Multi-Period Analysis Present Value Mathematics

Real Estate Values Set by Cash Flows at different points in time. Single period Analysis revisited  Single Period ratio analysis Cash on Cash return ROI – excess of 10%? From book  Depends upon inflation and interest rates

Present Value Analysis Single sum Analysis Review  FV = (1+r)’n PV  PV = FV/(1+r)’n  r=interest rate, n=# of periods Or PV and FV formula in excel Multi-period analysis discounts a stream of different cash flows at a particular rate.  The discount rate = risk free rate + risk premium (ie risk free rate = US T Bill yield)

Discounted Cash Flow (DCF) Three main steps 1) Forecast the expected future cash flows 2) Ascertain the required total return 3) Discount the cash flows to the Present Value at the required rate of return

1) Forecast Cash Flows Use Year One budget to expand to future periods.  Set assumed growth rate projection to income and expense items. Use exact numbers if know otherwise estimates Typical estimates include CPI, Mkt Study estimates, or past experience  Calculate the Terminal Value Based on the final years cash flow Typically apply a CAP rate to final year cash flow

Terminal Value/Resale Price Calculation Final Years cash flow determined by applying a CAP rate to final years cash flow. Net Operating Income Projected for Final Year CAP Rate Represents an inflow of cash as if property were sold at the end of the analysis period.  Need to deduct any expected selling costs  Don’t forget to deduct repayment of remaining balance of loan

Capitalization Rates Revisited Rate set for quick valuation of assets based on one years Net Operating Income The rate is usually set by comparison of what other similar properties are selling for in the market. A way of quoting observed market prices for real estate as Bond Yields are the way bond prices are reported. The CAP rate for terminal value may be slightly higher than one for a valuation today  Reflecting the age of the property  Higher uncertainty regarding inflation and interest factor

Amortization of Loans Will need to create an amortization table of the loan to know expected value of loan in last year. Calculate payment, calculate principle and interest portions of payments, deduct principle portion from prior years amount.

2) Determine Discount Rate Three Main Determinants of Discount Rates  Opportunity Cost of Capital How much can your money earn in other investments like stocks and bonds. Discount Rates move with Interest Rates  Inflation Rates  Risk Higher Risk, higher discount rate, Lower price Growth Expectations  Where is the property in its Life Cycle  Is the location a growing or declining area  Investors willing to pay more for growth prospects

3) Discount Cash Flows to Net Present Value NPV = PV(benefit)-PV (Cost) Net Present Value Rule  Maximize the NPV across all mutually exclusive alternatives  Never choose an alternative that has NPV<0 0 NPV deals are OK  Discount rate implies that at 0 investor is just earning their required return  Finding deals with very large NPV usually means you have an error in your calculations

Most Common Errors Rent and income growth assumption too high.  Do rents always grow with inflation? Depreciation of building real terms inflation vs inflation applied to today’s value Capital improvement expenditures projection too low  Can average 10 – 20% of NOI Terminal CAP rate too low  Typically slightly higher than going in cap rate Discount Rate too high  May offset the other mistakes  Unrealistic expectations

Example from Book P. 90 Year one Gross Rent – $1,000,000 Vacancy Rate 7% Year One Operating Expenses – $700,000 Net Operating Income - $230,000 Discount Rate 8% Terminal CAP 8.5% Income escalation 3% Operating Expense escalation 4% Sale of property at the end of year 6 Purchase Price $2,820,285

Internal Rate of Return The rate that discounts all the net cash flows to equal a 0 NPV Algebraic solution cannot be done. Must use computer. The IRR function in Excel asks for a guess of the expected IRR to help give the correct response A common measure used by companies in capital budgeting.

Remember It is All Still Just Estimates GIGO applies

The Nature of Risk The chance or probability that the investor will not receive the expected or required rate of return. We have already seen that as risk increases expected return is also increased

Business Risk Related to variances from estimates in  capital expenditures,  gross possible income,  vacancy and credit loss  Operating Expenses  Property Value Static or unsystematic business risk  Physical causes and beyond the control of the investor Fire, floods, injuries  Can be shifted to others through insurance Dynamic or systematic risk  Related to changes in general business conditions and conditions of the property. External not under the control of the investor. Market supply and demand, quality of property management, change in economic base or taxes.  Cannot be transferred to others therefore requires risk premium in return calculation

Financial Risk Risk of not receiving expected return due to financial obligations of debt financing Risk created by debt financing  Increases whenever the debt levels increase Debt decreases net cash flows however increase IRR’s if leverage is favorable  Because investors demand a higher return for the increased risk. Internal financial risk  Relates to the ability of the project to pay debt service External financial risk  Ability of the investor to obtain funds from external sources.  As sources become more difficult to obtain external financial risk increases.

Transfering or Eliminating Risk Play the real estate cycle  Wait for the right time for real estate decisions  Do not invest in overbuilt or recessionary markets Non recourse mortgages  Shifts the burden of financial risk to the property and the lender  In the event of default the investor could lose the property Avoid pre-payment penalties, indexed loans Insurance policies Limited-liability forms of ownership Long term leases with escalation clauses  Transfers vacancy risk to the tenant

Reducing the remaining Risks Negotiation of appropriate loan amount and terms  Lower amount has less risk Purchase Price  Negotiation of better purchase terms Diversification Good accounting controls and reporting systems Good research Good Property Management Superior location