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Chapter 15 Value, Leverage and Capital Structure © OnCourse Learning
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 © OnCourse Learning 2
Valuation of Real Estate Investments © OnCourse Learning 3
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 © OnCourse Learning 4
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 © OnCourse Learning 5
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 © OnCourse Learning 6
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) © OnCourse Learning 7
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) © OnCourse Learning 8
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) © OnCourse Learning 9
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) © OnCourse Learning 10
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) © OnCourse Learning 11
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 © OnCourse Learning 13
Cash Flows from Operations Year GR403,200423,360444,528 - VAC 20,160 21,168 22,226 +OI =EGI383,040402,192422,302 - OE153,216160,877168,921 =NOI229,824241,315253,381 © OnCourse Learning 14
Cash Flows from Operations Year 4 5 GR466,754490,092 - VAC 23,338 24,505 +OI 0 0 =EGI443,416465,587 - OE177,366186,235 =NOI266,050279,352 © OnCourse Learning 15
Cash Flows from Operations Year NOI229,824241,315253,381 - MP 91,097 91,097 91,097 =BTCF138,727150,218162,284 - TXS 36,523 39,878 43,710 =ATCF102,204110,340118,574 © OnCourse Learning 16
Cash Flows from Operations Year 4 5 NOI266,050279,352 - MP 91,097128,520 =BTCF174,953150,832 - TXS 47,754 36,506 =ATCF127,199114,326 © OnCourse Learning 17
Income Taxes from Operations Year NOI229,824241,315253,381 - INT 75,296 73,814 72,193 - AFC 1,266 1,266 1,266 - DEP 22,823 23,815 23,815 =TI130,439142,420156,107 x t =TXS 36,523 39,878 43,710 © OnCourse Learning 18
Income Taxes from Operations Year 4 5 NOI266,050279,352 - INT 70,419105,902 - AFC 1,266 20,249 - DEP 23,815 22,823 =TI170,550130,378 x t =TXS 47,754 36,506 © OnCourse Learning 19
Cash Flow from Resale ESP1,336,147 - SE 106,891 =NSP1,229,256 - UMB 748,466 =BTER 480,790 - TXR 39,511 =ATER 441,279 © OnCourse Learning 20
Income Taxes from Resale ESP1,336,147 - SE 106,891 =AR1,229,256 - AB1,043,909 =TG 185,347 © OnCourse Learning 21
Income Taxes from Resale DR117,091 CG 68,256 x t d 0.25 x t g 0.15 =DRT 29,273=CGT 10,238 DRT 29,273 +CGT 10,238 =TXR 39,511 © OnCourse Learning 22
Cash Flow Summary Year ATCF ATER 0-342, , , , , ,326441,279 © OnCourse Learning 23
Net Present Value (NPV) © OnCourse Learning 24
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 © OnCourse Learning 25
Internal Rate of Return (IRR) © OnCourse Learning 26
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 © OnCourse Learning 27
Cash Flow Analysis 15%:$256,668 IRR:35.50% © OnCourse Learning 28
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 © OnCourse Learning 29
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 30 © OnCourse Learning
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 © OnCourse Learning 31
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