Nonresidential Real Estate
Nonresidential Real Estate
The real estate investments considered in this section are investments in income-producing properties, such as office buildings, warehouses, and homes that are leased or rented. This type of property is nor- mally purchased by making a down payment and taking out a mortgage on the remainder of the purchase price.
Investing in income-producing property has many risks. It also yields handsome profits to those who can manage the risks successfully. The appreciation of property has been a major attraction to investors. Although market and rental rates have increased over the long run, there have been periods when they have dropped. Investors hope for positive cash flows that is, that rental income will be enough to cover mortgage payments and other expenses until they sell a property, when they expect to reap a handsome profit. Sometimes, however, cash flows are negative and investors must reach into their own pockets to make up the balance.
Determining the net present values and rates of return for investments in nonresidential real estate requires handling a number of factors discussed in earlier chapters, such as property depreciation, taxes on regular income, and capital gains and losses. However, the Internal Revenue Service has special rules for these that must be followed.
IRS rules require nonresidential real property to be depreciated by the straight-line method with a life of 39 years and zero salvage value. The MACRS depreciation schedule (Table 11-2 in Chapter 11) shows percentage values depending on the month the property is placed in service. Depreciation is lim- ited to buildings and installed equipment. No depreciation is allowed for land.
In general, a taxpayer will realize either a capital gain or loss when real estate investment property is sold. In recent years, real property has generally appreciated in value between the time of its purchase and sale, so that there is usually a capital gain when it is sold. The taxable capital gain is the amount realized from the sale (i.e., the selling price less selling expenses) minus the property’s “adjusted tax basis.” The property’s “adjusted tax basis” is its original acquisition cost, including purchase expenses, plus the cost of any capital improvements less the cumulative depreciation at the time of sale. A taxpayer bears the burden of proof to provide evidence for the “adjusted tax basis.”
The interest paid on mortgage loans is a deductible expense for figuring taxable income. Note that although the entire amounts of mortgage payments affect cash flows, only the interest portion is a deduct- ible expense.
Property insurance, management cost, and the cost of routine maintenance are operating expenses that affect net income. Capital improvements (e.g., building additions and major remodeling of interiors or exteriors) are depreciable expenses.
Capital Budgeting: Applications ❧ 413
Case Study: Armstrong Properties Armstrong Properties is a large corporation that owns and manages many business properties. It is currently
considering the purchase of an office building in downtown Central City. The purchase price of the building and the land on which it is built is $5 million. Armstrong would make a down payment of $1 million and take
a 30-year first mortgage for the balance. The annual rate of interest on the mortgage would be 9.25 percent, and mortgage payments would be made monthly, beginning at the end of the first month. Expenses incurred by Armstrong for purchasing the building and land will be $50,000.
The market value of the property is expected to increase at an annual rate of 4 percent. Armstrong would sell the property at the end of five years at its market value at the time. The company estimates its expenses for selling the property will be $250,000.
The building has a rentable floor area of 20,000 square feet. Armstrong would rent space the first two years at a monthly rate $5/square foot, and the rate would increase by 4 percent each year after the first two. Occupancy is expected to average 85 percent for the first year, 92 percent for the second year, 95 percent for the third year, and 98 percent thereafter. The sum of annual expenses for maintenance, management, and property taxes is expected to be $500,000 for the first year and to increase at a rate of 3.5 percent each year thereafter.
The building will be depreciated by straight-line depreciation, based on zero salvage value and a life of 39 years. Because land is not depreciable, the property’s depreciation is based on the initial cost of only the
building, which is 80 percent of the property’s purchase price. Assume that the property is placed in service in the first month of the first year. Depreciation, mortgage interest, and annual expenses for maintenance, man- agement, and property taxes are deductible expenses for computing taxable normal income. Use 40 percent for the tax rate on the taxable normal income.
Because of the property’s appreciation, there will be a substantial taxable capital gain when it is sold. The taxable capital gain is the amount realized from the sale (i.e., the price at which Armstrong sells the property less its selling expenses) minus the property’s “tax basis.” The property’s “tax basis” is its original $5 million purchase price plus any purchase expenses and capital improvement costs less the cumulative depreciation at the time of sale. Use a value of 25 percent for the tax rate on taxable capital gain. Armstrong uses a risk-adjusted rate of return of 13 percent to evaluate the net present value of this type of investment. You may assume that the rate of return for reinvesting any cash inflow from the investment will also be 13 percent.
Do a year-end financial analysis for the five years to determine the after-tax net present value, internal rate of return, and modified rate of return for the investment.
Solution: Figure 13-9 is a spreadsheet solution. A problem such as this has many related parts. To simplify the logic, it is helpful to divide the spreadsheet into segments, as shown in Figure 13-9. Data values are at the top of the spreadsheet, and key cell entries are indicated at the bottom.
The end-of-the-month mortgage payments are calculated in Cell F6 by the entry =PMT(F4/12,F5*12,F3). Because the rate of interest is given in Cell F4 as the nominal annual rate, it is necessary to divide by 12 to convert to the actual monthly rate. Also, because the term is expressed in Cell F5 in years, it is necessary to multiply by 12 to convert to the number of months.
Rental rates and occupancy are shown in Rows 14 to 16. Note that the initial values change with time according to the percentages in Rows 15 and 16. The annual rental income is calculated by entering =$B$8*C14*12*C16 in C21 and copying to D21:G21.
Annual operating expenses in Row 17 change with time according to the percentages in Row 18. The values in Row 18 are repeated as cash outflows in Row 22. The annual mortgage payments are calculated by entering =12*$F$6 in Cell C23 and copying to D23:G23.
When the property is sold at the end of five years, there is a cash inflow equal to the selling price; this is calculated by the entry =B3*(1+B6)^G13 in Cell G24. You should recognize this entry as the right side of the equation for calculating a future value—vis-à-vis, F = P*(1+i)^n. There are also cash outflows for paying the selling expenses and for paying off the principal remaining on the mortgage. The latter is calculated by entering =-F3-CUMPRINC(F4/12,F5*12,F3,1,G13*12,0) in Cell G26. Be careful to get the signs correct in this entry.
414 ❧ ® Corporate Financial Analysis with Microsoft Excel
Figure13-9
Solution for Real Estate Investment
1 Case Study: ARMSTRONG PROPERTIES (Sell at end of fifth year)
2 Property Information
Mortgage Information
3 Purchase price
$4,000,000 4 Down payment
Principal
9.25% 5 Purchase expenses
Annual rate
30 6 Annual appreciation in market value
Term, years
($32,907) 7 Selling expenses at sale
End-of-month payment
Tax Rates
8 Rentable area, sq.ft.
40.0% 9 Building value, as % of price
Taxable regular income
25.0% 10 Depreciable life, year
Taxable capital gains
11 Salvage value
12 Risk-adjusted rate of return or discount rate
13 Year
14 Rent rate, $/sq.ft/month
$5.408 $5.624 15 Rental rate increase, %
98.0% 98.0% 17 Annual operating expenses
$554,359 $573,762 18 Operating expenses increase, %
19 Year-end before-tax cash flows
20 Property purchase
21 Annual rental income
1,185,600 $ 1,271,962 $ 1,322,840 22 Annual operating expenses
(535,613) $ (554,359) $ (573,762) 23 Annual mortgage payment
(394,884) $ (394,884) $ (394,884) 24 Receipts from sale of property (i.e., selling price)
$ 6,083,265 25 Selling expenses
$ (250,000) 26 Pay unpaid balance of mortgage
255,103 $ 322,718 $ 2,344,895 28 Tax calculation for regular income
27 Total before-tax cash flow
29 Regular income (rental income)
1,185,600 $ 1,271,962 $ 1,322,840 30 Deductible Expenses 31 Operating Expenses
535,613 $ 554,359 $ 573,762 32 Depreciation (80% of purchase price/39 years)
103,590 $ 103,590 $ 103,590 33 Mortgage interest
363,663 $ 360,649 $ 357,345 34 Total deductible expenses
1,002,865 $ 1,018,598 $ 1,034,696 35 Taxable regular income
182,735 $ 253,364 $ 288,144 36 Tax on regular income
73,094 $ 101,346 $ 115,258 37 Tax calculation for capital gain
38 Amount realized from sale $ 5,833,265 39 Tax basis
$ 4,532,051 40 Taxable capital gain
$ 1,301,213 41 Tax on capital gain (@ 25%)
325,303 42 Total tax
73,094 $ 101,346 $ 440,561 43 After-tax results 44 After-tax income or cash flow
182,009 $ 221,373 $ 1,904,334 45 Net present value
(580,607) $ 452,989 46 Internal rate of return
23.09% 47 Modified internal rate of return
Cell entries for tax on regular income
Cell entries for cash flow from sale of property
C29: =C21, copy to D29:G29
G24: =B3*(1+B6)^G13
C31: =–C22, copy to D31:G31 G26: =–F3–CUMPRINC(F4/12,F5*12,F3,1,G13*12,0) C32: =$B$9*($B$3+$B$5)/$B$10, copy to D32:G32
Cell enries for tax on capital gain
C33: = –CUMIPMT($F$4/12,$F$5*12,$F3,12*C13–11,12*C13,0), copy to D33:G33
G38: =G24+G25
C34: =SUM(C31:C33), copy to D34:G34 G39: =B3+B5–SUM(C32:G32) C35: =C29–C34, copy to D35:G35
G40: =G38–G39
C36: =$F$8*C35, copy to D36:G36
G41: =G40*F9
Cell entries for total tax and after-tax income or cash flow
C42: =C36+C41, copy to D42:G42 (Total tax. Note that values in C41:F41 are zero.) B44: =B27–B42, copy to C44:G44 (After-tax income or cash)
Other cell entries
E14: =D14*(1+E15), copy to F14:G14 (Rental rate, $/sq.ft/month) C21: =$B$8*C14*12*C16, copy to D21:G21 (Annual rental income)
F6: =PMT(F4/12,F5*12,F3), (Monthly mortgage payment) D17: =C17*(1+D18), copy to E17:G17 (Annual operating expenses) C23: =12*$F$6, copy to D23:G23 (Annual mortgage payment)
(Continued)
Capital Budgeting: Applications ❧ 415
The regular income from rents is transferred from Row 21 by entering =C21 in Cell C29 and copying to D29:G29. The tax on the regular income is based on the taxable regular income, which is calculated in Row 35 as the difference between the rental income in Row 29 and the sum of the deductible expenses in Rows 31 to 33. Although the total mortgage payments are part of the cash flow, only the interest portion is a deduct-
ible expense. This is calculated by entering =CUMIPMT($F$4/12,$F$5*12, $F$3,12*C13-11,12*C13,0) in Cell C33 and copying the entry to D33:G33. Note that the initial month each year is calculated by the term 12*C13-11, and the final month of each year by the term 12*C13. (For example, for year 2, the first month is 12*2 - 11 = 13, and the last month is 12*2 = 24; and so on.)
Annual depreciation is based on 80 percent of the sum of the purchase price and purchase expenses. The entry in Cell C32 is =$B$9*($B$3+$B$5)/$B$10 and is copied to D32:G32.
The calculations of the capital gain tax for selling the property at the end of year 5 are given in Rows 38 to 41. The amount realized from the sale is the selling price minus the selling expenses; this is calculated by the
entry =G24-B7 or =G24+G25 in Cell G38. The tax basis is calculated by the entry =B3+B5-SUM(C32:G32) in Cell G39. The taxable capital gain is calculated by the entry =G38-G39 in Cell G40, and the tax on the capital gain is calculated by the entry =G40*F9 in Cell G41.
The total tax in Row 42 is the sum of the tax on regular income in Row 36 and the tax on the capital gain in Row 41. (The tax on capital gain is zero for all but year 5.) To calculate total tax, enter =C36+C41 in Cell C42 and copy to D42:G42.
The after-tax cash flow is the difference between the before-tax cash flow in Row 27 and the tax in Row 42. Enter =B27-B42 in Cell B44 and copy to C44:G44.
Once the after-tax cash flow is obtained, the net present value, internal rate of return, and modified internal rate of return are calculated as before, with Excel’s NPV, IRR, and MIRR functions.
Note that the net present value is less than zero until the property is sold in year 5. After the initial invest- ment in the property, the annual after-tax cash flow is positive throughout the balance of the analysis period— that is, the investment generates enough income to cover its costs. The investment pays off when the property is sold because of the appreciation in the property’s value and the amount of leverage obtained by the down payment of only 20 percent of the property’s cost. The gamble the investors have taken in making the invest- ment is their expectation that property values will rise. If property values go down instead of up, there would
be a substantial loss.
Case Study: Armstrong Properties Revisited The CFO of Armstrong Properties is concerned about what might happen if the annual rate of appreciation of
the property’s value is different from the anticipated value of 4 percent. After some study, Armstrong’s manage- ment staff reports that the annual rate of appreciation over the five-year period might go as low as a negative
4 percent to as high as a positive 10 percent. The staff also reports that their best estimates for the probabilities of the different rates are as shown in Table 13-1.
Table13-1
Probabilities for Different Rates of Appreciation of Property Value
8% 10% Probability
RateofAppreciation
6% 2% (Continued)
416 ❧ Corporate Financial Analysis with Microsoft Excel ®
The values in Table 13-1 are given in increments of 2 percent for the rate of appreciation. They show that there is 30 percent probability that the most probable rate of appreciation will be 4 percent. However, there is a 2 percent chance it might go as low as –4 percent and a 1 percent chance it might go as high as 10 percent. And there is a 10 percent chance the property’s value won’t change at all.
1. Evaluate the sensitivity of Armstrong’s earlier results (Figure 13-7) to variations in the annual rate of appreciation of the property’s value from –4% to +10% in increments of 2% (i.e., rates of –4%, –2%, 0, 2%, 4%, 6%. 8%, and 10%).
2. Use the probabilities for the different rates of appreciation to determine the expected value of the investment and the probabilities for the investment earning various levels of net present value at the end of the fifth year, or less.
Solution: Figure 13-10 shows the results.
1. A one-variable input table has been used to perform the sensitivity analysis. Values for the rate of appreciation are entered in Cells I5:I12. The entries for transferring values back and forth between the main body of the spreadsheet and the table are as follows:
CellI4: =B6 ThistransfersvaluesfromCellsI5:I12toB6. CellJ4: =G45
ThistransfersvaluesfromCellG45toJ5:J12. CellK4: =G46
ThistransfersvaluesfromCellG46toK5:K12. CellL4: =G47
ThistransfersvaluesfromCellG47toL5:L12. When these entries are made, the values in Cells I4:L4 will be 4.0%, $452,989, 23.09%, and 21.40%.
To hide these values, custom format the cells with the text entries shown. To do this for Cell I4, select the cell, click on Custom on the Format menu, type “Apprcn” in the dialog box, and enter. Cells J4:L4 are formatted the same way.
Drag the mouse over the Range I4:L12, access the Table dialog box from the Data menu, and enter B6 as the column input cell, as shown in Figure 13-11. Click on OK or press Enter to create the set of values shown in Cells J5:L12 in Figure 13-10.
The analysis shows that the investment will barely break even if there is no appreciation in the property’s value. It can lose as much as an NPV of $363,756 if the rate of appreciation drops to a negative 4 percent, which has only a 2 percent chance of happening. It can make as much as an NPV of $1,254,626 if the rate of appreciation is 10 percent, which has only a 2 percent chance of happening.
The middle portion of Figure 13-10 is a chart on which the net present value of the investment at the end of five years is plotted against the rate of appreciation. At a zero percent rate of appreciation, the investment does slightly better than breaking even (NPV equals $11,278, Cell J7).
2. An expected value analysis examines the payoffs and probabilities for all possible outcomes and discounts the payoffs by their probabilities. The analysis for Armstrong Properties has simplified this by classifying all possible outcomes to the eight rates of appreciation. The probabilities of these are entered in Cells M5:M12. The entry in Cell O5 is =$M5*J5 and is copied to O5:Q12. This multiplies each of the values in Cells J5:L12 by the probabilities in the same rows in M5:M12. The results in Cells O5:Q12 are called “weighted values”—that is, the payoffs are weighted by their probabilities of happening. The entry in Cell O13 is =SUM(O5:O12) and is copied to P13:Q13. The values in Cells O13:Q13 are known as the investment’s “expected values” for NPV, IRR, and MIRR.
If a company uses this strategy on a number of similar investments, the total payoff for all investments should be approximately equal to the sum of the expected values of the payoffs for the individual investments. That is, some investments will do better than expected, and others will do worse. Those that do better will be balanced by those that do worse, so the total result should be as expected.
(Continued)
Capital Budgeting: Applications ❧ 417
Figure13-10
Effect of Annual Rate of Appreciation of Property Value on Financial Payoff
1 Case Study: ARMSTRONG PROPERTIES (Sell at end of fifth year) 2 Effect of Rate of Appreciation of Property Value on Results at End of 5 Years
3 Rate of
Expected Value Analysis 4 Apprcn
Value at end of 5 years
13 Expected Values of NPV, IRR, and MIRR
19 $1,000,000 20 YEARS 21 22 $500,000 23 24 T END OF 5 25
32 ANNUAL RATE OF APPRECIATION
50 30% 51 52 WNSIDE RISK (Probability NPV will be less 20% 53 54 DO
58 NET PRESENT VALUE (NPV) AT END OF 5 YEARS
(Continued)
418 ❧ ® Corporate Financial Analysis with Microsoft Excel
Figure13-11
Table Dialog Box for One-Variable Input Table
Expected values are a less than satisfactory means for evaluating one-time investments. Better techniques will be demonstrated in Chapters 14 and 15. However, expected values are very useful to identify optimum operating tactics. A good example is the practice of airlines to overbook seats. Airlines use the probabilities of no-shows and standbys to determine the optimum number of seats to overbook on
a flight in order to minimize losses due to flying empty seats because of no-shows and the losses due to paying penalties when they cannot seat a ticketed customer. The optimum overbooking strategy is the one that minimizes the expected value of the loss on a flight. In the long run, over many flights, the average loss per flight for the optimum strategy equals the expected value. Investors can use expected values as part of their investment tactics for multi-stock portfolios.
3. Cumulative probabilities for the different levels of appreciation are calculated by entering =SUM($M$5:M5) in Cell N5 and copying the entry to N6:N12. The results show, for example, there is a probability of 72 percent (Cell N9) that the net present value will be $452,989 (Cell J9), or less. The lower chart in Figure 13-10 is a plot of the cumulative probabilities (Cells N5:N12) against the NPVs (Cells J5:J12). Such a chart is called a downside risk chart because it shows the probabilities that the NPV will be less than the values on the X-axis. We shall see more of this type of chart in later chapters.