1. Chapter 19 Investment Decisions: NPV and IRR
REAL ESTATE
FIN 331

2. A Cautionary Note
On occasion authors make some changes to simplify the examples.
Unhappily, when it comes to real property and tax issues, this can lead to incorrect conclusions regarding methodology.
Investment analysis requires precise data AND knowledge of IRS tax law and process.

3. Investment Valuation
Most commercial real estate decisions involve investment motive
Investments are made in expectation of future cash flows
The magnitude and timing of future cash flows will determine whether or not an investment is profitable or not
The Discounted Cash Flow method (DCF) is used to determine the feasibility of an investment

4. Investment Valuation B. Required inputs for DCF analysis
Estimate how long the investor will hold the property
Estimate the yearly net cash flows
Select an appropriate risk-adjusted discount rate to complete the calculations
DCF process will yield a net present value (NPV)

5. Shortcomings of NOI-Based Valuation
Limitation of NOI single-year return measures & ratios?
They do not explicitly incorporate income producing ability of property beyond 1st year of rental operations
May lead to suboptimal investment decisions
19-5

6. Multi-Year DCF
Many investors also perform multi-year analyses of potential acquisitions
When using multi-year discounted CF decision making methods, investor must
estimate how long she expects to hold property
make explicit forecasts of:
property’s net CF for each year,
net CF produced by expected sale of property
Select rate of return at which to discount all future CFs

7. Centre Point Office Building

8. 6-Year CF Projections Assuming 3% per Year Rent Escalation

9. Assumed Sale Price in Year 5 Based on Year-6 NOI
Sale Price = NOI6 / Cap Rate: 103,291 / = $ 1,180,469

10. Centre Point by the Text (with a some minor corrections)

11. Method of Depreciation per IRS

12. Recovery Periods Under ADS

13. Recovery Periods Under ADS

14. Centre Point by the IRS

15. DCF Investment Valuation
A. NPV decision rules
NPV = Present Value of ATCF minus the Initial contact Investment
If NPV is greater than 0, we make the investment
If NPV is less than 0, we will not make the investment

16. DCF Investment Valuation
B. Measuring the impact of leverage
Leverage involves the use of debt to finance part of the acquisition
The interest charges on debt will reduce our taxable income
Traditional analysis uses ATCF values to compute NPV

17. DCF Investment Valuation
Internal Rate of Return (IRR)
When NPVs are greater than 0, the internal rate of return will be greater than the discount rate used to compute NPV
if NPV is equal to 0, then the internal rate of return equals the discount rate
if NPV is less than 0, then the IRR is less than the discount rate

18. Measuring the Impact of Risk on NPV
Sensitivity analysis
Most likely scenario
Worst-case scenario
Best-case scenario
Value of computer
Excel spreadsheets
Specialized software such as ARGUS
Monte Carlo simulation (using random probabilities to develop outcome distributions)

19. homework assignment
Key terms: before tax cash flows, after-tax cash flows, leverage, leverage cash flow, unleveraged cash flow
Study questions: 2, 3, 5, 9, 11