With the never-ending cycle of real estate deals, it is imperative for real estate investors to make quick and accurate investment decisions. A Back-Of-The-Envelope (BOE) calculation provides players in the real estate space the ability to gather a preliminary understanding of an investment’s potential. This article will introduce how to create a BOE for real estate acquisitions or development. Understand that this concept can also be applied to other investment classes if key financial assumptions that lead to the Net Operating Income (NOI) are established.
What is a Back-Of-The-Envelope (BOE)?
A Back Of-the-Envelope (BOE) is a calculation method that allows for rapid assessment of the financial feasibility of an investment project. It involves creating assumptions for key financial parameters to quickly understand if a project will generate the desired returns. As the name suggests, this investment analysis is often done in the early stages of due diligence when detailed data is less readily available.
A BOE determines the financial viability of an investment project and assesses whether the project cost exceeds the projected value. In the context of a real estate investment, the projected NOI must exceed either the acquisition cost, or development cost (land price, hard cost, and soft cost). The asset’s value can then be calculated by dividing the projected NOI by a cap rate assumption.
Key Components of BOE
A BOE consists of three main sections:
- Potential Gross Income (PGI) = Net Square Footage * Rent Per Square Foot
PGI represents the maximum amount of income a real estate asset can earn if it is 100% occupied. For a residential property, an average rent per unit type can be assumed. For a commercial asset, a rent per square foot assumption can be multiplied by the total square footage. - Effective Gross Income (EGI): PGI * (1 – Loss Assumption)
EGI represents the gross income that the asset is reasonably expected to earn. It accounts for line items like vacancy and credit loss that will make PGI more realistic. These loss percentages are applied to PGI. - Operating Expense (OpEx):
OpEx represents the expenses incurred by operating the asset. The assumption can either be a percentage of EGI or can be broken down into more detailed categories. The level of detail depends on the depth of knowledge and experience of the asset.
Example
Let’s put these metrics into practice.
Imagine there is an acquisition opportunity for a 100,000 square foot commercial building. Buildings in the area rent for $80 per square foot. Additionally, commercial buildings have a 0-30% operating expense ratio.
First to calculate the PGI, the building square footage will be multiplied by the rent per square foot. Next, the PGI will be multiplied by a vacancy assumption of 5% to calculate the vacancy loss. EGI is calculated by subtracting vacancy from the PGI. An operating expense ratio of 20% is applied to the EGI to create an OpEx assumption. This concludes the quick back of the envelope as NOI is calculated by subtracting OpEx from EGI.
| Assumptions | Year 1 | Notes | |
| Net SF | 100,000 sqft | ||
| Annual Rent PSF | $80 | ||
| PGI | $8,000,000 | Gross Income | |
| Vacancy | 5% | -$400,000 | Less Vacancy |
| EGI | $7,600,000 | EGI | |
| OpEx | 20% | -$1,520,000 | Less OpEx |
| NOI | $6,080,000 | NOI | |
The BOE analysis is just the first step in evaluating a real estate investment.
Investors could then project future years of NOI by grossing up Year 1 NOI by inflation. The series of cash flows for each year could lead to other return metric calculations such as IRR and equity multiple. If the return metrics reach the desired level, this indicates that the investment can be pursued further. A loan sizing exercise can also be conducted to understand how much debt is needed to finance this investment to reach the desired returns.
While the BOE analysis cannot substitute the entire underwriting exercise, it is an excellent first step in valuing a property.
Key Takeaways
- A BOE analysis is a quick preliminary method of looking at real estate investments.
- A BOE calculation is the first step in the investment process and creates the foundation for further calculations of value and return.
- The accuracy of the assumptions used is critical in a good BOE. The more detailed the BOE is, the more reflective it will be on the actual asset and the more accurate the projection of the property will be.
- A BOE analysis is only a ballpark estimate. As a preliminary method, further valuation and due diligence exercise should be completed before committing to an investment.
