Investment Decisions: Ratios (RES 2150 CH 18 19 Edited PDF)

Chapter 18 & 19 Investment Decisions: Ratios © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.  Appraiser vs Investor Appraiser Investors Paid to estimate market value Mar...

Chapter 18 & 19 Investment Decisions: Ratios © MCGRAW HILL LLC. ALL RIGHTS RESERVED. NO REPRODUCTION OR DISTRIBUTION WITHOUT THE PRIOR WRITTEN CONSENT OF MCGRAW HILL LLC.  Appraiser vs Investor Appraiser Investors Paid to estimate market value Market Value is not the Basis for economic whole story transactions Make RE decisions with Buyer does not want to investment motive pay more than market value and seller doesn’t want to take less How does Investment Value differ from Market Value? Investors have different required returns Different risk assessment/opportunity cost of invested equity Different expectations about future: Rental rates Vacancies Operating expenses Other…  Many of the Steps are the same Estimate NOI over Next Year Sufficient to cover mortgage debt and provide investors with an acceptable return on equity  Why do Investors borrow? Limited Financial Resources / Wealth Borrowing (Leveragin Leverage Amplifies Equity Returns g) (& Risk) Permits more Portfolio Diversification  Reconciliation of Value Indicators Centre Point Office Building APPRAISER’S MARKET VALUE--> Effects of Leverage on Cashflows Centre Pointe Office Building Total Acquisition Price: $1,056,000 Loan: 75% Loan-To-Value; 30 Year Term, 6.5% Interest, Financing Cost 3% of Loan Amount Loan Amount: Loan Proceeds: $792,000 - (3% x $792,000) = Initial Equity Investment: $1,056,000 - $768,240 = Debt Service Payment:  Centre Point Office Building First-Year Pro Forma (next 12 months) © MCGRAW HILL LLC Centre Point: Estimated Before-Tax Cash Flow (BTCF) NOI (Unlevered – Represents the CF return on the entire investment) Before-tax cash flow (BTCF) (Levered) - Represents return on equity portion of the investment) Exhibit 18-3 Levered vs. unlevered Cashflows 10  Evaluating Cash Flow Estimates  The Key to meaningful cash flow analysis is to use defensible cash flow estimates  What questions can be asked while building a proforma cash flow statement… Are income & expense items appropriate?  Include only income & expenses that relate directly to income producing ability of property  Does not include:  Federal and State Income Taxes  CapEx  Business-Related Expenses not attributed to the property operations Have trends for each item been carefully considered?  Should not just extrapolate recent trends  Importance of rental rate growth & vacancy assumptions  Credit-worthy tenants  Lease length What about comparable properties?  Should obtain as much information as possible on comparable/substitute properties  Revenue and expense trends of comparable properties  How do investors get this information?  Data Subscriptions  Maintain relationships with developers, appraisers, brokers, lenders, other investors  What are social & legal environments?  Zoning, land use, & environmental controls change quickly at state & local levels  How has subject’s neighborhood been changing?  Are local public officials pro or anti-growth?  Trends in property taxes?  Trends in insurance premiums?  Prerequisite for successful real estate investing, even if changes are difficult to predict How is the demand and supply of properties similar to the subject likely to change?  Especially important in multiyear analysis  Information on what is under development  Absorption  Permits Assumptions Centre Pointe Office  Centre Point – Discounted Cash Flow Analysis PGI is projected to grow 3% per year, the assumed rate of growth in market rents If there are one or more leases, the contract rent on these leases would have to be incorporated into PGI projections Effects of Leverage on Cashflows Centre Pointe Office Building Total Acquisition Price: $1,056,000 Loan: 75% LTV; 30 Year Term, 6.5% Interest, Financing Cost 3% of Loan Amount Loan Amount: Loan Proceeds: $792,000 - (3% x $792,000) = Initial Equity Investment: $1,056,000 - $768,240 = Debt Service Payment:  Before-Tax Cash Flows (BTCF) “Levered “Cash Flows McGraw Hill: Exhibit 19-4 Owner has ‘residual claim’ to the cashflows Equity Investor discounts projected levered cashflows at required rate of return Centre Point with Mortgage Financing McGraw Hill: Exhibit 19-4 Original Mortgage Balance= McGraw Hill: Exhibit 19-5  Be Leverage Cashflow is more risky than unlevered Ca fore Cash Flow sh T (B Flo ax TC F) w Acquisition Price Loan Proceeds Investment Decision - Accept Centre Point investment opportunity Doing so will increase equity investor’s wealth by $31,831 Effect on NPV of Variation in Discount Rate McGraw Hill: Exhibit 19-7 Going-in IRR = 16.8727%  Profitability Ratios: Capitalization Rate  Is 8.44% an acceptable overall cap rate?  Question can only be answered by comparisons to cap rates on similar properties  Investors should rely on cap rate information abstracted from comparable transactions in the local market  However, regularly published surveys may also provide useful information on cap rate trends  Example: Real Estate Research Corporation Cap Rate Survey Exhibit 18-5 Centre Pointe Office (8.4% Cap)------------------------------------------------------>  Cap rates vary inversely with quality (i.e., “class”)  Cap rates vary by property type risk Example: Real Estate Research Corporation Cap Rate Survey- Converting to Price Diff Exhibit 18-5  $1/0.061 = $16.39 $1/0.079 = $12.66 $16.39/$12.66 = 1.29 or 29% diff  First-tier warehouse properties sell for 29% more, per dollar of in- place NOI, than third-tier properties  Warehouse investors are willing to pay 29% more for a first-tier property