CHAPTER 2

‹#›
VALUE: THE CENTRAL
IDEA
• Examples of alternative value concepts include:

– market value,

– investment value, and

– mortgage value.

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 What is Real Estate
‹#›
Valuation?

• Investors expect cash flow from operations and

from the sale of the property.

• Value is affected by the magnitude, timing, and

riskiness of the expected cash flows.

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 TIME-VALUE-OF-
‹#›
MONEY TERMS

• Interest Rate, Discount Rate, Rate of Return

• Present Value
• Future Value
• Lump Sum
• Annuity
• Compounding
• Discounting
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 Present Value of a Single
‹#›
Lump Sum

• Example: Assume Astute Investor has an

opportunity that provides $1,610.51 at the end of
five years. If Ms. Investor requires a 10 percent
annual return, how much can Astute pay today for
this future sum?

• Solution = $1,000.00

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 ‹#› Sinking Fund Payment

• Example: Assume Astute Investor wants to

accumulate $6,105.10 in five years. Assume Ms.
Investor can earn 10 percent, compounded
annually. How much must be invested each year
to obtain the goal?

• Solution = $1,000.00

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 Future Value of a Single
‹#›
Lump Sum

• Example: Assume Astute Investor invests $1,000

today which pays 10 percent, compounded
annually. What is the expected future value of
that deposit in five years?

• Solution = $1,610.51

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 ‹#›
Annuities

• Ordinary Annuity
– (e.g., mortgage payment)
• Annuity Due
– (e.g., a monthly rental payment)

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 Present Value of an
‹#›
Annuity

• Example: Assume Astute Investor has an

opportunity that provides $1,610.51 at the end of
each year for five years. If Ms. Investor requires a
10 percent annual return, how much can Astute
pay today for this future cash flow series?

• Solution = $6,105.10

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 Future Value of an
‹#›
Annuity

• Example: Assume Astute Investor invests $1,000

at the end of each year in an investment which
pays 10 percent, compounded annually. What is
the expected future value of that investment in
five years?

• Solution = $6,105.10

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 Payment to Amortize
Mortgage Loan
‹#›

• Example: Assume Astute Investor would like a

mortgage loan of $100,000 at 10 percent annual
interest, paid monthly, amortized over 30 years.
What is the required monthly payment of principal
and interest?

• Solution = $877.57

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 Loan Amortization
‹#› Schedule
Monthly Outstanding
Month Debt Service Interest Principal Balance
0 $100,000.00
1 877.57 833.33 44.24 99,955.76
2 877.57 832.96 44.61 99,911.15
3 877.57 832.59 44.98 99,866.17
4 877.57 832.22 45.35 99,820.82
5 877.57 831.84 45.73 99,775.09

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 Remaining Loan Balance
Calculation
‹#›

• Example: Determine the remaining balance of a

mortgage loan of $100,000 at 10 percent annual
interest, paid monthly, amortized over 30 years at
the end of year four.
– The balance is the PV of the remaining payments
discounted at the contract interest rate.
Solution = $97,402.22

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 Net Present Value (NPV)
‹#›

• The net present value is the present value of a

project’s cash inflows, minus the present value of
the cash outflows.
• The cash flows are discounted at the investor’s
required rate of return.

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 NPV Decision Criteria
‹#›

• If NPV>0, the project exceeds the investor’s

required rate of return.
• If NPV<0, the project does not meet the investor’s
required rate of return.
• If NPV=0, the project’s expected return equals the
investor’s required rate of return.

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 Internal Rate of Return
‹#›
(IRR)

• The internal rate of return is the discount rate at

which NPV = 0, the rate of return at which the
present value of the cash inflows equals the present
value of the cash outflows.

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 IRR Decision Criteria
‹#›

• If the IRR is greater than the investor’s required

return (the hurdle rate), the investment may be
accepted.

• The IRR decision criterion may be misleading

because it assumes that cash inflows can be
reinvested at the IRR rate.

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 Lender’s Yield and the
‹#› Effective Cost of Borrowing

• The lender’s yield is the IRR that equates the loan

amount with the present value of the payments to
be received.

• The borrower’s effective cost of borrowing is the

mirror image of the lender’s yield.

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 Capitalization Rate
‹#›

• The overall capitalization rate, Ro, is the ratio

between a property’s net operating income and its
value.
• Ro = CFt / SP,
– where CFt is the expected cash flow in year t, and
SP is the selling price of the property.

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