andrew baum and david hartzell, global property investment, 2011 asset appraisal

Andrew Baum and David Hartzell, Global Property Investment, 2011

Asset appraisal


Appraisal inputs

Space sq ft 50,000Rental value/psf £22.50Current contract rent £500,000 Remaining term 1 yearOccupancy Single tenantGRR year 1 £1,125,000Occupancy Multiple tenants


Appraisal inputs

Growth 3.50%Depreciation 2.00%Resale cap rate (NOI) 7.00%Inflation 2.50%OpEx £100,000Vacancy 10%


Appraisal inputs

Price £12,000,000Purchase fees 4.50%Total outlay £12,540,000Sale fees 1.75%Required return 8%


Gross potential income

Year GRR Other income GPI01 £500,000 £0 £500,0002 £1,158,332 £0 £1,158,3323 £1,175,366 £0 £1,175,3664 £1,192,651 £0 £1,192,6515 £1,210,190 £0 £1,210,1906 £1,227,986 £0 £1,227,986


Net operating income

Year GPI Vacancy GEI OpEx NOI01 £500,000 £0 £500,000 £102,500 £397,5002 £1,158,332 £115,833 £1,042,498 £105,063 £937,4363 £1,175,366 £117,537 £1,057,829 £107,689 £950,1404 £1,192,651 £119,265 £1,073,386 £110,381 £963,0045 £1,210,190 £121,019 £1,089,171 £113,141 £976,0306 £1,227,986 £122,799 £1,105,188 £115,969 £989,219


Net resale price

• NOI divided by cap rate (MVt = NOIt+1 / crt) less sale fees• NOIt+1 = NOI0*(1+g)^t+1/(1+d)^t+1

• Year 6 (t+1)NOI = £989,219• Year 5 (t) cap rate = 7%• MVt = NOIt+1 / crt = £989,219/0.07• Sale fees are 1.75%• (£989,219/0.07)*(1-0.0175) = £13,884,388


IRR, pre-tax, 100% equity, no carried interest

Year NOI Resale value Cash flow0 -£12,540,0001 £397,500 £0 £397,5002 £937,436 £0 £937,4363 £950,140 £0 £950,1404 £963,004 £0 £963,0045 £976,030 £13,884,388 £14,860,4186 £989,219

IRR 8.39%


The impact of debt finance

• Real estate provides collateral for debt• Financial mathematics changes

– Initial capital investment reduced– Cash flow reduced

• Return on equity different • Risk profile different• Required return?• Tax damage often reduced by debt • Amortisation?


Return on leveraged equity

Return on leveraged equity > return on unleveraged equity

when

Return on unleveraged equity > interest rate on debt


Using 70% debt

• Total purchase outlay £12,540,000 • IRR on 100% equity 8.39%• 70% loan $8,778,000• 30% equity $3,762,000 • Fixed interest rate 5.5% • Annual interest-only repayment £482,790• Assume no amortisation• Calculate the return on equity



Approximation

ke = [ka-(kd*LTV)]/(1-LTV)ka = return on unlevered asset 8.39%kd = cost of debt 5.50%LTV = loan to value ratio 70.00%

ke = return on levered equity 15.14%



Year Cash flow Interest Loan repaid Cash to equity0 -£12,540,000 -£3,762,0001 £397,500 -£482,790 -£85,2902 £937,436 -£482,790 £454,6463 £950,140 -£482,790 £467,3504 £963,004 -£482,790 £480,2145 £14,860,418 -£482,790 -£8,778,000 £5,599,628

IRR project 8.39% IRR equity 14.14%


Risk: impact of 1% higher exit yield


IRR project 6.07% IRR equity 7.37%


Risk: impact of 3% higher exit yield


IRR project 2.40% IRR equity -7.26%


Risk: impact of higher exit yields

Interest Exit cap IRR project IRR equity5.50% 7.00% 8.40% 14.10%5.50% 8.00% 6.10% 7.40%5.50% 9.00% 4.10% 0.42%5.50% 10.00% 2.40% -7.30%

Standard deviation 2.59% 9.19%


Risk: impact of higher exit yields

Exit cap 7.00% 8.00% 9.00% 10.00%

-10.00%

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

IRR projectIRR equity


The importance of debt terms

• Loan to value ratio - LTV – say maximum 80%– Outstanding loan as a percentage of value– £8,778,000 is 80% of approx £11m – Values can fall by 8.3% from £12m

• DSCV – debt service coverage ratio - say 1.2– Stabilised NOI / annual interest payment– Stabilised (year 2) NOI is 1.94 times interest– Rents can fall by 38%


Using debt

• Tax on income 30%• No tax on capital gains • Assume paid in year of receipt

• Calculate the return on equity after tax• (Required return after tax?)


100% equity before and after tax

Year Net cash flow Tax Net cash0 -£12,540,000 -£12,540,0001 £397,500 £119,250 £278,2502 £937,436 £281,231 £656,2053 £950,140 £285,042 £665,0984 £963,004 £288,901 £674,1035 £14,860,418 £292,809 £14,567,609

IRR before tax 8.39% IRR after tax 6.51%


30% equity before and after tax

Year Net cash to equity Tax Net cash0 -£3,762,000 -£3,762,0001 -£85,290 -£25,587 -£59,7032 £454,646 £136,394 £318,2523 £467,350 £140,205 £327,1454 £480,214 £144,064 £336,1505 £5,599,628 £151,029 £5,447,700

IRR before tax 14.14% IRR after tax 11.85%


Summary

• Required return pre-tax 8%• IRR on 100% equity pre-tax 8.39%• Required return after tax (0.7*8) 5.6%• IRR on 100 % equity after tax 6.52%• IRR on 30% equity pre-tax 14.14%• IRR on 30% equity after tax 11.85%• Required return on leveraged equity?• 100% equity pre-/post-tax return ratio: 78%• 30% equity pre-/post-tax return ratio: 84%


Carried interest

• The manager of this investment has agreed with the investor that he/she will receive 20% of all leveraged pre-tax returns over 10% achieved on sale of the property

• What year 5 income achieves 10% IRR?• By trial and error/goal seek, this is £13,746,000• NOI5 = £976,030, so net resale price is £12,769,970• With fees at 1.75% this is a property price of: • £12,769,970/1.0175 = c.£12,550,340 (cap rate 7.88%)


Carried interest: net exit value required

Year Cash flow Interest Loan repaid Net cash to equity0 -£12,540,000 -£3,762,0001 £397,500 -£482,790 -£85,2902 £937,436 -£482,790 £454,6463 £950,140 -£482,790 £467,3504 £963,004 -£482,790 £480,2145 £13,746,000 -£482,790 -£8,778,000 £4,485,210

IRR equity 10.00%


Carried interest

• Expected surplus: • £14,860,418 - £13,746,000 = £1,114,418

• 20% goes to manager: £222,884

• Net leveraged pre-tax return to investor: 13.36%

• Fee leakage: 14.14% - 13.36% = 0.78% = 5.51% of gross return


Performance fee impact: % of IRR

0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32 34 36 38 400

2

4

6

8

10

12

14

16

Fee impact

Fund IRR (%)

% of IRR

Source: PFR, 2010

andrew baum and david hartzell, global property investment, 2011 asset appraisal

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