Maximizing Your Return

Question 1

How are Equity and Equity from Sale different?

Answer 1

• Equity = Market Value - Loan Balance
• Equity from Sale = Market Value - Loan Balance - Sales Transaction Costs - Taxes

Question 2

What is the twin effect of equity build-up?

Answer 2

The property appreciates as the loan balance decreases.

Question 3

How does equity growth compare to cash flow growth?

Answer 3

Equity growth occurs at a faster rate than cash flows.

Question 4

How is the twin effect of equity growth a problem?

Answer 4

The Return on Equity shrinks because more equity remains illiquid in the property as income grows slowly.

Question 5

What is the best approach for analyzing the decision to sell, renovate or refinance?

Answer 5

1. Incremental or Marginal Cash Flows
2. Incremental or Marginal IRR

Question 6

How do you Calculate Marginal IRR?

Answer 6

Gain from Year 2 (NOI+Reversion)

_______________________ (Divide)

Forgone Cash Flows from Sale at End of Year 1 (Reversion, if you hold one more year you earn the NOI from that year)

Question 7

What is the rule for determining a sale using Marginal IRR?

Answer 7

As long as the marginal rate of return exceeds alternate investments you hold, when it dips below the alternative rate of return you sell.

Question 8

Why will the Marginal IRR reduce over time?

Answer 8

Because of the build up of equity, thus the Annual gain becomes smaller as a % of equity.

Question 9

What are the Pros and Cons of selling?

Answer 9

Pros:

• Liquidity to the Equity in a Property
• Relieves on-going management of asset being held.

Cons:

• Transaction Fees & Taxes Erode Equity (Can exceed 20% of equity from sale)
• Forces Investor to put 100% of equity into another project Transactions can be difficult and time consuming
• Closing a deal isn’t guaranteed

Question 10

What are the pros and cons of refinancing?

Answer 10

Pros:

• Re-establish financial leverage to supercharge the remaining equity in the deal.
• Allows you to leverage existing operational knowledge of current asset Much easier than a sale
• Allows for organic diversification (equity extraction into alternate properties)

Cons:

• Only releases a portion of total equity
• Pay on-going interest

Question 11

What is the incremental cost of borrowing?

Answer 11

Minimum rate or return required on extracted equity to justify the cost of a new loan.

Question 12

What happens if you refinance at a lower interest rate?

Answer 12

• The incremental cost of borrowing is low or negative. You make out big.

Question 13

What happens if you refinance at a higher interest rate?

Answer 13

Incremental cost of borrowing can escalate quickly and you take a kick in the nuts.

Question 14

What’s the rule of determining whether or not to refinance?

Answer 14

Refinance if an alternative investment exists with an IRR that exceeds the incremental cost of borrowing.

Question 15

Why is it worthwhile to extract the equity?

Answer 15

You get to borrow at debt rates, and invest at equity rates on the next project.

Question 16

What is the holding period IRR?

Answer 16

The IRR earned on the equity initially invested year 0, depends on the holding period (years)

Question 17

How do you determine the optimal holding period?

Answer 17

The point where the holding period IRR, and the marginal IRR intersect. It’s the maximum Holding Period IRR.

Question 18

What is the interaction between the holding period IRR and the marginal IRR?

Answer 18

1. The holding period IRR increases whenever the the marginal IRR is above it.
2. The holding period IRR decreases whenever the marginal IRR is below it.
3. Max Holding IRR at Intersection of 2

Question 19

What is the rule to determine whether or not to renovate?

Answer 19

Renovate if:

• IRR of Renovation Investment Exceeds
• The Minimum IRR on Borrowed Funds

Also if the IRR exceeds the next best alternative. (Kind of like buying a mini property)

Question 20

What specific forces are influencing the Cash Flows and IRR?

Answer 20

1. Initial Yield (IY)
2. Cash Flow Change (CFC)
3. Yield Change (YC)

Question 21

What is the IY?

Answer 21

Initial Yield -

Baseline

rrelationship between purchase price and initial NOI.

Current Cash-on-Cash Return Net Cash flow from 1st year/Initial Investment

Question 22

What is the CFC?

Answer 22

Cash Flow Change -

IRR increment to the IY caused by actual changes in cash flow over time

Question 23

What is the YC?

Answer 23

Yield Change -

The IRR increment to the IY caused by changes to the cap rate applied to cash flows from the project.

Generally a negative effect on cash flows.

Question 24

What are the four Property Level Investment Management Tasks?

Answer 24

1. Property Selection - picking good properties (Value)
2. Acquisition Transaction Execution (negotation)
3. Operational Management During the Holding Period (Marketing, positioning, etc.)
4. Disposition Transaction Execution (timing, negotiation the right buyer)

Question 25

Why is project level attribution important?

Answer 25

Provides information to focus energy on the most important areas of value creation.

Question 26

What is a marginal rate of return?

Answer 26

The rate of return for any single given year.

Question 27

How do property level decisions affect your investments performance?

Answer 27