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Transcript of 7 Investment&RiskAnalysis
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Investment and Risk Analysis forReal Property
ARU2010
Mr. Samwel Alananga
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Variables for income property investors
Market factors
Occupancy rates
Tax influences
The level of risk The amount of debt financing
Proper procedures for evaluating returns oninvestment.
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Motivation for Equity investment Expectations of returns net on initial investment
costs Expectations of higher sale price in the future
Investment ortfolio diversification to reduce the
overall risk of holding assets such as stocks, bonds,money market funds, real estate e.t.c.
Possibility of preferential tax benefits i.e. paying
less tax
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Projecting cash-flow
Consider an Example;
Current market rent
(per sq foot) Tsh. = 15/= Gross sq feet = 100,000.
Projected increase in
market rent per annum = 4% Management cost
(% of effective Gross income) = 5%
Estimated annual increase inthe consumer price index = 4%
Sale price Tsh. = 8.5Mil
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Projecting cash-flow Cont
Additional data
TenantsSquare
foot
Current
rent(per sq
feet)
Current
rentalincome
(Tsh)
Remaining
leaseterm
(years
CPI
adjustment (% of
CPI)
1 30 000 14 420 000 3 50
2 25,000 14 350,000 3 50
3 15,000 14 210,000 3 50
4 10,000 15.50 145,000 4 50
5 10,000 15 150,000 5 50
6 6,000 15 90,000 6 50
Total 96,000 1,365,000
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CPI Adjustment-1st
TenantThe projected base rent depends on:-
The initial base rent at the time of lease renewal
CPI adjustment to the base rent
The market rent revailin at the time of lease
Projected rental income
1 2 3 4 5 6420,00
0
420,000+(0.02x420,00
0)
428,400
428,400+(0.02x428,00
0)
436,968
436,968+
15(1.04)3 x
30000 =
506,189
506,189+(0.02x506,1
89)
516,313
516,313+(0.02x516,3
13)
526,639
renewal
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CPI Adjustment-All tenantsTenants Projected rental income
1 2 3 4 5 6
1 420,000 428,400 436,968 506,189 516,313 526,639
, , , , , ,
3 210,000 214,200 218,484 253,094 258,156 263,319
4 145,000 147,900 150,858 153,875 175,479 178,988
5 150,000 153,000 156,060 159,181 162,365 182,498
6 90,000 91,800 96,636 95,509 97,419 109,499
Total 1,365,000 1,392,300 1,420,146 1,589,672 1,639,992 1,699,809
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Expense Stops
The amount of the stops is based on:-
The tenants pro rata share (% of total leasable
area) Category of expenses to be included in the stops
as agreed between the lessor and the lessee.
The actual amount of operating expenses at the
time the lease is signed
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Expense stops Cont
To calculate expense stops additional
information is necessary:-
Lease Stops
enan s s =Tenants 2 Tsh 4/=
Tenants 3 Tsh 4/=
Tenants 4 Tsh 4.25
Tenants 5 Tsh 4.45
Tenants 6 Tsh 4.45
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Assumptions on expenses
Tsh: Tsh. Per sq ft: Projected increase.
Property tax, 148,800. 1.55, Level 2years, 10% increasethen level
Insurance 14 400. 0.15 increase 40% er ear
Utilities 120,000 1.25, 5%
Janitorial 76,800 0.50, 3%
Maintenance 67,200 0.70, 3%
Total 427,200 4.45
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Projected expenses
Projected expenses
1 2 3 4 5 6
Property tax 148,800 148,800 163,680 163,680 163,680 163,680
Insurance 14,400 14,976 15,575 16,198 16,846 17,520
Utilities 120,000 126,000 132,300 138,915 145,861 153,154
Janitorial 76,800 79,104 81,477 83,921 86,439 89,032
Maintenance 67,200 69,216 71,292 73,431 75,634 77,903
Total operatingexpenses 427,200 438,096 464,325 476,146 488,460 501,289
Expenses pr sq
ft 4.45 44.56 4.84 4.96 5.09 5.22
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Expense re-imbursements1 (4.45-4.00) x 30,000 = 13,500
2 (4.56-4.00) x 30,000 = 16,905
3 (4.8367- 4.00) x 30,000 = 25,101
4 (4.9599-4.9599) x 30,000 = 0
5 (5.0881-4.9599) x 30,000 = ,846
6 (5.2218-4.9599) x 30,000 = 7,857
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Expense re-imbursements
Tenant
s
Projected expense reimbursements
1 2 3 4 5 6
1 13,500 16,905 25,101 0 3,848 7,857
, , , , ,
3 6,750 8,453 12,551 0 1,924 3,929
4 2,000 3,135 5,867 7,099 0 1,336
5 0 1,135 3,867 5,099 162,365 06 0 618 2,320 3,059 97,419 0
Total 33,500 44,396 70,625 15,256 19,189 19,670
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Net Operating IncomeProjected expenses
1 2 3 4 5 6
Base rent 1,365,000 1,392,300 1,420,146 1,589,672 1,639,992 1,699,809
Vacancy 0 0 0 79,484 82,000 84,990
EGI 1,365,000 1,392,300 1,420,146 1,510,189 1,557,992 1,614,819
Operating
expenses 427,200 438,096 464,325 476,146 488,460 501,289
reimbursements 33,500 44,396 70,625 15,256 19,189 19,670
Subtotal 393,700 393,700 393,700 460,890 469,271 481,619
Add:
Management
expenses
(5% of EGI) 68,250 69,615 71,007 75,509 77,900 80,741
Total expenses 461,950 463,315 464,707 536,399 547,170 562,360
Net Operating
Income 903,050 928,985 955,439 973,790 1,010,822 1,052,459
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Debt Financing
1 2 3 4 5
Assume the investor can obtain a 70% (5,950,000)
loan with the following financing terms:- (interest
rate = 10%)
Annual
Payments 689,025 689,025 689,025 689,025 689,025
Mortgage
balance 5,851,543 5,742.776 5,622,620 5,489,883 5,343,245
Interests590,569 580,259 568,569 556,288 542,388
Principal98,457 108,767 120,156 132,738 146,637
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Debt Financing Cont
The total payment comprises the principle
and interest payments
The mortgage balance is reduced only by the
principle payment The debt financing cost should be included
in the calculation of cash flows to the equity
investor as shown below:-
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Debt Financing Cont
1 2 3 4 5
Net Operating
Income (NOI) 903,050 928,985 955,439 973,790 1,010,822
(DS) 689,025 689,025 689,025 689,025 689,025
Before tax Cash
Flow (BTCF) 214,025 239,960 266,414 284,765 321,797
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Introduction to Investment Analysis
Emphasizes on:-
Should the property be purchased?
How ong s ou it e e How should it be financed?
What are the tax implications of owning the
property (investment)? How risky is the investment?
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Should the property be purchased?
sqft
TshsSqfticeperGros
000,100
/000,500,8.Pr
==
Performance ratios
= Tsh 85 per sq ft
sqft
Tsh
ableSqfticeperrent 000,96
/000,500,8.
Pr
=
=
= Tsh 88.54 per sq ft
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Performance ratios Cont
iceAsking
NOICapRate
Pr=%62.10000,500,8
050,903
==CapRate
%1
Equity
BTCFdendRateEquityDivi =
%39.8000,550,2
025,214==dendRateEquityDivi
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Performance ratios Cont
DSNOIDCR =
31.1025,689
050,903==
DCR
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Price on sale of the property Estimated Property value increases i.e. the
average NOI increases over the local area. Let
it be 3% thus price will be:-
8,500,000 x 1.035
= 9,850,000/=
Use the capitalisation rate which was about
11% (Terminal Capitalisation Rate)
=== /809,567,9Pr,Pr
459,052,1%11 ice
ice
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Price on sale of the property Cont
Two different possible sale price
It is common sense to use the average of the
two i.e. a out,
Tsh. 9,700,000/=
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Before Tax Cash flow from Sale.
Sale price 9,700,000/=
, ,
BTCFs 4,356,755/=
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Cash-flow Based Performance
Year Cash flow Present Value (18%)
1 214.025 181,377
2 239,960 172,335
Net Present Value (NPV):
, ,
4 284,765 146,878
5 4,678,551 2,045,038
Total PV
Less Initial Equity
NPV
2,707,776
2,250,000
157,776
The investor could invest more up to 157,776/= and still earn
a return of 18% on his investment.
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Cash-flow Based Performance Cont
06.1776,707,2
===PV
PI
Profitability Index (PI):-
,,
A PI greater than 1, means that the
expected rate of return exceeds the
discount rate.
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Cash-flow Based Performance Cont
Internal Rate of return (IRR)
- Establish the higher and the lower of discountrate an y terat on t en app y:-
100)( xPVPV
PVLdHdLdIRR
HdLd
Ld
++=
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Internal Rate of return (IRR)
Cont Where = Lower discount rate (The higher of the
discount rate leading to a positive NPV-
0.19)
= Higher Discount rate (The lower of thediscounts rate leading to a negative NPV-0.2)
= NPV at the lower discount rate= NPV at the Higher discount rate
1964.01006.735,3397.943,59
97.943,59)19.020.0(19.0 =
+
+ x
Whether a particular IRR is adequate or not depend on
what the investor can earn on comparable investment -
(Mkt IRR)
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Cash-flow Based Performance Cont
Adjusted/Modified IRR:-
It considers the possibility for reinvestment
),(
= n
ntratereinvestmeshflowPositivecaFV
),( efinancerathflownegativecaPV
%01.181000,500,2
50.742,835,55 =
=MIRR
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Risk AnalysisDifferent type of risks:-
Business risk
Financial risk
Liquidity risk Inflation Risk
Management Risk
Legislative risksEnvironmental risk
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Risk Analysis Cont Sensitivity Analysis
This involves violating one or moreassumptions involved in investment analysis
. .
Expected market rental rate
Vacancy rate Operating expenses
Expected resale price
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Sensitivity Analysis Cont Sensitivity analysis starts with a base case
which is a set of assumptions which reflect theanalysts best estimate of the most likelysituation:
performance I.e. NPV, PI, IRR
The analyst then varies one or more of theassumptions to see how they affect the results.
The approach is as follows: Change a single assumption at a time
Identify several scenario for which one or morevariables changes
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Try to vary prices??
Resale Price Annual
Change
BTIRR
7,300,00 -3% 6.17%
7,900,000 -1.45 10.25
8,500,000 0 13.769,100,000 1.37 16.86
9,700,000 2.68 19.64
10,300,000 3.92 22.1610,900,000 5.10 24.48
11,500,000 6.23 26.63
12,100,000 7.32 28.64
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Graph the results
20
25
30
35
0
5
10
15
7,30
0,00
7,90
0,00
0
8,50
0,00
0
9,100,00
0
9,70
0,00
0
10,300
,000
10,900
,000
11,500
,000
12,100
,000
Resale Price
IRResale Price
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Variations in return and risks
The pessimistic investor assumes to sell the
property at 7.3mil while the optimistic investor
expects to sell at 12.1Mil
Return(R)
Probability(P)
R x P R ExpReturn
Px(R-expR)^2
Pessimistic 6.17% 25% 1.54% -12.35% 0.3812
Most likely 19.64 50 9.82 1.12 0.0062
optimistic 28.64 25 7.16 10.12 0.2559
Expected return 18.52 Variance 0.6434%
Std Dev 8.02%
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Variations in return and risks Cont
Apartment building
Return
(R)
Probability
(P)
R x P R Exp
Return
Px(R-exp
R)^2
Pessimistic 10.0% 25% 2.50% -5% 0.0625%
Most likely 15 50 7.50 0 0.00
optimistic 20 25 5.0 5 0.0625
Expected return 15 Variance 0.1250%
Std Dev 3.54%
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Variations in return and risks Cont
Hotel building
Return
(R)
Probabilit
y (P)
R x P R Exp
Return
Px(R-exp
R)^2
Most likely 20 50 10 5.0 0.1250
optimistic 35 25 8.75 15.0 0.5625
Expected return 20.0% Variance 0.9375%
Std Dev 9.68
The higher the returns the more the risk
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Taxation of Income producing Real Estate
Developers of income generating properties
are called investors while dealers develop
properties for resale.
These properties are taxable i.e.Property tax
Depreciation allowances
Capital gain tax
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Taxable Income Taxable income = NOI Interest- Depreciation
Depreciation of physical assets, ceteris peribus,
reduces their economic values
tax a ty s o ta ne y mu t p y ng t e taxa e
income with the investors marginal tax rate
To determine whether there is a capital gain or
capital loss on the sale of the property we need to
determine the Gross Sale Price.
Taxable Income Cont
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Taxable Income Cont
Gross sale Price = Cash received on property sale +Any liability assumed by the buyer against the property
Taxable income 1 2 3 4 5
Net Operating Income (NOI) 903,050 928,985 955,439 973,790 1,010,822
Less: Interest +depreciation 590,569 280,259 568,869 556,288 542,388
185,256 185,256 185,256 185,256 185,256
Table income/loss 127,225 163,470 201,313 232,246 283,177
Tax (36%) 45,801 55,849 72473 83,609 101,944
After tax cash Flow
Before-Tax Cash Flow (BTCF)
214,025 239,960 266,414 284,765 321,797
Less Tax 45,801 55,849 72473 83,609 101,944
After-Tax Cash Flow (ATCF)
168,224 181,110 193,941 201,156 219,853
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Taxable income Cont
Sale price 9,700,000/=
Less: Mortgage balance
5,343,245/=
BTCFs 4,356,755/=
Taxes in year of sale
Sale rice 9,700,00/=
Original cost basis 8,500,000/=Less: Accumulated
depreciation 926,282/=
Adjusted basis 7,573,718/=
Capital gain2,126,283/=
Tax on gain (28%) 596,359/=
ATCFs
3,761,396/=
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After tax Investment Analysis
BTIRR = 19.64
ATIRR = 14.54
After tax present Values (3% discount rate)
PV of ATCF from operation Tsh. 667,817/=PV of ATCF from Reversion Tsh. 2,041.543/=
Total PV Tsh. 2,709,352/=
Less: Original Equity Investment Tsh. 2,550,000/=
After Tax NPV Tsh.159,352/=
0 1 2 3 4 5
BTCF(2,550,000) 214,025 239,960 266,414 284,765 4,678,551
ATCF(2,550,000) 168,224 181,110 193,941 201,156 3,981,248
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The END