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1 © 2014 OnCourse Learning. All Rights Reserved.
Chapter 14: After-Tax Investment Analysis & Corporate Real Estate (Own vs Rent) © 2014 OnCourse Learning. All Rights Reserved.

2 © 2014 OnCourse Learning. All Rights Reserved.
Going from the “property before-tax cash flows” (PBTCF), to the “equity after-tax cash flows” (EATCF). . . 1) Property level (PBTCF): Net CF produced by property, before subtracting debt svc pmts (DS) and inc. taxes. CFs to Govt, Debt investors (mortgagees), equity owners. CFs due purely to underlying productive physical asset, not based on financing or income tax effects. Relatively easy to observe empirically. 2) Equity ownership after-tax level (EATCF): Net CF avail. to equity owner after DS & taxes. Determines value of equity only (not value to lenders). Sensitive to financing and income tax effects. Usually difficult to observe empirically (differs across investors). © 2014 OnCourse Learning. All Rights Reserved.

3 3 MAJOR DIFFERENCES between PBTCF & EATCF levels:
Depreciation: An expense that reduces income tax cash outflows, but not itself a cash outflow at the before-tax level. (IRS income tax rules for property income based on accrual accounting, not cash flow accounting.) Capital expenditures: Not an accrual “expense” (because adds to asset value, “asset”  life > 1 yr), hence not deducted from taxable income, even though they are a cash outflow. Debt principal amortization: Like capex, a cash outflow, but not deductible from taxable income. © 2014 OnCourse Learning. All Rights Reserved.

4 EXHIBIT 14-1A Equity- After-Tax Cash Flows from Operations
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5 EXHIBIT 14-1B Computation of CGT in Reversion Cash Flow
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6 © 2014 OnCourse Learning. All Rights Reserved.
Another perspective: (“Cash Flow Components”…) © 2014 OnCourse Learning. All Rights Reserved.

7 © 2014 OnCourse Learning. All Rights Reserved.
Another perspective: Glossary: PBTCF = Property Before-Tax Cash Flow DS = Debt Service IE = Interest Expense PP = Principal Payback EBTCF = Equity Before-Tax Cash Flow tax = Income Tax Owed (and payable), on operating income. NOI = Net Operating Income DE = Depreciation Expense DTS = Depreciation Tax Shield ITS = Interest Tax Shield EATCF = Equity After-Tax Cash Flow Glossary: OLB = Outstanding Loan Balance CGT = Capital Gains Tax SE = Selling Expenses (to sell asset) V0 = Original Purchase Price (for asset) VT = Current Selling Price (for asset) Glossary: AccCI = Accumulated Capital Improvement Expenditures AccDE = Accumulated Depreciation Expenses τ, τG , τR = Tax rates: Ordinary Income, Capital Gains, Recapture © 2014 OnCourse Learning. All Rights Reserved.

8 Depreciation Expense:
Straight-line 39 years, commercial 27.5 years, residential (apts) Land not depreciable: (typic. 20% in Midwest, South) (often 50% in big E. & W. Coast cities) © 2014 OnCourse Learning. All Rights Reserved.

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Exhibit 14-2 © 2014 OnCourse Learning. All Rights Reserved.

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Year 1 projection, Operating Cash Flow (details): NOI = $60,000, 1st yr. - Depr.Exp. = $800,000/27.5 = $29,091, ea. yr. - Int.Exp. = $750,000*5.5% = $41,250, 1st yr. =Net Income (BT) = = -$10,341. - IncTax = (.35)(-10341) = - $3,619, 1st yr. =Net Income (AT) = (-3619) = - $6,722, 1st yr. Adjusting Accrual to Reflect Cash Flow: - Cap. Imprv. Expdtr. = - $0, 1st yr. + Depr.Exp. = + $29,091, ea. yr. -DebtAmort = - $2,000, ea. yr (this loan). =EATCF = ( ) = $20,369, 1st yr. + IncTax = +(-$3,619) = -$3,619, 1st y r. =EBTCF = = $16,750, 1st yr. © 2014 OnCourse Learning. All Rights Reserved.

11 © 2014 OnCourse Learning. All Rights Reserved.
Reversion Cash Flow, Year 10 (details): Sale Price = VT - SE = NOI11/.06 - SE = 1.01*$65,621/0.06 – 0 = $1,104,620 - Book Val = - (V0 + AccCI - AccDE) = - ( – ) = - $809,091 =Book Gain = – = $295,531 Inclu – ( ) = 4620 Gain, Recapture  - CGT = (.15)(4620) + (.25)(290910) = -$73,421 =Gain (AT) = – = $222,111 Adjusting Accrual to Reflect Cash Flow: + Book Val = + $809,091 -LoanBal = - ( – 10*2000) = -$730,000 =EATCF = – = $301,202 + CGT = + $73,421 =EBTCF = = $374,622 © 2014 OnCourse Learning. All Rights Reserved.

12 Another perspective: (“Cash Flow Components”…)
PBTCF = NOI – CI = 60,000 – 0 = 60,000. IE = OLB*int = 750,000*.055 = 41,250. PP = amort = 2,000 (given exogenous). DS = IE + PP = 41, ,000 = 43,250. EBTCF = PBTCF – DS = 60,000 – 43,250 = 16,750. TaxRate*NOI = .35*60000 = 21,000. DTS = .35*800000/27.5 = 10,182. ITS = TaxRate*IE = .35*41250 = 14,438. EATCF = EBTCF – tax = 16,750 – (21000 – – 14,438) = – (21000 – 24619) = – (-3619) = 20,369 = EATCF Yr 1 operating. Reversion EBTCF: = SaleProceeds – OLB = 1,104,620 – 730,000 = 374,622 = EBTCF. CGT = .15*[ – 0 – ( )] + .25*(10*800000/27.5) = .15* * = = 73,421 = CGT. Reversion EATCF = EBTCF – CGT = – = 301,202 = EATCF. © 2014 OnCourse Learning. All Rights Reserved.

13 © 2014 OnCourse Learning. All Rights Reserved.
Exhibit 14-2 14.2.5: Cash Flow Components: Recall our previous apt property investment… © 2014 OnCourse Learning. All Rights Reserved.

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Here are the example property’s cash flows by component… Exhibit 14-3: Risky Riskless Net + © 2014 OnCourse Learning. All Rights Reserved.

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Projected Total Return Calculations: (Based on $1,000,000 price…) 10-yr Going-in IRR: Property (Unlvd) Equity (Levd) Before-tax 6.04% 7.40% After-tax 4.34% 6.44% AT/BT 434/604 = 72% 644/740 = 87%  Effective Tax Rate With ord inc=35%, CGT=15%, Recapt=25%. 100% – 72% = 28% 100% - 87% = 13% © 2014 OnCourse Learning. All Rights Reserved.

16 © 2014 OnCourse Learning. All Rights Reserved.
Does the lower effective tax rate on levered equity imply that borrowing is profitable (in the sense of NPV>0)? (Do you believe in a “free lunch”?...) Recall from Chapter 13: Leverage increases expected total return, But it also increases risk. Risk increases proportionately to risk premium in E[r]. Hence E[RP] / Unit of Risk remains constant. Hence, NPV(borrowing)=0 (No “free lunch”). This holds true after-tax as well as before-tax (at least for marginal investors – those with tax rates typical of marginal investors in the debt market). © 2014 OnCourse Learning. All Rights Reserved.

17 © 2014 OnCourse Learning. All Rights Reserved.
Lower effective tax rate on levered equity does not imply any “free lunch” . . . In equilibrium, the linear relationship (RP proportional to risk) must hold after-tax for marginal investors in the relevant asset market. (See Ch.12, sect.12.1.) rf RP Thru here 11/07/02 © 2014 OnCourse Learning. All Rights Reserved.

18 © 2014 OnCourse Learning. All Rights Reserved.
Using these returns from our apartment bldg example, we could have this linear relationship Lower effective tax rate in levered return does not imply that risk premium per unit of risk is greater with leverage than without. 6.4% = rL AT 4.3% = rU AT 2% = rf AT RP © 2014 OnCourse Learning. All Rights Reserved. Technically, the line in this graph is not a “Security Market Line” (SML), because an SML reflects the market equilibrium, and after-tax returns are based on Investment Value (IV) not Market Value (MV). There isn’t really a market as such for after-tax returns per se (directly), as these are individually based and not necessarily tradable. Although IV=MV on the margin, the same investors may not be “marginal” at different leverage ratios.

19 14.3 After-Tax Equity Valuation & Capital Budgeting
After-Tax (AT) analysis generally applies to “Investment Value” (IV), while before-tax (BT) analysis applies to “Market Value” (MV). After-Tax DCF in General: Discount Equity After-Tax Cash Flows (EATCF), At Equity After-Tax Discount Rate (Levered), To arrive at PV of Equity. Add PV of Loan (cash borrower obtains), To arrive at Investment Value (IV) of property: That’s the maximum price investor should pay (if they must): Don’t forget caution against paying more than MV (Recall sect re joint use of IV & MV):  Always consider MV, not just IV. © 2014 OnCourse Learning. All Rights Reserved.

20 © 2014 OnCourse Learning. All Rights Reserved.
Although it makes theoretical sense, there is a major practical problem with the EATCF/EATOCC approach described above: It is very difficult to empirically observe or to accurately estimate the appropriate levered equity after-tax opportunity cost of capital, E[r], the appropriate hurdle going-in IRR. Can observe market-based unlevered (property) going-in IRR, and adjust for leverage using WACC (as in Ch.13), but WACC not accurate for long-term IRRs (Recall Ch.13: WACC exact for simple ratio return only), And we still must account for the effective tax rate on the marginal investor (Recall Ch.12: Discount rate OCC even for investment value is market OCC, reflecting marginal investor’s after-tax OCC). This is a function not only of tax rates, but holding period and degree of leverage (of marginal investors). © 2014 OnCourse Learning. All Rights Reserved.

21 © 2014 OnCourse Learning. All Rights Reserved.
e.g., In Ch.14’s apartment building example, If we did not already (somehow) know that $1,000,000 was the market value of the property, What would be the meaning of the 6.44% equity after-tax IRR expectation that we calculated? But if we already know the property market value, then what does the 6.44% equity after-tax IRR tell us, that matters? . . . How can we compare it to that offered by other alternative investments unless we know they are of the same risk (or we can quantify the risk difference in a way that can be meaningfully related to the required going-in IRR risk premium)? Have we gone to a lot of trouble to calculate a number (the equity after-tax going-in IRR) that has no rigorous use in decision making? . . . Fasten your seatbelts… The latter part of Chapter 14 is an attempt to bring some rigor into micro-level real estate investment valuation based on fundamental economic principles. © 2014 OnCourse Learning. All Rights Reserved.

22 In the above circumstances, The PBT approach is not only simpler,
PBT Shortcut… Shortcut for Marginal Investors (& for Market Value): Ignore the equity after-tax level! Work with the Property Before-Tax (PBT) level cash flows and OCC (use only PBTCF & PBTOCC, Module 2). This always works for Market Value (MV) analysis, And also works for Investment Value (IV) analysis for marginal investors (those who are typically about equally on both the buy and sell side of the relevant asset market – recall Ch.12). In the above circumstances, The PBT approach is not only simpler, It is more accurate (fewer parameters to be estimated  less chance of estimation error). © 2014 OnCourse Learning. All Rights Reserved.

23 © 2014 OnCourse Learning. All Rights Reserved.
Recall Ch.12: IV=MV for marginal investors… Exhibit 12-1: Relation between Investment Value (IV) and Market Value (MV) in a well-functioning asset market BUYER IV SELLER IV ASSET PRICE=MV D S Q $ Q* Q0 $ = Property prices (vertical axis). Q = Volume of investment transaction per unit of time. Q0 = Volume of transactions by investors with more favorable circumstances, hence would enter market at less favorable prices (i.e., “intra-marginal” market participants, e.g., investors with different tax circumstances than marginal investors in the market). Q* = Total volume of property transactions, including marginal investment (investors on margin are indifferent between investing and not investing in property). Note: Prices, and hence market values (MV) are determined by the IV of the marginal investors (the investors for whom NPV=0 on both an IV and MV basis). © 2014 OnCourse Learning. All Rights Reserved.

24 © 2014 OnCourse Learning. All Rights Reserved.
Transition… Suppose you want to analyze investment value (IV) and you’re not marginal (e.g., PF or C-corp) or you don’t know whether you are or not, or you want to develop a deeper understanding of what is driving your IV… Suppose you want to understand where the PBT shortcut comes from, why/how/when it is valid… More generally, how can you get around the aforementioned problem of empirical difficulty quantifying the correct levered equity after-tax OCC (EATOCC, the correct “hurdle” for the investment, where the Angus Cartwright “12%” came from, or should have come from)?... The simplest and theoretically most correct (and therefore most elegant) solution to this problem is to break the problem into two parts and analyze the property and the debt separately, and then put them back together: Value Additivity or APV. This also allows deeper analytical understanding of prop.mkt. © 2014 OnCourse Learning. All Rights Reserved.

25 14.3.5 After-Tax Valuation of Debt Financing
First consider the debt part… After-tax valuation of debt: After-Tax Valuation of Debt Financing Let’s now delve into more depth in the valuation of the debt component of the deal… Suppose a certain investor in bond mkt (call her Mary) faces effective income tax rate of 25% on her bond returns. And faces an after-tax OCC (from the capital mkt) of 3%. What will be the IV to this investor of a $100 (par) 4% perpetual bond (pays $4/yr forever)? Answer: Discount Mary’s after-tax cash flows, at the mkt-based after-tax OCC. . . © 2014 OnCourse Learning. All Rights Reserved.

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Suppose Mary typifies the marginal investor in the bond mkt. What will be the MV of this bond? Answer: MV = IV (marginal investor) = IVM = $100. What will be the observed “mkt yield” in the bond mkt? Answer: Observable mkt returns are pre-tax, so: Mkt yield = going-in observed mkt price: = IRR(-100, 4, 4, 4, . . .) = 4%. This slide and the previous give you the fundamental causal order in which things happen: 1st) There are investors, who face the after-tax cash flows that they can earn from investments, and who face after-tax opportunity costs for their investment derived from the market of other alternative investments comparable to the subject investment. Put these two together and you get the investors’ IVs, based on the investors’ after-tax return expectations. 2nd) In the trading of the subject investment there is a market, and there are some investors who are “on the margin” in that market, just indifferent between buying or selling. Who are the marginal investors is determined by the equilibrium (balance betw supply & demand) in the market. But whoever they are, their IV determines and underlies the MV of the asset, the market price at which it trades. 3rd) Those market prices reflect a before-tax expected return that can be calculated by determining the IRR implied by the (more readily observable) before-tax cash flows of the asset and the market price (MV) of the asset. © 2014 OnCourse Learning. All Rights Reserved.

27 Market for Taxed Debt Assets: L = PV of a Loan (Debt Asset).
Here is a picture of what we have just discovered about the bond market . . . L Market for Taxed Debt Assets: Mkt Int.Rate = 4% S MV = $100 = $4/0.04 = $3/0.03 = IVM D Q* Q L = PV of a Loan (Debt Asset). © 2014 OnCourse Learning. All Rights Reserved.

28 © 2014 OnCourse Learning. All Rights Reserved.
Note: We started out with the assumption that Mary was the marginal investor (her after-tax 3% OCC was mkt OCC). Suppose we didn’t know that she was the marginal investor. Or suppose that we didn’t know that the marginal investor faced an effective tax rate of 25%. How could we derive (from empirically observable data) that the market’s after-tax OCC is 3%? Answer: If there is a simultaneous market for tax-exempt bonds, and investors can trade between the two markets, then we can directly observe market after-tax OCCs as yields on tax-exempt (municipal) bonds. Find muni bonds of similar risk (duration & default) to the mortgage we’re evaluating. Note: This is an empirical device, not a causal model. © 2014 OnCourse Learning. All Rights Reserved.

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A shortcut is to derive effective margl tax rate of margl investor in bond mkt, and assume this tax rate applies to all investors in debt or debt-like assets… i.e., Compare yields across the two types of bond mkts (taxed & tax-exempt), back out what must be the effective tax rate of the marginal investor. In the previously described situation (4% yield in bond mkt, marginal investors face 25% tax rate), what will be the observed mkt yield in the municipal (tax-exempt) bond mkt? Answer: 3%, because 3% = (1-.25)4% = after-tax yield for marginal investors in bond mkt. Otherwise, what?... © 2014 OnCourse Learning. All Rights Reserved.

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If muni yield were > 3%, marginal investors in taxed (corp) bond mkt would sell corp bonds and buy munis, driving up muni price (driving down muni yield) until the 3/4 relationship in yields existed. If muni yield were < 3%, marginal investors in muni bond mkt would sell munis and buy corps, driving down muni price (driving up muni yield) until the 3/4 relationship in yields existed. © 2014 OnCourse Learning. All Rights Reserved. Thus, ratio: muni yld / taxable bond yld = 1 – effective tax rate on margl investor in bond mkt. Margl tax rate = 1 – muniYld/corpYld (For otherwise similar muni & corp bonds - LT like mortgs)

31 © 2014 OnCourse Learning. All Rights Reserved.
Suppose Abner is a tax-advantaged investor compared to the marginal investor (Mary). Abner faces only 20% tax on bond returns. What is the IV of the 4% perpetual bond to Abner? Answer: Discount Abner’s after-tax cash flows, at the mkt-based after-tax OCC. . . Note that if we used as the discount rate Abner’s personal OCC of the rate he could earn after-tax on similar investments, the discount rate would be (1-.20)4% = 3.2%, and we would get that Abner’s IV = $100, the same as Mary’s, and the same as the MV of the asset. This couldn’t be right, as Abner is tax-advantaged compared to Mary, and so the asset should be worth more to him (not in terms of market value, but in terms of IV, which should reflect Abner’s tax advantage). When Abner borrows, the Govt gains some tax revenue (becaues lender pays 25% of interest in taxes, while borrower Abner deducts only 20% of interest from his taxes). Thus, money is removed net from the private sector, hence there must be some loss of value in the private sector. This is reflected in the net -$7 NPV of the borrowing transaction for Abner. Abner’s wealth declines by the $7 negative NPV resulting from his borrowing. His loss is the Govt’s gain. (The marginal lender in the debt market remains neutral, by definition.) Thus: IVA = $107 > $100 = MV = IVM . Which makes sense, to reflect Abner’s tax advantage compared to the market’s marginal investor who determines the price in the mkt. © 2014 OnCourse Learning. All Rights Reserved.

32 © 2014 OnCourse Learning. All Rights Reserved.
Suppose Clarence is a tax-disadvantaged investor compared to the marginal investor (Mary). Clarence faces 30% tax on bond returns. What is the IV of the 4% perpetual bond to Clarence? Answer: Discount Clarence’s after-tax cash flows, at the mkt-based after-tax OCC. . . Note that if we used as the discount rate Clarencs’s personal OCC of the rate he could earn after-tax on similar investments, the discount rate would be (1-.30)4% = 2.8%, and we would get that Clarence’s IV = $100, the same as Mary’s, and the same as the MV of the asset. This couldn’t be right, as Clarence is tax-disadvantaged compared to Mary, and so the asset should be worth less to him (not in terms of market value, but in terms of IV, which should reflect Clarence’s tax disadvantage). When Clarence borrows, the Govt loses some tax revenue (becaues lender pays 25% of interest in taxes, while borrower Clarence deducts 30% of interest from his taxes). Thus, money is added net to the private sector, hence there must be some increase in value in the private sector. This is reflected in the net +$7 NPV of the borrowing transaction for Clarence. His wealth increases by the $7 positive NPV resulting from his borrowing. His gain is the Govt’s loss. (The marginal lender in the debt market remains neutral, by definition.) Thus: IVC = $93 < $100 = MV = IVM . Which makes sense, to reflect Clarence’s tax disadvantage compared to the market’s marginal investor who determines the price in the mkt. © 2014 OnCourse Learning. All Rights Reserved.

33 Market for Taxed Debt Assets:
Abner & Clarence are intra-marginal market participants in the bond mkt. Abner is an intra-marginal buyer. Clarence is an intra-marginal seller. IVA = $107 = $3.20/0.03 MV = $100 = $4/0.04 = $3/0.03 = IVM D S Q L Q* Q0 IVC = $93 = $2.80/0.03 Exhibit 14-5: Market for Taxed Debt Assets: Mkt Int.Rate = 4% © 2014 OnCourse Learning. All Rights Reserved.

34 Market for Taxed Debt Assets:
Trading occurs at the mkt price of $100 (4% yield). NPV(for Abner buying, based on his IV) = $107 - $100 = +$7. NPV(for Clarence selling, based on his IV) = $100 - $93 = +$7. IVA = $107 = $3.20/0.03 MV = $100 = $4/0.04 = $3/0.03 = IVM D S Q L Q* Q0 IVC = $93 = $2.80/0.03 Market for Taxed Debt Assets: Mkt Int.Rate = 4% Exhibit 14-7: © 2014 OnCourse Learning. All Rights Reserved.

35 © 2014 OnCourse Learning. All Rights Reserved.
NPVIV of borrowing to finance real estate investment mkt interest rate, no subsidy): Even though the ITS have substantial value to all three investors, Borrowing is zero NPV for the marginal investor in bond mkt (Mary). Borrowing is negative NPV for the tax-advantaged investor (Abner). Borrowing is only positive NPV for the tax-disadvantaged investor (relative to the marginal investor in the bond mkt), And even for him (Clarence) the NPV of borrowing is much smaller than the PV of his ITS ($7 vs $40). © 2014 OnCourse Learning. All Rights Reserved. Note that the NPV of borrowing (selling a bond) is just the negative of the NPV of lending (buying a bond). (Note: All this is NPV based on IV. NPV based on MV is zero by defn in non-subsidized loan.)

36 © 2014 OnCourse Learning. All Rights Reserved.
Why might each of these investors (Clarence, Mary, Abner) borrow to finance their real estate investment?... Clarence (alone) can justify the loan purely for the positive NPV in its tax shelter (with the caveat that it is not a large positive NPV). Clarence and Mary can justify the loan if they want leverage (to magnify risk & return in their R.E. investment, move out on the SML to reach a “target return” for example – Ch 13 stuff), but Abner can’t use this justification due to his NPV<0 (he should look for other ways to increase risk & return if he really wants to, such as buy diversified risky underlying assets without leverage). All three investors can justify the loan if they are capital constrained and the R.E. investment has a sufficient positive NPV. (For Clarence, the R.E. NPV can even be a bit negative.) For Abner, the positive R.E. NPV may result from his tax advantage (if he is also tax advantaged relative to the marginal investor in the R.E. asset mkt, not just relative to the marginal investor in the bond mkt). © 2014 OnCourse Learning. All Rights Reserved.

37 © 2014 OnCourse Learning. All Rights Reserved.
Value of the ITS: The amount of the ITS each year equals the income tax savings that year: the investor’s tax rate times the interest expense. The PV is found by discounting at the OCC… The ITS are worth more to the more heavily-taxed investor (Clarence), and for everyone they are worth a large fraction of the loan amount ($100). But what is the NPV of the borrowing transaction, to Mary, Abner, & Clarence? . . . © 2014 OnCourse Learning. All Rights Reserved.

38 © 2014 OnCourse Learning. All Rights Reserved.
ITS valuation must be combined with rest of loan (liability apart from shield) to get NPV(financing): Note that the NPV of borrowing (selling a bond) is just the negative of the NPV of lending (buying a bond). © 2014 OnCourse Learning. All Rights Reserved.

39 © 2014 OnCourse Learning. All Rights Reserved.
Alternative approach (intuitive but wrong…): Use each investor’s “personalized” OCC (reflecting their own tax rate) as the discount rate in the denominators … Gives loan valuation IV identical by construction to loan valuation MV. (Negates concept of “IV” distinct from “MV”). Results by definition in NPV(financing) = 0 always. (Doesn’t make sense for tax-advantaged or tax-disadvantaged intra-marginal investors’ IV-based NPVs. Recall IV methodology “theory” proposed in Ch.12 (sect p.266): get discount rate from capital mkt. © 2014 OnCourse Learning. All Rights Reserved.

40 © 2014 OnCourse Learning. All Rights Reserved.
Alternative approach (employed by neophytes…): Include consideration of the ITS in the numerators, but discount at the loan interest rate… Obviously wrong: Inconsistent to apply before-tax discount rate (OCC) to after-tax cash flows. Gives impression ITS are far more valuable than they actually are. (Hence  debt more useful than it really is.) Gives misleading impression ITS are valuable for low-tax investors. Ignores what happens on the other side of the debt market. Makes it look like it’s always pos.NPV to borrow! All too common mistake in the real world! © 2014 OnCourse Learning. All Rights Reserved.

41 Problems with the “neophyte’s mistake”…
You cannot ignore what happens on other side of the debt market. Taxes saved by borrower may be paid by lender. Value cannot be created from nothing: If no net value remains in private sector, then asset valuations in the private sector cannot reflect such non-existent value. Positive net values in property mkt would have to be offset by negative net values in debt market. But that would not be consistent with equilibrium across the two markets (property & debt). Prices would be bid up in the property market, and bid down in the bond market, until zero net value (on margin) in both markets. Thus, effectively, lender “passes through” the taxes (of the marginal investor in the debt mkt) to the borrower. Only the net remains in the private sector. E.g., if Clarence borrows (effectively, indirectly) from lenders like Mary, hence Clarence saves $1.20 in taxes each year, but Mary pays $1.00 in taxes each year, as a result of the loan: (1.20–1.00)/.03 = +$7 = NPV borrowing (for Clarence). © 2014 OnCourse Learning. All Rights Reserved.

42 Valuing subsidized loans:
Now suppose the seller of the real estate offers $100 below-market financing (subsidized loan), an interest rate of 3% instead of the mkt rate of 4%, on the same (perpetual) loan. What would be the MV of this loan (if the seller sold it in the 2ndary mkt)? Answer: Discount the loan’s before-tax cash flows at the market interest rate . . . Normally, the first procedure is used, the before-tax analysis, because it is much easier to accurately observe the relevant numbers: the loan before-tax cash flows are inherent in the asset, you don’t need to know anything about anyone’s tax rate; and the before-tax market yield is observable via the market prices at which such loans are trading in the debt market. Or (more fundamentally), discount the loan’s after-tax cash flows to the marginal investor in the bond mkt (Mary), at the mkt-based after-tax OCC. . . © 2014 OnCourse Learning. All Rights Reserved.

43 © 2014 OnCourse Learning. All Rights Reserved.
What is the IV based NPV of the subsidized loan offer to each of our investors? . . . How much more should each of the investors be willing to pay for the property (more than they think it is otherwise worth), as a result of the subsidized loan offer from the seller? . . . Mary  $25 more. Abner  $20 more. Clarence  $30 more. (Note: These IV-based NPV effects of loan rate subsidies are reduced the shorter the loan term.) © 2014 OnCourse Learning. All Rights Reserved.

44 © 2014 OnCourse Learning. All Rights Reserved.
Preceding used perpetuity example. Suppose finite loan (extreme case 1-period). Compare for subsidized loan NPV(IV after-tax for margl investor: 25% tax rate) vs NPV(MV before-tax)… Perpetuity: MV) = Perpetuity: IVM) = © 2014 OnCourse Learning. All Rights Reserved. It’s the same (as you would expect, for margl investor). 1-period: MV) = 1-period: IVM) = It’s different! IVM) ≈ (1 – MV): $0.73 ≈ (1 – 0.25)$0.96. Recall Ch.12 (sect.12.1) rules about what to do when NPV differs from MV and IV perspectives: Use common sense! (e.g., don’t pay more than +$0.73 unless could quickly sell for close to $0.96.)

45 Summarizing NPV(loan) from borrower’s perspective:
Unsubsidized (mkt rate) loans: NPV(loan) = 0 from MV (before-tax) perspective. NPV(loan) > 0 (but much less than PV(ITS)) for high tax-bracket taxable investors from IV perspective. NPV(loan) < 0 for low tax-bracket taxable investors from IV perspective. Subsidized (below mkt rate) loans: NPV(loan) > 0 from MV perspective (by definition). NPV(loan) > 0 from IV perspective for high or average tax bracket investors, but NPV(loan) IV (after-tax) ≤ NPV(loan) MV (before-tax): For margl investr NPV(loan) IV (after-tax) converges to (1-T)NPV(loan) MV (before-tax) as loan-term approaches zero (where T is borrower’s tax rate); For margl investr NPV(loan) IV (after-tax) converges to exactly equal NPV(loan) MV (before-tax) as loan-term approaches infinity (perpetual debt). Recall Ch 12 discussion about what to do when IV ≠ MV: Satisfy NPV≥0 both ways (conserv) or either way (liberal). © 2014 OnCourse Learning. All Rights Reserved.

46 14.3.4 Value Additivity & the APV Decision Rule
Now synthesize debt valuation with property valuation: APV (valuation by components)… Value Additivity & the APV Decision Rule The PBT approach is an example of use of the principle of “Value Additivity”: Value Additivity  “The value of the whole equals the sum of the values of the parts, i.e., the sum of the values of all the marketable (private sector) claims on the asset.” Therefore: E = V – D “D” is usually straightforward to compute (unless loan is subsidized, MV of loan equals loan amount). So, use PBT to compute MV of “V”, then subtract MV of “D” to arrive at MV of “E”, rather than trying to estimate “E” directly. © 2014 OnCourse Learning. All Rights Reserved.

47 “Adjusted Present Value” (APV) Decision Rule…
Like NPV, only accounts for financing… APV(equity) = NPV(property) + NPV(financing) Based on the Value Additivity Principle: Prop.Val = Equity Val + Dbt Val V = E + D Where: V = Value of the property, E = Value of the equity, D = Value of the debt. Define: P = Price paid for the property, L = Amount of the loan… V-P = E+D – P = E+D – ((P-L)+L) = E-(P-L) + D-L = E-(P-L) – (L-D) Thus: E-(P-L) = (V-P) + (L-D) Or: APV(Equity) = NPV(Prop)+ NPV(Fin) Note: Arbitrage basis of Value Additivity applies to MV, but the common sense of Value Additivity can be applied to IV as well. Note: NPV(fin) here is the NPV of the loan transaction for the borrower. © 2014 OnCourse Learning. All Rights Reserved.

48 “Adjusted Present Value” (APV)…
APV Investment Decision Rule: Analogous to that of NPV… Maximize APV over mutually exclusive alternatives; Never do a deal with APV < 0. (APV = 0 is OK.) (APV = 0 is normal from a MV perspective.) (APV = 0 from IV pespective by definition for marginal investors) © 2014 OnCourse Learning. All Rights Reserved.

49 © 2014 OnCourse Learning. All Rights Reserved.
Competition in the property asset market drives APV to zero for marginal investors in that market… Asset Value S Asset Market: APV = 0 MV = IVM D Q* Q We can use this condition for analytical purposes… Q = quantity of assets trading © 2014 OnCourse Learning. All Rights Reserved.

50 APV(equity) = NPV(property) + NPV(financing)
NPV(property) = NPV of unlevered (all equity) investment in the property (as if no debt). For MV based NPV, this can (should) be computed using the PBT approach. NPV(financing) = NPV of loan transaction (for the borrower). Debt market is relatively efficient & competitive (debt products are relatively homogeneous, often securitized in 2ndary mkt, relatively transparent and straightforward to evaluate). Hence, in the absence of subsidized (below market interest rate) financing: NPV(financing) = 0, normally (on an MV basis). Recall: NPVMV(buyer) = -NPVMV(seller). So, for the loan transaction: NPVMV(borrower) = -NPVMV(lender) In this (normal) situation (from an MV perspective): APV(equity) = NPV(property). i.e., Evaluate the deal without the loan. (Use the PBT shortcut). © 2014 OnCourse Learning. All Rights Reserved. [ Thus, PBT shortcut comes from APV, which is based on Value Additivity. Works for MV & for IV for margl investr in property mkt.]

51 © 2014 OnCourse Learning. All Rights Reserved.
APV procedure can be expanded to any number of additive components of a complex deal structure. e.g., APV(equity) = NPV(property) + NPV(preferred) + NPV(debt) + NPV(tax credits) Try to use fundamental economic principles to help evaluate the deal: Market equilibrium (competition), Rational behavior (Max NPV). For example… If the deal structure is typical (e.g., of a “class”), and sufficiently common that there is a functioning market for these types of deals, then market equilibrium will tend to make it reasonable to expect: APV(equity)=0. (You can use this as a working assumption to help ascertain the MV of the individual deal components and positions.) Even if the overall deal structure is unique (such that there is not a market for the equity as structured), many (or even all) of the individual components and positions may be typical enough that there is a market for them. It should then be assumed that rational behavior on the part of all the parties to the deal would tend to drive NPV toward zero for each component of the deal. If all the components of the APV are zero, then so is the APV. Even in the absence of a well functioning market, Investment Value based APV analysis is relevant as a normative valuation. The equation in this slide refers to the NPV components with respect to the equity investor. Thus, for example, NPV(debt) refers to the NPV to the borrower (equity investor) of the borrowing transaction; NPV(preferred) refers to the NPV to the (subordinated) equity investor of the transaction of issuing the preferred claims; NPV(tax credits) refers to the NPV to the equity investor of the issuance or acquisition of the tax credits. © 2014 OnCourse Learning. All Rights Reserved.

52 14.3.6 Example Application of APV to a Marginal Investor
Recall apartment numerical example: Suppose $1,000,000 = MV of property, & 25% is tax rate of marginal investor in debt mkt,  ATOCC dbt = (1-.25)*5.5% = 4.13% Suppose the modeled investor (tax rates = 35%, 15%, 25%) is typical of marginal investors in mkt for this type of property, & modeled leverage & holding period (75% LTV, 10-yr hold) is typical of marginal investors in mkt for this type of property.  IV-based APV = 0 for whole deal (inclu debt). Then we know margl invstr in prop mkt is intra-marginal in debt mkt on the sell (borrow) side: Debt part is pos-NPV, thus: APV = 0 (mkt equilibr)  Property (unlevrd) is neg-NPV. © 2014 OnCourse Learning. All Rights Reserved. This and the next slides circle back to our previous anatomy of the apartment property market, only now treating the marginal property investor as intra-marginal in the debt market. This is probably slightly more accurate for a typical U.S. commercial property market, but it makes little difference…

53 APV = 0 (mkt equilibr)  Property (unlevrd) is neg-NPV.
Suppose $1,000,000 = MV of property, & 25% is tax rate of marginal investor in debt mkt,  ATOCC dbt = (1-.25)*5.5% = 4.13% Suppose the modeled investor (tax rates = 35%, 15%, 25%) is typical of marginal investors in mkt for this type of property, & modeled leverage & holding period (75% LTV, 10-yr hold) is typical of marginal investors in mkt for this type of property.  IV-based APV = 0 for whole deal (inclu debt). Then we know margl invstr in prop mkt is intra-marginal in debt mkt on the sell (borrow) side: Debt part is pos-NPV, thus: APV = 0 (mkt equilibr)  Property (unlevrd) is neg-NPV. IV(loan 4.13% = -$717,119 Exhibit 14-6: © 2014 OnCourse Learning. All Rights Reserved. This and the next slides circle back to our previous anatomy of the apartment property market, only now treating the marginal property investor as intra-marginal in the debt market. This is probably slightly more accurate for a typical U.S. commercial property market, but it makes little difference… 0 = APV = NPV(prop) + NPV(loan) = (X - $1,000,000 ) + ($750,000 - $717,119); X = $967,119 = IV(prop);  AT(unlevrd)OCC = 4.76%; Therfore: NPV(prop) = $967,119 - $1,000,000 = -$32,881; NPV(loan) = $750,000 - $717,119 = +$32,881.

54 © 2014 OnCourse Learning. All Rights Reserved.
Start with the known after-tax OCC of debt observable from muni bond market. (Here, 4.13%, based on 25% margl tax.) Exhibit 14-6: IV(loan 4.13% = -$717,119 This and the next slides circle back to our previous anatomy of the apartment property market, only now treating the marginal property investor as intra-marginal in the debt market. This is probably slightly more accurate for a typical U.S. commercial property market, but it makes little difference… 0 = APV = NPV(prop) + NPV(loan) = (X - $1,000,000 ) + ($750,000 - $717,119); X = $967,119 = IV(prop);  AT(unlevrd)OCC = 4.76% Then back out the value of the property without debt using the APV = 0 equilibrium condition for marginal investor. © 2014 OnCourse Learning. All Rights Reserved.

55 Here’s another way to use Value Additivity to dissect the apartment deal…
Consider the investment by a typical (taxed) marginal investor again (for whom IVM = MV, not now the intra-marginal P.F. for whom IVA > MV). Break the cash flows into components by risk class… Exhibit 14-7: DTS & loan ATCF are relatively low risk (legally fixed): OCC = 4.13%. PBTCF & tax w/out shields are relatively high risk: OCC = 4.76%. © 2014 OnCourse Learning. All Rights Reserved.

56 © 2014 OnCourse Learning. All Rights Reserved.
PBTCF - Tax w/out Shlds = Tot.Risky DTS loan ATCF = Tot.Fixed _ _ = = 4.13% = - $683,592 4.76% = $933,257 Fixed Risky = EATCF Risky Val: $933,257 + Fixed Val: ,592 = Eq. Val: $249,664 IRR(risky for PV $933,257) = 4.75% = Risky OCC + = 6.44% = $250,000  PV(risky) = $250,000 – (-$683,592) = $933,592 ≈ $933,257 © 2014 OnCourse Learning. All Rights Reserved.

57 This is consistent with PV of depreciation tax shields:
$967,119 val w/out Dbt = $933,257 Risky + $33,527 Fixed in IVM tax shields to margl investor . This is consistent with PV of depreciation tax shields: 4.13%) = $33,527: © 2014 OnCourse Learning. All Rights Reserved.

58 Summarizing the Equity After-tax IV Valuation Procedure:
Estimate MV of subject property using PBT analysis: a. Estimate market PBT level by empirical obs of relevant property market (e.g., prevailing cap rates, typical realistic growth expectations, etc., as we studied in Mods1&2 esp Chs 5 & 11) Apply estd OCC to realistic forecast of subj property’s PBTCF. (Stop here if all you need is estimate of mkt value of property, or if your subj invstr is margl: IV=MV.) 2. Create a “model” of a “typical marginal investor” in subject property market : a. Estimate typical leverage and debt terms for “least advantaged” type of buyer that is widely buying this type of real estate. (In U.S. typically a taxed investor in a high tax bracket but subject to only one layer of taxation.) b. Compute margl investor’s NPV(debt) by discounting margl investor’s after-tax debt debt mkt’s after-tax OCC of debt (observe muni/corp yld spread, typically has implied approx 25% tax in dbt mkt). 3. Assume marginal investor buys property at estd MV from Step 1 and obtains APV=0 (by defn of “margl investor”). Hence, compute margl investor’s IV of property-without-debt as MV minus NPV(debt) for margl investor from Step 2b . 4. Model the market’s after-tax OCC for the property (unlevered) as the IRR this marginal investor achieves on her the IV price from Step 3 (with PATCFs computed as the PBTCFs from Step 1 minus taxes as if no debt). Use this unlevered PATCF IRR rather than levered EATCF IRR because you may employ different leverage than marginal investor. 5. Apply market after-tax OCC from Step 4 to your (subject investor’s) PATCFs for subject property, to derive your IV for the property-without-debt. (This IV may differ from the marginal investor’s.) Compute your NPV(debt) based on your after-tax debt CFs and debt mkt after-tax OCC. (This may differ from that employed in Step 2b if your debt has different risk, but use same muni/corp spread procedure to derive marginal tax rate in debt market that you apply to the market interest rate on your loan to convert it to after-tax mkt OCC.) Add your NPV(debt) from Step 6 to your property IV-without-debt from Step 5 to arrive at your total IV that you could pay for the deal (for IV-based NPV ≥ 0). © 2014 OnCourse Learning. All Rights Reserved.

59 Market for Taxed Debt Assets:
Why go to all this trouble?... Wealth Maximization makes sense as an investment objective… Opportunity Cost is fundamentally important and makes sense for quantifying the wealth impact of investment decisions. Markets determine opportunity costs. © 2014 OnCourse Learning. All Rights Reserved. IVA = $107 = $3.20/0.03 MV = $100 = $4/0.04 = $3/0.03 = IVM D S Q L Q* Q0 IVC = $93 = $2.80/0.03 Market for Taxed Debt Assets: Mkt Int.Rate = 4% The previously described methodology is simply a way to apply these principles in a reasonably practical manner.

60 Exhibit 14A-1: Regular fee simple property purchase, no debt…
Capital Account (balance sheet) “T-chart”: Assets Liabs & Equity Purchase Price: P Liabilities: none Owner’s Equity: P Structure: S Land: L © 2014 OnCourse Learning. All Rights Reserved. P P Income Statement (accrual): Revs – Oper Expns NOI – Depreciation (of P-L) Net Income

61 Exhibit 14A-2: Regular fee simple property purchase, with mortgage…
Capital Account (balance sheet) “T-chart”: Assets Liabs & Equity Purchase Price: P Liabilities: M = Mortgage Amt Owner’s Equity: P – M Structure: S Land: L © 2014 OnCourse Learning. All Rights Reserved. P P Income Statement (accrual): Revs – Oper Expns NOI – Depreciation (of P-L) – Interest (on M) Net Income

62 Exhibit 14A-3: Property purchase, with mortgage & ground lease…
Capital Account (balance sheet) “T-chart”: Assets Liabs & Equity Purchase Price (Leasehold): P* – RV – GL GL = PV(GrndLse Rent) Liabilities: M* = Mortgage Amt GL = PV(GrndLse Rent) RV=ResidVal Owner’s Equity: P* – RV – M* – GL © 2014 OnCourse Learning. All Rights Reserved. P* – RV P* – RV Income Statement (accrual): Revs – Oper Expns P* may be less than P due to loss of optionality or lessor/lessee conflict of interest M* may be less than M due to P*-RV<P or priority of GrndLse Rent over debt svc. NOI – Depreciation (of P*-RV-GL) – GrndLse Rent – Interest (on M*) Net Income

63 © 2014 OnCourse Learning. All Rights Reserved.
Appendix 14B: Example Application of APV to an Intra- Marginal Investor Consider again the tax-exempt P.F.’s investment in our $1,000,000 apt property… 6.44% = $270,548. Exhibit 14B-1: Working directly with the EATCF, recall that we computed: NPV(IVA) = 6.44%)+Loan] - $1,000,000 = $1,020,548 - $1,000,000 = + $20,548. © 2014 OnCourse Learning. All Rights Reserved.

64 Now let’s apply the APV approach to dissect the deal…
APV(equity) = NPV(property) + NPV(financing) From an IV perspective, the NPV(property) for the P.F. is: NPV = IV(property) – Prop.Price = 4.76%) - $1,000,000 = 4.76%) - $1,000,000 = $1,104,714 - $1,000,000 = +$104,714. = mkt unlevd AT OCC, from marginal investor’s AT IRR without leverage MV = $1,000,000). Because P.F. tax-exempt: PATCF = PBTCF. © 2014 OnCourse Learning. All Rights Reserved. From an IV perspective, the NPV(financing) for the P.F. is: NPV = Loan Amt - IV(loan) = $750,000 - PV(loan muni yld%) = $750,000 - PV(loan 4.13%) = $750,000 - $832,202 = -$82,202. Suppose muni yld = 4.13% = ( )5.5%. APV(equity) = +104,714 - $82,202 = +$22,512 ≈ 20,548*. *In principle this equation should be exactly equal, otherwise there is some sort of “arbitrage” opportunity between the markets. But in reality valuations are not that precise. © 2014 OnCourse Learning. All Rights Reserved.

65 © 2014 OnCourse Learning. All Rights Reserved.
Tax-exempt investor (e.g., pension fund) “Value Additivity” valuation of apartment investment by components . . . Exhibit 14-10: 6.44% = $270,548. 4.76% = $1,104,714 4.13% = $832,202 Value Additivity: E = V - D IV(equity) = $1,104,714 - $832,202 = $272,512 ≈ $270,548*. *In principle this equation should be exactly equal, otherwise there is some sort of “arbitrage” opportunity between the markets. But in reality valuations are not that precise. © 2014 OnCourse Learning. All Rights Reserved.

66 From property investment
APV(equity) = +104,714 - $82,202 = +$22,512. From property investment From loan P.F. has: Positive NPV (+104,714) in property investment as intra-marginal buyer, Negative NPV (-82,202) in loan borrowing transaction as its tax-exempt status makes it an intra-marginal lender (not borrower). Net is still slightly positive (APV). Would be better off not using debt to finance the investment (unless capital constrained). © 2014 OnCourse Learning. All Rights Reserved.

67 Market for Apt Properties:
Representing this as in Ch.12 market model, we have for the property market . . . P S Market for Apt Properties: Mkt going-in IRR = 6.04% Pension Fund: IVA = $1,104,714 = 4.76%) MV = $1,000,000 = 6.04%) = 4.76%)+loan amt – 4.13%) = IVM Marginal investor (M) is marginal in property market (faces 35% tax rate). D Q0 Q* Q Quantity of Trading Pension fund is an intra-marginal buyer. © 2014 OnCourse Learning. All Rights Reserved.

68 Pension fund is an intra-marginal buyer (lender, not borrower).
Representing this as in Ch.12 market model, we have for the mortgage market . . . P S Market for Mortgages: Mkt Interest Rate = 5.5% Pension Fund: IVA = $832,202 = 4.13%) MV = $750,000 = 5.5%) = 4.13%) = IVM Marginal investor (M) is marginal in debt market (faces 25% tax rate). D Q0 Q* Q Quantity of Trading Pension fund is an intra-marginal buyer (lender, not borrower). © 2014 OnCourse Learning. All Rights Reserved.

69 CORPORATE REAL ESTATE:
APPENDIX 14C: CORPORATE REAL ESTATE: THE OWN VERSUS RENT DECISION FROM A FINANCIAL ECONOMIC PERSPECTIVE The threshold question: The Lease vs Own Decision Is a major corporate finance & investments issue. The lecture presented in the following slides, and the accompanying Excel spreadsheet example, relate to Geltner-Miller 2ne Ed., Appendix 14 on the CD accompanying Chapter 14. The major corporate real estate investment decision is the “buy vs lease” decision, which is addressed in this lecture and the accompanying spreadsheet in a manner consistent with the text. A coherent analysis based on the objective of maximizing the corporation’s pre-existing shareholder equity value (maximizing its stock price) requires consideration of tax effects at all levels (personal as well as corporate) and a simultaneous consideration of equilibrium asset pricing in all three asset markets relevant to the decision: (i) The property market; (ii) The debt market (or market for “debtlike” cash flows such as leases) as exemplified by the bond market; and (iii) The market for the corporation’s equity as represented by the stock market. The general result (noted in Chapter 15) is that it typically makes more sense for profitable, taxed corporations that are not in the real estate business to lease rather than own the real estate they use, due to the double-taxation faced by corporate investors. However, there may be exceptions in particular circumstances, as well as additional considerations beyond the easily-quantified tax-based analysis, that make corporate ownership rational in some cases (as noted at the end of the following lecture). © 2014 OnCourse Learning. All Rights Reserved.

70 Corporate Real Estate: (Based on Chs. 14 & 15 of Geltner-Miller.)
Lease vs Own Decisions (Based on Chs. 14 & 15 of Geltner-Miller.) © 2014 OnCourse Learning. All Rights Reserved.

71 © 2014 OnCourse Learning. All Rights Reserved.
First Rule: Don’t confuse corporate capital budgeting or capital structure decisions with the space finance decision . . . © 2014 OnCourse Learning. All Rights Reserved.

72 © 2014 OnCourse Learning. All Rights Reserved.
Example (from Brueggeman-Fisher, 10th Ed.) . . . New Branch Office: Office startup cost $1,300,000 Building would cost $1,800,000 Expected value after 15 yrs: $3M © 2014 OnCourse Learning. All Rights Reserved.

73 © 2014 OnCourse Learning. All Rights Reserved.
Cash flows if Lease : IRR = 12.50% after tax © 2014 OnCourse Learning. All Rights Reserved.

74 © 2014 OnCourse Learning. All Rights Reserved.
Cash flows if Buy: IRR = 12.95% after tax © 2014 OnCourse Learning. All Rights Reserved.

75 © 2014 OnCourse Learning. All Rights Reserved.
Lease: 12.50% Buy: 12.95% Should the corp buy? . . . Answer: You don’t know. Analysis has mixed capital budgeting decision with project finance decision. © 2014 OnCourse Learning. All Rights Reserved.

76 © 2014 OnCourse Learning. All Rights Reserved.
Buy/Lease decision depends only on the INCREMENTAL cash flows (own - lease) . . . IRR = 13.79% after tax © 2014 OnCourse Learning. All Rights Reserved.

77 © 2014 OnCourse Learning. All Rights Reserved.
Answer: You still don’t know: Is 13.79% a good expected return, considering the risk of buying? . . . Will buying add to or subtract from the corporate shareholders’ value in the stock market? . . . Buy instead of Lease: IRR = 13.79% Should the corp buy? . . . © 2014 OnCourse Learning. All Rights Reserved.

78 (Don’t just apply the corporate WACC.) Corporate Borrowing Rate
Second Rule: Opportunity cost of capital for “debtlike” (i.e., contractually fixed) cash flows is: Corporate Borrowing Rate © 2014 OnCourse Learning. All Rights Reserved.

79 Back out from Prop.Price & CFs
Don’t just apply the corporate WACC. (Real estate assets may not have the same risk/return characteristics as the corporation’s other assets.) Third Rule: Opportunity cost of capital for real estate cash flows is found in property market: Back out from Prop.Price & CFs © 2014 OnCourse Learning. All Rights Reserved.

80 © 2014 OnCourse Learning. All Rights Reserved.
Note: These evaluation principles are consistent with mainstream corporate finance principles as elaborated in texts such as Brealey & Myers (e.g., see B-M 5th Ed. Chs.18 & 19). ==> WACC is not hurdle . . . Suggests NPV (instead of IRR) approach to lease/buy decision . . . © 2014 OnCourse Learning. All Rights Reserved.

81 © 2014 OnCourse Learning. All Rights Reserved.
1) Discount “debtlike” Corp Borrowing Rate: - Lease CFs - Depreciation tax shields - Loan CFs 2) Discount real estate resale proceeds at property mkt “reversion” rate. 3) Work with after-tax CFs & after-tax discount rates. © 2014 OnCourse Learning. All Rights Reserved.

82 Low-tax institutions buy. High-tax institutions lease.
Sale/leasebacks often make sense for profitable taxed corporations. (See spreadsheet example) Typical Result: (based on investment value, including consideration of all levels of taxation) © 2014 OnCourse Learning. All Rights Reserved.

83 © 2014 OnCourse Learning. All Rights Reserved.
Recall Exhibit 12-1 (Ch.12): Relation between Investment Value (IV) and Market Value (MV) in a well-functioning asset market P S INTRA-MARGL.BUYER IV ASSET PRICE = MV INTRA-MARGL.SELLER IV D Q0 Q* Q P = Asset prices (vertical axis). Q = Volume of investment transaction per unit of time. Q0 = Volume of transactions by investors with more favorable circumstances, hence would enter market at less favorable prices (i.e., “intra-marginal” market participants). Q* = Total volume of asset transactions, including marginal investment (investors on margin are indifferent between investing and not investing in assets: NPV=0). © 2014 OnCourse Learning. All Rights Reserved.

84 Market for Taxed Debt Assets:
Recall Exhibit 14-5: Relation between Investment Value (IV) and Market Value (MV) in the asset market, for tax-advantaged (e.g. tax-exempt pension fund) and tax-disadvantage (e.g., double-taxed C-Corp) investors... IVA = $107 = $3.20/0.03 MV = $100 = $4/0.04 = $3/0.03 = IVM D S Q L Q* Q0 IVC = $93 = $2.80/0.03 Market for Taxed Debt Assets: Mkt Int.Rate = 4% Asset provides 4% mkt return ($4.00/yr for $100 investmt). 4% is mkt return because marginal investors have 3% after-tax required return and they are subject to effective tax rate of 25% ( 3% = mkt after-tax OCC). Corporate income tax rate of 30% reduces pre-tax earnings of $4.00 to $2.80. Mkt after-tax OCC of 3% applied to $2.80/yr  Asset PV = $93 for Corp shareholders,  NPV of sale-leaseback = $100 - $93 = +$7. Same principle applies with lease vs own… © 2014 OnCourse Learning. All Rights Reserved.

85 Low-tax institutions buy. High-tax institutions lease.
Typical Result: (based on investment value, including consideration of all levels of taxation) Low-tax institutions buy. High-tax institutions lease. Sale/leasebacks often make sense for profitable taxed corporations. However. . . © 2014 OnCourse Learning. All Rights Reserved.

86 © 2014 OnCourse Learning. All Rights Reserved.
Other considerations . . . 1) Small space requirements => Lease. © 2014 OnCourse Learning. All Rights Reserved.

87 © 2014 OnCourse Learning. All Rights Reserved.
Other considerations . . . 1) Small space requirements => Lease. 2) Short time need for space => Lease. © 2014 OnCourse Learning. All Rights Reserved.

88 © 2014 OnCourse Learning. All Rights Reserved.
Other considerations . . . 1) Small space requirements => Lease. 2) Short time need for space => Lease. 3) R.E. info disadvantage => Lease. © 2014 OnCourse Learning. All Rights Reserved.

89 © 2014 OnCourse Learning. All Rights Reserved.
Other considerations . . . 1) Small space requirements => Lease. 2) Short time need for space => Lease. 3) R.E. info disadvantage => Lease. 4) Special purpose bldgs, need for control: => Own. © 2014 OnCourse Learning. All Rights Reserved.

90 © 2014 OnCourse Learning. All Rights Reserved.
Other considerations . . . 1) Small space requirements => Lease. 2) Short time need for space => Lease. 3) R.E. info disadvantage => Lease. 4) Special purpose bldgs, need for control: => Own. 5) Info advantage, positive spillovers (e.g., Disney): => Own, RE profit ctr. © 2014 OnCourse Learning. All Rights Reserved.

91 © 2014 OnCourse Learning. All Rights Reserved.
Other considerations . . . 2) Short time need for space => Lease. 3) R.E. info disadvantage => Lease. 4) Special purpose bldgs, need for control: => Own. 5) Info advantage, positive spillovers (e.g., Disney): => Own, RE profit ctr. 6) UPREIT structure allows corp to defer cap gains in sale/leaseback © 2014 OnCourse Learning. All Rights Reserved.


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