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© JR DeLisle, Ph.D. Discounted Cash Flow: Ratio Analysis by James R. DeLisle, Ph.D. March 20, 2014

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© JR DeLisle, Ph.D. Lecture Preview The Value Proposition Frontdoor/Backdoor Models DCF Prelude DCF: A Visual Overview One Word: GiNiTiBtAtNR Basic Inputs Introduction to Discounted Cash Flow Schedule 1: Pro Forma Cash Flow Schedules II-III: Depreciation and Loan Amortization Schedules IV-V: Capital Gain Taxes and Net Reversion Schedules VI: Financial Ratios DCF Schedules

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DCF MODELS: A VISUAL PERSPECTIVE

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© JR DeLisle, Ph.D. Equity Justified: PV of CF + PV Net Reversion NIr GIr PV CF +

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© JR DeLisle, Ph.D. Net Reversion TRCm NIr GIr Stabilized NOI Sales Price - Sales Exp Net Reversion Appreciation Land Value Depreciation Amortization Mortgage CG Appr x 15% CG Depr x 25% Pb Net Sales Price

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© JR DeLisle, Ph.D. Equity Justified: PV of CF + PV Net Reversion = Ej NIr GIr Sales Price - Sales Exp - Tax on Sale - Mtg. Bal. Net Reversion PV CF + PV NR

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© JR DeLisle, Ph.D. Cash Flow: The One Key Word GINITIBTATNR Gross Income Net Income Taxable Income Before Tax Cash Flow After Tax Cash Flow Net Reversion

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DCF CASE STUDY: INPUTS AND SCHEDULES

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© JR DeLisle, Ph. D. Real Estate Fundamentals © JR DeLisle, Ph. D. Cash Flow Variables and TRC/FD/BD Inputs Selling Expense Exit Cap Rate DeprLife39 CGTxR15.00% CGTxV25.00%

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© JR DeLisle, Ph.D. Discounted Cash Flow and Financial Ratios Schedule I: Cash Flow Schedule II: Depreciation Schedule III: Loan Amortization Schedule IV: Net Reversion Schedule V: Capital Gain Tax Schedule VI: Financial Ratios

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© JR DeLisle, Ph.D. Schedule I: Cash Flow Overview

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© JR DeLisle, Ph.D. Schedule II: Depreciation $3,436,567*(1/39) = $88,117

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© JR DeLisle, Ph.D. Schedule III: Loan Amortization Calculate Payment Calc. Principal Balance Calc. Prin. Reduction Calc. Interest

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© JR DeLisle, Ph.D. Schedule III(b): Loan Amortization

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© JR DeLisle, Ph.D. Schedule IV-V: CGTaxes on Sale & AT Proceeds Schedule IV: AT Proceeds Schedule V: Capital Gain Tax On Sale If, CapGain * 15% AccDepr * 25%

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© JR DeLisle, Ph.D. Schedule I: Cash Flow 1- 10

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© JR DeLisle, Ph.D. Teams

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INTRODUCTION TO DCF RATIOS: KEY FINANCIAL INDICATORS

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© JR DeLisle, Ph.D. Schedule VI: Financial Ratios

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© JR DeLisle, Ph.D. Schedule VI: Financial Ratios

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© JR DeLisle, Ph. D. Real Estate Fundamentals © JR DeLisle, Ph. D. Debt Coverage Ratio Interpretation – DCR provides a measure of the safety of the mortgage position, indicates the cushion between required payments and NOI. – DCR’s should normally be 1.2 or more Equation DCR: 1.3 Target

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© JR DeLisle, Ph. D. Real Estate Fundamentals © JR DeLisle, Ph. D. Default Ratio What DR is a measure of financial risk of real estate investments In essence it is the ratio of Fixed Costs to Gross Income How Used: Establish maximum variation expectations vs. realizations DR:.85 Target

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© JR DeLisle, Ph.D. Profitability Index What Ratio of PV Receipts to PV Outlays Variation of NPV; shows when hit breakeven point How Used: Determine economic viability; insights to minimum Holding Period

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© JR DeLisle, Ph. D. Real Estate Fundamentals © JR DeLisle, Ph. D. Before Tax Cash on Cash Return What Measure of Nominal Return using Initial Investment as base Ratio of pretax distributable cash to initial investment How Used: Determine economic viability and optimal Holding Period Compare alternative investments

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© JR DeLisle, Ph.D. After Tax Cash on Cash Return What Measure of Nominal Return using Initial Investment as base Ratio of After Tax distributable cash to initial investment How Used: Determine economic viability and optimal Holding Period Compare alternative investments

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© JR DeLisle, Ph.D. Implicit Cap Rate What Ratio of NI in current period divided by end of year Value Measure corresponds with “cap rate” rule of thumb How Used: Indication of relative pricing level; establish reasonableness of exit pricing Fixed in this case due to application of Exit Cap to NOIn+1

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© JR DeLisle, Ph.D. Gross Income Multiplier What Ratio of current period Market Value to Gross Income How Used: Rule of thumb comparison of alternative projects Relatively stable in this case due to use of Exit Cap in estimating Sales Price

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© JR DeLisle, Ph.D. Net Income Multiplier What Ratio of current period Market Value to Net Income Analogous to the PE ratio in finance How Used: An industry rule of thumb sometimes used to compare projects Relatively fixed in this case due to Exit Cap on NOI

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© JR DeLisle, Ph.D. Payback Ratio (w/o Sale) What Cumulative sum of After Tax Cash Flow/Equity Ratio Multiperiod look at return of initial equity How Used: Ratio that determines speed of return of equity Used to compare risk vs. other investments

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© JR DeLisle, Ph.D. Modified Payback Ratio (w/o Sale) What Cumulative sum of FV of After Tax Cash Flow/Equity Ratio How Used: Compare timing of returns against other alternatives Understand exposure period with reinvestment

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© JR DeLisle, Ph.D. NPV Equity What Cumulative sum of PV of Benefits less PV of Equity How Used: Determines whether discount rate is exceeded at specified cost of capital If NPV is Positive (>1), indicates return exceeds required yield

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© JR DeLisle, Ph.D. Marginal Rate of Return What The net increase/decrease in total return relative to prior year The additional return from owning from period to period How Used: Determining optimal holding period Project has peaked when it drops off $637,873 $507,878 = $129,995 = 25.6% $507,878 $637,873

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© JR DeLisle, Ph.D. Marginal Rate of Return

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© JR DeLisle, Ph.D. Internal Rate of Return: Overview Net Reversion PV CF PV NR PV EQUITY $ PV NR + PV CF IRR Interpretation Rate that balances PV Outlays against PV Benefits; NPV=0 It assumes reinvestment at the IRR Equation

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© JR DeLisle, Ph.D. Internal Rate of Return: Overview Net Reversion PV CF PV NR PV EQUITY $ PV NR + PV CF IRR Interpretation Rate that balances PV Outlays against PV Benefits; NPV=0 It assumes reinvestment at the IRR Equation

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© JR DeLisle, Ph.D. Internal Rate of Return Interpretation – Rate that balances PV Outlays against PV Benefits; NPV=0 – It assumes reinvestment at the IRR Equation 14.76%

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© JR DeLisle, Ph.D. Modified Internal Rate of Return Interpretation – Rate that balances PV Outlays vs. PV of the FV of Benefits – FV is ATCF reinvested at a specified rate and NPV=0 – It may have multiple solutions, or may not converge Equation

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© JR DeLisle, Ph.D. Modified Internal Rate of Return Net Reversion PV CF PV NR PV EQUITY $

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© JR DeLisle, Ph.D. Modified Internal Rate of Return 13.48%

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© JR DeLisle, Ph.D. GIGO Caveats in DCF Analysis Forecasted Cash Flows – Must Be REALISTIC Expectations – Neither Optimistic, Nor Pessimistic Discount Rate should be Opportunity Cost of Capital – Based on Ex Ante Total Returns in Capital Market – REALISTIC Property Market Expectations – Target Most Probable Buyer

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© JR DeLisle, Ph.D. Most Common Mistakes in DCF Rent & income growth assumption is too high – “We all know rents grow with inflation, don’t we!”?... – Remember: Properties tend to depreciate over time – Usually, rents within a building do not keep pace with inflation, long run Cap Ex &/or exit cap rate projection, are too low – – Capital expenditures typically average at least 10%-20% of the NOI (1%- 2% of the property value) over the long run. – Going-out cap rate is typically higher than going-in cap rate (older properties are more risky and have less growth potential). Discount rate (expected return) is too high – – This third mistake may offset the first two – End result may be realistic estimate of current value, – No guarantee and often not true

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© JR DeLisle, Ph.D. Lecture Review The Value Proposition Frontdoor/Backdoor Models DCF Prelude DCF: A Visual Overview One Word: GiNiTiBtAtNR Basic Inputs Introduction to Discounted Cash Flow Schedule 1: Pro Forma Cash Flow Schedules II-III: Depreciation and Loan Amortization Schedules IV-V: Capital Gain Taxes and Net Reversion Schedules VI: Financial Ratios DCF Schedules

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