Real Estate Investment and Risk Analysis

1
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

2
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

3
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

4
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

5
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

6
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

7
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

8
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
• Asking price of a property
• Limited equity resources
• Available debt financing
• Evaluates investment in terms of IRR as well as
  NPV

9
Quick Tools for Investment Analysis

• Price per Unit
• Going in Cash on Cash Yield
• Debt Service Coverage Test
• Equity Dividend Analysis

10
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?

11
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?

12
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
• DCR may vary between deals
• Property type
• Market conditions
• Lender portfolio concerns

13
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?

14
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?

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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
  rate
• 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?

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The Levered DCF Model (cont.)

• Calculate a pro forma levered IRR to equity
• 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 expectations?
• Does the IRR exceed your discount rate?

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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

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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

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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

20
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

21
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

22
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

23
Calculating the Tax Benefit

• Before Tax Cash Flow vs. Taxable Income
• BTCF is NOT taxable income
• This is a cash-basis number
• Taxable income
• NOI (interest deprec./amort.)
• ATCF BTCF less tax due

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Comparison of BTCF ATCF
25
Comparison of BT AT Residual Values
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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

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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