CHAPTER 3: Decision-Making Approaches to Investment
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CHAPTER 3: Decision-making Approaches to Investment Popular Approaches to Investment Selection
Nickerson approach
Bockl approach
Haroldson approach Nickerson Approach
Use maximum safe leverage
Buy only property that can be improved
Make selective improvements
Keep selling at a profit Assumptions and Fallacies With Nickerson
Assumes orderly market
Ignores value of "sweat equity"
Expanding local economy Bockl Approach
Use maximum leverage
Young serve as "conduit" for other's money
Entrepreneurial leverage (full 30 year amortization)
Four way benefits test Cash flow return Amortization return Tax shelter Appreciation Assumptions and Fallacies With Bockl
Assumes rich pigeon
Ignores financial risk
Expanding local economy
Ignores time value of money Haroldson Approach
Success = Planning + Savings + Investment + Compounding
Plan your work and work your plan
Begin aggressive savings program
Buy a bargain (Make your money on the purchase) Haroldson’s “Bargain” Properties
Undervalued properties
Property that can be fixed up
Property where rents are too low
Property where expenses are too high
Property whose use is not optimal
Property that can be overleveraged Assumptions and Fallacies of Haroldson
Assumes orderly market
Ignores value of "sweat equity"
Expanding local economy
Bigger fool theory Assumptions and Problems With All Three “Popular” Approaches
Bigger fool theory (win/loss)
Ignores risk
Get rich quick Success without planning or education promotes failure Many who make a million also loose a million Traditional Approaches
Investment value approach (Invest where IV (IV=I/R) exceeds Cost)
Single period Equity valuation (VP=VE+mortgage)
Ellwood
Rate-of-return approach Ellwood Mortgage Equity Easy to use to get a quick estimate of investment value
Developed originally by Ellwood to screen potential investments for his insurance company
More commonly used to estimate the rate in income-property appraisal using Value=NOI/Rate
Based upon a logical extension of the band of investment appraisal technique Ellwood Mortgage Equity (Continued) Reasons that the return yielded (NOI/Investment) by the expected annual income does not need to be as high if the annual cash flows are used to pay down the debt since the investor will receive the debt reduction cash flow when the property is sold Ellwood Mortgage Equity (Continued) Further reasons that the annual return overall might be lower or higher if the property appreciates or depreciates during the holding period since that appreciation or depreciation cash flow is realized when the property is sold Steps in Computing the Return Overall With Ellwood
Ellwood begins with the rate of return demanded by the typical investor. Usually determined through interviews of typical investors
Next the annual impact of debt financing is computed Includes impact of leverage Includes impact of debt amortization during holding period
Finally the annual impact of expected appreciation or depreciation is computed Computing the Annual Impact of Debt Financing
Basic formula: m(ye - Rm + p * an) where:
m = the percentage loan
ye - Rm = the difference between what the investor expects to earn (ye) and what the lender is charging (Rm). p = the percentage of the loan paid off during the holding period
an = annualizer (a factor which converts a future value into an annual percentage This is known as a sinking fund factor.) Calculation of p Simply begin with 100% or 1 as the PV and calculate the percentage mortgage payment just as any mortgage payment is calculated. From the original term of the loan, subtract the holding period and enter as N. (If there is more than one payment per year, remember that the number of years must be multiplied by the payments per year before entering as N. Solve for the percentage of the original balance remaining by recomputing PV. Finally, subtract the percentage remaining from 100% to determine the percentage paid off.
Calculation of an The annualizer is the annual percentage of the whole necessary to invest to accumulate that amount in the future. It is the payment necessary to accumulate a future value. Simply enter 100% or 1 into FV. Enter the number of years into N. (Annualizers assume only one payment per year.)
Enter the investor’s desired rate of return (ye) Solve for payment. This is the annualizer. Computing the Annual Impact of Appreciation or Depreciation
First the expected appreciation or depreciation in the sales price (overall) must be determined as a percentage change in the value of the property at the time of the valuation until the end of the expected holding period. This is usually estimated based upon percentage appreciation or depreciation of comparable properties unless the market is not expected to react as it had in the past.
This percentage is then multiplied by the annualizer (an) to convert it to an annual impact. The Complete Ellwood Formulation
The investor’s desired rate of return = ye
The debt financing component = m(ye - Rm + p * an)
The appreciation/depreciation component = ∆overall * an
The entire formula is: Ro = ye - m(ye - Rm + p * an) - ∆overall * an Example Ellwood Problem What is the indicated overall rate if an investor puts down 20%, requires a 15% rate of return, and the bank charges 9% on the 30 year, monthly payment mortgage? The property is expected to depreciate 20% over the 10 year holding period. Calculate each of the following first:
m
an
Rm
p Calculation of Debt Financing Component m = 100% - 20% investor’s equity = 80%
Rm = .0966 (P/YR =12; I/YR=9; PV=1; N=360 (30 cream N); solve for PMT; * 12) p = .1057 (Original term = 30 years - 10 year holding period = 20 years remaining; 20 cream key N; solve for PV = .8943; 1 - .8942 = .1057)
an = .0493 (P/YR = 1; I/YR = 15; n = 10; FV = 1; solve for PMT)
m(ye - Rm + p * an) = .8 (.15 - .0966 + .1057 * .0493) = .0469 Final Calculation of Ellwood
Appreciation/depreciation component = ∆overall * an = -.2 * .0493 = .0099
Thus: Ro = ye - m(ye - Rm + p * an) - ∆overall * an = .15 - .8 (.15 - .0966 + .1057 * .
0493) - (-.2 * .0493)
.15 - .0469 + .0099 = .1130 Rate-of-return Approach
Estimate expected rate of return ROI=NOI/V ROI=BTCF/Equity ROI=(BTCF+amortization)/Equity ROI=(BTCF+amortization+appreciation)/Equity
Estimate required rate of return ROI = Risk free rate+risk premium+inflation+liquidity
Compare two rates; go if ROI exceeds RROI Best-fit Approach
Basic value factors
Financial factors Basic Value Factors
Proper location
High-quality construction
Professional property management
Good maintenance
Appropriate market driven amenities
Attractive architecture and land use plan Basic Value Factors (Cont.)
Good interior layout
Property clearly market segmented
Competent previous owners
Sufficient cash flow
Verification and ratio analysis of income and expenses Financial Factors
Quantity and stability of projected cash flow
Amortization
Tax shelter
Mortgage refinancing benefits
Reversionary proceeds Modern Capital Budgeting Techniques: Discounted Cash Flow Investment value = h ATCF + CFR + ATER i=1 (1 + y)i (1 + y)rf (1 + y)h where: ATCF = after tax cash flow in year i y = equity yield rate h = holding period CFR = cash flow from refinancing rf = year of refinancing ATER = the value of the after tax equity reversion at end of year h i = year of cash flow Modern Capital Budgeting Techniques: Internal Rate of Return
Assumes reinvestment of cash flows at the internal rate of return
Improved by use of the financial manager’s rate of return (modified internal rate of return) which assumes a more realistic reinvestment rate
Select investment when IRR is grater than the required rate of return Modern Capital Budgeting Techniques: Risk Analysis Models
Ratio and sensitivity analysis
Direct utility approach (risk profile and expected return pattern)
Monte Carlo simulation Types of Risk: Systematic (Primarily Non-diversifiable)
Financial (risk of default)
Business (specific enterprise)
Purchase power (reversion amount)
Inflation (periodic cash flows)
Legislative
Management
Property inflation Types of Risk: Non-systematic (Diversifiable)
Liquidity
Business (cyclical) Modern Capital Budgeting Techniques: Portfolio Analysis
Examines investment in the context of the investor’s entire portfolio Mathematical models have had limited success in practical application to real estate portfolios