What’s included in NOI?
Rental income at full Occupancy + Other Income = PGI
– Vacancy & Collection Losses = EGI
– Real Estate Taxes – Insurance – Utilities – Operating Expenses = NOI
How do you get to Cap Rates?
NOI/Purchase Price = Cap Rate (p. 286)
Terminal Cap Rate vs. Going-In Cap Rate
Terminal Cap Rate (RT): RT = (r – g); where your (r) is your cap rate, and (g)
is your growth rate; useful when trying to come up w/ REV (or reversion
Going-In Cap Rate (R): the rate investors use to discount back expected
future cash flows to determine what you are willing to pay for something
Terminal Cap Rates are often greater than Going-In Cap Rates b/c over time,
as properties age & depreciate, the production of income declines; therefore,
the expected growth in NOI for an older property should be less than that of a
new property. This also means that, holding all else constant, when compared
to newly developed properties, a property that is 10 years old should sell for a
lower price relative to its NOI (higher cap rate) than a new one. (p. 292)
A careful analysis using both the present value approach and sales comparisons
can be helpful. It is always a good idea to use sales comp. b/c that truly shows you what
comparable properties are going for on the market. However, no two properties are ever
100% comparable, so that is why a balance of both approaches is good to use. (p.298)
Sales Comparison: value is based on data provided from recent sales of properties
highly comparable to the property being appraised (p.282)
Income Capitalization: based on the principle that the value of a property is
related to its ability to produce cash flow (p. 284)
o Gross Income Multipliers (GIM): relationships between gross income and
sale prices for all comparable properties that are applied to the subject
property (p. 285)
o Cap Rate (p. 286)
o Discounted Present Value (p. 288)
Mortgage-Equity Capitalization: explicitly taking into consideration the
requirements of the mortgage lender and equity investor (p. 296)
Highest & Best Use Analysis: determining what use will provide the highest total
land value (p. 294)
Cost: investors use this to make sure they are not paying more than it would cost
to purchase the land and build the structure (p.304)
A required return for a real estate investment based on its risk when compared
w/ returns earned on competing investments and other capital market
Debt-Coverage Ratio: NOI/annual mortgage payment (p. 333)
Cap Rate vs. Yield on Cost:
Cap Rate = 10% Yield on Cost = 12%
Cost = $100 Net Rents = $12
Sale for $120 Gain = $20
If Cap Rate is higher than Yield on Cost DON’T SELL!! B/c you will be
writing a check!!
Tax – No Depreciation Recapture
Depreciation Recapture: the portion of capital gain that is due to depreciation
taken. The tax rate on recapture is usually higher than the regular capital
Taxable Income = NOI – Interest – Depreciation Allowance (p. 337)
Depreciable Basis: The amount that can be depreciated for real estate
improvements depends on the depreciable basis of the asset. The basis for a
real estate investment is generally equal to the cost of the improvements. Cost
is generally defined to include the acquisition price of the improvements plus
any installation costs associated w/ placing them into service. The cost of any
capital improvements to the property made during the ownership period is
also included in the basis when such outlays are made. (p. 338)
Net Sales – Adjusted Taxable Basis = Net Gain (p.339)
Gross Sales Price: equal to any cash or other property received for the property
sold + any liabilities assumed against the property assumed by the buyer.
Selling Expenses: e.g. legal fees, recording fees, and brokerage fees
Net Sales Proceeds = Gross Sales Price – Selling Expenses
Adjusted Taxable Basis: original basis (cost of land & improvements, acquisition
& installation fees) + the cost of any capital improvement, alterations, or additions
made during the period of ownership – accumulated depreciation to date.
Before or After Tax Equivalent Yield
Pre-Tax Yield * (1 – Tax Rate) = After Tax Yield
Tax Rate = 10% Pre-Tax Yield = 10% Cost of Debt = 12%
10 (1 - .10) = 9 or 9/(1 - .10) = 10
If debt is < pre-tax yield, then there will be positive leverage.
If debt is > pre-tax yield, then there will be negative leverage.
If debt = after-tax yield, then you breakeven.
Depreciation on Residencies: residential properties maybe be depreciated over 27.5
years (39 years for non-residential), & must be depreciated in a straight-line basis. Also,
only the improvements, not land, can be depreciated.
Conditions for positive leverage (before and after tax) –
Before Tax: if the Before Tax IRR (BTIRR) w/o any debt is greater than the cost
of debt, you will have positive leverage.
o Formula: BTIRRequity = BTIRRproject w/o loan + (BTIRRp-Debt int
the more debt you take out, the greater the return on your equity is.
But the lender has risk limits & the borrower takes on greater risk
too. Debt service costs increase & depletes NOI a little more, the
more money you take out; and the more money you take out, the
lender could increase his rates b/c he’s taking on more risk,
decreasing your IRR. So there comes a point where you no longer
have positive leverage, but negative leverage (where the cost of
debt exceeds projected IRR). Either way, leverage will magnify
the returns or losses.
After Tax: Here the cost of debt is more complicated b/c it’s in terms of after tax.
So you figure it out by: Before Tax Debt rt.(1-tax rt) = ATIRRdebt. Then its just
the same formula as above, just after tax. ATIRR can be less than the BTIRRdebt
because interest is tax deductible, which offsets it. But ATIRR has to be greater
o Sale Price – Debt Balance = Net Price
o Original Price – Depreciation = Depr. Basis
o Net Price – Basis = Net Gain
o Net Gain (1 + tax rate) = After-tax Cash Flow
Breakeven Int. Rt. (Formula) pg 354 – Remember ATIRRdebt = BTIRRdebt(1-t), and
the break even point is going to be ATIRRdebt = ATIRRproject.
Diff types of loans (comparison on p. 376)
1) Participation Loans – borrower takes a chunk out of the NOI
2) Sale-leaseback of the land – borrower sells and leases land instead of trying to
own it and paying mortgage payments. So he breaks up the building and land
and only pays on building. For the land part, the lease payments he pays are
tax deductible. Less equity is required here because all you are really buying
is the building. The investor often has the option of purchasing the land back
after the lease.
3) Interest only loans – usually only during construction periods. Called bullet
4) Accrual loans – are less than monthly interest payments and have negative
5) Convertible mortgage – lender has option to purchase full or partial interest in
the property at the end of some specified period of time. The interest rate is
usually lower in exchange for the option.
Risk Analysis (no probability questions) – they look at market study and appraisals,
borrower financials (could be recourse or non recourse – where borrower has “put
option”). They stick to a LTV ratio or DCR that cuts off risk at a point. To get the max
amount that can be spent on debt service = NOI/Desired DCR target. Then you use the
max debt service you get and divide it by the loan constant, whatever interest rate it may
be, to get the maximum loan amount. To get the incremental cost of the Max Loan amt.-
planned loan amt, you do: (max loan amt*mortgage loan constant) – (planned loan
amt.*debt int. rt.) / max loan amt.- planned loan amt.
Due Dilligence –
1. An investigation or audit of a potential investment. Due diligence serves to
confirm all material facts in regards to a sale.
2. Due diligence is essentially a way of preventing unnecessary harm to either
party involved in a transaction.
Partitioning IRR – helps the investor determine how much of the return depends on
annual operating cash flow and how much depends on the projected cash flow from
Debt – coverage ratios: certain ratio of NOI that figures the max loan payment that the
borrower can pay. NOI/DCR=max loan pmt.
Interest only Loans
Real Option (pg 409) – Buy developer purchasing the land, he has the real option of
developing on it or not in the future should conditions be right.
What should investor do? Sell, hold, or renovate? (p. 416 – 418)
Based on incremental, or marginal, return criteria that investors should
utilize when faced w/ such decisions.
Must also consider:
(1) the alternative investments available in which cash realized from a sale
may be reinvested, and
(2) the tax consequences of selling one property and acquiring another.
Marginal Returns: One-year ATIRRe
MRR = ATCFs (year t + 1) + ATCFo (year t + 1) – ATCFs (year t)/ATCFs (year t)
ATCFo: cash flows throughout the next year
ATCFs: cash flow generated from sale at the end of next year (p. 423)
Incremental Cost of Financing: by refinancing we obtain additional funds. If the
interest rate on the new loan is higher than that on the existing loan, the incremental cost
of the additional funds will be even higher than the rate on the new loan. (p. 424)
Recall that when the interest rate is higher on the larger of two loan
amounts, the incremental cost of the additional funds borrowed is even
higher than the rate on the larger loan b/c the higher rate has to be paid on
all the funds borrowed, not just the additional funds.
20 year term, $16mm purchase price, 80% loan ($12.8mm), 9.5% interest
rate. 20 n, 12.8mm CHS PV, 9.5 i, pmt = ? pmt = 1.45mm
1.45mm pmt, 0 FV, 9.5 I, 10 n, PV = ? PV = 9.1mm (end principal
balance at the end of year 10)
Renovation: investor may consider improving a property by enlarging it or by making
major capital improvements to upgrade quality and reduce operating costs. Also, the
investor may consider converting the improvement to accommodate a different economic
Accelerated Depreciation: New buyer is going to have to pay more tax, b/c he has to
depreciate over a longer period of time than the previous owner. (e.g. 20 yrs vs. 10 yrs).
Point Problem: $100,000 loan 1 point (or 1 % of loan balance or $1,000)
Over a 10 year period, so there would be a $100 monthly expense over the loan term