Real estate
Internal Rate of Return (IRR)
0 = Sum [ CFO / (1 + IRR)^n ] - Initial Investment The percentage rate earned on each dollar invested for each period it is invested. It gives an investor the means to compare alternative investments based on their yield. Doesn't account for accumulated capital when we receive more cash flow each year than what is needed to earn the IRR. Shows you what the actual rate of return on your investment is, takes into account all cash inflows and outflows, and assumes all interim cash flows can be reinvested at that same rate.
Capitalization Rate
= (NOI or CFO)/purchase price or property value = (if NOI grows at constant rate:) Discount rate - growth rate When you use the number calculated by NOI/price not only as a derivative of the current yield, but also as a reflection of what we would pay for the current yield plus the future growth in that yield, that is called the cap rate. It reflects the PRESENT WORTH OF FUTURE PAYMENTS, which is the market value to us at this point in time. (For example, there might be an expectation of higher rental rates when leases roll over). A capitalization rate is the rate of return on a real estate investment property based on the income the property is expected to generate. A high cap rate is associated with a riskier property or market, and a lower cap rate is a more stable property or market. Compressing cap rate market heating up Risk-free rate of return + risk premium
Return on Equity (ROE)
= CFAF/cash invested or cash on hand (also called cash on cash return) What you make: yr1 + yr2 + yr3 + yr3 sale price= money generated You have to pay back the debt + interest What's left is profit Profit/initial equity contribution=ROE
Cash Flow after Financing (CFAF)
= CFO - FC Amount available to the investor after he or she meets the financing charges. CFAF is highly sensitive to small changes in CFO since many real estate transactions are highly leveraged
Return on Assets (ROA)
= CFO/purchase price The current yield from operating the property. Sometimes used interchangeably with the capitalization (cap) rate, which generally relates to the market value of a property. It's an effort to get a relevant yield on invested capital.
Promote
= It is really just the disproportionate share of the fund's profit (achieved by above average returns) which the GP receives thus incentivizing them to perform better in their role.
Debt service coverage ratio
= NOI/ annual debt service
Annual Mortgage Payment
= Principal * [ i+(1+i)^n ] / [ (1+i)^n-1 ] P = principal (initial amount borrowed) as a percentage of the purchase price i = monthly/annual interest rate n = number of payments In reality, principal payments build up equity, which complicates the cost-of-financing calculation. Built-up equity is realized when (1) the loan is refinanced (a non-taxable event) or (2) the property is sold (a taxable event). Assume that the principal payment does not create a current value for the back-of-the envelope set up because its simpler and more conservative.
Loan-to-value ratio
= loan amount/property value
Net Operating Income (NOI)
= net property revenues - building operating expenses = the income stream generated by the operation of the property, independent of external factors such as financing and income taxes. ≠ Rental Income
Cost of Equity
= the return that stockholders require for a company or Risk-free rate+ Beta * Equity Risk Premium
Vacancy allowance
A deduction from the projected income on the building based on an expected vacancy rate. Allowance varies with market conditions and type of property. Large retail centers often experience 10% vacancy in their stores, but a 10% vacancy rate in an apartment building would be uncomfortably high.
Yield
A measure of how much cash an asset produces each year as a percentage of that asset's value. For property, the yield calculation is the percentage of rental income for the purchase price. (Doesn't take operating expenses into account like cap rate).
Waterfall Structure
A waterfall is a structure that provides incentive to the GP. The GP will get some percentage of cash flows up to a certain IRR hurdle rate, and then will get an increasing percentage of cash flows once the IRR hits additional hurdle rates.
Financing Costs (FC)
Debt or mortgage payments of principal and interest, often in the form of a constant payment that amortizes the loan over a given period of time. FC as a percentage = annual mortgage payment/amount financed through debt
Levered IRR
Just the Internal Rate of Return when you take financing into account. So basically you run a DCF, take out interest payments and calculate the IRR over the hold period. This will be higher mainly because taking on debt juices your returns and more specifically the first year cash flow will be lower because you have debt.
Depreciation
Quantification of the rear and tear on a building and its systems.
Rental Yield
Rental Yield = (Net Annual Rental Income / Cost) X 100 Note that rental yield is calculated on Net Operating Income without considering interest payment, tax and depreciation. Rental yield is the net amount of money a landlord receives in rent over one year (after deducting operating expenses), shown as a percentage of the amount of money invested in the property.
Leverage - Financial Leverage
The greater the financial leverage, the greater impact that operating leverage has on the bottom line (ROE). If the total cost of the financing is less than the ROA, the result is positive leverage, which increases ROE above ROA.
Leverage - Operating Leverage
The percentage increase in CFAF due to an increase in the CFO There are great benefits to the investor from obtaining positive operating leverage.
Replacement Cost
The price of building a new, equivalent space. Compare the psf purchase price to the psf replacement cost. You want a low psf purchase price and a high psf replacement cost, because a high replacement costs is a barrier to entry for competitors. This is the best protection for your investment.
Amortization
The write-off of other prescribed expenditures, such as leasing commissions