Chapter 19
Investment Decisions: NPV and IRR
REAL ESTATE
FIN 331
Overview
A. Major theme: most RE decisions are made
with an investment motive
1.
magnitude of expected CFs--and the values they create—
are at the center of investment decision making
B. Chapter 18 focuses on widely used, singleyear, return measures, ratios, & income
multipliers
C. These criteria are relatively easy to calculate
& understand—an advantage in the eyes of
many industry professionals
Overview
D. Limitation of these single-year return
measures & ratios?
1. They do not explicitly incorporate income
producing ability of property beyond 1st year
of rental operations
2. May lead to suboptimal investment decisions
Overview
E. Many investors also perform multi-year
analyses of potential acquisitions
F. When using multi-year Discounted Cash
Flow (DCF) decision making methods,
investor must
1. Estimate how long she expects to hold property
2. Make explicit forecasts of:
a. property’s net CF for each year,
b. net CF produced by expected sale of property
3. Select rate of return at which to discount all
future CFs
Overview
G. NPV decision rules
1.
2.
3.
NPV = Present Value of ATCF minus the Initial Investment
If NPV is greater than 0, we make the investment
If NPV is less than 0, we will not make the investment
1.
Leverage involves the use of debt to finance part of the
acquisition
The interest charges on debt will reduce our taxable income
Traditional analysis uses ATCF values to compute NPV
H. Measuring the impact of leverage
I.
2.
3.
Internal Rate of Return (IRR)
1.
2.
3.
When NPVs are greater than 0, the internal rate of return will be
greater than the discount rate used to compute NPV
if NPV is equal to 0, then the internal rate of return equals the
discount rate
if NPV is less than 0, then the IRR is less than the discount rate
Centre Point Office Building
Centre Point: 5-Year Operating Pro
Forma-Unlevered
Sale of Centre Point at End of 5th Year
A. Assumptions
1.
2.
3.
4.
5.
6.
Annual market rent increases = 3% per year
Vacancy & Collection Losses = 10% per year
Operating Expenses = 40% of EGI
Capital Expenditures = 5% of EGI
Expected Holding Period = 5 years
Selling price based on Year 6 NOI
a. NOI6 = 103,291 (projected)
b. Sale Price = 103,291 / 0.0875 =$ 1,180,469
Net Present Value of Centre Point
NPV = PVin − PVout
PVout in this example is equal to original equity
investment of $287,760
NPV = $319,591 − $287,760
Decision: Accept Centre Point investment
opportunity because doing so will increase
equity investor’s wealth by $31,831
Measuring the Impact of Risk on NPV
A. Sensitivity analysis
1. Most likely scenario
2. Worst-case scenario
3. Best-case scenario
B. Value of computer
1. Excel spreadsheets
2. Specialized software such as ARGUS
C. Monte Carlo simulation (using random
probabilities to develop outcome
distributions)
HOMEWORK ASSIGNMENT
A. Key terms: before tax cash flows, after-tax
cash flows, leverage, leverage cash flow,
unleveraged cash flow
B. Study questions: 2, 3, 5, 9, 11