Chapter 19 Investment Decisions: NPV and IRR REAL ESTATE FIN 331

A Cautionary Note On occasion authors make some changes to simplify the examples. Unhappily, when it comes to real property and tax issues, this can lead to incorrect conclusions regarding methodology. Investment analysis requires precise data AND knowledge of IRS tax law and process.

Investment Valuation Most commercial real estate decisions involve investment motive Investments are made in expectation of future cash flows The magnitude and timing of future cash flows will determine whether or not an investment is profitable or not The Discounted Cash Flow method (DCF) is used to determine the feasibility of an investment

Investment Valuation B. Required inputs for DCF analysis Estimate how long the investor will hold the property Estimate the yearly net cash flows Select an appropriate risk-adjusted discount rate to complete the calculations DCF process will yield a net present value (NPV)

Shortcomings of NOI-Based Valuation Limitation of NOI single-year return measures & ratios? They do not explicitly incorporate income producing ability of property beyond 1st year of rental operations May lead to suboptimal investment decisions 19-5

Multi-Year DCF Many investors also perform multi-year analyses of potential acquisitions When using multi-year discounted CF decision making methods, investor must estimate how long she expects to hold property make explicit forecasts of: property’s net CF for each year, net CF produced by expected sale of property Select rate of return at which to discount all future CFs

Centre Point Office Building

6-Year CF Projections Assuming 3% per Year Rent Escalation

Assumed Sale Price in Year 5 Based on Year-6 NOI Sale Price = NOI6 / Cap Rate: 103,291 / 0.0875 = $ 1,180,469

Centre Point by the Text (with a some minor corrections)

Method of Depreciation per IRS

Recovery Periods Under ADS

Recovery Periods Under ADS

Centre Point by the IRS

DCF Investment Valuation A. NPV decision rules NPV = Present Value of ATCF minus the Initial contact Investment If NPV is greater than 0, we make the investment If NPV is less than 0, we will not make the investment

DCF Investment Valuation B. Measuring the impact of leverage Leverage involves the use of debt to finance part of the acquisition The interest charges on debt will reduce our taxable income Traditional analysis uses ATCF values to compute NPV

DCF Investment Valuation Internal Rate of Return (IRR) When NPVs are greater than 0, the internal rate of return will be greater than the discount rate used to compute NPV if NPV is equal to 0, then the internal rate of return equals the discount rate if NPV is less than 0, then the IRR is less than the discount rate

Measuring the Impact of Risk on NPV Sensitivity analysis Most likely scenario Worst-case scenario Best-case scenario Value of computer Excel spreadsheets Specialized software such as ARGUS Monte Carlo simulation (using random probabilities to develop outcome distributions)

homework assignment Key terms: before tax cash flows, after-tax cash flows, leverage, leverage cash flow, unleveraged cash flow Study questions: 2, 3, 5, 9, 11