McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 20Chapter 20

Prof. Hagen Sinodoru, MBA • Banking and Finance • www.sinodoru.comSt. Petersburg State University of Economics and Finance

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Understand the advantages and disadvantages of real assetsUnderstand the advantages and disadvantages of real assets Explain the portfolio significance of the correlations between Explain the portfolio significance of the correlations between

real estate and other assets real estate and other assets Explain the characteristics of investing in real estateExplain the characteristics of investing in real estate Discuss the various forms of financing for real estate Discuss the various forms of financing for real estate

investmentsinvestments Explain the traditional appeal of precious metals as a form of Explain the traditional appeal of precious metals as a form of

investmentsinvestments Understand the factors that influence the value of collectiblesUnderstand the factors that influence the value of collectibles

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Advantages and Disadvantages of Real AssetsAdvantages and Disadvantages of Real Assets Real Estate as an InvestmentReal Estate as an Investment Real Estate Returns and Correlations Real Estate Returns and Correlations Valuation of Real EstateValuation of Real Estate Forms of Real Estate OwnershipForms of Real Estate Ownership Gold and SilverGold and Silver Precious GemsPrecious Gems Other CollectiblesOther Collectibles Appendix 20A: A Comprehensive Analysis for Real Appendix 20A: A Comprehensive Analysis for Real

Estate Investment DecisionsEstate Investment Decisions

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Real assets are tangible assets that may be: Real assets are tangible assets that may be: ◦ SeenSeen◦ FeltFelt◦ HeldHeld◦ CollectedCollected

Real assets during inflationary environmentsReal assets during inflationary environmentshave at times outperformed financial assets.have at times outperformed financial assets.

Examples:Examples:• Real estateReal estate• Gold and silverGold and silver• DiamondsDiamonds• Coins, stamps, and antiquesCoins, stamps, and antiques

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An inflation hedgeAn inflation hedge Hedge against unknowns, fearsHedge against unknowns, fears Effective vehicle for diversificationEffective vehicle for diversification Improves portfolio risk-return alternativesImproves portfolio risk-return alternatives Low correlation with monetary assetsLow correlation with monetary assets May provide psychic pleasureMay provide psychic pleasure

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Lack of large, liquid, efficient marketsLack of large, liquid, efficient markets Larger commissions & spreads compared to Larger commissions & spreads compared to

securitiessecurities No current income except from real estateNo current income except from real estate Storage and insurance costs Storage and insurance costs Unit costs may be highUnit costs may be high Cyclical hysteria or overreactions Cyclical hysteria or overreactions

periodically occur (timing may be tricky)periodically occur (timing may be tricky)

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About half of U.S. households own real About half of U.S. households own real estate as a home or investmentestate as a home or investment

Brokerage and investment firms have Brokerage and investment firms have

entered the market to:entered the market to: ◦BuyBuy◦SellSell◦FinanceFinance◦Syndicate propertySyndicate property

Real estate has increased to 10% of pension Real estate has increased to 10% of pension fund portfolios todayfund portfolios today

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Investments may include: Investments may include: Homes Homes Duplexes Duplexes ApartmentsApartments OfficesOffices Industrial buildingsIndustrial buildings Shopping centersShopping centers Hotels and motelsHotels and motels Undeveloped landUndeveloped land

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The Tax Reform Act of 1986The Tax Reform Act of 1986 Substantially increased wait time to take full Substantially increased wait time to take full

advantage of real estate tax deductionsadvantage of real estate tax deductions Severely restricted writing-off of paper real Severely restricted writing-off of paper real

estate losses by passive investors against estate losses by passive investors against other forms of income other forms of income

Made real estate Made real estate investment less attractiveinvestment less attractive

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Negative impact of tax reform on realNegative impact of tax reform on realestate blamed for declining economicestate blamed for declining economicconditions of late 1980s and early 1990sconditions of late 1980s and early 1990s

1. Fewer new properties were developed1. Fewer new properties were developed2. Gluts in office space/apartments shrank2. Gluts in office space/apartments shrank3. Rents increased on existing properties3. Rents increased on existing properties4. Eventual higher real estate evaluations4. Eventual higher real estate evaluations

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Less supply plus higher demand equals Less supply plus higher demand equals higher real estate values higher real estate values

Historically low interest rates also Historically low interest rates also contributed to an increase in demandcontributed to an increase in demand

Bubble eventually burst in 2007Bubble eventually burst in 2007 An 18 month recession followedAn 18 month recession followed

◦ Second worse since Great DepressionSecond worse since Great Depression◦ 10% unemployment 10% unemployment

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What are the long-term portfolio implications of What are the long-term portfolio implications of holding real estate? holding real estate? ◦ Real estate has a low correlation with stocks/bondsReal estate has a low correlation with stocks/bonds◦ Low correlations could increase portfolio return and Low correlations could increase portfolio return and

reduce portfolio standard deviationreduce portfolio standard deviation Historically, only small cap stocks have out Historically, only small cap stocks have out

performed real estate on a risk-adjusted basis performed real estate on a risk-adjusted basis Real estate also provides steady cash flow Real estate also provides steady cash flow

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The Cost Approach The Cost Approach Comparative Sales ValueComparative Sales Value The Income Approach The Income Approach

In most cases, a final value may In most cases, a final value may be determined from a combination be determined from a combination

of the three approaches.of the three approaches.

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Easy for new propertyEasy for new property Harder for older buildings Harder for older buildings Poor location makes building worth less than Poor location makes building worth less than

its replacement costits replacement cost Economic conditions influence value Economic conditions influence value

Cost to replace an asset at current pricesCost to replace an asset at current pricesused as the value of real estateused as the value of real estate

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True comparables may be difficult to findTrue comparables may be difficult to find

Combine sale values of several comparable Combine sale values of several comparable properties to “average” out differencesproperties to “average” out differences

Find value using comparable property Find value using comparable property

prices in the neighborhoodprices in the neighborhood

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Annual net operating incomeAnnual net operating income

Capitalization rate (Cap rate)Capitalization rate (Cap rate)= Valuation= Valuation

The stream of net earnings generated by an The stream of net earnings generated by an income-producing property capitalized as a income-producing property capitalized as a

measure of that property’s worthmeasure of that property’s worth

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Annual net operating income

Capitalization rate (Cap rate)= Valuation

Future realistic values of annual rentals minus expenses such as property taxes, insurance, …

The rate of return required by investors in similar-type investments

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Example:Example:

Projected annual net operating income = $17,500 Projected annual net operating income = $17,500 Market capitalization rate = 10% Market capitalization rate = 10%Value based on this approach:Value based on this approach:

$17,500$17,500 0.100.10

= $175,000= $175,000

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Income approach helpful but overly simplistic:Income approach helpful but overly simplistic:

Annual Annual NOI*NOI* changes over time changes over time

Difficulty of choosing a capitalization rate Difficulty of choosing a capitalization rate

* NOI = Net operating income

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Benefits of combining the 3 approaches: Benefits of combining the 3 approaches: Can use insights provided by each Can use insights provided by each

individual approachindividual approach Can overcome some limitations involved Can overcome some limitations involved

in using only single approachin using only single approach

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Fixed-Payment Mortgage◦ Most frequently used

Adjustable Rate Mortgage (ARM) Graduated Payment Mortgage (GPM) Shared Appreciation Mortgage (SAM) Other Forms of Mortgages (equity

participation arrangement)

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Ownership of real estate can take many forms:Ownership of real estate can take many forms:

Individual or Regular PartnershipIndividual or Regular Partnership

Syndicate or Limited PartnershipSyndicate or Limited Partnership

Real estate investment trust (REIT)Real estate investment trust (REIT)

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Individual ownership or regular Individual ownership or regular partnershippartnership

Simplest way from a legal viewpointSimplest way from a legal viewpoint Take advantage of personal knowledge of local markets and Take advantage of personal knowledge of local markets and

changing conditions to enhance returnschanging conditions to enhance returns Well-defined center of responsibility often leads to quick Well-defined center of responsibility often leads to quick

corrective actionscorrective actions Often lacks ability to pool adequate capital to engage in Often lacks ability to pool adequate capital to engage in

large-scale investmentslarge-scale investments Often lacks expertise to develop wide range of investmentsOften lacks expertise to develop wide range of investments Unlimited liability for the investorUnlimited liability for the investor

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Syndicate or Limited PartnershipSyndicate or Limited Partnership General partner forms partnershipGeneral partner forms partnership

◦ Unlimited liabilityUnlimited liability◦ Responsible for managing propertyResponsible for managing property

Limited partners purchase participation unitsLimited partners purchase participation units◦ Liability limited to initial investmentLiability limited to initial investment◦ No responsibilities – merely investorsNo responsibilities – merely investors

Front-end fees to General PartnerFront-end fees to General Partner◦ 5-25%5-25%

Blind poolBlind pool or are specific projects identified?or are specific projects identified? Public offeringPublic offering

◦ Involves larger total amountsInvolves larger total amounts◦ SEC registrationSEC registration

Private offeringPrivate offering◦ Local in scopeLocal in scope◦ Maximum 35 investorsMaximum 35 investors

Secondary (resale) markets exist but dealer spreads and commissions Secondary (resale) markets exist but dealer spreads and commissions highhigh

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Real Estate Investment TrustReal Estate Investment Trust

Similar to mutual funds or investment companiesSimilar to mutual funds or investment companies Trade on organized exchanges or over-the-counterTrade on organized exchanges or over-the-counter Pool investor fundsPool investor funds No minimum investment other than cost of shareNo minimum investment other than cost of share Most liquid type of real estate investmentMost liquid type of real estate investment Large secondary marketLarge secondary market

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Real Estate Investment Trust (continued)Real Estate Investment Trust (continued)

To qualify, trust must receive 75% of income from real estateTo qualify, trust must receive 75% of income from real estate◦ RentsRents◦ Interest on mortgage loansInterest on mortgage loans

Must distribute at least 95% of income as cash dividendMust distribute at least 95% of income as cash dividend Equity TrustsEquity Trusts

◦ Buy, operate, and sell real estate as investmentBuy, operate, and sell real estate as investment Mortgage TrustsMortgage Trusts

◦ Make long-term loans to real estate investorsMake long-term loans to real estate investors Hybrid TrustsHybrid Trusts

◦ Engage in activities of both equity and mortgage trustsEngage in activities of both equity and mortgage trusts There are more than 400 REITS in existenceThere are more than 400 REITS in existence

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Precious metals Precious metals ◦Most volatile of real asset investmentsMost volatile of real asset investments

Historically, gold and silver:Historically, gold and silver:◦Move up in value during troubled timesMove up in value during troubled times◦Decline in value during stable & predictable Decline in value during stable & predictable

periodsperiods

20-29

Major factors that drive up gold prices are: Major factors that drive up gold prices are: Fear of warFear of war Political instabilityPolitical instability InflationInflation

Different forms of gold ownership: Gold Bullion Gold Coins Gold Stocks Gold Futures Contracts Gold ETF (GLD)

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20-31

Many of the same investment characteristics Many of the same investment characteristics as goldas gold

◦ Hedge against inflationHedge against inflation

◦ Potential safe haven investment during troubled Potential safe haven investment during troubled timestimes

Silver’sSilver’s 19761976 19801980 20062006 20102010

price per price per ounceounce

$5$5 $50$50 $12$12 $29$29

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Used for:Used for:◦ Heavy industrial and commercial applicationsHeavy industrial and commercial applications◦ PhotographyPhotography◦ Electronic Electronic ◦ Electrical manufacturingElectrical manufacturing◦ ElectroplatingElectroplating◦ Silverware and jewelrySilverware and jewelry

Different forms of silver ownership:Different forms of silver ownership:◦ Silver BullionSilver Bullion◦ Silver CoinsSilver Coins◦ Silver Futures ContractSilver Futures Contract◦ Silver Mining StocksSilver Mining Stocks

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DiamondsDiamonds RubiesRubies SapphiresSapphires Emeralds Emeralds Gems appeal to investors because of their: Gems appeal to investors because of their:

◦ Small sizeSmall size◦ Easy concealmentEasy concealment◦ Great durabilityGreat durability

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Market knowledge is most importantMarket knowledge is most important

Must either be an expert or deal with Must either be an expert or deal with “honest” expert“honest” expert

Better to buy higher quality, smaller-carat Better to buy higher quality, smaller-carat diamond than lesser quality, higher-carat diamond than lesser quality, higher-carat diamonddiamond

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ArtArt AntiquesAntiques StampsStamps Chinese ceramicsChinese ceramics Rare booksRare books

Psychic pleasure as well as opportunity for Psychic pleasure as well as opportunity for profitprofit

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Appendix 20AAppendix 20A

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Any asset’s ultimate worth is based on the present value

of its future cash flows

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1.1. Determine purchase price, size of mortgage, annual mortgage Determine purchase price, size of mortgage, annual mortgage paymentpayment

2.2. Compute the net operating income for each year of the Compute the net operating income for each year of the anticipated holding periodanticipated holding period

3.3. Translate this to annual cash flow during the holding periodTranslate this to annual cash flow during the holding period

4.4. Project the selling price of the property after the holding periodProject the selling price of the property after the holding period

5.5. Discount the annual cash flows and the anticipated selling price Discount the annual cash flows and the anticipated selling price after the holding period back to the present to determine the after the holding period back to the present to determine the present value of the future benefitspresent value of the future benefits

6.6. Compare the upfront cash commitment to the present value of Compare the upfront cash commitment to the present value of future benefits to determine if the property provides a positive net future benefits to determine if the property provides a positive net present valuepresent value

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Assume:Assume: Six-unit apartment complex Six-unit apartment complex Purchased for $180,000 Purchased for $180,000 Loan 80% of the value at 12% for 20 years Loan 80% of the value at 12% for 20 years The loan would be for $144,000 ($180,000 x 80%)The loan would be for $144,000 ($180,000 x 80%) Balance of $36,000 ($180,000 - $144,000) put up in cashBalance of $36,000 ($180,000 - $144,000) put up in cash From table below, annual mortgage payment for 20 years at From table below, annual mortgage payment for 20 years at

12% is 12% is $19,280$19,280

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Assume buyer intends to hold property for 4 years and then sell it. We can determine the value each year from the table below:

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Income from operations must be adjusted by Income from operations must be adjusted by nonoperating factors such as: nonoperating factors such as: Interest expenseInterest expense DepreciationDepreciation Taxable income/lossesTaxable income/losses Related taxes or tax shield benefitsRelated taxes or tax shield benefits Repayment of the mortgageRepayment of the mortgage

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Table 20A-3 Subtracts depreciation and interest expense Table 20A-3 Subtracts depreciation and interest expense from net operating income to find from net operating income to find taxable income or loss taxable income or loss for each yearfor each year

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To the extent the investor is actively involved with the To the extent the investor is actively involved with the property, the losses during the first two years can be used property, the losses during the first two years can be used as a as a tax shield (shelter)tax shield (shelter) for other income as reflected in for other income as reflected in Table 20A-4Table 20A-4

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Net Operating Income is combined with annual tax shield Net Operating Income is combined with annual tax shield benefits or taxes owed & the annual mortgage payments to benefits or taxes owed & the annual mortgage payments to determine the determine the total annual value of cash flowtotal annual value of cash flow in Table in Table 20A-520A-5

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Property purchased for $180,000 Property purchased for $180,000 Appreciates 6% per year over 4 year periodAppreciates 6% per year over 4 year period Sales value: $180,000 x 1.262Sales value: $180,000 x 1.262** = = $227,160$227,160

Net proceedsNet proceeds from selling the property after subtracting sales from selling the property after subtracting sales commission & fees of 7% commission & fees of 7%

= $277,160 – (0.07 x $227,160) = = $277,160 – (0.07 x $227,160) = $211,259$211,259

*Appendix A – Compound sum 4 periods at 6% the factor is 1.262

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To the extent that the net proceeds exceed the book value of the property, a To the extent that the net proceeds exceed the book value of the property, a capital gains tax has to be paid:capital gains tax has to be paid:

• Book valueBook value = = Purchase price of Purchase price of $180,000$180,000minus [4 years of depreciation: 4 x $5,096] minus [4 years of depreciation: 4 x $5,096] $ 20,384$ 20,384

== $159,616$159,616

• Capital gainCapital gain = Net proceeds of sale = Net proceeds of sale $211,259$211,259minus book value minus book value $159,616$159,616

= = $ 51,643$ 51,643

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• Funds from saleFunds from sale = Net Proceeds = Net Proceeds $211,259$211,259 minus Capital gains tax [15% x $51,643]minus Capital gains tax [15% x $51,643] $ 7,746$ 7,746

= = $203,513$203,513

• From the funds from the sale, the investor must pay off the mortgage balance From the funds from the sale, the investor must pay off the mortgage balance of $134,432 that exists after four years of repayments of principal:of $134,432 that exists after four years of repayments of principal:

Funds from saleFunds from sale $203,513 $203,513 Payoff of mortgage Payoff of mortgage - $134,432 - $134,432

Net cash flow (from sale)Net cash flow (from sale) = = $ 69,081$ 69,081

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If investor’s required rate of return on real estate If investor’s required rate of return on real estate

investments is 12%, the present value of the future cash investments is 12%, the present value of the future cash

flows is $52,461.flows is $52,461.

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The Net Present Value of the Investment:The Net Present Value of the Investment:

$52,461$52,461 Present value of future cash flowsPresent value of future cash flows

- $36,000 Upfront cash investment- $36,000 Upfront cash investment

= = $16,461$16,461 Net present value Net present value

Investment earns more than the required return of 12% and is Investment earns more than the required return of 12% and is attractive, earning about 22%.attractive, earning about 22%.

Caveat: Real estate is illiquid investment and Caveat: Real estate is illiquid investment and almost the entire return here is based on the almost the entire return here is based on the assumption of a 6% yearly increase in valueassumption of a 6% yearly increase in value

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An essential consideration in a real estate An essential consideration in a real estate investment analysis is the cost of financing investment analysis is the cost of financing

Prior example: Prior example: ◦Loan of $144,000 Loan of $144,000 ◦Over 20 years Over 20 years ◦At 12% interest At 12% interest ◦Payments $19,280Payments $19,280

Table 20–1 page 542 shows the effects of Table 20–1 page 542 shows the effects of various interest rates on annual paymentsvarious interest rates on annual payments