Transcript Stone Arch Village - University of Illinois at Urbana

Fundamentals of Real Estate
Lecture 5
Spring, 2003
Copyright © Joseph A. Petry
www.cba.uiuc.edu/jpetry/Fin_264_sp03
Investment Property Analysis

Measuring Value and Returns
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Once the cash flows have been estimated and
verified, the value of those cash flows must be
evaluated.
Many different means of measuring returns exist. The
trick is to know the strengths and weaknesses of
each, such that an accurate representation of the
return and risk of the investment is clear.
Investment Property Analysis

Measuring Value andn Returns: NPV
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NPV Formula: IV0   NOIt  NSPn
t
n
(1  y)
(1  y)
IV=investment value; NOI=net operating income; NSP=net
sales proceeds; y=required rate of return.
t 1
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Discounted cash flow measures (NPV & IRR) are the
most important measurement criterion because of
their inclusion of all cash flows (operating and
disposition). Assumptions become critical.
Provides a clear decision rule.
Dollar value of calculation makes more difficult to
compare across investment opportunities.
Investment Property Analysis

Measuring Value and Returns: IRR
n
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IRR Formula: AP   NOIt t  NSPnn
t 1
(1  r )
(1  r )
AP=acquisition price; r=internal rate of return
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Discounted cash flow measures (NPV & IRR) are the
most important measurement criterion because of
their inclusion of all cash flows (operating and
disposition). Assumptions become critical.
Comparable across investments regardless of size of
investment.
Assumes you can re-invest at the IRR.
Investment Property Analysis
Capitalization Rate, Overall Cap Rate, Overall
Rate of Return (OR)
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Formula: Net Operating Income/purchase price=OR.
Uses the NOI from first year of operation and compares to
purchase price.
Quick calculation that can be thought of as the total rate of
return in year 1 (equity AND debt)-- remember, no debt service
is included in NOI.
Similarly, can be thought of as return assuming there is no
debt financing. Buyer pays acquisition price in cash, and gets
NOI as return.
In this form, does not include future cash flows.
Investment Property Analysis

Direct Capitalization (R)
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Assuming that property NOI changes by a constant rate over
life of investment, the NPV formula becomes:
n
V0 
 (1  y)
t 1
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t

NSPn
(1  y) n

NOI1
yg
The investors required rate of return (y), less the expected
growth rate (g) of NOI can be used to find quick estimate of
market value of property. (NOI/R=purchase price)
Ranges 8.0% – 13.0%. Lower implies safer investment.

Example: Fairfield Ave Apartments have a potential gross income
of $153,000, and NOI of $84,150. It is in a relatively poor
neighborhood of a large city. Assume 12% for y, 1.5% for g
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NOIt
Is this NOI reasonable without knowing more about the property?
– Using an appropriate cap rate, what would be a quick estimate of this
property’s worth?
Investment Property Analysis

Return on Equity, or Equity Dividend Rate (EDR)
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Formula: Before Tax Cash Flow (BTCF)/Initial Equity
Investment.
Sometimes referred to as “cash-on-cash” return.
Unlike “cap rate”, EDR incorporates the impact of
debt financing. In numerator, debt service is
subtracted from NOI to obtain BTCF. In the
denominator, only the equity put in by the investor is
considered.
As with all except NPV & IRR, only one year is
considered.
Investment Property Analysis

Return on Equity, or Equity Dividend Rate (EDR)
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Using the Fairfield Ave Apartments example, calculate
the EDR assuming a cap rate of 12%, a loan of 80%
loan-to-value (LTV), 20 year amortization, at 8%
interest, with monthly payments.
Investment Property Analysis

Income Multipliers: Gross Rent Multiplier (GRM)
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Formula: Acquisition price/Potential Gross Income.
GRM ranges from 4-11. Used for quick estimate of
value. Varies by area and appreciation potential.
The book uses two income multipliers (NIM, GIM),
and doesn’t introduce Gross Rent Multiplier until Ch
12. They are all similar measures. NIM uses NOI
instead of PGI and GIM uses EGI instead of PGI.
Know them all, but most frequently used for a quick
and dirty estimate of value is GRM because all you
need is a rent roll to estimate value.
Investment Property Analysis
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Income Multipliers: Gross Rent Multiplier (GRM)
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Your realtor has just faxed you a description of a
property on Hackett Circle, in suburban Chicago. The
fax includes the current rent roll, which is $96,000.
Comparable properties in the area have sold for
GRM’s of 7-10.
Is the asking price of $910,000 reasonable?
How would you modify your answer if you knew that
operating expenses on the building were very low,
and the area had significant potential for
appreciation?
Investment Property Analysis
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Operating Expense Ratio (OER)
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Formula: OE/EGI
Indicates the portion of rental income consumed by
operating expenses.
A normal range for this figure is 25-50%. Newer
buildings tend to have lower variable costs, but are
sometimes hit harder with higher taxes.
Investment Property Analysis
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Loan-To-Value (LTV)
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Formula: Mortgage Balance/Property Value
Limited by lenders to no more than 75-80% in most
cases to protect against default. While there is
modest variation among lenders, the investor pays
considerably higher interest rates and/or up-front
costs for a higher LTV.
Investment Property Analysis
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Debt Coverage Ratio (DCR)
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Formula: NOI/DS
Indicates the amount that NOI can decline before the
building will not generate sufficient cash flow to pay
the debt service. Lenders generally use 1.25 as a
minimum, with 1.20 if other indicators are strong.
Example: Find the DCR of Fairfield Ave Apartments.
Common Returns & Ratios Used In Real Estate Analysis
Ratio
Form
Use
Comment
n
NSP
NOI
t
n
Net present value
To indicate dollar value of investment Along with IRR most appropriate
IV 0  

t
n
(
1

y
)
(
1

y
)
t 1
(NPV)
including net sale proceeds; assumes measure of total return over entire
a required rate of return for investor
investment horizon
n
NOI
t
NSP
Internal rate of
To indicate total rate of return, including NPV provides dollar value at required
n
AP  

t
n
(
1

r
)
(
1

r
)
return (IRR)
net sale proceeds; assumes at outset rate of return, IRR provides rate of
t 1
an acquisition price for investment
return at assumed acquisition price
Overall cap
NOI
To indicate the rate of return on total
Does not incorporate future cash flows
rate (OR)
Acquisition Price
investment (both lender and equity
in this form
position) for first period
Direct capitalization
R=y-g
Commonly used in appraisals
Incorporates future cash flows provided
rate (R)
y=required rate of return Ranges from 8.0% - 13%; low = safe
NOI grows at constant rate (g)
Equity dividend
BTCF
To indicate the invesotr's one-period
This ratio accounts only for the
rate (EDR)
Initial Equity Investment rate of return
income benefits; it ignores tax and
appreciation advantages
Net income
Acquisition Price
To indicate the relationship between
A quick method of comparing the
multiplier (NIM)
NOI
NOI and total investment
total investment to income of
one property to others in the market
Gross income
Acquisition Price
To indicate the relationship between
A quick method of comparing the
multiplier (GIM)
EGI
gross income and total investment
total investment to income of
one property to others in the market
Gross rent
Acquisition Price
To indicate the relationship between
Most common method of comparing
multiplier (GRM)
PGI
gross income and total investment
the total investment to income of
one property to others in the market
Operating expense
OE
To indicate the portion of rental
Normal range is 25-50% percent
ratio (OER)
EGI
income consumed by expenses
of EGI
Loan-to-value
ratio (LTV)
Mortgage Balance
Property Value
Debt coverage
ratio (DCR)
NOI
DS
Limited by lenders to protect their
capital from default and foreclosure
losses
Used by lenders to see how much
NOI can decline before it will not
cover debt service
Maximum allowable on income
property usually 75-80 percent
Lenders usually seek 1.20 to 1.30
coverage ratio but may vary their
requirements