DISCLAIMER: Copyright: 2014

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1 DISCLAIMER: This publication is intended for EDUCATIONAL purposes only. The information contained herein is subject to change with no notice, and while a great deal of care has been taken to provide accurate and current information, UBC, their affiliates, authors, editors and staff (collectively, the "UBC Group") makes no claims, representations, or warranties as to accuracy, completeness, usefulness or adequacy of any of the information contained herein. Under no circumstances shall the UBC Group be liable for any losses or damages whatsoever, whether in contract, tort or otherwise, from the use of, or reliance on, the information contained herein. Further, the general principles and conclusions presented in this text are subject to local, provincial, and federal laws and regulations, court cases, and any revisions of the same. This publication is sold for educational purposes only and is not intended to provide, and does not constitute, legal, accounting, or other professional advice. Professional advice should be consulted regarding every specific circumstance before acting on the information presented in these materials. Copyright: 2014 by the UBC Real Estate Division, Sauder School of Business, The University of British Columbia. Printed in Canada. ALL RIGHTS RESERVED. No part of this work covered by the copyright hereon may be reproduced, transcribed, modified, distributed, republished, or used in any form or by any means graphic, electronic, or mechanical, including photocopying, recording, taping, web distribution, or used in any information storage and retrieval system without the prior written permission of the publisher.

2 LESSON 7 Real Estate Investment Analysis Note: Selected readings can be found under "Online Readings" on your Course Resources webpage Assigned Reading 1. Real Estate Division Real Estate Investment Analysis and Advanced Income Appraisal. Vancouver: UBC Real Estate Division. Chapter 8: Real Estate Investment Analysis Recommended Reading 1. Akerson, C.B Capitalization Theory and Techniques, Study Guide Second Edition. Lesson 15. Boston: Appraisal Institute. Financial Publishing Company. 2. Appraisal Institute of Canada and Appraisal Institute (US) The Appraisal of Real Estate, Third Canadian Edition. Vancouver: UBC Real Estate Division. Chapter 24: Discounted Cash Flow Analysis and Special Applications in Income Capitalization 3. Brown, R.J "Sins of the IRR". Journal of Real Estate Portfolio Management. 12(2). pp IRR is a useful tool, but has mathematical limitations that require understanding. 4. Crean, M.J "Revealing the True Meaning of the IRR via Profiling the IRR and Defining the ERR". Journal of Real Estate Portfolio Management. 11(3). pp IRR must consider reinvestment of an investment's cash flows and capital recovery in order to truly represent an investment s return. 5. Fisher, J.D. and Martin, R.S Income Property Valuation. Dearborn Publishing, Inc. Chapter Francis, J.M "Deriving IRR Sets from Market Transactions". Appraisal Journal. 63(2). p Ginsberg, R "IRR Miscalculations Waste Time and Money". National Real Estate Investor. July Shows how IRR is more accurate if calculated with monthly cash flows rather than assuming annual cash flows and the difference is higher reported profit. 8. Sherman, L.F. and Walters, K.D "Sensitivity of the FMRR Technique in a Fluctuating Market". Appraisal Journal. 65(2). p Talmage, P "What's the IRR for an REO?" Appraisal Journal. 63(2). p. 202.

3 7.2 Lesson 7 Learning Objectives After completing this lesson, the student should be able to: 1. Define, apply, and evaluate the advantages and disadvantages of single-period investment criteria used by investors. 2. Describe various return methods that evaluate investment returns over either a portion of or the entire investment holding period. 3. Calculate the justified investment price or net present value (NPV) of a real estate investment, including before- and after-tax. 4. Distinguish between an internal rate of return (IRR) on equity and an IRR on capital. 5. Describe alternatives to IRR and the objectives of each. 6. Explain deficiencies implicit in the IRR technique. 7. Explain the objectives of the financial management rate of return (FMRR) and how it differs from the IRR. 8. Calculate the IRR, adjusted rate of return (ARR), and FMRR. 9. Discuss the reinvestment rate issue. Instructor's Comments This section of the course considers measures appropriate to analyzing returns over either a portion of, or the entire investment-holding period. Financial calculators and spreadsheets facilitate complex calculations in determining these measures. However the student should be aware that discipline, objectivity, and consistency are essential to avoid wide differences in results from such calculations. In Deriving IRR Sets from Market Transactions, Francis explains three important reasons for extracting IRR rates from market transactions as opposed to simply relying on published surveys or experience tempered by judgement. He points to an example where manipulation of published survey data can produce value results that vary from a low of $3.2 to $17.4 million for the same property. Francis further makes the point that published surveys, which generally relate to large, investment-grade properties, prove less useful for property types that represent most appraisers' assignments properties having values of less than $20 million and which may not have strong credit tenants. In What's The IRR For An REO?, Talmage reinforces Francis' position pointing out that published surveys may include trophy, or at least good quality properties that generally experience high occupancies in more stable markets and therefore present less risk for the investor. In Sensitivity of the FMRR Technique in a Fluctuating Market, Sherman and Walters describe differences between the IRR and FMRR. They perform a sensitivity analysis to show that the FMRR should produce a less risky result. This is because the FMRR rates, when compared with IRR rates, tend to fluctuate less with changes in holding periods and disposition (selling price) assumptions. Their findings are particularly important where cash flow overtakes anticipated appreciation in the ROE. A greater interest by investors in holding properties for their operating potential over their appreciation might drive increased interest in

4 Real Estate Investment Analysis 7.3 FMRR over IRR. The claim of FMRR's more realistic results and increased ease of application through offthe-shelf software applications may similarly broaden its use. Akerson argues in Capitalization Theory and Techniques that the presumption of different "borrowing rates" and reinvestment assumptions can be accommodated within the IRR by including the expected costs and benefits of reinvestment in the projection of cash flows. Appraisers and analysts may experience some fascination with technology that provides complex return measure calculations instantly and with seeming accuracy. Kurt Andersen, in the December 2000 issue of Inside Magazine captured the paradox of expectations built on sophisticated models. He encourages analysts to consider the "Columbus project". In the Christopher Columbus business venture, return on investment (ROI) may not have turned out positively but he still discovered America. It is essential that the return measure selected by appraisers be synthesized with realistic investor expectations and within the context of market experience. Akerson suggests that the IRR can be an extremely valuable tool if the decision-maker appreciates its shortcomings and also explores other complementary analytical tools.

5 7.4 Lesson 7 Review and Discussion Questions The following questions are based on the information in Table 7.1 below: Table 7.1: The Shortt Building C Total initial purchase price $700,000 C Initial value of building $595,000 C Initial value of land $105,000 C Initial loan-to-value ratio 80% C The mortgage loan: Face Value Interest Rate Amortization period Payments are made monthly (Round monthly payment up to next higher cent) C Investor's marginal rate of taxation Class 1 building, CCA rate Taxable portion of capital gain $560,000 j 2 = 15% 300 months 45% 4% 50% C Initial Potential Gross Income (growing at 6% per year over five years) $175,000 C Initial Operating Expenses (growing at 6% per year over five years) $70,000 C Vacancy rate 4% C Property is sold at the end of the 5th year C Disposition price $945,500 C Transaction Costs 6% C No capital gains exemption available 1. Complete an after-tax cash flow pro forma for the Shortt building, for years 1 to 5, and the after-tax equity reversion for Year Compute the net present value of equity and the justified investment price using an after-tax discount rate of 16%. 3. Compute the before-tax net present value of equity and justified investment price and explain why you think these calculations are different than those found in Question 2.

6 Real Estate Investment Analysis 7.5 ASSIGNMENT 7 CHAPTER 8: Real Estate Investment Analysis Marks: 1 mark per question. 1. Consider the following: an investor buying a refurbished motel for $4 million expects to experience a net operating income of $250,000 in the first year. The property will bear a 75% mortgage with a 3-year term, upon which interest only payments at j1 =11% are to be made annually. Which of the following represents the first year "cash throw-off" return? (1) 2.67% (2) +2.67% (3) 8.00% (4) +8.00% 2. Consider the following statement: Where an investment is 100% financed and projected net cash flows are all positive, IRR can produce a reliable measure of return for the investment. (1) This statement is true. (2) This statement is false because there can be no reasonable discount rate that can equate a set of positive cash flows to zero. (3) This statement is false because when the equity investment is very small, the IRR produces an unreliable measure slight changes in income produce enormous differences in the rate of return (or loss). (4) Both Options (2) and (3) are correct. 3. Which of the following statements regarding discounted cash flow (DCF) return measures are FALSE? A. IRR on equity and IRR on capital provide an investor with essentially the same information. B. An alternative approach to the IRR in eliminating the possibility of multiple rates of return and explicitly recognizing a reinvestment rate is the FMRR. C. IRR provides the return on investment whereas NPV provides the value of the investment. D. IRR as a measure of success is relative to the investment amount, whereas NPV is more independent and applicable to all cases. (1) Only Statements A and B are false. (2) Only Statements A and D are false. (3) Only Statements B and C are false. (4) Only Statements C and D are false. ***Assignment 7 continued on next page***

7 7.6 Lesson 7 4. Consider the following statement: The IRR is a widely-used, popular measure of investment performance that serves as a good and sufficient measure for all investments. (1) This statement is true. (2) This statement is false because when there are negative cash flows during an investor's holding period there is the potential for multiple rates of return. (3) This statement is false because the IRR calculation normally assumes that cash flows during the holding period are reinvested at a rate similar to the derived IRR. (4) Both Options (2) and (3) are correct. THE NEXT SIX (6) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: Larry Jones recently sold an apartment complex in North Vancouver. He purchased the property 5 years ago for $1,350,000 and financed it with a $1,100,000 mortgage. During his holding period the investment generated the following after-tax cash flows: Year ATCF 1 $40, , , , ,000 The sale of the property at the end of Year 5 resulted in an after-tax equity reversion of $350,000. When he applies the IRR measure, Jones' goal is to only invest where he can earn an annual after-tax rate of return on equity of j1 = 8%. For FMRR calculations, Jones assumes a "safe" rate of j1 = 6% and his "run of the mill" reinvestment rate is j1 = 12%. The minimum reinvestment requirement for investment at the "run of the mill" rate is $60,000. Assume that Jones' marginal tax rate is 45%. 5. Based on the information above, determine which of the following represents the cash on cash return for this investment in the first year of Jones' holding period? (1) 16.0% (2) 3.0% (3) 2.8% (4) None of the above 6. Based on the information above, calculate the IRR and determine whether this investment satisfies Jones' required rate of return (RRR)? (1) IRR = 11.76%, which does satisfy Jones' RRR (2) IRR = 12.55%, which does satisfy Jones' RRR (3) IRR = 13.12%, which does satisfy Jones' RRR (4) IRR = 7.68 %, which does not satisfy Jones' RRR ***Assignment 7 continued on next page***

8 Real Estate Investment Analysis Based on the information above, calculate the NPV and determine whether this investment satisfies Jones' investment goal? Hint: Remember BOP (beginning of period) and EOP (end of period) for initial investment. (1) NPV = $300,994.36, which does satisfy Jones' investment goal (2) NPV = -$187,209.76, which does not satisfy Jones' investment goal (3) NPV = -$50,994.36, which does not satisfy Jones' investment goal (4) NPV = $50,994.36, which does satisfy Jones' investment goal 8. Based on the information above, calculate the FMRR and determine whether this investment satisfies Jones' investment criteria? (1) FMRR = 11.90%, which does satisfy Jones' investment goal (2) FMRR = 11.22%, which does satisfy Jones' investment goal (3) FMRR = 12.06%, which does satisfy Jones' investment goal (4) FMRR = 6.43%, which does not satisfy Jones' investment goal 9. Based on the information above, calculate the justified investment price or maximum price that Jones should have paid for the property to earn a return of 8% per annum, compounded annually? (1) $1,242,424 (2) $1,337,630 (3) $1,400,995 (4) $1,332, Based on the information above, which of the following represents the before-tax return rate that relates to Jones' RRR? (1) 20.82% (2) % (3) % (4) % THE NEXT TEN (10) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: Brendan has recently purchased the Hashimoto Building for $1,000,000, with 30% of the purchase price apportioned to the land and 70% to the building (a Class 1 asset with a 4% CCA rate). To finance the purchase, he borrowed $650,000 at j2 = 8.25%, with a 25-year amortization period and a 3-year term. The loan calls for monthly payments rounded up to the next higher dollar. The property is expected to generate a potential gross income of $350,000 in the first year. Brendan expects this amount to increase at 6% per annum. The vacancy and collection loss allowances are 4% and 2% of potential gross income, respectively. Brendan estimates that the annual operating expenses will be $200,000 for the first year, increasing at 5% per annum. The investor has a 45% marginal tax rate. Depreciation is calculated on a straight line basis, and the building has an estimated life of 50 years with no salvage value. Assume that the property appreciates at 5% per annum and that it will be sold at the end of the third year. The closing costs at the time of sale will be 6% of the sale price. One half of any capital gain will be taxable. The percentage apportionment between land and building will remain the same throughout the holding period. ***Assignment 7 continued on next page***

9 7.8 Lesson Calculate the NOI for Years 1, 2, and 3. (1) $296,100; $313,866; $332,697 (2) $129,000; $138,740; $149,164 (3) $135,579 each year (4) $126,100; $143,866; $149, Calculate the CCA claimed in Years 1, 2, and 3. (1) $14,000; $27,440; 0 (2) $21,000; $20,160; $19,353 (3) $21,000; $20,160; 0 (4) $15,000; $29,400; Calculate the interest paid in Years 1, 2, and 3. (1) $36,290; $35,803; $35,274 (2) $8,360; $9,064; $9,827 (3) $52,420; $51,716; $50,952 (4) $42,078; $36,073; $35, Calculate the income tax payable in Years 1, 2, and 3. (1) $37,809; $41,979; $46,437 (2) $35,689; $40,078; $44,772 (3) $28,161; $26,813; $44,195 (4) $25,689; $25,542; $39, Calculate the capital gain tax and recapture tax payable upon sale. (1) $16,337; $27,231 (2) $19,838; $18,648 (3) $14,878; $13,986 (4) $29,406; $19, Calculate the after-tax equity reversion. (1) $223,087 (2) $366,784 (3) $401,573 (4) $426, Calculate the justified investment price (based on after-tax cash flows) at an after-tax return of j1=7%. (1) $803,244 (2) $959,534 (3) $1,116,689 (4) $1,178,245 ***Assignment 7 continued on next page***

10 Real Estate Investment Analysis Calculate the investor's IRR on equity, rounded to two decimal places. (1) 18.92% (2) 15.26% (3) 20.63% (4) 22.12% 19. Assuming that all after tax cash flows are reinvested at a rate of j1 = 8%, calculate the adjusted rate of return, rounded to two decimal places. (1) 22.63% (2) 20.24% (3) 19.94% (4) Based on single period measures (Year 1 data), calculate the return on investment (ROI), cash on cash (C on C) return, and equity dividend rate (EDR). (1) 5.65%; 9.89%; 17.54% (2) 12.90%; %; 19.49% (3) 13.75%; 15.28%; 18.21% (4) 16.34%; 29.23%; 15.98% 20 Total Marks ***End of Assignment 7***

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