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Finance
FINC 371 Chapters 17,18,19
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Gravity
Terms in this set (71)
Rate of Return
Is forecasted and based on uncertainty
Business Risk
Changing economic conditions
Financial Risk
Risk of default on borrowed funds
Purchasing Power Risk
Risk of Inflation
Liquidity Risk
Ability to convert an asset to cash
1. Initial investment
2. Cash Flows from operations during the holding period
3. Cash Flow from disposition (sales proceeds)
4. Holding Period
Cash Flow Model has 4 basic components:
More is better than less.
Sooner is better than later
Rational investor preferences
Compounding
What will an investment made today be worth in the future?
Discounting
What is a payment to be received in the future worth today?
Discounted Cash Flow (DCF)
Advanced application of compounding and discounting. Reduces each investment alternative being analyzed to the amounts and timing of all the cash flows to calculate the internal rate of return (IRR) or the NPV
Compounding
The process of determining the FV of an investment made today and/or a series of equal payments made each period. Assumes interest earned is reinvested.
Discounting
The process of determining the PV of money to be received in the future. PV reflects the loss of earnings over the time spent waiting to receive the money.
1. Compound a single amount to a FV
2. Compound and annuity to a FV
3. Sinking fund payments
4. Discount a single future amount to a PV
5. Discount an annuity to a PV
6. Determine a series of equal payments necessary to amortize a PV
Six Functions of the Dollar
Sinking Fund
A stream of equal payments that is set aside to reach a future target amount. Lump sum of FV is known. Calculate for PMT
Used to set up capital expenditure reserves for items such as new roofs, repaved parking lot, new heating plant, other repairs or improvements
Sinking Funds examples in Real Estate
Buying Mortgages or leasehold interests
Real Estate example of discounting an annuity to a present value
Investments such as raw land
Real Estate example of discounting a single future amount to a present value
Rent or lease payments
Real Estate example of compounding an annuity to a future value
Certificate of Deposit, Buying land to hold for appreciation in value
Real Estate example of compounding a single amount to a future value
Amoritization
Calculates the periodic payment required to repay a specific amount of principal over a set amortization period
IRR
The rate of return each dollar in an investment earns while it is in the investment. (interest rate, discount rate, yield)
NPV
Sum of discounted values of all cash flows, including end of period zero cash flow, discounted using an appropriate discount rate
Positive NPV
The investment will exceed desired yield (GREAT)
Zero NPV
The investment will achieve exactly the desired yield. (GOOD)
Negative NPV
The investment will not exceed desired yield. (BAD)
Interest only
Pay only interest each period. Pay all principle at the end (Balloon Payment)
Balloon Payment
Pay all principle at the end
Amortizing
Pay equal payments each period consisting of interest and principle
Beginning
Do you pay more interest at the beginning or end of the loan?
1. Same payment amount through life of loan
2. Interest amount of payment decreases
3. Principal amount of payment increases
4. Outstanding balance declines to zero by last payment
Characteristics of Amortization Schedule
Fixed Rate Mortgage
Most common, Interest Rate fixed at beginning of loan, will not change
Prepayment
Loan is repaid before its full term has expired
Refinancing
Retiring existing loan with proceeds of a new loan for same property. Calculate "Payback period" of cost savings to loan costs
Discount Point
1 __________= 1%____________. 1 applied to $100,000 loan is a charge of $1000
Origination Fee
Loan cost expressed as a dollar amount
Effective Interest Rate
Refers to the actual cost of borrowing funds from a lender, after consideration of loan costs
Two-step Mortgages (aka "Reset Mortgages)
Initial payments are based off of mortgage payment formula. After 5-7 the remaining balance and term based on "prevailing interest rate" + Spread
Adjustable-rate mortgages (ARMs)
Typically have annual rate adjustments. Typically tied to one year T-Bill + spread of 2 or 3%. Often have "Teaser" rate of 1-2% spread
Hybrid Arm
Begins with fixed rate then converts to standard ARM
Negative Amortization Loan
Payments made are less than what is required for Annual Debt Service. What is not paid off with each payment is added to the Principal Amount.
1. Return ON your money
2. Return OF your money
3. Renters PAYOFF your loan amount
3 Ways to Make Money with 1 investment
Interest
____________ from mortgage loan is tax deductible
Advantages of of Real Estate Investments
Cash flow from Operations, Appreciation, Portfolio Diversification, Financial Leverage
Cash Flow from Operations
Source: Rent checks. Money in wallet of investor at the end of each year
Appreciation
Real Estate values typically grow at least at the rate of inflation
After Tax equity reversion (ATER)
Return of money invested in property + change in value
Portfolio Diversification
Maximizing investment returns while spreading risk exposure across different types of investments
Financial Leverage
aka "OPM"- other people's money. Can amplify returns by investor. Risky
1. Involve high money amounts
2. Lack of liquidity
3. Changing economic environments
Disadvantages of Real Estate Investments
Investment
Present sacrifice in anticipation of expected future benefit
Wealth Maximization Objective
Investors will choose only those projects that offer expected benefits in excess of the costs; especially those whose benefits exceed costs by the largest amount
IRR
The discount rate that makes the NPV exactly equal to zero
Great
IRR>Discount rate
Good
IRR=Discount rate
Bad
IRR<Discount rate
Discount rate
also termed "hurdle rate"
Potential Gross Income
Rental income assuming 100% occupancy. Sometimes referred to as a potential gross revenue (PGR)
Historical experience of subject property
Competing properties in the market
"Natural vacancy" rate (what rate of vacancy expected)
Vacancy and collection loss is based on:
Miscellaneous income
Garage rentals and parking fees, laundry and vending machines, clubhouse rentals
Potential gross income (PGI)
- Vacancy and collection loss (VC)
+ Miscellaneous income (MI)
Effective Gross Income equation
Operating Expenses
Ordinary and regular expenditures necessary to keep a property functioning competitively
Fixed Operating Expenses
Expenses that do not vary with occupancy (at least in the short run)(hazard insurance, local property taxes)
Variable Operating Expenses
Expenses that tend to vary with occupancy (utilities, maintenance and supplies)
-Mortgage payments
-Tax depreciation
-Capital expenditures
Operating Expenses do not include:
Capital Expenditures (CAPX)
Non-recurring expenditures that increase value of structure/prolong its useful life. (roof replacements, additions, resurfacing of parking areas)
Appraisers
Most _________ treat CAPX as "above line" expense and a part of NOI
Institutional Investors
_____________ usually treat CAPX below the line expense and not part of NOI
Dividend
NOI is property's ___________
Fundemental
Projected stream of NOI is _________ determinant of property's value
1. Service the mortgage debt
2. Provide equity investor with an acceptable return on equity
NOI must be sufficient to do to 2 things:
V= NOI(1) / R(0)
R(0) is a "cap" rate not a discount rate
Basic Value equation=
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