Real Estate Finance Exam 3 Chapter 15 Value Leverage and Capital Structure Valuation of Real Estate Investments o The value of an income producing asset is a function of the income accruing to the asset flows of that asset o In other words the value of an asset is equal to the discounted future cash o Income in Real Estate is always measured as some sort of cash flow whether it is PGI EGI NOI BTCF or ATCF o Each more accurate than the last in the valuation process but the more accurate the more information is needed and the more time consuming the process becomes But to generalize PGI is the least accurate measure of a cash flow and ATCF is the most accurate measure because of how many factors go into it Financial Leverage o Investors have 2 basic sources of financing debt and equity Obviously the equity is the money the investor actually spent out of his her pocket for a given project and debt is the portion of the project paid for using a mortgage o Financial Leverage o Positive Leverage is simply the use of debt in financing is the use of debt at a cost less than the return on the asset Effective Cost IRR Meaning that the money you are making off of the project your cash flow is more than enough to cover your effective cost of borrowing Mortgage PMT etc Positive leverage increases the return on your equity o Negative Leverage on the other hand is the use of debt at a cost greater than the expected rate of return Meaning the opposite is occurring where your cash flows are not enough to cover your effective cost of borrowing This reduces the return on equity o Unlevered Return A return with no leverage using no debt to finance An example will help explain how positive leverage can actually increase your return Say you loan invest 1000 10 for one year to your buddy The Debt portion would be 0 you didn t make a loan and your equity portion is the full 1000 out of your pocket You make 100 on your investment 10 of 1000 so your total cash flow is 1100 at the end of the year The number you re looking for is a percentage return on your equity so you use the return on equity equation Debt 0 Equity 1000 Return on Equity Total CF Equity Invested Equity Invested So for our first example you would do 1100 1000 10 1000 If we redo this problem but instead of loaning out the full 1000 ourselves borrow 500 from the bank at an interest rate of 8 the equation would look like this Debt 500 8 for 1 yr Equity 500 Cash Flow is still 1100 and our Debt portion would come out to 540 500 x 1 08 1100 540 560 total cash flow Return on Equity 560 500 12 cid 223 this is the point we ve been trying to make 500 your return on equity has gone up by 2 because you added financing into the equation Now we ll see that the more financing we add the higher our return becomes Say you borrow a full 900 from the bank at an 8 interest rate and only use 100 out of your own pocket in equity Debt 900 8 Equity 100 Your CF stays the same at 1100 because you are still requiring the 10 from your buddy on the 1000 but your debt portion comes out to 972 at the end of the year 900 x 1 08 1100 972 128 Total Cash Flow So Return on Equity 128 100 28 because you financed 90 of what you 100 invested your return increased by 18 The rule of thumb for this is that the expected rate of return increases w the more financing you use as long as the effective cost of borrowing 8 is less than the expected rate of return 10 The risk of the equity is increased by the use of financial leverage and since you re the one holding the risk your return is the one that increases Real Estate Cash Flows There is a difference between cash flows and taxable income Cash Flows contain items that are actually inflows and outflows of money Taxable Income contains items that are tax deductible depreciation interest pmts financing costs etc and that are not necessarily cash inflows outflows Real Estate Cash Flow Structure PGI VC Vacancy EGI OE Operating Expenses NOI DS Annual Mortgage Payment BTCF TAXES ATCF Taxable Income NOI Interest Payment Depreciation Amortized Financing Cost Taxable Income Remember that the DS jumps up to include the outstanding balance payment and the prepayment penalty if applicable in the year you sell it We can find up to BTCF fairly easily because most of the variables required are given to us The TAXES is where things get a little harder To find the amount of taxes we pay we first have to find out our taxable income or the income we pay taxes on after all our tax deductions are subtracted It is a relatively simple formula but we have to do some calculation to find out some of the factors within the formula For instance we find the interest payment by using the annuity function in your calculator INT P1 P12 would be the interest for year one and so on If you have no idea what function I am talking about in your calculator google search annuity payments and your calculator type to find out it will save you a ton of time Another thing to remember is that if you are selling the piece of real estate and you are acquiring a prepayment penalty this too is tax deductible and is included in the deduction of the interest payment Interest Payment Prepayment Penalty Just think of it as deducting everything you are paying back to the bank for that year Depreciation for one year is simple to find because there are only two ways to go about it Depreciation is ALWAYS straight line depreciation in real estate meaning PV 100 000 any acquisition cost Depreciable Amount will be given 80 this 80 is simply telling you how much of the cost of the property is the building because land never depreciates So you can depreciate 80 000 worth of the property You take the 80 000 and simply divide it by 39 for a commercial income producing property or 27 5 for a residential Don t quote me but we re only using 39 for this test 80 000 39 2 051 so your depreciation expense every single year until you sell the property will be 2 051 The only way that number changes is if you buy or sell the property in the middle of the month Amortized Financing Cost is the easiest of the three you simply take your financing costs say 10 000 and divide it by number of years you own the mortgage say 20 years 10 000 20 500 so 500 is your AFC every single year until you sell the property A …