Cash Flow Analysis

1
Lecture 12

• Cash Flow Analysis

2
Evaluation of Future Investment Performance

• TWO INITIAL FACTORS TO BE ANALYZED
• 1. Holding Period
• Many assume 10-year for simplicity
• Established at the time the investor is analyzing
  the property
• Most investors recalculate holding periods, and
  compare to initial evaluation

3
Evaluation of Future Investment Performance

• If a 10-year holding period is not assumed, an
  investor viewing periodic cash flow as their
  investment objective could consider the
  following
• Link the holding period to a certain time/event
  in which the funds would be required
• Hold the property while BTCF growth occurs and
  sell when BTCF stabilizes
• Hold the property as long as BTCF is positive
• Hold the property as long as tax sheltering
  occurs

4
Evaluation of Future Investment Performance

• If a 10-year holding period is not assumed, an
  investor viewing price appreciation as their
  investment objective would choose a holding
  period equal to the time required for anticipated
  future benefits to occur (selling time).
• Anticipated market price increases
• Increases in neighboring values in the future
• Beneficial changes in future uses

5
Evaluation of Future Investment Performance

• TWO INITIAL FACTORS TO BE ANALYZED
• 2. Discounting Interest Rate
• Investors expected rate of return (easiest, most
  utilized)
• Cost of Capital (interest rate plus risk factor)
• Capitalization Rate
• Utilized to estimate future appreciated values,
  based on one income stream
• Direct Capitalization

6
Lecture 12

• Discounted Cash Flow Analysis
• (Net Present Value)

7
Process of a Discounted Cash Flow Analysis for
Net Present Value

• 1. Determine BTCFs
• 2. Determine Before Tax Equity Reversion
• - Proceeds from sale after deducting loan
  balances and selling costs
• 3. Discount BTCFs and BTER
• 4. Calculate Present Values of BTCFs and BTER,
  and sum
• 5. Net Initial Equity to derive Net Present
  Value of the Investment

8
Step 1 Before-Tax Cash Flows

• Potential Gross Income (PGI)
• Less Vacancy/Collection Loss Allowance
• Effective Gross Income (EGI)
• Less Operating Expenses, Management Fees, Cap.
  Impvt. Allow.
• Before Debt Net Operating Income (NOI)
• Less Debt Service
• Before-Tax Cash Flow (BTCF)

9
Step 2 Before-Tax Equity Reversion

• Utilize Direct Capitalization to estimate value
  (selling price) at end of holding period
• Formula NOI for year immediately following
  holding period, divided by market-supported
  capitalization rate
• 2. Estimate selling and closing costs (broker
  commissions, prepayment penalties)
• 3. Calculate remaining loan balance (determines
  net proceeds from sale)

10
Step 2 Before-Tax Equity Reversion

• Estimated Appreciated Value
• Less Selling/Closing Costs
• Net Proceeds From Sale
• Less Unpaid Mortgage Loan Balance
• Before-Tax Equity Reversion (BTER)

11
Step 3 Discount BTCFs and BTER

• Formula to calculate discounting factors
• PV 1 / (1 i)n
• i interest rate
• n holding period

12
Step 3 Discount BTCFs and BTER

• Discount factors, assuming a 10 rate and a
  5-year holding period
• Year One .9091
• Year Two .8265
• Year Three .7513
• Year Four .6830
• Year Five .6209
• Year Six .5645

13
Step 4 Calculate Present Values of BTCFs and
BTER

• Formula to calculate present values
• PV BTCFs Each BTCF Discount Factors
• PV BTER BTER Discount Factor for year
  immediately following end of holding period
• Sum all discounted BTCFs and BTER to derive
  Present Value of the Property

14
Step 5 Net Present Value

• Present Value of Property
• Less Initial Equity Invested
• Net Present Value (NPV)

15
Investment Decision Criterionfor NPV
If the following statements are true after your
analysis, then the project is a feasible
investment (PV of all BTCFs) (PV of BTER)
gt Initial Equity Invested (PV of all BTCFs)
(PV of BTER) - Initial Equity Invested gt 0