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The Real Estate Investment Decision

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Title: The Real Estate Investment Decision


1
The Real Estate Investment Decision
  • Chapter 1

2
State of the Investment Analysis Art
  • Historically lagged behind mainstream finance and
    investment thought great strides recently
  • Treats real estate as capital asset desired for
    stream of benefits
  • Real estate investment as special case of modern
    capital budgeting

3
Real Estate as an Investment
  • Investors Passive or Active
  • Active investors acquire direct title to real
    property either oversee property themselves or
    hire management firms
  • Passive investors place assets with professional
    money managers who acquire interests in real
    property may acquire shares in corporations or
    partnerships that hold real property interests
    make no operating decisions

4
Real Estate as an Investment
  • Investors take equity or debt position
  • Distinction between investors in real assets and
    investors in financial assets
  • While both are investors, exclude mortgage
    lenders from this study of investment analysis
    and decision making

5
Figure 1.1
6
Who Are the Investors?
  • Private investors
  • Institutions, such as REITs and pension funds
  • Small level of foreign holdings
  • Concentrated in locales and types of properties
  • Surged during early 1980s and later moderated
  • Level shifts with foreign exchange rates
  • Level impacted by relative interest rates

7
Figure 1.2
8
Real Estate Investment Performance
  • Data for investment comparisons scarce, but
    frequently concluded that real estate generates
    returns roughly comparable to common stock, with
    greater predictability of returns
  • More data for investment return comparisons
    available recently, but heavily influenced by
    period from which data are drawn
  • Brueggeman, Chen and Thibodeau analysis--real
    estate funds outperformed Standards and Poors
    500 stock index and Ibbotson Associates bond index

9
Real Estate Investment Performance
  • Giliberto compared REIT yields with Standard and
    Poors 500 stock index, 1978 1989 found
    advantage in common stocks
  • Zerbst and Cambon (1984) analyzed earlier
    studies found real estate tends to outperform
    stocks during periods of inflation
  • Clayton and MacKinnon (2001) find REIT returns
    now closely correspond to returns on small
    capitalization stocks

10
Concepts and Definitions
  • Most Probable Selling PriceProbabilistic
    estimate of the price at which a future
    transaction will occur
  • Investment Value Value of a property as an
    investment to a present or prospective owner

11
Concepts and Definitions
  • Transaction Investment value from the present
    owners perspective sets the lower end of the
    range of possible transaction prices. Investment
    value from the perspective of the most likely
    buyer determines the upper end of the range.
  • To be motivated to sell, seller must conclude
    most probable selling price is greater than
    investment value
  • To be motivated to buy, buyer must conclude
    investment value is greater than most probable
    selling price
  • For transaction to be possible, investment value
    from prospective buyers point of view must be
    greater than from the prospective sellers point
    of view

12
Figure 1.3
13
Figure 1.4
14
Figure 1.5
15
Estimating Investment Value An Overview
  • Investor who buys property buys set of
    assumptions about ability of property to generate
    cash flows over the expected holding period and
    likely market value of property at end of
    proposed holding period. Analysis
  • Estimate the stream of expected benefits
  • Adjust for timing differences in expected streams
    of benefits from investment alternatives
  • Adjust for differences in perceived risk
    associated with alternatives
  • Rank alternatives according to relative
    desirability of the perceived risk-return
    combinations they embody

16
Estimating Investment Value An Overview
  • Value of an investment property is sum of the
    debt and equity positions
  • Investment can be expressed as present value of
    the equity position plus the present value of
    debt position

17
Figure 1.6
18
Figure 1.7
19
Investors Disagree on Investment Values
  • Investors unlikely to arrive at same investment
    value conclusions as they differ on
  • Future stream of rental revenue and operating
    expenses
  • Perceived levels of risks
  • Willingness to defer immediate consumption in
    interest of future benefits
  • Desire for precisely determinable future
  • Investors in higher-income brackets benefit more
    from tax-deductible losses

20
Investor Objectives and Risk
  • Seek financial return as reward for committing
    resources and as compensation for bearing risk
  • Emotional temperament plays a large role in an
    investors attitude
  • Relate expected return to risk accept additional
    perceived risk only if accompanied by additional
    expected return
  • Tend to become increasingly averse to additional
    risk as total perceived risk increases

21
Figure 1.8
22
Figure 1.9
23
Investment Strategy and the Concept of Market
Efficiency
  • Chapter 2

24
Supply, Demand, and the Price of Real Estate
Assets
  • Demand
  • Relationship between market price and the
    quantity of a good or service that will be bought
    per time period, over the entire range of
    possible prices
  • For real estate assets, demand is inversely
    related to their price

25
Figure 2.1
26
Supply, Demand, and the Price of Real Estate
Assets
  • Demand Schedule is the relationship between price
    and quantity demand curve is the graphic form of
    the same information
  • A specific demand schedule applies only to a
    defined population vying for a particular class
    of property

27
Supply, Demand, and the Price of Real Estate
Assets
  • Shift in demandthe entire range of relationships
    between price and quantity demanded changes.
    Among determinants of location and shape of
    demand curves for real estate assets, and of
    changes in demand are
  • Number of prospective tenants
  • Changes in operating expenses
  • Yields available on other assets
  • Technology
  • Tastes

28
Figure 2.2
29
Supply, Demand, and the Price of Real Estate
Assets
  • Example - demand schedule for downtown office
    space
  • Price changes alter quantity demanded
  • Decline in after-tax cash flow
  • Market areas become relatively more desirable,
    drop bidding for downtown property
  • Less downtown space purchased at each possible
    price per square foot

30
Figure 2.3
31
Supply, Demand, and the Price of Real Estate
Assets
  • Relative Scarcity
  • Property in abundance commands no substantial
    value
  • Supply is defined as the relationship between
    price and the quantity of a product suppliers
    place on the market during a specified time
    period, for all possible prices

32
Supply, Demand, and the Price of Real Estate
Assets
  • Supply function differs as specified time period
    is lengthened or shortened
  • Short runvariations in the supply of real estate
    placed on the market are an individuals
    perceptions of the relationship between market
    value and investment value
  • Long runthe supply curve of real estate is
    influenced by cost of construction

33
Supply, Demand, and the Price of Real Estate
Assets
  • Quantity supplied refers to amount of product
    that will be placed on the market per period of
    time at a specified price
  • Supply the relationship between price and
    quantity supplied over the entire range of
    possible prices

34
Supply, Demand, and the Price of Real Estate
Assets
  • Equilibrium price price at which there will be
    sufficient quantity of a product to satisfy
    desires of all consumers at that price, but with
    no surplus remaining on the market. Quantity
    demanded and quantity supplied meet at the point
    where the supply and demand functions intersect.

35
Figure 2.4
36
Figure 2.5
37
Figure 2.6
38
Market Efficiency and Profit Opportunities
  • Markets institutional arrangements or mechanisms
    whereby buyers and sellers are brought into
    contact with each other. There are not
    necessarily physical entities or geographical
    location

39
Market Efficiency and Profit Opportunities
  • Marketscommonality of product
  • Owner-occupant market
  • Renter-occupant market
  • Multifamily investment
  • Nonresidential market

40
Figure 2.7
41
Market Efficiency and Profit Opportunities
  • Range of Markets
  • In an atomistic market, each participant is so
    insignificant relative to the size of the total
    market that he has no perceptible effect on
    price, Every buyer can purchase as much as
    desired, every seller can sell as much as
    desired.
  • In an absolute monopoly, there is only one
    supplier or a good or service for which there are
    not reasonably acceptable substitutes

42
Figure 2.8
43
Market Efficiency and Profit Opportunities
  • Price Searchers and Market Efficiency
  • In an efficient market, information is
    transmitted quickly and without cost, eliminating
    above average profit
  • Time required for information to be reflected in
    price is a measure of market efficiency
  • In less efficient market, information is scarce
    and costly greater degree of price searching

44
Market Efficiency and Profit Opportunities
  • Sources of Market Inefficiency
  • Information costly and difficult to obtain
    comparison shopping expensive and time consuming
  • High transaction costs prohibit portfolio
    adjustment
  • No two properties exactly alike

45
Strategy Implications
  • In atomistic markets, economic rent will be rare
    and short-lived
  • Less efficient the market, longer the adjustment
    process takes

46
Figure 2.9
47
Land Utilization and the Rental Value of Real
Estate
  • Chapter 3

48
Economic Factors in Land Use Decisions
  • Location choice is primarily economic decision
  • Economic models investigate land development
    patterns
  • Market imperfections create deviations, yet
    systematic pattern is discernible
  • Clusters of stores for multiple nuclei that
    create peaks in local land values

49
Economic Factors in Land Use Decisions
  • Friction of space
  • Linkages
  • Transfer costs
  • Processing costs

50
Figure 3.2
51
Figure 3.3
52
Figure 3.4
53
Figure 3.5
54
The Market for Rental Space
  • Competitive bids for best space create highest
    rents rents tend to decline as distance from 100
    percent location increases
  • Overlapping of uses

55
Market Structure and the Need for Market Research
  • Atomistic markets (price takers) have little
    need for market research sellers deliver
    homogeneous product to whatever buyer is
    currently in the market and sell for established
    market price
  • Price searchers (those who operate in
    monopolistically competitive or oligopolistic
    markets) face more complex problem control over
    market price is closely related to the extent
    that their product is distinguished from closest
    substitute
  • Each piece of real estate is unique with respect
    to exact location
  • Product differences desensitize buyers to price
    differentials
  • Price searchers with access to market
    intelligence benefit

56
Market Research Tools and Techniques
  • Chapter 4

57
The Need for Market Research
  • Investment analysts and portfolio managers need
    market information at every stage in their
    decision-making efforts
  • Market information is required not only for
    rational acquisition decisions, but for managing
    the existing investment portfolio
  • Market research is also need to facilitate
    operating management decisions

58
How Much Market Research?
  • Justified by market stability and degree of
    investment complexity
  • Maximum net benefit from research occurs when
    pursued to point where marginal benefits equal
    marginal cost
  • Decision makers must identify point of maximum
    benefit

59
Figure 4.1
60
A Design for Market Research
  • Formulate nature of problem
  • Proceed from general to specific
  • Four quadrant forecasting matrix

61
Figure 4.2
62
Preparing the Research Report
  • Summarizes procedures employed and describes
    conclusions reached
  • Everything in research report should be explained
    in terms of its bearing on the conclusion
  • Report format is determined by nature of research
    problem and needs of user

63
Data Sources
  • Primary data
  • Secondary data

64
Primary data
  • Statistics gathered by researcher precisely for
    problem at hand
  • Can be gathered by communication or by
    observation

65
Secondary data
  • Less costly and time consuming to generate
  • Never precisely in desired form
  • Available from agencies

66
Descriptive Research
  • Examples
  • Describing profile of typical tenants
  • Estimating proportion of people in a specific
    population who behave in a particular manner
  • Describes aspect of problem
  • Requires planning and catalog system
  • Cross-sectional or time series

67
Statistical Research
  • Permit reliable generalizations to be drawn after
    examination of a limited portion of the total
    pool of information
  • Descriptive statistics
  • Inferential statistics

68
Geographic Information Systems
  • (GIS) relate information to geographic location
    series of map overlays
  • Computerized systems

69
Figure 4.3
70
Reconstructing the Operating History
  • Chapter 5

71
Overview of Operating Statement
  • Concerned with actual cash flows into and out of
    investors funds
  • Present cash inflows and outflows from operations
    and extend the presentation to include
    non-operating cash flows such as those from debt
    service, income taxes and capital expenditures

72
Table 5.1
73
Overview of Operating Statement
  • Potential gross rent amount of rental revenue a
    property would generate with no vacancies
  • Operating expenses include all cash expenditures
    required to maintain and operate the property so
    as to generate the gross rent
  • Net operating income the difference between
    effective gross income and operating expenses
  • Debt service consequence of using borrowed money
    to acquire property
  • After-tax cash flow bottom linethe amount of
    cash remaining at the end of the reporting period

74
Estimating Ability to Command Rent
  • History of recent operations
  • Verify records of comparable properties
  • Estimate recent gross income through research
  • Find comparable properties
  • Define market area
  • Identify properties that prospective tenants
    would consider as close substitutes

75
Figure 5.1
76
Figure 5.2
77
Estimating Operating Expenses
  • Subject propertys operating history
  • Recent expense history of comparable properties
  • Published compendiums of similar properties as
    benchmarks

78
Table 5.2
79
Table 5.3
80
Table 5.4
81
Table 5.5
82
Table 5.6
83
Forecasting Income and Property Value
  • Chapter 6

84
Forecasting Gross Income
  • Desirability of space, attractiveness, price of
    competing space
  • Prospects for continued income-generating ability
  • Physical (natural and man-made) and location
    characteristics
  • Forecast changes in physical and location
    characteristics
  • Linkages and transfer costs
  • Inharmonious or incompatible land usage
  • Changes in supply of comparable rental space

85
Forecasting Operating Expenses
  • Extend prior years trend into future (simple
    straight-line extrapolation)
  • Alter trend line based on predicted changes
    during forecast period

86
The Net Operating Income Forecast
  • Difference between forecast of rental revenue and
    forecast of operating expenses

87
Table 6.1
88
Table 6.2
89
Estimating Future Market Value
  • Cash flow from eventual disposal
  • Capitalization rate ratio between operating
    income and market value
  • Note current capitalization rate applicable to
    comparable properties and estimate how rate might
    change over forecasting period

90
Financial Leverage and Investment Analysis
  • Chapter 7

91
Why Leverage is So Popular
  • Financial leverage using borrowed funds to
    amplify the outcome of equity investment
  • Greater ratio of borrowed funds to equity,
    greater degree of financial leverage
  • Leverage is favorable so long as the rate of
    return on assets exceeds the cost of borrowing

92
Why Leverage is So Popular
  • Spread difference between rate of return on
    assets and cost of borrowing
  • Favorable spread magnifies return on equity of
    highly leveraged investment
  • When debt service constant is less than the rate
    of return on total assets, additional financial
    leverage increases cash flow to the equity
    position

93
Table 7.1
94
Why Leverage is So Popular
  • Federal income tax law creates major incentive to
    use financial leverage
  • Interest payments generally tax deductible
  • Depreciation allowance to recover costs
  • Gains on disposal treated as capital gains

95
Measuring Financial Leverage
  • Debt/equity ratio ratio between borrowed funds
    and equity funds
  • Loan/value ratio ratio between borrowed funds
    and market value of asset being financed

96
Measuring Financial Leverage
  • Greater leverage increases risk that cash flow
    from investment will be insufficient to meet debt
    service obligation (financial risk)
  • Debt coverage ratio degree to which actual net
    operating income can fall below expectations and
    still be sufficient to meet debt service
    obligation

97
How Much is Enough Financial Leverage?
  • Lenders frequently express maximum amount of loan
    in terms of minimum permissible debt coverage
    ratio
  • Lenders specify maximum permissible loan-to-value
    ratio
  • As more money is borrowed to finance an
    investment, the venture becomes increasingly
    risky
  • Increasing amount of borrowed funds relative to
    equity funds drive up cost of borrowing

98
Table 7.3
99
Who Are the Lenders?
  • Commercial banks
  • Life insurance companies
  • Pension funds
  • Commercial mortgage-backed securities (CMBs)

100
Credit Instruments and Borrowing Arrangements
  • Chapter 8

101
Credit and Security Instruments
  • Promissory notes
  • Mortgages
  • Purchase-money mortgages
  • Blanket mortgages
  • Open-ended mortgage
  • Deed of trust

102
Credit Terms
  • Fully amortizing
  • Partially amortizing
  • Straight/term/bullet
  • Portion of interest deferred
  • Fluctuating interest rates

103
Alternative Financing Methods
  • Installment sales contracts
  • Sale and leaseback
  • Junior mortgages

104
Government-Sponsored Credit Arrangements
  • Department of Housing and Urban Development
  • State and local government private activity bonds
  • Redevelopment bonds

105
The Cost of Borrowed Money
  • Chapter 9

106
The Many Faces of Interest Expense
  • Nominal rate or contract rate interest rate
    based on face amount of promissory note
  • Effective rate rate actually paid
  • After-tax borrowing costs are usually lower than
    before-tax costs
  • Real rate of interest effective rate, adjusted
    for price inflation

107
Table 9.1
108
Comparing Financing Alternatives
  • Effective interest rates differ
  • Different contract rates
  • Differences in effective rates due to differences
    in loan origination fees or discount fees
  • Lenders often refuse to quote rate until late in
    loan approval process

109
Table 9.5
110
Basic Income Tax Issues
  • Chapter 10

111
Nature and Significance of the Tax Basis
  • Newly acquired propertys initial tax basis is
    starting point in determining income tax
    consequences of operating the property and,
    ultimately, the tax consequence of disposal
  • During holding period, tax basis is adjusted to
    reflect disinvestment or additional capital
    investment

112
Nature and Significance of the Tax Basis
  • Selling or exchanging a property generates a gain
    or loss equal to the difference between the sales
    price and the adjusted basis of the property at
    the time of disposal

113
The Initial Tax Basis
  • Property acquired as gift, initial tax basis the
    same as donors, unless donor incurs gift tax
    liability
  • Property acquired by inheritance, initial tax
    basis is market value as determined for estate
    tax purposes
  • Property acquired by purchase, cost forms buyers
    initial tax basis

114
Allocating the Initial Tax Basis
  • Two or more assets acquired together, initial tax
    basis must be allocated between them using ratio
    of their relative market value
  • Specify price of each in original purchase
    contract
  • Use ratio of land value to building value
    estimated by tax assessor
  • Have independent appraiser estimate relative
    value of land and buildings

115
Adjusting the Basis in Cost Recovery
  • Depreciation allowance An allowance of capital
    invested in improvements of property held for
    business or investment purposes.
  • Does not apply to property held for personal use
    or primarily for resale
  • Land, considered virtually indestructible, is not
    included in depreciation allowance computation

116
Adjusting the Basis in Cost Recovery
  • Claiming tax deduction for cost recovery
    allowances reduces a propertys tax basis
  • Lower the adjusted tax basis when property is
    sold, the greater the taxable gain on disposal

117
Recovery of Building and Other Improvements
  • 27.5 years for buildings intended for residential
    rental purposes
  • 39 years for buildings intended for other
    allowable purposes
  • 15 years for land improvements such as walks,
    roads, sewers, and fences

118
Recovery of Building and Other Improvements
  • Allowance for buildings are computed using
    straight-line method
  • Allowances for improvements on and to the land
    may be computed using the 150 percent declining
    balance method

119
Other Adjustments to the Tax Basis
  • Basis is reduced when portion of asset is sold or
    destroyed by casualties such as fire, flood, or
    storm
  • Owners tax basis is increased by expenditures
    that materially increase the propertys value or
    useful life
  • Transaction costs are added to the tax basis

120
Table 10.2
121
Tax Consequences of Ownership Form
  • Title may vest in owners as individuals
  • Title may vest in a corporation
  • Tax Option Corporations
  • Investors may form a general partnership
  • Limited partnership may hold title
  • Limited liability company

122
Tax Consequence of Property Sales
  • Adjusted tax basis at time of sale is the initial
    tax basis plus all additional capital
    investments, minus cumulative depreciation
    allowances, plus-or-minus certain other
    adjustments that may sometimes apply
  • Gain or loss on propertys sale is difference
    between the value of consideration received and
    the adjusted tax basis at the time of the
    transaction

123
Tax Consequences of Financial Leverage
  • Borrowing or repaying debts are not taxable
    events
  • Interest expense is usually tax-deductible in the
    year the interest is paid
  • Exception--prepaid interest is not deductible
    until actually earned by the lender

124
Tax Consequences of Financial Leverage
  • Construction period interest is special
    exceptionmust be capitalized reflected in
    annual depreciation allowances
  • Deductibility of mortgage interest is limited by
    passive asset loss limitation rules
  • Strategyborrow against equity rather than
    selling, as selling will trigger a taxable gain

125
Income Tax Credits for Property Rehabilitation
  • Tax credits direct, dollar-for-dollar offsets
    against ones income tax obligation
  • Expenditures to rehabilitate certain buildings
    qualify for a 10 percent rehabilitation tax credit

126
Limitations on Deductibility of Losses
  • Limited partners income and expenses from a
    partnership are always considered passive asset
    items
  • Real estate held for rental purposes is passive
    unless it is incidental to the primary business
    activity
  • Special exception for real estate investors who
    are not actively engaged in a real estate trade
    or business to deduct up to 25,000 of passive
    asset losses each year

127
Figure 10.1
128
Taxation of Foreign Investors
  • Taxpayer who acquires a U.S. real estate interest
    from a foreign owner must withhold and remit to
    the IRS 10 percent of the gross sales price,
    unless
  • Property is worth no more than 300,000 and is to
    be used by purchaser as personal residence
  • Transaction is protected from taxation pursuant
    to a U.S. tax treaty
  • Seller or buyer obtains a certificate form the
    IRS that reduces the amount to be withheld

129
Taxation of Foreign Investors
  • Buyer who fails to withhold the correct amount
    may be liable for the under-withheld amount, plus
    interest and penalties

130
Alternative Minimum Tax
  • After figuring tax liability the regular way,
    taxpayers must perform an alternative
    computation, and pay taxes on whichever
    computation method results in the greater
    liability
  • Alternative computation tax credits, and many tax
    deductions, that are permitted in the regular
    computation must be excluded

131
Tax Consequence of Property Disposal
  • Chapter 11

132
Computing the Realized Gain or Loss
  • Everything of economic value received in exchange
    for a property comprises the consideration
  • If seller receives other property or services as
    part of the transaction, these must be included
    at their fair market value
  • Difference between consideration received and the
    adjusted tax basis at the time of the transaction
    is the realized gain or loss on disposal

133
Tax Treatment of Realized Gains or Losses
  • Gains are ordinary income when they result from
    recapture of depreciation allowances.
  • Gains are also ordinary income when they result
    from selling real estate that has been held for
    resale in the normal course of business (dealer
    property).
  • Gains on the sale or exchange of real estate held
    for business or investment purposes are capital
    gains. If the holding period exceeds one year,
    the gain is a long-term capital gain.

134
Tax Treatment of Realized Losses
  • Real estate used in a trade or business (includes
    actively managed rental property) and held for
    more than one year are called Section 1231
    assets. Gains on their disposal are treated as
    capital gains, losses are treated as offsets
    against ordinary income.
  • Losses on real estate held for investment
    purposes are capital losses. If the real estate
    is held for more than one year, the loss is a
    long-term capital loss

135
Computing Net Gain or Loss on Sale of Assets Held
for Use in Trade or Business
  • Offset Section 1231 gains and losses against each
    other.
  • Offset long-term capital gains against long-term
    capital losses
  • Offset short-term capital against against
    short-term capital losses
  • If there are net losses in one category and gains
    in the other, offset the two

136
Tax Consequences Depends Upon Outcome of
Offsetting Gains and Losses
  • If outcome is net short-term gains, lump them
    with ordinary income
  • If outcome is net long-term gains, they are taxed
    at the maximum rate of 20, regardless of
    taxpayers marginal tax bracket.
  • If outcome is net losses, they are offset against
    ordinary income on a dollar-for-dollar basis, but
    only to the extent of 3,000 per year

137
When Realized Gains or Losses Are Recognized
  • Gains are realized when a transaction is
    completed
  • They may be recognized (and tax consequences
    experienced) in that year or at another time

138
Using the Installment Method
  • If seller takes back a promissory note in part
    payment for property, it may be possible to defer
    recognition of part of the taxable gain until
    principal amount of the note is collected
  • Gain that may be deferred is the installment
    method gain total gain minus any portion that
    represents recapture of accelerated depreciation
    allowances

139
Using the Installment Method
  • Contract price is total selling price, less
    balance of any mortgage note payable by the
    purchaser to a third party
  • Each year, recognized gain is determined by
    multiplying the amount of the sales price
    actually collected by the seller, multiplied by
    the ratio of the installment method gain to the
    contract price

140
Using the Installment Method
  • Installment note must include a provision for
    reasonable rate of interestotherwise, IRS
    imputes a reasonable rate and recalculates the
    tax consequences of the transaction
  • Complex tax rules limit the extent to which a
    taxpayer can defer a gain by using the
    installment method when they themselves own
    substantial amount of mortgage indebtedness

141
Like-Kind Exchanges
  • An otherwise taxable gain realized on an exchange
    of like-kind assets need not be recognized in the
    year of the transaction. Tax liability is
    postponed until a future, taxable transaction
    occurs with respect to the newly acquired
    property.

142
Like-Kind Exchanges
  • Enabling legislation for like-kind exchanges
    (called tax-free exchanges) is contained in
    Section 1031 of the Internal Revenue Code.

143
Like-Kind Exchanges
  • To qualify under Section 1031
  • Must have been bona fide exchange of assets
    involved
  • Property conveyed must have been held for
    productive use in a trade or business or an
    investment and must be exchanged for like-kind
    property that is also to be used in a trade or
    business or held as an investment
  • Property must be of like-kind

144
Like-Kind Exchanges
  • Certain types of property are specifically
    excluded form Section 1031
  • Foreign real estate is never considered
    like-kind with domestic real estate

145
Tax Consequences of Like-Kind Exchanges
  • If all property involved in an exchange qualifies
    as like-kind and all parties qualify, then no
    party to the exchange may recognize any gain or
    loss on the transaction.
  • Should some of the property involved in an
    exchange fail the like-kind test, then some
    portion of a gain must be recognized in the year
    of the transaction.
  • Receipt of property that does not meet the
    like-kind definition has the effect of partially
    disqualifying a gain from deferral under Section
    1031.

146
Giving Property Away
  • Gifts and legacies are subjected to a unified,
    graduated gift and estate tax that is imposed on
    the person who makes a gift or to the estate of a
    decedent

147
Giving Property Away
  • Exemptions and exclusions from the gift and
    estate tax
  • One may give as much as 11,000 each to as man
    persons as one wishes each year with no gift tax
    implications (22,000 for spouses)
  • Unlimited exemption for gifts or legacies to a
    spouse who is a United States citizen
  • Unlimited exemption for payment of tuition and
    medical expenses for others

148
Giving Property Away
  • Gifts are cumulative over the givers lifetime
    for purposes of determining the graduated tax
    rate, but gift taxes are due in the year the gift
    is made
  • Each taxpayer has a lifetime credit against the
    unified gift and estate tax. The amount of the
    credit will shelter 1,000,000

149
Giving Property Away
  • Gift of property that is subject to a mortgage
    will have sale as well as gift elements
  • The tax basis of a recipients interest in
    property received as a gift is the same as the
    basis of the givers, unless the giver incurred a
    gift tax liability.
  • Letting title pass as a legacy rather than a gift
    works better for highly appreciated property

150
Traditional Measures of Investment Worth
  • Chapter 12

151
Ratio Analysis
  • Ratios are employed to gauge the reasonableness
    of relationships between various measures of
    value and performance
  • Income multipliers
  • Financial ratios

152
Income Multipliers
  • Express the relationship between price and either
    gross or net income
  • Multiplier analysis permits obviously
    unacceptable opportunities to be weeded out
  • Gross income multipliers
  • Net income multipliers

153
Financial Ratio Analysis
  • Frequently employed to facilitate inter-property
    comparisons.
  • Operating ratio
  • Break-even ratio
  • Debt coverage ratio

154
Traditional Profitability Measures
  • Attempt to relate cash investment to expected
    cash returns in some systematic fashionnot
    equally successful
  • Overall capitalization rate (free-and-clear rate
    of return)
  • Equity dividend rate (Cash-on-Cash rate of
    return)

155
Traditional Profitability Measures
  • Brokers rate of return
  • Payback period

156
Traditional Profitability Measures
  • Shortcomings of traditional measures of
    investment performances
  • Ignore cash-flow expectations during the later
    years of the holding period
  • Ignore cash-flow expectations from disposal

157
Toward More Rational Analysis
  • Five major factors governing the relative
    attractiveness of a real estate investment must
    be incorporated into rational real estate
    investment analysis

158
Toward More Rational AnalysisMajor Factors
  • Anticipated stream of net cash flow to the
    investor
  • Expected timing of cash receipts
  • Degree of certainty with which expectations are
    held
  • Yields available from alternative investment
    opportunities
  • Investors attitude toward risk

159
Toward More Rational Analysis
  • Time-adjusted investment evaluation measures
  • Discount expected future cash flows to make them
    more nearly comparable to those receivable in the
    present

160
Discounted Cash-Flow Analysis
  • Chapter 13

161
Present Value
  • Present value is the value today of benefits that
    are expected to accrue in the future
  • When discounting is done at the minimum
    acceptable rate of return on equity
  • Present value in excess of the required initial
    equity cash outlay implies that a project is
    worthy of further considerations
  • A present value totaling less than the required
    initial equity expenditure results in automatic
    rejection

162
Present Value
  • To use this approach, discount all anticipated
    future cash flows at the minimum acceptable rate
    of return. The result is the present value of
    expected cash flows.
  • PVCF1/(1i)CF2(1i)2CF3/(1i)3.(CFn/(1i)n

163
Net Present Value
  • Subtracting the required initial equity
    expenditure from the present value yields net
    present value
  • A positive net present value means a project is
    expected to yield a rate of return in excess of
    the discount rate, and therefore merits further
    consideration
  • A net present value of less than zero means the
    project is expected to yield a rate of return
    less than the minimum acceptable rate, and
    therefore should be rejected

164
Internal Rate of Return
  • There is an inverse relationship between discount
    rates and present value
  • The rate that will exactly equate the present
    value of a projected stream of cash flows with
    any positive initial cash investment is the
    internal rate of return

165
Internal Rate of Return
  • n
  • Cost S CF1/(1k)t
  • t1
  • Where CF is the cash flow projected for year
    t, cost is defined as the initial cash outlay,
    and k is the discount rate that makes the present
    value of the expected future cash flows exactly
    equal to the initial cash outlay

166
Internal Rate of Return
  • Decision criteria using the IRR is
  • If the internal rate of return is equal to or
    greater than an investors required rate of
    return, a project is considered further
  • If the internal rate of return is less than the
    minimum acceptable rate of return, the project is
    rejected

167
Problems with the Internal Rate of Return
  • Can result in conflicting decision signals
  • Might result in investment error

168
ReinvestmentRate Problem
  • Interproject comparison using internal rate of
    return analysis involves an implicit assumption
    that funds are reinvested at the internal rate of
    return. The internal rate of return method
    reliably discriminates between alternatives only
    if there are available other acceptable
    opportunities expected to yield an equally high
    rate.

169
The Multiple-Solutions Problem
  • Generally, a projects net present value is a
    decreasing function of the discount rate
    employed. Thus, with successively a higher
    discount rates, a point is reached where the net
    present value is zero. This is the internal rate
    of return, and any greater discount rate will
    result in a negative net present value.

170
The Multiple-Solutions Problem
  • Not all cash-flow forecasts have one internal
    rate of return equating all cash inflows with all
    cash outflows.
  • Investment proposals may have any number of
    internal rates of return, depending on the
    cash-flow pattern.

171
Comparing Net Present Value and IRR
  • When using internal rate of return, reject all
    projects whose internal rate of return is less
    than the minimum required rate of return.
    Projects with an internal rate of return equal to
    or greater than the minimum acceptable rate are
    considered further.

172
Comparing Net Present Value and IRR
  • When using net present value, discount at the
    minimum acceptable rate of return and reject all
    projects with a net present value of less than
    zero. Projects with a net present value of zero
    or greater are considered further.

173
Comparing Net Present Value and IRR
  • Under most circumstances, the internal rate of
    return and net present value approaches will give
    the same decision signals
  • In some conditions, contradictory signals emerge
  • Given different decision signals, results of net
    present value are usually preferred

174
Modified Internal Rate of Return
  • Discounts all negative cash flows back to the
    time at which the investment is acquired, and
    compounds all positive cash flows forward to the
    end of the final year of the holding period.

175
Financial Management Rate of Return
  • Findley and Messner have developed a variation on
    the internal rate of return called financial
    management rate of return which incorporates two
    intermediate rates
  • Cost of capital rate employed to discount
    negative cash flows back to year zero
  • Specified reinvestment rate for compounding
    positive cash flows to the end of the projection
    period

176
Investment Goals and Decision Criteria
  • Chapter 14

177
Choosing a Discount Rate
  • Choice is critical in selecting between
    alternative opportunities and deciding what
    opportunities merit additional considerations
  • Summation technique
  • Risk-adjusted discount rate

178
Investment Decisions and Decision Rules
  • Precise rules for making investment decisions
    depend of the nature of the problem
  • Net present value does not give an unambiguous
    decision signal when projects require different
    levels of initial cash outlay
  • Profitability index (PI) is calculated by
    dividing the present value of expected future
    cash flows by the amount of the initial cash
    outlay. The quotient represents present value per
    dollar of initial cash expenditure

179
Investment Decisions and Decision Rules
  • General decision rule is to accept the project
    with the greatest profitability index (assuming
    there is no difference in the risk profile of
    competing opportunities)

180
Investment Decisions and Decision Rules
  • Investors must select from between investment
    alternatives, all of which are considered
    desirable.
  • Investors constantly face mutually exclusive
    investment decisions
  • The most appropriate technique for deciding
    between mutually exclusive alternatives when
    using the net present value approach is to accept
    the alternative producing greater (positive) net
    present value.
  • When using the internal rate of return, the most
    appropriate approach is to accept the proposal
    having the higher internal rate of return,
    providing it is greater than the predetermined
    rate.

181
Investment Decisions and Decision RulesMutually
Dependent Proposals
  • Investment proposals are mutually dependent if
    acceptance of one forces the investor to accept
    the other. Acquisition of more than one property
    at a time requires consideration of results from
    alternative combinations.

182
Investment Decisions and Decision RulesMutually
Dependent Proposals
  • Group mutually dependent ventures into
    consolidated units, and treat each unit as a
    single investment venture
  • Accept mutually dependent combination having the
    highest net present value
  • If packages differ in amount of initial equity
    cash expenditure, compare the profitability
    indexes of the combinations
  • If internal rate of return method is being used,
    accept the combination having the highest
    calculated return

183
Investment Value and Investment Strategy
  • Investment value is value of an income producing
    property to a particular investor
  • Prospective investors will be motivated to buy if
    they believe their subjective investment value is
    greater than the amount they will have to pay for
    a property

184
Investment Value and Investment Strategy
  • Owners will be motivated to sell if they believe
    they will receive more than their properties are
    worth to them as elements in their personal
    investment portfolios
  • The greater the spread between investment value
    and transaction price for both buyer and seller,
    the greater the possible increase in both
    investors wealth

185
Risk in Real Estate Investment
  • Chapter 15

186
Major Risk Elements
  • Financial risk
  • Insurable risk
  • Business risk

187
Figure 15.1
188
Controlling Risk
  • Risk analysis
  • Invest in less risky projects
  • Eliminates opportunities for extraordinary
    profits
  • Financial market assigns appropriate level of
    return to each opportunity, commensurate with
    level of risk perceived
  • In an efficient market, the only way to reduce
    risk associated with single investment ventures
    is to choose a venture with a lower expected
    return

189
Figure 15.4
190
Controlling Risk
  • Real estate markets tend to be somewhat less
    efficient than are organized securities markets.
    Real estate investors who can exploit market
    inefficiencies are able to reap extraordinary
    profits without shouldering commensurately
    greater risk.

191
Controlling Risk
  • Investors can control risk exposure by
    considering the relationship between assets
    already held and potential new acquisitions.

192
Controlling Risk
  • Real estate investors are forced to make
    assumptions about a ventures ability to generate
    income over an extended period. Risk is often
    viewed as the possibility of variance between
    assumptions and actual outcomes.

193
Controlling Risk
  • Lease agreements often permit landlords to shift
    some risk to tenants.
  • Hedging may also reduce risk.

194
Risk Preferences and Profit Expectations
  • Rational investors prefer a higher to a lower
    return for a given level of risk for a specified
    level of return they prefer less risk to more
    risk
  • They accept additional risk only if accompanied
    by additional expected investment rewards

195
Figure 15.6
196
Risk Preferences and Profit Expectations
  • Configuration of risk-reward indifference curves
    will depend upon the individual investors
    personal attitude toward risk.

197
Risk Preferences and Profit Expectations
  • The more risk averse the individual, the more
    steeply sloped the indifference curve showing
    that persons preference
  • The indifference curve of an investor who is
    indifferent toward risk has no curvature at all
  • Some investors may be willing to trade expected
    return for the opportunity to bear greater risk,
    and will therefore have a downward-sloping risk
    reward indifference curve

198
Successful Insurance Firms as Rational Risk Takers
  • Allow insured parties to substitute the certainty
    of a small loss for the uncertainty of a larger,
    possibly catastrophic loss
  • Astute risk management
  • Risk takers by design

199
Measuring Risk
  • Rational investors will seek to determine the
    amount of risk associated with an investment
    opportunity and will decide upon a minimum
    expected return that will justify the perceived
    risk

200
Measuring Risk
  • Traditional approaches to incorporating a risk
    premium have included
  • Using a shorter payback period
  • Higher required rate of return
  • Downward adjustment to projected cash flows

201
Measuring Risk
  • Traditional risk-adjustment techniques share a
    serious shortcomingthey do not permit
    quantification of the risk element.

202
Traditional Risk-Adjustment Methods
  • Chapter 16

203
The Payback-Period Approach
  • Payback period is the time required for cash
    inflows from an investment to equal the original
    cash outlay.
  • Proponents of this technique adjust for risk by
    varying the minimum acceptable payback period.
  • Inadequate method
  • Desirability of real estate opportunities often
    depend heavily upon expected gain from disposal

204
Risk-Adjusted Discount Rate
  • Involves varying the discount rate to reflect
    risk perception the higher the perceived risk,
    the greater the size of the discount rate.
  • Risk-adjusted discount rate is composed of a
    risk-free rate plus a risk premium
  • Probably most commonly used approach, but fatally
    flawed

205
Certainty-Equivalent Technique
  • Instead of best estimate of future cash flows,
    substitutes an amount that leaves the client
    indifferent between expected receipt of the best
    estimate and absolute certainty of receiving the
    substitute amount. Substitute amount (certainty
    equivalent) is discounted at the risk-free rate.

206
Partitioning Present Values
  • Real estate investments are valued solely for the
    anticipated future stream of benefits ownership
    bestows. Real estate investment can be seen as
    the purchase of a set of assumptions about a
    propertys ability to produce a benefit stream
    (after-tax cash flow).

207
Partitioning Present Values
  • Factors contributing to flow include
  • income tax consequences
  • loan amortization
  • change in property value over projected holding
    period

208
Partitioning Present Values
  • Investment value can be divided into present
    value of equity and present value of debt.
    Present value of equity position can also be
    partitioned into its component parts.
  • Expressing each component as a percentage of
    total permits the relative importance of each to
    be assessed.
  • Components that comprise major segments of the
    total present vale of the equity position will
    merit extended analysis.

209
Sensitivity Analysis
  • Sensitivity analysis is a logical extension of
    partitioning to determine what portions of the
    forecast merit further refinement.
  • Revels how possible forecasting error will affect
    the present value of actual after-cash flows.
  • Consists of altering components of the forecast
    one at a time, and studying the impact on
    investment value or present value of the equity
    position.

210
Contemporary Risk Measures
  • Chapter 17

211
Probability as a Risk Measure
  • Probability the chance of occurrence associated
    with any possible outcome. Probabilities
    associated with any possible occurrence range
    from zero to one.
  • If probability equals zero, event certainly will
    not occur
  • A probability of one indicates certainty of
    occurrence

212
Probability as a Risk Measure
  • Decisions are divisible
  • Certaintyonly one possible outcome decisions
    based solely on the decision makers preference
    between certain alternatives
  • Risk-probabilities associated with various
    possible outcomes are either known or can be
    estimated
  • Uncertaintyprobabilities are neither known or
    estimable implies unknown number of possible
    outcomes

213
Probability as a Risk Measure
  • Uncertainty is not measurable
  • As better information becomes available,
    uncertain elements can be converted to risk
    factors by incorporating into analysis their
    associated probability distributions
  • Analysts generate information to estimate the
    probability of occurrence of each risk

214
Probability as a Risk Measure
  • Estimating future cash flows from real estate
    ventures is part art and part science.
  • No way to determine future, instead develop
    informed estimates
  • Couple estimates with probability estimate
  • Multiple law of probability used to determine the
    probability of occurrence of an event whose
    outcome depends in turn on the outcome of some
    prior event

215
Interpreting Risk Measures
  • Probabilistic estimates of possible investment
    outcomes provide valuable intelligence about
    relative risk
  • Probability distribution array of all possible
    outcomes and their related probabilities of
    occurrence
  • Discrete probability distribution
  • Continuous probability distribution

216
Figure 17.1
217
Interpreting Risk Measures
  • Expected Value of probability distribution of
    possible cash flows is the weighted average of
    the possible cash flows making up the
    distribution, with each value weighted by its
    attendant probability of occurrence
  • n
  • CF S CFiPi
  • i1
  • Where CF is the expected value of cash flow
    distribution, CFix is the value of the ith
    probability, and , Pi is the probability
    associated with that value.

218
Interpreting Risk Measures
  • Variance weighted average of the squared
    differences between each possible outcome and the
    expected outcome
  • n
  • V S (CFx CF)2 Px
  • x1

219
Interpreting Risk Measures
  • V is variance
  • CFx is value of the xth possible outcome
  • CF is expected value
  • Px is related probability

220
Interpreting Risk Measures
  • Square root of variance is standard deviation
  • Standard deviation has other mathematical
    properties that make it useful as a measure of
    risk
  • Once the mean and standard deviation are
    established, it is possible to determine the
    probability of occurrence of values over any
    desired interval within the distribution

221
Figure 17.2
222
Figure 17.3
223
Figure 17.4
224
Figure 17.5
225
Figure 17.6
226
Risk Management in a Portfolio Context
  • Chapter 18

227
Modern Portfolio Theory and Risk Management
  • Among the universe of possible portfolios, there
    is a subset of combinations that represent
    optimum combinations of expected return and risk.
  • Precise choice from among the subset depends upon
    the investors attitude toward risk.

228
Modern Portfolio Theory and Risk Management
  • Systematic market risk reflection of market
    prices can only by reduced in efficient market
    by accepting lower expected returns
  • Unsystematic risk function of characteristics of
    particular properties, such as location and
    design can be eliminated by diversifying the
    assets in a portfolio

229
Figure 18.1
230
Modern Portfolio Theory and Risk Management
  • Among universe of possible portfolios, the subset
    that represents the best-obtainable combinations
    of risk and return represent the efficient
    frontier, which can be altered by
  • Mixing a risk-free asset into the risky portfolio
  • Incorporating borrowing into the analysis

231
Figure 18.2
232
Real Estates Role in the Efficient Portfolio
  • Efficient frontier is a theoretical model which
    moves as the market changes
  • Studies indicate that real estate should be 10 to
    20 percent of an efficient portfolio, which is
    substantially above the average amount of real
    estate in institutional investors portfolios

233
Figure 18.4
234
Real Estate Diversification Strategies
  • Geographic localepic
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