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Real Estate Investment and Risk Analysis

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.

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Real Estate Investment and Risk Analysis

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  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 investor’s 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 investor’s 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?

  15. 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?

  16. 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?

  17. 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

  18. 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 IRR • Same for residual value

  19. 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

  24. Comparison of BTCF & ATCF

  25. Comparison of BT & AT Residual Values

  26. Calculating the Effective Tax Rate • 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

  27. 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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