Financing Decisions in Real Estate

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Financing Decisions in Real Estate

• Paper 15
• Lent term - Lecture 3

2
Key Points

• Financing decisions and valuation - a review of
  adjusted present value (APV).
• Residual equity income (REI) approach

3
References
Jaffe Sirmans - Chpt 12 Brealey and Myers -
Chpt 19 Brown and Matysiak - Chpt 8 (incl
appendices) Tirtiroglu, D. (1998) Property
Investment Analysis Using Adjusted Present
Values Modifications, Appraisal Journal, July,
pp 298-304. Locke, S.M. (1990) Property
Investment Analysis Using Adjusted Present
Values, Appraisal Journal, July, pp 373-78.
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Traditional Approach

• The following steps for the traditional approach
  to project valuation
• Forecast projects incremental after-tax cash
  flows.
• Assess the projects risk.
• Estimate the opportunity cost of capital.
• Calculate PV or NPV, using discounted cashflow
  method.

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Valuation Illustration
This example is taken from Tirtirogu (1998)
Property Investment Analysis Using Adjusted
Present Values, Appraisal Journal.
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When there is no financing

• Recall from last term, value of project is PV of
  all after tax cash flows.
• After tax cash flow is defined as
• ATCFt (NOIt - Dt)(1-T) Dt
• where
• NOIt net operating income period t
• Dt depreciation in period t
• T investors marginal tax rate

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Valuation - all equity financed
First work out building expenses and before tax
income
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Valuation - all equity financed
Calculate after tax cash flow
Calculate present value (note discount
Depreciation benefit at risk free rate)
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Valuation - all equity financed
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Valuation under leverage

• Three common approaches to dealing with this
  problem
• WACC (effect of tax shelter operates through
  discount rate)
• Adjusted present values (PV of project under
  equity finance PV of tax side effects)
• Residual equity income

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Benefits of APV

• The different methods should give the same
  results (given correct formulation of the
  problem).
• At a practical level WACC when loan-value ratio
  is a constant proportion. Why?
• APV has more flexibility to capture unusual
  cash-flows.

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Valuation under leverage

• Recalculate investment decision if a loan of
  525,000, amortised over five years, is used in
  the purchase of the property (interest is tax
  deductible, principal repayments are not).
  Repayments are made annually.
• What to do - repeat analysis including tax shield
  generated by interest repayments.

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Valuation under leverage
Calculate PV of tax shield (assume interest rate
is 12). Note that interest shield is discounted
at a rate equal to that of the loan - why?
PV(tax shelter) 78,035.
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Valuation under leverage

• APV PVAE PV(tax shelter)
• Therefore APV 877,144 78,035 955,180
• NAPV 955,180 - 830,000 128,120.
• Question - if a non-tax paying institution (e.g.
  a Cambridge college) was bidding against a
  property development company for this building,
  what would be the outcome?
• Question - do investors really gain from these
  tax breaks?

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Valuation under leverage

• What would the result of the analysis be if an
  interest only loan (with repayment at the end of
  the term) was used instead of an amortisation
  loan?

PV(tax shelter) 113,550. Clearly financing
decisions are important!
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Finance and Valuation - comments

• Unlike the MM world, financing decisions are
  important.
• WACC vs APV (APV preferred in many real estate
  investment decisions).
• APV PV (under equity) PV(tax shelter)
• APV is flexible framework which can be used to
  investigate other issues (eg non-market
  financing, tax breaks/incentives, negative
  gearing).

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Residual Equity Income (REI)

• APV analyses debt and equity project components
  separately.
• Could add debt payments to cashflows and analyse
  residual cashflows.
• Fewer steps but problem with identifying correct
  discount rate.

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Residual Equity Income (REI)

• First step - Estimate the residual equity
  cashflow.
• Residual equity cashflow After tax NOI
  Depn Benefit - Loan repayment
  (capital) - Interest payment After tax
  interest shield

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Residual Equity Income (REI)
Final line is cashflow of project after taking
into account finance repayments (and associated
tax benefit of interest relief). Which discount
rate do we apply to this cashflow?
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Residual Equity Income (REI)

• Step 2 - Estimate PV of residual equity income.
• Discount by expected rate of return demanded of
  geared cashflow (the expected rate of return of
  investors in the companys equity, i.e. re)
• Not clear from article what this rate of return
  is, need to calculate it. Could use CAPM if
  company was listed on stock exchange.

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Residual Equity Income (REI)

• Alternatively assume similar gearing for company
  as there is in project. Hence Recall from finance
  theory
• For this project the following values hold rp
  17.5 D 525,000 V 830,000 E D - V
  305,000 rd 12

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Residual Equity Income (REI)

• Therefore re 26.97.
• However, this rate is based on initial gearing of
  project. Gearing of company may differ from that
  of the project. Also gearing will reduce over
  time (because of amortisation).
• If discount at 26.97, PV 238,449 and NPV
  238,440 (-830000 535000)Therefore do not go
  ahead with project.
• If discount at 17.5, PV 473,646, NPV
  170,646

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Conclusion

• NPV under APV 128,120
• NPV under REI 170,646
• Note the is greater uncertainty about appropriate
  discount rate for REI approach.
• Also note result can give different answers.
• APV provides more explicit information on nature
  of tax impact on project.