The mathematics of real-estate cash flows

Module 2 stopped at NOI — the building's operating profit. NOI is enough to value a stabilised property using a cap rate. But NOI is not what the equity owner takes home. The equity owner takes home NOI minus capital expenditure, minus debt service, minus the carrying cost of leasing up vacant space. The journey from NOI to that final equity cash flow is the bridge a deal memo carries on its first page.

The full cash-flow bridge

  Net Operating Income (NOI)
  − Capital Expenditure (capex)               (replacement reserves, major repairs)
  − Leasing Costs                             (tenant improvements, leasing commissions)
  ───────────────────────────────────────
  Unlevered Cash Flow                         (cash available to all capital providers)
  − Debt Service                              (interest + principal amortisation)
  ───────────────────────────────────────
  Levered Cash Flow                           (cash available to equity)

Variable glossary

• Capital Expenditure (capex) — cash spent this period on long-life improvements to the building: HVAC replacement, roof, lifts, structural repairs, building-system upgrades. Capex is real cash leaving the property, but it doesn't reduce NOI (it's capitalised, not expensed). The replacement-reserves line in a pro forma is the smoothed annual provision for these lumpy events. Typical reserve: 0.5–1.5% of property value per year for residential, 1.5–3% for older office.
• Leasing Costs — tenant improvements (TI: the build-out money the landlord gives a new tenant to fit out their space) plus leasing commissions (LC: the broker's fee, typically 3–5% of total lease value). Concentrated in years when leases roll. Significant: in a year when 30% of the building's leases turn over, leasing costs can consume 40–60% of NOI.
• Unlevered Cash Flow — NOI minus capex minus leasing costs. The cash the property generates available to all capital providers. The equivalent of FCFF in corporate DCF. The right number to discount at an unlevered discount rate for an enterprise-style valuation.
• Debt Service — annual cash paid to the mortgage lender, including both interest and principal amortisation. From an amortisation schedule (covered in module 4) the split between interest and principal changes over the loan life but the total debt service is roughly constant for a fixed-rate, fully-amortising loan.
• Levered Cash Flow — unlevered cash flow minus debt service. The cash available to equity in this period. The equivalent of FCFE in corporate finance. The number you discount at the equity-required return to get equity value.

Cash-on-cash return

  Cash-on-Cash Return  =  Annual Pre-Tax Cash Flow to Equity  ÷  Equity Invested

Cash-on-cash is the simplest and most widely-quoted real-estate yield metric. The numerator is the levered cash flow in a typical (stabilised, not lease-up) year; the denominator is the equity that went into the deal at close — down payment plus closing costs plus initial reserves. For a stabilised Kilimani apartment block bought at KES 180m with 50% leverage at a 13% mortgage rate, the equity is ~KES 95m, levered cash flow ~KES 7–10m, cash-on-cash ~7.5–10.5%. Useful as a quick yield comparison against alternatives (Kenyan 10-year T-bonds, dividend yields on NSE financials). What it misses: appreciation, the timing of capex, the financing reset risk.

The two IRRs: unlevered and levered

IRR — internal rate of return — is the discount rate that makes the net present value of a series of cash flows zero. For a property investment, you compute it over the full hold period: an outflow at acquisition (the purchase price for unlevered, or the equity check for levered), a series of operating cash flows, and a final inflow at sale (the sale price for unlevered, or the equity proceeds after loan payoff for levered).

Unlevered IRR uses the unlevered cash flows and the full purchase / sale prices. It measures the return the building itself produces, independent of how it's financed. Useful for comparing properties without the noise of different financing structures.

Levered IRR uses the equity cash flows and the equity invested / equity returned. It measures the return the equity investor actually sees. Almost always higher than the unlevered IRR when interest rates are below the unlevered IRR — that gap is the 'leverage premium'.

Typical commercial deal in Kenya, 5-year hold:

  Unlevered IRR  ~  12 – 14%   (the building's return)
  Loan cost (mortgage rate)  ~  13 – 15%
  Levered IRR  ~  10 – 18%     (depends on whether unlevered > loan cost)

When mortgage rates are above the unlevered IRR (typical in 2022-2024),
leverage actually DEPRESSES the levered return. That's the often-missed
fact about high-interest-rate environments: borrowing destroys value if
the yield doesn't beat the cost of debt.

DSCR and LTV — the two ratios lenders care about

  Debt Service Coverage Ratio (DSCR)  =  NOI  ÷  Annual Debt Service
  Loan-to-Value (LTV)                =  Loan Amount  ÷  Property Value

DSCR is the lender's primary safety metric. It measures how comfortably the building's operating profit covers its debt payments. A DSCR of 1.0 means NOI exactly equals debt service — any vacancy or NOI shock and the loan goes into distress. Commercial-property lenders typically require DSCR ≥ 1.25× at underwriting; conservative lenders want 1.40×. Anything below 1.20× is considered a stretched deal.

LTV is the lender's primary collateral metric. It measures how much of the property value is financed by the loan. Conservative residential mortgage lenders cap LTV at 70–80%; commercial property typically caps at 60–75%; the Kenyan market historically caps at 60–70% for commercial because the loan-default and recovery process is slow and expensive. Higher LTV = lender carries more loss exposure if the property has to be sold in distress.

Together, DSCR and LTV bound the maximum loan a building can carry. The binding constraint switches depending on which is tighter. In low-rate environments LTV usually binds (the building's NOI easily covers the small debt service, but the loan size is capped by the property value). In high-rate environments DSCR binds (the building's value supports a bigger loan than the NOI's debt-service capacity does).

Pro forma forecasting — the 5–10 year view

A pro forma is the year-by-year cash flow forecast for the hold period, typically 5–10 years. Each line in the NOI bridge gets a trending assumption: rent growth (typically 3–6% per year for Kenyan residential, 2–4% for office in a stable market), vacancy (smoothed to a stabilised long-run number after a lease-up curve), operating expense growth (usually matched to inflation, with property tax and insurance often growing faster), capex (lumpy — model the actual replacement schedule), leasing costs (tied to scheduled lease expiries). The forecast feeds into a discounted cash flow valuation in module 6 and into the underwriting IRR.