Chapter 15 VALUE, LEVERAGE, AND CAPITAL STRUCTURE

Chapter 15Chapter 15VALUE, LEVERAGE, VALUE, LEVERAGE,

AND CAPITAL AND CAPITAL STRUCTURESTRUCTURE

Chapter 15Chapter 15Learning ObjectivesLearning Objectives

Understand the value of an equity Understand the value of an equity investment in real estateinvestment in real estate

Understand how the use of debt Understand how the use of debt can alter cash flowscan alter cash flows

Understand the concept of an Understand the concept of an optimal balance of debt and equity optimal balance of debt and equity financing financing

15-1

VALUATION OF REAL VALUATION OF REAL ESTATE INVESTMENTSESTATE INVESTMENTS

The value of an income-producing The value of an income-producing asset is a function of the income asset is a function of the income accruing to the assetaccruing to the asset

Income is generally measured as Income is generally measured as some form of cash flowsome form of cash flow

Cash flows and discount rate can Cash flows and discount rate can be hard to determine because of be hard to determine because of the nature of the assetthe nature of the asset

FINANCIAL LEVERAGEFINANCIAL LEVERAGE

Investor has two basic sources of Investor has two basic sources of financing: debt and equityfinancing: debt and equity

Financial leverage is the use of debt Financial leverage is the use of debt in financingin financing

Positive leverage is the use of debt Positive leverage is the use of debt at a cost less than the return on the at a cost less than the return on the assetasset

Positive leverage increases the Positive leverage increases the return on equityreturn on equity


Negative leverage is the use of Negative leverage is the use of debt at a cost greater than the debt at a cost greater than the return on the assetreturn on the asset

Negative leverage reduces the Negative leverage reduces the return on equityreturn on equity

Neutral leverage is when the debt Neutral leverage is when the debt cost is equal to asset return and cost is equal to asset return and return on equity is not affectedreturn on equity is not affected


The risk to the equity is increased The risk to the equity is increased by the used of financial leverageby the used of financial leverage

Leverage allows the cash flows to Leverage allows the cash flows to be divided into two components: be divided into two components: less risky and more riskyless risky and more risky

Value can be created if debt holder Value can be created if debt holder and equity holder have different and equity holder have different risk-return preferencesrisk-return preferences


More risk-averse investor can invest in More risk-averse investor can invest in the lower-risk debt and less risk-averse the lower-risk debt and less risk-averse investor can invest in riskier equityinvestor can invest in riskier equity

Tax-deductibility of interest payments Tax-deductibility of interest payments on debt make it advantageouson debt make it advantageous

Federal government subsidizes the use Federal government subsidizes the use of debt by providing tax reliefof debt by providing tax relief

REAL ESTATE CASH REAL ESTATE CASH FLOWSFLOWS

Can be a difference between cash Can be a difference between cash flow and taxable income calculationsflow and taxable income calculations

Cash flow contains items that are Cash flow contains items that are actual inflows and outflows actual inflows and outflows regardless of whether or not they regardless of whether or not they are tax-deductibleare tax-deductible

Taxable income contains items that Taxable income contains items that are tax-deductible whether or not are tax-deductible whether or not they are actual cash flowsthey are actual cash flows

REAL ESTATE CASH FLOW REAL ESTATE CASH FLOW STRUCTURESTRUCTURE

Cash Flow Structure isCash Flow Structure is Gross Rent (GR)Gross Rent (GR) minus Vacancy (VAC)minus Vacancy (VAC) plus Other Income (OI)plus Other Income (OI) equals Effective Gross Income (EGI)equals Effective Gross Income (EGI) minus Operating Expenses (OE)minus Operating Expenses (OE) equals Net Operating Income (NOI)equals Net Operating Income (NOI)


Cash Flow Structure continued isCash Flow Structure continued is Net Operating Income (NOI)Net Operating Income (NOI) minus Mortgage Payment (MP)minus Mortgage Payment (MP) equals Before-Tax Cash Flow (BTCF)equals Before-Tax Cash Flow (BTCF) minus Tax Liability (Savings) (TXS)minus Tax Liability (Savings) (TXS) equals After-Tax Cash Flow (ATCF)equals After-Tax Cash Flow (ATCF)

INCOME TAXES FROM INCOME TAXES FROM OPERATIONSOPERATIONS

Taxes From Operations areTaxes From Operations are Effective Gross Income (EGI)Effective Gross Income (EGI) minus Operating Expenses (OE)minus Operating Expenses (OE) equals Net Operating Income (NOI)equals Net Operating Income (NOI) minus Interest Expense (INT)minus Interest Expense (INT) minus Depreciation (DEP)minus Depreciation (DEP) equals Taxable Income (TI) equals Taxable Income (TI) times Investor’s Marginal Tax Rate (t)times Investor’s Marginal Tax Rate (t) equals Taxes (Savings) TXSequals Taxes (Savings) TXS


After-Tax Equity Reversion isAfter-Tax Equity Reversion is Estimated Selling Price (ESP)Estimated Selling Price (ESP) minus Selling Expenses (SE)minus Selling Expenses (SE) equals Net Sales Price (NSP)equals Net Sales Price (NSP) minus Unpaid Mortgage Balance (UMB)minus Unpaid Mortgage Balance (UMB) equals Before-Tax Equity Reversion equals Before-Tax Equity Reversion

(BTER)(BTER) minus Taxes on Resale (TXR)minus Taxes on Resale (TXR) After-Tax Equity Reversion (ATER)After-Tax Equity Reversion (ATER)


Taxable Income from Resale isTaxable Income from Resale is Estimated Selling Price (ESP)Estimated Selling Price (ESP) minus Selling Expenses (SE)minus Selling Expenses (SE) equals Amount Realized on Sale (AR)equals Amount Realized on Sale (AR) minus Adjusted Basis (AB)minus Adjusted Basis (AB) equals Total Gain from Sale (TG)equals Total Gain from Sale (TG) minus Depreciation Recovery (DR)minus Depreciation Recovery (DR) equals Capital Gain from Resale (CG)equals Capital Gain from Resale (CG)


Income Taxes on Resale areIncome Taxes on Resale are Depreciation Recovery (DR)Depreciation Recovery (DR) times Depreciation Recovery Tax Rate times Depreciation Recovery Tax Rate

(t(tdd)) equals Depreciation Recovery Tax (DRT)equals Depreciation Recovery Tax (DRT)

Capital GainCapital Gain times Capital Gains Tax Rate (ttimes Capital Gains Tax Rate (tgg)) equals Capital Gains Tax (CGT)equals Capital Gains Tax (CGT)


Total Tax on Resale isTotal Tax on Resale is Depreciation Recovery Tax (DRT)Depreciation Recovery Tax (DRT) plus Capital Gains Tax (CGT)plus Capital Gains Tax (CGT) equals Total Tax on Resale (TXR)equals Total Tax on Resale (TXR)

R.E. CASH FLOW EXAMPLER.E. CASH FLOW EXAMPLE

A real estate investor has the A real estate investor has the following information on a warehouse:following information on a warehouse: Purchase Price is $1,125,000 with Purchase Price is $1,125,000 with

acquisition costs of $36,000acquisition costs of $36,000 33,600 leasable square feet33,600 leasable square feet Initial rent of $12/sq. ft. per year and will Initial rent of $12/sq. ft. per year and will

increase 5 percent per yearincrease 5 percent per year Vacancy rate of 5% of gross rent per yearVacancy rate of 5% of gross rent per year


Operating Expenses are 40% of EGIOperating Expenses are 40% of EGI Mortgage is 75% LTV ratio, 20 years, Mortgage is 75% LTV ratio, 20 years,

monthly payments, 9% contract rate, monthly payments, 9% contract rate, 3% financing costs, 5% prepayment 3% financing costs, 5% prepayment penalty for the first six years of penalty for the first six years of mortgage lifemortgage life

Expected increase in value is 3.50% Expected increase in value is 3.50% per year, 8% selling expensesper year, 8% selling expenses

Holding period is 5 yearsHolding period is 5 years


80% depreciable80% depreciable Investor is an active participant, is in a Investor is an active participant, is in a

28% marginal tax bracket, and 28% marginal tax bracket, and requires an after-tax equity yield of requires an after-tax equity yield of 15%15%

Compute the ATCFs and the ATER for Compute the ATCFs and the ATER for the holding periodthe holding period

Calculate the NPV and the IRRCalculate the NPV and the IRR

R.E. CASH FLOWS FROM R.E. CASH FLOWS FROM OPERATIONSOPERATIONS

YearYear 1 1 2 2 3 3 GRGR 403200403200 423360423360 444528444528 - VAC- VAC 20160 20160 21168 21168 22226 22226 +OI+OI 0 0 00 00 =EGI=EGI 383040383040 402192402192 422302422302 - OE- OE 153216153216 160877160877 168921168921 =NOI=NOI 229824229824 241315241315 253381253381


YearYear 4 4 5 5 GRGR 466754466754 490092490092 - VAC- VAC 23338 23338 24505 24505 +OI+OI 0 0 0 0 =EGI=EGI 443416443416 465587465587 - OE- OE 177366177366 186235186235 =NOI=NOI 266050266050 279352279352


YearYear 1 1 2 2 3 3 NOINOI 229824229824 241315241315 253381253381 - MP- MP 91097 91097 91097 91097 91097 91097 =BTCF=BTCF 138727138727 150218150218 162284162284 - TXS- TXS 36523 36523 39878 39878 43710 43710 =ATCF=ATCF 102204102204 110340110340 118574118574


YearYear 4 4 5 5 NOINOI 266050266050 279352279352 - MP- MP 91097 91097 128520128520 =BTCF=BTCF 174953174953 150832150832 - TXS- TXS 47754 47754 36506 36506 =ATCF=ATCF 127199127199 114326114326


YearYear 1 1 2 2 3 3 NOINOI 229824229824 241315241315 253381253381 - INT- INT 75296 75296 73814 73814 72193 72193 - AFC- AFC 1266 1266 1266 1266 1266 1266 - DEP- DEP 22823 22823 23815 23815 23815 23815 =TI=TI 130439130439 142420142420 156107156107 x tx t 0.28 0.28 0.28 0.28 0.28 0.28 =TXS=TXS 36523 36523 39878 39878 43710 43710


YearYear 4 4 5 5 NOINOI 266050266050 279352279352 - INT- INT 70419 70419 105902105902 - AFC- AFC 1266 1266 20249 20249 - DEP- DEP 23815 23815 22823 22823 =TI=TI 170550170550 130378130378 x tx t 0.28 0.28 0.28 0.28 =TXS=TXS 47754 47754 36506 36506

CASH FLOW FROM RESALECASH FLOW FROM RESALE

ESPESP 13361471336147 - SE- SE 106891 106891 =NSP=NSP 12292561229256 - UMB- UMB 748466 748466 =BTER=BTER 480790 480790 - TXR- TXR 39511 39511 =ATER=ATER 441279 441279

INCOME TAXES FROM INCOME TAXES FROM RESALERESALE

ESPESP 13361471336147 - SE- SE 106891 106891 =AR=AR 12292561229256 - AB- AB 10439091043909 =TG=TG 185347 185347

INCOME TAXES FROM INCOME TAXES FROM RESALERESALE

DRDR 117091117091 CG CG 68256 68256 x tx tdd 0.25 0.25 x tx tgg 0.15 0.15 =DRT=DRT 29273 29273 =CGT 10238=CGT 10238

DRTDRT 29273 29273 +CGT+CGT 1023810238 =TXR=TXR 3951139511

CASH FLOW SUMMARYCASH FLOW SUMMARY

YearYear ATCF ATCF ATER ATER 00 -342563-342563 11 102204 102204 22 110340 110340 33 118574 118574 44 127199 127199 55 114326 114326 441279441279

CASH FLOW ANALYSISCASH FLOW ANALYSIS

NPV @ 15%:NPV @ 15%: $256,668$256,668

IRR:IRR: 35.50%35.50%


Net Present Value (NPV)Net Present Value (NPV) The present value of the cash flows The present value of the cash flows

minus the present value of the cash minus the present value of the cash outflowsoutflows

Appropriate discount rate is the risk-Appropriate discount rate is the risk-adjusted required rate of returnadjusted required rate of return

In the previous example the after-tax In the previous example the after-tax cash flows are equity cash flows thus cash flows are equity cash flows thus the appropriate discount rate is the the appropriate discount rate is the required equity yieldrequired equity yield


nn

NPV = NPV = ΣΣ CF CFtt / (1 + r / (1 + ree))tt

t=0t=0 where CFwhere CFtt is the cash flow in time is the cash flow in time

t, rt, ree is the discount rate for equity, is the discount rate for equity, and t is the number of time periodsand t is the number of time periods


The Internal Rate of Return (IRR) is The Internal Rate of Return (IRR) is the discount rate at which the NPV the discount rate at which the NPV is zero, i.e., the discount rate at is zero, i.e., the discount rate at which the present value of the which the present value of the cash inflows is equal to the present cash inflows is equal to the present value of the cash outflowsvalue of the cash outflows


The IRR equation is:The IRR equation is: nn 0 = 0 = ΣΣ CF CFtt / (1 + IRR / (1 + IRRee))tt

t=0t=0 where CFwhere CFtt is the cash flow in time is the cash flow in time

t, rt, ree is the discount rate for equity, is the discount rate for equity, and t is the number of time periodsand t is the number of time periods


Decision rule for NPVDecision rule for NPV Accept those independent projects Accept those independent projects

that have positive or zero NPVsthat have positive or zero NPVs Reject those independent projects Reject those independent projects

that have negative NPVsthat have negative NPVs

CASH FL0W ANALYSISCASH FL0W ANALYSIS

Decision rule for IRRDecision rule for IRR Investor’s required return is used as Investor’s required return is used as

the benchmarkthe benchmark Accept those independent projects Accept those independent projects

with IRRs equal to or greater than the with IRRs equal to or greater than the required returnrequired return

Reject those independent projects Reject those independent projects with IRRs less than the required with IRRs less than the required returnreturn


Comparing NPV and IRRComparing NPV and IRR In making a simple accept/reject In making a simple accept/reject

decision, NPV and IRR cannot give decision, NPV and IRR cannot give conflicting recommendationsconflicting recommendations

Mutually exclusive projects may lead Mutually exclusive projects may lead to conflicting recommendations, to conflicting recommendations, usually resolved in favor of NPVusually resolved in favor of NPV

Multiple IRRSMultiple IRRS Reinvestment rate assumptionReinvestment rate assumption


Optimal Capital StructureOptimal Capital Structure The proportions of debt and equity The proportions of debt and equity

used in financing that maximize the used in financing that maximize the value of the assetvalue of the asset

NPV and IRR may be affected by the NPV and IRR may be affected by the use of debtuse of debt

Arguments that the use of debt Arguments that the use of debt cannot affect value: Modigliani and cannot affect value: Modigliani and MillerMiller


Reconciling MM argument with the Reconciling MM argument with the use of debtuse of debt With income taxes the use of debt With income taxes the use of debt

could increase the after-tax cash could increase the after-tax cash flowsflows

Agency costs could increase the cost Agency costs could increase the cost of debtof debt


Real estate investing in the real Real estate investing in the real worldworld Acquisition costs must be written off Acquisition costs must be written off

over the depreciable life of the propertyover the depreciable life of the property Financing costs must be written off Financing costs must be written off

over the life of the mortgageover the life of the mortgage A prepayment penalty is fully A prepayment penalty is fully

deductible in the year it is paiddeductible in the year it is paid A set-aside into a replacement reserve A set-aside into a replacement reserve

is not a tax-deductible expenseis not a tax-deductible expense

Documents

Chapter 15 VALUE, LEVERAGE, AND CAPITAL STRUCTURE