Fundamentals of Real Estate Lecture 4 Spring, 2002 Copyright © Joseph A. Petry

2 Housekeeping Note: – We will not cover “Valuation Using Direct Capitalization” in text (pp 76-77). – Schedule of visitors—absences must be excused. There will be a question or two on exams from each guest lecture. If you have an excused absence, be sure you get notes from your team members. Investment Property Analysis

3 Measuring Value and Returns – Once the cash flows have been estimated and verified, the value of those cash flows must be evaluated. – Many different means of measuring returns exist. The trick is to know the strengths and weaknesses of each, such that an accurate representation of the return and risk of the investment is clear. Investment Property Analysis

4 Measuring Value and Returns: NPV – NPV Formula: IV=investment value; NOI=net operating income; NSP=net sales proceeds; y=required rate of return. – Discounted cash flow measures (NPV & IRR) are the most important measurement criterion because of their inclusion of all cash flows (operating and disposition). Assumptions become critical. – Provides a clear decision rule. – Dollar value of calculation makes more difficult to compare across investment opportunities. Investment Property Analysis

5 Measuring Value and Returns: IRR – IRR Formula: AP=acquisition price; r=internal rate of return – Discounted cash flow measures (NPV & IRR) are the most important measurement criterion because of their inclusion of all cash flows (operating and disposition). Assumptions become critical. – Comparable across investments regardless of size of investment. – Assumes you can re-invest at the IRR. Investment Property Analysis

6 Capitalization Rate, Overall Cap Rate, Overall Rate of Return (R) – Formula: Net Operating Income/purchase price=R. – Uses the NOI from first year of operation and compares to purchase price. – Quick calculation that can be thought of as the total rate of return in year 1 (equity AND debt)-- remember, no debt service is included in NOI. – Similarly, can be thought of as return assuming there is no debt financing. Buyer pays acquisition price in cash, and gets NOI as return. – Cap rates vary from 8.0%-13%. low=safe. Investment Property Analysis

7 Capitalization Rate, Overall Cap Rate, Overall Rate of Return (R) – Can be used to find quick estimate of market value of property by assuming an R, estimating NOI, and solving for purchase price. (NOI/R=purchase price) Example: Fairfield Ave Apartments have a potential gross income of $153,000, and NOI of $84,150. It is in a relatively poor neighborhood of a large city. – Is this NOI reasonable without knowing more about the property? – Using an appropriate cap rate, what would be a quick estimate of this property’s worth? Investment Property Analysis

8 Return on Equity, or Equity Dividend Rate (EDR) – Formula: Before Tax Cash Flow (BTCF)/Initial Equity Investment. – Sometime referred to as “cash-on-cash” return. – Unlike “cap rate”, EDR incorporates the impact of debt financing. In numerator, debt service is subtracted from NOI to obtain BTCF. In the denominator, only the equity put in by the investor is considered. – As with all except NPV & IRR, only one year is considered. Investment Property Analysis

9 Return on Equity, or Equity Dividend Rate (EDR) – Using the Fairfield Ave Apartments example, calculate the EDR assuming a cap rate of 12%, a loan of 80% loan-to-value (LTV), 20 year amortization, at 8% interest, with monthly payments. Investment Property Analysis

10 Income Multipliers: Gross Rent Multiplier (GRM) – Formula: Acquisition price/Potential Gross Income. – GRM ranges from Used for quick estimate of value. Varies by area and appreciation potential. – The book uses two income multipliers (NIM, GIM), and doesn’t introduce Gross Rent Multiplier until Ch 12. They are all similar measures. NIM uses NOI instead of PGI and GIM uses EGI instead of PGI. Know them all, but most frequently used for a quick and dirty estimate of value is GRM because all you need is a rent roll to estimate value. Investment Property Analysis

11 Income Multipliers: Gross Rent Multiplier (GRM) – Your realtor has just faxed you a description of a property on Hackett Circle, in suburban Chicago. The fax includes the current rent roll, which is $96,000. Comparable properties in the area have sold for GRM’s of – Is the asking price of $910,000 reasonable? – How would you modify your answer if you knew that operating expenses on the building were very low, and the area had significant potential for appreciation? Investment Property Analysis

12 Operating Expense Ratio (OER) – Formula: OE/EGI – Indicates the portion of rental income consumed by operating expenses. – A normal range for this figure is 25-50%. Newer buildings tend to have lower variable costs, but are sometimes hit harder with higher taxes. Investment Property Analysis

13 Loan-To-Value (LTV) – Formula: Mortgage Balance/Property Value – Limited by lenders to no more than 75-80% in most cases to protect against default. While there is modest variation among lenders, the investor pays considerably higher interest rates and/or up-front costs for a higher LTV. Investment Property Analysis

14 Debt Coverage Ratio (DCR) – Formula: NOI/DS – Indicates the amount that NOI can decline before the building will not generate sufficient cash flow to pay the debt service. Lenders generally use 1.25 as a minimum, with 1.20 if other indicators are strong. – Example: Find the DCR of Fairfield Ave Apartments. Investment Property Analysis