CNB392 Property Investment Analysis Lecture One Notes – Investment Principles Asset •

A possession that has value in exchange.

Types of ‘assets’ •

Real asset – Physical assets e.g. land and equipment. – Opposite to financial assets

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Financial asset – Derives value from a contractual claim – ‘Paper claims’ e.g. stocks, bonds and bank deposits

Major Asset Classes (4 types) •

Shares

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Property

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Fixed Interest

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Cash

Return: overall gain or loss on an investment. Risk: the variability of returns or the change that the return will be different than expected.

Investment •

Committing capital expecting to receive some future benefit(s) (returns)

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Implies that the safety of the principal is important (vs. gambling or speculation)

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Any activity focused on the creation of more money (benefits) through the utilisation of capital.

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Benefits: future income or capital appreciation.

Types of Investors •

Institutional investor (wholesale) – Large investing entities e.g. banks, super/pension funds and insurance companies

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Retail investor – Individual investors

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Investment considerations • Owners either own or loan • Expected returns are a product of the TVM, expected inflation and future uncertainty (risk) Key Investment Objectives/Process 1) Investment purpose 2) Return preference and risk tolerance 3) Investment quantum 4) Investment horizon 5) Liquidity preferences 6) Tax considerations 7) Legal and regulatory requirements 8) Other specific considerations

Defensive Growth: Fixed interest and cash; less likely to rise in fall in value, less chance of negative value. Growth Asset: Shares and property; offer the greatest potential to increase in value. Risk •

Variability or chance that an investment’s actual return will be different than expected

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Indicator of potential gain/loss associated with investing overtime

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Implicitly related to potential return – Higher the risk = higher the potential reward – shares most volatile thus the highest risk = highest returns – bonds: fixed interest thus low risk = lower returns

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Factors influencing risk level: – Wealth – Existing risk exposure – Ability to absorb losses – Life considerations e.g. age – Levels differ from investor to investor

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Return •

Overall gain/loss on an investment in a particular period

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Returns are a product of: – Time value of money (TVM) – Expected inflation – Future uncertainty Types of Returns •

Income – Regular or periodic return – E.g. dividends, rent and interest on (bank) savings

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Capital Appreciation – Capital value change i.e. an increase in original value of asset – E.g. shares or property

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Combination of the income and capital appreciation (property).

The Investment Process 1) Define your investment objectives – Return preferences? – Risk tolerance? – Investment horizon? – Level of equity and amount available to invest? – Tax considerations? 2) Choose suitable investments – Must be consistent with investment objectives 3) Implement and monitor – Ensure investments remain consistent with investment objectives – Change investments if necessary Stereotypical Characteristics of Major Asset Classes •

Shares – – – – – – – –

Growth asset High liquidity Long-term horizon High risk Income and capital appreciation returns Overall high returns High growth Good inflation protection

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Property – – – – – – – –

Growth asset Low liquidity Long-term horizon Moderate to high risk Income and capital appreciation returns Overall moderate to high returns Moderate to high growth Good inflation protection

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Fixed Interest – Defensive asset – High liquidity – Short to medium term horizon – Low to moderate risk – Income and potential capital appreciation returns – Overall moderate returns – Low Growth – Poor inflation protection

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Cash – – – – – – – –

Defensive asset High liquidity Short-term horizon Lowest risk Income returns Overall lowest returns Nil growth Bad inflation protection

Financial factors affecting investment •

Required return

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Risk tolerance

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Inflation

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Security of regular cash flow return.

Non-financial factors affecting investment •

Quality of location

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Structurally sound building

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Aesthetically pleasing design

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Environmentally friendly

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Marketing desirability

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Lecture Two Notes – Strategy & Property Investment Vehicles Investment Strategy •

Basis/reason for any investment decision

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First stage of investment activity

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Implies mgt skills that will ‘place the investor in the winner’s circle’ (Pyhrr 1989)

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Requires clearly identified and defined: – Overall investment philosophy – Objectives and decision criteria – Plans and policies – Strategy of analysis

Investment Strategy Considerations •

External environment – E.g. regulations/controls, politics, competition

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Social mores of society – E.g. ethics, values

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Investor’s resources – E.g. mgt skills, borrowing capacity, available capital, timeframe

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Personal value – E.g. investor beliefs, goals, return preferences, risk tolerance, ideology, involvement, tax benefits

Investment Strategy Structure 1) Strategy – Risk/return definition 2) Analysis – Risk/return management 3) Decisions – Risk/return evaluation Property Investment Analysis & Structuring Process 1) Determine Investment Strategy – Overall investment philosophy – Objectives and decision criteria – Plans and policies – Basic screening criteria 2) Generate Alternatives – Locate property(s) that meet basic screening criteria – Collect preliminary date for analysis

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3) Analyse Property using Basic Financial Feasibility Models – Analyse basic economics returns and risks – Analyse financial package alternatives – Determine investment value range 4) Negotiate Basic Terms with Seller – Price – Financing terms – Tax considerations – Other purchase conditions 5) Do Detailed Feasibility Research – Market and marketability analysis – Physical and structural analysis – Legal/political/environmental analysis – Management analysis – Re-do pro forma and restructure if necessary 6) Complete Financial and Tax Structuring – Acquisition structure – Operating period structure – Termination planning 7) Perform DCF Analysis – Evaluate rate or return – Evaluate risk – Evaluate portfolio impacts – Make final investment decision 8) Final Negotiations and Closing – Negotiate final contract – Arrange closing details – Close/take over property 9) Manage the Property – Property management – Venture (asset) management – Financial reporting 10) Terminate the Property – Decision to sell – Tax planning considerations – Negotiate price and terms – Close/terminate venture – Begin reinvestment cycle

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Investment Criteria • Funds available • Timeframe • Involvement • Return expected • Risk level • Tax benefit Investment Principles • Buyer should buy the assumptions that create the yield, rather than the yield itself. • Investor should compare alternatives. • Investor should understand the potential profit and risks in terms of dollars and cents. • Never be forced to sell. • Buy below the market. • Exploit long term cycles. • Plan your exit strategy. • Research all aspects thoroughly. Property Investment Vehicles •

Direct (purchase is held by investor) – Freehold – Partial rights – Mortgage

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Indirect (purchase of an interest) – Redeemable (securities funds) - Listed (market based) - Unlisted (valuation based) – Unredeemable (property syndicates)

Property Syndicates •

Often a partnership, unit trust or JV

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Provide investors with an opportunity to invest in property

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Raise funds from investors by seeking subscriptions to purchase a specific property(s) – Not open-ended

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Unlisted investment entities

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Generally small size (<$50m)

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Has a Single Responsible Entity (SRE)

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Governed by the Managed Investments Act 1998

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Illiquid – Redeemable value of the units is usually only realised upon sale of property – Usually fixed for 5-10 years

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Unlisted Property Trusts (UPTs) •

Raise funds from investors by seeking subscriptions to purchase properties – Open-ended

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Unlisted investment entities

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Generally large size (>$50m)

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Deemed to be less risky than syndicates as larger investment portfolios can provide more diversification

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Has a Single Responsible Entity (SRE)

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Governed by the Managed Investments Act 1998

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Illiquid – Redeemable value of the units is determined by regular valuations of the Trust’s property – Usually fixed for over 10 years

Unlisted Property Trusts – Retail • Units offered to individual subscribers after trusts have secured options ton purchase their initial properties. • Prominent investors in non-traditional or emerging property sectors (self-storage, retirement, child care). Unlisted Property Trusts – Wholesale • Units offered to investing institutions. • Major wholesale fund managers. Evaluating an UPT or Syndicate •

Size of funds – How much equity is it seeking? – What debt has been arranged? – Open-ended or not

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Current properties – Quality – Type(s) – Acquisition s strategy

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Management – Track record of managers – Capacity

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Level of fees – In comparison to others – Justified by performance

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Liquidity – Ease of selling units – Life-span of fund

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Forecast income yield – Tax advantage position – Likelihood of capital growth – Risks to income and capital invested

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Ratings of funds e.g. PIR rating

Listed Property Trusts (LPTs) •

Pooled investment whose units are listed on the ASX

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Unit holders can trade their units on the ASX the same way as any share or other listed security

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Unit holders can receive benefits such as: – Distributions – Tax advantages – Capital gain in the price of traded units LPT Index •

A weighted average of unit prices in all LPTs

Evaluating a LPT •

Returns – Past and present rates of returns – Benchmark indices – Before and after tax

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Forecast and current income yield – Tax advantage position – Likelihood of capital growth – Risks to income and capital invested

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Forecasts of price movements

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Net Tangible Asset per Unit – Compared with market price of units – Quoted as percentage premium – Discount on NTA

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Ratio of Debt to Assets and Debt Coverage Ratio

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Volatility – LPTs beta – Past returns compared with LPT indices

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Property Securities Funds (PSFs) •

Investments made in LPTs

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Investors delegating the task of choosing individual LPTs to a professional fund manager e.g. AMP, Macquarie

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Largely driven by the performance of the LPT Index

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Available to retail and institutional investors

Evaluating a PSF •

Mix of units – Investment in a performing sector – Fully diversified

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Track record – Returns compared with LPT indices

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Volatility – Does the PSF smooth the volatility in the indices

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Management – Track record of managers – Capacity

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Level of fees – In comparison to others – Justified by performance

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Ratings of funds e.g. PIR rating

Other Property Funds •

Mortgage Funds: – Investment funds which hold mortgages over properties (to provide high interest income)

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Hybrid Funds: – Invest in a mixture of units in LPTs, UPTs and mortgage funds – Open-ended – Have some liquidity – Usually have a significant portion of LPT units and cash – Debt financing used to enhance investor’s returns

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Development Funds: – Seek equity to develop and sell property or parcels of land – Investors returns are from the development’s profits (after deducting fees)

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Evaluating Property Funds •

Property mix – Type/building – Location – Tenants/lease covenants

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Sources of capital – Percentage of debt – Ease of access to equity

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Liquidity – Ease to withdraw from investment

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Management – Track record of managers – Capacity

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Level of fees – In comparison to others – Justified by performance

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Return – Rates of returns – Past and present – Before and after tax

Real Estate: A tangible asset: real property constitutes the physical components of location and space. (land and improvements). Real Estate: A bundle of rights: bundle of intangible rights association with ownership. Including right to possession, control, enjoyment and disposition. In investment analysis with are essentially valuing these ‘bundled rights’. Value derives from the interaction between the 3 sectors of the economy: the real world or markets, the financial world or capital markets and the government. Real world: supply and demand = rental levels. Financial world: provides the resources necessary for development and acquisition. Government: influences using land use controls and tax policies. Characteristics of real estate asset: location/immobility, heterogeneous, indivisible, illiquidity, durability. Market Value vs. Investment Value Market Value − Objective market derived estimate of value − Value in the marketplace − Can assume only one value

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Investment Worth/Value − Subjective estimate of value, specific to an individual investor/group of investors − Value to an individual − May assume various values Page 11 of 40

Lecture Three Notes – Time Value Calculations Real and Nominal Interest Rates •

Monetary world is nominal unless stated otherwise

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Real interest rate (or discount rate) is adjusted for inflation

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Formulas:

rr = real interest rate rn = nominal interest rate i = inflation

1) rr = rn – i – Very simple version – Should only be used when rn – i < 5% 2) (1 + rn) = (1 + rr) (1 + i) – Fisher Formula – Example: rn = 6%, i = 3%, rr = ? a) (1 + rn) = (1 + rr) (1 + i) b) (1 + 0.06) = (1 + rr) (1 + 0.03) c) 1.06 = (1 + rr) 1.03 1.03 1.03 d) 1.0291 = 1 + rr e) 1.0291 – 1 = 1 + rr – 1 f) 0.0291 = rr g) rr ≈ 2.91% Return on Investment (ROI) •

Also known as rate of return, return or discount rate

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Used to measure/compare profitability

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Ratio of money gained/lost relative to the amount invested

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An annual rate of return (unless otherwise stated)

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Formula: ROI = Return/Invested Capital

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Example: Q: A $1,000 investment earns $50 interest in 1 year, what is the ROI? A: ROI = $50/$1,000 = 0.05 = 5%

Return of Investment (ROC) •

Also known as return on capital or recapture rate

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Recovery of invested capital back to capital owner(s)

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Key issues for Time Value of Money •

Real or nominal money returns

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Beginning or end period instalments

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Payments must be the same (or calculated separately)

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Instalment period (i.e. annually, monthly, daily)

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Apply real interest rate to cash flows expressed in real terms (and vice versa)

Time Value Calculations 1) Compounding a single amount 2) Discounting a single amount 3) Compounding an annuity 4) Discounting an annuity 5) Sinking fund annuity 6) Amortisation factor 7) Perpetuity factor 1) Compounding a Single Amount Q: What is the FV of $3,000 compounded at the rate of 9% for 10 years? A: PV = 3000, i = 9, n = 10 Comp FV = $7,102.09 2) Discounting a Single Amount Q: What is the PV of $15,000 to be received in 5 years at the rate of 12%? A: FV = 15000, i = 12, n = 5 Comp PV = $8,511.40 3) Compounding an Annuity Q: If you deposited $500 at the end of the each year for 25 years at 8%, how much would the balance be at the end of the 25th year? A: PMT (end) = 500, i = 8, n = 25 Comp FV = $36,552.97 4) Discounting an Annuity Q: What is the PV of $50,000 to be received at the end of each year for 25 years at 9%? A: PMT (end) = 50000, i = 9, n = 25 Comp PV = $491,128.98 5) Sinking fund Annuity Q: If deposits earn 6%, what is the annual payment required accumulating $40,000 in 10 years? A: FV = 40000, i = 6, n = 10 Comp PMT = $3,034.72 6) Amortisation Factor Q: If you borrowed $200,000 at 7% over 25 years, what would the annual rate be? A: PV = 200000, i = 7, n = 25 Comp PMT = $17,162.10

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7) Perpetuity Factor Q: What is the PV of $10,000 to be received at the end of each year indefinitely given an annual interest rate of 15%?? A: PMT = 10000, i = 15, n = ∞ Comp PV = $? = PMT/i = 10000/0.15 = $66,667 Lecture Four Notes – Direct Capitalisation Capitalisation Rate (Ro) •

Ratio of annual income to the value (or sale price) of a property

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Allows future benefits to be quantified as a PV

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Converts benefits to a rate – Represents the value of the benefits

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Used to estimate the market value of a subject property

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Affected by: – Growth in income - Faster growth = lower cap rate & higher value – Risk - Higher risk = higher cap rate & lower value – Economic obsolescence - Shorter life = higher cap rate & lower value – Interest rates - Higher interest rates = higher cap rate & lower value – Market conditions - Stronger rental market = lower cap rate & higher value – Property age - Older properties (higher risk) = higher cap rate & lower value

Net Operating Income (NOI) •

Annual net income before any financial charges (interest and income taxes)

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Deductions include: – Fixed and operating expenses (i.e. vacancies and statutory outgoings) – Rates and land taxes

Direct Capitalisation Model •

Used to develop an estimated value by capitalising a single year’s NOI

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Process of converting anticipated future income into a PV

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Relies on single period NOI projection

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Formula: V = NOI/Ro

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V = value, NOI = net operating income, Ro = cap rate

Example: Q: NOI is expected to be $50,000 in the year ahead; applicable cap rate is 10%, what is the estimated value of the subject property? A: V = NOI/Ro = 50000/0.1 = $500,000

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Direct Cap Approach: Steps 1) Estimate stabilised NOI for the year ahead 2) Estimate cap rate 3) Determine the subject properties value: V = NOI/Ro Stabilising NOI •

Represents a stream of level income amounts

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Has a PV equal to the PV of the uneven income amounts

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Formula: PV = ∑PV of NOIs/PV of Annuity

Stabilising NOI: Steps 1) Calculate the sum of the PVs for the NOI estimates at the equity yield rate (Ye) 2) Calculate the PV of each of the NOIs E.g. FV = 166,000, i = 12, n = 1 Comp PV = 148,214 Year NOI PV Ye=12% Year 1 $166,000 $148,214 Year 2 $120,000 $95,663 Year 3 $100,000 $71,178 Year 4 $180,000 $114,393 Year 5 $250,000 $141,857 Year 6 $210,000 $106,393 Total $677,698 3) Calculate the PV of Annuity (PMT = $1) E.g. PMT = 1, i = 12, n = 6 Comp PV = 4.1114 4) Compute the stabilised NOI E.g. PV = ∑PV of NOIs/PV of Annuity PV = 677,698/4.1114 = 164,834 Stabilised NOI = $164,834 Direct Cap Approach: Strengths •

Simple

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Readily understood by market participants

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Requires limited no. inputs – All assumptions are made implicitly

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Closely tracks investors movements in marketplace – Effectively mirrors market behaviours and thought processes

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Provides accurate and reliable market value estimates, where: – Sufficient no. comparable sales evidence – Approach is applied proficiently

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Direct Cap Approach: Weaknesses •

Relies on sufficient no. of comp. properties

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Absence of accurate/quality info on comp. properties

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Ignores future cash flow expectations i.e. from disposal – Usually only focuses on first year’s NOI

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Need a sound projection of single period stabilised NOI – For subject and comp. properties – Difficult when fluctuating income and expense profiles are expected

Deriving Cap Rates: Market Extraction •

Extracted from the market (comparable properties)

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Example: Sale Price NOI Implied Cap Rate

Sale 1 $125,000 $12,500 0.10

Sale 2 $375,000 $36,000 0.096

Sale 3 $260,000 $26,520 0.102

Indicated Capitalisation Rate = 10% •

Valuer must: – Obtain quality and reliable information – Compare apples with apples – Use a sufficient quantity of comparable properties – Know what is reflected in the rate

Strengths: Market Extraction •

Simple

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Links directly to market – Supported by market activities, actions and expectations

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Provides accurate and reliable cap rate estimates, where: – Sufficient no. comparable sales evidence – Approach is applied proficiently

Weaknesses: Market Extraction •

Relies on sufficient no. of comp. properties

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Absence of accurate/quality info on comp. properties

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Subject property must have similarities to properties from which the cap rate was obtained, e.g.: – Cash flow growth – Future income expectations – Risk pattern

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Need a sound projection of single period stabilised NOI – Difficult when fluctuating income and expense profiles are expected

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Methods Reconciling Market Derived Cap Rates 1) Assessing comparable properties’ superiority/inferiority to subject property – Example: Comp. NOI Sales Price Ro Superior/Inferior Property #1 $27,500 $290,000 0.0948=9.48% Similar/Inf. Property #2 $29,800 $310,000 0.0961=9.61% Superior Property #3 $26,900 $275,000 0.0978=9.78% Superior Property#4 $30,250 $325,000 0.0931=9.31% Similar/Sup. Applied Capitalisation Rate to Subject Property: 9.4% 2) Attaching formal weightings to each comparable property – Example: Comp. Ro Weighting Weighted Property #1 0.1100 0.40 0.0440 Property #2 0.1036 0.10 0.0104 Property #3 0.0984 0.10 0.0098 Property#4 0.1074 0.40 0.0430 Total 1.00 0.1072 Applied Capitalisation Rate to Subject Property: 10.72% Return is typically analysed within an accounting framework that focuses on the twopart cash flow associated with investment property. What is this two-part cash flow comprised of? The expected residual cash flow generated by income-producing real estate comes in two parts: 1. annual operating cash flows to be received throughout the holding period; and 2. capital appreciation or proceeds from sale. The estimation of cash residuals is developed in a similar vain to those derived under the accrual method of accounting. Explain this statement. Expenses and revenues are accounted for when they are due, irrespective of when they are in fact paid or received. Potential Gross Income (PGI): PGI is the total annual income a property would produce if it were fully rented and had no collection losses (in other words, no vacancies and no bad debts). Potential gross income is the estimated rent per unit (our rental rate per square metre) for each year multiplied by the number of units (number of square metres) available for rent. The estimation of NOI is a primary objective in cash flow forecasting. Why? Net operating income excludes debt financing expenses and other non-property expenses. In other words, NOI focuses on the income produced by the property after operating expenses but before debt service and the payment of income taxes.

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OPEX are divided into two categories: â€˘ Fixed expenses do not vary directly with the level of operation (i.e. occupancy) of the property. The most common fixed expenses are property taxes and property insurance -owners must pay them whether the property is vacant or totally occupied. â€˘ Variable expenses, as the name implies, vary with the level of operation of the property; they are higher for a higher level of occupancy and lower for a lower level. They include items such as utilities, supplies, and management. 1. Given the following information, what is the estimated net operating income (NOI) for the first year of operations? First-year PGI $340,000; vacancy and bad debt allowance 15% of PGI; OPEX 45% of EGI. Solution: Item Potential gross income less: V&C allowance (@ 15% of PGI) Effective gross income less: Operating expenses Net operating income

Amount $340,000 51,000 289,000 130,000 $158,950

2. Given the following information, reconstruct the operating statement. Total NLA Rental rate /m2 Vacancy and Bad Debt Allowance Other Income - naming rights OPEX Mortgage Payments Taxes on Operations

4,500 m2 $220.00 p.a. 7.5% $20,000 40% of PGI $200,000 $175,000

Operating Statement Property X Potential Gross Income - Vacancy and Bad Debt Allowance + Other Income = Effective Gross Income (EGI)

$990,000 $74,250 $20,000 $935,750

- Operating Expenses (OPEX)

$396,000

= Net Operating Income

$539,750

- Mortgage Payments

$200,000

= Before-tax Cash Flow

$339,750

- Taxes on Operations

$175,000

= After tax Cash Flows

$164,750

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Week 5: Property Cash Flows –NO CALCULATION Qs IN THE EXAM ON THIS. Alternative methods of deriving cap rates •

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Mortgage Equity Approach 1.

Weighted Average Cost of Capital (WACC)

2.

Band of Investment (BOI)

3.

Akerson Method

4.

Ellwood Method

Constant Growth Model

Estimating Ro: Mortgage Equity Approach (used when can’t derive from market sales) Ro is extracted by weighting the expected first year cash returns to lenders and equity investors. WACC: Weighted Average Cost of Capital Ro = [mKd + (1-m)Re] (reflects a weighted average return on investment) Ro = cap rate, m = LTV ratio, Kd = annual cost of debt (interest rate), Re=equity cap rate (equity dividend rate, cash flow rate)

Calculate Ro given that financing is available at 15% p.a. over a 25 year term with annual compounding at a LTV ratio of 80%, and equity investors operating in the subject market require a 13.12% return? m=loan-to-value ratio (0.8) Kd= annual cost of debt (financing rate) (0.15) Re=equity cap rate (equity interest) (0.1312) = 0.14624 or 14.26% NB: adjust if compounding monthly. Determining the equity capitalisation rate (Re) • Represents current one year cash return • Based on comparable sales analysis Re = BTCF/Ve BTCF = before-tax cash flow (NOI-ADS) Ve = value of the equity (sale price – mortgage balance)

Re = Ro – m (Rm) (1-m)

Other method: if other variables are know just rearrange WACC formula.

Rm=: the mortgage constant 1-m: Equity-to-value ratio (ETV)

Problems with WACC: doesn’t account for equity build up BOI method overcomes this by explicitly accounting for the equity increase that will occur with the amortisation of debt….

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Band of Investment Technique Ro = [mRm + (1-m)Re] Ro: overall capitalization rate; m: loan-to-value ratio; Rm: the mortgage constant; 1-m: the equity to value ratio (ETV) Re: the equity capitalisation rate (investor return)

Akerson Technique (improves BOI by incorporating changes in value over holding period) Mortgage Constant Rm • A 1 year cash return to lender • Reflects periodic annual payment of principle and interest on a mortgage. • Solve for PMT on calculator. Rm

Sinking Fund Factor (SFF)

%OLBt (% of loan amortised)

Adjust for appreciation/depreciation

PV=-1 n=25 (financing term) i=15 (financing rate) PMT=?=15.986

FV=-1 i=18.05 (equity/investor) n=8 (holding period) PMT=? = 0.065

PV=1 0.065 x 0.1 i=15 (financing rate) n=8 (holding period) PMT= -0.15986 FV=?= -0.9354 +1=0.0645

Ro=[mRm + (1-m)Ye] – (m x SFF x (1-%OLBt)) – (SFF x appreciation) + (SFF x depreciation) Calculate Ro if financing is available at an interest rate of 15% p.a over a 25 year term with annual amortisation at a loan-to-value ratio of 80%, equity investors in this market required a 18.05% yield on equity, the forecast holding period in this market is 8 years and the property appreciation over this period is anticipated to be 10%. Overall rate Ro: Weighted debt and equity factors – Equity build up credit - Appreciation Ro = [mRm + (1-m)Ye] Where Rm = PV = -1, i=15, n=25, PMT=? = 0.15986 = 15.986% -(m x SFF (1-%OLBt)) SFF = FV=-1, i=18.05, n=8, PMT=? = 0.0651 1-%OLBt = PV=1, i=15, n=8, PMT = -0.15986, FV=? = -0.9354 + 1* = 0.0645 = 0.80 x 0.0651 x 0.0645 = 0.003359 * when calculating the FV, the number displayed will represent the balance of the loan take the complement of this number for the % of loan paid off. +/- (SFF x depreciation/appreciation) = 0.0651 x 0.10 = 0.00651 Therefore Ro = 0.1546 – 0.003359 – 0.00651 = 0.14999 = 15%

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The Equity Yield Rate Ye • aka discount rate or IRR • Used in place of Re in Akerson technique as it considers total returns. • Ye includes all anticipated cash flows over holding period. Ellwood Method (Akerson Rearranged) Rm PV=-1 n= 25x12=300(financing term) i=8/12=0.66 (financing rate) PMT=?=0.007x12=0.0926

Sinking Fund Factor (SFF) FV=-1 i=15(equity/investor) n=15 (holding period) PMT=? = 0.0210

%OLBt (% of loan amortised) PV=1 i=8/12=0.66 (financing rate) n=15x12=180 (holding period) PMT= -0.007 (not x12) FV=?= -0.9354 +1 = 0.3638

Adjust for appreciation/ depreciation

0.0210 x 0.1

Ro = Ye – m [Ye + (1-%OLBt) (SFF) – Rm] – App(SFF) + Dep (SFF) Calculate Ro if financing is available at 8% p.a, 25 years, monthly amortisation, loan-tovalue ratio of 66.66%, & equity investors operating in this market require a 15% equity yield. It is projected that the loan will be held for 15 years before the investment is sold and over that period the total appreciation will be 10%. NB: is compounded monthly, divide the interest and x the n by 12. Ro = 0.15 – (0.66 x (0.15 + (0.3638 x 0.0210) – 0.0926)) – (0.1 x 0.0210) = 10.46%

The DCF Model • Market value of subject = PV of future stream of cash flows. • Steps: 1. Forecast the expected cash flows (NOI) over the holding period. 2. Forecast the expected cash flow from the sale of the property following the holding period. 3. Estimate discount rate (Ye). 4. PV of cash flows (NOI + reversion) – the sum of the PVs = CV Discount Rates (Ye) • Rate of return used to converts a monetary sum into a PV estimate. • Will vary with perceived risk. Higher discount rate = lower CV Deriving Ye: • Benchmark against alternative investments: Ye is a market based rate of return the subject property must provide a return in line with that expected for competing investment opportunities (of similar risk) available in the marketplace. • Using comparable sales evidence: Complete a full DCF analysis for each competing property and solve for the IRR. • Using investor surveys: report investor expectations for different types of property in different locations ask market participants what their expectations are.

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•

Risk Premium Model: Ye = Rf + Rp

Rf: the risk free rate (as estimated by the return offered on Government bonds with a similar maturity to the holding period). Rp: the risk premium investors will demand for holding the risky real estate asset.

•

Constant Growth Model: Ye = Ro + g

Ro = the overall cap rate g = the expected growth rate (the weighted average of the NOI and the property value annual growth rate). •

Solve for the Subjects Property’s IRR: Ye can be determined by preparing a multi-period operating statement and then calculating the IRR when Ro, typical mortgage financing terms and the subjects NOI are known.

Calculating the Market Value (PV of the CFs) on Calculator Cfi for each amount; i = discount rate; NPV?

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Week 6: Property Financing The basic elements of the capital structure of a property can be divided into equity and debt. Typically a mix of these two components is used. Mortgage • Money advanced to buy/refinance property. • The offer of property as security becomes an interest in the land for the lender. • Consists of two documents: o The loan agreement: creates the debts and specifies loan terms and conditions. Sets out all particulars (amount, time, fees, interest rates). o The mortgage document: similar to loan agreement but includes the pledge of the property should the borrower default (not be able to make payments, the lender gets the property). Mortgage Structure 1. Interest only mortgage (aka flat, straight or term): payments comprise entirely of accrued interest (no principal during term of loan, entire principal is repaid when loan matures, normally used for investments with short holding periods 5-10yrs). PMTt = IPMTt = OLBt x it PMtt = total amount of loan pmt in period “t” IPMTt = interest owed in period “t” OLBt = Outstanding principle balance after period “t” pmt it = interest rate

No principal pmt occurs until end of last pmt period where a balloon pmt is made to fully discard the loan. Example Initial loan = $75,000. Fixed Interest rate of 7.75% Term: 5 years Monthly payments (12) Therefore, Interest payment = IPMT = OLBt x it = 75,000 x (0.0775/12) = $484.38 Advantages: • Low payments • Payments are tax deductible • PMTs are always the same Disadvantages: • Bib ‘balloon’ payment • Maximises total interest payments • Can have slightly higher interest rates than amortising loans

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2. Fully amortizing mortgages (aka constant payment mortgages): PMT is designed to pay off all interest currently owning AND retire the principle over the term of the loan. Regular payments will fully repay the loan by the end of the term. Each payment consists of the internet accrued since the last pmt + a portion of eh remaining principal balance. PMT is constant over term of loan but principle (PPMT) and interest (IMPT) components change over time. Longer loan terms (530yrs) Loan Schedule: Fully Amortizing Mortgage Over Time (Loan amount = $75,000; i = 7.75%; term = 30 yrs; monthly pmts)

Example: $180,000, 30-year, 8.5% fixed rate mortgage with mthly pmts – PMTt=1 = $1,384 (on calculator PV = -180,000; i = 8.5/12; n = 30x12; solve for PMT) – IPMTt=1 = $180,000(0.085/12) = $1,275 Balance of pmt is credited towards principal: – PPMTt=1 = $1,384 - $1,275 = $109 As a result, OLB is only $179,891 after 1st PMT i.e. at end t=1/beg t=2 – Opening OLBt=2 = $180,000 - $109 = $179,891 As part of the loan has been repaid, less interest accrues during period 2 – IPMTt=2 = $179,891(0.085/12) = $1,274 even more of the pmt is left over to pay down principal – PPMTt=2 = $1,384 - $1,274 = $110 – Opening OLBt=3 = $179,891 - $110 = $179,781 Advantages • Build equity faster • No balloon pmt • Longer loan term can reduce risk Disadvantages • Higher PMTs than interest only • Pmt not all tax deductible MORGAN_FESO_NOTES.doc

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Interests • Fixed: common rate to be use throughout the period of the loan. • Variable: variable rate based on lenders standard variable rate, in Aus this rate is based on the official cash rate (set by the RBA to implement monetary policy). • Capped variable & Hybrid products: portion of loan is subject to a fixed rate with the reminder secured under a viable rate. Mortgage PMTs: Fully–Amortizing Loans You want to borrow $100,000. A lender agrees to loan you the money at a rate of 10% pa, compounded annually over a 20 year period. What annual PMT (the annuity) is necessary to amortize (pay off) the loan? Calculating Loan Affordability You can afford to pay $500 per month on a 30 year mortgage at an interest rate of 10%pa, compounded monthly. What is the maximum amount you can borrow? FV=0 n = 30x12 = 360 i = 10/12=0.8333 COMP PV = ? = 56975 If you can borrow up to 80% of the value of your house, what is the most expensive house you can afford to purchase? = $56,975 x 0.8 = $71,218 Calculating OLB (Outstanding Loan Balance) What is the remaining balance on a $100,000, 10%pa, 30 year, mthly-pmt, loan after 5yrs? (ie after 60 payments) Then n=30*12=360 n=60 i=10/12-0.833 i=10/12=0.833 PV = 100000 PMT=-877 COMP PMT=?=-877 FV=?=96,574 Determining IMPT and PPMt Components of PMT (and OLB) Pv=100000, n = 30, i=10%, m = 12, break out the principal and interest components of the payments in year 5 (months 49-60) Solve for PMT N=30x12=360 I=10/12=0.833 PV = 100000 PMT=?=-877 Then enter the key strokes: 49 P1P2, 60 P1P2, ACC The calculator will display -827.90 for the principal ACC again 9,702 = interest To calculate the remaining balance (don’t clear the calculator) press 60 AMRT = -$72.18 = principal (only for month 60), press AMRT again -805 for interest (only for month 60), press AMRT again to give $96,574.32 for outstanding balance at month 60. * You can change the period by pressing the period then AMRT.

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Leverage: •

The use of borrowed money

•

The greater the ratio of borrowed money to equity, the greater the degree of financial leverage.

•

Using borrowed funds may amplify the outcome of an investment, but also cerates more risk. The more debt the more risk.

Why use financial leverage when it creates risk? •

To buy more expensive property more separate properties (can reduce overall risk)

•

Leverage can increase returns to equity. The more leverage the higher the potential returns.

•

Leverage favorable when the difference between rate of return and cost of borrowing is favorable, but not when cost of borrowing exceeds rate of return.

•

As long as debt service constant (the annual debt as a % of amount borrowed) is less than the rte of return, then additional leverage the better the equity CF.

•

Tax regimes offers and incentive to use leverage (Interest expenses are deductible).

•

Borrowing allows investors to invest in more and therefore provide a potential for greater capital gains. UDB246 Property Feasibility Studies

An Example of the Impact of leverage Property cost = $1 mil, net income = $100,000, LTV ratio = 80%, mortgage at 8% p.a. The return on 3 different equity situations is illustrated below:

* CF to equity = the cash the equity investor (the owner) receives after paying the mortgage. * Return on Equity (ROE) = cash flow to equity/equity e.g. 36,000/200,000 = 18%

UDB246 Property Feasibility Studies

An Example of the Impact of leverage However, an interest rate of 18% the return on the 3 equity situations

In contrast to the first example, here, in order for the investor to maximise the % return on the equity invested it pays to maximise the cash put into the property (the equity in the investment) & minimise the amount of borrowed money.

How the use of leverage is measured? •

Ratio between borrowed funds and market value of asset. (LTV ratio).

•

LTV = Mortgage balance/Property Value. The higher the ratio the greater the leverage.

•

Leverage increases risk.

•

The degree to which NOI covers debt services is the debt coverage ratio (ratio between NOI & the debt service obligation (DCR = NOI/Debt Service (PMT)

How much financial leverage is enough? •

Determined by NOI

•

Max amount of a loan in terms of a minimum permissible debt coverage ratio.

•

NOI/the minimum acceptable DCR yields the maximum amount of annual debt service a property will support.

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Week 7 & 8: Property Taxation The Investment Property Taxation Cycle

P o te n tia l G ro s s In c o m e

V acancy + bad debts

E ffe c t iv e G r o s s In c o m e

E x p e n d itu re s

N e t o p e ra tin g In c o m e

PMT

B e fo r e t a x c a s h flo w

Taxes on o p e ra tio n

In t e r e s t o n d e b t

D e p re c ia to n

Taxes on o p e r a t io n

A fte r T a x C a s h F lo w

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Taxed by Whom? When? On What? •

Income taxed at 3 levels: Federal, State and Local

•

Taxes can be levied: annually (income, gst, land) or on transactions (stamp duty)

•

And be applied to: Value (land tax, rates, capital gain) and activity level (income).

The 3 Tiers of Property Taxation 1. Federal (ATO) Government Taxation: taxation of operating income, disposal and GST. 2. State Government: transfer duties, land taxation 3. Local Government Taxation: council rates, water rates. Taxes/Duty on Purchase: Duty: a general revenue tax imposed on various documents (eg. Transfers, agreements to sell, mortgages). Administered under the Duties Act 2001 and Taxation Administration Act 2001 (TAA). In Qld there are different rates for ‘stamping’ – investment v PPOR. •

Transfer Duty on Conveyances: Conveyance = transfer of real property by any means (sale, gift etc). Tax usually based on amount or value of consideration. Discount rates are available ro first home owners and residential and non residential properties.

•

Duty on Mortgages: 40c for each $100. Mortgage duty is to be reduced by 50% in 2008 and abolished in 2009.

•

Settlement Fees: Not a tax by a charge to be “added-in” so as to cost purchase on all inclusive basis. Solicitors & Selling Agents.

•

Lenders Mortgages Insurance: Not a tax by another change. Protects lender in borrower defaults and OLB is > proceeds from sale. If LTV is > 80% lender will usually require this insurance. Usually charged as a one off premium.

Total Purchase Cost Net equity calculation: Purchase price + Purchase costs = Gross Purchase Price – Debt Funding = Net Equity Net equity – initial equity contribution, initial cash outlay. After Tax Cash Flow at Disposal Gross Disposal Price less Selling Expenses = Net Disposal Price

$120,000 $4,800 $115,200

less Outstanding Debt Balance

$70,000

= Before Tax Net Disposition Value

$45,200

less Taxes on Disposal? = After Tax Net Reversionary (disposal) Value

MORGAN_FESO_NOTES.doc

$4,289 $40,697

Page 28 of 40

Taxation on Operation •

Land Tax (State): Annual taxed based on assessed ‘unimproved value’ of land. PPOR exempt. Individuals taxed if unimproved value > $500,000 at 30 June. Groups > $300,000.

•

Rates (Local): Based on unimproved land value. Amount depends on local authority.

•

Income (Federal): All income must be declared. o Marginal rate: taxed on portion of income less deductions (taxable income)

•

Deductions: o Operating expenses (OPEX): normal periodic operating expenditure. o Financing Costs: interest payments on mortgage are tax deductible. o Depreciation: not based on purchase price or market value. Buildings (building allowance, capital works), 2.5% per year Plant & Equipment (depreciable assets): can it be removed from building? YES = P&E.

Calculating Depreciation 1. Diminishing value method o Annual depreciation rate = 150%/effective life of plant (before 10 May 06, 200% after) o Eg. Depreciation for yr1 = initial plant value x annual rate of depreciation o Depreciation for yr2 = written down value (WDV) of yr1 x annual rate of depreciation. o Depreciation for year n = WDV from previous year x annual rate of dep. 2. Straight line method o Annual depreciation rate = 1/effective life of plant (period of entity that represents its ability to produce income) o Eg. Carpet has an effetive life of 10yrs. Therfore the applicable depreciation rate is 1/10 = 0.10 Taxation on Operation (calculating the tax liability) NOI – Interest Payments – Loan Establishment Fee* – Depreciation = Taxable Income Taxes on Operation = Taxable income x Investors marginal rate. Eg. MTR = 40%. $632 x 0.4 = $253 * Loan Fee can be divided over course of loan in annual payment.

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Taxation on Disposal •

Capital Gains Tax: tax on the profit you make from the sale of investment assets.

•

3 methods: o Indexation adjusts the cost base for inflation, requires the indexation factor, pay tax on your real gain (inflation adjusted) not your nominal gain. Used to assets before 11.45am 21/09/99 o Discount method After 11.45am 21/09/99, held for at least 12 mths. 50% for individuals, 33.3% for funds on CG realized. o Other: assets held < 12mths. CG not discounted, its just the discount method without the discount applied.

•

Plant depreciation recapture: Where WDV (assessed value) > value when sold, you can make a balance adjustment you can write off the difference, but if you sell it for more the excess must be declared as income. o Net disposal value > Depreciated value o Added to taxable income in year of disposal. o Partial Recapture: Where TV is < Net acquisition cost ($ can be offset) o Full Recapture: Where TV > Net acquisition cost o Depreciation Recapture: Where TV < WDV ($ can be deducted from income)

UDB246 Property Feasibility Studies

Capital Gains Tax: Discount Method (Example) After Tax Cash Flow at Disposal

Gross Disposal Price

less Selling Expenses

= Net Disposal Price

$4,800

$115,200

less Outstanding Debt Balance

$70,000

= Before Tax Net Disposition Value

$45,200

less Taxes on Disposal?

= After Tax Net Reversionary (disposal) Value

MORGAN_FESO_NOTES.doc

$120,000

$4,289

$40,697

Page 30 of 40

UDB246 Property Feasibility Studies

Capital Gains Tax: Discount Method (Example) 1. How much have we or are we likely to earn? •Anticipated sale price in year 5 = $120,000. •Selling expenses are estimated at 4% •The estimated disposal value of the depreciable assets = $2,350. Tax Due on Disposal Calculated under the Discount Method 1. Total Gross Disposal Price (estimated sale price)

Net Disposal Price

$120,000

2. Selling Expenses Incurred at Disposal ($120,000 x 0.04)

$4,800

3. Estimated Disposal Value of Depreciable Assets

$2,350

4. Transaction Cost (on depreciable assets = $2,350 x 0.04)

$94

5. Net Disposition Value of Depreciable Assets

$2,256

Net Disposal Price (land and building)

$112,944

Calculated as: Estimated sales price (1) less Selling expenses (2) less Net disposal value depreciable assets (5 = 3 – 4)

Reflects net proceeds from sale i.e. what you’d expect to receive having paid all expenses associated with selling the property. Note: we’re only interested in the proceeds associated with the land & building elements of the property so we also deduct the estimated net value of the depreciable assets.

UDB246 Property Feasibility Studies

Capital Gains Tax: Discount Method (Example) whatt we 2. How much did we or are we likely to have to spend to earn wha expect to earn? •Original cost base (land & building, excludes depreciable assets) = $93,000 •Building allowance claimed over holding period = $8,500 •Acquisition costs = $4,500 •Capital expenditure = $2,500 1. Original Asset Base/Cost Base (building and land)

$93,000

2. less: Building Depreciation Allowance

$8,500 $4,500

3. plus: Acquisition Costs

$2,500

4. plus: Capital Expenditure 5. = Reduced Asset Base (cost base)

$91,500

Reflects the overall cost base the ATO will permit you to use when determining your capital gain. This figure is compared against the capital proceeds from (or expected from) the sale of the property – with the difference representing your capital gain.

UDB246 Property Feasibility Studies

Capital Gains Tax: Discount Method (Example) 3. What is your capital gains tax liability? Tax Due on Disposal: Discount Method Gross Disposition Price (estimated sale price)

$4,800

Estimated Disposal Value of Depreciable Assets

$2,350

Transaction Cost (depreciable assets)

$94

Net Disposition of Depreciable Assets

$2,256

1. Net Disposal Price (building and land) Original Asset Base/Cost Base (building and land)

$112,944 $93,000

less: Building Allowance

$8,500

plus: Acquisition Costs

$4,500

plus: Capital Expenditure 2. Reduced Asset Base (cost base)

$2,500 $91,500

3. Capital Gain (= 1 – 2)

$21,444

4. Taxable Capital Gain (= 50% of gain for individual investors ∴ = 3 ($21,444) ÷ 0.50)

$10,722

5. Balancing Adjustment (plant depreciation recapture) 6. Marginal Tax Rate 7. Capital Gains Taxation on Disposal (= 4 x 6)

MORGAN_FESO_NOTES.doc

$120,000

Selling Expenses Incurred at Disposition

$0 40% $4,289

Page 31 of 40

Lecture 9 – Static Return Measures & Analysis Traditional Static Measures •

Involves use of ratios/multipliers for comparing “i” (income) with “v” (value) and for evaluating profitability, operations and financial risk.

•

Don’t account for TVM! o This is bad as the timing of cash flow inflows and outflows is a major element in the comparative desirability of investment alternatives.

•

Strengths: isolates investment specific factors to asset attractiveness of investments.

Income/Cash Flow Multipliers & Ratios •

Explore relationship between “i” and “v” or equity.

•

All forms assess relationship between price or equity and some measure (eg. Gross or net income).

•

None service as a complete tool of analysis but play a role as preliminary filters.

•

Gross Income Multiplier: relationship between price and EGI. GIM = V/EGI o Eg. The GIM for a property that is expected to cost 500k and produce EGI or 140k during the firs year of operation is = 500k/140k = 3.6 o # of years required to recover purchase price eg. A GIM of 3.6 implies it takes 3.6 years of gross income to recover the 500k cost of property. o Can be used to get a rough value estimate if GIM is known. GIM x EGI = Value. V = 140,000 x 3.6 = 500,000

•

Gross Rate of Return: reciprocal of GIM. = EGI/V. o GRR = 140k/500k = 0.28 or 28% = a GIM of 3.6 implies a 28% of gross return on the total value of the investment. (Note: haven’t adjusted for OPEX and taxes yet!)

•

Net Income Multiplier: Like GIM but uses NOI instead of EGI (which offers a better operational picture by using an after-expenses measure of income). o NIM = NOI/V. NIM o NOI takes a long time to develop so GUM used to develop an initial ‘ballpark’ figure. o NIM=500k/50,000 = 10 o The lower the NIM, the better the investment.

•

The Capitalisation Rate: reciprocal of NIM. Aka Net Rate of Return o Expresses the 1st years NOI as a % of the value of the investment. o Reveals in the relationship between income and value (i and v). o Cap rate (r) = NOI/V o Eg. V = 500,000. NOI = 55,000. R = 55000/500000 = 0.11 (11%) o To determine value = NOI/r

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â€˘

Before-Tax Equity Return: express BTCF as a % of initial equity outlay (purchase price less borrowed funds) provides a measure of the return on cash invested. Calculated on an after-debt basis. o BTER = BTCF / Eo o E.g Debt Servicing = $4358, NOI = $6,000, Eo = $10,000 o BTER = (6000-4358)/10,000 = 16.4%

â€˘

Operating and Financial Ratio Analysis: applied to assess income generating potential relative to operating and financial expenses. o Used to compare alternative property investment opportunities. o Operating Expense Ratio (OER): Gives the % of EGI consumed by OPEX OER = OPEX / EGI o Break-even Ratio (BER) Reflects relationship between cash inflows and outflows Gives as a %, the minimum occupancy rates for which expenses are covered by EGI. BER = (OPEX + PMT) / EGI o BER and Profit Margin Ratio Given EGI of 25,000, OPEX of 13,000 and annual debt servicing commitments of $7,533, The BER is: BER = (13000 + 7533)/25000 = 82%. Therefore the minimum occupancy rate for which expenses are covered is 82% o Running Yield: Measures the speed at which net income is expected to grow or decline. RY = NOI / Purchase Price If RY increases over holding period = return relies heavily on rental growth If RY decreases it indicates the property should be sold or refurbished. o Debt Coverage Ratio (DCR): measures ability to pay mortgage and shows extent to which NOI can decrease before it wont cover debt provides indication of safety/risk associated with using debt. DCR = NOI / PMT Eg. NOI = 12000, PMT = 7533. DCR = 12000/7553 = 1.59 Therefore a property with a DCR of 1.59 generates 1.59 times as much NOI as is required to cover annual debt servicing obligations. A DCR < 1 means NOI does not cover debt and OPEX (0.9=negative income = can only service 90% of debt). o Loan to Value Ratio (LTV): measures relationship between borrowed funds and price of the asset being financed. LTV = Debt/Value (LTv=D/V) LTC is a dynamic rate that will decrease as the loan is amortized.

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Conclusions •

Static Measures fail to appropriately consider TVM

•

Tend to concentrate on only the year 1 CFs

•

Fail to account for CF at disposal. Therefore dynamic measures incorporating multi-period and time adjusted models need to be used.

Lecture 10 – Dynamic Return Measures & Analysis There are two commonly used dynamic measures of return: 1. Net Present Value (NPV) 2. Internal Rate of Return (IRR) Present Value (PV): the value today of benefits that are expected to accrue in the future. An investment proposal is expected to generate $15,000 of after-tax cash flow each year for eight years and $40,000 of after-teas cash flow from disposal at the end of the eighth year. The required equity cash outlay to acquire the asset is $90,000 (equity expenditure). The minimum acceptable rate of return is 10%.

PV less: Initial investment Net Present Value

$98,686 $90,000 $8,686

Year 1 2 3 4 5 6 7 8

Expected CF PV Factor PV @10% $15,000 0.9091 $13,636 $15,000 0.8264 $12,397 $15,000 0.7513 $11,270 $15,000 0.6830 $10,245 $15,000 0.6209 $9,314 $15,000 0.5645 $8,467 $15,000 0.5132 $7,697 $55,000 0.4665 $25,658 Total $98,684

•

A positive NPV = will yield a rate of return in excess of the discount rate and therefore merits further consideration

•

A negative NPV = expected to yield a rate of return less than the minimum acceptable rates of return and therefore should be rejected.

Profitability Index (PI): used when investment budget is limited. Accept if PI > 1 Internal Rate of Return: •

The discount rate that equates all the properties cash flows to the our flows.

•

Where NPV = 0

•

Measures the yield of the investment.

•

IRR can be estimate thru a series of approximation (when not using a calculator).

•

If IRR > 1 Invest!

•

Shortfalls: o Multiple IRSS when CFs switch signs o Difficult to compute and interpret ….still a single rate of return estimate is attractive.

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Modified IRR (terminal IRR): resolves the earlier problems by equating the annual cash flows with the original equity. •

MIRR is the interest rate that solve the equation where Io is the initial investment and Tn is the terminal value.

•

If MIRR . i invest!

NPV and IRR Conflict NPV is held to be superior and should be adopted. 1. NPV and IRR may give conflicting decisions where projects differ in their scale of investment. 2. Differences in the timing of the cash flows 3. Difference in the timing of the cash flows resulting from differing investment horizons Other Investment Decision Making Tools •

Annuity: NPV x Annuity Factor. If Annuity > 0 Invest! o

•

•

Calculate the PV of Annuity (PMT = $1) E.g. PMT = 1, i = 12, n = 6 Comp PV = 4.1114

Payback Period (PP): How many years it takes to get return of capital. o Consider sum of CF’s o If PP < Benchmark Invest! Discounted Payback Period (DPP): How many years it takes to get return of and return on capital o If DDP < economic life Invest! Payback Period

Year 1 2 3 4 5 6 7 8

▼ Expected CF Sum of CF PV Factor $15,000 $15,000 0.9091 $15,000 $30,000 0.8264 $15,000 $45,000 0.7513 $15,000 $60,000 0.6830 $15,000 $75,000 0.6209 $15,000 $90,000 0.5645 $15,000 $105,000 0.5132 $55,000 $160,000 0.4665 Total

Discounted Payback Period ▼ PV @10% Sum (PV of CF) $13,636 $13,636 $12,397 $26,033 $11,270 $37,303 $10,245 $47,548 $9,314 $56,862 $8,467 $65,329 $7,697 $73,026 $25,658 $98,684 $98,684

Using PP and DPP, a $90,000 equity cash outlay to acquire the asset is recoverable in 6 and 7 years respectively.

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Lecture 11 & 12: Risk Analysis Risk: the chance or probability that the investor will not received the expected required rate of return on the investment or the chance of something planned varying. Property Risk Assessment Process 1. Valuation of a property: used as a reference point and the markets view of the transaction price that can be expected. 2. Qualitative analysis: framework for ranking competing investments using a number of categories. PEST or SWOT analysis are used. 3. Quantitative analysis: a DCF can be undertaken to produce the expected or best estimate of the IRR and NPV. 4. Risk analysis of the property: sensitivity and scenario analysis; probability weighted scenarios, simulation techniques such as Monte Carlo 5. Conclusion Sources of Risk •

Market Risk – chance the entire market falls in value.

•

Business Risk – degree of uncertainty with an investments earnings and ability to pay investors.

•

Financial Risk – debt and equity financing – the higher the debt the higher the risk and vice versa,

•

Interest rate Risk – the chance that the banks interest rates will change. Higher rates = lower returns on stocks and bonds, but higher returns on interest paying investments.

•

Inflation Risk – chance the PV falling because their income is fixed.

•

Credit Risk – chance a company selling bonds is unable to make debt payments business goes out of business without paying investors.

•

Liquidity Risk – chance an investment cannot be sold easily because of lack of buyers may be forced to sell at a lower price

•

Currency Risk – risk that an investment in foreign currency will fall due to the exchange rate falling.

Investment Property Risk 1. Market transparency risk: mispricing occurs due to low volume of comparable transactions. 2. Investment quality risk: rental growth, lease length, rent review, location, market factors. 3. Covenant strength risk: impact thru credit quality of income, the weighted average lease expiry profile (WALE) and tenancy concentration. 4. Depreciation and obsolescence risk: eased by the inclusion of maintenance and capital expenditure reserves (eg. Sinking funds).

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Risk Management and Control 1. Avoiding or eliminating risk a. Playing the real estate cycle: when the market is in recession, avoid investment, instead wait until the bottom of the cycle has ended. b. Avoiding market-indexed loans: reduces inflationary effects on mortgage interest rats. 2. Transferring or shifting risk a. Insurance: fire, rent loss, liability. b. Limited partnership form of ownership c. Long term leases with escalation clauses – shift vacancy risk to tenant and lessens inflation and expenses uncertainties. 3. Reducing the remaining risks 1. Loan amount and terms – reducing loan amount and improving terms reduces internal financial risk. 2. Purchase price – better terms lowers equity investment exposure and increases the expected rate of return. This reduces dynamic business risk. 3. Diversification – spreading risk thru diversification with respect to size, type and location. This reduces static business risk. 4. Good accounting controls and reporting system – quick identification and remedial action reduces expenses. 5. Better financial feasibility research 6. Superior location – attracts good tenants who pay top rents. Risk Analysis Approaches : Qualitative (before Quantitative) 1. PEST analysis: considers property within the following: a. Political: impact on performance drivers (gdp, employment) b. Economic: state of economy c. Social: social support; importer or exporter of labour. d. Technological: competitive of high tech business. 2. SWOT analysis: considers the property in more focused context a. Strengths b. Weaknesses c. Opportunities d. Threats Risk Analysis Approaches: Quantitative 1. Focuses on the future expected cash flows that an investment will produce. 2. DCFs and its key variables are at the heart of Quantitative analysis.

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Levels of Quantitative Risk Analysis 1. Basic Feasibility Model: using a 1-year cash model, investors uses the Debt Coverage Ratio (DCR). Low DCR indicates high risk. No different rate-of-return outcomes are looked at. 2. DCF Most Likely Outcome: using annual data the DCRs, trends in these ratios over time give more information about the risk involved. a. IRRtc (on total capital) and IRRe (on equity) can be used. If IRRe > IRRtc then a favorable leverage situation is achieved. 3. Sensitivity Analysis: test the impact of uncertainties on the investment decision by varying the values of the input variables in the basic financial feasibility and DCF modes to show how they affect the property value, the ROE, the IRR, the DCR. 4. Monte Carl Simulation: tests the impact of uncertainties on the investment decision taking into account the probability that different returns will actually occur. Measurement of Risk •

Standard deviation or variance is the conventional measure of risk.

•

It is a statistic used to measure the absolute dispersion (spread) of returns around an asset’s average expected return (mean). The greater the spread, the greater the risk and vice versa. Measuring Risk – 1 Asset (1) Percent Rate of Return

(2) Deviation from Mean

(3) Squared Deviation

+40 +10 +10 -20

+30 0 0 -30

900 0 0 900

Variance = average of squared deviations = 1800/4 = 450 Standard deviation =square of root variance = = 21.2%

450

Coefficient of Variation gives ration of risk to expected return. • • •

CV = standard deviation / mean

CV is useful if you need to compare the risk of similar investments. Example of Use of Coefficient of Variation The historical performance of three Brisbane office buildings is shown below. Rate these properties on a risk/return basis. PROPERTY A

PAST 5 Yr ANNUAL RETURNS % 8.6, 10.0, 9.8, 13.0, 7.0

B

14.0, 11.4, 6.7, 5.8, 11.0

C

8.0, 8.5, 8.7, 9.4, 11.4

Hint: Calculate the Coefficient of Variation for each property

Property A B C

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Y1 8.6 14.0 8.0

Y2 10.0 11.4 8.5

Y3 9.8 6.7 8.7

Y4 13.0 5.8 9.4

Y5 7.0 11.0 11.4

STD 2.21 3.44 1.33

Mean 9.7 9.8 9.2

CV 0.23 0.35 0.14

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Property Distributions •

Can’t simply forecast a single figure of cash flows – must involve an opinion on the probable distribution of key variables: rtes, rents, prices etc.

•

On the basis of probabilities distributions, expected values can be derived by multiplying the anticipated monthly rents by the probability each investor assigned. Market Situation Anticipated Monthly Rent

Probabilities and Expected Values: 3 Investors

Probability Strong Average Slow

$1,200 $1,000 $800

0.33 0.33 0.33

Expected Values of Monthly Rents

Investor A Investor B Expected Probability Expected Probability Values Values $396 0.70 $840 0.10 $330 0.20 $200 0.30 $264 0.10 $80 0.60 $990

$1,120

Investor C Expected Values $120 $300 $480 $900

Sensitivity Analysis: tests the impacts of uncertainties on the investment decision. Performed by varying the values of the input variables. Can be done at 3 levels: 1. Single variable analysis: altering each variable by a fixed proportion (say 10%)., whilst holding all other variables constant, and testing its impact. 2. Break-even analysis: identifies the level of break even for investment for each variable to indicate the level of change necessary to erode profit completely. In excel – the goal seek function. 3. Two variable analysis: a matrix of outcomes by combining two risky variables together at differing values. Scenarios •

Extension to sensitivity analysis

•

Involve undertaking a number of different DCF analyses, each based on different assumptions, an then calculating the outputs (IRR and NPV).

•

Changes to each variable: High Realistic Low

•

Probabilities are attached to the outcomes, resulting in probability adjusted or expected return (IRR, NPV).

Simulations •

Tests permutations (variations) and combinations of change for the variables.

•

Run a series of DCFs which one drawing on new figures for each variables in accordance with pre-set probability distributions.

•

The probability distributions are estimated for each uncertain variable in a cash flow model and then resulting values are used to determine the range of possible outcomes.

•

2 main types are Monte Carlo and Latin Hypercube

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Results = Assumptions (eg. Discount rate and cap rate) shows their means and standard deviation their probability distributions.

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Exam Notes 4. 20 Multi Choice 20% 5. 5 Short Answers 40% 6. 5 Calculations 40% •

DCF Calculations (format with blanks)

•

Know Formulas

•

Bring Calculators

•

After Tax Cash Flow

•

Stabilize Net Income

•

Leverage

•

Taxation Life cycle

•

Risk Assessment

•

TV Calculations – know how to do it on calculator, don’t need to know the formulas.

•

Cash flows – don’t need to know the formulas – Multi Choice Qs

•

Taxation: Acquisition, Operation, Disposal – Multi Choice Qs

•

Operating Tree – Important

•

Calculate Depreciation – Multi Choice Qs

•

Static Return – Multi Choice & Short Answer

•

Dynamic Return – Multi Choice & Short Answer & Calculations

• Always go with NPV if conflict with IRR Risk Analysis •

Sources of Risk: look in detail Short Answer

•

Qual v Quan Short Answer

•

Not in Calculations Section but in Multi and Short Answer Sections

• Report, Ration, SWOT, Sensitivity Investment Calculations Questions

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