MASTER S THESIS. Online System for Real Estate Investment Analysis CZECH TECHNICAL UNIVERSITY IN PRAGUE. Faculty of Electrical Engineering.

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1 CZECH TECHNICAL UNIVERSITY IN PRAGUE Faculty of Electrical Engineering Department of Economics, Management and Humanities MASTER S THESIS Online System for Real Estate Investment Analysis Jan Kincl Supervisor: prof. Ing. Oldřich Starý, CSc. Branch of study: Economics and Management in Electrical Engineering May 2010

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3 Acknowledgements I would like to thank to prof. Ing. Oldřich Starý, CSc., my supervisor for his time and guidance during my work on this thesis.

4 I hereby declare, that I have worked on this master s thesis by myself and that I have used only the sources, which are cited and listed in the bibliography Prague May 18,

5 Abstract This thesis deals with the theoretical analysis of profitability measurements of a Real Estate investment and also applies these measurements in a real online application. The analytic part of this thesis describes the general definitions of Real Estate investments; the various profitability and financial calculations; and comparison with alternative investments. The application development consists of design, implementation, testing and deployment. The application serves as a tool for investors to analyze and compare various investment properties. Keywords Real Estate investment analysis, Real Estate calculations, Real Estate analysis software Abstrakt Tato práce se zabývá teoretickou analýzou výpočtů návratností investice do nemovitosti a také aplikuje tyto výpočty v reálné online aplikaci. Analytická část této práce popisuje obecné definice investic do nemovitostí, různé finanční výpočty návratností a porovnání s alternativními investicemi. Vývoj aplikace obsahuje návrh, implementaci, testování a nasazení. Aplikace slouží jako nástroj pro investory na analýzu a porovnávání různých investičních nemovitostí. Klíčová slova Investice do nemovitostí, výpočty investice do nemovitostí, software pro analýzu investice do nemovitostí

6 Contents Contents 1. INTRODUCTION DEFINITION OF REAL ESTATE INVESTMENT ANALYSIS DEFINITION OF REAL ESTATE TYPES OF REAL ESTATE OPTIMAL HOLDING PERIOD FOR REAL ESTATE INVESTMENT MORTGAGE AND ITS CONSEQUENCES ON REAL ESTATE INVESTMENT Types of mortgages Consequences of mortgage on Real Estate investment TAXES, DEDUCTIONS AND OPTIMAL OWNERSHIP STRATEGY DIVERSIFICATION CALCULATIONS OF THE ECONOMICAL EFFECTIVENESS DEFINITION OF INPUT PARAMETERS Gross Scheduled Income Vacancy Rate Operating Expenses Loan to Value Ratio CALCULATIONS OF THE OPERATION EFFECTIVENESS Vacancy and Credit Loss Gross Operating Income (GOI) Net Operating Income (NOI) Taxable Income Cash Flow Operating Expense Ratio Break-Even Ratio (BER) CALCULATIONS OF THE FINANCIAL EFFECTIVENESS Net Present Value (NPV) Profitability Index Internal Rate of Return (IRR) Debt Coverage Ratio (DCR) House P/E Ratio... 24

7 Contents Depreciation INVESTMENT RETURN CALCULATIONS Capitalization Rate Cash on Cash Return Return on Equity (ROE) Gross Rent Multiplier Gross Rental Yield Return on Investment RECOMMENDATION CALCULATIONS Optimal Holding period Sell vs. Rent out Indicator Optimal Leverage Desired Rent MARKET INDICATORS Price to Income Ratio Housing Debt to Income Ratio Price to Rent Ratio Vacancy Rate COMPARISON OF ALTERNATIVE INVESTMENTS INVESTMENT IN REAL ESTATE INVESTMENTS IN STOCKS INVESTMENT IN PRECIOUS METALS (GOLD) INVESTMENT IN SAVINGS ACCOUNTS NET PRESENT VALUE OF VARIOUS INVESTMENTS ANALYSIS AND DESIGN DETAILED SPECIFICATIONS OF THE APPLICATION ACCEPTANCE TESTS User module Administrator module ARCHITECTURE OF THE APPLICATION Model View Controller Modules of the application... 42

8 Contents 5.4 ANALYSIS OF THE USER MODULE Use case diagram Class design Design of the user interface ANALYSIS OF THE ADMINISTRATOR MODULE Use Case Diagram Class Design Design of the user interface DATABASE DESIGN IMPLEMENTATION TECHNOLOGIES USED IN THE DEVELOPMENT PHP MySQL Apache Wampserver Smarty JavaScript Asynchronous JavaScript and XML (AJAX) JavaScript Object Notation (JSON) jquery LiveValidation Google maps API Open Flash Chart dompdf Swift Mailer DEVELOPMENT ENVIRONMENT GRAPHIC DESIGN USER MANUALS TESTING FUNCTIONAL TESTING USER TESTING PERFORMANCE TESTING... 62

9 Contents 7.4 ACCEPTANCE TESTING DEPLOYMENT COMPETITORS ANALYSIS KEYWORD RESEARCH SEARCH ENGINE OPTIMIZATION CONCLUSIONS GOAL OF THE PROJECT DESCRIPTION OF THE PROJECT DEVELOPMENT EVALUATION OF THE PROJECT, FUTURE DEVELOPMENT BIBLIOGRAPHY APPENDIX A GRAPHICAL USER INTERFACE USER MODULE ADMINISTRATOR MODULE APPENDIX B USER REVIEW APPENDIX C USER MANUALS USER MODULE USER MANUAL ADMINISTRATOR MODULE USER MANUAL APPENDIX D PDF PROPERTY REPORT APPENDIX E CONTENTS OF THE ATTACHED CD... 89

10 List of images List of images Image 1. Chart: Price indicies in the Czech Republic Image 2. Chart: Price to income ratio in the Czech Republic Image 3. Chart: Dow Jones Industrial Average Image 4. Chart: Gold Prices Image 5. Scheme of Model View Controller Image 6. Scheme of adjusted Model View Controller Image 7. State diagram of the user module Image 6. Use case diagram: User module Image 9. Use case diagram: Administrator module Image 10. Database model... 53

11 List of tables List of tables Table 1. Average house price growth, Table 2. Capitalization rates for various types of properties in the Czech Republic Table 3. Price to Rent ratio in some referal countries Table 4. Classes of the user module Table 5. MVC in the user module Table 6. Classes of the administrator module Table 7. MVC in the administrator module Table 8. Relevant keywords and its data Table 9. SEO Competition analysis of Real Estate calculator keyword Table 10. SEO Competition analysis of Real Estate analysis keyword... 65

12 Introduction 1. Introduction There are many tools for different types of Real Estate analyses and calculations on the internet nowadays. However most of them are not using sophisticated financial indicators and usually stay only with the simplest ones. Even though Real Estate investment is a very specific type of investment (especially when comparing with securities), there are some standard indicators which can be used in its analysis. The main goal of this thesis is to cover in research all relevant indicators for Real Estate investment analysis and then produce an online application which will calculate values of these indicators for specific cases. This application will be designed using the latest software engineering methods and implemented with modern tools and libraries, which will make the application highly user friendly. The application will contain user and administrator interface. Users will be able to save, analyze and compare multiple properties and download PDF reports. More detailed specifications are included in the chapter Analysis and Design

13 Definition of Real Estate Investment Analysis 2. Definition of Real Estate Investment Analysis 2.1 Definition of Real Estate Real Estate is an English legal term which defines Land and anything fixed or permanently attached to it. This usually includes buildings, but also fences, roads, sewers etc. The title to Real Estate usually includes also air and mineral rights, which can be then sold together with the original Real Estate property or separately. [1] From an etymological point of view, Real refers to Royal (Royal in Spanish means Real in English). Royal family always owned the land in Spain and peasants only paid rent or taxes to use the Royal land. Even though Real Estate Property has many specifics, it is still a form of goods, which is traded on the market. In the following paragraphs are described some of the specifics involved. Real Estate is a complex type of goods. Each piece of Real Estate (property) is different from the others. The main characteristics are usually: size (square footage), number and sizes of rooms, year when built, etc. Then there are many characteristics which are connected with the area of the property such as quality of the neighborhood, criminality rates, schools, etc. Even two identical apartments in one building will have at least different views from the windows making their prices differentiated. Most of the Real Estate is usually represented by houses, flats or condominiums, which are always fixed to a specific location. This is the second specific of Real Estate. Real Estate cannot usually be moved and therefore location is dominantly the most important factor affecting the price of the property. It is obvious that the value of land differs according to the distance of the center of employment. Land further away from this center, has to accommodate future costs of daily commuting to work, and therefore the price of this land and property standing on it will be lower. Example of this can be suburbs of the cities in contrast with locations near the centers. Real Estate is a form of goods of a long term use. Ordinary people buying a piece of Real Estate are counting on the possible resale in many years to come. Even a Real Estate investor does not buy and sell a property within a couple of hours, which can be easily done with stocks for example

14 Definition of Real Estate Investment Analysis Real Estate is not only a type of goods for a long term use, but also a specific type of investment. In comparison with other goods, i.e. a car, value of Real Estate usually grows in time. Purchase or building of a new Real Estate property is accompanied with high transaction costs. These costs include fees to Real Estate agents, moving costs, Real Estate taxes or fees paid to banks on mortgage. Another specific of the Real Estate market is the influence of local community and government. Local neighborhood and its quality can change the value of each property in it rapidly. These all specifics and the complexity of Real Estate make it very difficult to estimate a market value of a property. Luckily even in this specific market there exist the laws of supply and demand which make it possible to estimate the value of a property. [3] 2.2 Types of Real Estate There are many types of Real Estate. Mainly people divide Real Estate into commercial and residential. Commercial Real Estate includes office buildings, shops, factory halls, hotels, farm land etc. In some cases multi-family apartments are considered as commercial Real Estate as well. Residential Real Estate includes apartments, condominiums, houses (multi-family or single-family, townhouses). We will be focusing only on a residential Real Estate, in this thesis. The main reason is that we are trying to look at Real Estate from a small investor s point of view and not as a huge corporation. We are trying to show the possibilities of investing in Real Estate in comparison with investing in securities (such as stocks or bonds), which are also accessible for a small investor. However most of the calculations and indicators described and used in this thesis could be used in commercial Real Estate as well

15 Definition of Real Estate Investment Analysis 2.3 Optimal holding period for Real Estate investment In this thesis we are focusing on long term holding investment strategies. We are not speculating on enormous appreciation of the properties, rather we will count on positive cash flow from the rent incomes and reasonable rate of appreciation (i.e. 5%), even though the long term appreciation was even higher in the past. In the table below, you can see the rate of price growth in OECD countries between the years 1970 and The average annual nominal price growth (appreciation) for all the countries is 7.6%. Country Average annual nominal house price growth (%) Australia Belgium Canada Denmark Finland France Germany Ireland Italy Japan The Netherlands New Zealand Norway Spain Sweden Switzerland United Kingdom United States Source: Bank for International Settlements (using national data) Table 1. Average house price growth, Average annual real house price growth (%) Unfortunately there does not exist a real property price index in the Czech Republic, and there are just some local measurements by Real Estate agencies, which are not very exact. Also the free market in the Czech Republic does not exist for long enough to determine the long term appreciation. At least the short term (5 year) development of Real Estate prices can be seen on the chart below

16 Definition of Real Estate Investment Analysis Source: Image 1. Chart: Price indicies in the Czech Republic The growth of the real estate prices is not usually steady, but instead it is changing in cycles. The full cycle can take a various number of years in each country. The period can even last ten years in some countries (Switzerland, Finland) and just four-years in other ones (Great Britain). Even though we will be counting on long term investing in this thesis, we will calculate the optimal holding periods using different approaches mainly depending on the type of mortgage used for the investment and calculated Net Present Value. [3] 2.4 Mortgage and its consequences on Real Estate investment Mortgage is defined as a transfer of an interest in a property to a lender as a security for a debt. This means that mortgage itself isn t a debt, but it is lender s security for a debt. If the borrower satisfies the conditions of the mortgage, the interest in land is transferred back. [2] There are many types of mortgages and there are also some important consequences of using mortgage in Real Estate investments. These are discussed in the following chapters

17 Definition of Real Estate Investment Analysis Types of mortgages The two most commonly used types of mortgages are fixed rate mortgage (FRM) and adjustable rate mortgage (ARM). While with fixed rate mortgage, the investor can count on the same interest rate through the whole period of the loan, the interest rate of the adjustable rate mortgage is going to change / adjust in time. In this thesis, we will be working mainly with the fixed rate mortgage. It s also recommended for investors to use this type of mortgage. Even though the interest rate is usually higher than with ARM, it is important to have the security that interest rates will not skyrocket and ruin the entire investment. This development of interest rates is impossible to estimate in the long term. Hopefully people realize this better now, after the major problems with mortgage defaults and foreclosures in the USA Consequences of mortgage on Real Estate investment Using mortgage is always highly recommended to Real Estate investors. The main reasons are leverage and tax purposes. Utilizing more debt decreases required equity needed for the investment and it increases the tax shelter. Both of these consequences are well contributing to the net present value of the investment. In other words, to increase NPV and Return on Investment, it is, in most of the cases, better to borrow as much as possible. On the other hand with higher loan-to-value ratio, the interest rate increases as well. In this thesis we will work with different loan-to-value ratios, to evaluate the optimal leverage strategy. 2.5 Taxes, Deductions and optimal ownership strategy In this thesis we will be mainly taking in account investing in a property through a corporation, mainly for the tax purposes. However in the final online tool, there will be possibilities of setting up different tax rates or even flat-rate expenses for taxation. In each country there are different types of corporations, but usually the most suitable for Real Estate business seems to be the Limited Liability Company (s.r.o. in the Czech Republic or GmBH in Germany)

18 Definition of Real Estate Investment Analysis Ownership of the investment property directly in person has some disadvantages. The tax laws are less favorable, the person cannot deduct many of the expenses which can be deducted in LLC and also the person would be 100% liable in a case of either financial problems or lawsuit involving the investment property. On the other hand in some countries there are some more favorable conditions on the resale of the property, especially when the person is living in the property for a certain amount of time. In the Czech Republic this person does not have to pay taxes on the capital gains, if living in the property for more than 2 years. Otherwise there is up to 32% in taxes from the capital gains to pay. In the USA or Great Britain the government makes it easier for the investors who resell the property even within a few months after the purchase, by taxiing that much from their capital gains. [3] 2.6 Diversification Similar to investments in stocks, it is always good to diversify a portfolio rather than putting all of the funds in one investment. By diversification investors can substantially lower the risk. Obviously it is much more difficult to diversify in Real Estate investments, but also while using a mortgage much higher returns can be achieved. When an investor decides to create a whole portfolio of Real Estate investments, it is important to choose properties from various market segments or even several separate markets. It can mean a combination of various types of properties (such as apartments, condominiums, houses etc.), various cities, or possibly states. There is even the option of differentiating the location by entire countries. Such a diversified portfolio will less likely suffer from local declines. [3] If an investor has the money to purchase one investment property without a mortgage, it would be smart to do a few calculations to see how the returns on investment would grow when using a mortgage. The returns can be several times higher and an investor can diversify better his portfolio. On the other hand the use of leverage can be risky in some cases as well. In the final online application, we will demonstrate these options to a user, in a form of sensitivity analysis of the loan-to-value ratio

19 Calculations of the economical effectiveness 3. Calculations of the economical effectiveness The calculations in this thesis are divided into five groups: Calculations of the operation effectiveness, Calculations of the financial effectiveness, Investment return calculations, Other calculations and Market indicators. 3.1 Definition of input parameters There are a few parameters, which has to be defined first, because of their use in calculations of various financial measures Gross Scheduled Income Gross scheduled income (GSI) represents the total of monthly rents for the particular property. The final amount includes not only the rents collected in reality, but also the potential rents from vacant units and uncollectable rents. [2] Vacancy Rate Vacancy rate is the ratio of the number of current occupied units compared with the total of units in a development, usually expressed as a percentage. [1] If the calculations are done on a single property, vacancy rate can also be understood as a percentage of the time the property will be vacant per year, while trying to be rented out. Usually this amount has to be estimated for the calculations and depends mainly on the current rental market and the type of property. Often the vacancy rate can be estimated between 3 15%. Zero vacancy rate is not probable and if it occurs in reality, most probably the units are rented for less than a current market rent Operating Expenses Operating expenses in Real Estate investment are all the expenses associated with operation and maintenance of a particular income producing property. They include items such as property insurance and taxes, repairs, utilities, management fees, accounting fees,

20 Calculations of the economical effectiveness attorney fees and advertising. Mortgage payments or capital improvements are not considered as operating expenses. [2] Loan to Value Ratio Loan to Value (LTV) ratio is the amount of the loan as it relates to the market value of the property which secures the loan. Banks are usually doing their own appraisals to define the market value of the property. It s expressed as a percentage. The majority of investors are trying to achieve high LTV to gain leverage on their invested money. Lenders have set requirements for LTV depending on various criteria. The LTV can be limited more for investment properties than for owner occupied ones. 3.2 Calculations of the operation effectiveness Vacancy and Credit Loss Vacancy and credit loss represents the part of the potential rental income that is lost because of unoccupied units or uncollectable rent from tenants. It is usually estimated as a percentage of gross scheduled income. VVVVVVVVVVVVVV aaaaaa CCCCCCCCCCCC LLLLLLLL = GGGGGGGGGG ssssheeeeeeeeeeee iiiiiiiiiiii eeeeeeeeeeeeeeeeee % VVVVVVVVVVVVVV aaaaaa CCCCCCCCCCCC LLLLLLLL Gross Operating Income (GOI) The gross operating income equals the property s annual gross scheduled income, less vacancy and credit loss (uncollectable rent). It is the actual income which is expected to be collected in the investment property. GGGGGG = GGGGGGGGGG ssssheeeeeeeeeeee iiiiiiiiiiii (1 eeeeeeiiiiiiiiiiii % VVVVVVVVVVVVVV aaaaaa CCCCCCCCCCCC LLLLLLLL) Net Operating Income (NOI) Net operating income is one of the most important measures of property s profitability. The NOI is simply the gross operating income minus operating expenses. Something of

21 Calculations of the economical effectiveness importance to realize is that mortgage payments and depreciation are not operating expenses. Operating expenses are expenses necessary for maintaining the property and ensuring its continued ability to produce income. NNNNNN = GGGGGGGGGG OOOOOOOOOOOOiiiiii IIIIIIIIIIII OOOOOOOOOOOOOOOOOO EEEEEEEEEEEEEEEE Taxable Income Taxable income is the amount on which the taxes have to be paid. It is different from the net operating income, because there are certain tax laws that dictate which expenses are deductible. It is not possible to deduct the whole mortgage payment, but it is generally possible to deduct the entire interest portion. Depreciation is also deductable. It is not possible to use the whole purchase price for tax deductions, because only the portion representing the buildings (not the land) can be deducted according to the tax code. TTTTTTTTTTTTTT IIIIIIIIIIII = NNNNNN MMMMMMMMMMMMMMMM IIIIIIIIIIIIIIII DDDDDDDDDDDDDDDDDDDDDDDD Cash Flow Cash flow simply represents all the inflows and outflows of cash for a certain property. Next to appreciation and tax shelter, it is one of the most important Real Estate investment returns. Cash flow is not affected by a depreciation deduction since it is not a cash item. However it is affected not only by the interest portion but by the entire amount of the mortgage payment. All the capital additions or improvements paid during the year have to be subtracted from the total incomes and therefore lower the Cash Flow. It is possible to calculate cash flow before taxes (CFBT), which is used more often or cash flow after taxes (CFAT) which is CFBT minus any tax liability arising from the operation of the property. CCCCCCCC = NNNNNN CCCCCCCCCCCCCC AAAAAAAAAAAAAAAAAA DDDDDDDD SSSSSSSSSSSSSS CCCCCCCC = CCCCCCCC IIIIIIIIIIII TTTTTT LLLLLLLLLLLLLLLLLL

22 Calculations of the economical effectiveness Operating Expense Ratio Operating expense ratio is the ratio of operating expenses to the gross operating income (GOI). It is advisable to count this ratio not only on the total of operating expenses, but separately on each one. This way any nonstandard expense can be identified, when comparing similar investment properties. [2] OOOOOOOOOOOOOOOOOO EEEEEEEEEEEEEE RRRRRRRRRR = OOOOOOOOOOOOOOOOOO EEEEEEEEEEEEEE GGGGGGGGGG OOOOOOOOOOOOOOOOOO IIIIIIIIIIII Break-Even Ratio (BER) Break-even ratio is another benchmark used by mortgage lenders. It estimates how vulnerable is a certain property to defaulting on its mortgage if part of the rental income is declined. Most of the lenders are looking for BER of 85% or less. BBBBBBBBBB EEEEEEEE RRRRRRRRRR = DDDDDDDD SSSSSSSSSSSSSS + OOOOOOOOOOOOOOOOOO EEEEEEEEEEEEEEEE GGGGGGGGGG OOOOOOOOOOOOOOOOOO IIIIIIIIIIII 3.3 Calculations of the financial effectiveness Net Present Value (NPV) Net Present Value is probably the best measure of any investment thanks to its complexity. It takes into account all the future cash flows including the selling price, and it converts all these amounts to their present values using discount rate required by the investor. In contrast with most of the measurements, NPV counts fully with the time value of money. NPV is calculated as a total of all future cash flows discounted to their present values using appropriate discount rate, minus initial investment (CF 0 ). Discount rate (i) is a rate of return that could investor earn on alternative investment with a similar risk (i.e. on financial markets). TT NNNNNN = CCCC tt (1 + ii) tt CCCC 0 tt=1-22 -

23 Calculations of the economical effectiveness Zero NPV indicates that the investor is earning exactly the discount rate. Negative NPV means that an alternative investment with the same rate of return as the discount rate would be a better investment. On the other hand positive NPV tells the investor how much he could have paid more to still achieve the requested yield (discount rate) and negative NPV tells how much less he should pay to achieve the same. [5] Profitability Index Profitability index (profit index) is very similar to NPV. It also calculates with the present values of future cash flows and discount rate, therefore it takes in account the time value of money. Profitability index is a ratio which shows if the present value of the cash flows is worth the initial investment. If these values equal (NPV = 0) profitability index will be 1.0. The advantage of using this ratio when comparing different investments is the fact that it tells the proportion of money returned to money invested, rather than the amount as NPV does. This way you can easily compare two investments opportunities which require different initial investments. [2] PPPPPPPPPPPPPPPPPPPPPPPPPP IIIIIIIIII = PPPP oooo FFFFFFFFFFFF CCCCCCh FFFFFFFFFF TTTTTTTTTT IIIIIIIIIIIIII IIIIIIIIIIIIIIIIIIII Internal Rate of Return (IRR) Internal Rate of Return (annualized yield rate) is a rate which an investment will return over the estimated period of ownership. It is in fact the discount rate that produces NPV of zero and profitability index of 1.0. There are a few setbacks when using IRR, such as dual IRR in certain cases or problems with negative cash flows in the future. [1] There is no simple equation for calculating IRR, however when using some programming language for the calculation, the method of interval halving can be used Debt Coverage Ratio (DCR) Debt coverage ratio is the ratio between the annual net operating income (NOI) and annual debt service (ADS) of the particular property. ADS is the total of 12 monthly mortgage payments. If NOI and ADS are the same amounts, DCR equals 1.0. This however would not

24 Calculations of the economical effectiveness be enough for a mortgage lender, who always requires some margin of safety and therefore DCR must always be higher than 1.0 (usually at least 1.20). [2] DDDDDDDD CCCCCCCCCCCCCCCC RRRRRRRRRR = NNNNNN AAAAAAAAAAAA DDDDDDDD SSSSSSSSSSSSSS House P/E Ratio P/E (Price to Earnings) ratio is often used when measuring other investment tools, such as stocks. The Real Estate P/E ratio counts with the initial investment and annual net operating income. It gives an investor a good comparison of possible use for his money in other investments, especially on the stock market. [6] HHHHHHHHHH PP/EE RRRRRRRRRR = TTTTTTTTTT IIIIIIIIIIIIII IIIIIIIIIIIIIIIIIIII NNNNNN Depreciation Depreciation (or sometimes called cost recovery) is the amount of the tax deductions that an investor can take each year from the depreciable asset, until this asset is fully written off. In Real Estate only the building part (not the land underneath it) can be counted for depreciation. The property can be depreciated over its useful life. The useful life is specified by the tax laws and usually is not the same as the expected actual physical life of the property. According to the current tax laws, residential properties are depreciated over 27.5 years in the USA and 30 years in the Czech Republic and nonresidential (commercial) over 39 years in the USA and 50 years in the Czech Republic. Closing costs and capital improvements are both depreciable in a similar way. [2] DDDDDDDDDDDDDDDDDDDDDDDD (aaaaaaaaaaaa) = DDDDDDDDDDDDDDDDDDDDDD BBBBBBBBBB UUUUUUUUUUUU LLLLLLLL

25 Calculations of the economical effectiveness 3.4 Investment return calculations Capitalization Rate Capitalization rate (cap rate) is in fact the discount rate, used for discounting the future income to determine its present value. There are two main purposes for which cap rate can be calculated and used. We can calculate property s cap rate and then compare it with other similar properties in a certain area. Capitalization rate is calculated as ratio of the net operating income and the value of the property and NOI has to be constant in time for this calculation. CCCCCC RRRRRRRR = NNNNNN VVVVVVVVVV In another case, when the cap rate of similar properties in a certain area is a known parameter, we can reasonably estimate the property value based on this cap rate. Again NOI has to be constant in time. EEEEEEEEEEEEEEeeee VVVVVVVVVV = NNNNNN CCCCCC RRRRRRRR This value estimation based on cap rate is quite widely used. However there are a few important setbacks which have to be known to each investor, before using this ratio. First, it is important to find very accurate information about cap rates in the local market area. For the USA market realtyrates.com can be used as a valuable source for this type of data. Other factors have to be considered as well, such as changes occuring to the local area and the fact that this calculation does not reflect adjustments in value for necessary capital improvements or expected vacancy losses. [4][1] Capitalization rate in the Czech Republic is not calculated separately for various locations, as it would be more relevant, instead there is a law dictating certain capitalization rate for the whole country (Zákon č. 151/1997 Sb, Vyhláška č. 3/2008 Sb). The only distinction in capitalization rates is the type of use of the Real Estate property. The rental investment property has a capitalization rate of 5% according to the table below, which is an attachment of that law (Příloha č. 16). [16]

26 Calculations of the economical effectiveness Source: Table 2. Capitalization rates for various types of properties in the Czech Republic Cash on Cash Return Cash on cash return is in fact equity dividend rate. It is a ratio between annual cash flow before taxes and the total initial investment, expressed as a percentage. It is not an exact measurement of an investment, because it does not take in account the future value of money. However if it is used with the expected cash flow of the first year of ownership, it can at least give a first idea about the investment and an easy comparison to other types of investments, but definitely it should not be the main comparison measurement, as it is presented in many popular investment publications. [2] CCCCCCh oooo CCCCCCh RRRRRRRRRRRR = CCCCCCCC TTTTTTTTTT IIIIIIIIIIIIII IIIIIIIIIIIIIIIIIIII Return on Equity (ROE) Return on equity is one of the financial measures used as well on other types of investments. In Real Estate the return on equity means a ratio between cash flow after taxes (CFAT) and the initial investment. ROE is calculated for the first year typically and is expressed as a percentage. It is advisable to calculate this measurement for other years as well, and in case of its increasing decline over the time, resale of the property can be evaluated. CCCCCCh FFFFFFFF aaaaaaaaaa TTTTTTTTTT RRRRRRRRRRRR oooo EEEEEEEEEEEE = TTTTTTTTTT IIIIIIIIIIIIII IIIIIIIIIIIIIIIIIIII

27 Calculations of the economical effectiveness Gross Rent Multiplier Gross rent multiplier is usually used for estimating the market value of the investment property. It is used when comparing properties in a similar area and of a similar type. It is assuming that when somebody has recently paid for example 8 times the gross scheduled income as a price for certain property, then the market value of a similar property, the investor is considering, should also be 8 times its gross scheduled income. This method is not very accurate, nor takes in count time value of money. It is advised to use it only as a simple benchmark, possible when comparing multiple properties between each other. [2] GGGGGGGGGG RRRRRRRR MMMMMMMMMMMMMMMMMMMM = MMMMMMMMMMMM VVVVVVVVVV GGGGGGGGGG SSSSheeeeeeeeeeee IIIIIIIIIIII Gross Rental Yield Gross rental yield is one of the simpler calculations and can be used for a particular property or also as a market indicator when using median values of rent and house prices. It is counted from gross scheduled rent and initial investment which includes purchase price of the property and closing fees. GGGGGGGGGG RRRRRRRRRRRR YYYYYYYYYY = GGGGGGGGGG SSSSheeeeeeeeeeee RRRRRRRR IInnnnnnnnnnnn IIIIIIIIIIIIIIIIIIII Return on Investment Return on investment is one of the very popular measurements, because it usually presents very high percentages. However it does not take in account time value of money, and it does take in count some assumptions such as appreciation. RRRRRRRRRRRR oooo IIIIIIIIIIIIIIIIIIII = CCCCCCh FFFFFFFF BBBBBBBBBBBB TTTTTTTTTT + AAAAAAAAAAAAAAAAAAAAAAAA IIIIIIIIIIIIII IIIIIIIIIIIIIIIIIIII

28 Calculations of the economical effectiveness 3.5 Recommendation calculations Optimal Holding period Economically the most accurate method of calculating optimal holding period is based on net present value. We can calculate NPV of the investment, when it would be hypothetically sold in each year starting from year 1 going till, for example, year 30. Then the highest NPV is chosen from these 30 values and the according year will be the optimal holding period. Since it is calculated from NPV, it takes in account the time value of money and is counted with Cash Flow after taxes. Sometimes the optimal holding period is shorter than the length of the mortgage and the reason is the shortening tax shelter, due to a smaller interest part of the mortgage payments every year. In the first years of mortgage, most of the mortgage payment is an interest payment with small principal payment and since the interest part is tax deductible, it creates higher tax shelter. Another method for estimating a holding period is using return on equity calculated for every year. When the return on equity starts to decline, it can be a good point for resale. This method is simpler; however it does not count with the time value of money and depends significantly on the estimated appreciation. Therefore it is not very exact. Both of these methods use estimation for future market conditions and therefore might not work correctly if the market is unpredictably changing in certain times. Therefore they should not be used as the only decision for selling a property, more as supportive information Sell vs. Rent out Indicator This indicator is especially valuable for investors who already bought an investment property in the past and now are thinking about selling. It takes in account the use of mortgage and lowering tax shield with the life of the mortgage, when the interest portion of mortgage payments is getting lower. This indicator compares NPV s of the selling decision with the cash flows from renting and the result is either recommendation to sell or to rent out the investment property. [7] Optimal Leverage Optimal leverage is calculated as a sensitivity analysis of net present value with various loan-to-value percentages for a certain property. It can give the investor another point of view

29 Calculations of the economical effectiveness and consideration of changing the investment strategy. However even though higher leverage creates usually higher NPV, it also comes with higher risk Desired Rent Desired rent can be calculated when other parameters are known, such as NPV or IRR. It can be valuable for investors who have some specific idea of IRR or NPV they want to achieve. In this case we will use reverse calculations for NPV or IRR, when the desired rent is a part of the cash flow. 3.6 Market Indicators Especially the recent development on Real Estate market in the USA showed the importance of Real Estate market analysis, even for small investors. There is a number of housing market indicators and ratios, which can identify whether properties in a certain local market are fairly priced. By comparing current values of these indicators with the past sustainable values, it is possible to identify a rising Real Estate bubble. Market bubbles periodically occur in local and global markets. They are recognized by huge increases in valuations of properties until the prices reach unsustainable levels and the bubble bursts. To identify the unsustainable level of prices, they are compared to median family incomes and other economic indicators Price to Income Ratio The price of Real Estate properties is a result of local demand and supply on the Real Estate market. It was proven that in a long term the demand is mainly influenced by the familial disposable income and therefore there is a close connection between the median familial disposable income and median house prices. PPPPPPPPPP tttt IIIIIIIIIIII RRRRRRRRRR = MMMMMMMMMMMM HHHHHHHHHH PPPPPPPPPP FFFFFFFFFFFFFFFF DDDDDDDDDDDDDDDDDDDD IIIIIIIIIIII This indicator says how many annual median incomes would have to be spent for a purchase of an average house. When having enough of past data, we can estimate if the

30 Calculations of the economical effectiveness current ratio is above the average or below it. If it is above the long term average, it is highly probable that the house prices will fall and vice versa. Many analytics say that the elasticity of house prices to median familial income is close to 1 in a long term. That means that the prices in a long term are rising the same way as the familial income. The ratio has different long term values in different local markets, for example 2.5 (USA), 3 (United Kingdom) or 2.8 (Spain). In the Czech Republic this ratio has been calculated for a very short period of time and therefore it cannot be exact enough, but for example in 2002 the ratio was 2.74 as a weighted average of all the regions in the Czech Republic. However Prague itself had the price to income ratio of [3] On the chart below is displayed the not weighted price to income ratio in the Czech Republic for the years Source: ČSÚ,vlastní výpočty Martina Luxe Image 2. Chart: Price to income ratio in the Czech Republic Housing Debt to Income Ratio Housing debt to income ratio is another indicator which helps to identify the Real Estate bubble. It is a ratio of annual debt service (ADS) and familial disposable income. If its value gets too high, the families become too dependent on rising property value of their house to service their mortgage. If then housing prices stop increasing, many families have to default on their mortgages and this would most probably start the burst of the Real Estate bubble

31 Calculations of the economical effectiveness HHHHHHHHHHHHHH DDDDDDDD tttt IIIIIIIIIIII RRRRRRRRRR = AAAAAAAAAAAA DDDDDDDD SSSSSSSSSSSSSS FFFFFFFFFFFFFFFF DDDDDDDDDDDDDDDDDDDD IIIIIIIIIIII Price to Rent Ratio Price to rent ratio (P/R) is a great and simple calculation showing the attractiveness of a certain Real Estate market or area. It compares median house price and median rent in that market. This ratio actually says how many annual rents would have to be spent for buying an average house. Some markets with very high ratio (i.e. California P/R is 25) do not show such a good opportunity for an investment, because the return on investment would be most probably low. This ratio can help an investor to decide which market to invest in. PPPPPPPPPP tttt RRRRRRRR RRRRRRRRRR = MMMMMMMMMMMM HHHHHHHHHH PPPPPPPPPP MMMMMMMMMMMM AAAAAAAAAAAA RRRRRRRR Below is a table of calculated price to rent ratios for some referral markets. Country P/R ratio Ukraine 11.0 Hungary 12.3 Netherlands 15.1 Poland 17.2 Germany 19.5 Italy 19.8 Slovak Republic 21.3 Canada 22.0 Finland 22.6 Austria 22.7 Bulgaria 24.0 Switzerland 24.3 Czech Republic 25.7 France 26.0 Spain 26.3 USA 27.0 Portugal 27.6 United Kingdom 28.7 Russia 29.0 Greece 40.3 Monaco 67.6 Source: Table 3. Price to Rent ratio in some referral countries

32 Calculations of the economical effectiveness The P/R ratio for the Czech Republic of 25.7 means, that it would take 25.7 years of median rents to buy median house in the Czech Republic Vacancy Rate Vacancy rate is a good market indicator for investors as well, because it shows possible problems in a certain rental market. Investment in such a market is much more risky and an investor should use at least the same vacancy rate in the property s calculations as the rate the market shows

33 Comparison of Alternative Investments 4. Comparison of Alternative Investments Investment in Real Estate can be very profitable, but every investor should definitely compare his investment with other investments, even of different type. This chapter will point out possibilities of comparing Real Estate with alternative investments in: stocks, commodities (gold) and savings accounts. The goal of this comparison will not be an exact and too detailed valuation of stocks or gold, but more a general comparison. Each investment has its specifics, its advantages and disadvantages, which will be discussed in each subchapter, including the advantages and disadvantages of Real Estate investment. 4.1 Investment in Real Estate Most of the specifics of Real Estate investment have been described in previous chapters; however there are certain characteristics of this investment which are important for the comparison. Real Estate investment is usually financed partially with a mortgage. This use of other people s money can make a huge difference in investment returns and is much more difficult to achieve with other types of investments. [9] Other advantages are low volatility and therefore slower changes in the market values of the properties; and tax implications. If a Real Estate property is hold for certain amount of years, there is very low tax income liability, when the property is sold. Until that moment, the investor can use depreciation and expenses tax deductions to lower his income tax liability as well. [10] The Real Estate investment is usually providing the investor with monthly positive Cash Flow and also is appreciating over time. Disadvantages of the Real Estate investment are definitely the minimum initial cost, which even with the help of mortgage are much higher than for other investments; very low liquidity, since it takes sometimes even months to sell a property; and the requirement of more complex management of the investment, either by investor himself or by a property management company

34 Comparison of Alternative Investments 4.2 Investments in stocks The characteristic advantages of investments in stocks are the very high liquidity, when stocks are nowadays bought and sold in matter of seconds over the internet; low minimum initial investment and the right of the investor for dividends during the holding period. [10] The volatility of stocks will not be considered as such a disadvantage in our case, because we will be comparing the investments only from a long term point of view. A disadvantage of the investment in stocks is the fact that the end companies and their profitability are influenced by the managers and not by the investor himself. The investor has low or almost no power over the situation of his stocks. Another disadvantage is the much more difficult use of leverage by using borrowed finances, compared to Real Estate. The chart below shows the development of the Dow Jones index in the last 20 years. Source: Yahoo Finance Image 3. Chart: Dow Jones Industrial Average Investment in precious metals (gold) Precious metals and especially gold were always used as means of exchange in the past, because of its characteristic of value holding. That is the main advantage of gold and therefore it is a great hedge against inflation. In average, investments in gold do not provide such a great return yields, but especially during hard economic times, when other investments are falling, gold does opposite. [11] When investor owns a piece of gold, for example in a form of golden coins, there is a considerable cost of security storage or insurance. In this case the liquidity is also quite low,

35 Comparison of Alternative Investments because such an investor has to find a buyer for his coins or go to an auction to sell. Investment in gold does not provide an investor with any kind of dividends or cash flow during the holding period. Another option for investing in gold is the stocks of companies in the field of precious metals. Their stocks are influenced directly by the price of the actual commodity. This way an investor gets higher liquidity and lower minimum initial costs with the same returns. However he still will not be able to influence the development of the gold prices. Those are substantially influenced by the actions of governments. [9] The chart below shows the development of the gold prices in the last 20 years. Image 4. Chart: Gold Prices Investment in savings accounts Savings accounts are the least risky, least volatile and most liquid type of investment. They are usually insured by the government and bring an annual interest to the investor. However the rates of interests are sometimes even lower than the rate of inflation and therefore the value of the money can actually lower over the time. Another disadvantage can be the penalties when certificates of deposit, a type of savings accounts, are cashed before their maturity date. [9]

36 Comparison of Alternative Investments 4.5 Net Present Value of Various Investments The most reliable way of comparing extensively different types of investments is the net present value. Net present value not only considers the time value of money, but also allows the investor to rate every investment with specific risk factor, using various discount rates. We will be considering the same holding period for all of the alternative investments, the same holding period as we would use for the Real Estate investment. The initial investment will be also used the same for all the investments. We will not consider specific tax implications, because they vary for every investment and in every country and the goal of this comparison is only a general idea of profitability of various investment possibilities. The discount rate is determined using the capital asset pricing model (CAPM). The key for the CAPM is determining the correct beta of each investment. We will be considering a risk free rate as the interest rate of the savings account in this thesis, therefore 2%. The investment in stocks will be represented by Dow Jones Industrial Average (DJIA) index. The predicted annual growth of the stock prices is estimated according to the values of past 20 years as 7%. The long term average dividend yield was set to 4.87% according to the sources. The beta of an index S&P 500 is considered as 1, and since the long term development of DJIA is very similar to S&P 500, its beta is considered as 1 for the purpose of this thesis. Therefore the discount rate is 7% - the long term return of the index. [12][13] The annual growth of the gold prices is estimated from the values of the past 20 years as 4.65%. The beta of investment in gold is considered to be 0, according to the literature. Even though it would seem probable for gold to have a negative beta, the research of McCown and Zimmerman proofed gold as a zero-beta asset. They have even verified this proposition with various methods, including CAPM, arbitrage pricing theory and testing cointegrating relation between gold prices and consumer prices. Their calculations of CAPM are using different risk-free rate than it is used in this thesis the US T-Bill. Therefore their discount rate was slightly higher than the one calculated in this thesis. With the beta equaling 0, the discount rate derived from CAPM is the risk free rate: 2% in this thesis. [14][17] The savings account interest rate is estimated from the current rates of various American banks to 2% and it is also considered as the risk free rate in our calculations. Since the beta of this type of investment is 0, the discount rate is set to 2% again. [15] These calculations of NPV will be used later in the actual application