Andrew Baum and David Hartzell, Global Property Investment, 2011 Asset appraisal

Andrew Baum and David Hartzell, Global Property Investment, 2011 Appraisal inputs Space sq ft50,000 Rental value/psf£22.50 Current contract rent£500,000 Remaining term1 year OccupancySingle tenant GRR year 1£1,125,000 OccupancyMultiple tenants

Andrew Baum and David Hartzell, Global Property Investment, 2011 Appraisal inputs Growth3.50% Depreciation2.00% Resale cap rate (NOI)7.00% Inflation2.50% OpEx£100,000 Vacancy10%

Andrew Baum and David Hartzell, Global Property Investment, 2011 Appraisal inputs Price£12,000,000 Purchase fees4.50% Total outlay£12,540,000 Sale fees1.75% Required return8%

Andrew Baum and David Hartzell, Global Property Investment, 2011 Gross potential income YearGRROther incomeGPI 0 1£500,000£0 £500,000 2£1,158,332£0 £1,158,332 3£1,175,366£0 £1,175,366 4£1,192,651£0 £1,192,651 5£1,210,190£0 £1,210,190 6£1,227,986£0 £1,227,986

Andrew Baum and David Hartzell, Global Property Investment, 2011 Net operating income YearGPIVacancyGEIOpExNOI 0 1 £500,000£0£500,000£102,500£397,500 2 £1,158,332£115,833£1,042,498£105,063£937,436 3 £1,175,366£117,537£1,057,829£107,689£950,140 4 £1,192,651£119,265£1,073,386£110,381£963,004 5 £1,210,190£121,019£1,089,171£113,141£976,030 6 £1,227,986£122,799£1,105,188£115,969£989,219

Andrew Baum and David Hartzell, Global Property Investment, 2011 Net resale price NOI divided by cap rate (MV t = NOI t+1 / cr t ) less sale fees NOI t+1 = NOI 0 *(1+g) ^t+1 /(1+d) ^t+1 Year 6 (t+1)NOI = £989,219 Year 5 (t) cap rate = 7% MV t = NOI t+1 / cr t = £989,219/0.07 Sale fees are 1.75% (£989,219/0.07)*( ) = £13,884,388

Andrew Baum and David Hartzell, Global Property Investment, 2011 IRR, pre-tax, 100% equity, no carried interest YearNOIResale valueCash flow 0-£12,540,000 1 £397,500 £0£397,500 2 £937,436 £0£937,436 3 £950,140 £0£950,140 4 £963,004 £0£963,004 5 £976,030 £13,884,388£14,860,418 6 £989,219 IRR 8.39%

Andrew Baum and David Hartzell, Global Property Investment, 2011 The impact of debt finance Real estate provides collateral for debt Financial mathematics changes –Initial capital investment reduced –Cash flow reduced Return on equity different Risk profile different Required return? Tax damage often reduced by debt Amortisation?

Andrew Baum and David Hartzell, Global Property Investment, 2011 Return on leveraged equity Return on leveraged equity > return on unleveraged equity when Return on unleveraged equity > interest rate on debt

Andrew Baum and David Hartzell, Global Property Investment, 2011 Using 70% debt Total purchase outlay£12,540,000 IRR on 100% equity8.39% 70% loan $8,778,000 30% equity $3,762,000 Fixed interest rate 5.5% Annual interest-only repayment£482,790 Assume no amortisation Calculate the return on equity

Andrew Baum and David Hartzell, Global Property Investment, 2011 Return on leveraged equity Approximation ke = [ka-(kd*LTV)]/(1-LTV) ka = return on unlevered asset 8.39% kd = cost of debt 5.50% LTV = loan to value ratio 70.00% ke = return on levered equity 15.14%

Andrew Baum and David Hartzell, Global Property Investment, 2011 Return on leveraged equity YearCash flowInterestLoan repaidCash to equity 0-£12,540,000-£3,762,000 1£397,500-£482,790-£85,290 2£937,436-£482,790£454,646 3£950,140-£482,790£467,350 4£963,004-£482,790£480,214 5£14,860,418-£482,790-£8,778,000£5,599,628 IRR project8.39%IRR equity14.14%

Andrew Baum and David Hartzell, Global Property Investment, 2011 Risk: impact of 1% higher exit yield YearCash flowInterestLoan repaidCash to equity 0-£12,540,000-£3,762,000 1£397,500-£482,790-£85,290 2£937,436-£482,790£454,646 3£950,140-£482,790£467,350 4£963,004-£482,790£480,214 5£13,124,870-£482,790-£8,778,000£3,864,080 IRR project6.07%IRR equity7.37%

Andrew Baum and David Hartzell, Global Property Investment, 2011 Risk: impact of 3% higher exit yield YearCash flowInterestLoan repaidCash to equity 0-£12,540,000-£3,762,000 1£397,500-£482,790-£85,290 2£937,436-£482,790£454,646 3£950,140-£482,790£467,350 4£963,004-£482,790£480,214 5£10,695,102-£482,790-£8,778,000£1,434,312 IRR project2.40%IRR equity-7.26%

Andrew Baum and David Hartzell, Global Property Investment, 2011 Risk: impact of higher exit yields InterestExit capIRR projectIRR equity 5.50%7.00%8.40%14.10% 5.50%8.00%6.10%7.40% 5.50%9.00%4.10%0.42% 5.50%10.00%2.40%-7.30% Standard deviation2.59%9.19%

Andrew Baum and David Hartzell, Global Property Investment, 2011 Risk: impact of higher exit yields

Andrew Baum and David Hartzell, Global Property Investment, 2011 The importance of debt terms Loan to value ratio - LTV – say maximum 80% –Outstanding loan as a percentage of value –£8,778,000 is 80% of approx £11m –Values can fall by 8.3% from £12m DSCV – debt service coverage ratio - say 1.2 –Stabilised NOI / annual interest payment –Stabilised (year 2) NOI is 1.94 times interest –Rents can fall by 38%

Andrew Baum and David Hartzell, Global Property Investment, 2011 Using debt Tax on income 30% No tax on capital gains Assume paid in year of receipt Calculate the return on equity after tax (Required return after tax?)

Andrew Baum and David Hartzell, Global Property Investment, % equity before and after tax YearNet cash flowTaxNet cash 0-£12,540,000 1£397,500£119,250 £278,250 2£937,436£281,231 £656,205 3£950,140£285,042 £665,098 4£963,004£288,901 £674,103 5£14,860,418£292,809 £14,567,609 IRR before tax8.39%IRR after tax6.51%

Andrew Baum and David Hartzell, Global Property Investment, % equity before and after tax YearNet cash to equityTaxNet cash 0-£3,762,000 1-£85,290-£25,587-£59,703 2£454,646£136,394£318,252 3£467,350£140,205£327,145 4£480,214£144,064£336,150 5£5,599,628£151,029£5,447,700 IRR before tax14.14%IRR after tax11.85%

Andrew Baum and David Hartzell, Global Property Investment, 2011 Summary Required return pre-tax8% IRR on 100% equity pre-tax8.39% Required return after tax (0.7*8)5.6% IRR on 100 % equity after tax6.52% IRR on 30% equity pre-tax14.14% IRR on 30% equity after tax11.85% Required return on leveraged equity? 100% equity pre-/post-tax return ratio: 78% 30% equity pre-/post-tax return ratio: 84%

Andrew Baum and David Hartzell, Global Property Investment, 2011 Carried interest The manager of this investment has agreed with the investor that he/she will receive 20% of all leveraged pre-tax returns over 10% achieved on sale of the property What year 5 income achieves 10% IRR? By trial and error/goal seek, this is £13,746,000 NOI 5 = £976,030, so net resale price is £12,769,970 With fees at 1.75% this is a property price of: £12,769,970/ = c.£12,550,340 (cap rate 7.88%)

Andrew Baum and David Hartzell, Global Property Investment, 2011 Carried interest: net exit value required YearCash flowInterestLoan repaidNet cash to equity 0-£12,540,000-£3,762,000 1£397,500-£482,790-£85,290 2£937,436-£482,790£454,646 3£950,140-£482,790£467,350 4£963,004-£482,790£480,214 5£13,746,000-£482,790-£8,778,000£4,485,210 IRR equity10.00%

Andrew Baum and David Hartzell, Global Property Investment, 2011 Carried interest Expected surplus: £14,860,418 - £13,746,000 = £1,114,418 20% goes to manager: £222,884 Net leveraged pre-tax return to investor: 13.36% Fee leakage: 14.14% % = 0.78% = 5.51% of gross return

Andrew Baum and David Hartzell, Global Property Investment, 2011 Performance fee impact: % of IRR Source: PFR, 2010