1 the real estate investment decision chapter 1. 2 state of the investment analysis art ...

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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

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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

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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

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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 Standard’s and Poor’s 500 stock index and Ibbotson Associates bond index

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Real Estate Investment Performance

Giliberto compared REIT yields with Standard and Poor’s 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

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Concepts and Definitions

Most Probable Selling Price—Probabilistic 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

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Concepts and Definitions

Transaction Investment value from the present owner’s 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 buyer’s point of view must be greater than from the prospective seller’s point of view

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Figure 1.3

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Figure 1.4

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Figure 1.5

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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

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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

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Figure 1.6

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Figure 1.7

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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

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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 investor’s 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

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Figure 1.8

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Figure 1.9

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Investment Strategy and the Concept of Market Efficiency

Chapter 2

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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

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Figure 2.1

26


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

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Shift in demand—the 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

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Figure 2.2

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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

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Figure 2.3

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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

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Supply function differs as specified time period is lengthened or shortened

Short run—variations in the supply of real estate placed on the market are an individuals’ perceptions of the relationship between market value and investment value

Long run—the supply curve of real estate is influenced by cost of construction

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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

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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.

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Figure 2.4

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Figure 2.5

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Figure 2.6

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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

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Markets—commonality of product Owner-occupant market

Renter-occupant market

Multifamily investment

Nonresidential market

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Figure 2.7

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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

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Figure 2.8

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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

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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

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Strategy Implications

In atomistic markets, economic rent will be rare and short-lived

Less efficient the market, longer the adjustment process takes

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Figure 2.9

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Land Utilization and the Rental Value of Real Estate

Chapter 3

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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

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Economic Factors in Land Use Decisions

“Friction of space”

Linkages

Transfer costs

Processing costs

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Figure 3.2

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Figure 3.3

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Figure 3.4

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Figure 3.5

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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

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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

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Market Research Tools and Techniques

Chapter 4

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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

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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

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Figure 4.1

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A Design for Market Research

Formulate nature of problem

Proceed from general to specific

Four quadrant forecasting matrix

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Figure 4.2

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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

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Data Sources

Primary data

Secondary data

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Primary data

Statistics gathered by researcher precisely for problem at hand

Can be gathered by communication or by observation

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Secondary data

Less costly and time consuming to generate

Never precisely in desired form

Available from agencies

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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

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Statistical Research

Permit reliable generalizations to be drawn after examination of a limited portion of the total pool of information

Descriptive statistics

Inferential statistics

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Geographic Information Systems

(GIS) relate information to geographic location; series of map overlays

Computerized systems

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Figure 4.3

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Reconstructing the Operating History

Chapter 5

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Overview of Operating Statement

Concerned with actual cash flows into and out of investor’s 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

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Table 5.1

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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 line—the amount of cash remaining at the end of the reporting period

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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

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Figure 5.1

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Figure 5.2

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Estimating Operating Expenses

Subject property’s operating history

Recent expense history of comparable properties

Published compendiums of similar properties as benchmarks

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Table 5.2

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Table 5.3

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Table 5.4

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Table 5.5

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Table 5.6

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Forecasting Income and Property Value

Chapter 6

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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

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Forecasting Operating Expenses

Extend prior years’ trend into future (simple straight-line extrapolation)

Alter trend line based on predicted changes during forecast period

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The Net Operating Income Forecast

Difference between forecast of rental revenue and forecast of operating expenses

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Table 6.1

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Table 6.2

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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

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Financial Leverage and Investment Analysis

Chapter 7

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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

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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

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Table 7.1

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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

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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

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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

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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

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Table 7.3

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Who Are the Lenders?

Commercial banks

Life insurance companies

Pension funds

Commercial mortgage-backed securities (CMBs)

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Credit Instruments and Borrowing Arrangements

Chapter 8

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Credit and Security Instruments

Promissory notes

Mortgages Purchase-money mortgages Blanket mortgages Open-ended mortgage

Deed of trust

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Credit Terms

Fully amortizing

Partially amortizing

Straight/term/bullet

Portion of interest deferred

Fluctuating interest rates

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Alternative Financing Methods

Installment sales contracts

Sale and leaseback

Junior mortgages

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Government-Sponsored Credit Arrangements

Department of Housing and Urban Development

State and local government private activity bonds

Redevelopment bonds

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The Cost of Borrowed Money

Chapter 9

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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

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Table 9.1

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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

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Table 9.5

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Basic Income Tax Issues

Chapter 10

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Nature and Significance of the Tax Basis

Newly acquired property’s 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

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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

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The Initial Tax Basis

Property acquired as gift, initial tax basis the same as donor’s, 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 buyer’s initial tax basis

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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

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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

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Adjusting the Basis in Cost Recovery

Claiming tax deduction for cost recovery allowances reduces a property’s tax basis

Lower the adjusted tax basis when property is sold, the greater the taxable gain on disposal

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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

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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

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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

Owner’s tax basis is increased by expenditures that materially increase the property’s value or useful life

Transaction costs are added to the tax basis

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Table 10.2

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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

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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 property’s sale is difference between the value of consideration received and the adjusted tax basis at the time of the transaction

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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

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Tax Consequences of Financial Leverage

Construction period interest is special exception—must be capitalized; reflected in annual depreciation allowances

Deductibility of mortgage interest is limited by passive asset loss limitation rules

Strategy—borrow against equity rather than selling, as selling will trigger a taxable gain

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Income Tax Credits for Property Rehabilitation

Tax credits – direct, dollar-for-dollar offsets against one’s income tax obligation

Expenditures to rehabilitate certain buildings qualify for a 10 percent rehabilitation tax credit

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Limitations on Deductibility of Losses

Limited partner’s 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

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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

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Tax Consequence of Property Disposal

Chapter 11

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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

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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.

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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

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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

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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 taxpayer’s 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

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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

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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

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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


Installment note must include a provision for reasonable rate of interest—otherwise, 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.

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Like-Kind Exchanges

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

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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

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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

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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.

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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


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


Gifts are cumulative over the giver’s 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


Gift of property that is subject to a mortgage will have sale as well as gift elements

The tax basis of a recipient’s interest in property received as a gift is the same as the basis of the giver’s, 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 fashion—not equally successful

Overall capitalization rate (free-and-clear rate of return)

Equity dividend rate (Cash-on-Cash rate of return)

155


Broker’s rate of return

Payback period

156


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 Analysis—Major 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

Investor’s 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.

PV=CF1/(1+i)+CF2(1+i)2+CF3/(1+i)3+….+(CFn/(1+i)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


n Cost = Σ CF1/(1+k)t

t=1

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


Decision criteria using the IRR is:

If the internal rate of return is equal to or greater than an investor’s 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

Reinvestment–Rate 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 project’s 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


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


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


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


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 Rules—Mutually 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 Rules—Mutually 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 venture’s 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


Configuration of risk-reward indifference curves will depend upon the individual investor’s personal attitude toward risk.

197


The more risk averse the individual, the more steeply sloped the indifference curve showing that person’s 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 shortcoming—they 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 property’s ability to produce a benefit stream (after-tax cash flow).

207


Factors contributing to flow include: income tax consequences loan amortization change in property value over

projected holding period

208


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


Decisions are divisible: Certainty—only one possible

outcome; decisions based solely on the decision maker’s preference between certain alternatives

Risk-probabilities associated with various possible outcomes are either known or can be estimated

Uncertainty—probabilities are neither known or estimable; implies unknown number of possible outcomes

213


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


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


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 = Σ CFiPi i=1 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


Variance – weighted average of the squared differences between each possible outcome and the expected outcome:

n

V = Σ (CFx – CF)2 Px

x=1

219


V is variance CFx is value of the xth

possible outcome CF is expected value Px is related probability

220


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 investor’s attitude toward risk.

228


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


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 Estate’s 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 investor’s portfolios

233

Figure 18.4

234

Real Estate Diversification Strategies

Geographic locale—picking locales where the real estate cycle is not highly correlated

Product type—including a range of buildings such as apartments, retail, industrial, office

Product-life cycle—including some properties that are near the end of their life-cycle, some that have reached a stabilized growth path, and others that are in the early stages of development and growth

235

Investment Feasibility Analysis

Chapter 19

236

The Nature of the Feasibility Question

Feasibility analysis attempts to estimate the probability of success of a specific proposed course of action Formal or informal Early step in investment or

development process Involves estimating the amount

and timing of required cash expenditures and expected cash inflows, and an assessment of the degree of confidence that attaches to the estimates

237


Feasible project must be: Physically possible Legally feasible Financially feasible

238

Figure 19.1

239


Feasibility analysis problems:

With a predetermined site, investigate alternative uses

With a predetermined use, investigate alternative sites

With predetermined funds, investigate alternative investment opportunities

240


Limitations should be identified and defined in analysis Limits of resources Values, goals, and objectives Physical characteristics of sites Society, through ordinances and

regulatory oversight

241

Steps in Feasibility Analysis Process

1. Assess physical and legal aspects of the site.2. Estimate demand for the proposed real estate

services.3. Analyze competitive space.4. Estimate the cost of constructions, alteration,

rehabilitation or fix-up, as proposed in the initial concept, and the cost of facility operations.

5. Estimate the cost of financing various possible combinations of equity and debt financing packages.

6. Estimate the rate at which vacant units will be rented.

7. Develop a schedule of cash inflows and outflows.

8. Evaluate the anticipated cash flows for adequacy, given the investor’s minimum acceptable rate of return and the degree of risk the investor is prepared to accept.

242

Preliminary Financial Feasibility

Analysis should be viewed as continuous process

To be feasible, project must be attractive both to equity investors and to mortgage lenders

Preliminary financial feasibility deals with the threshold questions concerning a proposed venture (solvency testing)

243

Figure 19.2

244

Figure 19.3

245

Format for a FeasibilityReport

Organization should reflect purpose; designed to facilitate use.

Common format: Title page Table of contents List of tables and exhibits Executive summary Scope and limitations Regional and city analysis Location and site analysis Market analysis Financial analysis and cash flow

projections Conclusions and recommendations

246

Analyzing Subdivision Proposals

Chapter 20

247

Overview of the Subdivision Process

Subdivision ventures grow out of developer’s perception of unsatisfied demand for certain types of buildable sites.

Implement site acquisition strategy Title acquisition, land planning, land

survey Physical improvements follow surveying

process Sale

248

Location Decisions

Subdivision location decisions must be responsive to needs of ultimate users

Subdividers also need to consider current and potential uses of abutting sites

249

Coping with Regulatory Requirements

Governmental land use control is exercised through zoning laws and master land use plans. Small-scale subdividers may limit land

acquisition to appropriately zoned tracts

Large-scale subdividers frequently develop plans requiring extensive rezoning and government approvals

Municipalities seek to influence level of subdivision activity through control over public utilities Capacity Special assessments

250

Creating the Subdivision Plan

Contents of land plans vary with size of developments Large-scale plans divide area by

specialized use categories Modest subdivision plans may simply

plot individual sites and make provision for utility easements

251

Financing the Project

Subdividers use land acquisition and development loans to raise capital

Lenders usually disburse loan proceeds on piecemeal basis as improvements are completed

Most lenders view subdivision loans as more risky than construction loans Subdividers depend upon proceeds form

land sales for funds to repay loans Project marketability is vital

252

Development and Rehabilitation

Chapter 21

253

Overview of Development

Real estate development projects range in complexity and size

Ventures often originate with a concept for finished urban space; a perception of unmet demand

Development project may be investor’s desire to use previously acquired site (“a site in search of an idea”)

254

Feasibility Analysis

Two sections of feasibility study: Market research and attempts

to determine physical and location characteristics that will have the greatest consumer appeal

Economics of proposed project

255

Feasibility Analysis

Steps: Completion of feasibility study Market research Search for site Estimate costs Estimate value Estimate operating expenses

256

Financing Real Estate Development

Construction lenders Lender risk reduced by

requiring that developers acquire end-loan commitments

If developer cannot obtain an end-loan commitment prior to arranging a construction loan, standby or gap financing may be used

257

Construction Phase

Construction projects are carried out on either a custom or speculative basis.

Custom

Speculative

258

Construction Phase

Construction companies expand and contract size in response to economic conditions and differences in scale of projects

General contractors Subcontract tasks Contract with user; General

contractors contract with subcontractors

General contractors coordinate work and oversees progress

259

Overview of Rehabilitation

Begins with existing structures in need of extensive renovation Takes deteriorated or

functionally obsolete building and improves its physical condition or brings it up to modern design standards

Gentrification impetus for much rehabilitation activity

Prime areas seem to be older inner-city neighborhoods with convenient transportation links

260

Incentive for Rehabilitation

Profit expectations

Tax legislation rewards

261

Judging Feasibility of Rehabilitation Proposals

Analysis of rehabilitation proposals

Cost estimates Subtracting all costs and

expected profit from estimated value as completed leaves the amount available for purchase of property

If property can be purchased for less, project is feasible; if cost is greater, project not feasible

262

Industrial Property, Office Building and Shopping Center Analysis

Chapter 22

263

Investing in Industrial Buildings

Industrial buildings have the advantages of reliable, credit-worthy tenants, long-term leases, and opportunities to shift many operating expenses to tenants

Business operators, short on capital, prefer to channel resources into business expansion rather than real estate ownership

264

Demand for Industrial Space

Largely a function of demand for products produced by industrial sector

Periodic shifts in demand for industrial space of various types and in different locations reflect alterations in composition of the industrial sector Growth in service and

technology Decrease for products of heavy

industry

265

Locations Factors

Near fuel or power supply

Near markets

Footlose Industries

266

Types of Industrial Buildings

No official classification system for industrial buildings. Can be characterized by nature of building’s construction or type of tenant it attracts: Heavy industrial buildings Loft buildings Modern one-story structures Incubator Buildings

267

Investing in Office Buildings

Dramatic growth in service sector has increased demand

Demand for office space is a derived demand –related to demand for services supplied by occupants of office buildings

Unlike owner-owned office buildings, investor-owned buildings tend to be more functional and less luxurious

Multi-year leases Options to renew on occupied space

268

Investing in Shopping Centers

Investors and developers have long provided favorable lease terms to anchor tenants—major stores that attract customers

Recently, developers have allowed major tenants to construct their own buildings on sites leased from owners

269

Lease Arrangement in Shopping Centers

Owners set base rental rate and increase rental rates as tenant’s sales volume increases (percentage clause)

Large shopping center tenants typically lease space on net basis, paying all expenses associated with operation of their space; smaller tenants often pay own utility expenses

Shopping center tenants often pay common area maintenance fee

270

Types of Shopping Centers

Neighborhood shopping centers

Community shopping centers

Regional shopping malls

Super regional shopping malls

Lifestyle centers

271

Real Estate Investment Trusts

Chapter 23

272

REIT Regulations

REITS are organized as corporations or trusts; each REIT is chartered in the state in which it is headquartered and is subject to regulations and statutes of that state

273

REIT Regulations

REITS are subject to provisions of IRS code, which specify minimum conditions under which they will be granted the special income tax status to which they owe their popularity with investors

274

REIT Regulations--IRS

Shares must be held by at least 100 persons, and five or fewer shareholders cannot own 50 percent or more of the shares during the last half of any tax year

REIT must be a passive investor rather than active participant in property operations

At least 75 percent of assets must consist of real estate, mortgage notes, cash, cash items, or government securities, and at least 75 percent of gross income must come from rents, mortgage investment income, and gains on the sale of real estate

At least 90 percent of ordinary income must be distributed to shareholders

275

REIT Ownership

Shareholders have approximately same rights as stockholders in any other corporation

Shareholders elect trustees or directors to conduct REIT investment and business activities

Trustees and directors hire managers to conduct general affairs

276

REIT Management

Some REITs hire internal managers, or external advisors

Advisors may select property managers to oversee operation of rental property

North American Securities Administrators Association, in a Statement of Policy on Real Estate Investment Trusts that was adopted April 28, 1981, provides guidelines for setting advisory fees

277

REIT Assets

Equities accounted for approximately 72 percent of total REIT assets in 2001; mortgage loans accounted for about 11 percent; balance held as cash or miscellaneous other assets

Equity REITs invest primarily in real estate equities; mortgage REITs invest primarily in mortgage secured loans; hybrid REITs favor a balance between equities and mortgage loans

278

REIT as Investment Vehicles

Shareholders benefit from: Limited liability Centralized management Continuity of entity life Free transferability of interests

Tax consequences of REIT investment: Shareholders are taxed directly on

distributed earnings—no double taxation as with corporations

Losses do not flow through to shareholders

REITs permit diversification on limited budget

REITs low-cost way to benefit from professional management

279


REIT ownership entails the risk associated with stock market fluctuations

280


REIT Mutual Funds permit investors to hold a diversified portfolio with a relatively modest total investment

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