Chapter 19Investment Decisions: NPV and IRR

REAL ESTATEFIN 331

Overview

A. Major theme: most RE decisions are made with an investment motive1. magnitude of expected CFs--and the values they

create—are at the center of investment decision making

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

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

Overview

D. Limitation of these single-year return measures & ratios?1. They do not explicitly incorporate

income producing ability of property beyond 1st year of rental operations

2. May lead to suboptimal investment decisions

Overview

E. Many investors also perform multi-year analyses of potential acquisitions

F. When using multi-year Discounted Cash Flow (DCF) decision making methods, investor must1. Estimate how long she expects to hold property2. Make explicit forecasts of:

a. property’s net CF for each year, b. net CF produced by expected sale of property

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

Overview

G. NPV decision rules1. NPV = Present Value of ATCF minus the Initial Investment2. If NPV is greater than 0, we make the investment3. If NPV is less than 0, we will not make the investment

H. Measuring the impact of leverage1. Leverage involves the use of debt to finance part of the

acquisition2. The interest charges on debt will reduce our taxable income3. Traditional analysis uses ATCF values to compute NPV

I. Internal Rate of Return (IRR)1. When NPVs are greater than 0, the internal rate of return will be

greater than the discount rate used to compute NPV2. if NPV is equal to 0, then the internal rate of return equals the

discount rate3. if NPV is less than 0, then the IRR is less than the discount rate

Centre Point Office Building

Centre Point: 5-Year Operating Pro Forma-Unlevered

Sale of Centre Point at End of 5th Year

A. Assumptions1. Annual market rent increases = 3% per year2. Vacancy & Collection Losses = 10% per year3. Operating Expenses = 40% of EGI4. Capital Expenditures = 5% of EGI5. Expected Holding Period = 5 years6. Selling price based on Year 6 NOI

a. NOI6 = 103,291 (projected)

b. Sale Price = 103,291 / 0.0875 =$ 1,180,469

Net Present Value of Centre Point

NPV = PVin − PVout

PVout in this example is equal to original equity investment of $287,760

NPV = $319,591 − $287,760

Decision: Accept Centre Point investment opportunity because doing so will increase equity investor’s wealth by $31,831

Measuring the Impact of Risk on NPV

A. Sensitivity analysis1. Most likely scenario2. Worst-case scenario3. Best-case scenario

B. Value of computer1. Excel spreadsheets2. Specialized software such as ARGUS

C. Monte Carlo simulation (using random probabilities to develop outcome distributions)

HOMEWORK ASSIGNMENT

A. Key terms: before tax cash flows, after-tax cash flows, leverage, leverage cash flow, unleveraged cash flow

B.Study questions: 2, 3, 5, 9, 11