Investment Decisions: Ratios and Value

Investment Decisions: Ratios

• Investment decisions involve understanding ratios.
• Appraisers estimate market value for economic transactions.
• Buyers want to pay market value and sellers want to minimize losses.
• Investors consider the investment motive, not just market value.

Appraiser vs Investor

• Appraisers are paid to estimate market values based on economic transactions, focusing solely on the property's worth.
• Investors consider the whole investment story, including future projections of factors like rental rates, vacancies, and operating expenses, and the relevant investment motive.

How Does Investment Value Differ From Market Value?

• Investors have differing required returns and risk assessments.
• Investors consider the opportunity cost of invested equity.
• Investors have different expectations concerning future factors like rental rates, vacancies, and operating expenses.

NOI Estimation

• Potential Gross Income (PGI)
• Vacancy and Collection Loss (VC)
• Miscellaneous Income (MI)
• Effective Gross Income (EGI)
• Operating Expenses (OE)
• Capital Expenditures (CAPX)
• Net Operating Income (NOI): NOI is sufficient to cover debt and give investors an acceptable return on equity.

Why Investors Borrow

• Limited financial resources or wealth
• Leverage amplifies equity returns and risk
• Flexibility to diversify portfolios

Reconciliation of Value Indicators

• Various approaches are used to indicate property values, including income approach (DCF analysis, direct capitalization, EGIM analysis), cost approach, and sales comparison approach.
• Weights are assigned to each approach to combine these factors into a final value estimate.

Effects of Leverage on Cashflows

• This involves the total acquisition price, loan, loan amount, loan proceeds, loan equity, and an annual debt service payment.

Evaluating Cash Flow Estimates

• Meaningful cash flow analysis relies on defensible estimates of cash flows.
• Questions should be asked about cash flow statements to ensure accuracy.

Are Income & Expense Items Appropriate?

• Income and expense items directly relating to producing income are included; federal and state income taxes and business costs not attributable to the property are excluded.

Have Trends Been Considered?

• Considering trends is crucial; extrapolating recent trends is insufficient and factors like rental rate growth, vacancy assumptions, credit-worthy tenants, and lease length must be examined.

What About Comparable Properties?

• Gathering data on comparable/substitute properties is necessary, including revenue and expense trends.
• Investor data subscriptions and ongoing relationships with developers, appraisers, brokers, and other investors are valuable.

Social & Legal Environments

• Understanding social, legal, and environmental factors influencing property values (zoning, environmental controls, community trends, and taxes).
• Assessing local officials' views concerning growth is essential.

Demand & Supply of Properties

• Analyzing and forecasting potential changes in demand and supply of properties similar to the subject.
• Information on upcoming developments and permits provides useful insight.

Assumptions for Centre Pointe Office

• Annual market rent increases: 3% per year.
• Vacancy and collection losses: 10% per year.
• Operating expenses: 40% of effective gross income annually.
• Capital expenditures: 5% of effective gross income annually.
• Holding period: 5 years.

Centre Point - Discounted Cash Flow Analysis

• Rent is expected to originate from estimated data before being aggregated, and PGI projections are based on a 3% annual growth rate, assuming lease agreements are in place.

Effects of Leverage on Cashflows (Centre Pointe)

• 75% LTV, 30-year term, 6.5% interest financing costs and 3% loan charges are considered.
• Loan amortization, loan proceeds, and initial equity, are other pertinent aspects.

Before-Tax Cash Flows (BTCF)

• Cash flows are levered, and NOI, debt service, and BTCF are presented.
• Equity investors discount levered cash flows given a required rate of return.

Centre Point with Mortgage Financing

• Calculations show NOI, debt service, and BTCF, along with sale price, expenses, net sale proceeds, remaining mortgage balance, and before-tax equity reversion.

Leverage Cashflow Analysis

• Includes total CF, PV inflows, PV outflows, and NPV; NPV is a crucial part to consider, along with the initial equity investment, loan proceeds, cost of debt financing, other factors, and discount rates.

Investment Decision - Centre Pointe

• Accepting the Centre Point investment opportunity will boost equity investors' wealth by $31,831.

Effect of NPV of Variation in Discount Rates

• Net present value (NPV) responses concerning variations in the required rate of return are presented.

Profitability Ratios: Capitalization Rate

• Evaluating the 8.44% capitalization rate, comparing to rates of similar properties, and looking for other data to inform investment decisions.

Example: Real Estate Research Corporation Cap Rate Survey

• Cap rates fluctuate inversely with property quality (class) and vary based on property type/risk.

Example: Real Estate Research Corporation Cap Rate Survey

• Prices of first-tier warehouse properties are 29% higher than those of third-tier properties.