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Chapter 15
Value, Leverage and Capital Structure
© OnCourse Learning
Chapter 15 Learning Objectives
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
Valuation of Real Estate Investments
The value of an income-producing asset is a function of the income accruing to the asset Discounted cash flow (DCF) model
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
Financial Leverage
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
Financial Leverage
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
Financial Leverage
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
Real Estate Cash Flow Structure – NOI
Gross Rent (GR)
– Vacancy (VAC)
+ Other Income (OI)
= Effective Gross Income (EGI)
– Operating Expenses (OE)
= Net Operating Income (NOI)
© OnCourse Learning 7
Real Estate Cash Flow Structure – ATCF
Net Operating Income (NOI)
– Mortgage Payment (MP)
= Before-Tax Cash Flow (BTCF)
– Tax Liability (Savings) (TXS)
= After-Tax Cash Flow (ATCF)
© OnCourse Learning 8
Taxes from Operations
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
After-Tax Equity Reversion
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
Taxable Income from Resale
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
Taxes Due on Resale 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
Cash Flow Example – Assumptions 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
Cash Flows from Operations
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
Cash Flows from Operations
Year 4 5
GR 466,754 490,092
- VAC 23,338 24,505
+OI 0 0
=EGI 443,416 465,587
- OE 177,366 186,235
=NOI 266,050 279,352
© OnCourse Learning 15
Cash Flows from Operations
Year 1 2 3
NOI 229,824 241,315 253,381
- MP 91,097 91,097 91,097
=BTCF 138,727 150,218 162,284
- TXS 36,523 39,878 43,710
=ATCF 102,204 110,340 118,574
© OnCourse Learning 16
Cash Flows from Operations
Year 4 5
NOI 266,050 279,352
- MP 91,097 128,520
=BTCF 174,953 150,832
- TXS 47,754 36,506
=ATCF 127,199 114,326
© OnCourse Learning 17
Income Taxes from Operations
Year 1 2 3
NOI 229,824 241,315 253,381
- INT 75,296 73,814 72,193
- AFC 1,266 1,266 1,266
- DEP 22,823 23,815 23,815
=TI 130,439 142,420 156,107
x t 0.28 0.28 0.28
=TXS 36,523 39,878 43,710
© OnCourse Learning 18
Income Taxes from Operations
Year 4 5
NOI 266,050 279,352
- INT 70,419 105,902
- AFC 1,266 20,249
- DEP 23,815 22,823
=TI 170,550 130,378
x t 0.28 0.28
=TXS 47,754 36,506
© OnCourse Learning 19
Cash Flow from Resale
ESP 1,336,147
- SE 106,891
=NSP 1,229,256
- UMB 748,466
=BTER 480,790
- TXR 39,511
=ATER 441,279
© OnCourse Learning 20
Income Taxes from Resale
ESP 1,336,147
- SE 106,891
=AR 1,229,256
- AB 1,043,909
=TG 185,347
© OnCourse Learning 21
Income Taxes from Resale
DR 117,091 CG 68,256
x td 0.25 x tg 0.15
=DRT 29,273 =CGT 10,238
DRT 29,273
+CGT 10,238
=TXR 39,511
© OnCourse Learning 22
Cash Flow Summary
Year ATCF ATER
0 -342,563
1 102,204
2 110,340
3 118,574
4 127,199
5 114,326 441,279
© OnCourse Learning 23
Net Present Value (NPV)
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
© OnCourse Learning 24
Net Present Value (NPV)
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
Internal Rate of Return (IRR)
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: = 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
Comparing NPV and IRR
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
Cash Flow Analysis
NPV @ 15%: $256,668
IRR: 35.50%
© OnCourse Learning 28
Optimal Capital Structure
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 after-tax cash flows
Agency costs could increase the cost of debt
© OnCourse Learning 29
Practical Considerations in the Use of Debt
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
30© OnCourse Learning
Real Estate Investing in the Real World
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