Decision Making in Real Estate Centers Around Valuation Chapter 18 Investment Decisions: Ratios We examined the concept of market value in Chapters 7 & 8 As noted, professional RE appraisers are often called on to estimate the market value of a property Market value is the basis for economic transactions buyer does not want to pay more than the market value of the property McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 18-2 Decision Making in Real Estate Centers Around Valuation For many investors, however, market value is not the whole story In fact, most RE decisions are made with an investment motive Chapter Overview Chapter introduces framework for making singleasset RE investment decisions Focus is on a set of widely used ratios & multipliers These measures are relatively easy to calculate, but may not explicitly consider cash flows beyond 1 st year of the analysis Many investors also perform multi-year discounted cash flow (DCF) analyses, discussed in Chapter 19, and include these ratio s each year 18-3 18-4 A Word of Caution This chapter & the next focuses on quantitative decision tools Although quantitative tools are widely used, their usefulness is limited by the quality of the cash flow assumption used by the analyst. In short, the garbage in, garbage out maxim apples to real estate investing Why Investment Value Differs from Market Value Investors have different required yields Different risk assessment Different opportunity cost of equity Different expectations: Future rental rates Vacancies Expenses 18-5 18-6 1
Centre Point Office Building: Assumptions Total acquisition price: Nine office suites: 4 on 1 st floor, 5 on 2 nd Contract rents: 6 @ $1,800/mo., 3 @ 1,400/mo. Annual market rent increase: 3% Vacancy & collection losses: 10% Operating expenses: 40% of EGI Capital expenditures: 5% of EGI 1 st Step in Investment Analysis: Estimating NOI Over Next 12 Months PGI Potential Gross Income - VC Vacancy & Collection Loss + MI Miscellaneous Income = EGI Effective Gross Income - OE Operating Expenses - CAPX Capital Expenditures = NOI Net Operating Income 18-7 18-8 Centre Point: Projected 1st-Year NOI How Are Capital Expenditures Treated in the Pro Forma? (It Depends) Potential gross income (PGI) Vacancy & collection loss (VC) = Effective gross income (EGI) Operating expenses (OE) Capital expenditures (CAPX) = Net operating income (NOI) $180,000 18,000 162,000 64,800 8,100 89,100 Appraisal Terminology and Pro Forma: ( Above line ) PGI VC = EGI OE CAPX Reserve = NOI Investment Terminology and Pro Forma: ( Below line ) PGI VC = EGI OE = NOI CAPX = Net cash flow For consistency, we will assume an above-line treatment throughout the book 18-9 18-10 Maintenance vs. Capital Expenditures Operating expenses: Keep property operating & competitive Do not increase value or extend useful life Examples: Minor roof repairs, air conditioner servicing Capital Expenditures: Increases market value of property Examples: Roof replacement, air-conditioner replacement More on Net Operating Income NOI: $'s that flow out of the property NOI is the property's expected "dividend" Projected stream of NOI is the fundamental determinant of value NOI must be sufficient to: service the mortgage debt and Provide investor with an acceptable return on equity 18-11 18-12 2
Borrowing (Leveraging) Why do investors borrow? Limited financial resources/wealth Leverage amplifies equity returns (& risk) Also permits more portfolio diversification May create tax advantages Cash flow effect of borrowing: Net operating income Debt service = Before-tax cash flow (BTCF) Financing for Centre Point Terms 75% loan, 30 years, 8%, up-front fees of 3% Net loan proceeds: = $663,750 (0.03 x 663,750) = $663,750 $19,913 = $643,837.50 Initial equity = - $643,837.50 = $241,163 Payment: $4,870.36 or $58,444 per year (P/Yr=12): PMT(N=360, I/YR=8, PV=-663750) = 4870.36 18-13 18-14 Centre Point: Estimated Before-Tax Cash Flow (BTCF) = Net operating income $89,100 - Debt service 58,444 = Before-tax cash flow (BTCF) $30,656 Evaluating Cash Flow Estimates Are income & expenses items appropriate? Include only income & expenses that relate directly to income producing ability of property Have trends for each item been carefully considered? Should not just extrapolate recent trends Importance of rental rate growth & vacancy assumptions 18-15 18-16 Evaluating Cash Flow Estimates What about comparable properties? Should obtain as much information as possible on comparable/substitute properties What are social & legal environments? Zoning, land use, & environmental controls change quickly at state & local levels How has the subject s neighborhood been changing? Are local public officials pro or anti-growth? Trends in property taxes? Partnerships, Limited Liability Co., Etc. Centre Point Pro forma displays expected total CFs available for distribution to equity investors When using partnerships & limited liability companies, all CFs & income tax consequences flow through h to individual id investors Thus, further analysis is usually required to determine expected CFs & returns earned by various investors complicated unless all distribution are based on investors pro rata share of contributed equity 18-17 18-18 3
Traditional Single-Year Investment Criteria Profitability ratios Capitalization rate Equity dividend rate Multipliers Net income multiplier Effective gross income multiplier (EGIM) Financial risk ratios Operating expense ratio Loan-to-value ratio (LTV) Debt coverage ratio (DCR) Breakeven Occupancy (BEO) Profitability Ratios: Capitalization Rate Capitalization rate (going-in) NOI R0 Acquisition price R $89,100 0 0.1007, or 10.1% R o is return on funds supplied by both equity investor(s) and lender. As such, it measures overall income producing ability of property. 18-19 18-20 Profitability Ratios: Capitalization Rate Is 10.1% an acceptable overall cap rate? Question can only be answered by comparisons with cap rates on similar properties Investors should rely on cap rate information abstracted from comparable transactions in the local market However, regularly published surveys also provide useful information on cap rate trends Example: Real Estate Research Corporation Cap Rate Survey Cap rates vary inversely with quality (i.e., class ) Cap rates vary by property type risk 18-21 18-22 Cap Rate (%) Cap Rates by Property Type Since 1996 Cap Rate Levels 12.0 11.0 10.0 9.0 8.0 7.0 6.0 5.0 Apart Hotel Ind R&D Ind Ware CBD Office Sub Office Neigh Ret Power Center Malls Profitability Ratios: Equity Dividend Rate Equity dividend rate (EDR): Before tax cash flow EDR Equity investment $30,656 EDR 0.1271, or 12.7% $241,163 1996Q1 1996Q4 1997Q3 1998Q2 1999Q1 1999Q4 2000Q3 2001Q2 2002Q1 2002Q4 2003Q3 2004Q2 2005Q1 2005Q4 2006Q3 2007Q2 2008Q1 2008Q4 Cap rates are obtained from the Real Estate Research Corporation s Real Estate Report, which publishes results from RERC s quarterly Real Estate Investment Survey. The Real Estate Report summarizes the expected rates of return, property selection criteria, and investment outlook of a sample of institutional investors and managers throughout the U.S. The property level cap rates displayed above are aggregated across all metropolitan markets. Residual cash flow return to equity investment Commonly called cash-on-cash return Common reference point for smaller investments 18-23 18-24 4
Multipliers: Net Income Multiplier Net income multiplier: Acquisition price NIM NOI NIM 9.9 $89,100 Reciprocal of cap rate; conveys identical information Would you always prefer the opportunity with the lowest NIM? Effective Gross Income Multiplier Effective gross income multiplier (EGIM): Acquisition price EGIM Effective gross income Centre Point Example: EGIM 5.5 $162,000 18-25 18-26 Financial Risk Ratios: Operating Expense Ratio Operating expense ratio: Operating expenses OER Effective gross income OER Note: Operating expenses, as used here, includes CAPEX, which we shall also do $72,900 0.45, or45% $162,000 Seasoned analysts watch deviations from normal Financial Risk Ratios: Loan-to-Value Ratio Loan-to-value ratio (LTV): Mortgage Balance LTV Acquisition Price $663,750 LTV 0.75, or 75% Lenders generally want LTV to be no greater than 75 80% of acquisition price 18-27 18-28 Financial Risk Ratios: Debt Coverage Ratio Debt coverage ratio (DCR): Net Operating Income DCR Debt Service $ 89,100 DCR 1.52 $58,444 Primary risk assessment ratio used by lenders Indicates amount of cash flow cushion above that needed to pay debt service Financial Risk Ratios: Breakeven Occupancy Ratio Break Even Occupancy Ratio Operating Expense Debt Service BEO Gross Potential Income $ 72,900 58,444 BEO 73% $180,000 Remember: We include CAPEX as part of Operating Exp A risk assessment ratio used by lenders Indicates how low occupancy can be and still have enough cash flow to meet expenses plus the debt service. 18-29 18-30 5
Pros and Cons of Ratios & Multipliers Pros Quick & easy to compute Intuitive Facilitates comparison with similar properties Cons No clear benchmarks for acceptable range Only a partial view of performance Example 18-1 You are considering purchasing a small office building for $1,975,000 Your expectations include: First-year gross potential income of $340,000; Vacancy & collection losses equal to 15% of PGI; Operating expenses = 40% of EGI; Capital expenditures = 5% of EGI $1,481,250 mortgage (75% LTV) @ 7% Mortgage will be amortized over 25 years with a monthly payment of $10,469.17 Total up-front financing costs = 2% of the loan amount Required equity investment is $523,375 [$1,975,000 ($1,481,250 - $29,625)] 18-31 18-32 Example 18-1: 1 st Year Projections Item Amount Potential gross income (PGI) $340,000 - Vacancy & collection loss (VC) 51,000 = Effective gross income (EGI) 289,000 - Operating expenses (OE) 115,600 - Capital expenditures (CAPX) 14,450 = Net operating income (NOI) 158,950 - Debt service (DS) 125,630 = Before-tax cash flow (BTCF) $33,320 Example 18-1: 1 st Year Ratios Going in cap rate: NOI $158,950 R 0.080 8.0% 0 Acqusition Pr ice $1,975,000 or Equity dividend rate: Before Tax EDR Cash Flow Equity Investment (Effective) gross income multiplier: $33,320 0.063063 or 6.3% $523,375 Acquisition Pr ice $1,975,000 EGIM 6.83 Effective Gross Income $289,000 18-33 18-34 Example 18-1: 1 st Year Ratios Operating expense ratio: OER Effective Debt coverage ratio: Operating Expenses Gross Income $130500 0.45 or 45% $289,000 Nt Net Operating Income $158,950 DCR 1.27 Debt Service $125,630 Breakeven Occupancy Ratio Remember: We include CAPEX as part of Operating Exp Operating Expense DebtService $130,050 125,630 BEO 75% PotentialGrossIncome $340,000 End of Chapter 18 18-35 6