Multi-Period Analysis

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Multi-Period Analysis

• Present Value Mathematics

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Real Estate Values

• Set by Cash Flows at different points in time.
• Single period Analysis revisited
• Single Period ratio analysis
• Cash on Cash return
• ROI excess of 10? From book
• Depends upon inflation and interest rates

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Present Value Analysis

• Single sum Analysis Review
• FV (1r)n PV
• PV FV/(1r)n
• rinterest rate, n of periods
• Or PV and FV formula in excel
• Multi-period analysis discounts a stream of
  different cash flows at a particular rate.
• The discount rate risk free rate risk premium
  (ie risk free rate US T Bill yield)

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Discounted Cash Flow (DCF)

• Three main steps
• Forecast the expected future cash flows
• Ascertain the required total return
• Discount the cash flows to the Present Value at
  the required rate of return

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1) Forecast Cash Flows

• Use Year One budget to expand to future periods.
• Set assumed growth rate projection to income and
  expense items.
• Use exact numbers if know otherwise estimates
• Typical estimates include CPI, Mkt Study
  estimates, or past experience
• Calculate the Terminal Value
• Based on the final years cash flow
• Typically apply a CAP rate to final year cash flow

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Terminal Value/Resale Price Calculation

• Final Years cash flow determined by applying a
  CAP rate to final years cash flow.
• Net Operating Income
• Projected for Final Year
• ------------------------------------
• CAP Rate
• Represents an inflow of cash as if property were
  sold at the end of the analysis period.
• Need to deduct any expected selling costs
• Dont forget to deduct repayment of remaining
  balance of loan

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Capitalization Rates Revisited

• Rate set for quick valuation of assets based on
  one years Net Operating Income
• The rate is usually set by comparison of what
  other similar properties are selling for in the
  market.
• A way of quoting observed market prices for real
  estate as Bond Yields are the way bond prices are
  reported.
• The CAP rate for terminal value may be slightly
  higher than one for a valuation today
• Reflecting the age of the property
• Higher uncertainty regarding inflation and
  interest factor

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Amortization of Loans

• Will need to create an amortization table of the
  loan to know expected value of loan in last year.
• Calculate payment, calculate principle and
  interest portions of payments, deduct principle
  portion from prior years amount.

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2) Determine Discount Rate

• Three Main Determinants of Discount Rates
• Opportunity Cost of Capital
• How much can your money earn in other investments
  like stocks and bonds.
• Discount Rates move with Interest Rates
• Inflation Rates
• Risk
• Higher Risk, higher discount rate, Lower price
• Growth Expectations
• Where is the property in its Life Cycle
• Is the location a growing or declining area
• Investors willing to pay more for growth prospects

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3) Discount Cash Flows to Net Present Value

• NPV PV(benefit)-PV (Cost)
• Net Present Value Rule
• Maximize the NPV across all mutually exclusive
  alternatives
• Never choose an alternative that has NPVlt0
• 0 NPV deals are OK
• Discount rate implies that at 0 investor is just
  earning their required return
• Finding deals with very large NPV usually means
  you have an error in your calculations

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Most Common Errors

• Rent and income growth assumption too high.
• Do rents always grow with inflation?
• Depreciation of building real terms inflation vs
  inflation applied to todays value
• Capital improvement expenditures projection too
  low
• Can average 10 20 of NOI
• Terminal CAP rate too low
• Typically slightly higher than going in cap rate
• Discount Rate too high
• May offset the other mistakes
• Unrealistic expectations

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Example from Book P. 90

• Year one Gross Rent 1,000,000
• Vacancy Rate 7
• Year One Operating Expenses 700,000
• Net Operating Income - 230,000
• Discount Rate 8
• Terminal CAP 8.5
• Income escalation 3
• Operating Expense escalation 4
• Sale of property at the end of year 6
• Purchase Price 2,820,285

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Internal Rate of Return

• The rate that discounts all the net cash flows to
  equal a 0 NPV
• Algebraic solution cannot be done. Must use
  computer.
• The IRR function in Excel asks for a guess of the
  expected IRR to help give the correct response
• A common measure used by companies in capital
  budgeting.

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Remember It is All Still Just Estimates

• GIGO applies

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The Nature of Risk

• The chance or probability that the investor will
  not receive the expected or required rate of
  return.
• We have already seen that as risk increases
  expected return is also increased

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Business Risk

• Related to variances from estimates in
• capital expenditures,
• gross possible income,
• vacancy and credit loss
• Operating Expenses
• Property Value
• Static or unsystematic business risk
• Physical causes and beyond the control of the
  investor
• Fire, floods, injuries
• Can be shifted to others through insurance
• Dynamic or systematic risk
• Related to changes in general business conditions
  and conditions of the property. External not
  under the control of the investor.
• Market supply and demand, quality of property
  management, change in economic base or taxes.
• Cannot be transferred to others therefore
  requires risk premium in return calculation

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Financial Risk

• Risk of not receiving expected return due to
  financial obligations of debt financing
• Risk created by debt financing
• Increases whenever the debt levels increase
• Debt decreases net cash flows however increase
  IRRs if leverage is favorable
• Because investors demand a higher return for the
  increased risk.
• Internal financial risk
• Relates to the ability of the project to pay debt
  service
• External financial risk
• Ability of the investor to obtain funds from
  external sources.
• As sources become more difficult to obtain
  external financial risk increases.

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Transfering or Eliminating Risk

• Play the real estate cycle
• Wait for the right time for real estate decisions
• Do not invest in overbuilt or recessionary
  markets
• Non recourse mortgages
• Shifts the burden of financial risk to the
  property and the lender
• In the event of default the investor could lose
  the property
• Avoid pre-payment penalties, indexed loans
• Insurance policies
• Limited-liability forms of ownership
• Long term leases with escalation clauses
• Transfers vacancy risk to the tenant

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Reducing the remaining Risks

• Negotiation of appropriate loan amount and terms
• Lower amount has less risk
• Purchase Price
• Negotiation of better purchase terms
• Diversification
• Good accounting controls and reporting systems
• Good research
• Good Property Management
• Superior location