Real Estate Investment and Risk Analysis

1. Real Estate Investment and Risk Analysis • Lecture Map • Review investor motivations • Review investment objectives • Investment Analysis • The due diligence process • “Quick steps” for determining risk and value • Calculating a levered return to equity • Before and after tax cash flow analysis

2. Why Invest in Real Estate? • Yield • Excellent current return generating asset class • Diversification • Historically strong returns with lower risk • Tax benefits • Ability to shelter portfolio ordinary income with ordinary losses • Price appreciation • Long term returns • Inflation hedge

3. When to Invest in Real Estate • Current investment research indicates that real estate should be a part of every investor’s portfolio • However, real estate is cyclical • Investors can choose different styles, investment vehicles based on timing of market cycles and risk profiles

4. Real Estate Investment Styles • Property specific investing • Type, size of property – sector investing • Tenant strategy • Trophy characteristics • Diversified, “core” strategies • Distressed or market timing investing • Special situation, turnaround

5. Steps in Investment Analysis • Conduct due diligence • Build property cash flow model • Validate assumptions inherent in the asking price for the asset • Conduct a sensitivity analysis • Calculate levered and unlevered returns on purchase price • Before and after tax

6. The Due Diligence Process • Investigating and evaluating investment risks • Translate the risks into cash flow projections • Risks are reflected in timing and size of expected streams of income • Investor rates of return should vary based on type, extent of risk identified

7. Elements of Real Estate Investment Risk • Business risk → macroeconomic trends • Inflation risk → time value loss • Liquidity risk → real estate is illiquid • Financial risk → loss of principal • Influenced by capital structure and interest rates • Execution risk → management • Legislative risk → change in the rules • Environmental risk → exposure to hazards

8. Comparing Financial Analysis to DCF • DCF typically looks at an unlevered return, while most real estate investment are financed • Investment analysis looks at unlevered and levered returns to investment based on • Asking price of a property • Limited equity resources • Available debt financing • Evaluates investment in terms of IRR as well as NPV

9. Quick Tools for Investment Analysis • Price per Unit • Going in Cash on Cash Yield • Debt Service Coverage Test • Equity Dividend Analysis

10. Price Per Square Foot • What is the asking price per unit? • Relative to reproduction cost for property • How vulnerable is the property to new supply? • Relative to current market comps • Is seller asking for more/less than the market is willing to pay for comparable assets?

11. Going in Cash on Cash Yield • Equivalent to the purchase cap rate • Does the property meet your minimum initial yield requirements? • How does this compare to cap rates for other, recent trades?

12. Debt Service Coverage Ratio • Evaluate how much debt the property can support • “DCR” • Multiple of NOI to debt service payment • One of the key lender underwriting tests • DCR may vary between deals • Property type • Market conditions • Lender portfolio concerns

13. Equity Dividend Analysis • Determining the annual leveraged return to equity • Equity = (Price – Debt) • ROE = (NOI – Debt Service) / equity • Does this yield meet investor’s current yield requirement? • How closely does NOI resemble actual free cash flow? • i.e., will capex requirements diminish annual equity returns in future?

14. Detailed Tools of Investment Analysis • Create a levered DCF model • NPV of the investment • IRR on the equity • Conduct sensitivities on the model • Partition the IRR • Where is your return coming from?

15. The Levered DCF Model • Calculate the annual after debt cash flows • Calculate the residual value • (CF10 ÷ exit cap rate) LESS debt balance • Exit cap rate ≥ going in cap rate • Discount the cash flows to PV at the discount rate • NPV of the net cash flow after payment of debt • NPV ≥ equity investment • Should the equity discount rate be higher or lower than the unlevered discount rate?

16. The Levered DCF Model (cont.) • Calculate a pro forma levered IRR to equity • CF0 = (equity investment) • CF1-9 = annual, net cash flows after DS • CF10 = year 10 cash flow PLUS Residual • How does the IRR compare to your expectations? • Does the IRR exceed your discount rate?

17. Conducting Sensitivity Analysis • Vary your modeling assumptions: • Growth rates • In rents, expenses • Absorption and long term occupancy • Debt/equity ratio • Holding period • Exit cap rates

18. Partitioning the IRR • Determining how much of the IRR comes from annual cash flows versus residual value • PV ratio of the cash flow to the total PV equals the cash flow’s contribution to IRR • Same for residual value

19. Why Partition the IRR? “A 20% IRR from a property with steady annual cash flows does NOT have the same risk profile as a 20% IRR from a property with no annual cash flow”

20. After Tax Returns to Equity • Most investment valuations are done before tax • Tax brackets differ among investors • Real estate does offer significant tax advantages, however • Residential → mortgage interest deduction • Commercial → benefits if property is held “for use in trade or business”

21. Tax Benefits of Income Producing Property • Mortgage Interest Deduction • Actual annual interest expense • NO deductibility of principal amortization • Tax Depreciation • 27.5 years for residential properties • Only allowed for third party owned rental homes • 39 years for commercial properties • Varying terms for property improvements, systems, etc. • Other, such as: • Amortization of loan points

22. Tax Benefits of Income Producing Property (cont.) • Tax benefits are always calculated at the highest marginal rate • 36% for annual income • 20% for capital gains on the sale price • Interest and depreciation deductions lower tax due each year • Depreciation must be “recaptured” at time of sale • Can not take the deduction twice

23. Calculating the Tax Benefit • Before Tax Cash Flow vs. Taxable Income • BTCF is NOT taxable income • This is a cash-basis number • Taxable income: • NOI – (interest + deprec./amort.) • ATCF = BTCF less tax due

24. Comparison of BTCF & ATCF

25. Comparison of BT & AT Residual Values

26. Calculating the Effective Tax Rate • Equals the percentage difference between the BT and AT IRR’s on investment • Effective Tax Rate is less than the marginal tax rate because of the deductions have reduced annual tax burdens • Example: • BTIRR = 14% • ATIRR = 12% • (14-12)/14 = 14.3% = Effective Tax Rate

27. Using the Tax Benefit • Reducing taxes owed on a property • Using losses to shelter other, passive investment income • Real Estate can produce “NOLs” • To the extent that interest and depreciation deductions exceed NOI • NOL’s can be applied to other passive income • NOL’s can be carried forward to future years