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The Real Estate Investment Decision

Chapter 1

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

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

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

Figure 1.1

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

Figure 1.2

Real Estate Investment Performance

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

Real Estate Investment Performance

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

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 owners perspective sets the lower end of the range of possible transaction prices. Investment value from the perspective of the most likely buyer determines the upper end of the range.

To be motivated to sell, seller must conclude most probable selling price is greater than investment value To be motivated to buy, buyer must conclude investment value is greater than most probable selling price For transaction to be possible, investment value from prospective buyers point of view must be greater than from the prospective sellers point of view

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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 taxdeductible 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 investors attitude Relate expected return to risk; accept additional perceived risk only if accompanied by additional expected return Tend to become increasingly averse to additional risk as total perceived risk increases

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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

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Supply, Demand, and the Price of Real Estate Assets

Demand Schedule is the relationship between price and quantity; demand curve is the graphic form of the same information

A specific demand schedule applies only to a defined population vying for a particular class of property

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Supply, Demand, and the Price of Real Estate Assets

Shift in demandthe entire range of relationships between price and quantity demanded changes. Among determinants of location and shape of demand curves for real estate assets, and of changes in demand are:

Number of prospective tenants Changes in operating expenses Yields available on other assets Technology Tastes

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Figure 2.2

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Supply, Demand, and the Price of Real Estate Assets

Example - demand schedule for downtown office space

Price changes alter quantity demanded Decline in after-tax cash flow


Market areas become relatively more desirable, drop bidding for downtown property Less downtown space purchased at each possible price per square foot

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Figure 2.3

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Supply, Demand, and the Price of Real Estate Assets

Relative Scarcity

Property in abundance commands no substantial value Supply is defined as the relationship between price and the quantity of a product suppliers place on the market during a specified time period, for all possible prices

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Supply, Demand, and the Price of Real Estate Assets

Supply function differs as specified time period is lengthened or shortened

Short runvariations in the supply of real estate placed on the market are an individuals perceptions of the relationship between market value and investment value Long runthe supply curve of real estate is influenced by cost of construction

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Supply, Demand, and the Price of Real Estate Assets

Quantity supplied refers to amount of product that will be placed on the market per period of time at a specified price Supply the relationship between price and quantity supplied over the entire range of possible prices

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Supply, Demand, and the Price of Real Estate Assets

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

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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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Market Efficiency and Profit Opportunities

Marketscommonality of product

Owner-occupant market Renter-occupant market Multifamily investment Nonresidential market

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Figure 2.7

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Market Efficiency and Profit Opportunities

Range of Markets

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

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Figure 2.8

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Market Efficiency and Profit Opportunities

Price Searchers and Market Efficiency

In an efficient market, information is transmitted quickly and without cost, eliminating above average profit Time required for information to be reflected in price is a measure of market efficiency In less efficient market, information is scarce and costly; greater degree of price searching

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Market Efficiency and Profit Opportunities

Sources of Market Inefficiency

Information costly and difficult to obtain; comparison shopping expensive and time consuming

High transaction costs prohibit portfolio adjustment


No two properties exactly alike

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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 investors funds Present cash inflows and outflows from operations and extend the presentation to include non-operating cash flows such as those from debt service, income taxes and capital expenditures

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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 propertys 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 incomegenerating 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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Why Leverage is So Popular

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

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Table 7.1

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Why Leverage is So Popular

Federal income tax law creates major incentive to use financial leverage

Interest payments generally tax deductible Depreciation allowance to recover costs Gains on disposal treated as capital gains

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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 propertys initial tax basis is starting point in determining income tax consequences of operating the property and, ultimately, the tax consequence of disposal During holding period, tax basis is adjusted to reflect disinvestment or additional capital investment

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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 donors, unless donor incurs gift tax liability Property acquired by inheritance, initial tax basis is market value as determined for estate tax purposes Property acquired by purchase, cost forms buyers initial tax basis

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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 propertys 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 Owners tax basis is increased by expenditures that materially increase the propertys 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 propertys 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 exceptionmust be capitalized; reflected in annual depreciation allowances Deductibility of mortgage interest is limited by passive asset loss limitation rules Strategyborrow against equity rather than selling, as selling will trigger a taxable gain

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Income Tax Credits for Property Rehabilitation

Tax credits direct, dollar-fordollar offsets against ones 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 partners income and expenses from a partnership are always considered passive asset items Real estate held for rental purposes is passive unless it is incidental to the primary business activity Special exception for real estate investors who are not actively engaged in a real estate trade or business to deduct up to $25,000 of passive asset losses each year

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Figure 10.1

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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

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Taxation of Foreign Investors

Buyer who fails to withhold the correct amount may be liable for the under-withheld amount, plus interest and penalties

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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 taxpayers marginal tax bracket. If outcome is net losses, they are offset against ordinary income on a dollar-for-dollar basis, but only to the extent of $3,000 per year
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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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Using the Installment Method

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

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Using the Installment Method

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

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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 likekind exchanges (called taxfree 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

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Giving Property Away

Exemptions and exclusions from the gift and estate tax:

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

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Giving Property Away

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

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Giving Property Away

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

Chapter 12

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Ratio Analysis

Ratios are employed to gauge the reasonableness of relationships between various measures of value and performance:

Income multipliers Financial ratios

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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

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Financial Ratio Analysis

Frequently employed to facilitate inter-property comparisons. Operating ratio Break-even ratio Debt coverage ratio

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Traditional Profitability Measures

Attempt to relate cash investment to expected cash returns in some systematic fashionnot equally successful Overall capitalization rate (free-and-clear rate of return) Equity dividend rate (Cashon-Cash rate of return)

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Traditional Profitability Measures

Brokers rate of return Payback period

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Traditional Profitability Measures

Shortcomings of traditional measures of investment performances:

Ignore cash-flow expectations during the later years of the holding period Ignore cash-flow expectations from disposal

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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

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Toward More Rational AnalysisMajor Factors

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

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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

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Discounted Cash-Flow Analysis

Chapter 13

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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

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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

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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

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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

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Internal Rate of Return


n

Cost = 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

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Internal Rate of Return

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

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Problems with the Internal Rate of Return

Can result in conflicting decision signals Might result in investment error

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ReinvestmentRate Problem

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

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The Multiple-Solutions Problem

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

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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.

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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.

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Comparing Net Present Value and IRR

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

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Comparing Net Present Value and IRR

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

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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.

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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

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Investment Goals and Decision Criteria

Chapter 14

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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

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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

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Investment Decisions and Decision Rules

General decision rule is to accept the project with the greatest profitability index (assuming there is no difference in the risk profile of competing opportunities)

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Investment Decisions and Decision Rules

Investors must select from between investment alternatives, all of which are considered desirable.

Investors constantly face mutually exclusive investment decisions The most appropriate technique for deciding between mutually exclusive alternatives when using the net present value approach is to accept the alternative producing greater (positive) net present value. When using the internal rate of return, the most appropriate approach is to accept the proposal having the higher internal rate of return, providing it is greater than the predetermined rate.

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Investment Decisions and Decision RulesMutually Dependent Proposals

Investment proposals are mutually dependent if acceptance of one forces the investor to accept the other. Acquisition of more than one property at a time requires consideration of results from alternative combinations.

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Investment Decisions and Decision RulesMutually Dependent Proposals

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

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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

183

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
184

Risk in Real Estate Investment

Chapter 15

185

Major Risk Elements

Financial risk Insurable risk Business risk

186

Figure 15.1

187

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

188

Figure 15.4

189

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.

190

Controlling Risk

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

191

Controlling Risk

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

192

Controlling Risk

Lease agreements often permit landlords to shift some risk to tenants. Hedging may also reduce risk.

193

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

194

Figure 15.6

195

Risk Preferences and Profit Expectations

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

196

Risk Preferences and Profit Expectations

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

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

198

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

199

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

200

Measuring Risk

Traditional riskadjustment techniques share a serious shortcomingthey do not permit quantification of the risk element.

201

Traditional RiskAdjustment Methods

Chapter 16

202

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

203

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

204

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.

205

Partitioning Present Values

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

206

Partitioning Present Values

Factors contributing to flow include:


income tax consequences loan amortization change in property value over projected holding period

207

Partitioning Present Values

Investment value can be divided into present value of equity and present value of debt. Present value of equity position can also be partitioned into its component parts.

Expressing each component as a percentage of total permits the relative importance of each to be assessed. Components that comprise major segments of the total present vale of the equity position will merit extended analysis.

208

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.

209

Contemporary Risk Measures

Chapter 17

210

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

211

Probability as a Risk Measure

Decisions are divisible:

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

212

Probability as a Risk Measure


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

213

Probability as a Risk Measure

Estimating future cash flows from real estate ventures is part art and part science.

No way to determine future, instead develop informed estimates Couple estimates with probability estimate Multiple law of probability used to determine the probability of occurrence of an event whose outcome depends in turn on the outcome of some prior event

214

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

215

Figure 17.1

216

Interpreting Risk Measures

Expected Value of probability distribution of possible cash flows is the weighted average of the possible cash flows making up the distribution, with each value weighted by its attendant probability of occurrence: n CF = 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.

217

Interpreting Risk Measures

Variance weighted average of the squared differences between each possible outcome and the expected outcome: n V = (CFx CF)2 Px x=1

218

Interpreting Risk Measures


V is variance CFx is value of the xth possible outcome CF is expected value Px is related probability

219

Interpreting Risk Measures


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

220

Figure 17.2

221

Figure 17.3

222

Figure 17.4

223

Figure 17.5

224

Figure 17.6

225

Risk Management in a Portfolio Context

Chapter 18

226

Modern Portfolio Theory and Risk Management

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

227

Modern Portfolio Theory and Risk Management

Systematic market risk reflection of market prices; can only by reduced in efficient market by accepting lower expected returns

Unsystematic risk function of characteristics of particular properties, such as location and design; can be eliminated by diversifying the assets in a portfolio

228

Figure 18.1

229

Modern Portfolio Theory and Risk Management

Among universe of possible portfolios, the subset that represents the bestobtainable 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

230

Figure 18.2

231

Real Estates Role in the Efficient Portfolio

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

232

Figure 18.4

233

Real Estate Diversification Strategies

Geographic localepicking locales where the real estate cycle is not highly correlated Product typeincluding a range of buildings such as apartments, retail, industrial, office Product-life cycleincluding 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

234

Investment Feasibility Analysis

Chapter 19

235

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
236

The Nature of the Feasibility Question

Feasible project must be:


Physically possible Legally feasible Financially feasible

237

Figure 19.1

238

The Nature of the Feasibility Question

Feasibility analysis problems:

With a predetermined site, investigate alternative uses With a predetermined use, investigate alternative sites With predetermined funds, investigate alternative investment opportunities

239

The Nature of the Feasibility Question

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

240

Steps in Feasibility Analysis Process


1. 2.

3.
4.

5.

6. 7. 8.

Assess physical and legal aspects of the site. Estimate demand for the proposed real estate services. Analyze competitive space. Estimate the cost of constructions, alteration, rehabilitation or fix-up, as proposed in the initial concept, and the cost of facility operations. Estimate the cost of financing various possible combinations of equity and debt financing packages. Estimate the rate at which vacant units will be rented. Develop a schedule of cash inflows and outflows. Evaluate the anticipated cash flows for adequacy, given the investors minimum acceptable rate of return and the degree of risk the investor is prepared to accept.

241

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)

242

Figure 19.2

243

Figure 19.3

244

Format for a Feasibility Report

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

245

Analyzing Subdivision Proposals

Chapter 20

246

Overview of the Subdivision Process

Subdivision ventures grow out of developers 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

247

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

248

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

249

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

250

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

251

Development and Rehabilitation

Chapter 21

252

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 investors desire to use previously acquired site (a site in search of an idea)

253

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

254

Feasibility Analysis

Steps:

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

255

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

256

Construction Phase

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

Custom

Speculative

257

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

258

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

259

Incentive for Rehabilitation

Profit expectations Tax legislation rewards

260

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

261

Industrial Property, Office Building and Shopping Center Analysis

Chapter 22

262

Investing in Industrial Buildings

Industrial buildings have the advantages of reliable, creditworthy 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

263

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

264

Locations Factors

Near fuel or power supply Near markets Footlose Industries

265

Types of Industrial Buildings

No official classification system for industrial buildings. Can be characterized by nature of buildings construction or type of tenant it attracts:

Heavy industrial buildings Loft buildings Modern one-story structures Incubator Buildings

266

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

267

Investing in Shopping Centers

Investors and developers have long provided favorable lease terms to anchor tenantsmajor stores that attract customers Recently, developers have allowed major tenants to construct their own buildings on sites leased from owners

268

Lease Arrangement in Shopping Centers

Owners set base rental rate and increase rental rates as tenants 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

269

Types of Shopping Centers

Neighborhood shopping centers Community shopping centers

Regional shopping malls


Super regional shopping malls

Lifestyle centers

270

Real Estate Investment Trusts

Chapter 23

271

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

272

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

273

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

274

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

275

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

276

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

277

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 earningsno 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

278

REIT as Investment Vehicles

REIT ownership entails the risk associated with stock market fluctuations

279

REIT as Investment Vehicles

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

280

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