Private Real Estate Investment: Data Analysis and Decision Making_10

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Private Real Estate Investment: Data Analysis and Decision Making_10 236 211 The Lender’s Dilemma 2. If the borrower experiences a period of inflation unanticipated by the lender (especially if the loan is granted at a fixed rate of interest), he will reap leveraged equity growth as the appreciation of the entire property value is credited to his equity. Of course, these benefits come at the expense of risk because leverage magnifies both profits and losses. The choice of how much debt to use often discloses a difference of opinion between borrowers and lenders about inflation expectations. When borrowers view inflation expectations differently than lenders, they place a different value on the property. This results, given fixed net operating income (noi), in borrower capitalization rates differing from lender capitalization rates. Some rearranging of the identities for ltv, dcr, and value will convince you that market value may be represented as either of the two identities in Equation (9-1) noi noi ¼ market value ¼ ð9-1Þ cr 12 à constant à dcr à ltv where ‘‘constant’’ is the ratio of monthly installment payments required on the loan to the loan balance (also the factor from Elwood Table #6, the payment to amortize $1). Setting the two expressions for market value (mv) equal to each other and solving for capitalization rate (cr) produces Equation (9-2). cr ¼ 12 à constant à dcr à ltv ð9-2Þ Although lenders have some discretion in the setting of interest rates, due to competition and the influence of the Federal Reserve Bank, the lender’s discretion is across such a narrow range that it may be ignored for our purposes. Thus, using an amortization period of 360 months and exogenously determined interest rates, we assume that the choice of constant is essentially out of the control of the parties to the loan contract. (This is not to preclude the borrower from electing a shorter amortization term to retire debt faster, something he can do without agreeing to a shorter loan provided prepayment is allowed.) We pointed out in Chapter 3 that, if one does not model individual cash flows separately as part of an economic forecast, DCF analysis adds nothing of value to capitalization rate. Indeed, a primary benefit of using DCF analysis is to be able to vary cash flows as part of arriving at value. The lender that fixes both the ltv and the dcr is, in effect, dictating that the buyer use outdated 236 212 Private Real Estate Investment capitalization rate methodology. Two important consequences follow: 1. It forces the buyer to use an inferior valuation tool. 2. It requires the buyer to accept the lender’s inflation expectations. THE LENDER’S PERSPECTIVE To illustrate we will analyze a sale of a property that has been arranged at a price of $1,000,000. The property has $100,000 of net operating income, thus the buyer’s capitalization rate is 10%. The buyer requires an 80% loan to complete the transaction. Assume that 30-year loans are available at 8% interest. The monthly loan constant is .00733765. The lender’s underwriting policy provides that the loan may not exceed 80% of appraised value and net income must exceed debt service by 50%. (These are admittedly stringent standards to make our point.) Using the right side of Equation (9-1), we find that the lender’s value of $946,413 is $53,587 below the buyer’s, a shortfall of about 5%. The lender places a higher capitalization rate of 10.566% on the property, and the loan approved of $757,131 satisfies both the ltv and the dcr requirement, but is insufficient for the buyer’s needs. This is because the lender employs a valuation technique that depends on annual NOI, the constant, and both a fixed predetermined dcr and ltv. THE BORROWER’S PERSPECTIVE The buyer’s approach to value is different. By agreeing to pay $1,000,000 for the property and to borrow $800,000 at market rates and terms, the borrower is saying that the equity is worth $200,000 to him. Thus, he has examined the present and anticipated cash flows in light of his chosen discount rate and, after considering payments on an $800,000 loan, makes the following calculation using Equation (3-9) from Chapter 3. X atcf t atert n 200,000 ¼ nþ ð1 þ dÞt ð1 þ d Þ n ¼1 The connection between the difference in the parties’ opinion of value and the differences in their inflation expectations is found in their differing opinions of g in Equation (3-12) of Chapter 3. 236 213 The Lender’s Dilemma Regardless, the lender’s capitalization rate, produced by his fixed ltv and dcr, is higher than the buyer’s. The lender believes that the buyer has overvalued the property. Assuming both are rational and in possession ...