Chapter 19

Investment Decisions: NPV and IRR

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

19-2

Overview

Major theme: most RE decisions are made with an investment motive magnitude of expected CFs--and the values they

create—are at the center of investment decision making

Chapter 18 focuses on widely used, single-year, return measures, ratios, & income multipliers

These criteria are relatively easy to calculate & understand—an advantage in the eyes of many industry professionals

19-3

Overview

Limitation of these single-year return measures & ratios? They do not incorporate income producing ability of

property beyond the 1st year of rental operations May lead to suboptimal investment decisions

19-4

Overview

Many investors also perform multi-year analyses of potential acquisitions

When using multi-year discounted CF decision making methods, investor must1. estimate how long she expects to hold property

2. make explicit forecasts of: property’s net CF for each year, net CF produced by expected sale of property

3. Select rate of return at which to discount all future CFs

19-5

Centre Point Office Building

19-6

Centre Point: 5-Year Operating Pro Forma

19-7

Centre Point: Reversion Sale Price

10.0

NOI000,033,1$

6

10.0

291,103$000,033,1$

19-8

Levered vs. Unlevered Cash Flows

Levered CFs measure property’s income after subtracting mortgage payments

Valuation of levered CFs? Discount expected BTCFs rather than stream of NOIs

Why is owner’s claim on a property’s CFs refereed to as a “residual claim”?

19-9

Effects of Leverage on Centre Point Equity Investment & Future Cash Flows Loan Terms

75% loan, 30 years, 8%, total up-front fees of 3%

Net loan proceeds:

= $663,750 − (0.03 x 663,750)

= $643,837.50 Equity = $885,000 - $643,837.5 = $241,163 Payment: $4,870.36 or $58,444 per year

19-10

Centre Point with Mortgage Financing

$41,838

19-11

Present Value of Levered Cash Flows

Justification for increasing discount rate from 11.75% to 16%?

19-12

Net Present Value of Centre Point

NPV = PVin − PVout

NPV = $279,354 − $241,163

PVout in this example is equal to original equity investment of $241,163

NPV = $38,191

Decision: Take on Centre Point investment because doing so will increase equity investor’s wealth by $38,191

19-13

Effect on NPV of Variation in Required Yield/IRR

At a discount rate of 20.2584%, NPV = 0, this is the going-in IRR

19-14

Why IRR Is Technically Inferior to NPV as a Guide to Investment Decisions IRR & NPV will always give the same accept-

reject signal w.r.t. an individual investment But…..

IRR may rank investment opportunities differently than NPV

If projected CFs change signs more than once over expected holding period, there may be multiple IRRs

19-15

Leverage Can Increase Both NPV & IRR

But…leverage also increases risk, thus required equity return (review related discussion in Chapter 16)

19-16

Impact of Leverage on Investment Risk

19-17

Reality Checks on Investment Value

Claim of project organizer (promoter) on returns Compensation for idea, time, effort, & knowledge

Claim of taxes on returns Federal taxes (IRS): Up to 35% State taxes: Up to 10% Complexity of tax computations

19-18

Centre Point: After-Tax Cash Flows

Assumed income tax rate on additional income: 30%

19-19

How is Required After-Tax Discount Rate Determined? Assume: required before-tax return = 16% Assumed income tax rate on additional income = 30% After-tax required return = 16% − (0.30 x 16%)

= 16 (1 − 0.30) = 11.2%

That is, after-tax required return = Before-Tax Required

Return x (1−MTR) MTR is investor’s “marginal” tax rate

19-20

Centre Point: After-Tax NPV & IRR

Note: IRR falls less than 30%: (20.258 – 15.4) ÷ 20.258 = 0.24

19-21

Comparison of Three Scenarios

Some conclusions: Leverage increased expected Centre Point equity returns

Each dollar of debt cost 8% but produced 12.2% for equity investor

Taxes significantly reduce net investor CFs

19-22

More Detailed Cash Flow Projections The pro formas detailed in Exhibits 18-2 through

18-12 display major categories of revenues & expenses

However, most RE pro formas provide significantly more detail on projections of revenue sources vacancies operating expenses capital expenditures

See Exhibit 19-15 for an example

19-23

Varying the Assumptions

Sensitivity analysis Most likely scenario Worst-case scenario Best-case scenario

Value of computer Excel spreadsheets Specialized software such as ARGUS

Monte Carlo simulation

End of Chapter 19