Property Investment Risk by nzo10276


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									Real Estate Investment and
Risk Analysis
   Lecture Map
       Review investor motivations
       Review investment objectives
       Investment Analysis
            The due diligence process
            “Quick steps” for determining risk and value
            Calculating a levered return to equity
            Before and after tax cash flow analysis
Why Invest in Real Estate?
   Yield
       Excellent current return generating asset class
   Diversification
       Historically strong returns with lower risk
   Tax benefits
       Ability to shelter portfolio ordinary income with
        ordinary losses
   Price appreciation
       Long term returns
       Inflation hedge
When to Invest in Real Estate
   Current investment research indicates
    that real estate should be a part of
    every investor’s portfolio
   However, real estate is cyclical
       Investors can choose different styles,
        investment vehicles based on timing of
        market cycles and risk profiles
Real Estate Investment Styles
   Property specific investing
       Type, size of property – sector investing
       Tenant strategy
       Trophy characteristics
   Diversified, “core” strategies
   Distressed or market timing investing
       Special situation, turnaround
Steps in Investment Analysis
   Conduct due diligence
   Build property cash flow model
       Validate assumptions inherent in the asking
        price for the asset
       Conduct a sensitivity analysis
   Calculate levered and unlevered returns
    on purchase price
       Before and after tax
The Due Diligence Process
   Investigating and evaluating investment
       Translate the risks into cash flow
       Risks are reflected in timing and size of
        expected streams of income
   Investor rates of return should vary
    based on type, extent of risk identified
Elements of Real Estate
Investment Risk
   Business risk → macroeconomic trends
   Inflation risk → time value loss
   Liquidity risk → real estate is illiquid
   Financial risk → loss of principal
       Influenced by capital structure and interest rates
   Execution risk → management
   Legislative risk → change in the rules
   Environmental risk → exposure to hazards
Comparing Financial Analysis
to DCF
   DCF typically looks at an unlevered return,
    while most real estate investment are
   Investment analysis looks at unlevered and
    levered returns to investment based on
          Asking price of a property
          Limited equity resources
          Available debt financing
   Evaluates investment in terms of IRR as well
    as NPV
Quick Tools for Investment
   Price per Unit
   Going in Cash on Cash Yield
   Debt Service Coverage Test
   Equity Dividend Analysis
Price Per Square Foot
   What is the asking price per unit?
       Relative to reproduction cost for property
            How vulnerable is the property to new supply?
       Relative to current market comps
            Is seller asking for more/less than the market is
             willing to pay for comparable assets?
Going in Cash on Cash Yield
   Equivalent to the purchase cap rate
       Does the property meet your minimum
        initial yield requirements?
       How does this compare to cap rates for
        other, recent trades?
Debt Service Coverage Ratio
   Evaluate how much debt the property can
       “DCR”
       Multiple of NOI to debt service payment
       One of the key lender underwriting tests
   DCR may vary between deals
       Property type
       Market conditions
       Lender portfolio concerns
Equity Dividend Analysis
   Determining the annual leveraged return to
   Equity = (Price – Debt)
   ROE = (NOI – Debt Service) / equity
       Does this yield meet investor’s current yield
       How closely does NOI resemble actual free cash
            i.e., will capex requirements diminish annual equity
             returns in future?
Detailed Tools of Investment
   Create a levered DCF model
       NPV of the investment
       IRR on the equity
   Conduct sensitivities on the model
   Partition the IRR
       Where is your return coming from?
The Levered DCF Model
   Calculate the annual after debt cash flows
   Calculate the residual value
            (CF10 ÷ exit cap rate) LESS debt balance
                 Exit cap rate ≥ going in cap rate
   Discount the cash flows to PV at the discount
       NPV of the net cash flow after payment of debt
       NPV ≥ equity investment
   Should the equity discount rate be higher or
    lower than the unlevered discount rate?
The Levered DCF Model (cont.)
   Calculate a pro forma levered IRR to
       CF0 = (equity investment)
       CF1-9 = annual, net cash flows after DS
       CF10 = year 10 cash flow PLUS Residual
   How does the IRR compare to your
       Does the IRR exceed your discount rate?
Conducting Sensitivity Analysis
   Vary your modeling assumptions:
       Growth rates
            In rents, expenses
       Absorption and long term occupancy
       Debt/equity ratio
       Holding period
       Exit cap rates
Partitioning the IRR
   Determining how much of the IRR
    comes from annual cash flows versus
    residual value
   PV ratio of the cash flow to the total PV
    equals the cash flow’s contribution to
       Same for residual value
Why Partition the IRR?

“A 20% IRR from a property with steady
  annual cash flows does NOT have the
  same risk profile as a 20% IRR from a
  property with no annual cash flow”
After Tax Returns to Equity
   Most investment valuations are done
    before tax
       Tax brackets differ among investors
   Real estate does offer significant tax
    advantages, however
       Residential → mortgage interest deduction
       Commercial → benefits if property is held
        “for use in trade or business”
Tax Benefits of Income
Producing Property
   Mortgage Interest Deduction
       Actual annual interest expense
       NO deductibility of principal amortization
   Tax Depreciation
       27.5 years for residential properties
            Only allowed for third party owned rental homes
       39 years for commercial properties
       Varying terms for property improvements,
        systems, etc.
   Other, such as:
       Amortization of loan points
Tax Benefits of Income
Producing Property (cont.)
   Tax benefits are always calculated at the
    highest marginal rate
       36% for annual income
       20% for capital gains on the sale price
   Interest and depreciation deductions lower
    tax due each year
   Depreciation must be “recaptured” at time of
       Can not take the deduction twice
Calculating the Tax Benefit
   Before Tax Cash Flow vs. Taxable
       BTCF is NOT taxable income
           This is a cash-basis number
       Taxable income:
           NOI – (interest + deprec./amort.)
   ATCF = BTCF less tax due
Comparison of BTCF & ATCF
Comparison of BT & AT
Residual Values
Calculating the Effective Tax
   Equals the percentage difference between the
    BT and AT IRR’s on investment
   Effective Tax Rate is less than the marginal
    tax rate because of the deductions have
    reduced annual tax burdens
   Example:
       BTIRR = 14%
       ATIRR = 12%
       (14-12)/14 = 14.3% = Effective Tax Rate
Using the Tax Benefit
   Reducing taxes owed on a property
   Using losses to shelter other, passive
    investment income
       Real Estate can produce “NOLs”
            To the extent that interest and depreciation
             deductions exceed NOI
            NOL’s can be applied to other passive income
            NOL’s can be carried forward to future years

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