Chapter 19: Investment value: NPV and IRR

Outline DCF framework Discounting NOI

Investment value Investment value (to a particular investor) is different from market (appraisal) value. Commercial real estate decisions are made with an investment motive: expecting cash flows from the investment. The discounted cash flow (DCF) analysis addresses this motive. Decision rule: if NPV > 0, accept the project.

Inputs for DCF The holding (investment) horizon. Applicable required return. Expected cash flows.  In traditional finance, we’d like to use after (corporate) tax cash flows, e.g., dividends or FCFs to the firms.  In RE, there are a variety of cash flow choices, both before taxes and after taxes.  Thus, be clear about the types of cash flows and then use the appropriate discount rate.  Do not compare apples with oranges.

The example A possible purchase of a 96,000 sf building for $9 million (V 0 ). There are three tenants now. Current market rent: $15 / sf, and this is expected to increase at 4% per year. Expected CPI rate: 4%. This example is based on Brueggeman and Fisher (2008).

CPI adjustment The base rent is $1,365,000, which is based on current rent price. Current rent prices for A and B are lower than the market rent price because they are older leases. Rent prices are usually adjusted based on CPI; but this adjustment is usually partial (50% here). Thus for Year 1, we would expect a 2% (50% of 4% CPI) adjustment for older leases: A and B. The lease for C is just signed, its rent price is set to the current market price: $15 / sf. Since this is a new lease, there would be no CPI adjustment for C in Year 1.

Pro forma rental income and CPI adjustments; horizon = 5

Expense reimbursements as another source of income Expense stop: a clause often found in commercial leases that requires landlords to pay property operating expenses up to a specified amount and tenants to pay the expenses beyond that amount. Expense stop is usually stated in per sf amount. For example, if the expense stop is $4.25 / sf and the current expense is $4.5 / sf, the tenant must pay the landlord 25 cents / sf as an expense reimbursement (income to the landlord). Suppose that expense reimbursement estimates for Year 1-6 are 33500, 44396, 70625, 15256, 19189, and

Formula for PGI Base income + CPI adj. + Expected reimbursement = Potential (gross) income (PGI)

Projected NOI

Discounting NOI Note that NOI is a before-tax cash flow. Thus, when we assign a discount rate to discount NOI, this must be a before-tax discount rate. Suppose that the investor requires a before- tax discount rate of 12%. Note that this discount rate is somewhat individual-specific; some investors have higher costs of capital than the others.

The terminal market value For an NPV analysis, we need to know the terminal market value at the end of 5-year horizon. V 5 = NOI 6 / R 5, where R 5 is going-out cap rate. Suppose the going-out cap rate is expected to be 10%. Note that the going-out cap rate is determined in the market; not individual- specific. V 5 = NOI 6 / R 5 = / 0.1 = $10,617,780.

NPV and IRR

Decision Would you purchase the building?

Other cash flows/discount rates The previous example does not take taxes into consideration. One of course can use after-tax cash flows for the basis for DCF. If so, the discount rate needs to be a after-tax one. For this, see Chapter 11, Brueggeman and Fisher (2008).

Profitability ratios Going-in capitalization rate R 0 = NOI 1 / V 0 = / = 10.26%. Net income multiplier (NIM) = V 0 / NOI 1 = / = Gross income multiplier (GIM) = V 0 / EGI 1 = / = 6.33.

Financial risk ratios These ratios try to measure the income-producing ability to meet operating and financial obligations. Operating expense ratio (OER) = operating expenses / EGI; for year 1, OER = / = 35.00%. Loan-to-value (LTV) ratio = mortgage balance / acquisition price (V 0 ).

Pros and cons of financial ratios Easy to calculate and communicate. Their calculations are usually based on a single year’s numbers; they tend not to consider future cash flows. They do not have a formal decision rule.