Lesson 7 Flashcards
2 categories of return on equity measures for income-producing real estate investments
Single-period measures that evaluate the income of an investment over 1 year (direct capitalization)
Discounted cash flow measures that use time value of money concepts to summarize investment returns over a multiple-year holding period (yield capitalization)
Examples of single-period measures
Return on investment, net income multiplier (p-e ratio/payback period), equity dividend rate, cash on cash return, holding period return
Return on Investment (ROI)
NOI / Purchase Price
Also called capitalization rate or broker’s yield
Free & clear rate of return - investor’s return on a before-financing, before-tax basis
Net Income Multiplier (NIM)
Purchase Price / NOI
Indicates how much investor pays per dollar of earnings / how much $1 in income translates to dollars in price or value
Closely related to payback period, which shows how many years of income it takes to recover the investment cost
Equity Dividend Rate (EDR)
BTCF / Equity Investment
BTCF = NOI - debt payments
Equity Investment = purchase price - mortgage financing
Known in appraisal circles as cash throw-off return or equity capitalization rate
Measures either the realized or projected return of investors on their equity invested in the property
Cash on Cash Return (C on C)
ATCF / Equity Investment
Equity return measure derived on an after-tax basis
Holding Period Return (HPR)
OCF + RCF / Equity Investment
OCF = Operating cash flow
RCF = Reversion cash flow
Return measure that recognizes the before-tax or after-tax reversion cash flow to the equity investors
Can be derived on either before-tax (where OCF & RCF are equal to BCTF & BTER) or after-tax basis (where OCF & RCF are equal to ACTF & ATER) and will typically be for a period of 1 year
Viable Investment (NPV)
NPV ≥ 0
Justified Investment Price
Maximum price that investor would be willing to pay to obtain a return equal to or greater than the discount rate = PV of cash flows + PV of reversion + debt
After-tax JIP = PV(ACTF) + PV(ATER) + debt
Before-Tax Discount Rate
DISb = DIS x 1/(1-MRT) DISb = before-tax discount rate DIS = after-tax discount rate MRT = marginal rate of taxation
Before-tax or after-tax Internal Rate of Return on Equity
The rate of return that equates the discounted value of the operating cash flows plus the equity residual on a before- or after-tax basis to the initial equity investment
Viable Investment (IRR)
IRR ≥ investor’s minimum required rate of return
Internal Rate of Return on Capital
Derived on an all-equity basis, assuming no debt financing
Primary application is in the analysis of whether financial leverage is favourable or unfavourable. This return is the highest after-tax rate of interest at which capital can be borrowed and the investment generates sufficient cash flow to pay off the debt.
Represents cut-off rate for whether specific financing arrangement represents positive or negative leverage
Alternatives to IRR
Alternative multiple-period measures have been designed to eliminate the potential for multiple rates of return, enabling the investor to explicitly include a reinvestment rate in the analysis.
ARR - adjusted rate of return
FMRR - financial management rate of return
Internal Rate of Return
The rate of return that equates the discounted values of the operating cash flows plus the equity residual on a before-tax or after-tax basis to the initial equity investment (E0)
