Joseph Hahs Real Estate Principle Importance In Business Management

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Information about Joseph Hahs Real Estate Principle Importance In Business Management

Published on March 15, 2016

Author: josephhahs


Chapter 14: Real estate value : Chapter 14: Real estate value Real Estate Principles: A Value Approach Ling and Archer Outline: Outline Investment risk Time-value-of-money Internal rate of return Determining the discount rate Appraisal Investment and risk; a classical view: Investment and risk; a classical view Investment is about involving costs (cash outflows) now for the sake of future benefits (cash inflows). Investment risk is about uncertainty. This uncertainty comes from two possible sources: (1) costs can be uncertain, and (2) benefits can be uncertain. Examples of uncertain costs: (1) renovating an aged house frequently leads to cost overrun, and (2) developing a subdivision may be surprised by soil contamination. Question: should high costs, in equilibrium, lead to high benefits (returns)? The spectrum of risk (Exhibit 14-10): The spectrum of risk (Exhibit 14-10) The spectrum of cost uncertainty: The spectrum of cost uncertainty The spectrum of CF uncertainty: The spectrum of CF uncertainty Risky hotels: Risky hotels “Heading into an economic downturn, hotels are often among the first industries to suffer as travel slows and room rates weaken.” “Lodging analyst Smedes Rose estimates Marriott is trading at 17 times its expected earnings per share this year. It traded as high as 30 times a year ago.” Source: WSJ, Apr. 30, 2008. Definitions: Definitions Investment-grade (vs. speculative-grade) properties: commercial properties that are large (values generally well over $10 million), relatively new, located in major metropolitan areas, and fully leased. Alternatively, properties can be grouped into class A (new to newer quality construction in prime to good locations), class B (aging properties in good to average locations), and class C (older properties with functional inadequacies and/or marginal locations) 2 notions of RE values: 2 notions of RE values Investment value: value to a particular individual (e.g., NPV): Chapters 18 & 19. Appraised value: value to a “typical” investor, or probable selling price: Chapters 7 & 8. Investment cash flows: Investment cash flows Cash Flow at Sale Cash Flow From Operations Initial Cost Discounting cash flows: Discounting cash flows The fundamental, economic value of a real investment is the sum of discounted future cash flows. A dollar in the future is worth less than a dollar today. One of the main reasons for this is inflation. Net present value (NPV): the difference between fundamental value and initial costs. If a real estate investment has a positive NPV, the investment project should be accepted. Internal rate of return: Internal rate of return In addition to fundamental value, practitioners often obtain estimates of the internal rate of return (IRR). The IRR is also known as the “ investment yield ” or the “ total yield ” in the RE industry. If the IRR is higher than the required IRR (the benchmark), the investment project is accepted. Cost of equity: Cost of equity For publicly traded stocks, the cost of equity is estimated by using an asset pricing model, say the CAPM. For private RE investment, it is harder to infer the cost of equity from public market data. One possible way to estimate this required rate of return is to identify the return investors could typically earn on real estate investments of similar risk via a survey. Going-in IRR: Going-in IRR An investor’s required going-in IRR = risk-free rate + required risk premium. The required risk premium is higher when the investment has higher risk (risk-return tradeoff). Investment-grade properties usually require a risk premium of 4-8%. Note that the notion of going-IRR is usually stated as “before-tax.” The reason for being before-tax because before-tax cash flows are used for appraisals. See Exhibit 18-5, p. 493 for range and average going-in cap rates. Going-in IRR example: Going-in IRR example Suppose that Hill Inc. is thinking about investing in an investment-grade office building in Manhattan. The investment horizon is 10 years. The return for investing in T-bonds with a maturity of 10 years is 5%. Given the perceived investment risk, Hill Inc. estimates that the required risk premium for investing in this building is 6%. What is the going-in IRR? Going-in IRR = risk-free rate + required risk premium = 5% + 6% = 11%. Appraisal: Appraisal Appraisal provides an estimate of the most probable selling price of a property. This estimation provides valuable information to the seller and potential buyers of the property. The ask price and bid prices are often established around the appraisal value. Chapters 7 & 8.

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