Real Estate Finance and Investments: Lecture 4

1
Real Estate Finance and Investments Lecture 4

• Operating Statements and Forecasting Income and
  Value

2
Overall Types of Investment Opportunities

• Ownership of Income-Earning Assets
• Investment Real Estate
• REITS
• Savings Accounts
• Corporate Bonds
• Govt Bonds
• Common/Preferred Stock
• Non-Financial Assets
• Commodities
• Business Ventures
• Luxury Items

3
Specific Investor Objectivesin Real Estate

• Periodic Cash Flow
• Liquidity
• Price Appreciation
• Increase in Equity Through Mortgage Reduction
• Tax Shelter
• High Rate of Return Equity
• Leverage
• Estate Building
• Inflation Hedging
• Psychological Factors

4
Risks in Real Estate Investment

• Business or Income Risk
• Unanticipated changes in the economy
• Financial Risk
• Expenses exceed income
• Principal Risk
• Property value expected to increase when market
  values for the property in fact decline
• Interest/Money Market Risk
• Changes in Capitalization Rates
• Purchasing Power Risk
• Inflationary changes in the economy

5
Obstacles in Real Estate Investment

• Objective information sources about the Subject
  are difficult to obtain
• Inefficient Market
• Reliable price quotations are not available on a
  frequent basis
• Typically only a select amount of buyers/sellers
  in a market
• Transactions are cumbersome, time-consuming,
  inefficient, etc.
• Time-consuming negotiating and bargaining
• Legal factors and tax considerations

6
Purpose of Investment Analysis

• Estimate property value based on
  specific-investor economics
• Income and Expense Factors (historical and
  trended)
• Investment objectives dependent upon investor and
  project

7
Income Items

• Rents for competing properties
• Miscellaneous income based on competing
  properties
• Vacancy and collections based on competing
  properties

8
Expense Items

• Operating Expenses and Management Expenses
• Variable vs. Fixed
• DOES consider debt obligations
• Appraisal DOES NOT consider debt obligations
• DOES consider income taxes and depreciation
  allowances
• Appraisal DOES NOT consider income taxes or
  depreciation
• DOES consider allowances for capital improvements
• Appraisal MAY OR MAY not consider a Cap. Impv.
  Allowance

9
Net Operating Income

• Potential Gross Income (PGI)
• Less Vacancy/Collection Loss Allowance
• Effective Gross Income (EGI)
• Less Operating Expenses/Management Fees
• Before Debt Net Operating Income (NOI)

10
Real Estate Finance and Investments Lecture 4

• Cash Flow and Present Value Analysis

11
Cash Flow Analysis in Investment Decision
Criterion

• Net Present Value (NPV)
• Most-Commonly Used
• Better Indication of Expected Value
• Allows for Better Assumptions in Analysis
• Internal Rate of Return (IRR)
• Carries weaknesses that are not found in
  alternative indicators

12
Evaluation of Future Investment Performance

• TWO INITIAL FACTORS TO BE ANALYZED
• 1. Holding Period
• Many assume 10-year for simplicity
• Investor- and property-specific
• Longer period provides better analysis (better
  snapshot of a true economic cycle)

13
Evaluation of Future Investment Performance

• TWO INITIAL FACTORS TO BE ANALYZED
• 2. Discounting Interest Rate and Capitalization
  Rate

14
Value Sources from Income-Producing Property

• (Expected) Periodic Cash Flow
• Market Appreciation
• Recognized at the end of the holding period (at
  sale of property)

15
Discount Rate and Capitalization Rate

• Discount Rate
• Discounts streams of cash flows into present
  values based on the theory of Time Value of
  Money
• Utilizes the investors minimally-acceptable
  Rate of Return, along with the analyzed holding
  period
• Capitalization Rate
• Converts one cash flow into a value determinant
• Changes with the cost of capital and investor
  perceptions of future cash flows from the
  investment
• Can be determined by historic trends of Cap
  Rates, specific to time markets, property type,
  and market locations

16
Estimating Market Value of Income-Producing
Property

• (Expected) Periodic Cash Flow
• Utilizes Discount Rate
• Market Appreciation
• Utilizes Capitalization Rate

17
Real Estate Finance and Investments Lecture 4

• Discounted Cash Flow Analysis
• (Expected Income)

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Discount Cash Flows

• Formula to calculate discounting factors
• PV 1 / (1 i)n
• i interest rate
• n holding period

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Discount Cash Flows

• Discount factors, assuming a 10 minimum required
  Rate of Return, and a 5-year holding period
• Year One .9091
• Year Two .8265
• Year Three .7513
• Year Four .6830
• Year Five .6209

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Real Estate Finance and Investments Lecture 4

• Income Capitalization
• (Market Appreciation)

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Income Capitalization

• Net Operating Income (of year following
  expiration of HP)
• Divided By Capitalization Rate
• Estimated Property Value at Sale

22
Equity Reversion

• Utilize Income Capitalization to estimate value
  (selling price) at end of holding period
• Formula NOI for year immediately following
  holding period, divided by capitalization rate
• 2. Estimate selling and closing costs (broker
  commissions, prepayment penalties, etc.)
• 3. Calculate remaining loan balance (determines
  net proceeds from sale)

23
Equity Reversion

• Estimated Property Value at Sale (Income
  Capitalization)
• Less Selling/Closing Costs
• Net Proceeds From Sale
• Less Unpaid Mortgage Loan Balance
• Equity Reversion (BTER)

24
Calculate Present Values

• Formula to calculate present values
• PV Each CF Discount Factors PLUS
• Reversion Discount Factor
• Provides the Present Value of the project, which
  gives the BUYERS perception of investment value,
  based on his/her specific perception of risk, and
  his/her specific investment return requirements

25
Net Present Value

• Present Value
• Less Initial Equity Expenditure (Equity
  Capital)
• Net Present Value (NPV)
• Decision Criterion
• NPV is Positive Project increases investors
  wealth (merits further consideration)
• NPV is lt Zero Investment opportunity should be
  rejected

26
Real Estate Finance and Investments Lecture 4

• Internal Rate of Return (IRR)

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Internal Rate of Return (IRR)

• Rate that exactly equates the present value of a
  projected stream of cash flows with any positive
  cash investment (equity capital)
• Calculation better extrapolated using calculator
  or software programs, as margins of error exist

28
Calculation ofInternal Rate of Return (IRR)

• Using most standard financial calculators
• PMT Constant Cash Flow (assuming annunity)
  non-constant Cash Flow assumptions can be entered
  as CF1, CF2, CFn
• FV Before (or After) Tax Cash Flow
• N Holding Period
• I Investors Minimally Acceptable Rate of Return

29
Decision Criterion fromInternal Rate of Return
(IRR)

• IRR Equals or Exceeds Required Rate of Return
  Project Merits Further Consideration
• IRR Less than Required Rate of Return Reject
  Investment Opportunity
• NOTE Ultimate acceptance or rejection depends on
  estimates of relative riskiness and on the
  relative attractiveness of alternative invest
  opportunities)