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The Real Estate Investment Decision
Chapter 1
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State of the Investment Analysis Art
Historically lagged behind mainstream finance and investment thought; great strides recently
Treats real estate as capital asset desired for stream of benefits Real estate investment as
special case of modern capital budgeting
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Real Estate as an Investment
Investors Passive or Active Active investors acquire direct
title to real property; either oversee property themselves or hire management firms
Passive investors place assets with professional money managers who acquire interests in real property; may acquire shares in corporations or partnerships that hold real property interests; make no operating decisions
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Real Estate as an Investment
Investors take equity or debt position
Distinction between investors in real assets and investors in financial assets
While both are investors, exclude mortgage lenders from this study of investment analysis and decision making
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Figure 1.1
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Who Are the Investors?
Private investors Institutions, such as REITs
and pension funds Small level of foreign holdings
Concentrated in locales and types of properties
Surged during early 1980s and later moderated
Level shifts with foreign exchange rates
Level impacted by relative interest rates
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Figure 1.2
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Real Estate Investment Performance
Data for investment comparisons scarce, but frequently concluded that real estate generates returns roughly comparable to common stock, with greater predictability of returns
More data for investment return comparisons available recently, but heavily influenced by period from which data are drawn
Brueggeman, Chen and Thibodeau analysis--real estate funds outperformed Standard’s and Poor’s 500 stock index and Ibbotson Associates bond index
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Real Estate Investment Performance
Giliberto compared REIT yields with Standard and Poor’s 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
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Concepts and Definitions
Most Probable Selling Price—Probabilistic estimate of the price at which a future transaction will occur
Investment Value —Value of a property as an investment to a present or prospective owner
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Concepts and Definitions
Transaction Investment value from the present owner’s 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 buyer’s point of view must be greater than from the prospective seller’s point of view
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Figure 1.3
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Figure 1.4
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Figure 1.5
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Estimating Investment Value: An Overview
Investor who buys property buys set of assumptions about ability of property to generate cash flows over the expected holding period and likely market value of property at end of proposed holding period. Analysis:
Estimate the stream of expected benefits
Adjust for timing differences in expected streams of benefits from investment alternatives
Adjust for differences in perceived risk associated with alternatives
Rank alternatives according to relative desirability of the perceived risk-return combinations they embody
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Estimating Investment Value: An Overview
Value of an investment property is sum of the debt and equity positions
Investment can be expressed as present value of the equity position plus the present value of debt position
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Figure 1.6
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Figure 1.7
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Investors Disagree on Investment Values
Investors unlikely to arrive at same investment value conclusions as they differ on: Future stream of rental revenue
and operating expenses Perceived levels of risks Willingness to defer immediate
consumption in interest of future benefits
Desire for precisely determinable future
Investors in higher-income brackets benefit more from tax-deductible losses
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Investor Objectives and Risk
Seek financial return as reward for committing resources and as compensation for bearing risk
Emotional temperament plays a large role in an investor’s attitude
Relate expected return to risk; accept additional perceived risk only if accompanied by additional expected return
Tend to become increasingly averse to additional risk as total perceived risk increases
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Figure 1.8
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Figure 1.9
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Investment Strategy and the Concept of Market Efficiency
Chapter 2
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Supply, Demand, and the Price of Real Estate Assets
Demand Relationship between market
price and the quantity of a good or service that will be bought per time period, over the entire range of possible prices
For real estate assets, demand is inversely related to their price
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Figure 2.1
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Supply, Demand, and the Price of Real Estate Assets
Demand Schedule is the relationship between price and quantity; demand curve is the graphic form of the same information A specific demand schedule
applies only to a defined population vying for a particular class of property
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Supply, Demand, and the Price of Real Estate Assets
Shift in demand—the entire range of relationships between price and quantity demanded changes. Among determinants of location and shape of demand curves for real estate assets, and of changes in demand are: Number of prospective tenants Changes in operating expenses Yields available on other assets Technology Tastes
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Figure 2.2
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Supply, Demand, and the Price of Real Estate Assets
Example - demand schedule for downtown office space Price changes alter quantity
demanded Decline in after-tax cash flow
Market areas become relatively more desirable, drop bidding for downtown property
Less downtown space purchased at each possible price per square foot
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Figure 2.3
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Supply, Demand, and the Price of Real Estate Assets
Relative Scarcity
Property in abundance commands no substantial value
Supply is defined as the relationship between price and the quantity of a product suppliers place on the market during a specified time period, for all possible prices
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Supply, Demand, and the Price of Real Estate Assets
Supply function differs as specified time period is lengthened or shortened
Short run—variations in the supply of real estate placed on the market are an individuals’ perceptions of the relationship between market value and investment value
Long run—the supply curve of real estate is influenced by cost of construction
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Supply, Demand, and the Price of Real Estate Assets
Quantity supplied —refers to amount of product that will be placed on the market per period of time at a specified price
Supply —the relationship between price and quantity supplied over the entire range of possible prices
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Supply, Demand, and the Price of Real Estate Assets
Equilibrium price –price at which there will be sufficient quantity of a product to satisfy desires of all consumers at that price, but with no surplus remaining on the market. Quantity demanded and quantity supplied meet at the point where the supply and demand functions intersect.
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Figure 2.4
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Figure 2.5
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Figure 2.6
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Market Efficiency and Profit Opportunities
Markets –institutional arrangements or mechanisms whereby buyers and sellers are brought into contact with each other. There are not necessarily physical entities or geographical location
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Market Efficiency and Profit Opportunities
Markets—commonality of product Owner-occupant market
Renter-occupant market
Multifamily investment
Nonresidential market
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Figure 2.7
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Market Efficiency and Profit Opportunities
Range of Markets In an atomistic market, each
participant is so insignificant relative to the size of the total market that he has no perceptible effect on price, Every buyer can purchase as much as desired, every seller can sell as much as desired.
In an absolute monopoly, there is only one supplier or a good or service for which there are not reasonably acceptable substitutes
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Figure 2.8
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Market Efficiency and Profit Opportunities
Price Searchers and Market Efficiency In an efficient market,
information is transmitted quickly and without cost, eliminating above average profit
Time required for information to be reflected in price is a measure of market efficiency
In less efficient market, information is scarce and costly; greater degree of price searching
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Market Efficiency and Profit Opportunities
Sources of Market Inefficiency
Information costly and difficult to obtain; comparison shopping expensive and time consuming
High transaction costs prohibit portfolio adjustment
No two properties exactly alike
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Strategy Implications
In atomistic markets, economic rent will be rare and short-lived
Less efficient the market, longer the adjustment process takes
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Figure 2.9
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Land Utilization and the Rental Value of Real Estate
Chapter 3
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Economic Factors in Land Use Decisions
Location choice is primarily economic decision
Economic models investigate land development patterns
Market imperfections create deviations, yet systematic pattern is discernible
Clusters of stores for multiple nuclei that create peaks in local land values
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Economic Factors in Land Use Decisions
“Friction of space”
Linkages
Transfer costs
Processing costs
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Figure 3.2
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Figure 3.3
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Figure 3.4
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Figure 3.5
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The Market for Rental Space
Competitive bids for best space create highest rents; rents tend to decline as distance from 100 percent location increases
Overlapping of uses
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Market Structure and the Need for Market Research
Atomistic markets (price takers) have little need for market research; sellers deliver homogeneous product to whatever buyer is currently in the market and sell for established “market price”
Price searchers (those who operate in monopolistically competitive or oligopolistic markets) face more complex problem; control over market price is closely related to the extent that their product is distinguished from closest substitute
Each piece of real estate is unique with respect to exact location
Product differences desensitize buyers to price differentials
Price searchers with access to market intelligence benefit
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Market Research Tools and Techniques
Chapter 4
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The Need for Market Research
Investment analysts and portfolio managers need market information at every stage in their decision-making efforts
Market information is required not only for rational acquisition decisions, but for managing the existing investment portfolio
Market research is also need to facilitate operating management decisions
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How Much Market Research?
Justified by market stability and degree of investment complexity
Maximum net benefit from research occurs when pursued to point where marginal benefits equal marginal cost
Decision makers must identify point of maximum benefit
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Figure 4.1
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A Design for Market Research
Formulate nature of problem
Proceed from general to specific
Four quadrant forecasting matrix
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Figure 4.2
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Preparing the Research Report
Summarizes procedures employed and describes conclusions reached
Everything in research report should be explained in terms of its bearing on the conclusion
Report format is determined by nature of research problem and needs of user
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Data Sources
Primary data
Secondary data
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Primary data
Statistics gathered by researcher precisely for problem at hand
Can be gathered by communication or by observation
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Secondary data
Less costly and time consuming to generate
Never precisely in desired form
Available from agencies
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Descriptive Research
Examples Describing profile of typical
tenants Estimating proportion of people
in a specific population who behave in a particular manner
Describes aspect of problem Requires planning and
catalog system Cross-sectional or time series
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Statistical Research
Permit reliable generalizations to be drawn after examination of a limited portion of the total pool of information
Descriptive statistics
Inferential statistics
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Geographic Information Systems
(GIS) relate information to geographic location; series of map overlays
Computerized systems
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Figure 4.3
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Reconstructing the Operating History
Chapter 5
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Overview of Operating Statement
Concerned with actual cash flows into and out of investor’s funds
Present cash inflows and outflows from operations and extend the presentation to include non-operating cash flows such as those from debt service, income taxes and capital expenditures
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Table 5.1
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Overview of Operating Statement
Potential gross rent –amount of rental revenue a property would generate with no vacancies
Operating expenses –include all cash expenditures required to maintain and operate the property so as to generate the gross rent
Net operating income –the difference between effective gross income and operating expenses
Debt service –consequence of using borrowed money to acquire property
After-tax cash flow= bottom line—the amount of cash remaining at the end of the reporting period
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Estimating Ability to Command Rent
History of recent operations Verify records of comparable
properties Estimate recent gross income
through research Find comparable properties
Define market area Identify properties that
prospective tenants would consider as close substitutes
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Figure 5.1
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Figure 5.2
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Estimating Operating Expenses
Subject property’s operating history
Recent expense history of comparable properties
Published compendiums of similar properties as benchmarks
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Table 5.2
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Table 5.3
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Table 5.4
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Table 5.5
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Table 5.6
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Forecasting Income and Property Value
Chapter 6
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Forecasting Gross Income
Desirability of space, attractiveness, price of competing space
Prospects for continued 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 land
usage Changes in supply of comparable
rental space
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Forecasting Operating Expenses
Extend prior years’ trend into future (simple straight-line extrapolation)
Alter trend line based on predicted changes during forecast period
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The Net Operating Income Forecast
Difference between forecast of rental revenue and forecast of operating expenses
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Table 6.1
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Table 6.2
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Estimating Future Market Value
Cash flow from eventual disposal
Capitalization rate – ratio between operating income and market value
Note current capitalization rate applicable to comparable properties and estimate how rate might change over forecasting period
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Financial Leverage and Investment Analysis
Chapter 7
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Why Leverage is So Popular
Financial leverage – using borrowed funds to amplify the outcome of equity investment
Greater ratio of borrowed funds to equity, greater degree of financial leverage
Leverage is favorable so long as the rate of return on assets exceeds the cost of borrowing
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Why Leverage is So Popular
Spread – difference between rate of return on assets and cost of borrowing
Favorable spread magnifies return on equity of highly leveraged investment
When debt service constant is less than the rate of return on total assets, additional financial leverage increases cash flow to the equity position
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Table 7.1
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Why Leverage is So Popular
Federal income tax law creates major incentive to use financial leverage Interest payments generally tax
deductible Depreciation allowance to
recover costs Gains on disposal treated as
capital gains
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Measuring Financial Leverage
Debt/equity ratio – ratio between borrowed funds and equity funds
Loan/value ratio – ratio between borrowed funds and market value of asset being financed
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Measuring Financial Leverage
Greater leverage increases risk that cash flow from investment will be insufficient to meet debt service obligation (financial risk)
Debt coverage ratio – degree to which actual net operating income can fall below expectations and still be sufficient to meet debt service obligation
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How Much is Enough Financial Leverage?
Lenders frequently express maximum amount of loan in terms of minimum permissible debt coverage ratio
Lenders specify maximum permissible loan-to-value ratio
As more money is borrowed to finance an investment, the venture becomes increasingly risky
Increasing amount of borrowed funds relative to equity funds drive up cost of borrowing
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Table 7.3
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Who Are the Lenders?
Commercial banks
Life insurance companies
Pension funds
Commercial mortgage-backed securities (CMBs)
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Credit Instruments and Borrowing Arrangements
Chapter 8
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Credit and Security Instruments
Promissory notes
Mortgages Purchase-money mortgages Blanket mortgages Open-ended mortgage
Deed of trust
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Credit Terms
Fully amortizing
Partially amortizing
Straight/term/bullet
Portion of interest deferred
Fluctuating interest rates
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Alternative Financing Methods
Installment sales contracts
Sale and leaseback
Junior mortgages
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Government-Sponsored Credit Arrangements
Department of Housing and Urban Development
State and local government private activity bonds
Redevelopment bonds
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The Cost of Borrowed Money
Chapter 9
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The Many Faces of Interest Expense
Nominal rate or contract rate –interest rate based on face amount of promissory note
Effective rate – rate actually paid
After-tax borrowing costs are usually lower than before-tax costs
Real rate of interest – effective rate, adjusted for price inflation
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Table 9.1
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Comparing Financing Alternatives
Effective interest rates differ Different contract rates Differences in effective rates due to
differences in loan origination fees or discount fees
Lenders often refuse to quote rate until late in loan approval process
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Table 9.5
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Basic Income Tax Issues
Chapter 10
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Nature and Significance of the Tax Basis
Newly acquired property’s initial tax basis is starting point in determining income tax consequences of operating the property and, ultimately, the tax consequence of disposal
During holding period, tax basis is adjusted to reflect disinvestment or additional capital investment
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Nature and Significance of the Tax Basis
Selling or exchanging a property generates a gain or loss equal to the difference between the sales price and the adjusted basis of the property at the time of disposal
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The Initial Tax Basis
Property acquired as gift, initial tax basis the same as donor’s, 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 buyer’s initial tax basis
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Allocating the Initial Tax Basis
Two or more assets acquired together, initial tax basis must be allocated between them using ratio of their relative market value Specify price of each in original
purchase contract Use ratio of land value to
building value estimated by tax assessor
Have independent appraiser estimate relative value of land and buildings
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Adjusting the Basis in Cost Recovery
Depreciation allowance –An allowance of capital invested in improvements of property held for business or investment purposes.
Does not apply to property held for personal use or primarily for resale
Land, considered virtually indestructible, is not included in depreciation allowance computation
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Adjusting the Basis in Cost Recovery
Claiming tax deduction for cost recovery allowances reduces a property’s tax basis
Lower the adjusted tax basis when property is sold, the greater the taxable gain on disposal
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Recovery of Building and Other Improvements
27.5 years for buildings intended for residential rental purposes
39 years for buildings intended for other allowable purposes
15 years for land improvements such as walks, roads, sewers, and fences
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Recovery of Building and Other Improvements
Allowance for buildings are computed using straight-line method
Allowances for improvements on and to the land may be computed using the 150 percent declining balance method
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Other Adjustments to the Tax Basis
Basis is reduced when portion of asset is sold or destroyed by casualties such as fire, flood, or storm
Owner’s tax basis is increased by expenditures that materially increase the property’s value or useful life
Transaction costs are added to the tax basis
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Table 10.2
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Tax Consequences of Ownership Form
Title may vest in owners as individuals
Title may vest in a corporation Tax Option Corporations Investors may form a general
partnership Limited partnership may hold
title Limited liability company
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Tax Consequence of Property Sales
Adjusted tax basis at time of sale is the initial tax basis plus all additional capital investments, minus cumulative depreciation allowances, plus-or-minus certain other adjustments that may sometimes apply
Gain or loss on property’s sale is difference between the value of consideration received and the adjusted tax basis at the time of the transaction
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Tax Consequences of Financial Leverage
Borrowing or repaying debts are not taxable events
Interest expense is usually tax-deductible in the year the interest is paid
Exception--prepaid interest is not deductible until actually earned by the lender
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Tax Consequences of Financial Leverage
Construction period interest is special exception—must be capitalized; reflected in annual depreciation allowances
Deductibility of mortgage interest is limited by passive asset loss limitation rules
Strategy—borrow against equity rather than selling, as selling will trigger a taxable gain
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Income Tax Credits for Property Rehabilitation
Tax credits – direct, dollar-for-dollar offsets against one’s income tax obligation
Expenditures to rehabilitate certain buildings qualify for a 10 percent rehabilitation tax credit
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Limitations on Deductibility of Losses
Limited partner’s income and expenses from a partnership are always considered passive asset items
Real estate held for rental purposes is passive unless it is incidental to the primary business activity
Special exception for real estate investors who are not actively engaged in a real estate trade or business to deduct up to $25,000 of passive asset losses each year
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Figure 10.1
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Taxation of Foreign Investors
Taxpayer who acquires a U.S. real estate interest from a foreign owner must withhold and remit to the IRS 10 percent of the gross sales price, unless Property is worth no more than
$300,000 and is to be used by purchaser as personal residence
Transaction is protected from taxation pursuant to a U.S. tax treaty
Seller or buyer obtains a certificate form the IRS that reduces the amount to be withheld
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Taxation of Foreign Investors
Buyer who fails to withhold the correct amount may be liable for the under-withheld amount, plus interest and penalties
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Alternative Minimum Tax
After figuring tax liability the regular way, taxpayers must perform an alternative computation, and pay taxes on whichever computation method results in the greater liability
Alternative computation tax credits, and many tax deductions, that are permitted in the regular computation must be excluded
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Tax Consequence of Property Disposal
Chapter 11
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Computing the Realized Gain or Loss
Everything of economic value received in exchange for a property comprises the consideration
If seller receives other property or services as part of the transaction, these must be included at their fair market value
Difference between consideration received and the adjusted tax basis at the time of the transaction is the realized gain or loss on disposal
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Tax Treatment of Realized Gains or Losses
Gains are ordinary income when they result from recapture of depreciation allowances.
Gains are also ordinary income when they result from selling real estate that has been held for resale in the normal course of business (dealer property).
Gains on the sale or exchange of real estate held for business or investment purposes are capital gains. If the holding period exceeds one year, the gain is a long-term capital gain.
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Tax Treatment of Realized Losses
Real estate used in a trade or business (includes actively managed rental property) and held for more than one year are called Section 1231 assets. Gains on their disposal are treated as capital gains, losses are treated as offsets against ordinary income.
Losses on real estate held for investment purposes are capital losses. If the real estate is held for more than one year, the loss is a long-term capital loss
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Computing Net Gain or Loss on Sale of Assets Held for Use in Trade or Business
Offset Section 1231 gains and losses against each other.
Offset long-term capital gains against long-term capital losses
Offset short-term capital against against short-term capital losses
If there are net losses in one category and gains in the other, offset the two
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Tax Consequences Depends Upon Outcome of Offsetting Gains and Losses
If outcome is net short-term gains, lump them with ordinary income
If outcome is net long-term gains, they are taxed at the maximum rate of 20%, regardless of taxpayer’s marginal tax bracket.
If outcome is net losses, they are offset against ordinary income on a dollar-for-dollar basis, but only to the extent of $3,000 per year
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When Realized Gains or Losses Are Recognized
Gains are realized when a transaction is completed
They may be recognized (and tax consequences experienced) in that year or at another time
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Using the Installment Method
If seller takes back a promissory note in part payment for property, it may be possible to defer recognition of part of the taxable gain until principal amount of the note is collected
Gain that may be deferred is the installment method gain –total gain minus any portion that represents recapture of accelerated depreciation allowances
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Using the Installment Method
Contract price is total selling price, less balance of any mortgage note payable by the purchaser to a third party
Each year, recognized gain is determined by multiplying the amount of the sales price actually collected by the seller, multiplied by the ratio of the installment method gain to the contract price
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Using the Installment Method
Installment note must include a provision for reasonable rate of interest—otherwise, 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 like-kind exchanges (called tax-free exchanges) is contained in Section 1031 of the Internal Revenue Code.
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Like-Kind Exchanges
To qualify under Section 1031: Must have been bona fide
exchange of assets involved Property conveyed must have
been held for productive use in a trade or business or an investment and must be exchanged for like-kind property that is also to be used in a trade or business or held as an investment
Property must be of like-kind
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Like-Kind Exchanges
Certain types of property are specifically excluded form Section 1031
Foreign real estate is never considered like-kind with domestic real estate
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Tax Consequences of Like-Kind Exchanges
If all property involved in an exchange qualifies as like-kind and all parties qualify, then no party to the exchange may recognize any gain or loss on the transaction.
Should some of the property involved in an exchange fail the like-kind test, then some portion of a gain must be recognized in the year of the transaction.
Receipt of property that does not meet the like-kind definition has the effect of partially disqualifying a gain from deferral under Section 1031.
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Giving Property Away
Gifts and legacies are subjected to a unified, graduated gift and estate tax that is imposed on the person who makes a gift or to the estate of a decedent
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Giving Property Away
Exemptions and exclusions from the gift and estate tax: One may give as much as
$11,000 each to as man persons as one wishes each year with no gift tax implications ($22,000 for spouses)
Unlimited exemption for gifts or legacies to a spouse who is a United States citizen
Unlimited exemption for payment of tuition and medical expenses for others
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Giving Property Away
Gifts are cumulative over the giver’s lifetime for purposes of determining the graduated tax rate, but gift taxes are due in the year the gift is made
Each taxpayer has a lifetime credit against the unified gift and estate tax. The amount of the credit will shelter $1,000,000
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Giving Property Away
Gift of property that is subject to a mortgage will have sale as well as gift elements
The tax basis of a recipient’s interest in property received as a gift is the same as the basis of the giver’s, unless the giver incurred a gift tax liability.
Letting title pass as a legacy rather than a gift works better for highly appreciated property
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Traditional Measures of Investment Worth
Chapter 12
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Ratio Analysis
Ratios are employed to gauge the reasonableness of relationships between various measures of value and performance:
Income multipliers
Financial ratios
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Income Multipliers
Express the relationship between price and either gross or net income
Multiplier analysis permits obviously unacceptable opportunities to be weeded out
Gross income multipliers Net income multipliers
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Financial Ratio Analysis
Frequently employed to facilitate inter-property comparisons.
Operating ratio Break-even ratio Debt coverage ratio
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Traditional Profitability Measures
Attempt to relate cash investment to expected cash returns in some systematic fashion—not equally successful
Overall capitalization rate (free-and-clear rate of return)
Equity dividend rate (Cash-on-Cash rate of return)
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Traditional Profitability Measures
Broker’s rate of return
Payback period
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Traditional Profitability Measures
Shortcomings of traditional measures of investment performances:
Ignore cash-flow expectations during the later years of the holding period
Ignore cash-flow expectations from disposal
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Toward More Rational Analysis
Five major factors governing the relative attractiveness of a real estate investment must be incorporated into rational real estate investment analysis
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Toward More Rational Analysis—Major Factors
Anticipated stream of net cash flow to the investor
Expected timing of cash receipts
Degree of certainty with which expectations are held
Yields available from alternative investment opportunities
Investor’s attitude toward risk
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Toward More Rational Analysis
Time-adjusted investment evaluation measures Discount expected future cash
flows to make them more nearly comparable to those receivable in the present
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Discounted Cash-Flow Analysis
Chapter 13
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Present Value
Present value is the value today of benefits that are expected to accrue in the future
When discounting is done at the minimum acceptable rate of return on equity: Present value in excess of the
required initial equity cash outlay implies that a project is worthy of further considerations
A present value totaling less than the required initial equity expenditure results in automatic rejection
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Present Value
To use this approach, discount all anticipated future cash flows at the minimum acceptable rate of return. The result is the present value of expected cash flows.
PV=CF1/(1+i)+CF2(1+i)2+CF3/(1+i)3+….+(CFn/(1+i)n
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Net Present Value
Subtracting the required initial equity expenditure from the present value yields net present value A positive net present value means a
project is expected to yield a rate of return in excess of the discount rate, and therefore merits further consideration
A net present value of less than zero means the project is expected to yield a rate of return less than the minimum acceptable rate, and therefore should be rejected
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Internal Rate of Return
There is an inverse relationship between discount rates and present value
The rate that will exactly equate the present value of a projected stream of cash flows with any positive initial cash investment is the internal rate of return
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Internal Rate of Return
n Cost = Σ CF1/(1+k)t
t=1
Where CF is the cash flow projected for year t, cost is defined as the initial cash outlay, and k is the discount rate that makes the present value of the expected future cash flows exactly equal to the initial cash outlay
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Internal Rate of Return
Decision criteria using the IRR is:
If the internal rate of return is equal to or greater than an investor’s required rate of return, a project is considered further
If the internal rate of return is less than the minimum acceptable rate of return, the project is rejected
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Problems with the Internal Rate of Return
Can result in conflicting decision signals
Might result in investment error
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Reinvestment–Rate Problem
Interproject comparison using internal rate of return analysis involves an implicit assumption that funds are reinvested at the internal rate of return. The internal rate of return method reliably discriminates between alternatives only if there are available other acceptable opportunities expected to yield an equally high rate.
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The Multiple-Solutions Problem
Generally, a project’s net present value is a decreasing function of the discount rate employed. Thus, with successively a higher discount rates, a point is reached where the net present value is zero. This is the internal rate of return, and any greater discount rate will result in a negative net present value.
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The Multiple-Solutions Problem
Not all cash-flow forecasts have one internal rate of return equating all cash inflows with all cash outflows.
Investment proposals may have any number of internal rates of return, depending on the cash-flow pattern.
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Comparing Net Present Value and IRR
When using internal rate of return, reject all projects whose internal rate of return is less than the minimum required rate of return. Projects with an internal rate of return equal to or greater than the minimum acceptable rate are considered further.
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Comparing Net Present Value and IRR
When using net present value, discount at the minimum acceptable rate of return and reject all projects with a net present value of less than zero. Projects with a net present value of zero or greater are considered further.
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Comparing Net Present Value and IRR
Under most circumstances, the internal rate of return and net present value approaches will give the same decision signals
In some conditions, contradictory signals emerge
Given different decision signals, results of net present value are usually preferred
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Modified Internal Rate of Return
Discounts all negative cash flows back to the time at which the investment is acquired, and compounds all positive cash flows forward to the end of the final year of the holding period.
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Financial Management Rate of Return
Findley and Messner have developed a variation on the internal rate of return called financial management rate of return which incorporates two intermediate rates: Cost of capital rate employed
to discount negative cash flows back to year zero
Specified reinvestment rate for compounding positive cash flows to the end of the projection period
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Investment Goals and Decision Criteria
Chapter 14
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Choosing a Discount Rate
Choice is critical in selecting between alternative opportunities and deciding what opportunities merit additional considerations
Summation technique Risk-adjusted discount rate
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Investment Decisions and Decision Rules
Precise rules for making investment decisions depend of the nature of the problem
Net present value does not give an unambiguous decision signal when projects require different levels of initial cash outlay Profitability index (PI) is calculated by
dividing the present value of expected future cash flows by the amount of the initial cash outlay. The quotient represents present value per dollar of initial cash expenditure
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Investment Decisions and Decision Rules
General decision rule is to accept the project with the greatest profitability index (assuming there is no difference in the risk profile of competing opportunities)
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Investment Decisions and Decision Rules
Investors must select from between investment alternatives, all of which are considered desirable. Investors constantly face mutually
exclusive investment decisions The most appropriate technique for
deciding between mutually exclusive alternatives when using the net present value approach is to accept the alternative producing greater (positive) net present value.
When using the internal rate of return, the most appropriate approach is to accept the proposal having the higher internal rate of return, providing it is greater than the predetermined rate.
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Investment Decisions and Decision Rules—Mutually Dependent Proposals
Investment proposals are mutually dependent if acceptance of one forces the investor to accept the other. Acquisition of more than one property at a time requires consideration of results from alternative combinations.
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Investment Decisions and Decision Rules—Mutually Dependent Proposals
Group mutually dependent ventures into consolidated units, and treat each unit as a single investment venture
Accept mutually dependent combination having the highest net present value
If “packages” differ in amount of initial equity cash expenditure, compare the profitability indexes of the combinations
If internal rate of return method is being used, accept the combination having the highest calculated return
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Investment Value and Investment Strategy
Investment value is value of an income producing property to a particular investor
Prospective investors will be motivated to buy if they believe their subjective investment value is greater than the amount they will have to pay for a property
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Investment Value and Investment Strategy
Owners will be motivated to sell if they believe they will receive more than their properties are worth to them as elements in their personal investment portfolios
The greater the spread between investment value and transaction price for both buyer and seller, the greater the possible increase in both investors’ wealth
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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 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 venture’s 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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Risk Preferences and Profit Expectations
Rational investors prefer a higher to a lower return for a given level of risk; for a specified level of return they prefer less risk to more risk
They accept additional risk only if accompanied by additional expected investment rewards
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Figure 15.6
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Risk Preferences and Profit Expectations
Configuration of risk-reward indifference curves will depend upon the individual investor’s personal attitude toward risk.
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Risk Preferences and Profit Expectations
The more risk averse the individual, the more steeply sloped the indifference curve showing that person’s 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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Successful Insurance Firms as Rational Risk Takers
Allow insured parties to substitute the certainty of a small loss for the uncertainty of a larger, possibly catastrophic loss
Astute risk management Risk takers by design
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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
Traditional approaches to incorporating a risk premium have included: Using a shorter payback
period Higher required rate of
return Downward adjustment to
projected cash flows
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Measuring Risk
Traditional risk-adjustment techniques share a serious shortcoming—they do not permit quantification of the risk element.
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Traditional Risk-Adjustment Methods
Chapter 16
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The Payback-Period Approach
Payback period is the time required for cash inflows from an investment to equal the original cash outlay. Proponents of this technique
adjust for risk by varying the minimum acceptable payback period.
Inadequate method Desirability of real estate
opportunities often depend heavily upon expected gain from disposal
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Risk-Adjusted Discount Rate
Involves varying the discount rate to reflect risk perception; the higher the perceived risk, the greater the size of the discount rate. Risk-adjusted discount rate is
composed of a risk-free rate plus a risk premium
Probably most commonly used approach, but fatally flawed
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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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Partitioning Present Values
Real estate investments are valued solely for the anticipated future stream of benefits ownership bestows. Real estate investment can be seen as the purchase of a set of assumptions about a property’s ability to produce a benefit stream (after-tax cash flow).
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Partitioning Present Values
Factors contributing to flow include: income tax consequences loan amortization change in property value over
projected holding period
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Partitioning Present Values
Investment value can be divided into present value of equity and present value of debt. Present value of equity position can also be partitioned into its component parts. Expressing each component as a
percentage of total permits the relative importance of each to be assessed.
Components that comprise major segments of the total present vale of the equity position will merit extended analysis.
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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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Contemporary Risk Measures
Chapter 17
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Probability as a Risk Measure
Probability – the chance of occurrence associated with any possible outcome. Probabilities associated with any possible occurrence range from zero to one. If probability equals zero, event
certainly will not occur A probability of one indicates
certainty of occurrence
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Probability as a Risk Measure
Decisions are divisible: Certainty—only one possible
outcome; decisions based solely on the decision maker’s preference between certain alternatives
Risk-probabilities associated with various possible outcomes are either known or can be estimated
Uncertainty—probabilities are neither known or estimable; implies unknown number of possible outcomes
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Probability as a Risk Measure
Uncertainty is not measurable As better information
becomes available, uncertain elements can be converted to risk factors by incorporating into analysis their associated probability distributions
Analysts generate information to estimate the probability of occurrence of each risk
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Probability as a Risk Measure
Estimating future cash flows from real estate ventures is part art and part science. No way to determine future,
instead develop informed estimates
Couple estimates with probability estimate
Multiple law of probability used to determine the probability of occurrence of an event whose outcome depends in turn on the outcome of some prior event
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Interpreting Risk Measures
Probabilistic estimates of possible investment outcomes provide valuable intelligence about relative risk
Probability distribution – array of all possible outcomes and their related probabilities of occurrence Discrete probability distribution Continuous probability
distribution
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Figure 17.1
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Interpreting Risk Measures
Expected Value of probability distribution of possible cash flows is the weighted average of the possible cash flows making up the distribution, with each value weighted by its attendant probability of occurrence:
n CF = Σ 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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Interpreting Risk Measures
Variance – weighted average of the squared differences between each possible outcome and the expected outcome:
n
V = Σ (CFx – CF)2 Px
x=1
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Interpreting Risk Measures
V is variance CFx is value of the xth
possible outcome CF is expected value Px is related probability
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Interpreting Risk Measures
Square root of variance is standard deviation
Standard deviation has other mathematical properties that make it useful as a measure of risk
Once the mean and standard deviation are established, it is possible to determine the probability of occurrence of values over any desired interval within the distribution
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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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Risk Management in a Portfolio Context
Chapter 18
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Modern Portfolio Theory and Risk Management
Among the universe of possible portfolios, there is a subset of combinations that represent optimum combinations of expected return and risk.
Precise choice from among the subset depends upon the investor’s attitude toward risk.
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Modern Portfolio Theory and Risk Management
Systematic market risk– reflection of market prices; can only by reduced in efficient market by accepting lower expected returns
Unsystematic risk –function of characteristics of particular properties, such as location and design; can be eliminated by diversifying the assets in a portfolio
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Figure 18.1
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Modern Portfolio Theory and Risk Management
Among universe of possible portfolios, the subset that represents the best-obtainable 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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Real Estate’s Role in the Efficient Portfolio
Efficient frontier is a theoretical model which moves as the market changes
Studies indicate that real estate should be 10 to 20 percent of an efficient portfolio, which is substantially above the average amount of real estate in institutional investor’s portfolios
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Figure 18.4
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Real Estate Diversification Strategies
Geographic locale—picking locales where the real estate cycle is not highly correlated
Product type—including a range of buildings such as apartments, retail, industrial, office
Product-life cycle—including 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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Investment Feasibility Analysis
Chapter 19
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The Nature of the Feasibility Question
Feasibility analysis attempts to estimate the probability of success of a specific proposed course of action Formal or informal Early step in investment or
development process Involves estimating the amount
and timing of required cash expenditures and expected cash inflows, and an assessment of the degree of confidence that attaches to the estimates
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The Nature of the Feasibility Question
Feasible project must be: Physically possible Legally feasible Financially feasible
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Figure 19.1
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The Nature of the Feasibility Question
Feasibility analysis problems:
With a predetermined site, investigate alternative uses
With a predetermined use, investigate alternative sites
With predetermined funds, investigate alternative investment opportunities
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The Nature of the Feasibility Question
Limitations should be identified and defined in analysis Limits of resources Values, goals, and objectives Physical characteristics of sites Society, through ordinances and
regulatory oversight
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Steps in Feasibility Analysis Process
1. Assess physical and legal aspects of the site.2. Estimate demand for the proposed real estate
services.3. Analyze competitive space.4. Estimate the cost of constructions, alteration,
rehabilitation or fix-up, as proposed in the initial concept, and the cost of facility operations.
5. Estimate the cost of financing various possible combinations of equity and debt financing packages.
6. Estimate the rate at which vacant units will be rented.
7. Develop a schedule of cash inflows and outflows.
8. Evaluate the anticipated cash flows for adequacy, given the investor’s minimum acceptable rate of return and the degree of risk the investor is prepared to accept.
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Preliminary Financial Feasibility
Analysis should be viewed as continuous process
To be feasible, project must be attractive both to equity investors and to mortgage lenders
Preliminary financial feasibility deals with the threshold questions concerning a proposed venture (solvency testing)
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Figure 19.2
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Figure 19.3
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Format for a FeasibilityReport
Organization should reflect purpose; designed to facilitate use.
Common format: Title page Table of contents List of tables and exhibits Executive summary Scope and limitations Regional and city analysis Location and site analysis Market analysis Financial analysis and cash flow
projections Conclusions and recommendations
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Analyzing Subdivision Proposals
Chapter 20
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Overview of the Subdivision Process
Subdivision ventures grow out of developer’s 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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Coping with Regulatory Requirements
Governmental land use control is exercised through zoning laws and master land use plans. Small-scale subdividers may limit land
acquisition to appropriately zoned tracts
Large-scale subdividers frequently develop plans requiring extensive rezoning and government approvals
Municipalities seek to influence level of subdivision activity through control over public utilities Capacity Special assessments
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Creating the Subdivision Plan
Contents of land plans vary with size of developments Large-scale plans divide area by
specialized use categories Modest subdivision plans may simply
plot individual sites and make provision for utility easements
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Financing the Project
Subdividers use land acquisition and development loans to raise capital
Lenders usually disburse loan proceeds on piecemeal basis as improvements are completed
Most lenders view subdivision loans as more risky than construction loans Subdividers depend upon proceeds form
land sales for funds to repay loans Project marketability is vital
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Development and Rehabilitation
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 investor’s desire to use previously acquired site (“a site in search of an idea”)
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Feasibility Analysis
Two sections of feasibility study: Market research and attempts
to determine physical and location characteristics that will have the greatest consumer appeal
Economics of proposed project
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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 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
Construction projects are carried out on either a custom or speculative basis.
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
Begins with existing structures in need of extensive renovation Takes deteriorated or
functionally obsolete building and improves its physical condition or brings it up to modern design standards
Gentrification impetus for much rehabilitation activity
Prime areas seem to be older inner-city neighborhoods with convenient transportation links
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Incentive for Rehabilitation
Profit expectations
Tax legislation rewards
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Judging Feasibility of Rehabilitation Proposals
Analysis of rehabilitation proposals
Cost estimates Subtracting all costs and
expected profit from estimated value as completed leaves the amount available for purchase of property
If property can be purchased for less, project is feasible; if cost is greater, project not feasible
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Industrial Property, Office Building and Shopping Center Analysis
Chapter 22
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Investing in Industrial Buildings
Industrial buildings have the advantages of reliable, credit-worthy 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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Demand for Industrial Space
Largely a function of demand for products produced by industrial sector
Periodic shifts in demand for industrial space of various types and in different locations reflect alterations in composition of the industrial sector Growth in service and
technology Decrease for products of heavy
industry
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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 classification system for industrial buildings. Can be characterized by nature of building’s construction or type of tenant it 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 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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Investing in Shopping Centers
Investors and developers have long provided favorable lease terms to anchor tenants—major stores that attract customers
Recently, developers have allowed major tenants to construct their own buildings on sites leased from owners
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Lease Arrangement in Shopping Centers
Owners set base rental rate and increase rental rates as tenant’s 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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Types of Shopping Centers
Neighborhood shopping centers
Community shopping centers
Regional shopping malls
Super regional shopping malls
Lifestyle centers
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Real Estate Investment Trusts
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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REIT as Investment Vehicles
Shareholders benefit from: Limited liability Centralized management Continuity of entity life Free transferability of interests
Tax consequences of REIT investment: Shareholders are taxed directly on
distributed earnings—no 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 as Investment Vehicles
REIT ownership entails the risk associated with stock market fluctuations
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REIT as Investment Vehicles
REIT Mutual Funds permit investors to hold a diversified portfolio with a relatively modest total investment