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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?



Excellent current return generating asset class

Historically strong returns with lower risk Ability to shelter portfolio ordinary income with ordinary losses

Tax benefits

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 investors 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 risks

Translate the risks into cash flow projections 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 financed Investment analysis looks at unlevered and levered returns to investment based on

Evaluates investment in terms of IRR as well as NPV

Asking price of a property Limited equity resources Available debt financing

Quick Tools for Investment Analysis

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? Is seller asking for more/less than the market is willing to pay for comparable assets?

Relative to current market comps

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 support

DCR Multiple of NOI to debt service payment One of the key lender underwriting tests Property type Market conditions Lender portfolio concerns

DCR may vary between deals

Equity Dividend Analysis

Determining the annual leveraged return to equity Equity = (Price Debt) ROE = (NOI Debt Service) / equity

Does this yield meet investors current yield requirement? How closely does NOI resemble actual free cash flow?

i.e., will capex requirements diminish annual equity returns in future?

Detailed Tools of Investment Analysis

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

Discount the cash flows to PV at the discount rate

Exit cap rate going in cap rate

Should the equity discount rate be higher or lower than the unlevered discount rate?

NPV of the net cash flow after payment of debt NPV equity investment

The Levered DCF Model (cont.)

Calculate a pro forma levered IRR to equity

How does the IRR compare to your expectations?

CF0 = (equity investment) CF1-9 = annual, net cash flows after DS CF10 = year 10 cash flow PLUS Residual

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 flows contribution to IRR

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

Tax Depreciation

Actual annual interest expense NO deductibility of principal amortization

27.5 years for residential properties

Other, such as:

39 years for commercial properties Varying terms for property improvements, systems, etc. Amortization of loan points

Only allowed for third party owned rental homes

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 sale

Can not take the deduction twice

Calculating the Tax Benefit

Before Tax Cash Flow vs. Taxable Income

BTCF is NOT taxable income

This is a cash-basis number NOI (interest + deprec./amort.)

Taxable income:

ATCF = BTCF less tax due

Comparison of BTCF & ATCF

Example of BTCF NOI Debt Service @1.25 DCR: Principal Interest Total Debt Service BTCF Add Back Principal Deduct Depreciation Taxable Income Tax Due @ 36% ATCF: BTCF - Tax Due $65,000 2,600 49,400 52,000 13,000 Example of ATCF $65,000 2,600 49,400 52,000 13,000 2,600 ($15,000) 600 216 $12,784

Comparison of BT & AT Residual Values

Example of BT Residual NOI in Sale Year Exit Value @ 10% cap Less Selling Expense @ 3% Net Sale Value Less Debt Balance Net BT Sale Proceeds Net Sales Price less: "Adjusted Basis" ** Capital Gain on Sale Tax on Gain: Appreciation (sale - original price) @ 20% Depreciation Recapture (total depreciation @25%) Total Tax on Gain Net AT Sale Proceeds
**Adjusted Basis: Project Cost (land plus improvements) LESS Accumulated Depreciation Adjusted Basis

Example of AT Residual 65,000 650,000 19,500 630,500 520,000 110,500 630,500 545,000 85,500

65,000 650,000 19,500 630,500 520,000 110,500

26,100 35,000 61,100 $49,400

685,000 (140,000) 545,000

Calculating the Effective Tax Rate

Equals the percentage difference between the BT and AT IRRs 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 NOLs can be applied to other passive income NOLs can be carried forward to future years