Chapter 18 Real Estate Final Exam Why investment value differs from market value o Investment Definition Max a buyer is willing to pay and the minimum a seller is willing to accept Calculation will already take into account the general or average investment conditions in the market o Market o Investors have different required yields Different risk assessment Cash flows are estimated with significant uncertainty Different opportunity cost of equity o Different Expectations Future rental rate Vacancies Expenses Centre point office building assumptions o Total acquisition price 885 000 o Nine office suites 4 on 1st floor 5 on 2nd o Contract rents 6 1 800 mo 3 1 400 mo o Annual market rent increase 3 o Vacancy collection losses 10 o Operating expenses 40 of EGI o Capital expenditures 5 of EGI 1st step in investment analysis estimating NOI over next 12 months PGI Potential Gross Income VC Vacancy Collection Loss MI Miscellaneous Income EGI OE Effective Gross Income Operating Expenses CAPX Capital Expenditures NOI Net Operating Income Center point projected 1st year NOI Potential gross income PGI 180 000 Vacancy collection loss VC 18 000 Effective gross income EGI 162 000 Operating expenses OE 64 800 Capital expenditures CAPX 8 100 Net operating income NOI 89 100 Maintenance v Cap X o Cap X Treated above line in Pro Forma Increases market value of property Examples Roof replacement Appraisal Terminology and Pro Forma Above line PGI VC EGI OE CAPX Reserve NOI o Operating expenses Keep property operating and competitive Do not increase value or extend useful life Examples minor roof repair More on NOI o s that flow out of property o Is the propertys expected dividend o Projected stream of NOI is the fundamental determinant of value o NOI must be sufficient to Service the mortgage debt and Provide investors with an acceptable return on equity Financing for centre point o Terms o Net loan proceeds 75 loan 30 years 8 up front fees of 3 663 750 0 03 x 663 750 663 750 19 913 643 837 50 o Initial equity 885 000 643 837 50 241 163 o 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 o Are income and expenses items appropriate Include only income and expenses that relate directly to the income producing ability of the property Operating expense est shouldn t include financing costs and Fed Income tax these are specific to the investor Exclude CapX and business related expenditures not directly attributable to the property in estimates o Have trends for each item been carefully considered Avoid considering only recent events to the detriment of long trends Importance of rental rate growth and vacancy o What about comparable properties Should obtain as much info as possible on comparable substitute properties Information about revenue and expense items o What are social and legal environments Zoning land use and environmental controls change quickly at state and local levels How has the subjects neighborhood been changing Are local public officials pro or anti growth Trends in property taxes Partnerships limited liability Co Etc o Centre point pro forma displays expected total CFs available for distribution to equity investors o When using partnerships and limited liability companies all CFs and income tax consequences flow through to individual investors There is no separate entity that collects cash flows and distributes dividends o Thus further analysis is usually required to determine expected CFs and return earned by various investors Complicated unless all distribution are based on investors pro rata share of contributed equity Profitability ratios Ultimate determination of an investments desirability is its capacity to produce income in relation to the capital required to obtain that income 2 frequently used profitability ratios are discussed in this section the capitalization rate and the equity dividend rate Profitability ratios Capitalization rate o Cap Rate going in R 0 NOI Acquisitio n price o Centre point example R0 89 100 885 000 0 1007 or 10 1 o Ro is return on funds supplied by both equity investor s and lender As such it measures overall income producing ability of property first year cash flow return on investment o Is 10 1 an acceptable overall cap rate Question can only be answered by comparisons with cap rates on similar properties o Investors should rely on cap rate information abstracted from comparable transactions in the local market o However regularly published surveys also provide useful information on cap rate trends o Very important to be consistent in the treatment of capital expenditures Profitability ratios Equity Dividend Rate o Equity Dividend Rate EDR EDR Before tax cash flow Equity investment o Centre Point Example EDR 656 30 163 241 0 1271 7 12or o Shows investors what percentage of their equity investment is expected to be returned in cash o Difference between EDR and Ro is that the effects of debt financing has been subtracted from the numerator and denominator o Residual cash flow return to equity investment o Commonly called cash on cash return o Common reference point for smaller investments Multipliers Net Income Multiplier o Net Income Multiplier NIM Acquisitio n NOI price o Centre point example NIM 885 000 89 100 9 9 Reciprocal of cap rate conveys identical info Effective Gross Income Multiplier o EGIM EGIM Acquisition price Effective gross income o Centre point example EGIM 885 000 162 000 5 5 o Multipliers are used to provide an assessment of whether a property prices is reasonable in relation to its gross income Financial risk ratios Operating expense o Risk ratios measure income producing ability of the property to meet operating and financial obligations o Assess risk of lending o Commercial lenders typically require that borrowers include estimates of these ratios in the loan application package submittd to lenders o Operating expense ratio OER Operating Effective expenses income gross o Centre Point example OER 72 900 162 000 0 45 or 45 o The greater the OER the larger the portion of effective rental income consumed by operating expenses Financial risk ratios Loan to Value Ratio o LTV LTV Mortgage Balance Acquisition Price o Centre point example LTV 663 885 750 000 75 0 or 75 o Lenders generally want LTV to be no greater than 75 80 of acquisition price to protect their invested capital in the event