The Falbey Report

Tuesday, February 22, 2011

Discounted Cash Flow Analysis: Part 2 Revised

Part 1 of this discussion of discounted cash flow analysis, or DCF, was a general description of what it is and why it has significance for real estate investment and development. It is a means to measure or assess the present value of cash flows to be generated by the property (investment) in future periods (c.f., years of ownership). Here’s another way of looking at it:

· The initial investment to acquire or develop an income generating property is made today, in today’s dollars

· This property will generate income (primarily from rent) over a multiyear period of development and operation

· The dollars to be generated in these future year cash flows do not have the same value as today’s dollars

· The further out each succeeding year is, the less value the dollars generated in that year have in comparison to today’s dollars

· Therefore, these future cash flows have to be discounted (by some means) in order to determine their real value in today’s dollars

This process is called net present value or NPV. Because any type of investment – real estate or otherwise – is expected to produce cash flow, even if it’s simply a sale in a future year, NPV can be applied. As a consequence, NPV provides a means of comparing alternative investment opportunities to determine which one is likely to produce the greatest value or return on dollars invested today. Therefore, you can compare a real estate investment to an investment in pork belly futures, fine art, precious metals, equities, literally anything.

The components of NPV calculations for real estate are the following cash flows, positive and negative:

· The initial capital invested (negative)

· Subsequent capital investments (negative

· In-place (existing rents - positive)

· Forecasted (predicted future rent increases - positive)*

· Terminal or reversion (net sale proceeds - positive)*

*These latter two are highly speculative and not given much weight in today’s market.

First, let’s clear up any confusion about present value versus net present value. Present Value is a short-form methodology used to evaluate a property using its current-year NOI: Present Value (PV) = NOI ÷ cap rate. This is the essence of the cap rate that was discussed in an earlier posting to this blog.

Net Present Value, as noted above, is the value today of all future cash flows, positive and negative, to be generated by the project as discounted by the required rate of return (i.e., hurdle rate) minus the cost of acquiring the property. The discount or hurdle rate is a rate that reflects opportunity costs, inflation, and risks accompanying the passage of time. It is personal to every investor because each person assesses and weights risks differently.

NPV calculations produce a number, not a percentage. The key to interpreting the results of these calculations is in the nature and amount of the number produced:

· If NPV > 0, the financial value of the invested assets would be increased, (i.e., the return on invested capital is greater than the investor’s hurdle rate)

· If NPV = 0, the financial value of the invested assets would neither increase nor decrease, (i.e., the return on invested capital is equal to the investor’s hurdle rate)

· If NPV < 0, the financial value of the invested assets would be decreased, (i.e., the return on invested capital is less than the investor’s hurdle rate)

For example, suppose an investor is seeking a minimum return on capital invested (hurdle rate) of 15%. He or she has an opportunity to purchase a property that requires an investment $500,000 and will produce $125,000 per year in cash flow before taxes. Suppose also that the investor intends to sell the property after five years and expects the sale to net $1,000,000.

Will the investment produce a return at least equal to 15% under these circumstances? While the calculation requires use of a programmable financial calculator or spreadsheet software, the answer is “yes”. The calculation produces the number 416,196. Because we’re dealing with cash, this number actually is expressed as $416,196 and it’s a positive number. It means that the investment will produce the 15% return AND an additional $416,196. In fact, the actual rate of return (Internal Rate of Return or IRR) is 35.04%.

So, what actually happened here? Each year’s cash flow was discounted from the time it was (will be) generated back to the present using a discount rate of 15% (the investor's hurdle rate). Those respective annual cash flows, as discounted at 15%, have a value today of: $108,696, $94,518, $82,189, $71,469, and $559,324. That’s a total of $916,196. After deducting the initial capital outlay of $500,000, the result (NPV) is $416,196.

The next posting to this blog will discuss the Internal Rate of Return - IRR.

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Wednesday, February 16, 2011

Return on Investment in Real Estate: Discounted Cash Flow Analysis

In recent posts to this blog, we’ve looked at relatively simple methods for measuring the return on invested funds.

· The cash-on-cash method measures the rate of return, expressed as a percentage, on invested equity only.

· The capitalization rate, or cap rate, measures the rate of return on all capital invested, debt and equity. It also is expressed as a percentage.

While these methods are commonly used in the industry, they leave much to be desired. Primarily, they measure return for a single annual period, whereas most real estate investments or projects experience a multiyear cycle of development and operation. If your capital is at risk for a period of several years, shouldn’t your measure of return reflect this? Can you really understand and measure return on your investment by looking at a single year’s activity, such as the first year at stabilization?

Another issue is the time value of money. Is a dollar received in Year Ten’s cash flow worth as much as a dollar received in Year One’s cash flow? If you invested $100,000 today and received $200,000 within the first year, did you double your money? What if it took five years to get the $200,000? If you fail to see the difference, ask yourself this question: suppose you won $10,000,000 in your state’s lottery, but the state asked you if it could keep the funds for a couple of years then pay you – no interest accrues. Would you say, “Sure!”? Of course you wouldn’t. It’s the “bird in hand theory”. A dollar received today is worth more than a dollar received somewhere down the road, because, among other things, dollars lose purchasing power over time, inflation eats away at it’s value, there is the cost of lost opportunities, and there is the risk of default or nonperformance. This is the essence of the time value of money.

So, the question is: Given the effects of the time value of money, is there a way to measure return on investment over a multiyear period? The answer is yes, using discounted cash flow analysis. It is a means to measure or assess the present value of cash flows to be generated by the property (investment) in future periods (c.f., years of ownership).

There are three principal discounted cash flow methods utilized in real estate:

· Mortgage Amortization: In real estate, this essentially is a sinking fund in which regularly scheduled payments containing principal and interest are made over a specified period of years so that the final payment completely satisfies the mortgage debt.

· Net Present Value (NPV) : Measures and compares the attractiveness of alternative investment opportunities. This actual defies conventional wisdom by proving that you really can compare apples to oranges.

· Internal Rate of Return (IRR): Calculates the return earned on the invested capital over the life of the investment, not just the initial year.

In this discussion, we’ll concentrate on NPV and IRR.

The components of NPV and IRR calculations are the following cash flows, positive and negative:

· The initial capital invested (negative)

· Subsequent capital investments (negative)

· In-place (existing rents - positive)

· Forecasted (predicted future rent increases - positive)*

· Terminal or reversion (net sale proceeds - positive)*

*These latter two are highly speculative. Since the recent financial meltdown, investors and lenders are more conservative in underwriting the forecasted and terminal cash flows. Thus, in-place cash flows are a larger portion of the calculation – meaning cap rates have to rise, which pushes purchase prices (values) down if the investments are going to pencil out.

The next posting to this blog will discuss Net Present Value specifically.

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Tuesday, January 25, 2011

What Does the Future Hold for Master-Planned Communities?

According to ULI – The Urban Land Institute, master-planned communities (MPCs) “are usually a product of long-term, multiphase development programs that combine a complimentary mix of land uses…(that) typically occur on ‘greenfields’, that is, tracts of formerly undeveloped land often at or beyond the urban fringes.”¹ The classic MPC is primarily residential in nature with a mix of dwelling units of several different sizes and configurations as well as price points. They often include commercial and recreational components.

In today’s market, MPCs are the redheaded stepchild. The reasons are manifold:

MPCs are usually large-scale developments that have multiyear life cycles which means a commitment of substantial capital at the beginning, and capital is not currently interested in MPC development – too risky, thus too expensive;
With the current huge overhang of residential properties in most areas, there isn’t sufficient demand for more new housing;
The recent plunge in housing prices makes it impossible, in many instances, to build and sell new housing that is priced competitively with existing;
This often produces zero residual land value, and, so far, no one is giving land away;
In addition, in most areas where there might be some demand, the regulatory environment has produced added costs that at the present time eliminate any opportunity for competitive pricing.

That’s the story today, but what about the future? There is a lot of palavering to the effect that the day of the exurbs has passed, and all future development will consist of dense, compact (smaller units), mixed-use, high-rise properties on infill urban parcels. I’m not buying it and here’s why:

The job market will recover eventually;
When it does, the overhang of existing properties will be absorbed, thus creating demand for new;
This will result in an increase in housing starts, and not all of them will be compact urban development;
Why? Because Generation Y will age, and when it does, its members will begin to turn away from the live-work-play in the same place. They will start families and many will want detached single-family residences with yards. That’s not a desire that’s unique only to a particular generation.

Most of the residences in new MPCs undoubtedly will be smaller than in the past for at least two reasons:

The party’s over in the United States. The changes currently occurring in our world as well as our economy are imposing a downward shift in lifestyle affordability, which in turn affects quality of life. We will not see a return of the rising tide that lifted the Boomers’ ships to incredible highs. There will always be an affluent class, but the middle class will be poorer;
Housing costs, including the added costs of ever-increasing regulatory measures, as well as the costs of transportation from the exurbs to workplaces, schools, etc., will eat a greater hole in Generation Y members’ budgets.

These factors and others will be met only by downsizing the residence. But, the good news for the residential development community is that MPCs are not a class of dinosaur.

¹Trends and Innovations in Master-Planned Communities, 1998, Schmitz and Bookout, ULI-the Urban Land Institute, ISBN 0-87420-800-9.

Connect with us: visit FaceBook; Twitter, LinkedIn, YouTube, t he Falbey Institute for the Development of Real Estate . The Institute's web site currently is undergoing revision, and we apologize for any inconvenience experienced.

Monday, January 17, 2011

The Cap Rate – Part 3: What It Is; What It Does

In Parts 1 and 2 on the Capitalization Rate, we discussed how the cap rate is utilized and how it’s calculated. In this final section, we’ll discuss the flaws in the cap rate and what its recent history and usage tell us.

1. What is the basic flaw in the use of the cap rate as a measure of return on a long-term investment?

The basic flaw in the use of the cap rate is its focus on a single year, whereas a typical income property investment is a multi-year proposition. Thus, you have to recalculate the cap rate for every year of the projected life of the investment. You basically are estimating NOI for each of those years as well as the projected value for each year; then, using the IRV formula discussed in Part 2, you calculate the return those numbers indicate by dividing the given year’s NOI by that year’s estimate of value for the property (R=I÷V).

2. In the middle part of the last decade, cap rates compressed to as low as 1% - 2%, while bond rates hovered around 5%. What motivates “sophisticated” investors to settle for such a low rate of return in an investment that’s as high risk as real estate?

To put that into perspective, here’s an example:

· A property is producing NOI of $250,000 and is acquired for a total purchase price of $10,000,000, or a cap rate of 2.5% ($250K ÷ $10M);

· Assume the purchase price represents $500 per square foot;

· The purchaser expects to sell the property within 2 years at a price of $650 per square foot.

Where is the investor’s real profit motivation?

Obviously, it isn’t in the cap rate during the operating years. It’s in the anticipated appreciation of $3,000,000 realized in the resale two years or less down the line. In other words, the investment expectation was to flip the property quickly for a profit sufficient to lift the overall rate of return as measured on the short life of the investment, such as by using a discounted cash flow method like the Internal rate of Return (IRR) method. Discounted cash flow analysis will be a topic of future postings to this blog.

In a red-hot or bubble real estate market like the mid-2000’s, this form of thinking is prevalent.

But then cap rates decompress (rise) back to historic norms, or higher. Why? Because when the bubble bursts, realization sets in that properties were overvalued. The market is uncertain where values will stabilize, so sales are few. Most sales in this situation are short sales or distress sales (bankruptcy, foreclosure), and don’t represent fair market value. Compounding the problem is the rising vacancy rate and increasing concessions to tenants due to business failures and the reduction in space needed by those tenants who survive by eliminating jobs.

The uncertainty revives the awareness of risk inherent in real estate investments, so the required rate of return increases accordingly. The greater the risk, the greater the required rate of return on invested capital.

In this kind of market environment some investors foolishly assume an ability to raise rent levels or cut vacancies or lower operating expenses or some combination thereof, which will increase NOI in future years; thus, increasing the rate of return. That, however, won’t happen because leases are binding contracts that span years regardless of changes in the property’s ownership; thus rents cannot be raised arbitrarily until the lease expires or is breached by the tenant

In the meantime, it’s good to remember that in past recessions the recovery of the commercial real estate sector consistently has lagged that of the larger economy. On a brighter note, effective rent should start to grow once job growth begins. When that occurs, then we should start seeing an easing of vacancies and tenant concessions in the marketplace. With the growth of NOI, values will start to rise, confidence and investor interest will be enhanced, and cap rates will begin to compress again.

At the moment, however, cap rates in the 5% to 5.5% range are seen only where the property is a core asset. These usually are well constructed, well-located, modern buildings enjoying 95% to 98% occupancy on long-term leases with very creditworthy tenants and located in gateway cities.

Tuesday, January 11, 2011

The Cap Rate - Part 2: What It Is, What It Does

In an earlier posting to this blog, we introduced the concept of the capitalization rate or cap rate, and discussed the basics of it. This discussion will expand on that discussion.

Simply put, the cap rate measures the return on total capital invested in an income-producing property in any given year of operations. Total capital invested means all equity and all debt utilized in the deal. It also can be used to determine the market value of such a property.

There are three components to the cap rate: Income; Rate; and Value, which combine to form the acronym IRV. Income generally is net operating income or NOI. It is derived from Gross Income (expected income from all sources). First, loss of income from vacancies is subtracted, then credit losses are subtracted. This leaves Gross Operating Income (sometimes referred to as Adjusted Gross Income), or the funds generated by the property available for use by the owner.

Operating Expenses, or OPEX, are deducted from Gross Operating Income. This results in Net Operating Income (NOI).

Thus, expressed a little more clearly, the components of IRV are:

I = NOI

R = return on capital invested in any given year of operations, or the hurdle rate sought by investors

V = the market value of the property, given the NOI and hurdle rate

If you know any two of these components, you can calculate the third, as follows:

I = V x R

R = I ÷ V

V = I ÷ R

What’s reflected above is the overall cap rate. But this is a little more complicated than it appears to be at first blush. Because the overall cap rate measures the return on all capital invested, it consists of a lender’s component and an investor’s component. The lender’s component is known as the Lender’s Average Weighted Cost of Capital (WACC). The Investor’s component similarly is known as the Investor’s Average Weighted Cost of Capital.

The lender’s WACC is calculated as follows:

Mortgage Constant, depicted as the Greek letter kappa or К (i.e., Annual Debt Service ÷ Original Principal Balance of the Loan)

x Loan-to-Value Ratio (relationship between total cost and the loan amount, aka LTV)

= Lender’s WACC

Example: LTV = 70%; К = 8.25%, then the Lender’s WACC = .0508 or 5.08%

The investor’s WACC is calculated as follows:

Investors’ % of the investment (the equity portion of the deal)

x Investors’ hurdle rate (investor’s minimum acceptable rate of return)

= Investors’ WACC

Example: Investor contributes 30%; Investor seeks 9% minimum return

Investors’ WACC = .0270 or 2.7%

So the overall cap rate is:

Lender’s WACC (.0508)

Investors’ WACC (.0270)

Cap Rate = .0778 or 7.78%

So, what does all this really mean? The first year’s cap rate has to equal or exceed 7.78% for all parties to achieve their goals. Thus, the current year’s NOI, when divided by the purchase price (value), has to equal or exceed 7.78%.

The third and final installment on cap rates will explore its flaws and what’s been happening to cap rates in recent years.

Wednesday, December 29, 2010

The Cap Rate Part 1: What It Is, What It Does

Again, a reminder that postings on this blog site are sometimes aimed for those who are new to the real estate development industry or who are interested in learning more about it. This is one of those postings.

In an earlier blog, we discussed the concept of cash-on-cash as a means of measuring return on equity capital invested in a real estate project. Most real estate development capitalizations, however, include debt as well as equity.

In the current market, debt often provides 50% to 70% of the development capital needed. The balance generally is raised in the form of equity - money invested by individuals or entities with the expectation of profit or return of, as well as on, the investment. These are financial partners, not lenders who provide debt capital. Some sophisticated forms of debt can be converted to an equity position. Some may require participation in addition to interest on the debt capital. These arrangements sometimes are referred to as “equity Kickers”.

While cash-on-cash is a measure of return on equity, the capitalization rate, or cap rate, measures return on total capital invested: debt as well as equity. So, it is a measure of 100% of the capital utilized to develop or acquire an income producing property. In simple terms, it is the estimated rate of return on the capital invested in an income generating property at the time of its purchase or the initial stabilized year. It is expressed as a percentage.

For example, suppose a property generated net operating income, or NOI, (total income minus vacancies, credit losses, and operating expenses) of $500,000. Suppose also that the total capital (debt and equity) required to acquire the property is $7,500,000. The cap rate is 6.67%.

Cap Rate = $500,000/$7,500,000 = .0667 or 6.67%.

Thus, a common way the cap rate is used is as a means to identify investment properties that meet the investor’s desired rate of return. The investor analyzes the probable purchase prices of various properties and their respective NOIs. Using the formula above, it is easy to determine whether a given property meets the investor’s hurdle rate (minimum acceptable rate of return. In the example above, if the hurdle rate was 6.68% or higher, the investor probably would pass. If the hurdle rate was 6.67% or lower, the investor might be interested.

Instead of purchasing an existing income property, suppose you were going to develop one. If the total cost to develop it, including land, was $7,500,000, and it was expected to generate NOI of $500,000 in the initial year of operating after reaching stabilization (achieving the pro forma rents), the cap rate would be 6.67%, as demonsrated above.

In the next blog on cap rates, we’ll go into more detail.

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Wednesday, December 22, 2010

Another Way of Looking At Return on Investment in Real Estate

First, a reminder that this blog site is aimed more for those who are new to the real estate development industry or who are interested in learning more about it. Consequently, some of the postings, but not all, will be geared specifically for that audience. This is one of those postings.

Developers, whether newbies or old pros, have to raise the capital required to make the investment in the proposed project. In the current market, debt provides, at best, about 60% to 70% of the development capital needed. The balance generally is raised in the form of equity - money invested by individuals or entities with the expectation of profit or return of, as well as on, the investment. These are financial partners, not lenders.

While there are a number of ways to measure that return on investment - some more sophisticated than others, a classic method is what is called cash-on-cash. It means literally: cash returned on cash invested. It is calculated by dividing the amount of cash returned to an investor in a given year by the total amount of equity invested by that investor to date. The result is expressed as a percentage.

For example, if an investor contributes $100,000 to the project and receives $7,500 during the first year of operations, the cash-on-cash return would be measured as: $7,500/$100,000 or 7.5%.

One of the major flaws in this method is obvious. Investment in real estate projects is a long-term or multi-year proposition; whereas, the cash-on-cash method only expresses return on investment for a single year. Nevertheless, it continues to enjoy widespread usage.