© OnCourse Learning

 Understand the value of an equity investment in real estate
 Understand how the use of debt can alter cash flows
 Understand the concept of an optimal balance of debt and equity financing
 Understand how more practical institutional matters affect the debt structure of real estate investments
© OnCourse Learning 2

 The value of an income-producing asset is a function of the income accruing to the asset
 Discounted cash flow (DCF) model
𝑃𝑉
0 𝑛
=
(1 + 𝑟) 𝑖 𝑖=1
𝐶𝐹 𝑖
 Income is generally measured as some form of cash flow
 Cash flows and discount rate can be hard to determine because of the nature of the asset
© OnCourse Learning 3

 Investor has two basic sources of financing: debt and equity
 Financial leverage is the use of debt in financing
 Positive leverage – the use of debt at a cost less than the return on the asset; increases the return on equity
 Negative leverage – the use of debt at a cost greater than the return on the asset; reduces the return on equity
 Neutral leverage – the debt cost is equal to asset return and return on equity is not affected
© OnCourse Learning 4

 The risk to the equity is increased by the use of financial leverage
 Leverage allows the cash flows to be divided into two components: less risky and more risky
 Value can be created if debt holders and equity holders have different risk-return preferences
© OnCourse Learning 5

 More risk-averse investor can invest in the lower-risk debt and less risk-averse investor can invest in riskier equity
 Tax-deductibility of interest payments on debt make it advantageous
 Federal government subsidizes the use of debt by providing tax relief
© OnCourse Learning 6

Gross Rent (GR)
– Vacancy (VAC)
+ Other Income (OI)
= Effective Gross Income (EGI)
– Operating Expenses (OE)
= Net Operating Income (NOI)
© OnCourse Learning 7

Net Operating Income (NOI)
– Mortgage Payment (MP)
= Before-Tax Cash Flow (BTCF)
– Tax Liability (Savings) (TXS)
= After-Tax Cash Flow (ATCF)
© OnCourse Learning 8

Net Operating Income (NOI)
– Interest Expense (INT)
– Depreciation (DEP)
= Taxable Income (TI) x Investor’s Marginal Tax Rate (t)
= Taxes (Savings) from operations (TXS)
© OnCourse Learning 9

Estimated Selling Price (ESP)
– Selling Expenses (SE)
= Net Sales Price (NSP)
– Unpaid Mortgage Balance (UMB)
= Before-Tax Equity Reversion (BTER)
– Total Taxes on Resale (TXR)
= After-Tax Equity Reversion (ATER)
© OnCourse Learning 10

Estimated Selling Price (ESP)
– Selling Expenses (SE)
= Amount Realized on Sale (AR)
– Adjusted Basis (AB)
= Total Gain from Sale (TG)
– Depreciation Recovery (DR)
= Capital Gain from Resale (CG)
© OnCourse Learning 11

Depreciation Recovery (DR) x Depreciation Recovery Tax Rate (td)
= Depreciation Recovery Tax (DRT)
Capital Gain x Capital Gains Tax Rate (tg)
= Capital Gains Tax (CGT)
Depreciation Recovery Tax (DRT)
+ Capital Gains Tax (CGT)
= Total Tax on Resale (TXR)
© OnCourse Learning 12

 Investor purchasing a warehouse with a purchase price of $1,125,000; acquisition costs of $36,000
 80% depreciable
 33,600 leasable square feet; Initial rent of $12/sq. ft. per year and will increase 5 percent per year
 Vacancy rate of 5% of gross rent per year; Operating Expenses are 40% of
EGI
 Mortgage is 75% LTV ratio, 20 years, monthly payments, 9% contract rate,
3% financing costs, 5% prepayment penalty for the first six years of mortgage life
 Expected increase in value is 3.50% per year, 8% selling expenses
 Holding period is 5 years
 Investor is an active participant, is in a 28% marginal tax bracket, and requires an after-tax equity yield of 15%
 Compute the ATCFs and the ATER for the holding period; NPV and the IRR
© OnCourse Learning 13

Year 1 2 3
GR 403,200 423,360 444,528
- VAC 20,160 21,168 22,226
+OI 0 0 0
=EGI 383,040 402,192 422,302
- OE 153,216 160,877 168,921
=NOI 229,824 241,315 253,381
© OnCourse Learning 14

Year
GR
- VAC
+OI
=EGI
- OE
=NOI
4 5
466,754 490,092
23,338 24,505
0 0
443,416 465,587
177,366 186,235
266,050 279,352
© OnCourse Learning 15

Year 1 2 3
NOI 229,824 241,315 253,381
- MP 91,097 91,097 91,097
=BTCF138,727 150,218 162,284
- TXS 36,523 39,878 43,710
=ATCF 102,204 110,340 118,574
© OnCourse Learning 16

Year
NOI
- MP
=BTCF
- TXS
=ATCF
4 5
266,050 279,352
91,097 128,520
174,953 150,832
47,754 36,506
127,199 114,326
© OnCourse Learning 17

Year 1 2 3
NOI 229,824 241,315 253,381
- INT 75,296 73,814 72,193
- AFC 1,266
- DEP 22,823
1,266
23,815
1,266
23,815
=TI 130,439 142,420 156,107 x t 0.28
=TXS 36,523
0.28
39,878
0.28
43,710
© OnCourse Learning 18

Year
NOI
- INT
- AFC
- DEP
=TI x t
=TXS
4 5
266,050 279,352
70,419 105,902
1,266
23,815
20,249
22,823
170,550 130,378
0.28
47,754
0.28
36,506
© OnCourse Learning 19

ESP
- SE
=NSP
- UMB
=BTER
- TXR
=ATER
1,336,147
106,891
1,229,256
748,466
480,790
39,511
441,279
© OnCourse Learning 20

ESP
- SE
=AR
- AB
=TG
1,336,147
106,891
1,229,256
1,043,909
185,347
© OnCourse Learning 21

DR 117,091 x t d
0.25
=DRT 29,273
CG 68,256 x t g
0.15
=CGT 10,238
DRT 29,273
+CGT 10,238
=TXR 39,511
© OnCourse Learning 22

4
5
2
3
Year
0
1
ATCF
-342,563
102,204
110,340
118,574
127,199
114,326
© OnCourse Learning
ATER
441,279
23

 The present value of the cash flows minus the present value of the cash outflows
 Appropriate discount rate is the risk-adjusted required rate of return
 In the previous example the after-tax cash flows are equity cash flows thus the appropriate discount rate is the required equity yield
 𝑁𝑃𝑉 𝑒
= −𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝑛 𝑡=1
𝐶𝐹 𝑡
(1+𝑟 𝑒
) 𝑡
© OnCourse Learning 24

 Decision rule for NPV
 Accept those independent projects that have positive or zero NPVs
 Reject those independent projects that have negative NPVs
© OnCourse Learning 25

 The Internal Rate of Return (IRR) is the discount rate at which the NPV is zero, i.e., the discount rate at which the present value of the cash inflows is equal to the present value of the cash outflows
 IRR equation:
 𝑛 𝑡=0
𝐶𝐹 𝑡
(1+𝐼𝑅𝑅 𝑒
) 𝑡
= 0
 Decision rule for IRR
 Investor’s required return is used as the benchmark
 Accept those independent projects with IRRs equal to or greater than the required return
 Reject those independent projects with IRRs less than the required return
© OnCourse Learning 26

 In making a simple accept/reject decision, NPV and
IRR cannot give conflicting recommendations
 Mutually exclusive projects may lead to conflicting recommendations, usually resolved in favor of NPV
 Multiple IRRs
 Reinvestment rate assumption
© OnCourse Learning 27

 NPV @ 15%:
 IRR:
$256,668
35.50%
© OnCourse Learning 28

 The proportions of debt and equity used in financing that maximize the value of the asset
 NPV and IRR may be affected by the use of debt
 Arguments that the use of debt cannot affect value:
Modigliani and Miller
 Reconciling MM argument with the use of debt
 With income taxes the use of debt could increase the aftertax cash flows
 Agency costs could increase the cost of debt
© OnCourse Learning 29

 Form of ownership – structure to avoid double taxation
 Access to equity capital markets – limited; reliance on debt financing by small, non-institutional investors
 Risk of the property – larger equity contribution for riskier investments
 Bankruptcy costs – use of nonrecourse vs. recourse notes
 Special tax regulations – the extent to which operating losses from real estate investment can be used to offset OI and the tax rate
 Interest rate – lower rate, higher debt utilization
© OnCourse Learning 30

 Acquisition costs must be written off over the depreciable life of the property
 Financing costs must be written off over the life of the mortgage
 Prepayment penalty is fully deductible in the year it is paid
 A set-aside of funds (replacement reserve) is not a tax-deductible expense
© OnCourse Learning 31