Market value is the basis for economic transactions buyer does not want to pay more than the market value of the property Decision Making in Real Estate centers around Valuation For many investors however market value is not the whole story most RE decisions are made with an investment motive Although quantitative tools are widely used their usefulness is limited by the quality of the cash flow assumption used by the analyst In short the garbage in garbage out maxim apples to real estate investing Why Investment Value Differs from Market Value Investors have different required yields Different risk assessment Different opportunity cost of equity Different expectations Future rental rates Vacancies Expenses Centre Point Office Building Assumptions Total acquisition price 885 000 Nine office suites 4 on 1st floor 5 on 2nd Contract rents 6 1 800 mo 3 1 400 mo Annual market rent increase 3 Vacancy collection losses 10 Operating expenses 40 of EGI Capital expenditures 5 of EGI 1st Step in Investment Analysis Estimating NOI Over Next 12 Months How Are Capital Expenditures Treated in the Pro Forma It Depends Maintenance vs Capital Expenditures Operating expenses Reduces income that you have to pay taxes on Keep property operating competitive Do not increase value or extend useful life Examples Minor roof repairs air conditioner servicing Capital Expenditures major improvement Increases market value of property Examples Roof replacement air conditioner replacement Net Operating Income o o o o o o o o o o NOI s that flow out of the property NOI is the property s expected dividend Projected stream of NOI is the fundamental determinant of value NOI must be sufficient to service the mortgage debt and provide investors with an acceptable return on equity Financing for Centre Point 75 loan 30 years 8 up front fees of 3 Net loan proceeds 663 750 0 03 x 663 750 663 750 19 913 643 837 50 Initial equity 885 000 643 837 50 241 163 Payment 4 870 36 or 58 444 per year Centre Point Estimated Before Tax Cash Flow BTCF Net operating income 89 100 Debt service 58 444 Before tax cash flow BTCF 30 656 Evaluating Cash Flow Estimates Are income expenses items appropriate o Include only income expenses that relate directly to income producing ability of property Have trends for each item been carefully considered o Should not just extrapolate recent trends o Importance of rental rate growth vacancy assumptions What about comparable properties o Should obtain as much information as possible on comparable substitute properties What are social legal environments o Zoning land use environmental controls change quickly at state local levels o How has the subject s neighborhood been changing o Are local public officials pro or anti growth o Trends in property taxes Partnerships Limited Liability Co Etc Centre Point Pro forma displays expected total CFs available for distribution to equity investors When using partnerships limited liability companies all CFs income tax consequences flow through to individual investors Thus further analysis is usually required to determine expected CFs returns earned by various investors o complicated unless all distribution are based on investors pro rata share of contributed equity Traditional Single Year Investment Criteria Profitability ratios Capitalization rate Equity dividend rate Multipliers Net income multiplier Effective gross income multiplier EGIM Financial risk ratios Operating expense ratio Loan to value ratio LTV Debt coverage ratio DCR Profitability Ratios Capitalization Rate o o o o o o o Profitability Ratios Capitalization Rate Is 10 1 an acceptable overall cap rate Question can only be answered by comparisons with cap rates on similar properties Investors should rely on cap rate information abstracted from comparable transactions in the local market However regularly published surveys also provide useful information on cap rate trends Example Real Estate Research Corporation Cap Rate Survey Cap rates vary inversely with quality i e class Cap rates vary by property type risk Profitability Ratios Equity Dividend Rate Residual cash flow return to equity investment Commonly called cash on cash return Common reference point for smaller investments Financial Risk Ratios Operating Expense Ratio Financial Risk Ratios Loan to Value Ratio Financial Risk Ratios Debt Coverage Ratio Pros and Cons of Ratios Multipliers Pros o Quick easy to compute o Intuitive o Facilitates comparison with similar properties o No explicit assumptions about future Cons o No clear benchmarks for acceptable range o Only a partial view of performance o No explicit assumptions about future Example 18 1 You are considering purchasing a small office building for 1 975 000 Your expectations include o First year gross potential income of 340 000 o Vacancy collection losses equal to 15 of PGI o Operating expenses 40 of EGI o Capital expenditures 5 of EGI o 1 481 250 mortgage 75 LTV 7 o Mortgage will be amortized over 25 years with a monthly payment of 10 469 17 o Total up front financing costs 2 of the loan amount o Required equity investment is 523 375 1 975 000 1 481 250 29 625 Example 18 1 1st Year Projections Example 18 1 1st Year Ratios Example 18 1 1st Year Ratios Cash Flow Projections o Cash Flow from Operations and Sale Use of Leverage borrowed funds NPV Net Present Value IRR Internal Rate of Return Limitation of these single year return measures ratios o They do not incorporate income producing ability of property beyond the 1st year of rental operations o May lead to suboptimal investment decisions Overview Many investors also perform multi year analyses of potential acquisitions When using multi year discounted CF decision making methods investor must 1 estimate how long she expects to hold property 2 make explicit forecasts of o property s net CF for each year o net CF produced by expected sale of property 3 Select rate of return at which to discount all future CF s Centre Point Office Building Centre Point 5 Year Operating Pro Forma Centre Point Reversion Sale Price Levered vs Unlevered Cash Flows Levered CFs measure property s income after subtracting mortgage payments Valuation of levered CFs o Discount expected BTCFs rather than stream of NOIs Why is owner s claim on a property s CFs refereed to as a residual claim Effects of Leverage on Centre Point Equity Investment Future Cash Flows Loan Terms o 75 loan 30 years 8 total up front fees of 3 Net loan proceeds 663 750 0 03 x 663 750 643