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Chapter 19: Investment value: NPV and IRR

Chapter 19: Investment value: NPV and IRR. Outline. DCF framework Discounting NOI. Investment value. Investment value (to a particular investor) is different from market (appraisal) value.

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Chapter 19: Investment value: NPV and IRR

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  1. Chapter 19: Investment value: NPV and IRR

  2. Outline • DCF framework • Discounting NOI

  3. Investment value • Investment value (to a particular investor) is different from market (appraisal) value. • Commercial real estate decisions are made with an investment motive: expecting cash flows from the investment. • The discounted cash flow (DCF) analysis addresses this motive. • Decision rule: if NPV > 0, accept the project.

  4. Inputs for DCF • The holding (investment) horizon. • Applicable required return. • Expected cash flows. • In traditional finance, we’d like to use after (corporate) tax cash flows, e.g., dividends or FCFs to the firms. • In RE, there are a variety of cash flow choices, both before taxes and after taxes. • Thus, be clear about the types of cash flows and then use the appropriate discount rate. • Do not compare apples with oranges.

  5. The example • A possible purchase of a 96,000 sf building for $9 million (V0). There are three tenants now. • Current market rent: $15 / sf, and this is expected to increase at 4% per year. • Expected CPI rate: 4%. • This example is based on Brueggeman and Fisher (2008).

  6. CPI adjustment • The base rent is $1,365,000, which is based on current rent price. • Current rent prices for A and B are lower than the market rent price because they are older leases. • Rent prices are usually adjusted based on CPI; but this adjustment is usually partial (50% here). • Thus for Year 1, we would expect a 2% (50% of 4% CPI) adjustment for older leases: A and B. • The lease for C is just signed, its rent price is set to the current market price: $15 / sf. • Since this is a new lease, there would be no CPI adjustment for C in Year 1.

  7. Pro forma rental income and CPI adjustments; horizon = 5

  8. Expense reimbursements as another source of income • Expense stop: a clause often found in commercial leases that requires landlords to pay property operating expenses up to a specified amount and tenants to pay the expenses beyond that amount. • Expense stop is usually stated in per sf amount. • For example, if the expense stop is $4.25 / sf and the current expense is $4.5 / sf, the tenant must pay the landlord 25 cents / sf as an expense reimbursement (income to the landlord). • Suppose that expense reimbursement estimates for Year 1-6 are 33500, 44396, 70625, 15256, 19189, and 19670.

  9. Formula for PGI • Base income + CPI adj. + Expected reimbursement = Potential (gross) income (PGI)

  10. Projected NOI

  11. Discounting NOI • Note that NOI is a before-tax cash flow. • Thus, when we assign a discount rate to discount NOI, this must be a before-tax discount rate. • Suppose that the investor requires a before-tax discount rate of 12%. • Note that this discount rate is somewhat individual-specific; some investors have higher costs of capital than the others.

  12. The terminal market value • For an NPV analysis, we need to know the terminal market value at the end of 5-year horizon. • V5 = NOI6 / R5, where R5 is going-out cap rate. Suppose the going-out cap rate is expected to be 10%. • Note that the going-out cap rate is determined in the market; not individual-specific. • V5 = NOI6 / R5 = 1061778 / 0.1 = $10,617,780.

  13. NPV and IRR

  14. Decision • Would you purchase the building?

  15. Other cash flows/discount rates • The previous example does not take taxes into consideration. • One of course can use after-tax cash flows for the basis for DCF. • If so, the discount rate needs to be a after-tax one. • For this, see Chapter 11, Brueggeman and Fisher (2008).

  16. Profitability ratios • Going-in capitalization rate R0 = NOI1 / V0 = 923650 / 9000000 = 10.26%. • Net income multiplier (NIM) = V0 / NOI1 = 9000000 / 923650 = 9.74. • Gross income multiplier (GIM) = V0 / EGI1 = 9000000 / 1421000 = 6.33.

  17. Financial risk ratios • These ratios try to measure the income-producing ability to meet operating and financial obligations. • Operating expense ratio (OER) = operating expenses / EGI; for year 1, OER = 497350 / 1421000 = 35.00%. • Loan-to-value (LTV) ratio = mortgage balance / acquisition price (V0).

  18. Pros and cons of financial ratios • Easy to calculate and communicate. • Their calculations are usually based on a single year’s numbers; they tend not to consider future cash flows. • They do not have a formal decision rule.

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