Está en la página 1de 70

Real Estate Financial and Investment Analysis 1

FUNDAMENTALS OF PROJECT FINANCIAL


AND INVESTMENT ANALYSIS

This presentation will lay the groundwork for the remainder of the course, reviewing
basic principles of finance as they relate to real estate project financial-
investment analysis and evaluation.

There will be four sessions:

I. Structuring a real estate feasibility analysis

II. Evaluating the risk/return tradeoff for real estate projects

III. Developing techniques of financial analysis

IV. Examining problems and pitfalls of financial investment analysis.


Real Estate Financial and Investment Analysis 2

I. STRUCTURING A REAL ESTATE


FEASIBILITY ANALYSIS

This introductory session will address the concept of feasibility and real estate
investment analysis; development of the first-year pro forma; and the usefulness
of the CAP rate.
Real Estate Financial and Investment Analysis 3

Yes, Virginia there are only three things that matter in real estate...

LOCATION! LOCATION! LOCATION!

L x L x L
REGIONAL FACTORS NEIGHBORHOOD SITE-SPECIFIC
& ELEMENTS FEATURES
MACROECONOMIC
CIRCUMSTANCES
Real Estate Financial and Investment Analysis 4

OUTLINE OF A FEASIBILITY STUDY

1. Site Analysis
Survey of site to determine net useable land area
Zoning of site and related constraints
Availability of utilities to site
Subsurface soil conditions
Preliminary title report, CC & Rs
2. Initial Concept
Establish target land development concept in terms of developers goals,
permitted zoning, and developers financial resources
Real Estate Financial and Investment Analysis 5

OUTLINE OF A FEASIBILITY STUDY

3. Demand Analysis
Evaluate the economic base that supports the community in which project
is located:
Population projections
Employment projections
Income Projections
Study the demand forces that pertain to your specific project type
Analyze the competitive market within which you must operate
4. Supply Analysis
Determine market area related to project
Analyze the present and future inventory of product that you will be
competing with in relation to your delivery date
Determine product mix in relation to competitive rents, pricing, and
amenities
Real Estate Financial and Investment Analysis 6

OUTLINE OF A FEASIBILITY STUDY

5. Specific Development Scheme


With architects and engineers, developer relates concept to market
conditions, with a specific development scheme, land use plan
6. Cost Estimates
Based on a specific plan, developer then estimate all hard and soft costs
based on the bid date of the project
Real Estate Financial and Investment Analysis 7

OUTLINE OF A FEASIBILITY STUDY

7. Financial Structure
Reviews profitability for go/no go decisions
Review mortgage loan ratios, terms of borrowing, equity position, tax
considerations
Determine phasing, if any, and absorption rates
8. Rate of Return Analysis
Review risk factors related to project
Review length of investment period
Determine rate of return on and of the investment
Real Estate Financial and Investment Analysis 8

WILSHIRE BOULEVARD OFFICE BUILDING

Building Synopsis
Gross building area 205,000 sq. ft.
Net leasable area 176,000 sq. ft. (86%)
Parking structure 427 cars
Real Estate Financial and Investment Analysis 9

WILSHIRE BOULEVARD OFFICE BUILDING

Direct Costs
Office building: 205,000 sq. ft. at $43/sq. ft. $8,815,000
Parking structure
Above grade: 22,420 sq. ft. at $24/sq. ft. 538,000
Below grade: 125,000 sq. ft. at $28/sq. ft. 3,511,000
Tenant improvements: 176,000 sq. ft. at $11/sq. ft. 1,936,000
Site development 84,000
Architectural & Engineering
6% of hard costs ($14,984,000) 889,040
Contingency
5% of $15,883,040 794,152

TOTAL $16,667,192
Real Estate Financial and Investment Analysis 10

WILSHIRE BOULEVARD OFFICE BUILDING

Indirect Costs
Real estate taxes $123,000
1% of direct cost plus land; 15 mos./2
Permits, legal fees, title, escrow, insurance 150,000
Development fee: 3% of hard costs 500,015
Leasing commission: 3% on $22 x 176,000 x 5 years 580,800
Lease-up expense: $4/sq. ft. x 176,000 sq. ft. for 6 mos. 352,000
Consulting fee 150,000

TOTAL $1,855,815
Real Estate Financial and Investment Analysis 11

WILSHIRE BOULEVARD OFFICE BUILDING

TOTAL DIRECT AND INDIRECT COSTS $18,523,007

Financing cost: 16% for 15 mos./2 on total costs 2,058,112


& financing cost ($20,581,119)

Land 3,000,000

TOTAL COST INCLUDING FINANCING $23,581,119


Real Estate Financial and Investment Analysis 12

WILSHIRE BOULEVARD OFFICE BUILDING

FULL-YEAR OPERATING PRO FORMA


Gross rental income - $22/sq. ft. on 176,000 sq.ft. $3,872,000
Parking income - 40/car for 427 cars +204,960
Less 5% vacancy and collection problems -203,848

Effective Gross Income $3,873,112

Building operating expense - $4 x 176,000 sq. ft. -704,000


Parking garage operating -30,000

Net Effective Income or Net Operating Income (NOI) $3,139,112

Debt service on $20,581,927 Loan for 30 yrs. at 10.5% -2,259,252

Net Spendable Income $879,860


(Net cash flow before taxes and after debt service)

Economic value of building capped at 9% $34,879,022


Real Estate Financial and Investment Analysis 13

BASIC ACCOUNTING FOR INCOME PROPERTIES

GROSS POSSIBLE INCOME (GPI)


- VACANCY AND BAD DEBT FACTOR
EFFECTIVE GROSS INCOME (EGI)
- OPERATING EXPENSES
NET OPERATING INCOME (NOI) OR NET EFFECTIVE INCOME
- DEBT SERVICE
CASH FLOW BEFORE TAXES (CFBT)
- NET TAXES*
NET SPENDABLE INCOME (NSI)

* CFBT + Principal Paydowns - Depreciation = TAXABLE INCOME


Real Estate Financial and Investment Analysis 14

THE CAP RATE CONCEPT

NO I =MV, where
k

MV is the estimate of fair market value,


NO I is the estimate of the first normal year' s net operating income, and
k is the capitalization rate; 1/ k is a first year' s price (value) to earnings ratio.
Real Estate Financial and Investment Analysis 15

GRAPHIC INTERPRETATION OF CAP RATE

MV=(1/k)NOI

MV

NOI
Real Estate Financial and Investment Analysis 16

WHAT THE CAP RATE MUST TAKE INTO ACCOUNT

1. Riskless Rate of Return


real return
inflationary adjustment
2. Liquidity
3. Management Return
4. Parcel Specificity Risk
Real Estate Financial and Investment Analysis 17

HOW TO CHOOSE THE CORRECT CAP RATE

How do you know what the correct capitalization rate is? Only by knowing
intimately every feature of the property you are considering, along with the
basic factors touched upon above:
Investor demand for and the existing supply of the particular type of
property
Stability and security of future income
Capitalization rates of price earning ratios of alternate, non-real estate
investments with comparable risk.
Real Estate Financial and Investment Analysis 18

DETERMINING RISK AND DEMAND

The investor can determine risk and demand as it affects the CAP rate by carefully
examining the propertys features:

1. Exact Location
In the main business district, for example, even a few feet may make one
location better than another. Access to mass transportation becomes
increasingly important as the costs of private transportation and/or regulations
become increasingly higher.
2. Age of the Building
The older the building, the less future income can be derived from it in its
present state.
3. Size of the Land Parcel
Real Estate Financial and Investment Analysis 19

DETERMINING RISK AND DEMAND

4. Quality of the Tenancies


For example, other things being equal, a long-term lease represents more
stable value than a short-term lease (e.g., hotel/motel room rentals are far less
secure than apartment building leases).
5. Existing Financing on the Property Even between properties of otherwise equal
investment value, better financing on one may give it an apparently lower
CAP rate.
6. Operating Costs
Pay particular attention to higher energy costs for heating and air conditioning.
In any comparison of buildings for investment purposes, the type of
construction (glass walls, for example) can have an important bearing on those
costs. Labor costs and the likelihood of continued increases also need to be
considered.
Real Estate Financial and Investment Analysis 20

EXCEL SPREAD SHEET AND CHART INSERTS

PP 16 - 22
Real Estate Financial and Investment Analysis 21

II. EVALUATING THE RISK-RETURN TRADEOFF


FOR A REAL ESTATE PROJECT

Now we will address the generation of the discounted cash flow, and take a first
cut at financial ratio analysis.
Real Estate Financial and Investment Analysis 22

DISCOUNTED CASH FLOW MODELS

I. DCF Model-Basic Data Requirements

A. Investment outlays
land costs
building costs
depreciation method
useful life
B. Operational characteristics
rental income
vacancy and collection factors
operating expenses
changes over time
Real Estate Financial and Investment Analysis 23

DISCOUNTED CASH FLOW MODELS

I. DCF Model-Basic Data Requirements

C. Financing
amount of equity
amount of debt
amortization schedules
interest rates
required rate of return
D. Reversion
holding period
terminal value
debt retirement plans
reversion period expenses
Real Estate Financial and Investment Analysis 24

DISCOUNTED CASH FLOW MODELS

I. DCF Model-Basic Data Requirements

E. Taxation elements
ordinary income
capital gains
recapture provisions
minimum tax, preference items
Real Estate Financial and Investment Analysis 25

II. DCF MODEL: INPUTS AND OUTPUTS

Basic
BasicData
Data
Requirements
Requirements
ofofModel
Model

CASH
CASHFLOW
FLOWANALYSIS
ANALYSIS
Annual
AnnualCash
Cash Reversion
ReversionCash
Cash
Flows
Flowsduring
during Flow
FlowatatEnd
Endofof
Holding
HoldingPeriod
Period Holding
HoldingPeriod
Period

Riskiness Rate Implicit


ImplicitAssumptions
Riskiness RateofofReturn
Return Assumptions
--Leverage
Leverage --IRR/NPV --CAP
CAPRates
Rates
IRR/NPV
--Coverage
Coverage --Price/Rent
Price/RentRatios
Ratios
--Break-even
Break-evenPoints
Points --Expense
ExpenseRatios
Ratios
Real Estate Financial and Investment Analysis 26

RISK DICHOTOMY FOR REAL ESTATE

Risk
Risk

Assets
Assets Debt/Equity
Debt/Equity

Business
BusinessRisk
Risk Financial
FinancialRisk
Risk
Real Estate Financial and Investment Analysis 27

III. PROBLEMS INHERENT IN REAL ESTATE


INVESTMENT ANALYSIS FOR INCOME
PROPERTIES: UNDERLYING RISK ANALYSIS
A. Stabilized pro forma net operating income
B. Projected changes in operating expenses and revenue base
C. Projected selling price or refinancing value
D. Estimated holding period
E. Reinvestment opportunities
F. Tax effects and financing effects
Real Estate Financial and Investment Analysis 28

A HIDDEN ISSUE IN MANY ANALYSIS:


EXPECTED DISTRIBUTION OF RETURNS FOR INVESTMENTS

_
R Ri

ESTIMATED RATE OF RETURN

R = Expected mean rate of return


Ri = The ith investment expeced rate of return

IMPORTANT ISSUES TO CONSIDER


Is distribution stable?
Does the mean shift over time?
Does the shape change over time?
How is the distribution affected by tax changes, changes in
inflation, general economic conditions, and so forth?
Real Estate Financial and Investment Analysis 29

SPREAD SHEET ANALYSIS - 1986 TAX LAWS

EXCEL SPREAD SHEET AND CHART INSERTS


Real Estate Financial and Investment Analysis 30

OFFICE BUILDING MARKET ANALYSIS

1. KEY ELEMENT: Non manufacturing employment growth is the underlying


demand generation for office space.

2. Analysis of the office buildings, though related more or less to all sub-markets,
must stratify the market into appropriate subsections (see Figure 1).

Figure 1
Downtown Suburbs

High-rise Mid-rise Office Parks Other


Multiple Multiple Office use only Office use
Single Single Mixed use Mised use

Further subclassification is possible for each submarket based on age,


amenities, and locations.
Real Estate Financial and Investment Analysis 31

EXPLAINING OFFICE MARKET INSTABILITY

1. High financial leverage typical of office building finance makes new


construction highly sensitive to changes in mortgage money rates and terms.
2. Tax shelter resulting from depreciation and interest deduction from taxable
income provides a strong inducement to builders and investors to construct
office buildings during periods of prosperity.
3. Office building construction often reflects non-market considerations, such as
corporate prestige and image.
Real Estate Financial and Investment Analysis 32

EXPLAINING OFFICE MARKET INSTABILITY

4. The elasticity of supplies of existing office space facilitates the postponement of


new demand under conditions of uncertainty, high money rates, or recession.
5. The eternal optimism of developers, the naivete of lenders, and the lack of
sophisticated market analysis techniques prolong periods of over- and under-
construction.
6. The long planning and construction period required often results in continued
high construction volume long after weakness becomes apparent in the
demand for office space.
Real Estate Financial and Investment Analysis 33

OFFICE SPACE MARKET ANALYSIS


D - S = 1
1- Vn
Demand Supply Normal expanded demand
to allow for vacancy

(G + U + Or )
Net real growth from Office space for New space
net employment upgrading tenants removed

- ( On + Ov )
Space added Space overhang
previous years
Where, Vn = vacany rate(normal)
G = tenants coming from community employment growth
U = demand from present tenants for upgrading
Or = office space removed from inventory
On = office space added by new construction or rehabilitation
Ov = vacant space carryover from previous years
Real Estate Financial and Investment Analysis 34

OFFICE SPACE MARKET ANALYSIS

Demand for office space results from


Expansion of space requirements by existing tenants
New tenants moving from other cities
New business firms in the community

Increases in supply of office space may result from


Existing tenants going out of business, reducing space, or moving to other
cities
Addition of new office space being added (including remodeling)
Vacant office space available from previous years
Real Estate Financial and Investment Analysis 35

OFFICE SPACE MARKET ANALYSIS

Example 1: Consider a community with following characteristics


5 percent office-space vacancy target, Vn
Net real growth G of 1 million square feet of space
Upgrade demand U for 760,000 square feet
No space removed Or from inventory
200,000 square feet of space added Ou to the market
250,000 square feet of over hang Ov

Then:
D- S = 1 (G+U+Or )- (Ou +Ov )
1- Vn
= 1 (1,000,000+750,000+0)- (200,000+250,000)
1- 0.05
=1,392,105 square feet

This indicates than an additional 1.4 million square feet of space could be built
and absorbed.
Real Estate Financial and Investment Analysis 36

OFFICE SPACE MARKET ANALYSIS

Example 2: Using the above data and not knowing the amount of space added Ou
to the market, the absorption rate can be determined by first setting the market in
equilibrium:

Then,
D- S =0
Thus,
Ou = 1 (G+U +Or )- (Ou +Ov )
1- Vn
= 1 (1,000,000+750,000+0)- 250,000
1- 0.05
=1,592,105 square feet
Real Estate Financial and Investment Analysis 37

ANALYZING OFFICE BUILDING INVESTMENTS:


SPECIFIC BUILDINGS

1. Building-site specific
Street identity and prestige
Efficiency ratio for net rentable space
Percent of full floor users
Tenant improvements
Tenant mix
Tenant turnover and leasing conditions
Parking
2. Locational features
Downtown
Airport
Regional shopping centers
Freeways/heavily traveled main roads
Real Estate Financial and Investment Analysis 38

ANALYZING OFFICE BUILDING INVESTMENTS:


SPECIFIC BUILDINGS

3. Market elements
Amount and quality of competing space (correct strata)
Current rentals
Vacancies (and reasons for vacancies)
Absorption rates
Market capture potential
4. Key to office building investment analysis
Purchase price of the property
Financing terms
Lease terms
Present and future levels of operating income and expenses
Future selling price
Applicable depreciation rules
Income and capital gains tax rates
Real Estate Financial and Investment Analysis 39

PROFITABILITY RATIOS
(Calculated for each year of project)

1. NOI measures overall economic total property value (cost) return of


MV captial asset
does not take into account taxes, financing or time value of money

2. CFBT measures impact of leverage(before taxes) on equity investor return


I0 does not take into account tax benefits or time value of money

3. CFAT measures equity investor returns annually after taxes and financing
I0 does not take into account time value of money

One might also calculate profitability ratios which include loan amortization
build-up and/or equity build-ups from parcel appreciation.

Note: I0 = Initial investment


MV = Property Value
Real Estate Financial and Investment Analysis 40

RISK RATIOS

1. NOI measures liquidity of project


DS measures occupancy rate and rent rates needed to meet
debt service (coverage ratio)

2. Loan Balance measures leverage of project over time and riskiness as


Property Value seen by lender
measures potential for refinancing (loan-value ratio)

3. DS - OE measures total operating expenses (including debt service)


GPI as portion of gross possible income
measures occupancy rate needed to remain "liquid"
(break-even point)

Other variants of these ratios can be used to analyze specific cash flow risk
effects.

Note: DS = Periodic Debt Service


OE = Operating Expense
GPI = Gross Possible Income
Real Estate Financial and Investment Analysis 41

ASSUMPTION RATIOS

1. NOI measures overall capitalization rate over time


MV used to see if project's "numbers" are consistent with market
CAP rates for comparable properties

2. MV another measure of market comparability (gross rent


GPI multiplier)

3. OE OE measures operating expense characteristics of project which


GPI or GEI can be compared with comparable properties

Again, variants of these ratios can be used to check comparability of


specific property elements.
Real Estate Financial and Investment Analysis 42

PROFITABILITY RATIOS

TIME PERIOD NOI MV ATCF


(to be filled in by student) MV I0 I0

1
2
3
4
5
Real Estate Financial and Investment Analysis 43

RISK RATIOS*

TIME PERIOD NOI DS + OE


(to be filled in by student) DS GPI

1
2
3
4
5

*Initial loan-to-value ratio is __________ divided by __________


which equals __________.
Real Estate Financial and Investment Analysis 44

ASSUMPTION RATIOS

NOI1 = =
V0

V0 = =
GPI1
OE1 = =
GPI1
Real Estate Financial and Investment Analysis 45

III. DEVELOPNG THE TECHNIQUES OF


FINANCIAL ANALYSIS

This session will focus on two of the most widely used analytic tools:
Net present value (NPV)
Internal rate of return (IRR)
Real Estate Financial and Investment Analysis 46

FUNDAMENTALS OF INVESTMENT ANALYSIS


MESURING RETURNS

I. Time Value of Money: Time and Risk

A certain dollar today is worth more than a certain dollar tomorrow


A risky dollar tomorrow is worth less than a more certain dollar tomorrow
Real Estate Financial and Investment Analysis 47

I. TIME VALUE OF MONEY: TIME AND RISK

A. Timing: Present Value and Future Value


If $1.00 now could be invested at 10percent for one year, it would produce $1.10
as the total return. In this context, it is said that:
The present value (PV) of $1.10 next year is $1.00
The future value (FV) of $1.00 today is $1.10
The interest rate is the opportunity cost of funds

Q
PV = 1 , where 1 = discount factor and r = the discount rate.
1+r 1+r
1.00 = 1.10
1.1
Under the same circustances, $1.21 two years from now has a PV of $1.00:
Q
PV = 2 2 , thus 1.00= 1.212
(1+r) (1.1)
Real Estate Financial and Investment Analysis 48

I. TIME VALUE OF MONEY: TIME AND RISK

B. NPV (net present value) and IRR (internal rate of return)


NPV = Discounted cash flow of benefit stream - Discounted cash flow of cost
stream

Q Q Q
NPV = 1 + 2 2 +L + t t - C0
1+r (1+r) (1+r)

Example:

C0 =2.00, Q1 =1.10, Q2 =1.21


1.10 1.21
If r = 5%, then NPV = + - 2.00 =0.15
1.05 (1.05)2

If r = 10%, then NPV =1.10 + 1.212 - 2.00 =0


1.1 (1.1)

1.10 1.21
If r = 15%, then NPV = + - 2.00 =- 0.13
1.15 (1.15)2
Real Estate Financial and Investment Analysis 49

II. SIMPLE INVESTMENT DECISION RULES

A. NPV Rule
NPV 0 Accept
NPV 0 Reject

B. IRR Rule

IRR r Accept
IRR r Reject

Note: There is no conflict in NPV and IRR rules for simplest situations, where

i) Qt 0 for all t and C0 0.


ii) C0 Qt
Real Estate Financial and Investment Analysis 50

Definition: IRR is a discount rate that takes the NPV = 0. Hence 10 percent is
IRR of our example.

0.4
0.3
0.2
NPV 0.1
0
-0.1 0 5 10 15

-0.2
r
Real Estate Financial and Investment Analysis 51

Example: Two Mutually exclusive investments

Period Option A Option B

0 -2.00 -2.00
1 +1.10 0.00
2 +1.21 +2.42

IRR for Option A


1.10 1.21
0 =- 2.00+ + => IRR=10%
(1+r) (1+r)2

IRR for Option B


2.42
0 =- 2.00+ 2
=> IRR=10%
(1+r)

Discount Rate NPV Option A NPV Option B

0 0.31 0.22
5 0.15 0.20
10 0.00 0.00
15 -0.13 -0.17
Real Estate Financial and Investment Analysis 52

Reinvestment Assumption

For Option A, if 1.10 at the end of year 1 reinvested at 10% will yield
1.10(1.1)=1.21. Hence, if one can reinvest at the IRR=10%, Option As
Benefit Stream FV=1.21+1.21-2.42. This is identical to FV of Benefit Stream
for Option B.

Conclusion

If IRR, reinvestment, and discount rate are identical, IRR rate and NPV will yield
proper and consistent investment decisions.
Real Estate Financial and Investment Analysis 53

III. IRR and NPV Conflicts

A. Multiple IRR solutions


B. Mutually exclusive investments with different timing of cash flows
C. Mutually exclusive investments with scale differences
D. Reinvestment rate substantially different from IRR
Real Estate Financial and Investment Analysis 54

Class Problem

Consider two alternative income-generating real estate investments, Project A


and Project B, each with an initial outlays (purchase price) of $10,000 in cash.
Each project has a life of three years, with anticipated net cash flows after
taxes as follows in Table 1:

Table 1: Net Cash Flow After Taxes

Year 1 Year 2 Year 3

Project A $5,000 $5,000 $5,000


Project B $0 $0 $16,500

For each project, assume that there is no salvage value after Year 3 and that
net cash flows are received at the end of each year.

1. What is the internal rate of return for each investment? Show the formula
you used. (Table 2 may provide helpful data for those with "slow
calculators.")
Real Estate Financial and Investment Analysis 55

Table 2

Alternative Project A Project A Project B


Reinvestment Present Value of Year 3 Terminal Present Value of
Rates (percent) Cash Flow Value, Using Cash Flow,
Discount Rates Reinvestment Discount Rate
Indicated in Left Rates Indicated in Indicated in Left-
Column Left-Most Column Most Column

6.0 $13,365 $15,920 $13,860


10.0 12,435 16,550 12,391
18.2 10,900 17,900 10,000
20.0 10,520 18,200 9,553
23.0 10,000 18,750 8,415
Real Estate Financial and Investment Analysis 56

2. Using the internal rate of return criteria, which investment should be


undertaken? Does the IRR rule hold true for this problem? Explain fully.

3. Suppose now that there are possible reinvestment opportunities for net cash
flows for your investments. Explain where the "terminal value" calculations
for Project A in Table 2 come from. What are their significance in
determining optimal investment choice? Finally, what are the "terminal
values" for Project B at the corresponding reinvestment rates?

4. Assuming that each investment has a reinvestment rate for generated cash
flows of 20 percent and that investors have an opportunity cost for funds
provided for investment of 6 percent, which investment project should be
selected? Explain fully and show important calculations, formulae, and so
forth.
Real Estate Financial and Investment Analysis 57

SUGGESTED SOLUTION TO CLASS PROBLEM


5000 5000 5000
NPV A(r)=0 = + + - 10,000
(1+r) (1+r) 2 (1+r) 3
IRR
16,500
NPV B (r)=0= 3
- 10,000
(1+r)

PA = 23.0% and P B = 18.2%

20,000

15,000

10,000

5,000 r
0
0 10 18.2 23
Px Pb Pa
Real Estate Financial and Investment Analysis 58

1. Choose investment with greatest NPV which differs with interest rate used for
discounting PX.

2. NTVA = 5000(1+i)2 + 5000(1+ i)+5000


Terminal Value of Cash Flows, excluding initial cost of $10,000.
NTVB = 16,500
NTV and NPV rules yield same answers! Why?

3. At i = 20% NTVA = 18,000 > 16,500 = NTVB if A is preferred to B; does NPV


rule yield same result?
Real Estate Financial and Investment Analysis 59

IV. EXAMINING THE PROBLEMS AND PITFALLS OF


FINANCIAL ANALYSIS

The day concludes with a presentation on duration and reinvestment issues, how
to take uncertainty into account, and a summary of analytic techniques.

Approaches to risk analysis


Most likely outcome versus best/worst scenarios
Sensitivity analysis for key parameters
Probabilistic approaches

Problems with the use of IRR


Uniqueness
Assumed reinvestment rate = IRR
Borrowing/lending rate = market rate = IRR
Real Estate Financial and Investment Analysis 60

Three apparently different problems with the discount rate


Cash flow disparity
Project scale
Time horizon difference
Real Estate Financial and Investment Analysis 61

Reinvestment rate assumption and typical problems


Time disparity of cash flows

Year Investment A Investment B

0 (10,000) (10,000)
1 0 11,000
2 15,625 2,600

IRR 25% 30%


Real Estate Financial and Investment Analysis 62

Scale size differences

Year Investment A Investment B

0 (35,000) (50,000)
1 43,750 61,000

IRR 25% 22%


Real Estate Financial and Investment Analysis 63

Time horizon issue

Year Investment A Investment B

0 (100) (100)
1 0 0
2 0 0
3 0 0
4 0 0
5 147 0
6 0
7 0
8 0
9 0
10 (179)

IRR 8% 6%
Real Estate Financial and Investment Analysis 64

Other issues related to the use of IRR include:


Are the IRR and interest rates independent of one another for most
investment decisions?
How does the optimal holding period affect cash flows?
How does the analysis change if there are capital budgeting/rationing
constraints?
Real Estate Financial and Investment Analysis 65

DURATION: AN INTRODUCTION

The following formula can be used to derive duration:

T t Q
( 1 r)t t
Duration D t 1
T Q
( 1 tr)t
t 1

Weighted average time until cash flow payment. The


weights are the present value of the cash flows
themselves.


Note : D PV 1 r
PV ( 1 r)
Elasticity of Interest Rate - Value
Real Estate Financial and Investment Analysis 66

This illustration shows how duration can be calculated:

$10,000 loan at 10%, all due in 10 years

Q t Q
t t
Time Periods CF PV@10%
(1+r) t 10,000 (1+r) t 10,000

0 -10,000 -10,000 -1.0 0.0


1-9 0 0 0.0 0.0
10 29,937 10,000 1.0 1.0

D=10

For "zero coupon" instrument: maturity = duration


Real Estate Financial and Investment Analysis 67

For an interest-only instrument, the duration changes:

For Interest Only Instrument

Q t Q
t t
Time Periods CF PV@10%
(1+r) t 10,000 (1+r) t 10,000

0 -10,000 -10,000 -1.0000 0.0000


1 1,000 909 0.0909 0.0909
2 1,000 826 0.0826 0.1652



9 1,000 424 0.0424 0.3816
10 10,000 4,246 0.4246 4.2460

D = 6.7638
Real Estate Financial and Investment Analysis 68

For a fully amortized 10%, 10-year loan:

Q t Q
Time Periods CF PV@10% t t
(1+r) t 10,000 (1+r) t 10,000

0 -10,000 -10,000 -1.0000 0.0000


1 1,627 1,479 0.1479 0.1479
2 1,627 1,344 0.1344 0.2688



10 1,627 627 0.0627 0.6270

D = 4.7240
Real Estate Financial and Investment Analysis 69

Duration and overall investment returns are shown below:

(1) (2) (3) (4) (3+4) (2+3+4)


Time Project Reinvest at Reinvest at Total Total
Period Cash Flows iL iR Reinvest Investment

0 (-1,000) - - - -1,000
1 400 -400 - -400 0
2 560 +420 -980 -560 0
3 480 - 1,127 1,127 1,607

IRR 20% 5% 15% 11.86% 17.13%


Real Estate Financial and Investment Analysis 70

Finally, these charts show the computations for durations and overall return:
Qt t Qt
Time Periods CF PV@10%
(1+r) t 1,000 (1+r) t 1,000
0 -1,000 -1,000 -1.000 0.000
1 400 333 0.333 0.333
2 560 389 0.389 0.778
3 480 278 0.278 0.834
D = 1.945 yrs.

D
Overall Return =IRR ( D)+IRR( )
A T 1- T
1.945
=(.20)(1.945 )+(.1186 )( )
3 1- 3
=(.20)(.648)+(.1186 )(.352)
=.1713