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1. Chapter 18Investment Decisions: Ratios

   REAL ESTATE FIN 331
2. Investment Decision-Making The difference between Investment Value and Market Value Market Value reflects the value of the land and structures thereon Investment Value takes into consideration future income streams resulting from the acquisition of a property Rental rates Vacancy rates Operating expenses Potential future capital investment Risk attributes
3. Investment Decision-Making Estimating net operating income for the next year 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 - DS Debt Service = BTCF Before Tax Cash Flow - TAX Fed, State, Local Taxes = NI Net Income
4. Centre Point: Projected 1st-Year NOI
5. Operating vs. Capital Expenditures Operating expenses: Keep property operating & competitive Do not increase value or extend useful life Examples: minor roof repairs, air conditioner servicing, lawn maintenance, utilities, etc. Capital Expenditures: Capitalized Increases market value of property Examples: Roof replacement, air-conditioner replacement, installation of new landscaping
6. Investment Decision-Making C. More on Capital Expenditures Some treat CAPX as a Reserve (above the line), some below the line Above: PGI – VC = EGI – OE – CE = NOI Below: PGI – VC = EGI – OE = NOI – CE = NCF (Net Cash Flow) Note: Below the line CE is not a tax deductible as “expense” → capitalized: it gets amortized as depreciation D. NOI: Fundamental determinant of value Service the mortgage debt and Provide investor with an acceptable return on equity
7. Capital ExpendituresPro Forma Treatment Appraisal Terminology (“Above line”) PGI − VC = EGI − OE − CAPX Reserve = NOI Investment Terminology (“Below line”) PGI − VC = EGI − OE = NOI − CAPX = Net Cash Flow
8. Use of Leverage Why do investors borrow? Limited financial resources/wealth Leverage amplifies equity returns (& risk) Also permits more portfolio diversification Cash flow effect of borrowing: Net operating income − Debt service = Before-tax cash flow (BTCF)
9. Debt Financing for Centre Point Terms 75% loan, 30 year term, 6.5% contract rate, up-front fees of 3% of loan amount Net loan proceeds: = $792,000 − (0.03 x $792,000) = $792,000 – $23,760 = $768,240 Initial equity = $1,056,000 - $768,240 = $287,760 Payment: $5,005.98 or $60,072 per year
10. Centre Point: Estimated Before-Tax Cash Flow (BTCF) Potential Gross Income (PGI) $180,000 - Vacancy & Collection Loss (VC) $18,000 = Effective Gross Income (EGI) $162,000 - Operating Expenses (OE) $64,800 - Capital Expenditures (CE) $8,100 = Not Operating Income (NOI) $89,100 - Debt Service $60,072 = Before-Tax Cash Flow (BTCF) $30,656
11. Partnerships, Limited Liability Companies, etc. Centre Point Pro forma displays expected total CFs from property available for distribution to equity investors When using partnerships & limited liability companies, all CFs & income tax consequences are allocated and “flow through” to individual investors Thus, further analysis is usually required to determine expected CFs & returns earned by various equity investors All distributions are based on investors’ pro rata share of contributed equity
12. Financial Ratios (see Exhibit 18–6) Operating Expense Ratio = Operating Expenses divided by Effective Gross Income Loan-to-Value Ratio = Loan divided by Fair Market Value Debt Coverage Ratio = NOI divided by Debt Service Debt Yield Ratio = first year NOI divided by the first mortgage loan Profitability Ratios Capitalization Rate = NOI1 / Buy Price Equity Dividend Rate = BTCF / Equity Investment
13. Valuation Multipliers Appraisers use simple rules of thumb to value rental properties Multipliers* Net income multiplier NIM = Buy Price / NOI Effective gross income multiplier (EGIM) EGIM = Buy Price / EGI * Multipliers work best when properties have a high degree of similarity
14. Pros and Cons of Ratios & Multipliers Pros Quick & 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
15. Homework Assignment Key terms: after-tax cash flow, net income multiplier, operating expense ratio, capitalization rate, effective Gross income multiplier, Effects of Leverage Study Questions: 1, 2, 3, 7, 9, 10, 12
16. Practice Problem You are considering purchasing a small office building for $1,750,000. Your expectations include: First-year gross potential income of $325,000; Vacancy & collection losses equal to 12% of PGI; Operating expenses = 38% of EGI; Capital expenditures = 5% of EGI $1,312,500 mortgage (75% LTV) @ 7% Mortgage will be amortized over 25 years Total up-front financing costs = 2% of the loan amount Required equity investment is B. Prepare a Pro Forma Income Statement C. Compute the Following Ratios Cap Rate Equity Dividend Rate Effective Gross Income Multiplier Operating Expense Ratio Debt Coverage Ratio Debt Yield Ratio