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Fundamentals of Project Financial and Investment Analysis
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.
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...
L x L x L
REGIONAL FACTORS NEIGHBORHOOD SITE-SPECIFIC
& ELEMENTS FEATURES
MACROECONOMIC
CIRCUMSTANCES
Real Estate Financial and Investment Analysis 4
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
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
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
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
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
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
Land 3,000,000
NO I =MV, where
k
MV=(1/k)NOI
MV
NOI
Real Estate Financial and Investment Analysis 16
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
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
PP 16 - 22
Real Estate Financial and Investment Analysis 21
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
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
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
E. Taxation elements
ordinary income
capital gains
recapture provisions
minimum tax, preference items
Real Estate Financial and Investment Analysis 25
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
Risk
Risk
Assets
Assets Debt/Equity
Debt/Equity
Business
BusinessRisk
Risk Financial
FinancialRisk
Risk
Real Estate Financial and Investment Analysis 27
_
R Ri
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
(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
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
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
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
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)
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.
RISK RATIOS
Other variants of these ratios can be used to analyze specific cash flow risk
effects.
ASSUMPTION RATIOS
PROFITABILITY RATIOS
1
2
3
4
5
Real Estate Financial and Investment Analysis 43
RISK RATIOS*
1
2
3
4
5
ASSUMPTION RATIOS
NOI1 = =
V0
V0 = =
GPI1
OE1 = =
GPI1
Real Estate Financial and Investment Analysis 45
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
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
Q Q Q
NPV = 1 + 2 2 +L + t t - C0
1+r (1+r) (1+r)
Example:
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
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
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
0 -2.00 -2.00
1 +1.10 0.00
2 +1.21 +2.42
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
Class Problem
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
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
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.
The day concludes with a presentation on duration and reinvestment issues, how
to take uncertainty into account, and a summary of analytic techniques.
0 (10,000) (10,000)
1 0 11,000
2 15,625 2,600
0 (35,000) (50,000)
1 43,750 61,000
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
DURATION: AN INTRODUCTION
T t Q
( 1 r)t t
Duration D t 1
T Q
( 1 tr)t
t 1
Note : D PV 1 r
PV ( 1 r)
Elasticity of Interest Rate - Value
Real Estate Financial and Investment Analysis 66
Q t Q
t t
Time Periods CF PV@10%
(1+r) t 10,000 (1+r) t 10,000
D=10
Q t Q
t t
Time Periods CF PV@10%
(1+r) t 10,000 (1+r) t 10,000
D = 6.7638
Real Estate Financial and Investment Analysis 68
Q t Q
Time Periods CF PV@10% t t
(1+r) t 10,000 (1+r) t 10,000
D = 4.7240
Real Estate Financial and Investment Analysis 69
0 (-1,000) - - - -1,000
1 400 -400 - -400 0
2 560 +420 -980 -560 0
3 480 - 1,127 1,127 1,607
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