7 Investment&RiskAnalysis

7/31/2019 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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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

++=


28/43

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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Adjusted/Modified IRR:-

It considers the possibility for reinvestment

),(

= n

ntratereinvestmeshflowPositivecaFV

),( efinancerathflownegativecaPV

%01.181000,500,2

50.742,835,55 =

=MIRR


30/43

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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