MGMT 2035 Principles of Real Estate Final Exam
Fannie Mae and Freddie Mac
funded bonds "mortgage back securities"
Cash Throw- Off
how much cash will the property, produce, after debt service (including interest and principle), at the end of the year Cash Throw-Off = NOI - Annual Debt Service
Equity Analysis
how much equity is required to purchase this investment? Equity = Total Project Cost - Loan Amount
NPV Rule
if the present value of all the cash inflows is greater than or equal to the present value of all the cash outflows, the project should be accepted. This rule is all about wealth Maximization. PV of Inflows > PV of Outflows BREAKEVEN is not a bad thing: Means you're getting something worth exactly what you paid for it.
Net Present Value
present value of all inflows minus the present value of all outflows in a stream of cash flows. (CHANGE IN WEALTH) Net Present Value = PV of inflows - PV of outflows Excel formula: =NPV (Rate, Column X : Column Y) EXCLUDES Year 0 - looks at future payments)
Asset Market
purchase and sale of assets, ownership
Market Cap Rate
same formula: Cap Rate = NOI /Property value relationship between the NOI for properties in the market and the PRICE other investors are paying for those properties?
Net Income Multiplier
the number by which you multiply Net Operating Income in order to calculate the value of a property Intuitive definition: its the value of each $1.00 annual Net Operating Income generated by a property. Net Income Multiplier= $1.00 / Cap Rate
Space and Asset Market
the value of your property is driven by both markets Also connected by the development market.
Space Market
use of space, where landlords and tenants negotiate over use of existing space.
Capitalization Rate BIG IDEAS
1) Cap rate represents the rate of return investors expect to receive on comparable, alternative investments (DISCOUNT RATE in PERPETUITY FORMULA). 2) Price an individual investor is willing to pay for property depends on the minimum rate of return they require on their capital 3) actual market price of the property depends on the aggregation of the rate of return expectations of all of the investors in the market. (LIKE all other GOODS, a PROPERTY'S PRICE depends on the WILLINGNESS of investors to PAY for it).
7 criteria of credibility
1) Credit Scores and Credit Record: Major issues late payments bankruptcy (FICO score). 2)Capacity (Monthly Income). lenders sets a 28% housing-cost QUALIFYING RATIO. Stable, verifiable employment 3) Cash Reserves and Source of Down Payment: normally 80%. "larger cash balances, less likely storm will capsize your investment" Eldred. 4)Collateral: security pledged for the payment of a loan. Cross-collateralize (multiple properties). 5)Character and Personal Characteristics: Education level, career advancement, job stability, saving, spending, borrowing habits, dependability consistency 6)Competency and Experience: lenders want to know that you know what your doing. SHOW lender you have done homework. 7) Compensating Factors: employer letters, references, etc. prior business (payment history). Additional collateral: depository/other accounts.
Building Wealth Through Real Estate Investment
1) Look for Real Appreciation 2) Inflation of Real Estate Values 3) Cash Flows from Operations 4) Equity Gains amplified by Leverage 5) Cash Flow Returns Amplified by Leverage 6) Mortgage Payoff 7) Increases in Net Operating Income from Inflation 8) Increases in Cash Flows from Refinancing 9) Refinancing to Extract Equity 10) Buying at below Market Prices 11) Selling above Current Market Prices 12) Creating Value through Smarter Management 13) Creating Value through Renovation
IRR Rule
1) Only undertake a project if its Internal Rate of Return exceeds your Discount Rate (the generic alternative, comparable investment). 2) If you're choosing between two mutually exclusive projects, do not automatically go with the one with higher IRR. Instead, choose the project with higher NPV. INTUITION: your focus should be on your overall wealth, not on the rate of return you're getting on SOME of your dollars.
Ingredients for a financial crisis
1) Securitization of Home Loans ("Mortgage Backed Securities") 2) Tranching of Securities (Leading to the creation of Collateralized Debt Obligations and CDO^2 securities comprised soletly of residual or "mezzanine" tranches of MBS) 3) Credit Default swaps (Leading to creation of synthetic CDO)
Minor Components of Loan
1) Up-front fees and points 2)Prepayment option and back-end penalties 3) Recourse v. non-recourse debt
Four Main Sources of Real Estate Investment Returns
1)Cash flow from operating property- annual cash flow received from running the property 2)Appreciation of the property's value increase in property value between purchase and sale. 3)Loan amortization- decrease in loan balance between initial loan and when property is sold. 4)Tax Shelter- savings experienced on income taxes as a result of advantageous tax laws related to real estate ownership.
Major Components of Loan
1)Loan amount 2)Amortization 3)Loan Term (maturity) 4)Contract Interest Rate 5) Collateral (e.g. cross-collateralization)
Stage 1 Finanical Analysis
1a) Revenue from Operations Summary- cash inflows related to operations. 1b) Pro Forma Net Operating Income (NOI)- Income and expenses 1c) Maximum Debt Calculation 1d) Development Costs 1e) Summary Analysis and Simple Ratios if profitable move to Stage 2: Discounted Cash Flow Analysis.
Real Estate Finance Triangle
Achieve enough NET OPERATING INCOME... to pay for the FINANCING... which is sufficient to fund the... ACQUISITION/DEVELOPMENT... which is adequate to... achieve enough NOI......
Condos
Advantages: Disadvantages:
Single Family Homes
Advantages: 1) Familiarity- people understand product type 2) Financing widely available 3)Large Volume of transactions 4) Less transient (family may stay for years) Disadvantages: 1) Single-family home prices driven by economic factors over which you generally have no control: a. b. c.
Net Operating Income
Annual profit earned from operating a rental property (Rents minus operating expenses)
Debt Service Coverage Ratio
DSCR = Net Operating income / Annual Debt Service
Debt Service
Excel formula: PMT ("Payment") Function: =PMT(Rate, nper, pv, [fv], [type]) example: =pmt (6.0%, 5, 100000) RATE: interest rate of the loan Nper: The total number of payments for the loan. PV: the principle amount FV: Cash balance you want to attain after the last payment is made. If FV is omitted, it is assumed to be 0 - which is the standard approach TYPE: The number 0 or 1 and indicates when payments are due. If type is omitted, it is assumed to be zero (standard).
Loan Constant
Helps quickly calculate your debt service payments specifically a loan constant is the payment amount needed to service each $1.00 of borrowed money at a give rate of interest and over a given amortization period. Loan constant = -pmt (6%,25,1) Loan constant = $0.0782 ROUND TO FOUR DIGITS In words: For every $1.00 borrowed at 6% interest with a 25-year amortization period THE BORROWER WILL HAVE TO PAY $0.0782 PER YEAR.
Estimated Sale Price
How did you value stream of payments from the property when purchased? Property Value = NOI at Year 1 / i (cap rate at time of purchase) How will a new owner value the property in five years when they buy it? Property Value = NOI at Year 6 / i (at year 5 or current Market cap rate) Investors (reasonably) assume Going-Out Cap Rate that is slightly higher (about .50% for a five year holding period) than the Going-in Cap Rate. How do you estimate the costs and fees associated with a sale? 1) Sale Costs = 6% (typically) 2) Includes Broker Commissions, closing costs, etc.
Fundamental question of finance
How much should you pay today to receive a specific cash flow at a specific point in time? Fundamental answer: only as much as you'd have to pay today to receive the same cash flow at the same point in time... through some other investment. Time value of money
Capitalization Rate
Income producing Real Estate assets are valued using a "capitalization Rate" TWO FORMS: 1) GIVEN property's NOI and GIVEN Cap Rate, What is the Property's Value? USE: Property Value = Net Operating Income / Capitalization Rate 2) GIVEN property's NOI and GIVEN value the market placed on property, what is the property's CAP RATE? USE: Cap Rate = NOI/Property Value
DSCR Loan Sizing equation
Loan amount = Net Operating income / Loan constant x deb service coverage ratio Example: = $100,000 / $0.0806 x 1.50 = $827,130 Reminder: Loan Constant should go out FOUR DIGITS INTUITION: how much debt will this income stream support? need to produce 1.5 x the Loan constant ($0.0806) = $0.1209 So how many $0.1209 chunks are produced by a property with an NOI =$100,000? ANSWER: $827,130
Loan-to-Cost (LTC) constraint
Maximum Loan Amount = Project Cost x Loan-to-cost ratio LTC = Loan Amount / Project cost Often the case that the value of the property exceeds the cost (hence the twin constraints)
Loan-to-Value Constraint (LTV)
Maximum Loan Amount = Property value x Loan-to-value ratio LTV = Loan amount / Property value
Direct Capitalization Approach/Method
Net Present Value = PV of inflows - PV of outflows NPV = $120,000 / i - $1.2 Million Set NPV to Zero 0 = $120,000/i - 1.2 million 1.2million x i = $120,000 i = $120,000 / 1.2 million i or IRR = 10% Real Estate Formula ("Direct Capitalization") Property Value = Net Operating Income / Cap Rate PV = $120,000 / 10% = $1.2 million
Present Value Formula
PV = FV / (1 + i)^N PV = present value FV = Future value i = discount rate (the rate of return on the alternative investment ) N = Time ("periods") between now and future payment Excel Formula: = FV/ (1 + %)^N
Perpetuity Formula
PV of infinite stream of constant payments = Annual Payment / i (reminder: "i" is the Discount Rate) The land will exists and generate income forever. Hence why we have the perpetuity formula = infinite stream of cash flows.
Return On Equity (ROE)
ROE= income after financing costs / investor's equity Your slice of the asset.
ROA vs ROE
Return on Assets: Same for any owner of this property; is an inherent characteristic of the asset. Return on Equity: Different for any owner of this property; it varies depending on the amount of debt an owner chooses and how much they have to pay for it. (SPECIFIC to LEVERAGE)
Project Cap Rate
Same Formula: Cap rate = NOI/Sale Price Relationship between the specific property's NOI and ASKING PRICE.
Simple Profit
Simple Profit (Net Present Value) = Stabilized Value - Total Project Cost (PE ratio) or Simple Profit = Net Operating Income / Market Cap Rate - (Purchase Price + Development Costs)
Five Stages of Financial Analysis
Stage 1: Simple capitalization of pro forma net operating income (NOI) when it reaches stabilization. Stage 2: Discounted cash flow (DCF) analysis of annual cash flows during stabilized operating period Stage 3 & 4: Development (SKIP for these specific purposes) Stage 5: DCF analysis for investors
Finance
Study of cash flows think of every asset as simply a source of cash flows when pricing an asset, what you are really doing is valuing the expected cash flows from that asset.
Internal Rate of Return
The discount such that the Net Present Value of an investment is Zero. 0 = PV of inflows - PV of outflows (Solve for i) WHAT IRR REALLY MEANS: The equivalent annualized rate of return you're earning on your money while its invested in the project. Key Point: Discount Rate is the rate of return you would earn on the comparable asset. If the IRR on an investment is LESS THAN the rate of return on the comparable asset, that means you're better off investing your money in the COMPARABLE ASSET Excel Formula: =IRR(Column X : Column Y) INCLUDES year 0
Unleveraged vs. Leveraged Cash Flows
Unleveraged cash flows will be the SAME for every owner. 1) helps us understand return on Assets 2) Forms the basis for comparison of different properties. Leveraged Cash Flows DIFFERENT for every owner. 1)helps us understand return on EQUITY 2) depends on possibilities regarding our specific financing arrangements.
Relationship of Net Operating Income versus the Net Income Multiplier
Value of $100K of NOI from a property = NOI x Net Income Multiplier the relationship is NOI is the SPACE market and NIM is the ASSET market. Derive from completely separate markets. High CAP rates BUY Low CAP rate SELL
Wasting Asset Theory
When evaluating Going-Out Cap Rate: only certainty... five years older... All other things equal... 1) property accumulated more physical and functional obsolescence. 2) will be riskier because its closer to major systems repairs (requiring a higher initial return) 3) prospects for Income Growth will be diminished (also requiring higher initial return). Conclusion: You can intelligently and systematically assume investors will apply a HIGHER CAP RATE in the future than they would under the same market conditions as today.
Cash-on-Cash Return
cash throw-off expressed as a percentage of the equity you invested in the deal Cash-on-Cash Return = Cash Throw-off / Equity
Financial Leverage
controlling an asset whose value is greater than the amount of equity capital invested. Two main sources: DEBT & investors Why Financial Leverage: 1)raise money to buy property 2)supercharge returns Keep in mind both BENEFITS and RISK of leverage. Supercharge returns but also supercharges losses.
Discount Rate
discounting the value of future cash flows is how you are compensated for: 1) having to wait to receive your money and 2)for taking the risk of making the investment discount rate should be the rate of return you could reasonably expect to achieve by investing... the same amount of money.. in a similar investment.... posing comparable risk!
Credit Default Swap
fancy way of saying insurance policy
