Chapter 18
Investment Decisions: Ratios
REAL ESTATE
FIN 331
Investment Decision-Making
A. The difference between Investment Value
and Market Value
1. Market Value reflects the value of the land and
structures thereon
2. Investment Value takes into consideration future
income streams resulting from the acquisition of
a property
a.
b.
c.
d.
e.
Rental rates
Vacancy rates
Operating expenses
Potential future capital investment
Risk attributes
Investment Decision-Making
A Estimating net operating income for the next year
+
=
=
=
=
PGI
VC
MI
EGI
OE
CAPX
NOI
DS
BTCF
TAX
NI
Potential Gross Income
Vacancy & Collection Loss
Miscellaneous Income
Effective Gross Income
Operating Expenses
Capital Expenditures
Net Operating Income
Debt Service (Interest Only)*
Before Tax Cash Flow
Fed, State, Local Taxes
Net Income
* The authors acknowledge on page 489, 3rd paragraph, that the
principal portion of mortgage payments are not tax deductible.
Centre Point: Projected 1st-Year NOI
See Note regarding this table
Potential Gross Income (PGI)
- Vacancy & Collection Loss (VC)
= Effective Gross Income (EGI)
$180,000
$18,000
$162,000
- Operating Expenses (OE)
$64,800
- Capital Expenditures (CE)
$8,100
= Net Operating Income (NOI)
$89,100
- Debt Service (Interest)
$51,219
= Before Tax Income
$37,881
- Taxes (24%)
$ 9,091
= Net Income
$28,790
Note: This table differs from Exhibit 18-4 due to the fact that only
interest is a tax deductible expense.
Operating vs. Capital Expenditures
A. Operating expenses:
1. Keep property operating & competitive
2. Do not increase value or extend useful life
3. Examples: minor roof repairs, air conditioner
servicing, lawn maintenance, utilities, etc.
B. Capital Expenditures: Capitalized
1. Increases market value of property
2. Examples: Roof replacement, air-conditioner
replacement, installation of new landscaping
3. These expenditures are depreciated over time.
Investment Decision-Making
C. More on Capital Expenditures
1. Some treat CAPX as a Reserve (above the line),
some below the line
a. Above: PGI – VC = EGI – OE – CE = NOI
b. Below: PGI – VC = EGI – OE = NOI – CE = NCF (Net
Cash Flow)
c. Note: Below the line CE is not a tax deductible as
“expense” → capitalized: it gets amortized as depreciation
D. NOI: Fundamental determinant of value
a. Service the mortgage debt and
b. Provide investor with an acceptable return on equity
Capital Expenditures
Pro Forma Treatment
Appraisal Terminology
(“Above line”)
PGI
− VC
= EGI
− OE
− CAPX Reserve
= NOI
Investment Terminology
(“Below line”)
PGI
− VC
= EGI
− OE
= NOI
− CAPX
= Net Cash Flow
Use of Leverage
A. Why do investors borrow?
1. Limited financial resources/wealth
2. Leverage amplifies equity returns (& risk)
3. Also permits more portfolio diversification
B.Cash flow effect of borrowing:
Net operating income
− Debt service (interest only)
= Before-tax Income (BTI)
Debt Financing for Centre Point
A. Terms
75% loan, 30 year term, 6.5% contract rate, up-front
fees of 3% of loan amount
B.Net loan proceeds:
= $792,000 − (0.03 x $792,000)
= $792,000 – $23,760
= $768,240
A.Initial equity = $1,056,000 - $768,240
= $287,760
B.Payment: $5,005.98 or $60,072* per year
1. Interest Portion = $51,219
2. Principal Portion = $8,853
Centre Point: Estimated Before-Tax
Cash Flow (BTCF)
A. Potential Gross Income (PGI)
$180,000
B. - Vacancy & Collection Loss (VC) $18,000
C. = Effective Gross Income (EGI) $162,000
D. - Operating Expenses (OE)
$64,800
E. - Capital Expenditures (CE)
$8,100
F. = Not Operating Income (NOI)
$89,100
G. - Debt Service
$60,072*
H. = Before-Tax Cash Flow (BTCF)
$30,656
* Interest = $51,219 (the only tax deductible portion)
Partnerships, Limited Liability
Companies, etc.
A. Centre Point Pro forma displays expected total
CFs from property available for distribution to
equity investors
B. When using partnerships & limited liability
companies, all CFs & income tax consequences are
allocated and “flow through” to individual investors
C.Thus, further analysis is usually required to
determine expected CFs & returns earned by
various equity investors
1. All distributions are based on investors’ pro rata
share of contributed equity
Financial Ratios (see Exhibit 18–6)
A. Operating Expense Ratio = Operating Expenses
divided by Effective Gross Income
B. Loan-to-Value Ratio = Loan divided by Fair Market
Value
C. Debt Coverage Ratio = NOI divided by Debt
Payments
D. Debt Yield Ratio = first year NOI divided by the
first mortgage loan
E. Profitability Ratios
1. Capitalization Rate = NOI1 / Buy Price
2. Equity Dividend Rate = BTCF / Equity Investment
Valuation Multipliers
Appraisers use simple rules of thumb to
value rental properties
A. Multipliers*
1. Net income multiplier
NIM = Buy Price / NOI
2. Effective gross income multiplier (EGIM)
EGIM = Buy Price / EGI
* Multipliers work best when properties
have a high degree of similarity
Pros and Cons of Ratios & Multipliers
A. Pros
1.
2.
3.
4.
Quick & easy to compute
Intuitive
Facilitates comparison with similar properties
No explicit assumptions about future
B.Cons
1. No clear benchmarks for acceptable range
2. Only a partial view of performance
3. No explicit assumptions about future
Homework Assignment
A. Key terms: after-tax cash flow, net income
multiplier, operating expense ratio,
capitalization rate, effective Gross income
multiplier, Effects of Leverage
B. Study Questions: 1, 2, 3, 7, 9, 10, 12
Practice Problem
You are considering purchasing a small office building for $1,750,000.
A. Your expectations include:
1.
2.
3.
4.
5.
6.
7.
8.
First-year gross potential income of $325,000;
Vacancy & collection losses equal to 12% of PGI;
Operating expenses = 38% of EGI;
Capital expenditures = 5% of EGI
$1,312,500 mortgage (75% LTV) @ 7%
Mortgage will be amortized over 25 years
Total up-front financing costs = 2% of the loan amount
Required equity investment is
B. Prepare a Pro Forma Income Statement
C. Compute the Following Ratios
1.
2.
3.
4.
5.
6.
Cap Rate
Equity Dividend Rate
Effective Gross Income Multiplier
Operating Expense Ratio
Debt Coverage Ratio
Debt Yield Ratio
Solution
Potential Gross Income
Vacancy &Collection Loss
Effective Gross Income
Operating Expenses
Capital Expenditures
Net Operating Income
Debt Service (Interest only) 12m
Before Tax Income
Cap Rate = NOI / Purchase
Equity Dividend Rate
Effective Gross Income Multiplier
Operating Expense Ratio
Debt Coverage Ratio*
Debt Yield Ratio
Purchase Price
Mortgage Loan (0.75 LTV) 7.00%
Loan Costs (2%)
Initial Equity Investment
$
$
$
$
$
$
$
$
325,000
39,000
286,000
108,680
14,300
163,020
91,239
71,781
9.32%
17.45%
6.12
38.00%
1.46
12.42%
$1,750,000
$1,312,500
$26,250
$411,250
Gross D.S.
$
111,318
=NOI/DS
Monthly P&I
-9,276.48
* Debt Coverage uses total amount of payments (P&I) = 12 * 9276.28 = 111317.72