Teaching Real Estate Financial Analysis

Teaching Real Estate Financial Analysis Dr. James P. Gaines Research Economist Real Estate Center Texas A&M University jpgaines@tamu.edu Educators Conference Texas A&M University January 2006 ABCD Session Outline 1. Overview and Session Goals 2. 3. 4. 5. 6. Investment Decision Making Process Developing Investment Analysis Strategy Basic Financial Analysis Discounted Cash Flow Analysis Risk Analysis Slide 2 1. Overview and Session Goals 1. Focus on decision making and analysis rather than modeling or calculations 2. Understand relationships 3. Examples with insights of what to look for and how to interpret financial analyses prepared by others 4. Art or Science? Slide 3 2. Ten-Step Basic Investment Decision- Making Process 1. Determine Investment Strategy 10. Terminate the Property 2. Generate Alternatives DROP 9. Manage the Property 3. Analyze Property Using Basic Financial Feasibility Model DROP 8. Final Negotiations and Closing DROP 4. Negotiate Basic Terms With Seller DROP 7. Discounted Cash Flow Analysis DROP 5. Do Detailed Feasibility Research DROP 6. Structure the Tax Benefits DROP Slide 4 Source: Stephen A. Phyrr and James R. Cooper, Real Estate Investment, John Wiley & Sons,1982 Developing an Investment Analysis Strategy – Philosophy 1. Prioritize Purpose: cash flow, capital gains, tax 2. 3. effects Define type of property sought: apartments, retail, office, etc. Property managed on a business-like basis: • investment and operating decisions are based on return-on-investment and other cost-benefit criteria; • self manage or outsource management; • portfolio effects, if applicable Pricing based on investment requirements, market economics and utility of property Risk tolerance: high-risk; low-risk Slide 5 4. 5. Developing an Investment Analysis Strategy – Investment Principles 1. Price the assumptions that create the yield, not the yield itself 2. Be concerned about the next buyer and the residual value of the property – have an exit strategy 3. Price property based on economics, not on extraneous factors (tax considerations, pride of ownership) 4. Always compare alternatives – there are typically substitutes and other properties 5. Understand, evaluate and quantify risks and rewards Slide 6 Developing an Investment Analysis Strategy – Investment Objectives 1. Maximized revenues – minimized costs = optimized net return 2. Optimize financial leverage effects: type, amount, cost 3. Holding: long-term vs. short-term investment outlook 4. Before tax vs. After tax returns 5. Meeting competition 6. Portfolio effects: optimize total return or reduce total risk 7. Exit strategy, pricing Slide 7 Developing an Investment Analysis Strategy – General Financial Criteria: Office Example 1. Rate of Return Criteria: – A cash-on-cash return of 6%. – Appreciation of the property of at least 6% - 8% annually. – An IRR of at least 20%. 2. Risk Criteria: – An IRR with no more than a 10% standard deviation. – A break even point no greater than 85%. – A debt coverage ratio of at least 1.20 – Leverage of at least 65%. – A strong rental occupancy history 3. Both Risk and Return Criteria – A gross rent multiplier of no greater than 6.0. – A maximum price of no more than $180 per square foot for office space. – Rent not more than 110% of the average rent in the market area. Slide 8 Developing an Investment Analysis Strategy – General Non-Financial Criteria: Office Example 1. Structurally sound building 2. Aesthetically pleasing (acceptable) design 3. No special use buildings; general use, multi-tenant properties only 4. Leases no shorter than five years 5. No flat roofs or gas air conditioners 6. Amount of space needed based on 185 square feet per person 7. No property that has had asbestos abatement 8. Must be able to obtain clear, unclouded title 9. No property in a 100-year flood zone 10. Property must have minimum of 1.5 parking spaces per 1,000 square feet. Slide 9 4. Basic Financial Analysis - Introduction The basic financial model is used to test the basic economics of a project, the input data derived from the market analysis and the investment value range for the property based on a one-year or “stabilized” income flow. Although overly simple and with significant limitations, the basic model provides excellent early screen for decision making with a relatively small investment. The principles involved in the basic model are the same as for the more extensive discounted cash flow model. The basic model does not include any appreciation, inflation, equity build-up through loan repayment or tax effects. Slide 10 Basic Financial Model – Terms and Formulas Basic Income Capitalization Formula: Value = Income / Overall Capitalization Rate V=I/R Or R = I / V; Or I = R * V I is the Net Operating Income (Gross Income – vacancy – “normal” operating expenses) R is the Overall Cap Rate (the market relationship between income and value) V is the Value of the asset (the price that can be paid to earn R, given I) Slide 11 Session One: Basic Financial Model – Basic Ratios and Formulas: Example If a property produces $120,000 per year in net operating income, and the market indicates a 10% overall capitalization rate, then the value of the property is $1,200,000, as follows: V = I / R = $120,000 / .10 = $1,200,000 Similarly: V = I (1/R) = $120,000 x (1/.10) = $120,000 x 10 = $1,200,000 Slide 12 Session One: Basic Financial Model – Basic Ratios and Formulas Financing Ratios: Debt Service Coverage Ratio (DCR) = NOI/ DS; DS = NOI / DCR NOI = $120,000; DS = $100,000; DCR = $120,000/$100,000 1.20 or 120% Mortgage Constant (K) = DS / Mortgage Amount Mortgage $1,000,000; DS = $96,554.71; K = .09655471 at 9%, 30 yrs Rearranging, Mortgage Amount (Vm) = DS / K Total Value Components Income Components return; Rm = K VT = Ve + Vm where Ve = equity; Vm = Debt NOI = Ie + Im where Ie = equity income; Im = DS RO = Re + Rm where Re = equity Overall Capitalization Rate Components Gross Income Multiplier: Value = Gross Income x Gross Income Multiplier Slide 13 Basic Financial Model – Basic Tenets More income is preferable to less income Less expense is preferable to more expense Income sooner is preferable to income later Expense later is preferable to expense sooner Direct relationship between income and return, holding investment constant, i.e., the higher the required return, the higher the required income Indirect relationship between return and value, holding income constant, i.e., the higher the required return, the lower the value Slide 14 Basic Financial Model Gross Possible Income (GPI) [leaseable space x income per unit] Less Vacancy and Rent Loss [stabilized vacancy + nonpaid rents] Effective (Actual) Gross Income (EGI) Less Operating Expenses Net Operating Income (NOI) Less Annual Debt Service (DS) Cash Flow (CF) [Normal, recurring operating costs] [FFO] [Im] [If no financing, CF=NOI=Ie] Valuem = Annual Debt Service / Mortgage Constant (K) Valuee = CF / Re ; ValueT = Valuem + Valuee Slide 15 Basic Financial Model - Example Considering acquiring a 100,000 square foot office building. Assume we want to earn a 12% equity rate of return (Re), how much should we be willing to pay to acquire the property? • Indicated rent is $25 per square foot (all inclusive) • Vacancy and rent losses are estimated at 5% of potential gross income per year • Operating expenses are estimated at 45% of potential gross income per year • Debt Service based on minimum 1.3 debt service coverage ratio (DCR) and financing is available at 7%, 20 years Slide 16 Basic Financial Model - Example Gross Potential Income Vacancy Actual Gross Income Operating Expenses Net Operting Income Maximum Debt Service Cash Flow Mortgage Interest Rate Term of Borrowing Mortgage Constant (K) Maximum Amount of Debt (Vm) Required/Desired Rate of Return Value of Equity (Ve) Maximum offering price (value) (rounded) $2,500,000 100,000 sf $25 per sf $125,000 5% of GPI $2,375,000 $1,125,000 45% of GPI $1,250,000 $961,538 1.3 DCR $288,462 7% 20 0.093036 $10,335,137 12% $2,403,846 [CFBT/RoR] ($288,462/.12) (DS/K) ($961,538 / 0.093036) $12,738,983 Value of Equity + Debt $12,740,000 Slide 17 Basic Financial Model – Limitations Basic Model Does Not include or consider: 1. 2. 3. 4. 5. 6. 7. 8. Inflation or changes in market conditions over time as they affect rents, expenses, values or desired/expected returns Equity build-up through loan amortization Expected holding period of property and appreciation/depreciation Tax effects Start-up and transaction costs Time value of money [Income capitalization into perpetuity] Innovative debt financing: variable rate; interest only Distorted NOI and business and market risks of uneven NOI over time Slide 18 Basic Financial Model – Distorted NOI Several considerations often not included in estimating NOI (especially with existing properties): 1. 2. 3. 4. 5. 6. 7. 8. 9. Lower income during lease up period Deferred maintenance Substantial capital expenditures needed Short-lived replacement reserves for equipment Capitalization of certain expenses No allowance for vacancies when 100% occupied Special lease concessions and bona fide tenants Pass-through expenses and expense stops Management expenses by owner Slide 19 5. Discounted Cash Flow Analysis Introduction (1) Investment Outlays 1. Land cost 2. Building cost INPUT ASSUMPTIONS (2) (3) (4) Operations 1. Rental income 2. Vacancy 3. Operating costs 4. Changes over time 5. Tenant Turnover Financing 1. Amount of Equity 2. Amount of Debt 3. Amortization period 4. Interest rate 5. Required IRR Reversion 1. Holding period 2. Selling price of property 3. Debt retirement 4. Selling expenses (5) Taxation 1. Expenses 2. Capital outlays 3. Depreciation method 4. Useful life Annual Cash Flows During Holding Period DISCOUNTED CASH FLOW ANALYSIS Rate of Return Information 1. IRR/PV measures 2. Profitability ratios Reversion Cash Flow At End of Holding Period Assumption Base Information 1. Capitalization rate ratios 2. Price/rent ratios 3. Expense ratios Risk Information 1. Leverage ratios 2. Coverage/breakeven ratios 3. Sensitivity Analysis 4. Simulations Slide 20 Discounted Cash Flow Analysis - Introduction Extension of Basic Financial Model on an annual basis Time value of money: present value vs. future value Inflation (purchasing power) Risk (certainty of receipt) Include many of the items omitted in basic model: – Variable annual income: inflation, tenant turnover, market conditions, changes in expenses, transaction costs, refinancing – Multi-tenants, multi-uses for same property – Potential gain on sale after specific holding period (residual value) – Tax Effects annual depreciation and capital gains upon sale Slide 21 (1+i)n Discounted Cash Flow Analysis - Basic Present Value Concept and Math Invest $10 that earns 8% interest per year, what will it be worth in 3 years? or What is the Future Value of $10 at 8% for three years? End of Year 1 = $10 x (1+.08) = $10.80 End of Year 2 = $10 x (1+.08) x (1+.08) = $11.66 End of Year 3 = $10 x (1+.08) x (1+.08) x (1+.08) = $12.60 Summarize as: $10 x (1+.08)3 = $10 x 1.25971 = $12.5971 = $12.60 Slide 22 Discounted Cash Flow Analysis - Basic Present Value Concept and Math Similarly: Present Value of $12.60 three years from now at 8% is $10 $12.60 / (1+.08)3 = $12.60 / 1.25971 = $10.00 or $12.60 x 1/(1+.08)3 = $12.60 x 1/1.25971 = $12.60 x .79383 = $10.00 Slide 23 Discounted Cash Flow Analysis - Basic Present Value Concept and Math: Example What is the PV of the following opportunity? How much should you be willing to pay today to receive these cash flows in the future in order to earn a 12% rate of return? End of Year 1 2 3 Cash Flow $10,000 11,000 15,000 $36,000 Slide 24 Discounted Cash Flow Analysis - Basic Present Value Concept and Math: Example What is the PV of the cash flows in the example? How much should you be willing to pay today to receive these cash flows in the future in order to earn a 12% rate of return? Year 1 2 3 Cash Flow x PV Factor at 12% = Present Value $10,000 0.892857 $8,928.57 11,000 0.7971 8,769.13 15,000 0.71178 10,676.70 $36,000 $28,374.40 $28,374.40 is the maximum price you should pay to earn 12%. If you pay more, you will earn less than 12%; if you pay less you will earn more than 12%. Slide 25 Discounted Cash Flow Analysis - Formula PV = [CF1/ (1+IRR)1] + [CF2/ (1+IRR)2] + [CF3/ (1+IRR)3] + …+ [CFn/ (1+IRR)n] + [Net Proceeds from Salen / (1+IRR)n] PV = the Present Value of the income flow CF = Cash Flow in each year n IRR = required/desired Internal Rate of Return on the investment n = number of years the investment will be held and then sold Slide 26 Discounted Cash Flow Analysis – Standard Ratios for Decision Making Net Present Value (NPV) = PV of cash flows - Original Investment If NPV > 0, investment will earn more than the input rate. If NPV < 0, investment will earn less than the input rate. The greater the NPV the more desirable. Profitability Index (PI) = PV of cash flows / Original Investment. Essentially, the NPV expressed as an index. Internal Rate of Return = the rate that equates the present value of the cash flows to the original investment. The rate at which NPV = 0. n = number of years the investment will be held and then sold Slide 27 Discounted Cash Flow Analysis – Standard Ratios for Decision Making: An Example Assume a required rate of return of 20% on a $100,000 investment that generates $50,000 per year for three years. Year 1 2 3 Cash Flow $50,000 $50,000 $50,000 PV1 at 20% .833333 .694444 .578704 2.106481 Present Value $41,667 $34,722 $28,935 $105,324 $50,000 x 2.106481 [pv of 1 per period for three years] = $105,324 PV = $105,324 NPV = $105,324 - $100,000 = $5,324 Profitability Index = $105,324/$100,000 = 1.05 Slide 28 Discounted Cash Flow Analysis – Internal Rate of Return IRR by definition: the rate at which the PV of the cash flows is equal to the original investment outlay, i.e., NPV = 0. Consider the earlier example: $100,000 cost for $50,000 per year for three years. Estimating IRR is process of trial and error (even for the computer!) Estimated IRR Present Value $105,324 x 20% = 5,324 5% IRR? = 100,000 7,724 25% = 97,600 x / 5% = 5,324 / 7,724 = 3.45% IRR = 20% + 3.45% = 23.45% {Computer calculates 23.38%} Slide 29 Discounted Cash Flow Analysis – Internal Rate of Return Decision Rule Simple rule is to invest in projects that generate an IRR greater than the target or required IRR. This decision rule is consistent with the NPV and PI decision rules: you’ll get the same answer in all cases. Slide 30 6. Risk Analysis and Management 1. Nature and Definition of Risk 2. Types of Risk 3. Risk Measurement 4. Risk Management Slide 31 Risk Analysis and Risk Management The discounted cash flow (DCF) model includes several key additional variables beyond the basic financial model. DCF produces a deterministic solution with many inputs that could vary considerably. The DCF, however, does not include the probabilities that the expected incomes, expenses, terms, selling price and other variables will occur as specified. Risk analysis or risk assessment considers – The magnitude of deviations in the values of the variables – The probability associated with each variable’s actual value – The probability distribution of possible results Risk management addresses the mitigation actions that can be taken to avoid, shift or minimize the perceived risks. Slide 32 Risk Analysis and Risk Management – Nature and Definition of Risks Some definitions of risk The probability of loss The probability of not receiving what is expected The difference (variance) between expectations and actual results The possible variance of returns relative to the expected or most likely return The chance or probability that the investment will not produce the expected, desired or required rate of return Slide 33 Risk Analysis and Risk Management – Risk-Return Indifference 20 Investment Opportunities Level of Return • • Yes: Possibilities • • • • • • • t ves In Risk Free Rate of Return if Ind or’s • e urv C nce fere • • • • • No: Beyond Risk Tolerance • • • • No: Below Required Return • Level of Risk Slide 34 Max Risk Risk Analysis and Risk Management – Risk Measurement and Analysis Basic Financial Model and DCF Model have limited risk measures: debt coverage ratio, breakeven ratio, most likely result from DCF Financial-mathematical approaches – IRR Partitioning: look at components of IRR, e.g., first-year cash flow, growth in cash flow, financing, tax savings, appreciation – Risk Absorption Analysis: “annualized” cash flows represented as percentage of initial equity investment Sensitivity Analysis: test impact of selected key variable(s) and focus on those that most impact results – Probability Analysis: apply probability distributions to key variables – Monte Carlo Simulation Slide 35 Risk Analysis and Risk Management – Risk Management Identify the risks and manage the ones you can Like gambling really: – Don’t risk a lot to gain a little – Don’t invest more than you can afford to lose – Calculate the odds of winning and losing Basic considerations: – What creates the risks? – Which risks can be avoided or eliminated? – Are there “fatal flaws” that eliminate an opportunity? – Can remaining risk(s) be controlled? – How can losses be minimized? – Can risks be shifted to someone else? – What are the costs or trade-offs? Slide 36 Session Three: Risk Analysis and Risk Management – Risk Management Avoiding or Eliminating Risks – Don’t make the Deal!! – Good Due Diligence prior to investment – Know where the real estate cycle is – Nonrecourse debt – Avoid some types of commitments, leases and financing Transferring or Shifting Risk – Insurance – Partnerships with limited liability – Lease terms and conditions Slide 37 Risk Analysis and Risk Management – Risk Management Controlling or Reducing Remaining Risks – Amount of leverage – Carefully negotiated original price or rent – Diversification – Good financial controls and reporting system – Better property management and maintenance Slide 38 Teaching Real Estate Financial Analysis Dr. James P. Gaines Research Economist Real Estate Center Texas A&M University jpgaines@tamu.edu TRETA Texas A&M University January 2006 ABCD