Chapter 15

Value, Leverage and Capital Structure

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Chapter 15 Learning Objectives

Understand the value of an equity investment in real estate

Understand how the use of debt can alter cash flows

Understand the concept of an optimal balance of debt and equity financing

Understand how more practical institutional matters affect the debt structure of real estate investments

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Valuation of Real Estate Investments

The value of an income-producing asset is a function of the income accruing to the asset Discounted cash flow (DCF) model

Income is generally measured as some form of cash flow

Cash flows and discount rate can be hard to determine because of the nature of the asset

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Financial Leverage

Investor has two basic sources of financing: debt and equity

Financial leverage is the use of debt in financing Positive leverage – the use of debt at a cost less than the return on the asset; increases the

return on equity

Negative leverage – the use of debt at a cost greater than the return on the asset; reduces the return on equity

Neutral leverage – the debt cost is equal to asset return and return on equity is not affected

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Financial Leverage

The risk to the equity is increased by the use of financial leverage

Leverage allows the cash flows to be divided into two components: less risky and more risky

Value can be created if debt holders and equity holders have different risk-return preferences

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Financial Leverage

More risk-averse investor can invest in the lower-risk debt and less risk-averse investor can invest in riskier equity

Tax-deductibility of interest payments on debt make it advantageous

Federal government subsidizes the use of debt by providing tax relief

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Real Estate Cash Flow Structure – NOI

Gross Rent (GR)

– Vacancy (VAC)

+ Other Income (OI)

= Effective Gross Income (EGI)

– Operating Expenses (OE)

= Net Operating Income (NOI)

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Real Estate Cash Flow Structure – ATCF

Net Operating Income (NOI)

– Mortgage Payment (MP)

= Before-Tax Cash Flow (BTCF)

– Tax Liability (Savings) (TXS)

= After-Tax Cash Flow (ATCF)

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Taxes from Operations

Net Operating Income (NOI)

– Interest Expense (INT)

– Depreciation (DEP)

= Taxable Income (TI)

x Investor’s Marginal Tax Rate (t)

= Taxes (Savings) from operations (TXS)

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After-Tax Equity Reversion

Estimated Selling Price (ESP)

– Selling Expenses (SE)

= Net Sales Price (NSP)

– Unpaid Mortgage Balance (UMB)

= Before-Tax Equity Reversion (BTER)

– Total Taxes on Resale (TXR)

= After-Tax Equity Reversion (ATER)

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Taxable Income from Resale

Estimated Selling Price (ESP)

– Selling Expenses (SE)

= Amount Realized on Sale (AR)

– Adjusted Basis (AB)

= Total Gain from Sale (TG)

– Depreciation Recovery (DR)

= Capital Gain from Resale (CG)

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Taxes Due on Resale Depreciation Recovery (DR)

x Depreciation Recovery Tax Rate (td)

= Depreciation Recovery Tax (DRT)

Capital Gain

x Capital Gains Tax Rate (tg)

= Capital Gains Tax (CGT)

Depreciation Recovery Tax (DRT)

+ Capital Gains Tax (CGT)

= Total Tax on Resale (TXR)© OnCourse Learning 12

Cash Flow Example – Assumptions Investor purchasing a warehouse with a purchase price of $1,125,000;

acquisition costs of $36,000

80% depreciable

33,600 leasable square feet; Initial rent of $12/sq. ft. per year and will increase 5 percent per year

Vacancy rate of 5% of gross rent per year; Operating Expenses are 40% of EGI

Mortgage is 75% LTV ratio, 20 years, monthly payments, 9% contract rate, 3% financing costs, 5% prepayment penalty for the first six years of mortgage life

Expected increase in value is 3.50% per year, 8% selling expenses

Holding period is 5 years

Investor is an active participant, is in a 28% marginal tax bracket, and requires an after-tax equity yield of 15%

Compute the ATCFs and the ATER for the holding period; NPV and the IRR

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Cash Flows from Operations

Year 1 2 3

GR 403,200 423,360 444,528

- VAC 20,160 21,168 22,226

+OI 0 0 0

=EGI 383,040 402,192 422,302

- OE 153,216 160,877 168,921

=NOI 229,824 241,315 253,381

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Cash Flows from Operations

Year 4 5

GR 466,754 490,092

- VAC 23,338 24,505

+OI 0 0

=EGI 443,416 465,587

- OE 177,366 186,235

=NOI 266,050 279,352

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Cash Flows from Operations

Year 1 2 3

NOI 229,824 241,315 253,381

- MP 91,097 91,097 91,097

=BTCF 138,727 150,218 162,284

- TXS 36,523 39,878 43,710

=ATCF 102,204 110,340 118,574

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Cash Flows from Operations

Year 4 5

NOI 266,050 279,352

- MP 91,097 128,520

=BTCF 174,953 150,832

- TXS 47,754 36,506

=ATCF 127,199 114,326

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Income Taxes from Operations

Year 1 2 3

NOI 229,824 241,315 253,381

- INT 75,296 73,814 72,193

- AFC 1,266 1,266 1,266

- DEP 22,823 23,815 23,815

=TI 130,439 142,420 156,107

x t 0.28 0.28 0.28

=TXS 36,523 39,878 43,710

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Income Taxes from Operations

Year 4 5

NOI 266,050 279,352

- INT 70,419 105,902

- AFC 1,266 20,249

- DEP 23,815 22,823

=TI 170,550 130,378

x t 0.28 0.28

=TXS 47,754 36,506

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Cash Flow from Resale

ESP 1,336,147

- SE 106,891

=NSP 1,229,256

- UMB 748,466

=BTER 480,790

- TXR 39,511

=ATER 441,279

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Income Taxes from Resale

ESP 1,336,147

- SE 106,891

=AR 1,229,256

- AB 1,043,909

=TG 185,347

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Income Taxes from Resale

DR 117,091 CG 68,256

x td 0.25 x tg 0.15

=DRT 29,273 =CGT 10,238

DRT 29,273

+CGT 10,238

=TXR 39,511

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Cash Flow Summary

Year ATCF ATER

0 -342,563

1 102,204

2 110,340

3 118,574

4 127,199

5 114,326 441,279

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Net Present Value (NPV)

The present value of the cash flows minus the present value of the cash outflows

Appropriate discount rate is the risk-adjusted required rate of return

In the previous example the after-tax cash flows are equity cash flows thus the appropriate discount rate is the required equity yield

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Net Present Value (NPV)

Decision rule for NPV Accept those independent projects that have positive or zero NPVs

Reject those independent projects that have negative NPVs

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Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the discount rate at which the NPV is zero, i.e., the discount rate at which the present value of the cash inflows is equal to the present value of the cash outflows

IRR equation: = 0

Decision rule for IRR Investor’s required return is used as the benchmark Accept those independent projects with IRRs equal to or greater than the

required return Reject those independent projects with IRRs less than the required return

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Comparing NPV and IRR

In making a simple accept/reject decision, NPV and IRR cannot give conflicting recommendations

Mutually exclusive projects may lead to conflicting recommendations, usually resolved in favor of NPV

Multiple IRRs

Reinvestment rate assumption

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Cash Flow Analysis

NPV @ 15%: $256,668

IRR: 35.50%

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Optimal Capital Structure

The proportions of debt and equity used in financing that maximize the value of the asset

NPV and IRR may be affected by the use of debt

Arguments that the use of debt cannot affect value: Modigliani and Miller

Reconciling MM argument with the use of debt With income taxes the use of debt could increase the after-tax cash flows

Agency costs could increase the cost of debt

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Practical Considerations in the Use of Debt

Form of ownership – structure to avoid double taxation Access to equity capital markets – limited; reliance on debt

financing by small, non-institutional investors Risk of the property – larger equity contribution for riskier

investments Bankruptcy costs – use of nonrecourse vs. recourse notes Special tax regulations – the extent to which operating losses

from real estate investment can be used to offset OI and the tax rate

Interest rate – lower rate, higher debt utilization

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Real Estate Investing in the Real World

Acquisition costs must be written off over the depreciable life of the property

Financing costs must be written off over the life of the mortgage

Prepayment penalty is fully deductible in the year it is paid

A set-aside of funds (replacement reserve) is not a tax-deductible expense

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