Chapter 19
Investment Decisions: NPV and IRR
REAL ESTATE
FIN 331
A Cautionary Note
A. On occasion authors make some changes
to simplify the examples.
B. Unhappily, when it comes to real property
and tax issues, this can lead to incorrect
conclusions regarding methodology.
C. Investment analysis requires precise data
AND knowledge of IRS tax law and
process.
Investment Valuation
A. Most commercial real estate decisions
involve investment motive
1. Investments are made in expectation of future
cash flows
2. The magnitude and timing of future cash
flows will determine whether or not an
investment is profitable or not
3. The Discounted Cash Flow method (DCF) is
used to determine the feasibility of an
investment
Investment Valuation
B. Required inputs for DCF analysis
1. Estimate how long the investor will hold the
property
2. Estimate the yearly net cash flows
3. Select an appropriate risk-adjusted discount
rate to complete the calculations
4. DCF process will yield a net present value
(NPV)
Shortcomings of NOI-Based Valuation
A. Limitation of NOI single-year return
measures & ratios?
1. They do not explicitly incorporate
income producing ability of property
beyond 1st year of rental operations
a. May lead to suboptimal investment
decisions
19-5
Multi-Year DCF
A. Many investors also perform multi-year analyses of
potential acquisitions
B. When using multi-year discounted CF 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
Centre Point Office Building
6-Year CF Projections
Assuming 3% per Year Rent Escalation
Assumed Sale Price in Year 5
Based on Year-6 NOI
Sale Price = NOI6 / Cap Rate: 103,291 / 0.0875 = $ 1,180,469
Centre Point by the Text
(with a some minor corrections)
Method of Depreciation per IRS
Recovery Periods Under ADS
Recovery Periods Under ADS
Centre Point by the IRS
DCF Investment Valuation
A. NPV decision rules
1. NPV = Present Value of ATCF minus the
Initial contact Investment
2. If NPV is greater than 0, we make the
investment
3. If NPV is less than 0, we will not make the
investment
DCF Investment Valuation
B. Measuring the impact of leverage
1. Leverage involves the use of debt to finance
part of the acquisition
2. The interest charges on debt will reduce our
taxable income
3. Traditional analysis uses ATCF values to
compute NPV
DCF Investment Valuation
C. Internal Rate of Return (IRR)
1. When NPVs are greater than 0, the internal
rate of return will be greater than the
discount rate used to compute NPV
2. if NPV is equal to 0, then the internal rate of
return equals the discount rate
3. if NPV is less than 0, then the IRR is less than
the discount rate
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