Fundamentals of Real Estate

Lecture 2

Spring, 2002

Copyright © Joseph A. Petry

www.cba.uiuc.edu/jpetry/Fin_264_sp02

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Investment Analysis

A great deal of our time will be spent developing different ways of evaluating the profitability of various real estate investment alternatives.

We begin that process in Chapter 2, utilizing the time-value-of-money tools that we have just reviewed (Net Present Value or NPV), and related yield measures (Internal Rate of Return or IRR).

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Investment Analysis-NPV

Future Incomes from Two Alternate Apartment Investment Opportunities

Cedar Ridge Oak Glen

Estimated Estimated Estimated EstimatedCash Flows from Sale Cash Flows from Sale

Year-end Operations Proceeds Operations Proceeds2001 $45,000 $40,0002002 $45,000 $40,0002003 $45,000 $40,0002004 $45,000 $40,0002005 $45,000 $425,000 $40,000 $450,000

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Investment Analysis-NPV

NPV = PVin – PVout Assume:

– discount rate of 10%, purchase prices of $450,000 (Cedar Ridge) and $420,000 (Oak Glen)

NPV for Cedar Ridge: $-15,523.03– PVin = $434,476.97.

PV of cash flows and estimated sales proceeds in five years

– Pvout = $450,000.00 Purchase Price

– NPV = -15,523.03

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Investment Analysis-NPV

NPV for Oak Glen: ?

Which investment is better?

Which investment/s is/are acceptable?

What does our decision tell us about the return associated with our investment relative to our discount rate?

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Investment Analysis-Yield Measures

IRR is one of the most frequently used yield measures employed.

As you recall, IRR is the discount rate which equalizes inflows and outflows. In other words, if you used the IRR as your discount rate in the NPV examples above, you would have ended up with an NPV = 0.

It is much more easily compared across investments—it puts return into perspective.

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Investment Analysis-Yield Measures

To solve the Cedar Ridge example for IRR:N = 5, PV = -450,000, PMT = 45,000, FV = 425,000, I = ?

I CPT = 9.0731%

Solve Oak Glen for the IRR:

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Investment Analysis-Yield Measures

Decision Rules for NPV:– If NPV is positive, then invest– If NPV is positive on a number of investments, pick

the investment with the highest NPV– If NPV is 0, you are indifferent and can go either way.

If NPV is negative, keep looking! Decision Rules for IRR:

– If IRR is greater than your required return/hurdle rate than invest.

– If IRR is equal to required return you are indifferent, and if less don’t invest.

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Investment Analysis-Yield Measures

Lender Yield/Effective Cost of Borrowing:– From a lender’s perspective, the cash flows they are

most interested in are those associated with the loan itself--the face value of the loan vs. the present value of the loan payments. The mirror image of these cash flows is the effective cost of borrowing for the borrower.

– Assume two alternative lending/borrowing options: A $100,000 loan with terms of 11%, 30 years, annual. A $100,000 loan with terms of 10%, 30 years, annual, with 4

points up front borrowing cost.

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Investment Analysis-Yield Measures

Lender Yield/Effective Cost of Borrowing:– Which is best for borrower? For lender?– 1) Determine cash flows with each loan:

– A) annual payment =– B) annual payment =– Difference = In exchange for =

– 2) Determine IRR for each loan:– A) IRR = ?– B) IRR = ?

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Investment Analysis-Yield Measures

Capitalization (Cap) Rate:– The Cap rate is another frequently used yield

measurement. It is defined as NOI/Acquisition Price.– For example, for Oak Glen 40,000/450,000=8.888%– For Cedar Ridge:

– Also referred to as the “overall rate of return”. It is a measure between a property’s current income and its price (similar to dividend yield on a stock). Generally, higher cap rates are better—but this measure is very limited as it only measure one year’s cash flow.

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Investment Analysis-Yield Measures

Test Yourself:– 3) How much would you pay to receive $50 in one

year and $60 in the second year if you can earn 15% interest?

– 4) What amount invested each year at 10% annually will grow to $10,000 at the end of five years?

– 6) What is the present value of $500 received at the end of each of the next three years and $1,000 at the end of the fourth year, assuming a required rate of return of 15%?

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Investment Analysis-Yield Measures

Test Yourself:– 9) In an income-producing property is priced at

$5,000 and has the following income stream would an investor with a required rate of return of 15% be wise to invest at the current price?

– Year 11,000– Year 2 -2,000– Year 33,000– Year 43,000