Chapter 18 Investment Decisions: Ratios REAL ESTATE FIN 331

Investment Decision-Making A. The difference between Investment Value and Market Value 1.Market Value reflects the value of the land and structures thereon 2.Investment Value takes into consideration future income streams resulting from the acquisition of a property a.Rental rates b.Vacancy rates c.Operating expenses d.Potential future capital investment e.Risk attributes

Investment Decision-Making  Estimating net operating income for the next year PGIPotential Gross Income -VCVacancy & Collection Loss + MIMiscellaneous Income = EGIEffective Gross Income -OEOperating Expenses -CAPXCapital Expenditures = NOINet Operating Income - DSDebt Service (Interest Only)* =BTCFBefore Tax Cash Flow -TAXFed, State, Local Taxes =NINet Income * The authors acknowledge on page 489, 3 rd paragraph, that the principal portion of mortgage payments are not tax deductible.

Centre Point: Projected 1st-Year NOI See Note regarding this table 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 = Net Operating Income (NOI)$89,100 - Debt Service (Interest)$51,219 = Before Tax Income$37,881 - Taxes (24%) $ 9,091 = Net Income$28,790 Note: This table differs from Exhibit 18-4 due to the fact that only interest is a tax deductible expense.

Operating vs. Capital Expenditures A. Operating expenses: 1.Keep property operating & competitive 2.Do not increase value or extend useful life 3.Examples: minor roof repairs, air conditioner servicing, lawn maintenance, utilities, etc. B. Capital Expenditures: Capitalized 1.Increases market value of property 2.Examples: Roof replacement, air-conditioner replacement, installation of new landscaping 3.These expenditures are depreciated over time.

Investment Decision-Making C. More on Capital Expenditures 1.Some treat CAPX as a Reserve (above the line), some below the line a.Above: PGI – VC = EGI – OE – CE = NOI b.Below: PGI – VC = EGI – OE = NOI – CE = NCF (Net Cash Flow) c.Note: Below the line CE is not a tax deductible as “expense” → capitalized: it gets amortized as depreciation D. NOI: Fundamental determinant of value a.Service the mortgage debt and b.Provide investor with an acceptable return on equity

Capital Expenditures Pro 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

Use of Leverage A. Why do investors borrow? 1. Limited financial resources/wealth 2. Leverage amplifies equity returns ( & risk) 3. Also permits more portfolio diversification B.Cash flow effect of borrowing: Net operating income − Debt service (interest only) = Before-tax Income (BTI)

Debt Financing for Centre Point A. Terms 75% loan, 30 year term, 6.5% contract rate, up-front fees of 3% of loan amount B.Net loan proceeds: = $792,000 − (0.03 x $792,000) = $792,000 – $23,760 = $768,240 A.Initial equity = $1,056,000 - $768,240 = $287,760 B.Payment: $5, or $60,072* per year 1.Interest Portion = $51,219 2.Principal Portion = $8,853

Centre Point: Estimated Before-Tax Cash Flow (BTCF) A. Potential Gross Income (PGI) $180,000 B. - Vacancy & Collection Loss (VC) $18,000 C. = Effective Gross Income (EGI) $162,000 D. - Operating Expenses (OE) $64,800 E. - Capital Expenditures (CE) $8,100 F.= Not Operating Income (NOI) $89,100 G. - Debt Service $60,072* H. = Before-Tax Cash Flow (BTCF) $30,656 * Interest = $51,219 (the only tax deductible portion)

Partnerships, Limited Liability Companies, etc. A. Centre Point Pro forma displays expected total CFs from property available for distribution to equity investors B. When using partnerships & limited liability companies, all CFs & income tax consequences are allocated and “flow through” to individual investors C.Thus, further analysis is usually required to determine expected CFs & returns earned by various equity investors 1.All distributions are based on investors’ pro rata share of contributed equity

Financial Ratios (see Exhibit 18–6) A. Operating Expense Ratio = Operating Expenses divided by Effective Gross Income B. Loan-to-Value Ratio = Loan divided by Fair Market Value C. Debt Coverage Ratio = NOI divided by Debt Payments D. Debt Yield Ratio = first year NOI divided by the first mortgage loan E.Profitability Ratios 1.Capitalization Rate = NOI 1 / Buy Price 2.Equity Dividend Rate = BTCF / Equity Investment

Valuation Multipliers Appraisers use simple rules of thumb to value rental properties A. Multipliers* 1.Net income multiplier NIM = Buy Price / NOI 2.Effective gross income multiplier (EGIM) EGIM = Buy Price / EGI * Multipliers work best when properties have a high degree of similarity

Pros and Cons of Ratios & Multipliers A. Pros 1.Quick & easy to compute 2.Intuitive 3.Facilitates comparison with similar properties 4.No explicit assumptions about future B.Cons 1.No clear benchmarks for acceptable range 2.Only a partial view of performance 3.No explicit assumptions about future

Homework Assignment A. Key terms: after-tax cash flow, net income multiplier, operating expense ratio, capitalization rate, effective Gross income multiplier, Effects of Leverage B. Study Questions: 1, 2, 3, 7, 9, 10, 12

Practice Problem You are considering purchasing a small office building for $1,750,000. A.Your expectations include: 1.First-year gross potential income of $325,000; 2.Vacancy & collection losses equal to 12% of PGI; 3.Operating expenses = 38% of EGI; 4.Capital expenditures = 5% of EGI 5.$1,312,500 mortgage (75% 7% 6.Mortgage will be amortized over 25 years 7.Total up-front financing costs = 2% of the loan amount 8.Required equity investment is B. Prepare a Pro Forma Income Statement C. Compute the Following Ratios 1.Cap Rate 2.Equity Dividend Rate 3.Effective Gross Income Multiplier 4.Operating Expense Ratio 5.Debt Coverage Ratio 6.Debt Yield Ratio

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