LECTURE 9: Real Estate Investment Analysis (REIA)

Transcription

1 LECTURE 9: Real Estate Investment Analysis (REIA) Overview Why REIA? Motivations for Investing Debt and Equity Financing Scenario To Invest or Not to Invest? Cash Flow Pro Formas Performance Measures NPV & IRR Leverage Investment Risks Why REIA? So far, our analysis of residential real estate financing implicitly assumed that the property purchases were for owner-occupation(o/o). occupation(o/o). Now, we will study the financing of properties that are purchased for investment purposes. When a purchase is for investment rather than o/o, the considerations change. Some reasons for o/o are: pride of ownership, real estate is held as a form of wealth & for the consumption of housing services without rent. Motivations for Investing Why invest in income-producing properties? To generate net income For capital gains or price appreciation For portfolio diversification For preferential tax benefits For prestige and visibility Key motivation is income and capital gains Debt and Equity Financing The capital used to purchase a property typically comes from some combination of debt capital from a lender or borrowed funds equity capital or funds invested by an owner or person acquiring the property. Both parties expect a return on their capital that is a function of the risk they incur. Value of property = Value of mortgage/debt Value of equity Scenario You are considering the feasibility of purchasing an office building with an asking price of 8.M. Current market rent = psf Gross floor area = 00,000 sq ft Projected increase in market rent = % p.a. Rents are revised when existing leases expire. The project can be sold in years time for 9.7M. (Ignore all costs) To invest or not to invest? The required discount rate is %. Assume the investor uses his own equity. What is the present value of the project assuming that the building is sold at EOY? To answer this, the following info is required: Net Operating Income (): annual rental income net of all operating expenses Holding period: period of time before disposal

2 To invest or not to invest? Discount rate: the relevant interest rate p.a. Terminal value of property: projected value of the property at the end of the holding period You will also need Performance Measures for Investments Investment Rules Forecasting property cash flows (property pro forma) Operating CF: Rental income = (Rent/SF) SF) (Rentable SF) = Other income (e.g. parking) OI Potential gross income (PGI) = PGI Vacancy allowance = (vacancy rate) PGI = v Effective gross income (EGI) EGI Operating expenses = OE Capital improvement reserve CI Net operating income RI Computed Analysis of investment cash flow from operation Rent Vacancy EGI,6,000 -,6,000,9,00 -,9,00,0,6 -,0,6,89,67 79,8,0,88,69,99 8,000,7,99,699,809 8,990,6,89 Less Debt service Before-tax CF Less: Interest Less Depreciation Taxable income Tax rate = Tax payable Operating Expenses 6,90 90,00 6, 98,98 6,707 9,9 6,99 97,789 7,70,00,8 6,60,0,9 Before-tax CF Less: Tax After-tax CF Analysis of investment cash flow from operation A. Before-tax cash flow from operation: Net operating income () Debt services (DS) Before-tax cash flow (BTCF) Analysis of cash flow from reversion A. Before-tax cash flow Resale value Selling expenses Mortgage loan balance LB Before-tax cash flow RV SE BTCF s B. Taxable income or loss: Net operating income () Interest (IN) = (interest rate) (beginning balance of the loan) Depreciation (DN) = (improvement value)/(economic life) Taxable income (loss) Tax payable (TAX) = (tax rate) (Taxable income) C. After-tax tax cash flow from operation: Before-tax cash flow (BTCF) Tax After-tax tax cash flow (ATCF) B. Taxable income (loss) from sale Resale value Selling expenses Original cost basis accumulated depreciation Adjusted cost basis Capital gain Tax from sale = (tax rate) CG = TAX s C. After-tax tax cash flow RV SE OCB ACD ACB CG ATCF s

3 Total investment cash flow Summary of Cash Flows End of year 0 Property: -V 0 Lender: f-l DS DS DS DS RV DS LB 0 Cash Flow (8,00,000) 90,00 Remarks Purchase Price BT equity: L-f-V 0 BTCF AT equity: L-f-V 0 ATCF BTCF ATCF BTCF ATCF BTCF ATCF BTCF BTCFs ATCF ATCFs 98,98 9,9 97,789 V 0 is the acquisition price of the property L is the loan amount f = financing fee (if any),00,8 9,700,000 Sale Price A Note on Cash Flows Cash flows can be inflows or outflows. Convention: Cash inflows are positive cash flows and cash outflows are negative cash flows. Note that our project is financed entirely with equity (no debt). In a more general setting, we have debt and other types of cash flows. Another Look at Real Estate Cash Flows from the Equity Investor s s Viewpoint Time: t= t=t Asset: Purchase price Reversion Price ( ) (?) () Debt: Loan advance Debt service Loan balance () ( ) ( ) Equity investor: Net purchase expenditure. BTCF BT Reversion proceed ( ) (?) (?) Government: Stamp duty Income tax Capital gain tax ( ) (?) ( ) Equity investor: Initial investment ATCF AT Reversion proceed ( ) (?) (?) Measuring investment performance: real estate returns Periodical return: Property Yield = / Property value = Capitalization rate Total return = Yield Capital value appreciation Equity Equity yield = BTCF / Equity investment Total return = Equity yield Equity value appreciation Holding period return: Property IRR of property investment CF Equity Before-tax IRR = IRR of BT equity CF After-tax tax IRR = IRR of AT equity CF Measuring investment performance: real estate returns The Net Present Value (NPV) is the discounted cash flows less the initial investment cost (I). Where NPV T CF t = r t = ) CF t = cash flow at time t r = discount rate T = holding period t I

4 Steps to determine the NPV An NPV Calculation Estimate future cash flows, CF t Ascertain the appropriate discount rate, r. It should reflect the minimum rate of return the investor requires to make the investment, considering the riskiness of the investment (opportunity cost concept). Calculate the PV of all future cash flows. Subtract the initial outlay (equity) invested to get NPV. NPV>0 means the value of the investment exceeds the equity investment, i.e. the investment is profitable. NPV<0 means the investment is NOT profitable. 0 Cash Flow (8,00,000) 90,00 98,98 9,9 97,789,00,8 9,700,000 PVF NPV PV (8,00,000) 78,6 70,6 68,7 6,767 0,7,8,6 (0,8) Measuring investment performance: real estate returns The Internal Rate of Return ( is the rate of return required to make the present values of future cash flows equal to the initial investment cost (I). I = T CF t t= t An IRR Calculation 90,00 98,98 9,9 8,00,000 = 97,789,00,8 9,700,000 Where CF t = cash flow at time t T = holding period An IRR Calculation Leverage Solving, IRR =.% In other words, given the initial cost of 8.M and the cash flows projected, the project yields an internal rate of return of.%. Since IRR<% (required rate of return), the project cannot be undertaken. If you are making an evaluation to decide whether to invest or not, then the decision rule is simple: Invest if NPV>0 IRR>r So far, we have assumed that the initial investment is paid entirely using equity (the owner s s capital). What if the owner borrows.9m (70% of the initial cost of 8.M) on a constant amortization loan from a FI at an interest rate of 0% over 0 years? The amount borrowed represents debt. Now, the initial equity = (8.-.9)M=.M..9)M=.M.

5 Leverage Cash Flows with a 70% Loan At the end of years, assume that the property is sold and the loan is fully repaid. The monthly debt service = 7,8. The annual payment is 689,0. Every year, the cash flow is reduced by the amount of the debt service. This is referred to as the Before Tax Cash Flow (BTCF). At EOY, the unpaid mortgage balance is,,. 90,00 98,98 9,9 Debt Service 689,0 689,0 689,0 BTCF,0 9,960 66, Note: You can work out on a monthly basis as well. 97, ,0 8,76,00,8 689,0,797 Cash on Sale at EOY Levered NPV and IRR Sales Price 9,700,000 Less Unpaid MB,, BTCF,6,7 Note all items that debt financing changes Initial equity outlay Annual cash flows Terminal value that goes to the equity investor But what is the effect of leverage on NPV and IRR?,0 9,960 66, NPV = 0.) 0.) 0.) 8,76,797,6,7,0,000 0.) 0.) 0.) = 8,606 Levered NPV = 8,606 Levered IRR= 9.6% Can you explain these results? Types of Investment Risks Business Risk Due to fluctuations in economic activity Affects income of property and hence value of property Financial Risk Financial leverage magnifies business risk Financial risk increases in the amount of the debt Depends also on the type of loan (fluctuating cost of finance) Types of Investment Risks Liquidity Risk Ease of sale more illiquid implies a higher price concession. Inflation Risk Inflation erodes real income from property investment. Historically, real estate performed well during periods of inflation because rentals can be adjusted to reflect increases in inflation.

6 Risk and Return Types of Investment Risks % % Common stocks Management Risk Competence of management. Ability to innovate, respond to competitive conditions, operate efficiently, etc Interest Rate Risk Cost of finance. Required rate of return. Legislative Risk Environmental Risk Expected Return Real estate 0% Corporate bonds 8% Mortgage-backed 6% securities % Municipal bonds T-bills % Risk free 0% Risk Incremental leverage l and incremental borrowing costc Consider two financing options: Option : 70% financing at 0% p.a. interest rate. Option : 8% financing at 0.% p.a. interest rate. Both are interest-only loan. Is the % % additional leverage favorable, assume that Break Even Investment Return (BEIR) = % p.a.? Solution: Effective interest rate on additional loan: Additional interest charge: 0.% 8 8 0% 0% 70 =.9 Additional loan: 8 70 = Incremental borrowing cost =.9/ =.8% > BEIR Answer? Underwriting commercial mortgage Lender s s consideration Recourse vs. non-recourse loans Market study and property appraisal Direct capitalization method: value = / market capitalization rate Discounted cash flow (DCF) method: value = PV(CF, required rate of return) Loan-to to-value ratio (L/V) Debt coverage ratio (DCR) DCR= / Debt service Desired DCR>=. Max debt service = / Desired DCR Example: finding the max loan amount Readings Suppose the st year is,000 and the market capitalization rate for the property is 8%. What is the market value of the property? V=,000/8% = 0,000 Suppose the lender s s desired DCR is.. What is the max debt service? Max DS = /. = 0,000 Suppose the interest rate is 0%. If the loan requires full amortization over 0 years, what is the max loan amount? Max loan = 0,000/a(0%,0) =9,69; L/V = 6.8% If the loan requires interest-only debt service. What is max loan amount? Max loan = 0,000/0% =00,000; L/V = 66.7% Chapters 9, Brueggeman and Fisher