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A new evaluation procedure in

real estate projects


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
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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
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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:
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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.
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evaluation
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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.
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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
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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:
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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
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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
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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
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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
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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
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.
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.
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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.
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