Transcript CHAPTER 2 BASIC VALUATION CONCEPTS
INVESTMENT DECISION MAKING
LEARNING OBJECTIVES
Identify the basic types and characteristics of investment properties.
Forecast annual cash flows, net of expenses, from property operations.
Forecast cash flows from the eventual sale of the property.
INVESTMENT DECISION MAKING
LEARNING OBJECTIVES
Calculate the net present value and internal rate of return on a proposed investment.
Calculate and interpret the basic financial ratios which apply to real estate investment decisions.
Understand the effect of leverage on the investment decision.
INVESTMENT DECISIONS
Forecast cash flows from operations.
Forecast cash flow from sale.
Determine present value of expected cash flows.
Apply an investment decision criterion.
REAL ESTATE INVESTMENT ANALYSIS
Investment Strategy
Investment Philosophy
Investment Objectives
Investment Policies
CHARACTERISTICS OF INCOME PROPERTY INVESTMENTS
Property Types
Rental Income
Contract Rent
Market Rent
Purchasers as Investors
Geographic Scope
FORECASTING CASH FLOWS FROM OPERATIONS
Potential Gross Income
Effective Gross Income
Operating Expenses
Net Operating Income
Non-Recurring Expenses
Net Operating Income Calculation
Income/Expense Item
Potential Gross Income - Vacancy and Collection Losses + Other Miscellaneous Income = Effective Gross Income - Operating Expenses = Net Operating Income
Symbol
(PGI) (VCL) (MI) (EGI) (OE) (NOI)
Net Operating Income Example
Item
Potential Gross Income - Vacancy and Collection Losses + Other Miscellaneous Income = Effective Gross Income - Operating Expenses = Net Operating Income
Total
$ 180,000 18,000 0 72,900
Forecasted Cash Flows From Net Operating Income Item PGI - V&C Year 1 Year 2 Year 3 Year 4 Year 5 $180,000 $185,400 $190,962 $196,691 $202,592 18,000 18,540 19,096 19,669 20,259 = EGI - OE 162,000 166,860 171,866 177,022 182,333 72,900 75,087 = NOI $ 89,100 $ 91,773 77,340 94,526 79,660 82,050 97,362 $100,283
Forecasted Cash Proceeds From Sale
- = Item
Expected Sales Price Selling Expenses Net Sales Proceeds
Symbol
(SP) (SE) (NSP)
Year 5
$1,026,000 51,300 $974,700
Present Value Calculation
Yr Invest. NOI
0 $ 0 1 2 89,100 91,773 3 4 5 94,526 97,362 100,283
NSP
974,700
PV = PV@12%
$ 0 79,554 73,161 67,282 61,875 609,974 $ 891,846
Net Present Value (NPV)
The
net present value
is the present value of a project’s cash inflows, minus the present value of the cash outflows
.
The cash flows are discounted at the investor’s required rate of return--in this example 12 percent.
Net Present Value Calculation
Yr Invest.
0 $-885,000
NOI
1 2 89,100 91,773 3 4 5 94,526 97,362 100,283
NSP
974,700
NPV = IRR = PV@12%
$-885,000 79,554 73,161 67,282 61,875 609,974 $ 6,846 12.2%
NPV Decision Criteria
If NPV>0, the project exceeds the investor’s required rate of return.
If NPV<0, the project does not meet the investor’s required rate of return.
If NPV=0, the project’s expected return equals the investor’s required rate of return.
Internal Rate of Return (IRR)
The
internal rate of return
is the discount rate at which NPV = 0, the rate of return at which the present value of the cash inflows equals the present value of the cash outflows.
NPV and the IRR
Required Rate of Return
10.00% 11.00% 12.00% 12.2062% 13.00% 14.00%
NPV
$76,844 40,957 6,846 0 (25,596) (56,465)
IRR Decision Criteria
If IRR > the required rate of return, then accept.
If IRR< the required rate of return, then reject.
If IRR= the project’s expected return equals the investor’s required rate of return.
NPV and the IRR
NPV: Cash flows assumed reinvested at discount rate
Generally preferred to IRR for making decisions
IRR: Cash flows assumed reinvested at the IRR rate
May provide inferior wealth maximizing ranking of alternative opportunities to the NPV
Multiple solutions possible
Easily compared to other investments and widely used
The Effects of Mortgage Financing on Cash Flows, Values, and Returns
Effect on the Initial Investment
Effect on the Cash Flows from Operations
Effect on the Cash Flow from Sale
INVESTMENT CRITERIA Profitability Ratios
Capitalization Rate:
R o = NOI / Acquisition Price
Equity Dividend Rate:
R e = EDR = BTCF / Initial Equity
Mortgage Constant:
R m = MC = DS / Initial Loan Amount
INVESTMENT CRITERIA Multiplers
Net Income Multiplier:
NIM = Acquisition Price / NOI
Effective Gross Income Multiplier:
GIM = Acquisition Price / EGI
INVESTMENT CRITERIA Financial Ratios
Operating Expense Ratio:
OER = Operating Expenses / EGI
Loan-to-Value Ratio:
LTV = Mortgage Balance / Property Value
Debt Coverage Ratio:
DCR = Net Operating Income / Debt Service