Professional Documents
Culture Documents
Chapter 1
Historically lagged behind mainstream finance and investment thought; great strides recently Treats real estate as capital asset desired for stream of benefits
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
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
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
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
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
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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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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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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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 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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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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Chapter 2
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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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Demand Schedule is the relationship between price and quantity; demand curve is the graphic form of the same information
A specific demand schedule applies only to a defined population vying for a particular class of property
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Shift in 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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Figure 2.3
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Relative Scarcity
Property in abundance commands no substantial value Supply is defined as the relationship between price and the quantity of a product suppliers place on the market during a specified time period, for all possible prices
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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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Quantity supplied refers to amount of product that will be placed on the market per period of time at a specified price Supply the relationship between price and quantity supplied over the entire range of possible prices
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Equilibrium price price at which there will be sufficient quantity of a product to satisfy desires of all consumers at that price, but with no surplus remaining on the market. Quantity demanded and quantity supplied meet at the point where the supply and demand functions intersect.
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Figure 2.4
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Figure 2.5
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Figure 2.6
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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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Marketscommonality of product
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Figure 2.7
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Range of Markets
In an atomistic market, each participant is so insignificant relative to the size of the total market that he has no perceptible effect on price, Every buyer can purchase as much as desired, every seller can sell as much as desired. In an absolute monopoly, there is only one supplier or a good or service for which there are not reasonably acceptable substitutes
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Figure 2.8
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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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Information costly and difficult to obtain; comparison shopping expensive and time consuming
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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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Chapter 3
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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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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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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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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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Chapter 4
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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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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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Figure 4.2
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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
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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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(GIS) relate information to geographic location; series of map overlays Computerized systems
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Figure 4.3
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Chapter 5
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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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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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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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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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Chapter 6
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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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Extend prior years trend into future (simple straight-line extrapolation) Alter trend line based on predicted changes during forecast period
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Table 6.1
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Table 6.2
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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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Chapter 7
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Financial leverage using borrowed funds to amplify the outcome of equity investment Greater ratio of borrowed funds to equity, greater degree of financial leverage Leverage is favorable so long as the rate of return on assets exceeds the cost of borrowing
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Spread difference between rate of return on assets and cost of borrowing Favorable spread magnifies return on equity of highly leveraged investment When debt service constant is less than the rate of return on total assets, additional financial leverage increases cash flow to the equity position
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Table 7.1
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Federal income tax law creates major incentive to use financial leverage
Interest payments generally tax deductible Depreciation allowance to recover costs Gains on disposal treated as capital gains
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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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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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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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Commercial banks
Life insurance companies
Pension funds
Commercial mortgage-backed securities (CMBs)
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Chapter 8
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Promissory notes
Mortgages
Deed of trust
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Credit Terms
Fully amortizing
Partially amortizing
Straight/term/bullet
Portion of interest deferred
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Junior mortgages
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Chapter 9
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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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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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Chapter 10
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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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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Buyer who fails to withhold the correct amount may be liable for the under-withheld amount, plus interest and penalties
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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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Chapter 11
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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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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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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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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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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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If seller takes back a promissory note in part payment for property, it may be possible to defer recognition of part of the taxable gain until principal amount of the note is collected Gain that may be deferred is the installment method gain total gain minus any portion that represents recapture of accelerated depreciation allowances
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Contract price is total selling price, less balance of any mortgage note payable by the purchaser to a third party Each year, recognized gain is determined by multiplying the amount of the sales price actually collected by the seller, multiplied by the ratio of the installment method gain to the contract price
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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
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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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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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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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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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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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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Chapter 12
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Ratio Analysis
Ratios are employed to gauge the reasonableness of relationships between various measures of value and performance:
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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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Frequently employed to facilitate inter-property comparisons. Operating ratio Break-even ratio Debt coverage ratio
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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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Ignore cash-flow expectations during the later years of the holding period Ignore cash-flow expectations from disposal
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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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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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Discount expected future cash flows to make them more nearly comparable to those receivable in the present
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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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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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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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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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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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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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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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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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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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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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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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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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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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Chapter 14
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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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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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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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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 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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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 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
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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
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Chapter 15
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Figure 15.1
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Controlling Risk
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
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Figure 15.4
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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.
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Controlling Risk
Investors can control risk exposure by considering the relationship between assets already held and potential new acquisitions.
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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.
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Controlling Risk
Lease agreements often permit landlords to shift some risk to tenants. Hedging may also reduce risk.
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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
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Figure 15.6
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Configuration of risk-reward indifference curves will depend upon the individual investors personal attitude toward risk.
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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
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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
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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
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Measuring Risk
Using a shorter payback period Higher required rate of return Downward adjustment to projected cash flows
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Measuring Risk
Traditional riskadjustment techniques share a serious shortcomingthey do not permit quantification of the risk element.
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Chapter 16
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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
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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
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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.
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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).
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income tax consequences loan amortization change in property value over projected holding period
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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.
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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.
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Chapter 17
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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
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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
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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
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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
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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
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Figure 17.1
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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.
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Variance weighted average of the squared differences between each possible outcome and the expected outcome: n V = (CFx CF)2 Px x=1
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V is variance CFx is value of the xth possible outcome CF is expected value Px is related probability
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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
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Figure 17.2
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Figure 17.3
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Figure 17.4
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Figure 17.5
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Figure 17.6
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Chapter 18
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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.
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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
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Figure 18.1
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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
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Figure 18.2
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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
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Figure 18.4
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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
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Chapter 19
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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
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Figure 19.1
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With a predetermined site, investigate alternative uses With a predetermined use, investigate alternative sites With predetermined funds, investigate alternative investment opportunities
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Limits of resources Values, goals, and objectives Physical characteristics of sites Society, through ordinances and regulatory oversight
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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.
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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)
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Figure 19.2
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Figure 19.3
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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
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Chapter 20
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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
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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
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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
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Large-scale plans divide area by specialized use categories Modest subdivision plans may simply plot individual sites and make provision for utility easements
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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
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Chapter 21
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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)
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Feasibility Analysis
Market research and attempts to determine physical and location characteristics that will have the greatest consumer appeal Economics of proposed project
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Feasibility Analysis
Steps:
Completion of feasibility study Market research Search for site Estimate costs Estimate value Estimate operating expenses
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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
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Construction Phase
Custom
Speculative
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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
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Overview of Rehabilitation
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
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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
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Chapter 22
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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
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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
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Locations Factors
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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
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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
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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
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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
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Lifestyle centers
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Chapter 23
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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
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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
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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
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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
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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
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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
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Limited liability Centralized management Continuity of entity life Free transferability of interests
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
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REIT ownership entails the risk associated with stock market fluctuations
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REIT Mutual Funds permit investors to hold a diversified portfolio with a relatively modest total investment
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