of an investment, the higher the required equity ratio of the financing bank will be.
Moreover, the equity ratio is an important indicator of the independence of a company. The lower the proportion of outside capital, the less influence those providing such funding will have on investment decisions. However, a high equity ratio does not only have a positive side, because it also plays an important role in optimizing the rate of return. In this context, an increase in the equity ratio generally takes place at the expense of the rate of return on equity. The equity ratio should therefore always be assessed in terms of the corporate investment strategy. Financing with equity capital has the advantage of strengthening an enterprise’s security. But focusing on a high equity ratio has other downsides. In Germany, in some cases wholly-owned self-financing has tax disadvantages. If you solely take return on investment into consideration, then you would not be in a position to determine what strategy should be employed as part of an investment and what should be the proper balance between rate of return and security. Yet a detailed investigation based on the RoI system can grant profound insights into the strategic direction of an investment and profile the profitability of a company in detail.
In addition to its role in the key figure system for analysing the rate of return on investments, the annual financial statement can be viewed from the perspective of other key performance indicators. Such an opportunity is presented by the quite complicated analysis method of the internal rate of return (IRR). This ascertains the effective interest rate and therefore the actual rate of return on an investment, thereby providing support in advance of investment, primarily in regard to the decision as to whether or not the real estate should be acquired, because it summarizes the success of the property during the entire period during which it will be held.
However, one must also bear in mind the difficulties associated with the IRR viewpoint. On the one hand, the reinvestment premise of the internal rate of return viewpoint must be called into question. It maintains that all of the proceeds on an investment can be re-invested on the same terms again, something that is but rarely realistic in the case of real estate. Moreover, the formula for determining IRR can lead to more than one result if the individual cash flows have different signs. Moreover, a negative cash flow generates several results, the correct one having to be determined manually. The internal rate of return method is nonetheless necessary—quite simply because it is the only means available.
Cash on cash (CoC) offers yet another perspective that can be taken in regard to financial information. An investor will primarily be interested in the cash on cash analysis if he/she is pursuing a long-term holding strategy. For long-term strategies, for example, the acquisition of super core real estate that will be held for 25 years, perspectives such as those of return on equity or IRR are unsuitable. In particular, the IRR will fall increasingly with the duration of the investment. Long-term investments are primarily for a stable and secure rate of return that is subject to a minimal risk. As a result, there should always be annual cash on cash analysis of longterm investments indicating the annual interest on the cash flows. The cash on cash return shows the annual return after all taxes have been paid. Tax burdens are excluded from this. The cash on cash return is thereby calculated based on the following formula: cash flow before taxes divided by invested capital. The cash on cash return analysis is primarily suited for real estate investments that derive their revenue from rental income without a trade component. A factor related to this key figure is funds from operation (FFO), which plays a significant role primarily in the cash of REITs and AGs. It is used for calculations as the net cash flow from rental income is increased by depreciation. Here, too, one must make sure that all expenses have been adjusted and do not receive income from cash flow collection.
FFOs often provide more transparent information over the performance of REITs and AGs than do those of the official annual financial statements. Especially in the analysis of companies that generate income from long-term, safe investments, it may be advisable to neglect sales proceeds, as they actually run counter to the strategy of long-term investments. Depreciation is added to the FFOs. Therefore real estate can be written down when its market value significantly increases due to macro-cyclic developments. As a sustainable indicator of the performance of long-term real estate investments that generate returns through rental income, the CoC return as well as the funds from operation are much more suitable than the return on equity or IRR. In the last article of this column, we will look at real estate rating in the context of the dynamic method and show how such a rating is designed.
George Salden is the author of the book “Die Dynamische Methode” [The Dynamic Method] based on his 19 years of experience as an expert and manager in property and transaction management which highlights the way towards a whole new method of determining the profitability of properties. He was previously a director at alt+kelber Immobilienmanagement, a subsidiary of conwert Immobilien Invest SE, where he was responsible for major international transactions. He then took over as International Head of M&A at AK Holding GmbH & Co. KG. He is now Head of Transaction/ Executive Board Member at Dr. Lübke & Kelber / Arbireo.