Powerpoint class 6 Flashcards
Why Investment Value Differs from Market Value
Investors have different required returns
–> Different risk assessment/opportunity cost of invested equity
Investors have different expectations about future:
–> rental rates
–> vacancies
–> operating expenses
–> etc.
Operating expenses
Keep property operating & competitive
Do not increase value or extend useful life
Examples: minor roof repairs, air conditioner servicing, lawn maintenance, utilities, etc.
Capital Expenditures
Increases market value of property/extend life
Examples: roof replacement, air-conditioner replacement, installation of new landscaping
Why do investors borrow?
Limited financial resources/wealth
Leverage amplifies equity returns (& risk)
Also permits more portfolio diversification
Cash flow effect of borrowing
Net operating income
− Debt service
= Before-tax cash flow (BTCF)
Questions to ask ourselves regarding cash flow estimates
Are income & expenses items appropriate?
Have trends for each item been carefully considered?
What about comparable properties?
What are the social & legal environments?
which are the only income and expenses that we should include?
Include only income & expenses that relate directly to income producing ability of property
what should we consider regarding trends?
Should not just extrapolate recent trends
Importance of rental rate growth & vacancy assumptions
what should we do with comparable properties?
Should obtain as much information as possible on comparable/substitute properties
what should we know about social & legal environments?
Zoning, land use, & environmental controls change quickly at state & local levels
How has subject’s neighborhood been changing?
Are local public officials pro or anti-growth?
Trends in property taxes?
How are all CFs & income tax consequences considered when using partnerships & limited liability companies?
all CFs & income tax consequences are allocated and “flow through” to individual investors
further analysis is usually required to determine expected CFs & returns earned by various equity investors
–>
Profitability ratios we need
Capitalization rate (Ro)
Equity dividend rate
Multipliers we need
Net income multiplier
Effective gross income multiplier (EGIM)
Financial risk ratios we need
Operating expense ratio
Loan-to-value ratio (LTV)
Debt coverage ratio (DCR)
Debt yield ratio (DYR)
Capitalization rate formula
NOI / Acquisition price
Equity Dividend rate formula
BTCF / Equity Investment
Net Income Multiplier formula
Acquisition price / NOI
Effective gross income multiplier formula
Acquisition price / Effective gross Income (EGI)
Operating expense ration formula
OE / EGI
Loan-to-value ratio formula
Mortgage amount / property value
debt coverage ratio formula
NOI / Debt service
this should ideally be over 1
Debt yield ratio formula
NOI / Loan amount
Pros of Ratios & Multipliers
Quick & relatively easy to compute
Intuitive
Facilitates comparison with similar properties
No explicit assumptions about future
Cons of Ratios & Multipliers
No clear benchmarks for acceptable range
Only a partial view of performance
No explicit assumptions about future
what must investors do when using multi-year discounted CF decision making methods?
- Estimate how long she expects to hold property
- Make explicit forecasts of:
–> property’s net CF for each year,
–> net CF produced by expected sale of property
- Select rate of return at which to discount all future CFs
BTCFs
“levered” cash flows
who has first claim on the property’s cash flows
Lender(s)
Owner’s claim on a property’s CFs refereed to as what?
as a “residual claim”
Levered Cash Flow
measure property’s income after subtracting mortgage payments
Valuation of levered CFs?
Discount expected levered BTCFs rather than yearly NOIs
which is more risky between levered cashflows and unlevered cashflows?
levered cashflows
Net Present Value (NPV)
NPV = PV(Cash Inflows) – PV (Cash Outflows)
Discount Rate at which NPV = 0
IRR
Effect of Leverage on NPV and IRR
Increased leverage usually increases both NPV & IRR—holding mortgage rate & all other assumptions constant
But…leverage also increases risk to equity investor, thus required equity return should increase with leverage
Cash flows & returns most important to investors are?
after-tax cash flows & returns
After-tax required return
before-tax return x (1−TR)
