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Chapter 19:

Chapter 19:. Investment Decisions: Ratios. Decision Making in Real Estate Centers Around Valuation. We examined the concept of market value in Chapters 8 & 9. As noted, professional real estate appraisers are often called on to estimate the market value of a property

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Chapter 19:

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  1. Chapter 19: Investment Decisions: Ratios

  2. Decision Making in Real Estate Centers Around Valuation • We examined the concept of market value in Chapters 8 & 9. • As noted, professional real estate appraisers are often called on to estimate the market value of a property • Market value is the basis for economic transactions…..a buyer does not want to pay more than the market value of the property

  3. Decision Making in Real Estate Centers Around Valuation • For many investors, however, market value is not the whole story • In fact, most real estate decisions are made with an investment motive

  4. Decision Making in Real Estate Centers Around Valuation • Investment valuation calculations, whether implicit or explicit, are required: • When a property acquisition is contemplated • When a structure is • Modernized • Renovated • Abandoned • Demolished • When a site is developed • When a property is used as collateral for a loan.

  5. Chapter Overview • Chapter introduces framework for making single-asset RE investment decisions • Focus is on a set of widely used ratios and multipliers • These single-year measures are relatively easy to calculate, but do not explicitly consider cash flows beyond 1st year of the analysis • Many investors also perform multi-year discounted cash flow (DCF) analyses, discussed in Chapter 20

  6. A Word of Caution • This chapter and the next focuses on quantitative decision tools • Although quantitative valuation tools and techniques are widely used, their usefulness is limited by the quality of the cash flow assumption used by the analyst. • In short, the “garbage in, garbage out” maxim apples to real estate investing

  7. Why Investment Value Differsfrom Market Value • Investors have different required yields • Different risk assessment • Different opportunity cost • Different access to financing(e.g., subprime vs. standard) • Different expectations: • Future rental rates • Vacancies • Uncertainty level

  8. Centre Point Office Building: Assumptions • Total acquisition price: $885,000 • Property has 9 offices: 4 on 1st floor, 5 on 2nd • Contract rents: 6 @ $1,800/mo., 3 @ $1,400/mo. • Annual market rent increase: 3% • Vacancy & collection loss: 10% • Operating expenses: 40% of EGI • Capital expenditures: 5% of EGI

  9. 1st Step in Investment Analysis:Estimating NOI PGI Potential Gross Income • VC Vacancy & Collection Loss +MI Miscellaneous Income = EGI Effective Gross Income • OE Operating Expenses • CAPX Capital Expenditures = NOI Net Operating Income

  10. Centre Point: Projected 1st-Year NOI Potential gross income (PGI) − Vacancy & collection loss (VC) = Effective gross income (EGI) Operating expenses (OE) − Capital expenditures (CAPX) = Net operating income (NOI) $180,000 18,000 162,000 64,800 8,100 89,100

  11. Appraisal Terminology and Pro Forma: (“Above line”) PGI −VC = EGI − OE − CAPX Reserve = NOI Investment Terminology and Pro Forma (“Below line”) PGI −VC = EGI −OE = NOI − CAPX = Net cash flow How Are Expected Capital Expenditures Treated in the Proforma? For consistency, we will assume an “above-line treatment throughout the course

  12. Maintenance vs. CapitalExpenditures • Operating expense: • Keeps property operating and competitive • Does not increase value or extend useful life • Examples: Minor roof repairs, air conditioner servicing • Capital Expenditures: • Increases market value • Or extend useful life of property • Examples: Roof replacement, air-conditioner replacement

  13. More on Net Operating Income • NOI: $'s that flow out of the property • NOI is the property's "dividend" • The projected stream of NOI is the fundamental determinant of value • NOI must be sufficient to service the mtg debt and provide equity investor with an acceptable return on equity.

  14. Evaluating Cash Flow Estimates • Are income and expenses items appropriate? • Only income and expenses that a landlord with a full service lease would pay. • Are they consistent with comparable properties? • Are projected trends reasonable? • Vacancy and rental rate growth? • Expense growth? • Are social and legal environments stable? • Evidence of neighborhood change? • New land use controls? • Tax law changes?

  15. Borrowing (Leveraging) • Why do investors borrow? • Limited financial resources • Leverage amplifies equity returns • To permit portfolio diversification • Cash flow effect of borrowing: Net operating income −Debt service_____________ = Before-tax cash flow (BTCF)

  16. Financing for Centre Point • Terms • 75% loan, 30 years, 8%, up-front fees of 3% • Net loan proceeds: = $663,750 − (0.03 x 663,750) = $663,750 – $19,913 = $643,837.50 • Equity = $885,000 - $643,837.5 = $241,163 • Payment: $4,870.36 or $58,444 per year

  17. Centre Point: Estimated Before-Tax Cash Flow = Net operating income $89,100 - Debt service_____________ 58,444 = Before-tax cash flow (BTCF) $30,656

  18. Traditional Ratios to AnalyzeInvestment Real Estate • Profitability ratios • Capitalization rate • Equity dividend rate • Multipliers • Net income multiplier • Gross income multiplier (GIM) • Financial risk ratios • Operating expense ratio • Loan-to-value ratio (LTV) • Debt coverage ratio

  19. Profitability Ratios: Capitalization Rate • Capitalization rate (going-in) • Centre Point example: Ro is return on funds supplied by both equity investor(s) and lender. As such, it measures overall income producing ability of property.

  20. Profitability Ratios: Capitalization Rate • Is 10.1% an acceptable overall cap rate? • Question can only be answered by comparisons with cap rates on similar properties in the market • Investors will primarily rely on cap rate information they abstract from observed transactions in the local market • However, regularly published surveys also provide useful information on cap rate trends

  21. Example: Real Estate Research Corporation Cap Rate Survey • Cap rates vary inversely with quality • Rates vary by property type risk

  22. Profitability Ratios: Equity Dividend Rate • Equity dividend rate (EDR): • Residual cash flow return to equity investment • Commonly called “cash-on-cash” return • Common reference point for smaller investments • Centre Point example:

  23. Multipliers: Net Income Multiplier • Net income multiplier: • Centre Point example: Reciprocal of cap rate; conveys identical information Would you always prefer the opportunity with the lowest NIM?

  24. Multipliers: Gross Income Multiplier • Gross income multiplier (GIM): • Centre Point Example: • Cautions: • - Use only among similar properties • - Clarify PGI before using

  25. Financial Risk Ratios: Operating Expense Ratio • Operating expense ratio: • Centre Point example: • Seasoned analysts watch deviations from normal

  26. Financial Risk Ratios: Loan-to-Value Ratio • Loan-to-value ratio (LTV): • Centre Point example: • Lenders generally want LTV of first mortgage to be no greater than 75–80% of acquisition price

  27. Financial Risk Ratios: Debt Coverage Ratio • Debt coverage ratio (DCR): • Centre Point example: • Primary risk assessment ratio used by lenders • Indicates amount of “cash flow cushion” • above that needed to pay debt service

  28. Pros and Cons of Ratios • Pros • Quick and easy to compute • Intuitive • Facilitates comparison with similar properties • No explicit assumptions about future • Cons • No clear benchmarks for acceptable range • Only a partial view of performance • No explicit assumptions about future

  29. Example 19-1 • You are considering the purchase of a small office building for $1,975,000 today • Your expectations include these: • First-year gross potential income of $340,000; • Vacancy and collection losses equal to 15% of PGI; • Operating expenses equal to 40% of EGI; • Capital expenditures equal to 5% of EGI • A 1,481,250 first mortgage loan (75% LTV) with an annual interest rate of 7% • Loan will be amortized over 25 years with a monthly payment of $10,469.17 • Up-front financing cost will equal 2% of the loan amount • Required equity investment is $523,375 [$1,975,000 – ($1,481,250 - $29,625)].

  30. Example 19-1: 1st Year Projections

  31. Example 19-1: 1st Year Ratios Going in cap rate: Equity dividend rate: (Effective) gross income multiplier:

  32. Example 19-1: 1st Year Ratios Operating expense ratio: Debt coverage ratio:

  33. End of Chapter 19

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