Learning Module 2: Investments in Real Estate through Private Vehicles

Learning Module 2 Investments in Real Estate through Private Vehicles KNOWLEDGE CHECK Highest and Best Use Two uses have been identified for the property. One is an office building that would have a value of $20 million after construction. Development costs would be $16 million, including a profit for the developer. The second use is an apartment building that would have a value of $25 million after construction. Development costs, including a profit to the developer, would be $22 million. 1. What is the highest and best use of the site and the implied land value? Solution Office Apartment Value on completion $25,000,000 Cost to construct building (16,000,000) $4,000,000 (22,000,000) Implied land value $3,000,000 An investor/developer could pay up to $4 million for the land to develop an office building but only $3 million for the land to develop an apartment building. The highest and best use of the site is an office building with a land value of $4 million. Of course, this answer assumes a competitive market with several potential developers who would bid for the land to develop an office building. KNOWLEDGE CHECK Capitalizing NΟΙ 1. A property has just been let at an NOI of £250,000 for the first year, and the capitalization rate on comparable properties is 5%. What is the value of the property? Solution Value = NOI/Cap rate £250,000/0.05 £5,000,000. KNOWLEDGE CHECK Value of a Property to Be Renovated A property that requires some renovation to be competitive with otherwise comparable properties is being purchased. Renovations satisfactory to the purchaser will be completed by the seller at the seller's expense. If it were already renovated, it would have an NOI of 19 million next year, which is expected to increase by 3% per year thereafter. Investors would normally require a 12% IRR (discount rate) to purchase the property after it is renovated. Because of the renovation, the NOI will be only ¥4 million next year. But thereafter, the NOI is expected to be the same as it would be if it had already been renovated at the time of purchase. 1. What is the value of or the price a typical investor is willing to pay for the property? Solution If the property were already renovated (and the NOI had stabilized), the value would be as follows: Value if renovated ¥9,000,000/(0.12-0.03) = ¥100,000,000. But because of the renovation, there is a loss in income of ¥5 million during the first year. If for simplicity, we assume that this amount would have been received at the end of the year, then the present value of the lost income at a 12% discount rate is as follows: Loss in value=¥5,000,000/(1.12)¥4,464,286. Thus, the value of the property is as follows: Value if renovated Less loss in value Value ¥4,464,286 ¥95,535,714 An alternative approach is to get the present value of the first year's income and the value in a year when renovated: (¥4,000,000 [¥9,000,000(1.03)]/(0.12-0.03)]}/(1.12)=¥95,535,714. KNOWLEDGE CHECK Appraisal with Level NOI 1. Suppose the NOI from a property is expected to be level at $600,000 per year for a long period of time such that, for all practical purposes, it can be assumed to be a perpetuity. What is the value of the property, assuming investors want a 12% rate of return? Solution In this case, the growth rate is zero, so we have ValueNOI/Discount rate. Value $600,000/0.12 $5,000,000. Note that in this case, the cap rate will be the same as the discount rate. This is true when there is no expected change in income and value over time. KNOWLEDGE CHECK Loans on Real Estate 1. A property has been appraised for 55 million and is expected to have NOI of $400,000 in the first year. The lender is willing to make an interest-only loan at an 8% interest rate as long as the loan-to-value ratio does not exceed 80% and the DSCR is at least 1.25. The balance of the loan will be due after seven years. How much of a loan can be obtained? Solution Based on the loan-to-value ratio, the loan would be 80% of $5 million, or $4 million. With a DSCR of 1.25, the maximum debt service would be $400,000/1.25 $320,000. This amount is the mortgage payment that would result in a 1.25 DSCR for an interest-only loan. If the loan is interest only, then we can obtain the loan amount by simply dividing the mortgage payment by the interest rate. Therefore, the loan amount would be $320,000/0.08 $4,000,000 In this case, we obtain the same loan amount from either the LTV or the DSCR requirements of the lender. If one ratio had resulted in a lower loan amount, that would normally be the maximum that could be borrowed. KNOWLEDGE CHECK Equity Dividend Rate 1. Using the information in Question Set 23, what is the equity dividend rate. or cash-on-cash return, assuming the property is purchased at its appraised value? Solution The first-year cash flow is the NOI less the mortgage payment. NOI Debt service Cash flow $400,000 $320,000 $80.000 The amount of equity is the purchase price less the loan amount. Price Mortgage Equity $5,000,000 $4,000,000 $1,000,000 The equity yield rate is the cash flow divided by equity: $80,000/$1,000,000 8%. Keep in mind that this is not an IRR that would be earned over a holding period until the property is sold. The equity investor does not share any of the price appreciation in the value of the property with the lender. For loans called "participation" loans, the lender might receive some of the price appreciation, but it would be in exchange for a lower interest rate on the loan. KNOWLEDGE CHECK Leveraged IRR 1. Refer to Question Sets 23 and 24. Suppose the same property is sold for $6 million after five years. What IRR will the equity investor receive on his or her investment? Solution The cash flow received by the equity investor from the sale will be the sale price less the mortgage balance, or $6 million $4 million $2 million. Using a spreadsheet: Levered IRR Amount (S) Year Invested Capital (1,000,000) 0 Cash flow 80,000 1 Cash flow 80,000 2 Cash flow 80,000 3 Cash flow 80,000 4 Cash flow 2,080,000 5 IRR Levered IRR 21.14% This IRR is based on the equity invested in the property. KNOWLEDGE CHECK Unleveraged IRR 1. Refer to Question Sets 23, 24, and 25. What would the IRR be if the property were purchased on an all-cash basis (no loan)? Solution Now the equity investor will receive all the cash flow from the sale ($6 million) and the NOI ($400,000). The initial investment will be $5 million. Using a spreadsheet: Unlevered IRR Amount ($) Year Invested Capital (5,000,000) 0 1 Cash flow 2 Cash flow 3 Cash flow 4 Cashflow Cashflow 6,400,000 5 IRR 11.20% This IRR is based on an unleveraged (all-cash) investment in the property. The difference between this IRR (11.20%) and the IRR the equity investor receives with the loan calculated in Question Set 25 (21.14%) reflects positive financial leverage. The property earns 11.20% before adding a loan, and the loan is at 8%. So, the investor is benefiting from the spread between 11.20% and 8%.