real estate investments am0000_000_000000 direct investments techniques basic corporate finance...
TRANSCRIPT
Real Estate InvestmentsAM0000_000_000000
Direct Investments TechniquesBasic Corporate Finance Applications
Dirk Brounen
April 23rd, 2001
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About Last Week
The virtues of indirect investments are all true, but:
Is indirect real estate really real estate?
Correlation direct real estate - stocks/bonds is lower!
Direct real estate returns are less volatile
Institutional Investors have long horizons, less need for liquidity
Investing indirectly is simple
Direct investing requires specific tools and skills
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Today’s Program A Crash Course in Commercial Brokerage
Introduction
Theoretical standards- Cash-flow estimation - Ratio-Analysis- Cap-rate - NPV- IRR
Practical Applications- Buying the Rembrandt Tower- The effect of leverage
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Introduction
Owning Investing
buying acquiringoccupying leasingenjoying sellingmoving earning
Well-being Wealth
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Real Estate Investment Analysis = Risk Management
An Investor will face several types of uncertainties
– Paying the right price
– Finding suitable lessors at the right time
– Facing financing costs that can fluctuate (interest risk)
– Facing fluctuating maintenance costs
– Being exposed to the real estate cycle
– Receiving the right price
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Sector Differences
Cash-flow uncertainties along sector types:Apartments; steady rent flow, low cycle-sensitivityOffice; long-term contracts, quiet cycle sensitiveRetail; short-term overage contracts, very cycle sensitiveHotels; very short term rent contracts, very cycle sensitive
Hotel
Apartment
Office
Risk
E
xp.R
etu
rn
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Types of Risks
– Business Risk; economic fluctuations
– Inflation Risk; can increase cost more than income
– Financial Risk; by leveraging
– Liquidity Risk; little selling possibilities
– Management Risk; bad marketing policy
– Legislative Risk; tax law changes
– Environment Risk; ABN-AMRO/Schiphol
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Old School: Three things that matter in Real Estate Investment Decision Making
LOCATION Macro EnvironmentShould you buy/build megastore, or officeShould you locate in Amsterdam or Texel?
LOCATION Sub-regionShould you locate in Center or Suburb?
LOCATION Property SpecificHow Large, High and Modern should the building be?
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New School: Numerous things matter
ECONOMICS Macro, Region and Property Specific
FINANCIALS Crunching the Numbers Applying Modern, Objective Analytics
INTUITION Old fashioned Common Sense
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Some economics to consider
– GDP growth– Consumer Confidence Index– Personal Consumption Growth– Retail Sales– Unemployment Rates for each sector– Interest Rates– Regional Economics (infrastructure)
– Vacancy Rates (Central Business District, Suburb)
– Square Meter Rents (apartments, retail, office, warehouse)
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GDP Growth
Source: CBS
-4%
-2%
0%
2%
4%
6%
8%
10%
12%
14%
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997
GDP-Growth
Unemployment
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Financial number crunchingThe Cap-rate
Cap-rate = “Bruto Aanvangs Rendement (BAR)” = Net Operating Income1/ Fair Market Value
NOI = net rental incomeFMV = CFO/(1+r)t + CFS/(1+r)n
CFO = Cash flow from operationsCFS = Cash flow from sale
If Cap-rate of object exceeds the alternatives, the object is superior
Average Cap-rates in Netherlands
‘96 ‘97 ‘98 ‘99 ‘00 ‘01Office 7.00-8.25 7.00-8.00 6.75-7.25 6.40-7.00 6.75-7.25 6.90-7.30
Retail 7.75-8.50 7.50-8.50 6.75-7.75 6.75-7.75 6.75-7.25 6.75-7.25
Industrial 9.00-10.0 9.00-10.0 8.00-9.00 7.75-8.50 7.75-8.50 8.00-8.50
Source: DTZ Zadelhoff
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Financial number crunchingThe Cap-rate
Cap-rate = NOI1/FMV
In equilibrium market the cap-rate tracks the interest-rate.R discount-rate (r) FMV Cap-rateR discount-rate (r) FMV Cap-rate
At this moment R, but Cap-rate is constant:Because of lower future expectations there exists excess supply in the market, which means that FMV is not rising.
Suppose R development cost new supply excess demand FMV Cap-rate
Cap-rate is poor market indicator, and can only signal “cheapness” of deal compared to alternatives
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Financial number crunching
Widely Used Rules of thumb:
Discounted Pay-back Period = Time at which initial investment is repaid. Indicates liquidity-intensity of the project. Does not include profitability
differences, risk profiles.
Return On Investment (ROI) = Gross profit / total cost This is an accounting number, that does not say anything about profitability. Time value absence can bias the outcome.
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Financial number crunching
Corporate Finance tools:
Net Present Value = -Initial Investment + present value of future inflows If NPV exceeds 0, the project is profitable and exceeds the implicit cost of capital (that is included in the discount rate)
Profitability Index = PV of cash inflows / initial investment If PI exceeds 1, the project is profitable
Internal Rate of Return = Discount rate that equates the PV of future inflows to initial investment If IRR exceeds the return the investor can earn on alternative investments, the project is optimal.
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Discounting graphically:
NPV €
Discount Rate r
-Investment + Σ CFt
IRR
NPV = -Investment + CFt/(1+r)t
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Buying The Rembrandt Tower
To Invest or not to investThat’s the question
What cash flows should we consider?
How should we measure?
How should we decide?
How should we structure the deal?
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The Rembrandt Tower
Purchase Price = € 42.500.000
Building SynopsisGross Building Area 28,000 sqmNet Leasable Area 26,000 sqm
Rent Estimations 2002 2003 2004 2005 2006
Philips 2,388,750 2,436,525 2,485,256 2,781,926 2,869,986Newconony 1,023,750 1,044,225 1,065,110 1,192,254 1,229,994ABP 1,706,250 1,740,375 1,775,183 1,987,090 2,049,990Cap Gemini 1,706,250 1,740,375 1,775,183 1,987,090 2,049,990
Base rent 6,825,000 6,961,500 7,100,730 7,948,360 8,199,960Vacancy (5%) 0 0 0 397,420 410,000
EGI 6,825,000 6,961,500 7,100,730 7,550,940 7,789,960
EGI = Effective Gross Income
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Including Expenses
2002 2003 2004 2005 2006
EGI 6,825,000 6,961,500 7,100,730 7,550,940 7,789,960
Operating Expenses 1,968,500 1,968,500 1,968,500 2,304,450 2,346,355
Managem. Expenses 341,250 348,075 355,035 377,545 389,500
NOI 4,515,250 4,644,925 4,777,195 4,868,945 5,054,105Taxes* 1,282,838 1,328,224 1,374,518 1,406,631 1,471,437
ATCFo 3,232,413 3,316,701 3,402,677 3,462,314 3,582,668
Operating Expenses: NOI = Net Operating Income – Property Taxes NOI = EGI - Expenses – Insurance
– Utilities Corporate Taxes:– Janitorial 35% of (NOI - Interest - Depreciation)– Maintenance Annual Depreciation = 2% of Purchase price
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Including the Sale in 2006
Assume the office price will increase each year with 2%.
Expected Sales price in 2006:Sales Price = € 42.500.000 * (1.02)5 = € 46,923,434
Taxes = 28% of (sale price - purchase price + depreciation) = € 2,428,562
ATCFsale = € 44,494,873
2002 2003 2004 2005 2006NOI 4,515,250 4,644,925 4,777,195 4,868,945 5,054,105BTCFsale 46,923,434
BTCF 4,515,250 4,644,925 4,777,195 4,868,945 51,977,539
2002 2003 2004 2005 2006ATCFo 3,232,413 3,316,701 3,402,677 3,462,314 3,582,668ATCFsale 44,494,873
ATCF 3,232,413 3,316,701 3,402,677 3,462,314 48,077,541
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After Tax Cash Flows
3,232,413 3,316,701 3,402,677 3,462,314 48,077,541NPV8% = -42,500,000 + (1+0.08)1 + (1+0.08)2 + (1+0.08)3 + (1+0.08)4 + (1+0.08)5
NPV8% = 1,303,337
1 2 3 4 5
3,232,413 3,316,701 3,402,677 3,462,314
48,077,541
-42,500,000
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Profitability Ratio Analysis
Cap-Rate = BTNOI1/Market Value = 4,515,250/42.500.000 =0.1013 10.13%
NPV = -Equity Investment + Σ [CFt/(1+r)-t]
BTNPV8% = € 8,409,213 ATNPV8% = € 1,303,337 BTNPV11% = € 2,884,226 ATNPV11% = € -3,595,586 BTNPV14% = € -1,862,353 ATNPV14% = € -7,795,810
PI = Profitability Index = PV/Equity Investment
BTPI8% = 1.20 ATPI8% = 1.03BTPI11% = 1.07 ATPI11% = 0.91 BTPI14% = 0.96 ATPI14% = 0.82
IRR = Σ [CFt/(1 + IRR)-t] = Equity Investment
BTIRR = 12.77% ATIRR = 8.75%
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Discounting graphically:
€ 1,303,337
8%
NPV €
Discount Rate r
Σ BTCFt
ATIRR = 8.75%
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Leveraging the investment:
Finance 70% of the investment with interest-only loan @ 9%Annual Debt Services: 0.09 * 0.70 * 42.500.000 = 2,677,500
2002 2003 2004 2005 2006NOI 4,515,250 4,644,925 4,777,195 4,868,945 5,054,105Debt Inter. 2,677,500 2,677,500 2,677,500 2,677,500 2,677,500Taxes 345,713 391,099 437,393 469,506 534,312ATCFo 1,492,038 1,576,326 1,662,302 1,721,939 1,842,293
ATCFsale 44,494,873Loan Repayment 29,750,000
14,744,873
ATCF 1,492,038 1,576,326 1,662,302 1,721,939 16,587,166
Tax Advantage 2002: Taxes = 0.35 * (NOI - Depreciation - Debt Interest)
Taxes no loan: 0.35*(4,515,250 - 850,000 - 0) = 1,282,838 Taxes with loan 0.35*(4,515,250 - 850.000 - 2.677.500) = 345,713
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After Tax Levered Cash Flows
1,492,038 1,576,326 1,662,302 1,721,939 16,587,166 NPV13% = -42,500,000 + (1+0.13)1 + (1+0.13)2 + (1+0.13)3 + (1+0.13)4 + (1+0.13)5
NPV13% = 1,015,887
1 2 3 4 5
1,492,038 1,576,326 1,662,302 1,721,939
16,587,166
-12,750,000
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Ratio Analysis
Cap-Rate = BTNOI1/Market Value = 4,515,250/42.500.000 =0.1013 10.13%
NPV = -Equity Investment + Σ [CFt/(1+r)-t]
BTNPV13% = € 3,827,336 ATNPV13% = € 1,015,887 BTNPV17% = € 1,655,400 ATNPV17% = € -800,830 BTNPV21% = € -142,486 ATNPV21% = € -2,303,565
PI = PV/Equity Investment
BTPI13% = 1.30 ATPI13% = 1.08BTPI17% = 1.13 ATPI17% = 0.94 BTPI21% = 0.99 ATPI21% = 0.82
IRR = Σ [CFt/(1 + IRR)-t] = Equity Investment
BTIRR = 20.50% ATIRR = 15.10%
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The leverage effect on profitability:
In this case leveraging the investment increases profitability because:- You decrease your equity burden- You lower you Tax expenses (deduction)- You finance a 12.77% (initial BTIRR) deal using a 9% loan
The last reason can be used as general rule:Positive Leverage: BTIRR > Interest rate on LoanNegative Leverage: BTIRR < Interest rate on Loan No Leverage 70% LeverageBTIRR = 12.77% BTIRR = 20.50%ATIRR = 8.75% ATIRR = 15.10%
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The leverage effect on risk:
In every case leveraging the investment increases the risk because:- You take on a fixed burden- In case of disappointing earnings or unexpected expenses, income might be too little to service the debt The End- In case of a variable rate loan financing cost might increase suddenly
Ratio to use to analyze the risk: NOI 4,515,250
DCR = Debt Coverage Ratio = Mortgage Payment = 2,677,500 = 1.69
Mortgage Principal 29,750,000
LTV = Loan To Value Ratio = Property Value = 42,500,000 = 0.70