Overview Chapter 19 Investment Decisions: NPV and IRR Major theme: most RE decisions are made with an investment motive magnitude of expected CFs--and the values they create are at the center of investment decision making Chapter 18 focuses on widely used, single-year, return measures, ratios, & income multipliers These criteria are relatively easy to calculate & understand an advantage in the eyes of many industry professionals McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 19-2 Overview Centre Point Office Building Many investors also perform multi-year analyses of potential acquisitions When using multi-year discounted CF decision making methods, investor must 1. estimate how long she expects to hold property 2. make explicit forecasts of: property s net CF for each year, net CF produced by expected sale of property 3. Select rate of return at which to discount all future CFs 19-3 19-4 Centre Point: 5-Year Operating Pro Forma Centre Point: Reversion Sale Price 4% 19-5 NOI 6 $1,180,469 = 0.0875 $103,291 $ 1,180,469 = 0.0875 19-6 19-6 1
Levered vs. Unlevered Cash Flows Levered CFs measure property s income after subtracting mortgage payments Valuation of levered CFs? Discount expected BTCFs rather than stream of NOIs Why is owner s claim on a property s CFs referred to as a residual claim? Effects of Leverage on Centre Point Cash Inflows & Outflows Loan Terms 75% loan, 30 years, 6.5% annual interest rate, total up-front fees = 3% of loan amount Net loan proceeds: = $792,000 (0.03 x 792,000) = $768,240 Required equity = $1,056,000 - $768,240 = $287,760 Payment: $5,005.98 or $60,072 per year Can you compute this? What is the Mortgage Balance after 5 years? 19-7 19-8 19-8 Centre Point 5-Year Pro Forma with Leverage Present Value of Levered Cash Flows: Centre Point Why was the discount rate increased to 14%? 19-9 19-9 19-10 19-10 Net Present Value of Centre Point Effect on NPV of Variation in Discount Rate NPV = PV in PV out PV out in this example is equal to original equity investment of $287,760 NPV = $319,591 $287,760 NPV = $31,831 Decision: Accept Centre Point investment opportunity because doing so will increase equity investor s wealth by $31,831 At a discount rate of 16.8727%, NPV = 0, this is the going-in IRR 19-11 19-11 19-12 19-12 2
Selecting Discount Rates So From Where Do Discount Rates Come? Discount rate is composed of two parts: E(R j ) = r = R f + RP j R f is risk-free rate yield/return available on U.S. Treasury securities with maturity equal to the expected holding period of the property This benchmark rate is readily observable RP j is risk premium for subject property This component of discount rate is difficult to determine 19-13 19-13 19-14 19-14 U.S. Example: Class A Apartment Properties Source: quarterly survey conducted by Real Estate Research Corporation (www.rerc.com) Selecting Discount Rates Since risk premiums vary, so do required yields High quality, relatively safe RE investments: currently 6-8% required returns Development Project: 15%-30% or more (much more risky) So how do investors determine required risk premiums (RP j s)? 19-15 19-15 19-16 19-16 Why IRR Is Technically Inferior to NPV as an Investment Criterion IRR & NPV will always give the same accept-reject signal w.r.t. an individual investment But.. IRR may rank investment opportunities differently than NPV NPV ranking is always consistent with wealth maximization If projected CFs change signs more than once over expected holding period, there may be multiple IRRs Effects of Leverage on NPV & IRR Increased leverage usually increases both NPV and IRR holding mortgage rate and all other assumptions constant 19-17 19-17 But leverage also increases risk to equity investor, thus required equity return should increase with leverage 19-18 19-18 3
When Will Leverage Increase NPV & IRR? Impact of Leverage on Risk of Equity Investment Increased leverage will increase calculated NPV when. opportunity cost of equity capital (discount rate) exceeds effective borrowing cost Increased leverage will increase going-in IRR when. unlevered going-in IRR exceeds effective borrowing cost 19-19 19-19 19-20 19-20 Income Taxes, Cash Flows & Returns Centre Point: After-Tax Cash Flows Cash flows and returns most important to investors are after-tax cash flows & returns The following after-tax analysis assumes a 30 percent income tax rate More detail on the tax calculations is provided in Chapter 20 19-21 19-21 19-22 19-22 How is Required After-Tax Discount Rate Determined? Centre Point: After-Tax NPV & IRR Assume: required before-tax return = 14% Assumed income tax rate on additional income = 30% After-tax required return = 14% (0.30 x 14%) = 14% x (1 0.30) = 9.8% That is, a reasonable assumption is: after-tax return = before-tax return x (1 TR) wheretr is investor s marginal tax rate Note: IRR falls less than 30%: (16.9 12.8) 16.9 = 0.24 19-23 19-23 19-24 19-24 4
Effective Tax Rate Formula Effective tax rate on the project = (BTIRR ATIRR)/BTIRR From previous slide: (16.9 12.8)/16.9 = 0.24 = 24% Comparison of Three Scenarios Note: This is less than the 30% marginal tax rate on ordinary income Real Estate Investing may lower Effective Tax Rates! Alternately stated, real estate can be a tax shield Some conclusions: Leverage increases expected Centre Point equity returns Taxes significantly reduce net investor CFs and returns 25 19-25 19-26 19-26 Reality Checks on Investment Value Claim of project organizer (promoter) on returns Compensation for idea, time, effort, & knowledge Claim of taxes on returns Federal taxes (IRS): Up to 43.4% State taxes: Up to 10% Complexity of tax computations Varying the Assumptions Sensitivity analysis Most likely scenario Worst-case scenario Best-case scenario Value of computer Excel spreadsheets Let s try this! Specialized software such as ARGUS Monte Carlo simulation 19-27 19-28 19-28 Nathan Collier on Quantitative Analysis NPV and IRR are major ways in which investment decisions are evaluated. Each method has its strengths and weaknesses. Proper analysis of investment real estate requires a pro forma, an estimate of income and expenses over a period of time, usually 5 to 10 years. I can create the template for a rough pro forma from scratch in a couple of hours, a complete pro forma with all the bells and whistles and looking crisp could easily take a few days. It is amazing how many people in real estate and finance have never created a pro forma from scratch and couldn t to save their lives. I ve told my COO that the requirement to be a financial analyst for The Collier Companies should include the ability to at least create a rough pro forma from scratch solo. Otherwise, how can you truly understand what you are doing? I m a big back of the envelope kind of guy. If the deal is so close that it does not pencil out on a napkin at the table, I m pretty sure I don t want to go for it. But before we proceed we double and triple check our gut feel via sifting the deal numbers through a great pro forma. Nathan Collier: Chairman, The Collier Companies, a major owner/operator of student apartment communities 19-29 19-29 30 5
End of Chapter 19 31 6