Discounted Cash Flow: Ratio Analysis

1. Discounted Cash Flow:Ratio Analysis byJames R. DeLisle, Ph.D.March 20, 2014

2. Lecture Preview

3. DCF Models: A Visual Perspective

4. Equity Justified: PV of CF + PV Net Reversion PV CF + NIr GIr

5. Net Reversion Sales Price - Sales Exp Net Sales Price CG Appr x 15% Appreciation TRCm Land Value Depreciation CG Depr x 25% Mortgage Amortization Net Reversion Stabilized NOI Pb NIr GIr

6. Equity Justified: PV of CF + PV Net Reversion - Sales Exp - Tax on Sale - Mtg. Bal. Sales Price = Ej Net Reversion PV NR PV CF + NIr GIr

7. Cash Flow: The One Key Word GI NI TI BT AT NR Gross Income Net Income Taxable Income Before Tax Cash Flow After Tax Cash Flow Net Reversion

8. DCF Case Study:Inputs and Schedules

9. DeprLife 39 CGTxR 15.00% CGTxV 25.00% Selling Expense Exit Cap Rate Cash Flow Variables and TRC/FD/BD Inputs

10. Discounted Cash Flow and Financial Ratios • Schedule I: Cash Flow • Schedule II: Depreciation • Schedule III: Loan Amortization • Schedule IV: Net Reversion • Schedule V: Capital Gain Tax • Schedule VI: Financial Ratios

11. Schedule I: Cash Flow Overview

12. Schedule II: Depreciation $3,436,567*(1/39) = $88,117

13. Schedule III: Loan Amortization Calculate Payment Calc. Principal Balance Calc. Prin. Reduction Calc. Interest

14. Schedule III(b): Loan Amortization

15. Schedule IV-V: CGTaxes on Sale & AT Proceeds Schedule IV: AT Proceeds Schedule V: Capital Gain Tax On Sale If, CapGain * 15% AccDepr * 25%

16. Schedule I: Cash Flow 1- 10

17. Teams

18. Introduction to DCF Ratios:Key Financial Indicators

19. Schedule VI: Financial Ratios

20. Schedule VI: Financial Ratios

21. DCR: 1.3 Target Debt Coverage Ratio • Interpretation • DCR provides a measure of the safety of the mortgage position, indicates the cushion between required payments and NOI. • DCR’s should normally be 1.2 or more • Equation

22. DR: .85 Target Default Ratio • What • DR is a measure of financial risk of real estate investments • In essence it is the ratio of Fixed Costs to Gross Income • How Used: • Establish maximum variation expectations vs. realizations

23. Profitability Index • What • Ratio of PV Receipts to PV Outlays • Variation of NPV; shows when hit breakeven point • How Used: • Determine economic viability; insights to minimum Holding Period

24. Before Tax Cash on Cash Return • What • Measure of Nominal Return using Initial Investment as base • Ratio of pretax distributable cash to initial investment • How Used: • Determine economic viability and optimal Holding Period • Compare alternative investments

25. After Tax Cash on Cash Return • What • Measure of Nominal Return using Initial Investment as base • Ratio of After Tax distributable cash to initial investment • How Used: • Determine economic viability and optimal Holding Period • Compare alternative investments

26. Implicit Cap Rate • What • Ratio of NI in current period divided by end of year Value • Measure corresponds with “cap rate” rule of thumb • How Used: • Indication of relative pricing level; establish reasonableness of exit pricing • Fixed in this case due to application of Exit Cap to NOIn+1 Implicit Cap Rate

27. Gross Income Multiplier • What • Ratio of current period Market Value to Gross Income • How Used: • Rule of thumb comparison of alternative projects • Relatively stable in this case due to use of Exit Cap in estimating Sales Price

28. Net Income Multiplier • What • Ratio of current period Market Value to Net Income • Analogous to the PE ratio in finance • How Used: • An industry rule of thumb sometimes used to compare projects • Relatively fixed in this case due to Exit Cap on NOI

29. Payback Ratio (w/o Sale) • What • Cumulative sum of After Tax Cash Flow/Equity Ratio • Multiperiod look at return of initial equity • How Used: • Ratio that determines speed of return of equity • Used to compare risk vs. other investments

30. Modified Payback Ratio (w/o Sale) • What • Cumulative sum of FV of After Tax Cash Flow/Equity Ratio • How Used: • Compare timing of returns against other alternatives • Understand exposure period with reinvestment

31. NPV Equity • What • Cumulative sum of PV of Benefits less PV of Equity • How Used: • Determines whether discount rate is exceeded at specified cost of capital • If NPV is Positive (>1), indicates return exceeds required yield

32. Marginal Rate of Return • What • The net increase/decrease in total return relative to prior year • The additional return from owning from period to period • How Used: • Determining optimal holding period • Project has peaked when it drops off $637,873 $507,878 = $129,995 $637,873 = 25.6% $507,878 $507,878

33. Marginal Rate of Return

34. Internal Rate of Return: Overview • Interpretation • Rate that balances PV Outlays against PV Benefits; NPV=0 • It assumes reinvestment at the IRR • Equation Net Reversion PV NR PV NR + PV CF PV CF PV EQUITY $ IRR PV EQUITY $

35. Internal Rate of Return: Overview • Interpretation • Rate that balances PV Outlays against PV Benefits; NPV=0 • It assumes reinvestment at the IRR • Equation Net Reversion PV NR PV NR + PV CF PV CF PV EQUITY $ IRR PV EQUITY $

36. Internal Rate of Return • Interpretation • Rate that balances PV Outlays against PV Benefits; NPV=0 • It assumes reinvestment at the IRR • Equation 14.76%

37. Modified Internal Rate of Return • Interpretation • Rate that balances PV Outlays vs. PV of the FV of Benefits • FV is ATCF reinvested at a specified rate and NPV=0 • It may have multiple solutions, or may not converge • Equation

38. Modified Internal Rate of Return PV NR Net Reversion PV CF PV EQUITY $

39. Modified Internal Rate of Return 13.48%

40. GIGO Caveats in DCF Analysis • Forecasted Cash Flows • Must Be REALISTIC Expectations • Neither Optimistic, Nor Pessimistic • Discount Rate should be Opportunity Cost of Capital • Based on Ex Ante Total Returns in Capital Market • REALISTIC Property Market Expectations • Target Most Probable Buyer

41. Most Common Mistakes in DCF • Rent & income growth assumption is too high • “We all know rents grow with inflation, don’t we!”?... • Remember: Properties tend to depreciate over time • Usually, rents within a building do not keep pace with inflation, long run • Cap Ex &/or exit cap rate projection, are too low – • Capital expenditures typically average at least 10%-20% of the NOI (1%-2% of the property value) over the long run. • Going-out cap rate is typically higher than going-in cap rate (older properties are more risky and have less growth potential). • Discount rate (expected return) is too high – • This third mistake may offset the first two • End result may be realistic estimate of current value, • No guarantee and often not true

42. Lecture Review