Introduction to Real Estate Investment Appraisal

Transcription

1 Introduction to Real Estate Investment Appraisal NPV and IRR Pat McAllister

2 INVESTMENT APPRAISAL DISCOUNTED CASFLOW ANALYSIS

3 Investment Mathematics Discounted cash flow to calculate Gross present value Net present value Internal rate of return IRR is the discount rate at which the NPV equal zero

4 Basically We need to answer four questions. What do we get? When do we get it? What do we pay out? When do we pay it out?

5 Net Present Value Definition The discounted or present value of a series of future cash flows where the initial outlay is included as an outflow. The NPV is therefore the surplus of deficit present valued monetary sum above and below the initial outlay (purchase price).

6 Gross Present Value Definition The discounted or present value of a series of future cash flows where the initial outlay is not included as an outflow. The GPV is therefore the worth of the cash flow at the investor s target rate of return

7 Internal Rate of Return The rate of interest (expressed as a percentage) at which all future cash flows (positive and negative) must be discounted in order that the NPV of those cash flows should equal zero

8 Mathematically V p RI 1 (1 k) (1 RI 2 k) 2 (1 RI 3 k) 3... (1 RI n k) n (1 SP n k) n Where: V p = Value of property RI = Rental income SP = Selling price k = Target rate of return on property n = Holding period

9 As you know... (1 +i) -n

10 INVESTMENT APPRAISAL DISCOUNTED CASHFLOW Discounted Cashflow analysis - or DCF applies discounting techniques to the analysis of projects or investment opportunities; DCF techniques are used to determine buy/sell decisions and to decide whether or not to proceed with projects; There are two main techniques: NET PRESENT VALUE ANALYSIS (NPV) This provides a monetary sum: a positive NPV is a signal to proceed with a project; INTERNAL RATE OF RETURN (IRR) This provides a % return if the IRR% is sufficiently high then the project should proceed.

11 INVESTMENT APPRAISAL NET PRESENT VALUE All project cashflows are discounted back to today s prices at a firm s discount rate the target rate. The NPV is the SUM of the individual present values. Let Ct be the cashflow in year t. Then: NPV = C t for t = 0,1, n Recall that t t i i C t - I t i 0 for t = 1..n Sometimes you will see where I 0 is the Initial Investment or outlay. Key elements of NPV analysis are (i) estimating/forecasting the cashflows; (ii) deciding on an appropriate discount rate. = (1+i) -t

12 INVESTMENT APPRAISAL INTERNAL RATE OF RETURN The IRR is the rate of return or yield of the project or investment, expressed as a percentage. It is the discount rate which generates a Net Present Value of zero Formally, the IRR is i% such that Or C t = I t i 0 for t = 1, 2, n C t t i = 0 for t = 0, 1, 2, n As with the NPV it is vital that we can estimate/forecast the cashflows; We must also be able to specify The firm s target return (hurdle rate) for this type of project or investment

13 A very simple example An asset offered at a price of 10,000,000 We expect 1,000,000 for the next five years We will sell it for 10,000,000 in five years time. Our target rate of return is 10% What is the NPV? What is the GPV? What is the IRR? You should be able to guess!

14 Capital Year Income Out/In Cash flow PV factor PV 0 10,000,000 10,000, ,000, ,000,000 1,000, , ,000,000 1,000, , ,000,000 1,000, , ,000,000 1,000, , ,000,000 10,000,000 11,000, ,830,135 NPV 0 GPV 10,000,000 IRR 10.00%

15 INVESTMENT APPRAISAL WORKED EXAMPLES: PROJECTS S & B Consider two simplified projects: Year Project S ( m) Project B (3m) Both last exactly three years, have an initial investment in year zero (today) and generate income at the end of years 1 to 3 The cashflows in each year are net cashflows, that is income less any costs In property a net cash flow is sometimes called the net operating income

16 INVESTMENT APPRAISAL WORKED EXAMPLES NPV S Work out NPV of Project S, using a discount rate of 10% (we re using big rates for illustration here ) Cashflow t i Discounted cashflow This is a POSITIVE NPV: at this discount rate, the project is feasible. What if we used 20%? t Cashflow Discounted i cashflow Now the NPV is NEGATIVE so the project is NOT feasible, we should not go ahead.

17 INVESTMENT APPRAISAL WORKED EXAMPLES NPV B We can do exactly the same analysis for Project B: Year Cashflow 10% 20% Again, the project is feasible at 10% but not at 20%. The decision, then, rests on the choice of discount rate This will reflect, as always, anticipated inflation, time preference, risk, alternative opportunities and the cost of borrowing.

18 INVESTMENT APPRAISAL WORKED EXAMPLES IRR S The IRR generates an NPV = 0: it must lie somewhere between 10% and 20%. Assume a straight line rel. between NPV & i% (n.b. it isn t a straight line, it s just a convenience) % IRR 20% We can use this to give us a first estimate of the IRR

19 INVESTMENT APPRAISAL WORKED EXAMPLES IRR S The slope of the line is = or 2.89 That is, a 1% increase in i% leads to a 2.89 fall in NPV Now, at 20%, the NPV is We want NPV = 0 So, we must ADD 5.33 to the NPV. Divide by the Slope: / = We must reduce i% by 1.84% 20% % = 18.16% is our first estimate of the IRR If we d worked from 10%, we have NPV = Must reduce it by for an NPV of zero; Divide by slope: / = % % = 18.15% (difference = rounding error)

20 INVESTMENT APPRAISAL WORKED EXAMPLES IRR S Now NB that 18.15% is just our FIRST estimate We assumed a straight line an oversimplification We must CHECK our estimate by calculating NPV let s try 18% Year Cashflow That s close enough to zero, call IRR S 18% t i DCF

21 INVESTMENT APPRAISAL WORKED EXAMPLES IRR B We ll do exactly the same with Project B % IRR 20% Working from 10%, NPV = , must fall the slope of this line is = 42.7/10 = -4.27%. Divide by slope / = +6.4% 10% + 6.4% = 16.4% = our first estimate of IRR

22 INVESTMENT APPRAISAL WORKED EXAMPLES IRR B With a first estimate of 16.4%, we might check 16% and 16.5% Year Cashflow 16% 16.5% That s nearer to 16% so we ll use that as our estimate of the IRR In both cases, should really check on computer IRR s = %, IRR b = %

23 IRR/NPV DECISION RULES Net Present Value Decision rule - project/investment accepted if NPV zero or above : requires the selection of a target rate of return. Internal Rate of Return Decision rule - investment is accepted if the investment s IRR is equal to or greater than some pre-determined target rate

24 Decision rules GPV > Offer price Buy GPV = Asset valuation Hold GPV < Asset valuation Sell IRR > TRR Buy IRR < TRR Sell NPV/IRR debate

25 USE OF IRR/NPV NPV is preferred in finance literature to IRR. (see Lumby, 1991) Predictably, IRR used in real estate practice more than NPV. The greater the discount rate the greater the weight placed upon early rather than later cash flows Multiple (unreal) IRR (+ve and ve)