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Lecture 12

Lecture 12. Cash Flow Analysis. Evaluation of Future Investment Performance. TWO INITIAL FACTORS TO BE ANALYZED: 1. Holding Period Many assume 10-year for simplicity Established at the time the investor is analyzing the property

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Lecture 12

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  1. Lecture 12 Cash Flow Analysis

  2. Evaluation of Future Investment Performance TWO INITIAL FACTORS TO BE ANALYZED: 1. Holding Period • Many assume 10-year for simplicity • Established at the time the investor is analyzing the property • Most investors recalculate holding periods, and compare to initial evaluation

  3. Evaluation of Future Investment Performance If a 10-year holding period is not assumed, an investor viewing periodic cash flow as their investment objective could consider the following: • Link the holding period to a certain time/event in which the funds would be required • Hold the property while BTCF growth occurs and sell when BTCF stabilizes • Hold the property as long as BTCF is positive • Hold the property as long as tax sheltering occurs

  4. Evaluation of Future Investment Performance If a 10-year holding period is not assumed, an investor viewing price appreciation as their investment objective would choose a holding period equal to the time required for anticipated future benefits to occur (selling time). • Anticipated market price increases • Increases in neighboring values in the future • Beneficial changes in future uses

  5. Evaluation of Future Investment Performance TWO INITIAL FACTORS TO BE ANALYZED: 2. Discounting Interest Rate • Investors expected rate of return (easiest, most utilized) • Cost of Capital (interest rate plus risk factor) Capitalization Rate • Utilized to estimate future appreciated values, based on one income stream • Direct Capitalization

  6. Lecture 12 Discounted Cash Flow Analysis (Net Present Value)

  7. Process of a Discounted Cash Flow Analysis for Net Present Value 1. Determine BTCF’s 2. Determine Before Tax Equity Reversion - Proceeds from sale after deducting loan balances and selling costs 3. Discount BTCF’s and BTER 4. Calculate Present Values of BTCF’s and BTER, and sum 5. Net Initial Equity to derive Net Present Value of the Investment

  8. Step 1: Before-Tax Cash Flows Potential Gross Income (PGI) Less: Vacancy/Collection Loss Allowance Effective Gross Income (EGI) Less: Operating Expenses, Management Fees, Cap. Impvt. Allow. Before Debt Net Operating Income (NOI) Less: Debt Service Before-Tax Cash Flow (BTCF)

  9. Step 2: Before-Tax Equity Reversion • Utilize Direct Capitalization to estimate value (selling price) at end of holding period Formula: NOI for year immediately following holding period, divided by market-supported capitalization rate 2. Estimate selling and closing costs (broker commissions, prepayment penalties) 3. Calculate remaining loan balance (determines “net proceeds from sale”)

  10. Step 2: Before-Tax Equity Reversion Estimated Appreciated Value Less: Selling/Closing Costs Net Proceeds From Sale Less: Unpaid Mortgage Loan Balance Before-Tax Equity Reversion (BTER)

  11. Step 3: Discount BTCF’s and BTER Formula to calculate discounting factors: PV = 1 / (1 + i)n i = interest rate n = holding period

  12. Step 3: Discount BTCF’s and BTER Discount factors, assuming a 10% rate and a 5-year holding period: Year One: .9091 Year Two: .8265 Year Three: .7513 Year Four: .6830 Year Five: .6209 Year Six: .5645

  13. Step 4: Calculate Present Values of BTCF’s and BTER Formula to calculate present values: PV BTCF’s = Each BTCF * Discount Factors PV BTER = BTER * Discount Factor for year immediately following end of holding period Sum all discounted BTCF’s and BTER to derive Present Value of the Property

  14. Step 5: Net Present Value Present Value of Property Less: Initial Equity Invested Net Present Value (NPV)

  15. Investment Decision Criterionfor NPV If the following statements are true after your analysis, then the project is a feasible investment: (PV of all BTCF’s) + (PV of BTER) > Initial Equity Invested [(PV of all BTCF’s) + (PV of BTER)] - Initial Equity Invested > 0

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