1 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin CHAPTER 3 INVESTMENT DECISIONS Forecast cash flows from operations. Forecast cash flow from sale. Determine present value of expected cash flows. Apply an investment decision criterion.

2 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin REAL ESTATE INVESTMENT ANALYSIS Investment Strategy Investment Philosophy Investment Objectives Investment Policies

3 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin CHARACTERISTICS OF INCOME PROPERTY INVESTMENTS Property Types Rental Income –Contract Rent –Market Rent Purchasers as Investors Geographic Scope

4 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin FORECASTING CASH FLOWS FROM OPERATIONS Potential Gross Income Effective Gross Income Operating Expenses Net Operating Income Non-Recurring Expenses

5 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Net Operating Income Calculation

6 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Net Operating Income Example

7 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Forecasted Cash Flows From Net Operating Income

8 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Forecasted Cash Proceeds From Sale

9 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Present Value Calculation

10 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Net Present Value (NPV) The net present value is the present value of a project’s cash inflows, minus the present value of the cash outflows. The cash flows are discounted at the investor’s required rate of return--in this example 12 percent.

11 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Net Present Value Calculation

12 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin NPV Decision Criteria If NPV>0, the project exceeds the investor’s required rate of return. If NPV<0, the project does not meet the investor’s required rate of return. If NPV=0, the project’s expected return equals the investor’s required rate of return.

13 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Internal Rate of Return (IRR) The internal rate of return is the discount rate at which NPV = 0, the rate of return at which the present value of the cash inflows equals the present value of the cash outflows.

14 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin NPV and the IRR

15 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin IRR Decision Criteria If IRR > the required rate of return, then accept. If IRR< the required rate of return, then reject. If IRR= the project’s expected return equals the investor’s required rate of return.

16 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin NPV and the IRR – NPV: Cash flows assumed reinvested at discount rate Generally preferred to IRR for making decisions –IRR: Cash flows assumed reinvested at the IRR rate May provide inferior wealth maximizing ranking of alternative opportunities to the NPV Multiple solutions possible Easily compared to other investments and widely used

17 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin The Effects of Mortgage Financing on Cash Flows, Values, and Returns Effect on the Initial Investment Effect on the Cash Flows from Operations Effect on the Cash Flow from Sale

18 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin INVESTMENT CRITERIA Profitability Ratios Capitalization Rate: –R o = NOI / Acquisition Price Equity Dividend Rate: –R e = EDR = BTCF / Initial Equity Mortgage Constant: –R m = MC = DS / Initial Loan Amount

19 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin INVESTMENT CRITERIA Multiplers Net Income Multiplier: –NIM = Acquisition Price / NOI Effective Gross Income Multiplier: –GIM = Acquisition Price / EGI

20 Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin INVESTMENT CRITERIA Financial Ratios Operating Expense Ratio: –OER = Operating Expenses / EGI Loan-to-Value Ratio: – LTV = Mortgage Balance / Property Value Debt Coverage Ratio: – DCR = Net Operating Income / Debt Service