Analysis of Investment Market Data - Term Paper Example

TABLE OF CONTENTS ANALYSIS OF INVESTMENT MARKET DATA Introduction 2 Part Discounted Cash Flow 2 a. Demonstrate that the capital value of a 15 year deal is £322,183 using PV of £1 2 b. Different scenarios of discount rate 3 c. Calculations presented in Discounted Cash Flow format 3 . DCF using explicit rent rises 3 DCF using RPI rent rises 4 II. Question 1. Assume that the business can borrow money at 8% p.a. and that the market rent is £35,374 p.a. with comparable evidence of 7% ARY and an expected 3% annual rise in rental value. State any other assumptions you may need to prepare the advice (if any) what is the IRR for each of these options? 4 a. Rental to be increased 3% per year 4 III. Question 2.. Suppose the company borrows same amount £322,183, at 8% per annum, what are the options advisable. a. Option 1 Consider bond market as bond issuer. (borrower) 5 b. Option 2. Consider bond market as bond holder (investor) 6 IV. Discussions and conclusion 7 Part II Property Cycle Review of the commercial property market. 8 Question 1. . Can data analysis identify the external and internal forces that produced the cycles in commercial property market? 8 Implication of the trend 9 Lowering of lending standards 10 US not alone in predicament 11 Prospects of commercial property markets 12 Question 2. . Looking towards the future, how reliable can data analysis predict the market trend in sufficient time for property professionals to react ahead of the market? 13 Discussions and conclusions 15 List of Tables and charts 16 List of references 17 ANALYSIS OF INVESTMENT MARKET DATA Introduction Part I of the study deals with analysis of prospective investment. The objective of any investment is profit maximization. Given this objective, the owner of the building should be able to choose the kind of investment, financing and decisions that will provide owner maximum benefit for the lease of the building. Any decision for investment requires commitment of funds now with the expectations of earning a satisfactory return on these funds over a period of time in the future. Conversely, the commitment on the use of asset (building) and funds is made with the expectation of a satisfactory return on the investment in the future. Illustrative of this commitment are decisions to be made on the lease of the building. Part 2 of the study pertains to the review of property cycle to provide information data analysis on the past and future performance of the property market. DISCOUNTED CASH FLOW DCF is defined as a method of evaluating an investment by estimating future cash flows and taking into consideration the time value of money. Also called capitalization of income. (OIC) a. Demonstrate that the capital value of a 15 year deal is £322,183 using PV of £1 Table 1. Present value of stream of payments for 15 years Capital value PV of £36,374 at Disc. Rate of 7% received annually for 15 years £331,290.75 Lease payment received at one time payment £322,183.35 Calculations provided by Bond Yield Calculator Table 1 shows that the present value of £36,374 stream of yearly rental payments using PV calculations at discount rate of 7% will have the capital value that is almost the same when the company receives one time lease payment for 15 years. b. Using different discount factor rates, let us look at the projected earnings of different scenarios taking into consideration 15 years of lease Table 2. Different scenarios of discount rate Discount rate factor Capital value PV of 36,374 @ 8% received yearly for 15 years (Disc. Factor 8.5593 £311,335,97 PV of 36,374 @ 5% received yearly for 15 years £377,547,57 At different rates of discount, 7% is almost equal to the amount of one time payment lease, 8% is less than the amount required, and 5% exceeds original capital value. The rule says, “An investment proposal should be accepted if the present value of its earnings equals or exceeds the amount of the investment required. (Robert A. p. 628) Earnings are cash flows earnings expected to be received from the investment decisions. To find the present value of these earnings, they are discounted at a specified rate of return found in a Table of Present Values (Hunt, et al. p. 932) These rate are also called the Required Rate of Return that will be needed to identify decisions for the project. In question no. 1, the required rate of return to compare lease option payments with one Time lease payment is RRR = 7% C, Calculations presented in Discounted Cash Flow format DCF using explicit rent rises. Present value of a stream of payment, with 10% increase of rental every year 5 years Table 3. DCF with explicit rent rise Year Cash Flow Disc. Factor @ 8% Disc. Value Capital Value -322,183.37 1-5 176,870 0.681 120,448.47 5-10 194,557 0.671 130,547.74 10-15 214,012 0.315 67,627.79 Total Disc Value 318,624.00` Net value -3,559.37 At 8% discount factor, present value is not equal to the original capital value of 322,183.37. DCF using RPI rent rises The retail price index for November 2008 is 216.0. Table 4 below considered inflation (RPI) in arriving at real cost. (1 + RPI) (IDS 2008)) Table 4. DCF with RPI Year Cash inflows before RPI Cash inflows after RPI Year 15 675,234.19 555,291.27 PV at 7% 244,735.94 201,263.11 Source: PV calculator As seen from the table, cash before RPI is more when inflation costs are considered. To arrive at RPI, divide cash inflows with (1 + RPI). (Sariaslan, H.) II. Question 1. Assume that the business can borrow money at 8% p.a. and that the market rent is £35,374 p.a. with comparable evidence of 7% ARY and an expected 3% annual rise in rental value. State any other assumptions you may need to prepare the advice (if any) what is the IRR for each of these options? a. Rental to be increased 3% per year. Table below shows net advantage of this proposal. Table 5. Yearly Rental with Increase of 3 % Year Cash Flow Disc. Factor @ 8% Disc. value Capital Value --322,183.37 1 35,374.00 0.926 33,682.32 2 36,436.22 0.857 31,225.84 3` 38,721.32 0.794 30,744.72 4 39,770,86 0.735 29,231.58 5 40,964.07 0.681 27,896.53 6 42,192.99 0.630 26,581.58 7 43,485.78 0.583 25,352.20 8 44,790.35 0.549 24,589.90 9 46,134/06 0.500 23,067.03 10 47,518.08 0.463 22,000.87 11 48,943.62 0.429 20,996.81 12 50,411.92 0.397 20,013.53 13 51,924.27 0.368 19,108.13 14 53,481.10 0.340 18,183.57 15 55,085.55 0.315 17,407.04 Total 675,234.19 370,081.65 Net value 47,898.28 Criterion Decision: Accept proposal if the earnings exceed initial investment required, or if it is more than 0. (Hunt, P. et. al p. 449) Owner can accept this proposition because of positive net earnings, with an IFF o 8% III. Question 2.. Suppose the company borrows same amount £322,183, at 8% per annum, what are the options advisable. Option 1 Consider bond market as issuer of bonds. When owner buys a bond, he becomes the lender, and the bond issuer is the buyer. Several entities may issue bonds such as a company, a city, a state, or a federal government agency. Bonds may be issued for short periods for operating costs, or for longer term to build facilities and technologies. (AARP). When the company issues a bond to the public, conditions are fixed and set. For instance, the interest rate is fixed and indicated as coupon rate. For example, the 7.5 percent coupon rate indicates that the issuer will pay $75 per annum for every $1,000 face value the bondholder holds. The yield to maturity is determined by solving for the rate of discount that equates with the present value of principal and interest payments with the current price of the bonds. (Van Horne, James. p. 558) Supposing the company needs $300,000 for his operational needs. Company will issue bonds to the public through the bond market trading that will give him the required amount. Here, company is borrower Current price 1,000 Par value` 1,000 Coupon rate 7.5% Current yield 7.5% Yield to maturity 15 years For every 1,000 invested, earnings per year is 75.00 payable annually. For 300 bonds issued, (equivalent to $300,000.00 issuer will pay $22,500 interests to bondholder per year for a period of 15 years. $22,500 x 15 yrs = $337,500.00 At the end of 15 years or maturity period, owner will have to return the capital to bond holder. Option 2. Consider bond market as bondholder.(investor) .Another option is to consider one time lease payment which the owner of the building could use in investments. Instead of being a borrower, owner in this instance, becomes an investor. Company may invest the amount at tax free bond, at 10%, 15 years to mature, coupon rate of 10%, at par. Table. 6. Investment in Bonds Current price £1000 Par value £1000 Coupon rate 10% Years to maturity 15 years Current yield 10% Yield to maturity 10% If the company invest the amount of £322,000 (the amount company received from one time lease) in bonds at par value of £1000, current price £1000, coupon rate 10% in 15 years, earnings per year is £32,000, or a total of £483,000 in 15 years. Bond interests are payable annually or semi-annually, and the invested capital payable at maturity. (Brokamp) Discussions and conclusion Choice of investment is a function of financial analysis which assesses the project’s commercial profitability and capability to service its obligations. It is most relevant to projects or parts of projects that generate commercially-traded goods, and or services which produce revenue. (Valdepenas, Vicente, p. 163) In this study, several options are open for the owner. The use of calculations using the present value and internal rate of return will make it easier to decide whichever is advantageous in the short run or long run analysis. Investment Earnings Bonds 483.000.00 Rental PV 370,081.65 Capital Value --322,183.37 Under the three options, investment in bonds appears to have greater value rather than a yearly rental of 15 years. But a one time payment of lease would be more advisable as this would free the owner from incurring long term debt. Owner could use payment of lease to capitalize his business. His investment is secured with the current cash as compared to a future stream of payment that has risks. Part II The Property Cycle Commercial property is defined as a property exclusively used for business purposes and operated to earn income from rentals. It is differentiated from residential property wherein most homes are occupied by owners to live in. Uses of commercial properties are for office space, retail units, industrial purposes, restaurants, farms, agricultural lands and many more. In the recent economic crisis that affected the capital market, has the commercial property been affected? What are the external and internal forces that could affect the commercial property market” What is the future of this market? These are the issues that will be addressed in this topic. Review of the commercial property market. Question 1. . Can data analysis identify the external and internal forces that produced the cycles in commercial property market? The commercial property market has seen turbulent years in its cycle in the recent past. There has been a period of sharp increase in capital values then followed by significant decline. This was shown in 1990’s crash in commercial market caused by rapid price increase and lending growth. At that time, several financing institutions suffered closure and failure and has caused strain on the financial on several countries like US and Japan. (Nigel Jenkinson) In his speech before the IPD/IPF Property Investment Conference, Jenkinson mentioned that the commercial property market has proven its instability before and therefore shows the need for study and monitoring. He mentioned incident problems caused by volatility of price and the rapid increase in price growth, but unaccompanied by increase in rental growth (Shown in Chart 1). Showing his apprehension, Jenkinson said that the historically low 5.5% yield now is only half the level of yield seen in 1990s. (Chart 2) Further, he said, the quantity of developments now is below the levels of 1990s as the quantity of office developments has been low for the past three years. (Chart 3) Implication of the trend The unstable condition of the commercial property market may pose risks to the financial system of the country. Recent reports cited by Jenkins showed that UK bank’s lending activities to the commercial property sector had increased by 15% during the past years, and had quadrupled since 1997. (Chart 4) The commercial property sector now accounts for the third proportion of lending to private non financial companies, twice the size seven years ago. “Property is also an important class for pension funds, insurance companies and other investors. So the fortunes of both investors and lenders are closely intertwined with the fortunes of the property sector.”(Jenkins) A study about bank lending and commercial property cycles, showed hat commercial property prices shows strong links of credit to commercial property that experienced property losses in 1985-95. This study further proved that property prices are “autonomous” since it tends to create credit expansion, rather than boosting property prices.(Davies, Philip. E and Zhu Hairbin, March 2004) In these concerns, data analysis as shown in the charts below gives a picture of the behavior and pattern of the external and internal forces that affects the property market. I Source of charts: Jenkins Lowering of lending standards. The matter of lending activities has been the subject of Jesse Eisinger who wrote about Wall Street’s Next Crisis and what happened in commercial real estate. In figuring out reasons for the next crisis, he said one of these is the lowering of the lending standards, and the gap between the cost of debt servicing and the cash generated and income on buildings and properties narrowed. On lending standards, the usual procedure is that banks provide loans for not more than 80 percent of the value of the property to provide a safeguards and protection to the bank. But early in 2007, Eisenger said, that banks were noted to grant loans for 120% of a property’s value, on the contention that property values must always go up.Eisenger cited classic examples of over priced purchases and loans of commercial properties. Tishman Speyer Properties purchased two giant New York apartment complexes at a record price, assuming to have more than double rate of return for first couple of years, and 10 per cent thereafter. The turnover rate at that time has been 6 percent. He now faces the problem of “kicking out” the current tenants who have stabilized rents by law, and replacing them with new ones who will pay more. To demonstrate the present loose standards in lending and signs of financial crisis, are two examples of real estate deals. Real estate deal of Blackstone group, a private equity ended up as paying too much for an office properties him bidded. But he managed to unload these properties fast, and the buyers of these properties are now ultimate losers. In another real estate setting, Harry Macklowe, a New York estate buccaneer bought 7 office buildings in New York and borrowed $7.6 billion, while putting $50 million as his own equity. According to Eisenger, to date, Macklowe had to refinance his debt, adding new collaterals for the debt. The loosening standards of lending had been the concern of financial market analysts, Standard & Poor’s, and Moody since it was noted in late 2004 and beginning of 2005. Eisenger said that Moodys are “seeing riskier and riskier loans” .as shown in the two examples. This concern is shared in GLG (2008) reports that during boom times, fundamentals in lending are ignored, as demographics, traditional underwriting processes and sound project planning are ignored. US not alone in predicament With the commercial real estate collapse US Analysts estimated that almost 1 million mortgage loans will default in 2008, and an estimate of 300,000 will default in 2009. (MISHS 2007) In UK, analyst said that the 15% housing market crash forecast has been fulfilled which cause banks to collapse in September and October of 2008 causing over $3 trillion dollars of taxpayers money. (Walayat, Nadeem, 2009) Germany has not been spared by the crisis, as GLG Expert Contributor reported that it s real estate sector is also suffering from financial crisis. (GLG) Prospects of commercial property markets Fred Harrison, an Analyst writing for Money week (August 5,2005) said that after a record high of house prices, as in history and cycle, property prices around the world will start to fall in three years’ time and a global economic depression will follow in 2010 as consumer consumption collapses. However, Anthony Ratcliffe an Analyst of Commercial Property Consultant Surveyors still believes in the market prospects of commercial properties. He said that this sector has continued to have a stable market performance. In this report, he stated that in 1992, property markets provided only 1.6^ return while UK securities had 20.6% return. In 2002, ten years after, the commercial properties had rose to 12.5% of return, while stock market returns dipped by 25% for three consecutive years. According to Ratcliffe, the commercial properties sector had showed continued increase in return in the same intense for the past 10 years, and has outperformed the securities market. In comparing securities market with commercial property, Ratcliffe said shares can suffer melt down along with its companies, while lands and buildings will not suffer extinction, although it value may yet depreciate. Question 2. Looking towards the future, how reliable can data analysis predict the market trend in sufficient time for property professionals to react ahead of the market? Forecasting is predicting something that is likely to happen and is being done using data analysis. Several analyses have been done by authorities on the property market who shared forecasts and opinions on the downturn of events in this market. In South Florida, the commercial and residential real estate suffered in 2008, and forecasts to have continued foreclosures due to weak economy and analysis of non-residential construction seen to fall by 11% in 2009.(Liggett, 2009). In a similar situation, a report said that the real estate downturn is already felt in West Los Angeles as analysis showed growth of vacant office spaces coupled with the lender’s crisis. He said that that the Westside market has experienced its first negative absorption in five years. (Gabbaran, 2009). In Dublin, economic crisis overturned income opportunities in office buildings which have reached new heights of construction in 2008. The growing rates of vacancy and falling of rents have added pressure to developers and investors which is feared to cause further hardship in funding (GLG expert contributor, 2009) Jack Kern, Managing Director of Kern Investment Research, shares this view as the decline will continue to be felt in core cities and central business districts, that worries the lenders. The commercial property forecast of RIC shows return on investments in 2009 will continue to fall although it will not be so fast. The assessments are shown in table below. Table 7. RIC Forecasts on Commeercial Property Market Property returns set to fall further in 2009 although at a slower pace Rising defaults and credit spreads will prevent a near-term recovery resulting in a sluggish investment market for some time to come Tenant demand likely to remain subdued for two years pushing rents sharply lower across some sectors. This quarter has seen UK plc entering the most pronounced period of weakness in over 16 years. A raft of economic data has confirmed the ongoing slide of the economy with survey indicators pointing to a recession as severe as that of the early 1990s. A contraction is well underway across the manufacturing sector with output having fallen over the past six months. More worryingly, the service sector shrank in Q3 for the first time since the early 1990s. Little solace can be found on the consumer front where spending is expected to be muted, in the face of negative wealth effects, subdued wage growth and higher unemployment. Consumer retrenchment and deleveraging are set to be major themes during the coming year pushing the savings rate higher from recent historic lows and acting as a drag on overall growth. Against a backdrop of greater domestic uncertainty and a weaker external environment, occupier activity in the UK commercial property market has been waning. The RICS Commercial Property Market Survey for Q3 saw tenant demand ease back for the fourth consecutive quarter as businesses put investment decisions on hold amid the malaise. The reversal in tenant activity has been most pronounced so far in the office sector although evidence now points to a broad based slowdown across both industrial and retail markets. Unlike the slowing UK economy in 2005, limited external support will be gained from a rapidly weakening global economy. Amid all the gloom, one positive is the dramatic declines in inflation which should accompany the global slowdown. Real incomes will gain some support as a result, although at an aggregate level, rising unemployment may act as a bigger drag on overall consumer demand in the economy Indeed, talk of deflation risks are now mounting which will ensure that aggressive cuts in global interest rates are not reversed any time soon. With UK rates set to fall to 1.0% in 2009 a positive yield gap is rapidly emerging in the commercial property market. However, with the banking sector set to shrink their balance sheets, credit in the commercial property sphere will remain restrictive for some time. That said, those with access to equity are starting to see some real value in the UK market. Commercial property prices in dollar terms are now over 50% down on the June 2007 peak and with further declines expected equity investors and sovereign funds may be tempted back into the market. Indeed the aggressive stance against deflation on a global scale could well support a shift to prime property assets (which could provide an inflation hedge in the coming years Source: RICS Chart below shows that recovery of the commercial property will have gradual progress and will gain positive recovery by 2011. It had seen glorious years of rise in 2003 to 2006 and started a downturn in 2007, with 2008 having its lowest trend, slowing down in 2009 to 2010. It has a forecast of going up on 2011 which other analysts have previously stated. Discussions and conclusions 1. Forecasts and data analysis have been used by experts for a long time in analyzing trends to predict future developments. Data provides analysts comparisons, growths and indices to base decisions. Data input on forecasting are based on real terms and events and should not be ignored. 2. When the “going is good” investors and financial institutions ignore these warning signals provided by data analysis and pin their expectations on the present situation. 3. The property crash happened in 1970s and is repeated in 2000s in a 30 year cycle. Slow recovery is forecast to be in 2011 4. Investors and financial institution should learn from this bitter experience and observe that every rise has a fall, but early warning could cushion the fall. End. Word count: 4034 LIST OF TABLES Table 1. Present value of stream of payments for 15 years 2 Table 2. Different scenarios of discount rate 3 Table 3. DCF with explicit rent rise 4 Table 4. DCF with RPI 4 Table 5. Yearly Rental with Increase of 3 % 4 Table. 6 Investment in Bonds 6 Table 7. RIC Forecasts on Commercial Property Market 13 LIST OF CHARTS Chart 1 Commercial Property Price Growth 1971-2006 10 Chart 2 Equivalent Yield & Annual Rental Growth, 1987-2006 10- Chart 3 Development Pipeline – City Offices 1984-2009 10 Chart 4 UK Bank’s Lending to the Commercial Property Sector 1997-2006 10 Chart 5 Commercial Property returns to show gradual recovery and turn positive by 2000 15 List of References AAAP.ORG. Bond Basics. [On line] Available from: Retrieved 19 Jan. 2009 Davies, Philip E. and Zhu Haibin. 2004 March. Bank Lending and Commercial Property Cycles: some Cross-country Evidence. Working Paper. .Social Science Research Network. [On line] Available from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=786506> retrieved 19 Jan. 2008. Eisinger, Jesse. 08 Sept. 2008. Wall Street’s Next Crisis. Portfolio.com. [on line} Available from < http://www.portfolio.com/views/columns/wall-street/2007/12/17/Commercial-Real-Estate-Crisis Retrieved 19 Jan. 2009. Gabbaian, Joseph. 13 Jan. 2009. Real Estate Downturn Finally Arrives in West Los Angeles [on line] Available from www.nytimes.com. Retrieved 19 Jan. 2009. | GLG Expert Contributor. 08 Jan. 2009. Analysis of German real estate industry suffers from financial crisis. [on line] Available from Retrieved 19 Jan. 2009 GLG Expert Contributor. 29 Dec. 2008. Fundamentals Ignored During Boom Times. [online] Available from Retrieved 19 Jan. 2009 Harrison, Fred. 05 Aug. 2005. Bust will follow boom – but when? Money Week {on line} Available from http://www.moneyweek.com/investments/property/bust-will-follow-boom Retrieved 19 Jan. 2009 Hunt, Pearson, Wiilliam, Charles & Donaldson Gordon. Present Value Table. Basic Business Finance. Richard D. Irwin, Inc. Homewood Illinois, 80430, 1861 4th ed. p 3 931 ----. Basic Security Types. Basic Business Finance. Richard D. Irwin, Inc. Homewood Illinois, 80430, 1861 4th ed. p 345. IDS. 18 Nov. 2008. Retail Price Index. Statistics. Thomson, Sweet & Maxwell [on line] Available from http://www.incomesdata.co.uk/statistics/rpitable.htm Retrieved 19 Jan. 2009 Kern, Jack. 07 Jan. 2009. Vacant Office Space Creates Vacant Stares from Lenders. [on line] Available from retrieved 18 Jan. 2009 Liggett, Howard 15 Jan. 2009. Analysis: Commercial Market Trends. GLG News, [on line} Available from www.cnbc.com. Retrieved 19 Jan. 2009. MISHS. 15 Dec. 2007. Implication of commercial real estate collapse [on line] Available from http://globaleconomicanalysis.blogspot.com/2007/12/implications-of-commercial-real-estate.html Retrieved 09 Jan. 2009 OIC. Discounted Cash Flow. Options. The Options Industry Council. [on line] Available from http://www.investorwords.com/1476/Discounted_Cash_Flow_Analysis Retrieved 28 Jan. 2009 Present Value Calculator. [on line] Available from Retrieved 18 Jan. 2009 Ratcliffe, Anthony. May, 2008. Investing in Prime Commercial Property by Syndicating. Commercial Property Consultant Surveyors [on line] Available from http://www.ratcliffes.com/syndicate_structures.htm Retrieved 19 Jan. 2009 RICS. 08 December 2008. RICS Commercial Property Forecast: December 2008 [on line} Available from http://www.rics.org/Newsroom/Economiccommentary/commercial_forecast> Retrieved 19 Jan. 2009 Robert, Anthony M. Present Value Method. Management Accounting, Richard D. Irwin, Inc. Homewood, Illinois, 4th ed. 1970. p.628 Sariaslan, Halil, Ph.D. Project Evaluation Under Inflationary Conditions. Faculty of Political Sciences, University of Ankara. {on line} Available from Retrieved 19 Jan. 2009. Valdepenas, Vicente P. Financial Analysis. Project Development Manual. Republic of the Philippines, NEDA, Sept. 1984, p. 163 Van Horne, James L. Some Definitions. Long Term Financing. Financial Management and Policy. Prentice Hall, Inc. Englewood, Cliffs, New Jersey, 4th ed. 1977. p. 558 Walayat, Nadeem. 07 Nov. 2008. UK Housing Market 15% Forecast Fulfilled The Market Oracle. [on line] Available from http://www.marketoracle.co.uk/article.7182.html> retrieved 18 Jan. 2009. Read More