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Real Estate Investments Real Estate Investments

Topic 12 Topic 12

I. The Nature & Scope of I. The Nature & Scope of Real Estate InvestmentsReal Estate Investments

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A. Definition of Real Estate A. Definition of Real Estate

Real Estate is artificially delineated Real Estate is artificially delineated space referenced to a fixed point on thespace referenced to a fixed point on the

surface of the earth with a fourthsurface of the earth with a fourthdimension of time. It is built to house andimension of time. It is built to house aneconomic activity that is subject toeconomic activity that is subject to

cultural preferences and restricted by cultural preferences and restricted by the public infrastructure.the public infrastructure.

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ConceptsConcepts

SpaceSpace- -Time Product Time Product Real estate is a spaceReal estate is a space- -time product, that is,time product, that is,

it generates income over time in exchangeit generates income over time in exchangefor the use of space. Examples:for the use of space. Examples:apartments, football tickets, wedding apartments, football tickets, wedding receptionsreceptions

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D . Characteristics D . Characteristics

The Real Estate Market Characteristics:The Real Estate Market Characteristics:

1. Highly Stratified, Local Markets1. Highly Stratified, Local Markets2. Heterogeneous Product 2. Heterogeneous Product 3. Private, not Public, Transactions3. Private, not Public, Transactions

4. Unsophisticated Investors4. Unsophisticated Investors5. Unorganized Market 5. Unorganized Market

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E . Investor Motivations E . Investor Motivations1. Pride in Ownership1. Pride in Ownership2. Personal Control 2. Personal Control 3. Self 3. Self--use and Occupancy use and Occupancy 4. Estate Building 4. Estate Building 5. Security of Capital 5. Security of Capital 6. High Operating Yield 6. High Operating Yield 7. Leverage7. Leverage8. Tax Shelter 8. Tax Shelter 9. Capital Appreciation9. Capital Appreciation10. Portfolio Diversification10. Portfolio Diversification

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F . Investment Disadvantages and F . Investment Disadvantages and

Risks Risks1. Illiquid 1. Illiquid 2. Management 2. Management 3. Depreciation of Value3. Depreciation of Value4. Government Controls4. Government Controls5. Real Estate Cycles5. Real Estate Cycles6. Legal Complexity 6. Legal Complexity

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G . ParticipantsG . Participants

1. Builder/developer 1. Builder/developer 2. Syndicator 2. Syndicator 3. Property Manager 3. Property Manager 4. Construction Lender 4. Construction Lender 5. Permanent Lender 5. Permanent Lender 6. Managing Equity Investor 6. Managing Equity Investor 7. Passive Equity Investor 7. Passive Equity Investor

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Real Estate Investments Real Estate Investments

Topic 12 Topic 12

II. Overview of II. Overview of Investment Decision ProcessInvestment Decision Process

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A. F ramework for Real Estate A. F ramework for Real Estate Investment Studies Investment Studies

1. Strategy 1. Strategy Develop an overall investment philosophy Develop an overall investment philosophy

2. Analysis2. AnalysisMeasuring returnMeasuring return

3. Decisions3. DecisionsRisk and return evaluationsRisk and return evaluations

4. Investment Transaction4. Investment Transaction5. Feedback 5. Feedback

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B . Investment A nalysis vs . B . Investment A nalysis vs . F easibility A nalysisF easibility A nalysis

1. Investment and Investment Analysis1. Investment and Investment Analysisa. Capital Assetsa. Capital Assets

b. Equity b. Equity c. Debt c. Debt d. NOI d. NOI

e. Lender/Equity Relatione. Lender/Equity Relationf. Maximizing Wealthf. Maximizing Wealthg. Return and Risk g. Return and Risk

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B . Investment A nalysis vs . B . Investment A nalysis vs . F easibility A nalysis (continued)F easibility A nalysis (continued)

2. Feasibility and Feasibility Analysis2. Feasibility and Feasibility Analysisa. Site in Search of a Usea. Site in Search of a Use

b. Use in Search of a Siteb. Use in Search of a Sitec. Investor Looking for the Best Investment c. Investor Looking for the Best Investment

Alternative Alternative

3. Investment Life Cycles3. Investment Life Cyclesa. Property Life Cyclea. Property Life Cycleb. Ownership Life Cycleb. Ownership Life Cyclec. Investor Life Cyclec. Investor Life Cycle

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B . Investment A nalysis vs . B . Investment A nalysis vs . F easibility A nalysis (continued)F easibility A nalysis (continued)

4. Ownership Life Cycle4. Ownership Life Cyclea. Acquisitiona. Acquisition

b. Operationb. Operationc. Disposal/Terminationc. Disposal/Termination

5. Investor Life Cycle5. Investor Life Cycle

a. Young Investor a. Young Investor b. Middle Aged Investor b. Middle Aged Investor c. Older Investor c. Older Investor

d. Institutional Investor d. Institutional Investor

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Real Estate Investments Real Estate Investments

Topic 12 Topic 12

III. Decision Making ApproachesIII. Decision Making Approachesto Real Estate Investment to Real Estate Investment

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B . Traditional F inancial Decision B . Traditional F inancial Decision

Making A

pproaches Making A

pproaches1. Investment Value Approach1. Investment Value Approach

a. Invest if: V a. Invest if: V u u C C

b. Reject if: V b. Reject if: V C C 2. IRV 2. IRV

Assumes: Assumes:

a. Productivity = NOI a. Productivity = NOI b. NOI is stabilized b. NOI is stabilized c. Holding period is infinitec. Holding period is infinite d. Capital is recaptured from income, except d. Capital is recaptured from income, except

land land

I

R o V

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Stabilized NOI Stabilized NOI

Y Y ee = 10.5%= 10.5%Year Year NOI * PV factor NOI * PV factor PV PV

11 $53,918 * .904977 $53,918 * .904977 $48,795 $48,795 2 2 56,645 * .81898456,645 * .818984 46.39146.39133 59,352 * .741162 59,352 * .741162 43,98943,98944 62,037 * .670735 62,037 * .670735 41,610 41,610 5 5 64,698 * .607000 64,698 * .607000 39,272 39,272 6 6 67,185 * .54932167,185 * .549321 36,906 36,906

Sum = $256,963Sum = $256,963

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Stabilized NOI (continued) Stabilized NOI (continued)

Stabilized NOI = PV of Stabilized NOI = PV of 7 7 NOI NOI /PV of /PV of Annuity Annuity

Stabilized NOI = $256,963 / 4.292179Stabilized NOI = $256,963 / 4.292179Stabilized NOI =Stabilized NOI = $59,868 $59,868

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Estimating R Estimating R ee

Consider:Consider:

a. Real Rate of Returna. Real Rate of Returnb. Inflationb. Inflationc. Risk Premiumc. Risk Premium

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C . Modern Capital B udgeting C . Modern Capital B udgeting A pproaches A pproaches

1. The Present Value Model 1. The Present Value Model 2. Internal Rate of Return2. Internal Rate of Return3. Modified Internal Rate of Return3. Modified Internal Rate of Return4. Risk Analysis4. Risk Analysis

a. Ratio and Sensitivity a. Ratio and Sensitivity b. Simulationb. Simulationc. Elasticity c. Elasticity

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Investment Principles Investment Principles

1. The investor should buy the1. The investor should buy theassumptions that create the yield rather assumptions that create the yield rather

than the yield itself.than the yield itself.2. The investor should be as concerned 2. The investor should be as concerned about what to offer the next buyer asabout what to offer the next buyer as

with what he is buying.with what he is buying.3. The investor should price the3. The investor should price the

property apart from the tax advantages. property apart from the tax advantages.

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Investment Principles Investment Principles

4. The investor must compare4. The investor must comparealternatives.alternatives.

5. The investor should understand the5. The investor should understand the potential profit and risk potential profit and risk in terms of in terms of DOLLARSDOLLARS..

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Sources of Return from a Sources of Return from a

Real Estate Investment Real Estate Investment Cash flow from operationsCash flow from operationsTax SavingsTax SavingsEquity buildup from loan amortizationEquity buildup from loan amortizationLoan refinancing proceedsLoan refinancing proceeds

Appreciation of property value (sales Appreciation of property value (sales proceeds) proceeds)

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The Market Revenue Model :The Market Revenue Model :( B ack Door)( B ack Door)

Market RentsEquityAcct.

CashMargin

= (1 - BEP) x x BEP =

- Reserves- Vacancy

- RE Taxes- Operating Exp.

CTO CASH FOR DEBTz z

R e R m

JEA JMA+

Justified Investment Value

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The Capital Revenue Model:The Capital Revenue Model:( F ront Door)( F ront Door)

Cost of ProjectEquity

AmountDebt

Amount= (1 - m) x x m =

x R e x R m

CTO ADS

+ N OI+ Operating Expenses

+ Real Estate Taxes+ Vacancy Allowance

PGIPGI/Net Leasable Area =Required Rent to be Charged

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Example Data Example Data

1. Project Cost: $7,000,000 1. Project Cost: $7,000,000 2. M = .80 2. M = .80 3. Loan Terms: .064, 20 yrs, annual pmts.3. Loan Terms: .064, 20 yrs, annual pmts.

Hence, R Hence, R mm = .09= .09

4. RE Taxes = 10%4. RE Taxes = 10%Operating Expenses = 30%Operating Expenses = 30%Vacancy Allowance = 5%Vacancy Allowance = 5%Market Rents = $4.00/S.F.Market Rents = $4.00/S.F.Reserve Account = $44,000 Reserve Account = $44,000 R R ee = 14%= 14%

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Example Data (continued) Example Data (continued)

1. Cost of Project:1. Cost of Project: $7,000,000 $7,000,000 2. Loan to Value:2. Loan to Value: 0.800 0.800 3. Mortgage Constant:3. Mortgage Constant: 0.140 0.140 4. Mortgage Constant:4. Mortgage Constant: 0.1290.1295. Operating Expenses:5. Operating Expenses: $343,000 $343,000 6. Vacancy Losses:6. Vacancy Losses: $55,500 $55,500 7. Net Leasable Area:7. Net Leasable Area: 260,000 260,000

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Capital Revenue Model (CRM)Capital Revenue Model (CRM)

Cost of Project:Cost of Project: $7,000,000 $7,000,000 Equity Amount:Equity Amount: $1,400,000 $1,400,000 Cash Throwoff:Cash Throwoff: $ 196,000 $ 196,000 Debt Amount:Debt Amount: $5,600,000 $5,600,000

Annual Debt Service: Annual Debt Service: $ 504,000 $ 504,000 Net Operating Income:Net Operating Income: $ 700,000 $ 700,000

Plus Operating Expenses:Plus Operating Expenses: $ 343,000 $ 343,000 Plus Vacancy Losses:Plus Vacancy Losses: $ 55,500 $ 55,500 Equals Potential Gross Income:Equals Potential Gross Income: $1,098,500 $1,098,500 PGI/Net Leasable Area EqualsPGI/Net Leasable Area Equals

REQUIRED RENT:REQUIRED RENT: $4.225 $4.225

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Example Data (continued) Example Data (continued)

1. Cost of Project: $7,000,000 1. Cost of Project: $7,000,000 2. Loan to Value:2. Loan to Value: 0.800 0.800 3. Equity Dividend Rate:3. Equity Dividend Rate: 0.140 0.140 4. Mortgage Constant:4. Mortgage Constant: 0.1290.1295. Operating Expenses:5. Operating Expenses: 37.21%37.21%6. Vacancy Losses:6. Vacancy Losses: 5.00%5.00%7. Net Leasable Area:7. Net Leasable Area: 80,000 80,000

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Market Revenue Model (MRM) Market Revenue Model (MRM)

Market Rents:Market Rents: $1,100,000 $1,100,000 Cash Retained for Equity Account:Cash Retained for Equity Account: $ 166,500 $ 166,500 Less Reserves:Less Reserves: $ 44,000 $ 44,000 Less Vacancy:Less Vacancy: $ 55,500 $ 55,500 Equals Cash Throw Equals Cash Throw- -Off:Off: $ 67,000 $ 67,000 Divided by R Divided by R ee Equals Just. Eq. Amt.: $ 478,571Equals Just. Eq. Amt.: $ 478,571

Account Allowing for Monies Account Allowing for Monies- -Out:Out: $ 943,500 $ 943,500 Less Operating Expenses:Less Operating Expenses: $ 333,000 $ 333,000 Less Real Estate Taxes:Less Real Estate Taxes: $ 10,000 $ 10,000 Equals Cash for Debt:Equals Cash for Debt: $ 600,500 $ 600,500

Divided by R Divided by R mm Equals Just. Debt Amt.:$6,672,222 Equals Just. Debt Amt.:$6,672,222

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Mark et Revenue M odel ( M R M) Mark et Revenue M odel ( M R M) (continued )(continued )

Justified Investment Value:Justified Investment Value: $7,150,793$7,150,793