Ch. 8 Financing Decisions I. Overview of Income Property Investment Analysis- many different variables come into play in doing analysis. Lenders look at same type of analysis and variables as investor, i.e. loan decision process similar to investment analysis process. Primary concern is value of collateral, plus cash flows to service debt. A. Property Types - when talk about income property investment, recognize that many different properties qualify, including single family residences all the way up to $ Billion mixed use developments. B. Motivations for Investing - many reasons for investing in income producing properties. Basic ones are: 1. Cash flow from operations. 2. Increase in value over time (reversion).
3. Tax benefits, both during operations and capital gain taxation on gain at sale. 4. Use of Leverage (positive if cost of financing (loan constant) is less than return generated). 5. Diversification of investor's portfolio, as well as "pride of ownership." II. Projecting Cash Flows - major component of investment analysis is cash flows from operations. While most investors interested in ATCF, must begin with verifiable projection of future income and expenses from operations: A. Cash Flow from Operations format: Gross Possible Income plus Other Income less Vacancy & Bad Debts equals Effective Gross Income less Operating Expenses equals Net Operating Income less Debt Service
2
GPI +OI -VBD EGI -OE NOI -DS
equals Before Tax Cash Flow less Depreciation plus Principal Amortization equals Taxable Income x Tax Rate equals Taxes plus Depreciation minus Principal Amortization equals ATCF
BTCF -Dep +Prin TI xRate Taxes +Dep -Prin ATCF
B. Gross Possible Income - comes from market rents. In estimating gross possible income, must assess whether rents to be used are contract or market rents (always use market rents unless have a long-term contract). Market rents (both current and future) will be dependent on supply and demand of property in the current market, as well as location and condition of the property, past trends in rents, underlying economic conditions (income and population changes), etc. Income will vary over time as market conditions change, which adds to the risk inherent in real estate investment. Income also will vary based on
3
how lease is structured, and how much of market risk is transfered to the lessee. 1. Lease structure - leases will include a variety of items that impact rent as well as responsibilities of lessor/lessee. These things will include lease term, use of property, finish-out allowance, rent terms and structure, who is responsible for expenses, concessions (i.e. free rent periods), renewal options, etc. All of these elements are negotiable, and ultimate package will affect total cost to the tenant (income to the owner) of the lease. Typical factors affecting risk and price of lease: a. Calculation of rent - several alternatives, including fixed rent, percentage rent (base plus overage as a percent of sales), index rent (tied to changes in an underlying indes, such as CPI), graduated payment lease. b. Payment of expenses - typically classify leases by extent of expenses paid by tenant. If none of the expenses are paid by tenant
4
(i.e. all expenses are paid by lessor) - called a gross lease (aka full service). If all expenses are paid by tenant, called a triplenet lease. If expenses split, typically referred to as a net (lessee pays taxes) or net-net (lessee pays taxes and insurance) lease. Very common arrangement today is a fixed amount of expenses being paid by the lessor, with any overage passed through to the tenant - referred to as an expense stop. Example, tenant pays $10 per square foot annual rent, with a $5 per square foot expense stop. This means that on a 1,000 square foot space, the monthly rent would be $833.33 ($10 x 1,000 / 12), with the lessor responsible for $416.66 ($5 x 1,000 / 12) per month of expenses. Anything over that amount would be paid by the tenant, typically on a pro-rata basis with any other tenants. c. Concessions - if supply exceeds demand, fairly common for lessor to offer concessions as an inducement to get tenants to sign long-term lease. Usually reduced or
5
free rent for an initial period, but may also be a larger finish-out or payment of expenses. Owner may also offer tenant a small equity participation in the ownership of the building to get them to commit to a long-term lease as an anchor tenant. d. Renewal and Relocation Options - another item of negotiation can give the tenants the right to renew their leases at relatively low rates in the future, or relocate in the event more desireable space in the same building comes available, or a new building is constructed by the owner, etc. C. Vacancy Allowance - Unfortunately, lessor will not always be able to have all space rented and paying rent all of the time. So investor must provide an allowance for vacancy and bad debts. This can be based on historical information, or can be taken from current market standards. Published sources available for income, vacancy and expense estimates for most property types for most major markets (downtown and suburban).
6
Even new or 100% occupied buildings need to allow for a vacancy allowance due to normal turnover. Vacancy can include rent concessions or extensive finish out allowances. D. Operating Expenses - typically two types of expenses, fixed and variable: 1. Fixed - expenses of the property regardless of the level of occupancy: a. b. c. d. property taxes insurance advertising and promotion repairs and maintenance
2. Variable - expenses vary based on the occupancy: a. utilities b. management expense c. cleaning
7
3. Replacement reserves – set aside funds to replace capital items, but not allowable property expenses that can be passed through or deducted for tax purposes. E. Net Operating Income (NOI) - result of subtracting operating expenses from Effective Gross Income (Gross Possible less Vacancy). Note that Operating Expenses do not include depreciation or financing. The reason is that NOI is the cash flow to the property, before taxes. Financing is not considered an expense of the property, but rather an expense of the owner. F. Before Tax Cash Flow (BTCF) - when financing is incorporated in the analysis, it is done in two ways. The first is to take out the entire annual debt service (i.e. principal and interest payment). This is subtracted from the NOI to arrive at BTCF. The second way financing is incorporated is to take out interest payments only to find taxable income, and then ultimately to take out the principal portion from after tax income to arrive at
8
After Tax Cash Flow. Due to potential positive leverage, financing often used in most deals. G. After Tax Cash Flow (ATCF) – simply subtract taxes from BTCF to arrive at ATCF. III. Cash Flow from Reversion – major component of investment is the sale of the property. A. Format: Sales Price less Selling Expenses equals Net Sales Proceeds less Mortgage Balance Remaining less Taxes equals After Tax Equity Rev. Taxes: Net Sales Proceeds less Adjusted Basis Taxable Gain x Gain Rate
9
SP -SE NSP -MBR -Taxes ATER
NSP -AB TG xGR
equals Taxes on Sale where AB = purchase price + capital improvements – depreciation claimed.
Taxes
IV. Lender Perspective - Primary concern of lender is whether borrower can repay the loan, and if there is a default, is the value of the property sufficient to cover the loan amount: A. Value of Collateral – arrived at from appraisal, where the property value can be derived from the reconciled income approach (static (V = NOI/R) and discounted cash flow analysis), sales comparison approach and the cost approaches to value. Cap rates are typically available in the market, and lenders can apply these to the first year NOI to get a preliminary estimate of value. B. Lender’s Decision Tools – in addition to the cap rate, lenders will want to look at other metrics such as:
10
1. Debt Coverage Ratio - measure of the riskiness of the loan, and is of interest to both the investor and the lender. DCR is the ratio of the NOI to the Debt Service, and provides a measure of the cushion the cash flow of the property has in covering mortgage payment. Most lenders require at least a 1.25 ratio (i.e. 25% cushion). DCR = NOI / DS
2. Loan to Value Ratio – relationship of loan amount to the lesser of the appraised value or actual cost. Normally will provide a maximum 75 – 80% L/V, meaning want 20 – 25% equity investment from borrower. L/V = Loan / Value 3. Mortgage Constant – aka amount to amortize $1. Includes the principal and interest payments necessary to completely pay the loan off over the agreed upon loan term, providing the lender an agreed upon rate of return for the use of the money. Includes
11
return ‘on’ and ‘of’ the investment, meaning the mortgage constant is greater than the contract interest rate. MC = Annual Debt Service Loan Amount 4. Breakeven Rate – most lenders concerned with the level of occupancy required to cover all of the property’s operating expenses and the debt service payments. The lower the BER the better for the lender. BER = OE + DS + Cap Exp Gross Possible Income C. Underwriting Process – after finding value of collateral, lender will examine the market analysis; location analysis; appropriateness of proposed improvements for site; borrower’s creditworthiness; developer’s construction and property management teams; and ultimately the project’s financial viability.
12
V. Investor Investment Analysis - ultimately the question to be answered in investment analysis is should a property be purchased or developed, and if so at what price? Correspondingly, if a certain price is asked for a property and it is purchased at that price, what return will the investment yield? Overview of the process: A. Ratio Analysis - quality of investment can be ascertained using ratios of various measurements: 1. Price per square foot or per unit - relative comparative measures with other projects. 2. Capitalization Rate - relationship of NOI divided by Value in first year - again a comparative measure with other projects in the market. Obviously this is a static measure that ignores future cash flows, reversion, time-value of money, etc. Value = NOI / R
13
3. Equity Dividend Rate (aka Cash on Cash Ratio or Return on Equity) - calculated by dividing the BTCF by the initial equity investment. This provides a measure of cash flow to equity, and is very common in a comparative analysis, although still a static ratio that ignores future cash flows, reversion, etc. EDR = BTCF / equity 4. Return on Assets (ROA) – same as cap rate but with the addition of capital reserves taken out in finding the NOI. Not widely used. ROA = NOI – Capital Reserves Purchase Price B. Discounted Cash Flow Analysis - an alternative to static ratio analysis is to project after tax cash flows for each year of the investment, and then estimate a reversionary value and corresponding after tax equity reversion. The selling price can be estimated by increasing the initial value of the
14
investment by so much per year, or capitalizing the future NOI in the year of sale. From the sales price the selling expenses and mortgage balance remaining are subtracted, as are the taxes due on sale. This analysis then provides the annual after tax cash flows from operations plus the after tax equity reversion. Several different analyses can be undertaken with this information: 1. Net Present Value - done on a before or after tax basis, where initial equity investment is related to the anticipated future flows. The future flows are effectively discounted back to the present at the required rate of return, and then compared to the initial equity investment. If the present value of the flows is greater than the initial investment, then a positive net present value exists, meaning the investment exceeds the required rate of return. 2. Internal Rate of Return (IRR) - similar concept to NPV, but now the initial equity investment is equated with the discounted future flows. That rate that equates to the two
15
is the IRR. Problems with the IRR exist primarily in the reinvestment assumption and the fact that multiple IRRs can result if investment has greater than one sign change. C. Optimal use of Debt – as long as ‘positive’ leverage exists, subject to lender criteria. Risk/return tradeoff, meaning more debt, the greater the risk and greater the required return. Also, lender may require higher interest rate to compensate for increased risk of higher L/V. VI. Clackamas Ridge Example – from text.
16