Real Estate Investments AM0000_000_000000 Direct Investments Techniques Basic Corporate Finance Applications Dirk Brounen April 23 rd, 2001

Real Estate InvestmentsAM0000_000_000000

Direct Investments TechniquesBasic Corporate Finance Applications

Dirk Brounen

April 23rd, 2001


About Last Week

The virtues of indirect investments are all true, but:

Is indirect real estate really real estate?

Correlation direct real estate - stocks/bonds is lower!

Direct real estate returns are less volatile

Institutional Investors have long horizons, less need for liquidity

Investing indirectly is simple

Direct investing requires specific tools and skills


Today’s Program A Crash Course in Commercial Brokerage

Introduction

Theoretical standards- Cash-flow estimation - Ratio-Analysis- Cap-rate - NPV- IRR

Practical Applications- Buying the Rembrandt Tower- The effect of leverage


Introduction

Owning Investing

buying acquiringoccupying leasingenjoying sellingmoving earning

Well-being Wealth


Real Estate Investment Analysis = Risk Management

An Investor will face several types of uncertainties

– Paying the right price

– Finding suitable lessors at the right time

– Facing financing costs that can fluctuate (interest risk)

– Facing fluctuating maintenance costs

– Being exposed to the real estate cycle

– Receiving the right price


Sector Differences

Cash-flow uncertainties along sector types:Apartments; steady rent flow, low cycle-sensitivityOffice; long-term contracts, quiet cycle sensitiveRetail; short-term overage contracts, very cycle sensitiveHotels; very short term rent contracts, very cycle sensitive

Hotel

Apartment

Office

Risk

E

xp.R

etu

rn


Types of Risks

– Business Risk; economic fluctuations

– Inflation Risk; can increase cost more than income

– Financial Risk; by leveraging

– Liquidity Risk; little selling possibilities

– Management Risk; bad marketing policy

– Legislative Risk; tax law changes

– Environment Risk; ABN-AMRO/Schiphol


Old School: Three things that matter in Real Estate Investment Decision Making

LOCATION Macro EnvironmentShould you buy/build megastore, or officeShould you locate in Amsterdam or Texel?

LOCATION Sub-regionShould you locate in Center or Suburb?

LOCATION Property SpecificHow Large, High and Modern should the building be?


New School: Numerous things matter

ECONOMICS Macro, Region and Property Specific

FINANCIALS Crunching the Numbers Applying Modern, Objective Analytics

INTUITION Old fashioned Common Sense


Some economics to consider

– GDP growth– Consumer Confidence Index– Personal Consumption Growth– Retail Sales– Unemployment Rates for each sector– Interest Rates– Regional Economics (infrastructure)

– Vacancy Rates (Central Business District, Suburb)

– Square Meter Rents (apartments, retail, office, warehouse)


GDP Growth

Source: CBS

-4%

-2%

0%

2%

4%

6%

8%

10%

12%

14%

1970 1973 1976 1979 1982 1985 1988 1991 1994 1997

GDP-Growth

Unemployment


Financial number crunchingThe Cap-rate

Cap-rate = “Bruto Aanvangs Rendement (BAR)” = Net Operating Income1/ Fair Market Value

NOI = net rental incomeFMV = CFO/(1+r)t + CFS/(1+r)n

CFO = Cash flow from operationsCFS = Cash flow from sale

If Cap-rate of object exceeds the alternatives, the object is superior

Average Cap-rates in Netherlands

‘96 ‘97 ‘98 ‘99 ‘00 ‘01Office 7.00-8.25 7.00-8.00 6.75-7.25 6.40-7.00 6.75-7.25 6.90-7.30

Retail 7.75-8.50 7.50-8.50 6.75-7.75 6.75-7.75 6.75-7.25 6.75-7.25

Industrial 9.00-10.0 9.00-10.0 8.00-9.00 7.75-8.50 7.75-8.50 8.00-8.50

Source: DTZ Zadelhoff


Financial number crunchingThe Cap-rate

Cap-rate = NOI1/FMV

In equilibrium market the cap-rate tracks the interest-rate.R discount-rate (r) FMV Cap-rateR discount-rate (r) FMV Cap-rate

At this moment R, but Cap-rate is constant:Because of lower future expectations there exists excess supply in the market, which means that FMV is not rising.

Suppose R development cost new supply excess demand FMV Cap-rate

Cap-rate is poor market indicator, and can only signal “cheapness” of deal compared to alternatives


Financial number crunching

Widely Used Rules of thumb:

Discounted Pay-back Period = Time at which initial investment is repaid. Indicates liquidity-intensity of the project. Does not include profitability

differences, risk profiles.

Return On Investment (ROI) = Gross profit / total cost This is an accounting number, that does not say anything about profitability. Time value absence can bias the outcome.


Financial number crunching

Corporate Finance tools:

Net Present Value = -Initial Investment + present value of future inflows If NPV exceeds 0, the project is profitable and exceeds the implicit cost of capital (that is included in the discount rate)

Profitability Index = PV of cash inflows / initial investment If PI exceeds 1, the project is profitable

Internal Rate of Return = Discount rate that equates the PV of future inflows to initial investment If IRR exceeds the return the investor can earn on alternative investments, the project is optimal.


Discounting graphically:

NPV €

Discount Rate r

-Investment + Σ CFt

IRR

NPV = -Investment + CFt/(1+r)t


Buying The Rembrandt Tower

To Invest or not to investThat’s the question

What cash flows should we consider?

How should we measure?

How should we decide?

How should we structure the deal?


The Rembrandt Tower

Purchase Price = € 42.500.000

Building SynopsisGross Building Area 28,000 sqmNet Leasable Area 26,000 sqm

Rent Estimations 2002 2003 2004 2005 2006

Philips 2,388,750 2,436,525 2,485,256 2,781,926 2,869,986Newconony 1,023,750 1,044,225 1,065,110 1,192,254 1,229,994ABP 1,706,250 1,740,375 1,775,183 1,987,090 2,049,990Cap Gemini 1,706,250 1,740,375 1,775,183 1,987,090 2,049,990

Base rent 6,825,000 6,961,500 7,100,730 7,948,360 8,199,960Vacancy (5%) 0 0 0 397,420 410,000

EGI 6,825,000 6,961,500 7,100,730 7,550,940 7,789,960

EGI = Effective Gross Income

+

-


Including Expenses

2002 2003 2004 2005 2006

EGI 6,825,000 6,961,500 7,100,730 7,550,940 7,789,960

Operating Expenses 1,968,500 1,968,500 1,968,500 2,304,450 2,346,355

Managem. Expenses 341,250 348,075 355,035 377,545 389,500

NOI 4,515,250 4,644,925 4,777,195 4,868,945 5,054,105Taxes* 1,282,838 1,328,224 1,374,518 1,406,631 1,471,437

ATCFo 3,232,413 3,316,701 3,402,677 3,462,314 3,582,668

Operating Expenses: NOI = Net Operating Income – Property Taxes NOI = EGI - Expenses – Insurance

– Utilities Corporate Taxes:– Janitorial 35% of (NOI - Interest - Depreciation)– Maintenance Annual Depreciation = 2% of Purchase price

-

-


Including the Sale in 2006

Assume the office price will increase each year with 2%.

Expected Sales price in 2006:Sales Price = € 42.500.000 * (1.02)5 = € 46,923,434

Taxes = 28% of (sale price - purchase price + depreciation) = € 2,428,562

ATCFsale = € 44,494,873

2002 2003 2004 2005 2006NOI 4,515,250 4,644,925 4,777,195 4,868,945 5,054,105BTCFsale 46,923,434

BTCF 4,515,250 4,644,925 4,777,195 4,868,945 51,977,539

2002 2003 2004 2005 2006ATCFo 3,232,413 3,316,701 3,402,677 3,462,314 3,582,668ATCFsale 44,494,873

ATCF 3,232,413 3,316,701 3,402,677 3,462,314 48,077,541

-

-

-


After Tax Cash Flows

3,232,413 3,316,701 3,402,677 3,462,314 48,077,541NPV8% = -42,500,000 + (1+0.08)1 + (1+0.08)2 + (1+0.08)3 + (1+0.08)4 + (1+0.08)5

NPV8% = 1,303,337

1 2 3 4 5

3,232,413 3,316,701 3,402,677 3,462,314

48,077,541

-42,500,000


Profitability Ratio Analysis

Cap-Rate = BTNOI1/Market Value = 4,515,250/42.500.000 =0.1013 10.13%

NPV = -Equity Investment + Σ [CFt/(1+r)-t]

BTNPV8% = € 8,409,213 ATNPV8% = € 1,303,337 BTNPV11% = € 2,884,226 ATNPV11% = € -3,595,586 BTNPV14% = € -1,862,353 ATNPV14% = € -7,795,810

PI = Profitability Index = PV/Equity Investment

BTPI8% = 1.20 ATPI8% = 1.03BTPI11% = 1.07 ATPI11% = 0.91 BTPI14% = 0.96 ATPI14% = 0.82

IRR = Σ [CFt/(1 + IRR)-t] = Equity Investment

BTIRR = 12.77% ATIRR = 8.75%


Discounting graphically:

€ 1,303,337

8%

NPV €

Discount Rate r

Σ BTCFt

ATIRR = 8.75%


Leveraging the investment:

Finance 70% of the investment with interest-only loan @ 9%Annual Debt Services: 0.09 * 0.70 * 42.500.000 = 2,677,500

2002 2003 2004 2005 2006NOI 4,515,250 4,644,925 4,777,195 4,868,945 5,054,105Debt Inter. 2,677,500 2,677,500 2,677,500 2,677,500 2,677,500Taxes 345,713 391,099 437,393 469,506 534,312ATCFo 1,492,038 1,576,326 1,662,302 1,721,939 1,842,293

ATCFsale 44,494,873Loan Repayment 29,750,000

14,744,873

ATCF 1,492,038 1,576,326 1,662,302 1,721,939 16,587,166

Tax Advantage 2002: Taxes = 0.35 * (NOI - Depreciation - Debt Interest)

Taxes no loan: 0.35*(4,515,250 - 850,000 - 0) = 1,282,838 Taxes with loan 0.35*(4,515,250 - 850.000 - 2.677.500) = 345,713

-

-

+


After Tax Levered Cash Flows

1,492,038 1,576,326 1,662,302 1,721,939 16,587,166 NPV13% = -42,500,000 + (1+0.13)1 + (1+0.13)2 + (1+0.13)3 + (1+0.13)4 + (1+0.13)5

NPV13% = 1,015,887

1 2 3 4 5

1,492,038 1,576,326 1,662,302 1,721,939

16,587,166

-12,750,000


Ratio Analysis

Cap-Rate = BTNOI1/Market Value = 4,515,250/42.500.000 =0.1013 10.13%

NPV = -Equity Investment + Σ [CFt/(1+r)-t]

BTNPV13% = € 3,827,336 ATNPV13% = € 1,015,887 BTNPV17% = € 1,655,400 ATNPV17% = € -800,830 BTNPV21% = € -142,486 ATNPV21% = € -2,303,565

PI = PV/Equity Investment

BTPI13% = 1.30 ATPI13% = 1.08BTPI17% = 1.13 ATPI17% = 0.94 BTPI21% = 0.99 ATPI21% = 0.82

IRR = Σ [CFt/(1 + IRR)-t] = Equity Investment

BTIRR = 20.50% ATIRR = 15.10%


The leverage effect on profitability:

In this case leveraging the investment increases profitability because:- You decrease your equity burden- You lower you Tax expenses (deduction)- You finance a 12.77% (initial BTIRR) deal using a 9% loan

The last reason can be used as general rule:Positive Leverage: BTIRR > Interest rate on LoanNegative Leverage: BTIRR < Interest rate on Loan No Leverage 70% LeverageBTIRR = 12.77% BTIRR = 20.50%ATIRR = 8.75% ATIRR = 15.10%


The leverage effect on risk:

In every case leveraging the investment increases the risk because:- You take on a fixed burden- In case of disappointing earnings or unexpected expenses, income might be too little to service the debt The End- In case of a variable rate loan financing cost might increase suddenly

Ratio to use to analyze the risk: NOI 4,515,250

DCR = Debt Coverage Ratio = Mortgage Payment = 2,677,500 = 1.69

Mortgage Principal 29,750,000

LTV = Loan To Value Ratio = Property Value = 42,500,000 = 0.70

Documents

Real Estate Investments AM0000_000_000000 Direct Investments Techniques Basic Corporate Finance Applications Dirk Brounen April 23 rd, 2001