INVESTMENT DECISION MAKING LEARNING OBJECTIVES Identify the basic types and characteristics of investment properties. Forecast annual cash flows, net of expenses, from property operations. Forecast cash flows from the eventual sale of the property.

LEARNING OBJECTIVES Calculate the net present value and internal rate of return on a proposed investment. Calculate and interpret the basic financial ratios which apply to real estate investment decisions. Understand the effect of leverage on the investment decision. INVESTMENT DECISION MAKING

INVESTMENT DECISIONS Forecast cash flows from operations. Forecast cash flow from sale. Determine present value of expected cash flows. Apply an investment decision criterion.

Investment Strategy Investment Philosophy Investment Objectives Investment Policies REAL ESTATE INVESTMENT ANALYSIS

CHARACTERISTICS OF INCOME PROPERTY INVESTMENTS Property Types Rental Income Contract Rent Market Rent Purchasers as Investors Geographic Scope

FORECASTING CASH FLOWS FROM OPERATIONS Potential Gross Income Effective Gross Income Operating Expenses Net Operating Income Non-Recurring Expenses

Net Operating Income Calculation

Net Operating Income Example

Forecasted Cash Flows From Net Operating Income

Forecasted Cash Proceeds From Sale

Present Value Calculation

Net Present Value (NPV) The net present value is the present value of a project’s cash inflows, minus the present value of the cash outflows. The cash flows are discounted at the investor’s required rate of return--in this example 12 percent.

Net Present Value Calculation

NPV Decision Criteria If NPV>0, the project exceeds the investor’s required rate of return. If NPV<0, the project does not meet the investor’s required rate of return. If NPV=0, the project’s expected return equals the investor’s required rate of return.

Internal Rate of Return (IRR) The internal rate of return is the discount rate at which NPV = 0, the rate of return at which the present value of the cash inflows equals the present value of the cash outflows.

NPV and the IRR

IRR Decision Criteria If IRR > the required rate of return, then accept. If IRR< the required rate of return, then reject. If IRR= the project’s expected return equals the investor’s required rate of return.

NPV and the IRR NPV: Cash flows assumed reinvested at discount rate  Generally preferred to IRR for making decisions IRR: Cash flows assumed reinvested at the IRR rate  May provide inferior wealth maximizing ranking of alternative opportunities to the NPV  Multiple solutions possible  Easily compared to other investments and widely used

The Effects of Mortgage Financing on Cash Flows, Values, and Returns Effect on the Initial Investment Effect on the Cash Flows from Operations Effect on the Cash Flow from Sale

INVESTMENT CRITERIA Profitability Ratios Capitalization Rate: R o = NOI / Acquisition Price Equity Dividend Rate: R e = EDR = BTCF / Initial Equity Mortgage Constant: R m = MC = DS / Initial Loan Amount

INVESTMENT CRITERIA Multiplers Net Income Multiplier: NIM = Acquisition Price / NOI Effective Gross Income Multiplier: GIM = Acquisition Price / EGI

INVESTMENT CRITERIA Financial Ratios Operating Expense Ratio: OER = Operating Expenses / EGI Loan-to-Value Ratio: LTV = Mortgage Balance / Property Value Debt Coverage Ratio: DCR = Net Operating Income / Debt Service