Transcript Multi-Period Analysis - Ohio State University

Multi-Period
Analysis
Present Value Mathematics
Real Estate Values
Set by Cash Flows at different points in
time.
 Single period Analysis revisited
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 Single
Period ratio analysis
Cash on Cash return
 ROI – excess of 10%? From book
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Depends upon inflation and interest rates
Present Value Analysis
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Single sum Analysis Review
 FV
= (1+r)’n PV
 PV = FV/(1+r)’n
 r=interest rate, n=# of periods
Or PV and FV formula in excel
 Multi-period analysis discounts a stream of
different cash flows at a particular rate.
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 The
discount rate = risk free rate + risk
premium (ie risk free rate = US T Bill yield)
Discounted Cash Flow (DCF)
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Three main steps
Forecast the expected future cash flows
2) Ascertain the required total return
3) Discount the cash flows to the Present Value
at the required rate of return
1)
1) Forecast Cash Flows
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Use Year One budget to expand to future
periods.
 Set
assumed growth rate projection to income
and expense items.
Use exact numbers if know otherwise estimates
 Typical estimates include CPI, Mkt Study
estimates, or past experience
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 Calculate
the Terminal Value
Based on the final years cash flow
 Typically apply a CAP rate to final year cash flow
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Terminal Value/Resale Price
Calculation
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Final Years cash flow determined by applying a CAP rate
to final years cash flow.
Net Operating Income
Projected for Final Year
-----------------------------------CAP Rate
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Represents an inflow of cash as if property were sold at
the end of the analysis period.
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Need to deduct any expected selling costs
Don’t forget to deduct repayment of remaining balance of loan
Capitalization Rates Revisited
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Rate set for quick valuation of assets based on
one years Net Operating Income
The rate is usually set by comparison of what
other similar properties are selling for in the
market.
A way of quoting observed market prices for real
estate as Bond Yields are the way bond prices
are reported.
The CAP rate for terminal value may be slightly
higher than one for a valuation today
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Reflecting the age of the property
Higher uncertainty regarding inflation and interest factor
Amortization of Loans
Will need to create an amortization table of
the loan to know expected value of loan in
last year.
 Calculate payment, calculate principle and
interest portions of payments, deduct
principle portion from prior years amount.

2) Determine Discount Rate

Three Main Determinants of Discount Rates
 Opportunity Cost of Capital
 How much can your money earn in other investments like
stocks and bonds.
 Discount Rates move with Interest Rates
 Inflation
Rates
 Risk
 Higher Risk, higher discount rate, Lower price
 Growth Expectations
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Where is the property in its Life Cycle
Is the location a growing or declining area
Investors willing to pay more for growth prospects
3) Discount Cash Flows to Net
Present Value
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NPV = PV(benefit)-PV (Cost)
Net Present Value Rule
 Maximize
the NPV across all mutually exclusive
alternatives
 Never choose an alternative that has NPV<0

0 NPV deals are OK
 Discount
rate implies that at 0 investor is just earning
their required return
 Finding deals with very large NPV usually means you
have an error in your calculations
Most Common Errors

Rent and income growth assumption too high.
 Do
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rents always grow with inflation?
Depreciation of building real terms inflation vs inflation
applied to today’s value
Capital improvement expenditures projection too
low
 Can
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average 10 – 20% of NOI
Terminal CAP rate too low
 Typically
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slightly higher than going in cap rate
Discount Rate too high
 May offset the other mistakes
 Unrealistic expectations
Example from Book P. 90
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Year one Gross Rent – $1,000,000
Vacancy Rate 7%
Year One Operating Expenses – $700,000
Net Operating Income - $230,000
Discount Rate 8%
Terminal CAP 8.5%
Income escalation 3%
Operating Expense escalation 4%
Sale of property at the end of year 6
Purchase Price $2,820,285
Internal Rate of Return
The rate that discounts all the net cash flows
to equal a 0 NPV
 Algebraic solution cannot be done. Must
use computer.
 The IRR function in Excel asks for a guess
of the expected IRR to help give the correct
response
 A common measure used by companies in
capital budgeting.

Remember It is All
Still Just Estimates
GIGO applies
The Nature of Risk
The chance or probability that the investor
will not receive the expected or required
rate of return.
 We have already seen that as risk
increases expected return is also
increased
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Business Risk
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Related to variances from estimates in
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capital expenditures,
gross possible income,
vacancy and credit loss
Operating Expenses
Property Value
Static or unsystematic business risk
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Physical causes and beyond the control of the investor
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Fire, floods, injuries
Can be shifted to others through insurance
Dynamic or systematic risk
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Related to changes in general business conditions and conditions of the
property. External not under the control of the investor.
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Market supply and demand, quality of property management, change in
economic base or taxes.
Cannot be transferred to others therefore requires risk premium in
return calculation
Financial Risk
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Risk of not receiving expected return due to financial
obligations of debt financing
Risk created by debt financing
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Debt decreases net cash flows however increase IRR’s if
leverage is favorable
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Because investors demand a higher return for the increased risk.
Internal financial risk
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Increases whenever the debt levels increase
Relates to the ability of the project to pay debt service
External financial risk
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Ability of the investor to obtain funds from external sources.
As sources become more difficult to obtain external financial risk
increases.
Transfering or Eliminating Risk
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Play the real estate cycle
 Wait for the right time for real estate decisions
 Do not invest in overbuilt or recessionary markets
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Non recourse mortgages
 Shifts
the burden of financial risk to the property and
the lender
 In the event of default the investor could lose the
property
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Avoid pre-payment penalties, indexed loans
Insurance policies
Limited-liability forms of ownership
Long term leases with escalation clauses
 Transfers
vacancy risk to the tenant
Reducing the remaining Risks
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Negotiation of appropriate loan amount and
terms
 Lower
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amount has less risk
Purchase Price
 Negotiation
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of better purchase terms
Diversification
Good accounting controls and reporting systems
Good research
Good Property Management
Superior location