Fin. 355 - All Chapters - Has Adobe - WLB Modified

7/29/2019 Fin. 355 - All Chapters - Has Adobe - WLB Modified

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The Real EstateInvestment Decision

Chapter 1


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State of the Investment

Analysis Art

Historically lagged behindmainstream finance andinvestment thought; greatstrides recently

Treats real estate as capitalasset desired for stream ofbenefits

Real estate investment as

special case of modern capitalbudgeting


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Real Estate as an

Investment

Investors Passive or Active Active investors acquire direct

title to real property; eitheroversee property themselves orhire management firms

Passive investors place assetswith professional moneymanagers who acquire interestsin real property; may acquireshares in corporations or

partnerships that hold realproperty interests; make nooperating decisions


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Real Estate as an

Investment

Investors take equity ordebt position

Distinction betweeninvestors in real assets andinvestors in financial assets

While both are investors,exclude mortgage lendersfrom this study ofinvestment analysis anddecision making


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Figure 1.1


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Who Are the Investors?

Private investors

Institutions, such as REITsand pension funds

Small level of foreign holdings

Concentrated in locales and

types of properties Surged during early 1980s and

later moderated

Level shifts with foreign

exchange rates Level impacted by relative

interest rates


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Figure 1.2


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Real Estate Investment

Performance

Data for investment comparisonsscarce, but frequently concluded

that real estate generates returnsroughly comparable to commonstock, with greater predictability ofreturns

More data for investment return

comparisons available recently, butheavily influenced by period fromwhich data are drawn

Brueggeman, Chen and Thibodeauanalysis--real estate funds

outperformed Standards andPoors 500 stock index andIbbotson Associates bond index


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Performance

Giliberto compared REIT yieldswith Standard and Poors 500

stock index, 1978 1989; foundadvantage in common stocks

Zerbst and Cambon (1984)analyzed earlier studies; found real

estate tends to outperform stocksduring periods of inflation

Clayton and MacKinnon (2001)find REIT returns now closelycorrespond to returns on smallcapitalization stocks


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Concepts and Definitions

Most Probable Selling Price

Probabilistic estimate of theprice at which a futuretransaction will occur

Investment ValueValue ofa property as an investment toa present or prospectiveowner


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Concepts and Definitions

Transaction Investment value from thepresent owners perspective sets thelower end of the range of possible

transaction prices. Investment value fromthe perspective of the most likely buyerdetermines the upper end of the range.

To be motivated to sell, seller mustconclude most probable selling price isgreater than investment value

To be motivated to buy, buyer mustconclude investment value is greater thanmost probable selling price

For transaction to be possible, investment

value from prospective buyers point ofview must be greater than from theprospective 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 ofassumptions about ability of property togenerate cash flows over the expected

holding period and likely market value ofproperty at end of proposed holdingperiod. Analysis:

Estimate the stream of expected benefits

Adjust for timing differences in expectedstreams of benefits from investmentalternatives

Adjust for differences in perceived riskassociated with alternatives

Rank alternatives according to relativedesirability of the perceived risk-returncombinations they embody


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Estimating Investment

Value: An Overview

Value of an investmentproperty is sum of the debtand equity positions

Investment can be expressed

aspresent value of the equityposition plus thepresent valueof 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 atsame investment value

conclusions as they differ on: Future stream of rental revenue

and operating expenses

Perceived levels of risks

Willingness to defer immediateconsumption in interest of futurebenefits

Desire for preciselydeterminable future

Investors in higher-incomebrackets benefit more from tax-deductible losses


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Investor Objectives and

Risk

Seek financial return as reward forcommitting resources and as

compensation for bearing risk

Emotional temperament plays a largerole in an investors attitude

Relate expected return to risk; acceptadditional perceived risk only ifaccompanied by additional expectedreturn

Tend to become increasingly averseto additional risk as total perceivedrisk increases


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Figure 1.8


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Figure 1.9


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Investment Strategy andthe Concept of Market

Efficiency

Chapter 2


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Supply, Demand, and the

Price of Real Estate Assets

Demand

Relationship between marketprice and the quantity of a goodor service that will be boughtper time period, over the entirerange of possible prices

For real estate assets, demandis inversely related to their price


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Figure 2.1


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Demand Schedule is therelationship between priceand quantity; demand curve isthe graphic form of the sameinformation

A specific demand scheduleapplies only to a definedpopulation vying for a particularclass of property


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Shift in demandthe entirerange of relationships

between price and quantitydemanded changes. Amongdeterminants of location andshape of demand curves for

real estate assets, and ofchanges in demand are: Number of prospective tenants

Changes in operating expenses

Yields available on other assets Technology

Tastes


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Figure 2.2


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Example - demand schedulefor downtown office space

Price changes alter quantitydemanded

Decline in after-tax cash flow

Market areas become relatively

more desirable, drop bidding fordowntown property

Less downtown space purchasedat each possible price per squarefoot


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Figure 2.3


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Relative Scarcity

Property in abundancecommands no substantial value

Supply is defined as therelationship between price andthe quantity of a productsuppliers place on the marketduring a specified time period,

for all possible prices


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Supply function differs asspecified time period islengthened or shortened

Short runvariations in thesupply of real estate placed onthe market are an individuals

perceptions of the relationshipbetween market value andinvestment value

Long runthe supply curve ofreal estate is influenced by costof construction


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Quantity suppliedrefers toamount of product that will beplaced on the market perperiod of time at a specifiedprice

Supplythe relationshipbetween price and quantitysupplied over the entire range

of possible prices


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Equilibrium price price atwhich there will be sufficientquantity of a product to satisfydesires of all consumers atthat price, but with no surplusremaining on the market.Quantity demanded andquantity supplied meet at thepoint 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 institutionalarrangements or mechanismswhereby buyers and sellersare brought into contact witheach other. There are notnecessarily physical entitiesor geographical location


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Marketscommonality ofproduct

Owner-occupant market

Renter-occupant market

Multifamily investment

Nonresidential market


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Figure 2.7


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Range of Markets In an atomistic market, each

participant is so insignificantrelative to the size of the totalmarket that he has noperceptible effect on price,Every buyer can purchase as

much as desired, every sellercan sell as much as desired.

In an absolute monopoly, thereis only one supplier or a good orservice for which there are notreasonably acceptablesubstitutes


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Figure 2.8


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Price Searchers and MarketEfficiency

In an efficient market,information is transmittedquickly and without cost,eliminating above average profit

Time required for information tobe reflected in price is ameasure of market efficiency

In less efficient market,

information is scarce and costly;greater degree of pricesearching


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Sources of Market Inefficiency

Information costly and difficult toobtain; comparison shoppingexpensive and time consuming

High transaction costs prohibitportfolio adjustment

No two properties exactly alike


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Strategy Implications

In atomistic markets,economic rentwill be rare andshort-lived

Less efficient the market,

longer the adjustment processtakes


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Figure 2.9


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Land Utilization and theRental Value of Real

Estate

Chapter 3


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Economic Factors in Land

Use Decisions

Location choice is primarilyeconomic decision

Economic models investigateland development patterns

Market imperfections create

deviations, yet systematicpattern is discernible

Clusters of stores for multiplenuclei 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 bestspace create highest rents;rents tend to decline asdistance from 100 percent

location increases

Overlapping of uses


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Market Structure and the

Need for Market Research

Atomistic markets (price takers) havelittle need for market research; sellersdeliver homogeneous product to whatever

buyer is currently in the market and sellfor established market price Price searchers (those who operate in

monopolistically competitive oroligopolistic markets) face more complexproblem; control over market price isclosely related to the extent that theirproduct is distinguished from closestsubstitute

Each piece of real estate is unique withrespect to exact location

Product differences desensitize buyers toprice differentials

Price searchers with access to marketintelligence 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 managersneed market information at every stage intheir decision-making efforts

Market information is required not only forrational acquisition decisions, but formanaging the existing investment portfolio

Market research is also need to facilitateoperating management decisions


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How Much Market

Research?

Justified by market stabilityand degree of investmentcomplexity

Maximum net benefit from

research occurs whenpursued to point wheremarginal benefits equalmarginal cost

Decision makers must identifypoint 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 tospecific

Four quadrant forecasting

matrix


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Figure 4.2


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Preparing the Research

Report

Summarizes proceduresemployed and describes

conclusions reached

Everything in research reportshould be explained in terms

of its bearing on theconclusion

Report format is determinedby nature of research problemand needs of user


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Data Sources

Primary data

Secondary data


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Primary data

Statistics gathered byresearcher precisely forproblem at hand

Can be gathered bycommunication or byobservation


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Secondary data

Less costly and timeconsuming 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 peoplein a specific population whobehave in a particular manner

Describes aspect of problem

Requires planning and

catalog system Cross-sectionalortime series


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Statistical Research

Permit reliable generalizationsto be drawn after examinationof a limited portion of the totalpool of information

Descriptive statistics

Inferential statistics


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Geographic Information

Systems

(GIS) relate information togeographic location; series ofmap overlays

Computerized systems


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Figure 4.3


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Reconstructing theOperating History

Chapter 5


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Overview of Operating

Statement

Concerned with actual cashflows into and out of investors

funds

Present cash inflows andoutflows from operations and

extend the presentation toinclude non-operating cashflows such as those from debtservice, income taxes and

capital expenditures


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Table 5.1


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Overview of Operating

Statement

Potential gross rentamount ofrental revenue a property wouldgenerate with no vacancies

Operating expenses include allcash expenditures required tomaintain and operate the propertyso as to generate the gross rent

Net operating income thedifference between effective grossincome and operating expenses

Debt service consequence ofusing borrowed money to acquireproperty

After-tax cash flow= bottom linethe amount of cash remaining atthe 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 thatprospective tenants wouldconsider 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 operatinghistory

Recent expense history of

comparable properties

Published compendiums of

similar properties asbenchmarks


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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 andProperty Value

Chapter 6


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Forecasting Gross

Income

Desirability of space, attractiveness,price of competing space

Prospects for continued income-generating ability

Physical (natural and man-made)and location characteristics

Forecast changes in physical and

location characteristics Linkages and transfer costs

Inharmonious or incompatible landusage

Changes in supply of comparablerental space


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Forecasting Operating

Expenses

Extend prior years trend into

future (simple straight-lineextrapolation)

Alter trend line based on

predicted changes duringforecast period


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The Net Operating

Income Forecast

Difference between forecastof rental revenue and forecastof 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 eventualdisposal

Capitalization rate ratiobetween operating income

and market value Note current capitalization

rate applicable to comparableproperties and estimate how

rate might change overforecasting period


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Financial Leverage and

Investment Analysis

Chapter 7


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Why Leverage is So

Popular

Financial leverage usingborrowed funds to amplify theoutcome of equity investment

Greater ratio of borrowed

funds to equity, greaterdegree of financial leverage

Leverage is favorable so longas the rate of return on assetsexceeds the cost of borrowing


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Why Leverage is So

Popular

Spreaddifference betweenrate of return on assets and

cost of borrowing Favorable spread magnifies

return on equity of highlyleveraged investment

When debt service constantisless than the rate of return ontotal assets, additionalfinancial leverage increases

cash flow to the equityposition


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Table 7.1


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Why Leverage is So

Popular

Federal income tax lawcreates major incentive to usefinancial leverage

Interest payments generally taxdeductible

Depreciation allowance torecover costs

Gains on disposal treated ascapital gains


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Measuring Financial

Leverage

Debt/equity ratio ratiobetween borrowed funds andequity funds

Loan/value ratio ratiobetween borrowed funds andmarket value of asset beingfinanced


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Measuring Financial

Leverage

Greater leverage increases risk

that cash flow from investment willbe insufficient to meet debt serviceobligation (financial risk)

Debt coverage ratio degree towhich actual net operating incomecan fall below expectations and stillbe sufficient to meet debt service

obligation


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How Much is Enough

Financial Leverage?

Lenders frequently expressmaximum amount of loan in termsof minimum permissible debtcoverage ratio

Lenders specify maximumpermissible loan-to-value ratio

As more money is borrowed tofinance an investment, the venturebecomes increasingly risky

Increasing amount of borrowedfunds relative to equity funds driveup 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 andBorrowing 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 andUrban 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 orcontract rateinterest rate based on faceamount of promissory note

Effective rate rate actuallypaid

After-tax borrowing costs areusually lower than before-taxcosts

Real rate of interest

effective rate, adjusted forprice 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 todifferences in loan origination fees ordiscount fees

Lenders often refuse to quote rateuntil 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 propertysinitial tax basis is starting

point in determining incometax consequences ofoperating the property and,ultimately, the tax

consequence of disposal

During holding period, taxbasis is adjusted to reflect

disinvestment or additionalcapital investment


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Nature and Significance

of the Tax Basis

Selling or exchanging aproperty generates a gain orloss equal to the differencebetween the sales price and

the adjusted basis of theproperty at the time ofdisposal


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The Initial Tax Basis

Property acquired as gift,initial tax basis the same asdonors, unless donor incurs

gift tax liability

Property acquired by

inheritance, initial tax basis ismarket value as determinedfor estate tax purposes

Property acquired by

purchase, cost forms buyersinitial tax basis


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Allocating the Initial Tax

Basis

Two or more assets acquiredtogether, initial tax basis must

be allocated between themusing ratio of their relativemarket value Specify price of each in original

purchase contract Use ratio of land value to

building value estimated by taxassessor

Have independent appraiser

estimate relative value of landand buildings


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Adjusting the Basis in

Cost Recovery

Depreciation allowanceAnallowance of capital invested in

improvements of property held forbusiness or investment purposes.

Does not apply to property held forpersonal use or primarily for resale

Land, considered virtuallyindestructible, is not included indepreciation allowance computation


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Adjusting the Basis in

Cost Recovery

Claiming tax deduction for costrecovery allowances reduces a

propertys tax basis

Lower the adjusted tax basis whenproperty is sold, the greater the

taxable gain on disposal


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Recovery of Building and

Other Improvements

27.5 years for buildingsintended for residential rentalpurposes

39 years for buildingsintended 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 arecomputed using straight-linemethod

Allowances for improvementson and to the land may be

computed using the 150percent declining balancemethod


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Other Adjustments to the

Tax Basis

Basis is reduced when portionof asset is sold or destroyedby casualties such as fire,flood, or storm

Owners tax basis is

increased by expendituresthat materially increase thepropertys 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 asindividuals

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 isthe initial tax basis plus all

additional capital investments,minus cumulative depreciationallowances, plus-or-minus certainother adjustments that may

sometimes apply Gain or loss on propertys sale is

difference between the value ofconsideration received and theadjusted tax basis at the time of

the transaction


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Tax Consequences of

Financial Leverage

Borrowing or repaying debtsare not taxable events

Interest expense is usually

tax-deductible in the year theinterest is paid

Exception--prepaid interest isnot deductible until actuallyearned by the lender


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Tax Consequences of

Financial Leverage

Construction period interest isspecial exceptionmust becapitalized; reflected in annualdepreciation allowances

Deductibility of mortgage

interest is limited by passiveasset loss limitation rules

Strategyborrow againstequity rather than selling, as

selling will trigger a taxablegain


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Income Tax Credits for

Property Rehabilitation

Tax credits direct, dollar-for-dollar offsets against onesincome tax obligation

Expenditures to rehabilitatecertain buildings qualify for a10 percent rehabilitation taxcredit


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Limitations on

Deductibility of Losses

Limited partners income andexpenses from a partnership

are always considered passiveasset items

Real estate held for rentalpurposes is passive unless it isincidental to the primary

business activity Special exception for real estate

investors who are not activelyengaged in a real estate tradeor business to deduct up to

$25,000 of passive asset losseseach year


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Figure 10.1


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Taxation of Foreign

Investors

Taxpayer who acquires a U.S. realestate interest from a foreign

owner must withhold and remit tothe IRS 10 percent of the grosssales price, unless

Property is worth no more than$300,000 and is to be used bypurchaser as personal residence

Transaction is protected from taxationpursuant to a U.S. tax treaty

Seller or buyer obtains a certificateform the IRS that reduces the amountto be withheld


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Taxation of Foreign

Investors

Buyer who fails to withholdthe correct amount may beliable for the under-withheldamount, plus interest andpenalties


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Alternative Minimum Tax

After figuring tax liability theregular way, taxpayers mustperform an alternativecomputation, and pay taxeson whichever computationmethod results in the greaterliability

Alternative computation taxcredits, and many tax

deductions, that are permittedin the regular computationmust 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 valuereceived in exchange for a

property comprises theconsideration

If seller receives other property orservices as part of the transaction,

these must be included at their fairmarket value

Difference between considerationreceived and the adjusted taxbasis at the time of the transactionis the realized gain orloss ondisposal


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Tax Treatment of

Realized Gains or Losses

Gains are ordinary incomewhen they result from recapture

of depreciation allowances. Gains are also ordinary income

when they result from sellingreal estate that has been heldfor resale in the normal course

of business (dealer property). Gains on the sale or exchange

of real estate held for businessor investment purposes arecapital gains. If the holding

period exceeds one year, thegain is a long-term capital gain.


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Tax Treatment of

Realized Losses

Real estate used in a trade orbusiness (includes actively

managed rental property) and heldfor more than one year are calledSection 1231 assets. Gains ontheir disposal are treated as capital

gains, losses are treated as offsetsagainst ordinary income.

Losses on real estate held forinvestment purposes are capitallosses. If the real estate is held for

more than one year, the loss is along-term capital loss


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Computing Net Gain or Losson Sale of Assets Held for

Use in Trade or Business

Offset Section 1231 gains andlosses against each other.

Offset long-term capital gainsagainst long-term capitallosses

Offset short-term capitalagainst against short-termcapital losses

If there are net losses in one

category and gains in theother, offset the two


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Tax Consequences DependsUpon Outcome of Offsetting

Gains and Losses

If outcome is net short-termgains, lump them with

ordinary income If outcome is net long-term

gains, they are taxed at themaximum rate of 20%,

regardless of taxpayersmarginal tax bracket.

If outcome is net losses, theyare offset against ordinary

income on a dollar-for-dollarbasis, but only to the extent of$3,000 per year


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When Realized Gains or

Losses Are Recognized

Gains are realizedwhen atransaction is completed

They may be recognized(andtax consequences

experienced) in that year or atanother time


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Using the Installment

Method

If seller takes back a promissorynote in part payment for property, it

may be possible to deferrecognition of part of the taxablegain until principal amount of thenote is collected

Gain that may be deferred is theinstallment method gain total gainminus any portion that representsrecapture of accelerateddepreciation allowances


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Method

Contract price is total sellingprice, less balance of anymortgage note payable by thepurchaser to a third party

Each year, recognized gain is

determined by multiplying theamount of the sales priceactually collected by theseller, multiplied by the ratio

of the installment method gainto the contract price


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Method

Installment note must include aprovision for reasonable rate of

interestotherwise, IRS imputes areasonable rate and recalculatesthe tax consequences of thetransaction

Complex tax rules limit the extentto which a taxpayer can defer again by using the installmentmethod when they themselves ownsubstantial amount of mortgage

indebtedness


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Like-Kind Exchanges

An otherwise taxable gainrealized on an exchange oflike-kind assets need not berecognized in the year of thetransaction. Tax liability ispostponed until a future,taxable transaction occurswith respect to the newlyacquired property.


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Like-Kind Exchanges

Enabling legislation for like-kind exchanges (called tax-free exchanges) is containedin Section 1031 of the InternalRevenue Code.


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Like-Kind Exchanges

To qualify under Section1031:

Must have been bona fideexchange of assets involved

Property conveyed must havebeen held for productive use in

a trade or business or aninvestment and must beexchanged for like-kind propertythat is also to be used in a trade

or business or held as aninvestment

Property must be of like-kind


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Like-Kind Exchanges

Certain types of property arespecifically excluded formSection 1031

Foreign real estate is never

considered like-kind withdomestic real estate


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Tax Consequences of

Like-Kind Exchanges

If all property involved in anexchange qualifies as like-kind and

all parties qualify, then no party tothe exchange may recognize anygain or loss on the transaction.

Should some of the propertyinvolved in an exchange fail the

like-kind test, then some portion ofa gain must be recognized in theyear of the transaction.

Receipt of property that does notmeet the like-kind definition has

the effect of partially disqualifying again from deferral under Section1031.


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Giving Property Away

Gifts and legacies aresubjected to a unified,graduated gift and estate taxthat is imposed on the personwho makes a gift or to theestate of a decedent


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Exemptions and exclusionsfrom the gift and estate tax:

One may give as much as$11,000 each to as manpersons as one wishes eachyear with no gift tax implications

($22,000 for spouses) Unlimited exemption for gifts or

legacies to a spouse who is aUnited States citizen

Unlimited exemption forpayment of tuition and medicalexpenses for others


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Gifts are cumulative over thegivers lifetime for purposes of

determining the graduated taxrate, but gift taxes are due inthe year the gift is made

Each taxpayer has a lifetimecredit against the unified giftand estate tax. The amountof the credit will shelter

$1,000,000


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Gift of property that is subjectto a mortgage will have saleas well as giftelements

The tax basis of a recipients

interest in property received

as a gift is the same as thebasis of the givers, unless thegiver incurred a gift taxliability.

Letting title pass as a legacyrather than a gift works betterfor highly appreciatedproperty


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Traditional Measures of

Investment Worth

Chapter 12


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Ratio Analysis

Ratios are employed to gaugethe reasonableness ofrelationships between variousmeasures of value andperformance:

Income multipliers

Financial ratios


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Income Multipliers

Express the relationshipbetween price and eithergross or net income

Multiplier analysis permitsobviously unacceptable

opportunities to be weededout

Gross income multipliers

Net income multipliers


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Financial Ratio Analysis

Frequently employed tofacilitate inter-propertycomparisons.

Operating ratio

Break-even ratio

Debt coverage ratio


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Traditional Profitability

Measures

Attempt to relate cashinvestment to expected cashreturns in some systematicfashionnot equallysuccessful

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

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


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Measures

Brokers rate of return

Payback period


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Measures

Shortcomings of traditionalmeasures of investmentperformances:

Ignore cash-flow expectations

during the later years of theholding period

Ignore cash-flow expectations

from disposal


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Toward More Rational

Analysis

Five major factors governingthe relative attractiveness of areal estate investment mustbe incorporated into rationalreal estate investmentanalysis


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AnalysisMajor Factors

Anticipated stream of net cashflow to the investor

Expected timing of cashreceipts

Degree of certainty with which

expectations are held Yields available from

alternative investmentopportunities

Investors attitude toward risk


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Analysis

Time-adjusted investmentevaluation measures

Discount expected future cashflows to make them more nearlycomparable to those receivablein the present


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Discounted Cash-Flow

Analysis

Chapter 13


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Present Value

Present value is the value today ofbenefits that are expected to

accrue in the future When discounting is done at the

minimum acceptable rate of returnon equity:

Present value in excess of therequired initial equity cash outlayimplies that a project is worthy offurther considerations

A present value totaling less than the

required initial equity expenditureresults in automatic rejection


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Present Value

To use this approach, discount allanticipated future cash flows at the

minimum acceptable rate of return.The result is the present value ofexpected 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 initialequity expenditure from the

present value yields net presentvalue

A positive net present value means aproject is expected to yield a rate ofreturn in excess of the discount rate,

and therefore merits furtherconsideration

A net present value of less than zeromeans the project is expected to yielda rate of return less than the minimum

acceptable rate, and therefore shouldbe rejected


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Internal Rate of Return

There is an inverserelationship between discountrates and present value

The rate that will exactlyequate the present value of a

projected stream of cashflows with any positive initialcash investment is the internalrate of return


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n

Cost = CF1/(1+k)t

t=1

Where CF is the cash flow

projected for year t, cost isdefined as the initial cashoutlay, and k is the discountrate that makes the present

value of the expected futurecash flows exactly equal tothe initial cash outlay


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Decision criteria using the IRRis:

If the internal rate of return isequal to or greater than aninvestors required rate of

return, a project is consideredfurther

If the internal rate of return isless than the minimum

acceptable rate of return, theproject is rejected


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Problems with the Internal

Rate of Return

Can result in conflictingdecision signals

Might result in investmenterror


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ReinvestmentRate

Problem

Interproject comparison usinginternal rate of return analysisinvolves an implicitassumption that funds arereinvested at the internal rateof return. The internal rate ofreturn method reliablydiscriminates betweenalternatives only if there are

available other acceptableopportunities expected toyield an equally high rate.


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The Multiple-Solutions

Problem

Generally, a projects net

present value is a decreasingfunction of the discount rateemployed. Thus, withsuccessively a higherdiscount rates, a point isreached where the netpresent value is zero. This isthe internal rate of return, and

any greater discount rate willresult in a negative netpresent value.


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The Multiple-Solutions

Problem

Not all cash-flow forecastshave one internal rate ofreturn equating all cashinflows with all cash outflows.

Investment proposals may

have any number of internalrates of return, depending onthe cash-flow pattern.


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Comparing Net Present

Value and IRR

When using internal rate ofreturn, reject all projectswhose internal rate of return isless than the minimumrequired rate of return.Projects with an internal rateof return equal to or greaterthan the minimum acceptablerate are considered further.


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Value and IRR

When using net presentvalue, discount at theminimum acceptable rate ofreturn and reject all projectswith a net present value ofless than zero. Projects with anet present value of zero orgreater are consideredfurther.


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Value and IRR

Under most circumstances,the internal rate of return andnet present value approacheswill give the same decisionsignals

In some conditions,contradictory signals emerge

Given different decisionsignals, results of net present

value are usually preferred


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Modified Internal Rate of

Return

Discounts all negative cashflows back to the time atwhich the investment isacquired, and compounds allpositive cash flows forward

to the end of the final year ofthe holding period.


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Financial Management

Rate of Return

Findley and Messner havedeveloped a variation on the

internal rate of return calledfinancial management rate ofreturn which incorporatestwo intermediate rates: Cost of capital rate employed

to discount negative cashflows back to year zero

Specified reinvestment rate for

compounding positive cashflows to the end of theprojection period


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Investment Goals and

Decision Criteria

Chapter 14


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Choosing a Discount

Rate

Choice is critical in selectingbetween alternative opportunities

and deciding what opportunitiesmerit additional considerations

Summation technique

Risk-adjusted discount rate


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Investment Decisions and

Decision Rules

Precise rules for makinginvestment decisions depend of

the nature of the problem Net present value does not give an

unambiguous decision signal whenprojects require different levels of

initial cash outlay Profitability index (PI) is calculated by

dividing the present value of expectedfuture cash flows by the amount of theinitial cash outlay. The quotient

represents present value per dollar ofinitial cash expenditure


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Decision Rules

General decision rule is toaccept the project with thegreatest profitability index(assuming there is nodifference in the risk profile ofcompeting opportunities)


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Decision Rules

Investors must select frombetween investment alternatives,

all of which are considereddesirable. Investors constantly face mutually

exclusive investment decisions

The most appropriate technique fordeciding between mutually exclusivealternatives when using the netpresent value approach is to acceptthe alternative producing greater(positive) net present value.

When using the internal rate of return,

the most appropriate approach is toaccept the proposal having the higherinternal rate of return, providing it isgreater than the predetermined rate.


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Investment Decisions andDecision RulesMutually

Dependent Proposals

Investment proposals aremutually dependentifacceptance of one forces theinvestor to accept the other.Acquisition of more than oneproperty at a time requiresconsideration of results fromalternative combinations.


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Investment Decisions andDecision RulesMutually

Dependent Proposals

Group mutually dependent ventures

into consolidated units, and treat eachunit as a single investment venture

Accept mutually dependentcombination having the highest netpresent value

If packages differ in amount of initialequity cash expenditure, compare theprofitability indexes of thecombinations

If internal rate of return method is

being used, accept the combinationhaving the highest calculated return


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Investment Value and

Investment Strategy

Investment value is value ofan income producing propertyto a particular investor

Prospective investors will bemotivated to buy if they

believe their subjectiveinvestment value is greaterthan the amount they willhave to pay for a property


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Investment Value and

Investment Strategy

Owners will be motivated tosell if they believe they willreceive more than theirproperties are worth to themas elements in their personalinvestment portfolios

The greater the spreadbetween investment valueand transaction price for both

buyer and seller, the greaterthe possible increase in bothinvestors wealth


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Risk in Real Estate

Investment

Chapter 15


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Major Risk Elements

Financial risk

Insurable risk

Business risk


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Figure 15.1


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Controlling Risk

Risk analysis

Invest in less risky projects Eliminates opportunities for

extraordinary profits

Financial market assignsappropriate level of return to

each opportunity,commensurate with level of riskperceived

In an efficient market, the onlyway to reduce risk associated

with single investment venturesis to choose a venture with alower expected return


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Figure 15.4


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Controlling Risk

Real estate markets tend tobe somewhat less efficientthan are organized securitiesmarkets. Real estate investorswho can exploit marketinefficiencies are able to reapextraordinary profits withoutshouldering commensuratelygreater risk.


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Controlling Risk

Investors can control riskexposure by considering therelationship between assetsalready held and potentialnew acquisitions.


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Controlling Risk

Real estate investors areforced to make assumptionsabout a ventures ability to

generate income over anextended period. Risk is oftenviewed as the possibility ofvariance betweenassumptions and actualoutcomes.


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Controlling Risk

Lease agreements oftenpermit landlords to shift somerisk to tenants.

Hedging may also reduce risk.


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Risk Preferences and

Profit Expectations

Rational investors prefer ahigher to a lower return for agiven level of risk; for aspecified level of return theyprefer less risk to more risk

They accept additional riskonly if accompanied byadditional expected

investment rewards


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Figure 15.6


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Profit Expectations

Configuration of risk-rewardindifference curves will depend

upon the individual investorspersonal attitude toward risk.


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Profit Expectations

The more risk averse theindividual, the more steeply

sloped the indifference curveshowing that persons

preference

The indifference curve of an

investor who is indifferenttoward risk has no curvature atall

Some investors may be willingto trade expected return for theopportunity to bear greater risk,and will therefore have adownward-sloping risk rewardindifference curve


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Successful Insurance Firms

as Rational Risk Takers

Allow insured parties tosubstitute the certainty of asmall loss for the uncertaintyof a larger, possiblycatastrophic loss

Astute risk management Risk takers by design


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Measuring Risk

Rational investors willseek to determine theamount of risk associatedwith an investmentopportunity and willdecide upon a minimumexpected return that willjustify the perceived risk


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Measuring Risk

Traditional risk-adjustment techniquesshare a seriousshortcomingthey do notpermit quantification ofthe risk element.


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Traditional Risk-

Adjustment Methods

Chapter 16


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The Payback-Period

Approach

Payback period is the timerequired for cash inflows from

an investment to equal theoriginal cash outlay. Proponents of this technique

adjust for risk by varying the

minimum acceptable paybackperiod.

Inadequate method

Desirability of real estateopportunities often depend

heavily upon expected gainfrom disposal


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Risk-Adjusted Discount

Rate

Involves varying the discountrate to reflect risk perception;the higher the perceived risk,the greater the size of thediscount rate.

Risk-adjusted discount rate iscomposed of a risk-free rateplus a risk premium

Probably most commonly usedapproach, but fatally flawed


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Certainty-Equivalent

Technique

Instead of best estimate of

future cash flows, substitutesan amount that leaves theclient indifferent betweenexpected receipt of the bestestimate and absolutecertainty of receiving thesubstitute amount. Substituteamount (certainty equivalent)

is discounted at the risk-freerate.


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Partitioning Present

Values

Real estate investments arevalued solely for theanticipated future stream ofbenefits ownership bestows.Real estate investment can beseen as the purchase of a setof assumptions about apropertys ability to produce a

benefit stream (after-tax cash

flow).


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Values

Factors contributing to flowinclude:

income tax consequences

loan amortization

change in property value overprojected holding period


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Values

Investment value can be dividedinto present value of equity and

present value of debt. Presentvalue of equity position can also bepartitioned into its componentparts.

Expressing each component as apercentage of total permits the relativeimportance of each to be assessed.

Components that comprise majorsegments of the total present vale ofthe equity position will merit extendedanalysis.


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Sensitivity Analysis

Sensitivity analysis is a logicalextension of partitioning to

determine what portions of theforecast merit furtherrefinement. Revels how possible forecasting

error will affect the presentvalue of actual after-cash flows.

Consists of altering componentsof the forecast one at a time,and studying the impact on

investment value or presentvalue of the equity position.


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Contemporary Risk

Measures

Chapter 17


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Probability as a Risk

Measure

Probability the chance ofoccurrence associated withany possible outcome.Probabilities associated withany possible occurrencerange from zero to one.

If probability equals zero, eventcertainly will not occur

A probability ofone indicatescertainty of occurrence


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Measure

Decisions are divisible: Certaintyonly one possible

outcome; decisions basedsolely on the decision makerspreference between certainalternatives

Risk-probabilities associatedwith various possible outcomesare either known or can beestimated

Uncertaintyprobabilities are

neither known or estimable;implies unknown number ofpossible outcomes


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Measure

Uncertainty is not measurable

As better informationbecomes available, uncertainelements can be converted torisk factors by incorporating

into analysis their associatedprobability distributions

Analysts generate informationto estimate the probability of

occurrence of each risk


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Measure

Estimating future cash flowsfrom real estate ventures ispart art and part science.

No way to determine future,instead develop informedestimates

Couple estimates withprobability estimate

Multiple law of probabilityusedto determine the probability of

occurrence of an event whoseoutcome depends in turn on theoutcome of some prior event


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Interpreting Risk

Measures

Variance weighted averageof the squared differencesbetween each possibleoutcome and the expectedoutcome:

n V = (CFx CF)2 Px

x=1


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Interpreting Risk

Measures

V is variance

CFx is value of the xthpossible outcome

CF is expected value

Px is related probability


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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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Risk Management in a

Portfolio Context

Chapter 18


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Modern Portfolio Theory

and Risk Management

Systematic market riskreflection of market prices;

can only by reduced inefficient market by acceptinglower expected returns

Unsystematic riskfunction ofcharacteristics of particularproperties, such as locationand design; can be eliminated

by diversifying the assets in aportfolio


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Modern Portfolio Theory

and Risk Management

Among universe of possibleportfolios, the subset thatrepresents the best-obtainable combinations ofrisk and return represent theefficient frontier, which can bealtered by:

Mixing a risk-free asset into therisky portfolio

Incorporating borrowing into theanalysis


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Figure 18.2


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Figure 18.4


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Real Estate

Diversification Strategies

Geographic localepicking localeswhere the real estate cycle is not

highly correlated Product typeincluding a range of

buildings such as apartments,retail, industrial, office

Product-life cycleincluding someproperties that are near the end oftheir life-cycle, some that havereached a stabilized growth path,and others that are in the earlystages of development and growth


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Investment Feasibility

Analysis

Chapter 19


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The Nature of the

Feasibility Question

Feasibility analysis attemptsto estimate the probability ofsuccess of a specificproposed course of action

Formal or informal

Early step in investment ordevelopment process

Involves estimating the amountand timing of required cashexpenditures and expected

cash inflows, and anassessment of the degree ofconfidence that attaches to theestimates


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Figure 19.1


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The Nature of the


Feasibility analysis problems:

With a predetermined site,investigate alternative uses

With a predetermined use,investigate alternative sites

With predetermined funds,investigate alternativeinvestment opportunities


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The Nature of the


Limitations should beidentified and defined inanalysis

Limits of resources

Values, goals, and objectives

Physical characteristics of sites Society, through ordinances and

regulatory oversight


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Preliminary FinancialFeasibility

Analysis should be viewed ascontinuous process

To be feasible, project mustbe attractive both to equityinvestors and to mortgage

lenders Preliminary financial feasibility

deals with the thresholdquestions concerning a

proposed venture (solvencytesting)


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Figure 19.2


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Figure 19.3


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Format for a Feasibility

Report

Organization should reflectpurpose; 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 flowprojections

Conclusions and recommendations


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Analyzing Subdivision

Proposals

Chapter 20


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Overview of the

Subdivision Process

Subdivision ventures grow out ofdevelopers perception of unsatisfied

demand for certain types of buildablesites.

Implement site acquisition strategy

Title acquisition, land planning, landsurvey

Physical improvements follow surveyingprocess

Sale


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Location Decisions

Subdivision location decisionsmust be responsive to needsof ultimate users

Subdividers also need toconsider current and potentialuses of abutting sites


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Coping with Regulatory

Requirements

Governmental land use control isexercised through zoning laws and

master land use plans. Small-scale subdividers may limit land

acquisition to appropriately zonedtracts

Large-scale subdividers frequently

develop plans requiring extensiverezoning and government approvals

Municipalities seek to influencelevel of subdivision activity through

control over public utilities Capacity

Special assessments


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Creating the Subdivision

Plan

Contents of land plans vary withsize of developments

Large-scale plans divide area byspecialized use categories

Modest subdivision plans may simplyplot individual sites and makeprovision for utility easements


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Financing the Project

Subdividers use land acquisition and

development loans to raise capital

Lenders usually disburse loan proceedson piecemeal basis as improvements arecompleted

Most lenders view subdivision loans asmore risky than construction loans

Subdividers depend upon proceeds formland sales for funds to repay loans

Project marketability is vital


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Development and

Rehabilitation

Chapter 21


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Overview of Development

Real estate developmentprojects range in complexityand size

Ventures often originate witha concept for finished urban

space; a perception of unmetdemand

Development project may beinvestors desire to use

previously acquired site (asite in search of an idea)


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Feasibility Analysis

Two sections of feasibilitystudy:

Market research and attemptsto determine physical andlocation characteristics that willhave 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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Financing Real Estate

Development

Construction lenders

Lender risk reduced byrequiring that developersacquire end-loancommitments

If developer cannot obtain anend-loan commitment prior toarranging a construction loan,standby or gap financing may

be used


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Construction Phase

Construction projects arecarried out on either a customor speculative basis.

Custom

Speculative


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Construction Phase

Construction companiesexpand and contract size inresponse to economicconditions and differences inscale of projects

General contractors Subcontract tasks

Contract with user; Generalcontractors contract with

subcontractors General contractors coordinate

work and oversees progress


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Overview of

Rehabilitation

Begins with existing structuresin need of extensiverenovation

Takes deteriorated orfunctionally obsolete buildingand improves its physical

condition or brings it up tomodern design standards

Gentrification impetus for muchrehabilitation activity

Prime areas seem to be olderinner-city neighborhoods withconvenient transportation links


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Incentive for

Rehabilitation

Profit expectations

Tax legislation rewards


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Judging Feasibility of

Rehabilitation Proposals

Analysis of rehabilitationproposals

Cost estimates Subtracting all costs and

expected profit from estimatedvalue as completed leaves the

amount available for purchaseof property

If property can be purchasedfor less, project is feasible; if

cost is greater, project notfeasible


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Industrial Property, OfficeBuilding and Shopping

Center Analysis

Chapter 22


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Investing in Industrial

Buildings

Industrial buildings have theadvantages of reliable, credit-worthy tenants, long-termleases, and opportunities toshift many operatingexpenses to tenants

Business operators, short oncapital, prefer to channelresources into business

expansion rather than realestate ownership


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Demand for Industrial

Space

Largely a function of demandfor products produced by

industrial sector Periodic shifts in demand for

industrial space of varioustypes and in different

locations reflect alterations incomposition of the industrialsector Growth in service and

technology Decrease for products of heavy

industry


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Locations Factors

Near fuel or power supply

Near markets

Footlose Industries


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Types of Industrial

Buildings

No official classificationsystem for industrial buildings.Can be characterized bynature of buildings

construction or type of tenantit attracts:

Heavy industrial buildings

Loft buildings

Modern one-story structures

Incubator Buildings


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Investing in Office

Buildings

Dramatic growth in service sector hasincreased demand

Demand for office space is a deriveddemandrelated to demand for servicessupplied 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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Investing in Shopping

Centers

Investors and developershave long provided favorablelease terms to anchortenantsmajor stores thatattract customers

Recently, developers haveallowed major tenants toconstruct their own buildings

on sites leased from owners


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Lease Arrangement in

Shopping Centers

Owners set base rental rate andincrease rental rates as tenants

sales volume increases(percentage clause)

Large shopping center tenantstypically lease space on net basis,

paying all expenses associatedwith operation of their space;smaller tenants often pay ownutility expenses

Shopping center tenants often paycommon area maintenance fee


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Types of Shopping

Centers

Neighborhood shoppingcenters

Community shopping centers

Regional shopping malls

Super regional shopping malls

Lifestyle centers


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Trusts

Chapter 23


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REIT Regulations

REITS are organized ascorporations or trusts; eachREIT is chartered in the statein which it is headquarteredand is subject to regulationsand statutes of that state


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REIT Regulations

REITS are subject toprovisions of IRS code, whichspecify minimum conditionsunder which they will begranted the special incometax status to which they owetheir popularity with investors


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REIT Regulations--IRS

Shares must be held by at least 100persons, and five or fewer shareholderscannot own 50 percent or more of theshares during the last half of any taxyear

REIT must be a passive investor ratherthan active participant in propertyoperations

At least 75 percent of assets mustconsist of real estate, mortgage notes,cash, cash items, or governmentsecurities, and at least 75 percent ofgross income must come from rents,

mortgage investment income, and gainson the sale of real estate

At least 90 percent ofordinary incomemust be distributed to shareholders


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REIT Ownership

Shareholders have approximatelysame rights as stockholders in

any other corporation Shareholders elect trustees or

directors to conduct REITinvestment and businessactivities

Trustees and directors hiremanagers to conduct generalaffairs


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REIT Management

Some REITs hire internalmanagers, or external advisors

Advisors may select propertymanagers to oversee operationof rental property

North American Securities

Administrators Association, in aStatement of Policy on RealEstate Investment Trusts thatwas adopted April 28, 1981,provides guidelines for setting

advisory fees


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REIT Assets

Equities accounted forapproximately 72 percent of total

REIT assets in 2001; mortgageloans accounted for about 11percent; balance held as cash ormiscellaneous other assets

Equity REITs invest primarily inreal estate equities; mortgageREITs invest primarily inmortgage secured loans; hybrid

REITs favor a balance betweenequities and mortgage loans


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REIT as Investment

Vehicles

Shareholders benefit from:

Limited liability

Centralized management Continuity of entity life

Fin. 355 - All Chapters - Has Adobe - WLB Modified

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