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Konstantinos J. Liapis, Manolis S. Christofakis and

Harris G. Papacharalampous

Department of Economic and Regional Development,

Panteion University, Athens, Greece

Abstract

Purpose The main purpose of this paper is the formulation of an integrated procedure for the

evaluation of real estate investments.

Design/methodology/approach The main methods for evaluation of real estate investments are

presented initially. The paper analyses both the academic and the professional points of view of all

these methods and compares them to each other, denoting that they could be implemented in the

evaluation of real estate projects. Also, it presents the internal and external variables that inuence the

evaluation.

Findings The primary focus is the calculation of the investors interest (required return) in relation

to the risk of the investment. In this framework the most common nancial methods that have been

used at an academic level in an attempt to estimate the risk-return ratio of an investment are used and

relevant proposals based on the available data and practices are made. The use of these components in

a real estate investment in the Greek real estate market is tested empirically, giving future trends and

prospects.

Originality/value A new integrated procedure for the evaluation of real estate investments is

proposed. This methodological approach helps in effective property management and decision making

in real estate projects.

Keywords Property management, Investments, Real estate, Accounting valuations, Decision making,

Project evaluation

Paper type Research paper

1. Introduction

There have been many studies addressing the issue of evaluating real estate

investments (Quigg, 1995; Buetow and Albert, 1998; Hendershott and Ward, 1999;

Holland et al., 2000); some of them present basic methods, others more complex

discounted cash ow methods and several advanced nancial methods. In this study

we suggest a procedure for evaluating real estate investments with a balance between

nancial analysis/sophistication and the ability of investors to apply them in practice.

In order to achieve this we suggest the discounted cash ow model with adjustments

and suggestions in several areas. We present basic evaluation measures (NPV, IRR)

along with some more complex special cases (projects of different durations),

(Luenberger, 1997; Copeland and Weston, 1992). In order for all these measures to be

meaningful we need, in all cases, to calculate the investors return depending on the

risk of the specic investment. This interest rate may take a different form in each

measure, i.e. in NPV it is the discount rate that we use to discount the cash ow, in IRR

it is the investors interest that we use as a benchmark, but in all cases, it is the

expected return that the investor must gain to make the investment in a risk-rewarding

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/1463-578X.htm

JPIF

29,3

280

Received February 2010

Accepted January 2011

Journal of Property Investment &

Finance

Vol. 29 No. 3, 2011

pp. 280-296

qEmerald Group Publishing Limited

1463-578X

DOI 10.1108/14635781111138091

way. From our reviews we have spotted that the area in which most investors use

empirical data is in the required return of the investment and in the relation with the

risk of the project. Therefore we focused on presenting the most advanced but practical

methods of quantifying this investor interest. We adopt the price to rent ratio (widely

used in several areas of real estate analysis) and we use it instead of the price to

earnings ratio (widely used in nancial methods in evaluations of other asset types) to

better dene investor interest (Peters, 1991; Luoma and Ruuhela, 2001; Luoma et al.,

2006). We determine a formula in which investor equity return is derived from direct

costs, a risk premium and a growth component. We present more advanced nancial

methods and we underline the lack of data (especially in the Greek market, in which

our case study is implemented) to apply these effectively.

2. The framework for evaluation of real estate projects

In order to conduct a common framework for investments in real estate, we combine

the framework of a typical investment with decision making in real estate projects. We

base our work on the aspects of the works by McIntosh and Sykes (1985), Farragher

and Kleinman (1996), Biezma and San Cristobal (2006), and Tziralis et al. (2006, 2008).

According to Farragher and Kleinman (1996), real estate investment

decision-making is a complex process that includes the following steps:

(1) setting strategy;

(2) establishing return/risk objectives;

(3) forecasting expected costs returns;

(4) assessing investment risk;

(5) making a risk-adjusted evaluation of the forecast costs and returns;

(6) implementing accepted proposals; and

(7) post-auditing the performance of operating investment.

Strategic analysis is intended to identify a companys competitive advantage and

suggest investment types that are appropriate for optimum application of the

companys resources and competencies. After developing a strategic plan, a company

should set minimum required rate of return and maximum acceptable risk objectives

that are consistent with their competitive advantages and targeted investment types.

This article focuses mainly on the evaluation methods that are used to calculate the

returns of a project while assessing investment risk and making a risk-adjusted

evaluation of the forecast costs and returns.

Institutional real estate investors have for some time employed fairly sophisticated

investment decision-making practices. Farragher et al. (1994) showed that most

investors quantify their return objectives and forecast cash returns over a ten-year

investment horizon. The most popular evaluation measures are discounted cash ow

(DCF) measures (IRR, NPV), which, according to the same article, were required by

70 per cent of investors in 1993; now this number is probably much higher. There is no

argument over which is the most practical and acceptable way to evaluate real estate

investments; the argument is how to adjust DCF and its measures to reect a realistic

risk return ratio. In this article we start by dening the calculations that are needed to

obtain the investment cash ows that we will apply to the selected measures. Finally,

A new

evaluation

procedure

281

we suggest a procedure for a coherent quantied evaluation of real estate investments,

addressing especially the fourth and fth steps in the decision-making process, i.e.

assessing investment risk and making a risk-adjusted evaluation of the forecast costs

and returns.

3. Cash ows and returns measures in real estate investments

3.1 Operating and net cash ows

The cash ow of an investment in real estate where we apply returns measures (IRR,

NPV) is the operating cash ow (OCF). The OCF is calculated if, from the revenues of

investment project, we remove its constant and variable costs as well as the cash

administrative cost (administrative cost, or cost of rent collection, taxes on property,

etc.). Thus:

OCF

t

R

t

2C

t

2AC

t

; 1

where R

t

is revenue, C

t

is xed and variable costs, and AC

t

is cash administrative

expenses.

In order for the net cash ows (NCF) of an investment to be calculated, we deduct

from the OCF the taxes that correspond to the revenues minus the tax deductive

amounts (i.e. the depreciation of the xed asset), i.e.:

NCF

t

R

t

2C

t

2AC

t

2w:R

t

2C

t

2AC

t

2D

t

2P

p

;

NCF

t

R

t

2C

t

2AC

t

:1 2w wD

t

2P

p

;

NCF

t

OCF

t

1 2w wD

t

2P

p

; 2

where t 1; . . . ; b; . . . ; n, p 1; . . . ; b; b is the initial period of investment or

acquisition period of a xed asset, w is the annual income tax rate, D

t

are the annual

depreciations, and P

p

is the initial cost of investment or the purchase amount of the

xed asset or the price of property of the asset.

If we make an assumption that we follow the constant depreciation method and

there is a residual value of an investment in real estate, we have:

NCF

t

OCF

t

1 2w waP

p

2RVI 2P

p

;

where a is the rate of constant depreciation of a xed asset, and RVI is the residual

value of investment in the xed asset.

Also, if we suppose that a property tax exists and is tax deductible, then:

OCF

t

R

t

2C

t

2AC

t

2w

p

t

*

P

p

;

where w

p

t

is the property tax rate.

3.2. Evaluation methods

Net present value (NPV). The NPV of an investment in real estate is calculated as

follows:

JPIF

29,3

282

NPV

n

t1

NCF

t

1 i

t

; 3

where t 1; . . . ; n is the years of investment, NCF

t

is the net cash ow for any year of

the investment, and i is the opportunity cost of the investor or the discount factor.

According to Remer and Nieto (1995), the NPV method is the most widespread.

According to Copeland and Weston (1992), Luenberger (1997), Kaplan and Atkinson

(1998), the NPV method is theoretically superior to any other method.

The new component that arises is the opportunity cost of the investor or the

discount factor. In the evaluation of a property the appropriate discount factor is

critical for the correct calculations of evaluations measures (as NPV) or to compare this

factor with other evaluation measures (IRR, as we see below) (Clark, 1995).

Internal rate of return (IRR). The IRR is the discount rate that equates the NPV of an

investment project with zero. The IRR is calculated using the method of trial and error

for discount rates to reduce NPV to zero. An investment plan is elected when the IRR is

greater than the opportunity cost of capital of investor or from the funding cost of

investment or the investments weighted average cost of capital (WACC).

According to the IRR technique, the NCF is discounted and compounded with IRR,

from the other hand at the method of NPV, with the opportunity cost of capital of

investor or from the funding cost of investment or the investments WACC.

4. The relationship between price and income in real estate projects

Following our analysis, the projected NCF incorporates several components, such as:

.

revenues or income;

.

direct and indirect costs; and

.

price or purchase amount (cost).

In real estate projects these items remain serious and are correspondingly changed to:

.

rent and capital gains of property;

.

cost of property or direct and indirect costs; and

.

price of property asset.

According to the existing literature, the model of prices and rents is described by the

following formula:

R

t

P

t

i

t

w

p

t

1 2w

y

t

d

t

L

t

2EG

t1

:

If depreciation of the property assets price is tax deductible, we have:

R

t

P

t

i

t

w

p

t

1 2w

y

t

aw

y

t

d

t

L

t

2EG

t1

;

where R

t

is the rent (annual rents), P

t

is the price of the property asset, i

t

is the nominal

interest rate, w

p

t

is the property tax, w

y

t

is the income tax on property yield (annual

rents), a is the depreciation rate on the tax deductible amount of the price of the

property, d

t

is the rate of maintenance, L

t

is the risk premium (which depends on the

kind of property asset), and EG

t1

is the expected capital gains.

A new

evaluation

procedure

283

We ignore transaction costs, or we assume that these costs are included in the price

of the property assets. All other taxes that are implied on property assets we suppose

to be deductible from income taxes or are incorporated in the property tax rate. We also

assume that interest payments are deductible from income taxes and that property

assets are fully nanced.

According to the above equation price should be high relative to rents. and from this

we take a similar formula for property assets like price per earnings (P/E) formula in

capital markets. Thus:

P

t

=R

t

1

i

t

w

p

t

1 2w

y

t

aw

y

t

d

t

L

t

2EG

t1

: 4

A number of restrictions exist for the above equation, such as:

EG

t1

, i

t

w

p

t

1 2w

y

t

aw

y

t

d

t

L

t

:

If this restriction does not exist, the above formula exists only for absolute prices as

abs[P

t

/R

t

].

If t 1; . . . ; n, then n

*

a

*

P

p

, P

p

2RVI ; and the cumulative depreciation is

never bigger than the depreciated part of property asset. In the case of buildings, the

land remains as a residual value (Leamer, 2002).

We assume that the external variables have equal inuence on both price and rent,

especially the environmental and the uniqueness in the property assets, and that

therefore the index P/R remains constant.

From the above equations, using logarithms, we take an index that is famous in

academic discussions for valuation and evaluation in property assets: the rent-price

ratio. If we denote as C

t

the direct cost of a property asset, which is equal with the cost

ratio exempt risk premium and capital gains, we have:

C

t

i

t

w

p

t

1 2w

y

t

aw

y

t

d

t

:

The rent-price index is dependent on the direct cost, risk premium and expected capital

gains.

Using logarithms and according to Campbell et al. (1997), we have:

ln R

t

2ln P

t

lnC

t

L

t

2EG

t1

;

p

t

r

t

2c

t

l

t

2EG

t1

;

p

t1

r

t1

2c

t1

l

t1

2EG

t2

;

EG

t1

p

t1

2p

t

Dr

t

2Dc

t1

2Dl

t1

;

p

t

2r

t

k

t

E

1

j0

r

j

c

t1j

l

t1j

2Dr

t1j

:

According to the last formula, price is high relative to rents when expected interest

rates or risk premiums are low and expected changes in rents are high.

JPIF

29,3

284

There is plenty of research that examines the characteristics and applications of the

price to rent ratio. Campbell et al. (2009) use the above equation to examine a variance

decomposition of the rent-price ratio, but not its predictive power or its application in

the evaluation procedure. Only a handful of papers deal directly with the question of

how much the rent-price ratio helps to predict future changes in rents, prices and

returns in the housing market. Capozza and Seguin (1996) used decennial census data

to examine how cross-sectional differences in the rent-price ratio among metropolitan

areas in the USA are related to ten-year changes in prices in those areas. They tested

whether the expected capital gains implicitly needed to support an areas rent-price

ratio were closely related to actual capital gains. Case and Shiller (1990) examined the

ability of the rent-price ratio to forecast house prices and excess returns on housing.

Mankiw and Weil (1989) found that the rent-price ratio did not have any statistically

signicant predictive power for house prices. They did nd that the rent-price ratio had

a positive and statistically signicant effect on excess returns, but the effect reversed

sign when other explanatory variables were included. Plazzi et al. (2008) examined

whether the rent-price ratio predicts expected returns and expected rent growth in the

commercial real estate sector. They found that the rent-price ratio does not have

predictive power for future rent growth for apartment, retail and industrial properties,

but that it does predict future returns for these types of property. They also found that

the rent-price ratio does not predict either rent growth or returns for ofce properties.

Therefore, all these research works verify and allow us make the assumption that the

price to rent ratio in real estate is very similar to the price to earnings ratio of a stock

(company). This assumption will be used in the evaluation procedure to better quantify

the investor interest. It is notable that direct cost contains as a main component the

nominal interest rate. This rate is the same as the discount factor in evaluation

measures, and it incorporates the total funding cost of investments in property assets.

5. Discount factor or weighted average cost of capital and creative nance

in real estate

A commonly used discount factor in evaluation measures is a rate from the funding

cost of investment. An investor could be using his own capital or debt nancing or a

mixture of the two. The investors total cost of capital is an important benchmark in

many popular forms of performance analysis in real estate projects. The total cost of

capital or WACC is equal to:

WACC or i

c

i

D

1 2w

D

D S

i

S

S

D S

; 5

where i

D

is the average interest rate of debt, i

S

is the average interest rate of investors

capital, D is debt, S is the investors capital, and w is the tax rate.

The investors equity return (average interest rate of investors capital) is equal to

an interest rate that aggregates the free interest rate and a risk premium for the risks

undertaken by investors in real estate:

Investors equity return i

S

risk free rate risk premium R

free

Di

S

:

Using a method called the dividends method or the Gordon (1962) method, the cost of

investors capital is equal to (we transform the original method, which focused on

investments in capital markets):

A new

evaluation

procedure

285

Cost of equity

_

i

S

EFAearnings fromasset

P

common asset price

_ _

expected long-termgrowth rate

_

;

i

investors capital

i

S

EFA

P

_ _

g:

A number of recent studies (Peters, 1991; Luoma and Ruuhela, 2001; Luoma et al., 2006)

based on the above method continue to analyse the price to earnings (P/E) ratio in order

to calculate a more accurate and relevant cost of equity. This method seems to be

appropriate for investments in real estate investment trusts (REITs). This ratio could

also be substituted by rent/price ratio.

In order to calculate the cost of equity, recent studies based on the above method

have used the P/E ratio. Focusing on real estate, the price (P) is equal to the present

value of the propertys earnings (approximately substituted by rent), and for a fund

fully nanced by investors, we have:

P

0

1

t1

R

t

1 i

S

t

;

for non-growing earnings (R

0

/i

S

) and for constant growth g, and:

P

0

1 g

i

s

2g

*

R

0

;

if we take for i

S

:

i

S

R

P

_ _

g:

So the interest of the investor in real estate capital is equal to the rent to price index

plus a constant growing rate. If we consider that there are growth opportunities then

can relax the constant growth with the present value of growth opportunities (PVGO):

P

0

R

0

i

S

PVGO

R0

R

free

Di

S

PVGO !

P

0

R

0

1

R

free

Di

S

PVGO

R

0

:

From the practical point of view, the main problem of the P/E ratio is that both risk and

growth opportunities affect the P/E ratio. Therefore, the P/E ratio is not a useful tool

for the valuation of assets with different growth rates or for assets with different risk

levels. For this reason, Luoma and Ruuhela (2001) present a generalised version of the

P/E ratio, the earn back period (EBP), which takes into account different growth rates.

EBP is dened as the number of years that a rm, with constant earnings growth rate,

needs to earn an amount equal to the price. If we change this formula to apply it in

property investments, we have:

R

t

R

0*

1 g

t

;

then:

JPIF

29,3

286

P

0

EBP21

t0

R

0*

1 g

t

;

P

0

R

0

EBP21

t0

1 g

t

1 g

EBP

21

1 g 21

!1 g

EBP

1

P

0

R

0

*

g

_ _

;

EBP

ln 1

P

0

R

0

*

g

_ _

ln1 g

;

and:

g!0

lim EBP

g!0

lim

ln 1

P

0

R

0

*

g

_ _

ln1 g

P

0

R

0

:

First, as we see above for zero growth rate the EBP is equal to the index. Second, for the

risk-free asset, using the maturity yield as its interest rate that also means:

g R

free

;

P

R

1

R

free

;

and:

EBP

free

ln 1

1

R

free

*

g

_ _

ln1 g

ln 2

ln1 R

free

:

The derivation of the risk premium using EBP is simply now:

EBP

ln 2

ln1 R

free

Di

S

!Di

S

e

ln 2

EBP

21 2R

free

exp

ln 2

EBP

_ _

21 2R

free

:

Substituting EBP into the above it emerges that the risk premium in property

investment is equal to:

Di

S

exp

ln 2

*

ln1 g

ln 1

P

R

*

g

_ _

_ _

21 2R

free

;

and:

i

S

exp

ln 2

*

ln1 g

ln 1

P

R

*

g

_ _

_ _

21:

Finally, if we use the rent-price index, we have:

A new

evaluation

procedure

287

i

S

exp

ln 2

*

ln1 g

ln 1

g

C

t

L

t

2EG

t1

_ _

_

_

_

_

21: 6

In many cases, when g EG

t1

, the above formula is transformed as:

i

S

exp

ln 2

*

ln1 g

ln

C

t

L

t

C

t

L

t

2g

_ _

_

_

_

_

21:

Thus, the investors equity return depends on the direct cost, the risk premium and a

growth component:

i

S

exp

ln 2

*

ln1 g

lnC

t

L

t

2lnC

t

L

t

2g

_ _

21:

6. Other nancial methods

Capital assets pricing model (CAPM)

Research exists that tries to quantify the risk-return ratio with the use of the CAPM.

Most of this research tries to estimate the expected return for the investor (the

investors interest) based on the risk of the investment (b). The CAPM formula is as

follows:

i

investors capital

R

free

bR

market

2R

free

;

or:

i

S

R

f

bR

m

2R

f

;

where R

free

or R

f

is the interest rate free of risk (commonly the interest rate of long-term

government bonds), R

market

or R

m

is the annual rate of performance of the market (i.e.

the predicted or realised performance rate in real estate markets), and b is the

coefcient of risk factor. If b . 1 the asset has greater volatility than the market, and if

b , 1 the asset has smaller volatility than the market. The b coefcient is produced by

regression of a single function that relates the price of asset to an index price of the real

estate market.

The key problem in applying the CAPM to private real estate is the calculation of a

meaningful b. Breidenbach et al. (2006) tried to identify a methodology for better

estimation of the right b. They estimated a market risk premium for direct private

real estate, and then developed a b analysis by property type so that investors could

differentiate risk premiums for each property type. They compared NCREIF property

b values to NAREIT (an index comprised of returns from private buildings valued on a

quarterly basis through the use of appraisals) property b values, and found some

similarities and some differences. They developed a metro market b for the ofce

property type using a long-term data set that encompassed one full market cycle. In

order for an investor to really use CAPMin real estate, there is a need for sufcient data

in the area and the type of the property. As a market b for real estate, various studies

JPIF

29,3

288

have concluded that the b calculated from the equity REIT is a better estimation (if

there are sufcient REITS in the market, and with a broad diversication).

Especially in Greece, where our case study is focused, there is a lack of sufcient

data. There is no index of prices/returns for real estate in order to calculate the b for a

specic property even though at times there have been attempts by different entities

to make such an index (at least for Athens). Also, there are not enough REITs (with

broad investments to cover all types and areas) to derive a b for the real estate market.

Generally, it is a good alternative to determine the required return for a project

compared to the use of traditional investor surveys.

Real options pricing model for evaluation real estate projects

Discounted cash ow (DCF) models do not incorporate valuations of the implicit

options embedded in capital projects. Recently, researchers have applied real option

pricing models to evaluate real estate projects and contracts. As a result of the increase

in popularity of this new area of real option analysis among nance researchers

during the early 1990s, several research papers in real estate valuation (Quigg, 1995;

Buetow and Albert, 1998; Hendershott and Ward, 1999; Holland et al., 2000) have

included real option valuation models. Current research on real estate options has

focused on mortgages, development rights and lease contracts. Owners of vacant land

have implied options associated with the timing of development (i.e. delay

development) or options to shut down or abandon a development after start-up.

Quigg (1995) presented a method of valuing these options as perpetual American

options. She based her model on the same theoretical calculus and partial differential

equations (PDEs) used in the Black-Scholes option-pricing model. Continuous time

models for valuing options typically follow the Black-Scholes (1973) model or use a

system of PDEs with boundary conditions. Both methods assume that the option has a

traded twin asset that follows a known well-dened process, such as a geometric

Brownian motion (GBM). DCF models obtain a value for the capital project that

includes the options. Estimated cash ows at each phase of the project contain an

implied future value of the option. Hence, the resulting value represents the present

value of the projects cash ows, which includes the implied option. Some applications

of binomial, lattice, Black-Scholes and PDE models only compute values for a projects

option. The option values can be added to a traditional DCF analysis to obtain an

overall value of the project.

Monte Carlo simulation and its use in real estate evaluation

A lot of academics have tried to use Monte Carlo simulations (Metropolis and Ulam,

1949) to evaluate real estate projects and quantify their risks. The main problem that

makes the use of this method inapplicable in real estate evaluation is that the critical

parameters of the assets are inter-dependent (which violates the main assumption of

the Monte Carlo method). This is strongly veried in the current crisis, where we see a

dependent increase in vacancies/decrease in rents/increase in cap rates.

Conclusion on estimating the expected return for the investor in the Greek market

The most common way to estimate investors interest in the Greek market is

empirically. This article argues that there are a lot of better ways to estimate investor

A new

evaluation

procedure

289

return, for example scientically and with nancial tools,. The primary focus of all

these methods is to try to link the expected return to the risk.

After reviewing the most popular and advanced nancial methods of estimating the

investors interest in regard to the risk of the project, we determine that the new

Gordon-Shapiro method adjusted with the price to rent ratio is the most applicable. The

problem with most of the other methods such as CAPM and real options is the lack of

market indexes.

7. The proposed methodology for evaluating real estate projects

Following the measures, models and procedures mentioned above, we construct a

proposed procedure for the evaluation of real estate investments. The necessary steps

are:

(1) Calculate the price to rent ratio of the project.

(2) Using the above ratio as a P/E ratio in the new Gordon-Shapiro formula we

calculate the cost of investors capital fund.

(3) Create the capital-fund structure for the investment as a mix of debt and the

investors capital fund. Creative nance is a necessity to calculate the weighted

average cost of capital (WACC).

(4) Create the projected cash ow of the investment using the operating cash ows

(OCF) and net cash ows (NCF).

(5) Using the above discount factor (WACC) in the projected cash ows of the

investment we calculate the discount cash ows (DCF), and with an evaluation

measure (NPV, IRR) we evaluate the project.

(6) Risk analysis through sensitivity.

8. Case study and results

In order to apply this methodology in a real estate investment we assumed variables

that were realistic for the Greek real estate market. We applied the steps given above

and according to the suggested methodology we derived a valuation for the

investment. We took different values for our variables in order to test our procedure.

According to our case study there is a commercial building (i.e. an ofce building)

with a cost of e100,000, an annual gross income (i.e. rent) of e8,500 and an annual

increase rate in gross income of 3 per cent.

Step 1: Calculation of direct users cost and price to rent ratio

We calculated the direct users cost for a range of free interest rates, from zero to 10 per

cent, property tax 0.1 per cent, income tax 25 per cent, depreciation rate 3 per cent, and

rate of maintenance cost 2 per cent. Then we calculated the price to rent ratio using the

above range of direct users cost, risk premium 5 per cent and expected capital gain

1 per cent. The results are presented in Table I.

Step 2: Calculation of investors rate of return

We calculated the investors rate of return according to the transformed formula with

the price to rent ratio for an expected growth rate of 2 per cent. The results are

presented in Table II.

JPIF

29,3

290

i

(

%

)

w

p

(

%

)

w

y

(

%

)

a

(

%

)

d

t

(

%

)

C

t

(

%

)

L

t

(

%

)

E

G

t

1

(

%

)

P

/

R

0

0

.

1

2

5

3

2

2

.

0

8

5

1

1

6

.

4

4

1

0

.

1

2

5

3

2

2

.

8

2

5

1

1

4

.

6

7

2

0

.

1

2

5

3

2

3

.

5

6

5

1

1

3

.

2

3

3

0

.

1

2

5

3

2

4

.

3

0

5

1

1

2

.

0

5

4

0

.

1

2

5

3

2

5

.

0

4

5

1

1

1

.

0

6

5

0

.

1

2

5

3

2

5

.

7

9

5

1

1

0

.

2

2

6

0

.

1

2

5

3

2

6

.

5

3

5

1

9

.

5

0

7

0

.

1

2

5

3

2

7

.

2

7

5

1

8

.

8

7

8

0

.

1

2

5

3

2

8

.

0

1

5

1

8

.

3

2

9

0

.

1

2

5

3

2

8

.

7

6

5

1

7

.

8

4

1

0

0

.

1

2

5

3

2

9

.

5

0

5

1

7

.

4

1

Table I.

Direct users cost and

price to rent ratio

A new

evaluation

procedure

291

8.3 Step 3: Calculation of weighted average cost of capital

We calculate the weighted average cost of capital using several leverage levels between

debt and capital. The interest rate of debt is calculated as free rate plus a credit spread

of 2 per cent. The results are presented in Table III.

8.4 Steps 4 and 5: Calculation of cash ows and net present value

We present the operating and net cash ows of the project for 20 years using annual

percentage growth rates. Using the middle WACC from Table III we calculated the

discounted cash ows and as the sum of them the net present value of the project. The

results are presented in Table IV.

8.5 Step 6: Risk analysis through sensitivity

According to the above assumptions the project evaluates positive NPV 1; 350:66

but following our methodology it is easy to make a sensitivity analysis of the project

by changing the levels of the parameters used. More specically:

D S (%) i

D

(%) i

S

(%) WACC (%)

80.00 20.00 2.01 4.95 2.20

70.00 30.00 3.00 5.48 3.22

60.00 40.00 4.00 6.02 4.21

50.00 50.00 5.00 6.57 5.16

50.00 50.00 6.00 7.11 5.81

50.00 50.00 7.00 7.66 6.46

50.00 50.00 8.00 8.21 7.11

50.00 50.00 9.00 8.77 7.76

40.00 60.00 10.00 9.32 8.59

30.00 70.00 11.00 9.88 9.39

20.00 80.00 12.00 10.45 10.16

Note: Credit spread 2 per cent

Table III.

Weighted average cost of

capital

g (per cent) C

t

(%) L

t

(%) EG

t1

(%) i

S

(%)

2 2.08 5.00 1.00 4.95

2 2.82 5.00 1.00 5.48

2 3.56 5.00 1.00 6.02

2 4.30 5.00 1.00 6.57

2 5.04 5.00 1.00 7.11

2 5.79 5.00 1.00 7.66

2 6.53 5.00 1.00 8.21

2 7.27 5.00 1.00 8.77

2 8.01 5.00 1.00 9.32

2 8.76 5.00 1.00 9.88

2 9.50 5.00 1.00 10.45

Table II.

Investors rate of return

for an expected growth

rate of 2 per cent

JPIF

29,3

292

.

if we suppose an increase in income tax from 25 per cent to 40 per cent, ceteris

paribus, the resulting NPV is 25,969.98, changing the positive evaluation of the

project;

.

if we suppose an increase in expected future property capital gains to the same

level of future income at the level of 2 per cent, ceteris paribus, the resulting NPV

is 4,353.44, increasing the positive evaluation of the project;

.

if we suppose an increase in the free interest rate from 5 per cent to 6 per cent, the

discount factor increases and, ceteris paribus, the resulting NPV is 23,616.54,

changing the positive evaluation of the project;

.

if we suppose an increase in the risk premium rate from 5 per cent to 6 per cent,

ceteris paribus, the resulting NPV is 21,535.17, changing the positive evaluation

of the project;

.

if we suppose an increase in the credit spread of the investor from 2 per cent to

4 per cent, ceteris paribus, the resulting NPV is 24,339.78, changing the positive

evaluation of the project; and

.

if we suppose an increase in property tax from 0.1 per cent to1 per cent, ceteris

paribus, the resulting NPV is 2590.43, changing the positive evaluation of the

project.

It should be mentioned that our model is more complicated if we change constant

future variable prices with projected future curves.

R C AC OCF OCF

*

1 2w D w

*

a

*

P NCF DCF

8,500 200 50 8,250 6,188 750 293,063 293,062.50

8,755 202 50 8,503 6,377 750 7,127 6,694.87

9,018 204 51 8,763 6,572 750 7,322 6,461.21

9,288 206 51 9,031 6,774 750 7,524 6,236.15

9,567 208 51 9,308 6,981 750 7,731 6,019.36

9,854 210 51 9,592 7,194 750 7,944 5,810.50

10,149 212 52 9,886 7,414 750 8,164 5,609.26

10,454 214 52 10,188 7,641 750 8,391 5,415.34

10,768 217 52 10,499 7,874 750 8,624 5,228.46

11,091 219 52 10,820 8,115 750 8,865 5,048.33

11,423 221 53 11,150 8,362 750 9,112 4,874.71

11,766 223 53 11,490 8,618 750 9,368 4,707.33

12,119 225 53 11,841 8,880 750 9,630 4,545.96

12,483 228 53 12,202 9,151 750 9,901 4,390.36

12,857 230 54 12,574 9,430 750 10,180 4,240.32

13,243 232 54 12,957 9,717 750 10,467 4,095.62

13,640 235 54 13,351 10,014 750 10,764 3,956.06

14,049 237 54 13,758 10,318 750 11,068 3,821.44

14,471 239 55 14,177 10,633 750 11,383 3,691.58

14,905 242 55 14,608 10,956 750 11,706 3,566.31

82,209 1,350.66

Notes: WACC 6.46 per cent; p 100,000; percentage growth: R 3.00; C 1.00; AC 0.50

Table IV.

Discounted cash ows

and net present value

using the middle WACC

A new

evaluation

procedure

293

9. Conclusion

In this paper we have suggested a coherent, complete and practical orientation

methodology for the evaluation of real estate investments. We have used the price to

rent ratio into the new Gordon-Shapiro formula to calculate the cost of the investors

capital fund. This integration of the formula to real estate makes it possible to quantify

the return of the investor in a more accurate manner, with data that is already available

to investors.

We have presented all the procedures of the methodology starting from the

calculation of the net cash ow that we apply the return measures. Then we presented

return measures that are widely used in the industry (i.e. NPV and IRR). We analysed

alternative methods to estimate the required return and to evaluate the investment as

CAPM and real option, while mentioning the data that is lacking in order to make these

methods practical and useful to investors.

From the case study, we can determine the relations between NPV and the models

variables. More specically, an increase in the price of the fundamental variables has

impact on NPV shown in Table V.

All the functional relationships in our model are compatible with theory and the

literature of the eld of evaluation in real estate projects. This new procedure for the

evaluation of real estate investments could be a useful tool for supporting

decision-making in real estate projects.

References

Biezma, M.V. and San Cristobal, J.R. (2006), Investment criteria for the selection of cogeneration

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Variable Effect on NPV

R

t

Revenue Increase

C

t

Fixed and variable costs Decrease

AC

t

Cash administrative expenses Decrease

P

t

Price of property asset Decrease

i

t

Nominal interest rate Decrease

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Property tax Decrease

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Income tax Decrease

a Depreciation rate Increase

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Rate of maintenance Decrease

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Risk premium Decrease

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Expected capital gains Increase

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NPV

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About the authors

Konstantinos J. Liapis is Assistant Professor in Accounting and Business Administration in the

Department of Economic and Regional Development, Panteion University, Athens. He is a

Scientic Collaborator of the Regional Development Institute (RDI) of Panteion University and

Head of the Investment and Real Estate Research Centre of the RDI. He has served as Deputy

General Manager and Finance Director in the banking industry and as a high-ranking ofcer in

many private-sector companies. Konstantinos J. Liapis is the corresponding author and can be

contacted at: Konstantinos.liapis@panteion.gr

Manolis S. Christofakis is Assistant Professor in Regional Development and Policy in the

Department of Economic and Regional Development, Panteion University, Athens. He has been a

Scientic Collaborator of the Regional Development Institute of Panteion University since 2000.

He has been a Research Associate of the European and Social Cohesion Laboratory (ESOC-LAB)

of the European Institute of London School of Economics and Political Science. He has published

books and scientic articles on regional and local development, urban and regional policy and

planning, transport policy, innovation strategy, etc.

Harris G. Papacharalampous is Collaborator of the Regional Development Institute, Panteion

University, Athens, and an Investment Ofcer in the real estate sector with Piraeus Bank. He

holds a Masters degree in Real Estate and Urban Development (MDesS) from the Urban

Planning Department, at Harvard Universitys Graduate School of Design. He graduated from

the Department of Civil Engineering, National Technical University of Athens.

JPIF

29,3

296

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