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FSU REE 4204 - Chapter 15: Value, Leverage, and Capital Structure

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Real Estate Finance Exam 3Chapter 15: Value, Leverage, and Capital Structure- Valuation of Real Estate Investmentso “The value of an income producing asset is a function of the income accruing to the asset”o In other words, the value of an asset is equal to the discounted future cash flows of that asset.o Income in Real Estate is always measured as some sort of cash flow whether it is PGI, EGI, NOI, BTCF, or ATCFo 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 is simply the use of debt in financingo Positive Leverage : 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 equityo 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 equityo Unlevered Return : A return with no leverage, using no debt to financeAn 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: $0Equity: $1000Return on Equity = Total CF – Equity Invested Equity InvestedSo for our first example you would do: $1100 - $1000 = 10%$1000If 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: $500Cash Flow is still = $1100and our Debt portion would come out to $540 ($500 x 1.08)$1100 - $540 = $560 total cash flowReturn on Equity = $560 - $500 = 12%  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 becomesSay 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: $100Your CF stays the same at $1100 because you are still requiring the 10% from your buddy on the $1000but 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/outflowsReal Estate Cash Flow Structure:PGI-VC (Vacancy)EGI-OE (Operating Expenses)NOI-DS (Annual Mortgage Payment)BTCF-TAXESATCFRemember 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.Taxable Income: NOI- Interest Payment- Depreciation- Amortized Financing CostTaxable IncomeIt 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 deductionof the interest payment (Interest Payment + Prepayment Penalty) Just think of it as deducting everything you are paying back to the bank for that yearDepreciation 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.


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