Economic Decision Making and Fair Housing 1 A wide variety of economic decisions are continuously being made in real estate 2 A developer or investor will not commit capital unless there will be benefit on the investment In economic decision making, forecasts must be made with the future in mind Real estate predictions must take into account the general economy 3 The break-even point occurs when the income covers total cost The break-even point for building an apartment can be reached sooner by reducing expenses, earlier occupancy, higher rents, or a combination of these methods 4 5 IMPLICIT COSTS (Opportunity Costs) - are the income that could have been made if the money was invested somewhere else These costs are NOT cash or expenses paid, but alternative income that could have been received In economic decision making, the developer weighs anticipated future profits against immediate explicit and implicit costs 6 Developers and investors want a profit to justify the risk Risk factors include: Costs Income Time delays 7 Developers often borrow funds at interest rates that are tied to the prime rate If a project CANNOT bear the cost, abandonment or modification of the project should be seriously considered 8 Leverage = Borrowing As leverage increases, so does risk A NEGATIVE CASH FLOW INVESTMENT is characterized by a larger cash out-flow from an investment than the cash in-flow 9 Generally, a buyer will obtain a lower interest rate for a loan with 20 percent or more down In a short sale, the lender agrees to accept the proceeds of the sale as total satisfaction of the owners debt 10 11 Development and investment decisions should be weighed against available alternatives Projects that offer several ways of making a profit are particularly attractive to developers 12 13 The pricing structure for the sale of real property is extremely important Too low a price will fail to maximize profits The price structure should be advantageous compared to the competition, unless the owner is somewhat willing to settle for a long holding period 14 Except when there is a flaw in the market, high interest rates result in a buyers market When interest rates are high, many buyers stop looking and wait for interest rates to drop A purchase made at a high interest rate in a slow market is likely to be the best economic decision 15 A higher price with a lower interest rate could result in the same payment as a lower price with a higher interest rate IMPUTED INTEREST is the federal governments requirement that the debt holder pay income tax on interest that should have been charged even if interest was not charged 16 IRS Section 1030 A tax-free exchange allows an owner to sell a property and acquire full use of the proceeds of the sale for the investment purposes without paying federal and state income taxes 17 There are times when it makes economic sense to give property away 18 IV. Rental Decisions 19 Rents are determined by the supply and demand of the marketplace, NOT by actual apartment construction or operating costs A vacant unit is in competition primarily with other vacant units VACANCY FACTOR is the percentage of rent that is not received due to vacancies 20 RENTAL CONCESSIONS are non-rent items granted by a landlord, which effectively lower the total rent paid Rental concessions offer many advantages over reducing rents 21 A long-term lease with a strong tenant helps owners borrow on their equity because lenders know that a good tenant is hard to find and makes the property attractive to purchasers In a LESSORS MARKET there are more lessees than lessors and the lessor would be able to dictate the lease terms Commercial leases may contain an ESCALTOR CLAUSE which provides for rental adjustments 22 23 Commercial developers frequently lease rather than purchase land Leases allow developers to reduce their capital requirements for the leased land and therefore lower the total development cost 24 A SALE-LEASEBACK is a financial maneuver in which the owner builds a structure, sells it and leases it back on a long-term lease Owners can build a structure of their own design, specifications, and choice of materials, and after the sale have no cash tied up in the new facility because they are now leasing it back F. Sale-Leaseback Decisions 25 V. Housing Development Decisions 26 New housing is built where the demand for houses is greater than the supply The risk profit trade-off is influenced by the way each developer views the economy and predicts the future New Development 27 Distinctive designs can attract high-priced renters to commercial structures The design will stand out and offer greater prestige for the tenants Distinctive, contemporary designed commercial structures bring premium rents A. Design Decisions 28 It would not cost much more than current construction costs to build structures that would have a life expectancy of several hundred years The additional costs would be: More steel in footings and slabs Greater use of treated lumber Better quality windows and doors Better quality hardware Cast-iron bath fixtures Hot-dipped, galvanized nails or screws Better attic ventilation Treating soil beneath structure for termite prevention Vapor barriers under slabs Access panels for all plumbing Use of standardized sizes for replacement Heavier gauge ducts and flashing Tile, slate, or copper roofs 29 Any amenity added to a development should garner an economic benefit AMENITIES are items people want and are willing to pay extra for, such as a Jacuzzi, tennis court, or beautiful view Builders should only make improvements that will pay for themselves 30 A property that no longer produces income attributable to the improvements alone has exceeded its economic life ECONOMIC LIFE is the period of time that an investment produces higher net income compared to what a propertys alternative uses could produce 31 When profits are increasing, inefficiencies tend to increase if care is NOT taken to maximize profits and reduce unnecessary expenses Efficiencies are often the direct result of necessity 32 The decision to hire employees or use contracted labor applies NOT only to construction, but to the provision of services such as maintenance and security The principal advantage of using ones own employees is the control of timing and quality 33 VI. Financing Decisions 34 While interest rates among lenders might vary only slightly, other loan provisions can vary significantly and should be considered when making a loan decision In addition to interest rates and points, all loan costs should be considered If the borrower believes interest rates will rise, then a fixed rate loan is preferable, even at slightly less advantageous terms A. Evaluating Loans 35 B. Adjustable Loans 36 PERMANENT FINANCING is a long-term loan that pays off a short-term construction loan In the past, many builders lost their projects because they were unable to obtain permanent financing C. Permanent Financing 37 REFINANCING is obtaining a new loan in order to pay off an existing loan When the purpose of refinancing is to reduce interest being paid on a loan, an owner should consider all loan costs to determine savings D. Refinancing 38 Refinancing and taking cash out of a property can obtain the same net effect as putting a second mortgage against the property to obtain the cash Refinancing will allow a borrower to obtain a favorable interest rate based on the present market A second mortgage (equity loan) would have a higher rate of interest E. Refinance or Equity Loan 39 By paying points, a seller can obtain advantageous institutional financing for purchasers Builders will often buy down the interest rate for a few years as an incentive for new buyers F. Seller Points 40 When a seller agrees to subordinate the sale of real property to anther loan, the sellers security position takes a secondary position to the new loan To keep risks at a minimum, the loan should be subordinate to a specified construction loan rather than all loans G. Subordination Decisions 41 VII. Other Economic Decisions 42 A very successful investor came up with a four- step analysis for when-to-sell decision making: 1.Ask yourself, If you didnt own this property, would you want to buy it at the price you think it should sell for? 2.Determine what you will have left after federal and state capital gains taxes, any loan payoffs, as well as brokerage fees and other selling costs 3.What would you do with the proceeds? 4.What would you prefer to do? A. When to Sell 43 Upon receipt of an offer to purchase, the offeree has three choices: 1.Reject the offer 2.Accept the offer 3.Counter offer B. Dealing with Purchase Offers 44 VIII. Noneconomic Decisions 45 Many decisions are NOT based on the careful weighing of alternatives, but rather because of: 1.Personal goals unrelated to profit 2.Current ownership of land 3.Greed 4.Substantial predevelopment costs and commitments 5.Short-term expenses 6.Personal attachment 7.Inertia 8.Ready availability of financing 9.Owners unwilling to accept a loss Noneconomic Decisions 46 IX. Fair Housing Laws 47 Passed shortly after the Civil War, this act was intended to prohibit racial discrimination only It was put aside and forgotten, because the courts refused to enforce the act as written 1. Civil Rights Act of Known as the Fair Housing Act, this act amended the original 1866 act to prohibit discrimination as to race, color, national origin, religion, sex, familial status, and handicap The act requires brokers and developers to post an Equal Housing Opportunity Poster 2. Civil Rights Act of 50 51 Most states also prohibit discriminatory actions by lessors, sellers, and their agents State laws allow aggrieved parties to sue in state courts including small claims courts Parties may also take their complaints to HUD or a state agency which can investigate and bring legal action against the wrong doer 3. State Fair Housing Laws 52 The Equal Credit Opportunity Act prohibits lender discrimination in providing credit It also prohibits the lender to use the source of income as a basis or denial of credit The act allows a person to know what is in his or her credit file, have wrong information removed or place an explanation in the file 53 Owners and of places of public accommodation must make their facilities accessible to handicapped to the extent that it is readily achievable Readily achievable is subjective based on value of the facility and cost to comply 54 The National Association of Realtors also enforces anti- discrimination in its Code of Ethics 55 Financial Forecasting Market Forecasting Break-Even Analysis Implicit Costs Risk in Investment Decisions Unstable Interest Rates Use of Leverage Leverage for Homebuyers Investment Alternatives Pricing Pricing Structure Price vs. Financing Price vs. Interest Rates Exchange Decisions Gift Decisions Rental Decisions Setting Rents Rent Concessions Length of Lease Rent or Buy Decisions Leasing Land Sale-Leaseback Decisions Housing Development Decisions Design Decisions Quality of Construction Evaluating Amenities Redevelopment or Demolition? Efficiencies of Development and Operation Employees or Independent Contractors Chapter Summary 56 Financing Decisions Evaluating Loans Adjustable Loans Permanent Financing Refinancing Refinancing or Equity Loans Seller Points Subordination Decisions Other Economic Decisions When to Sell Dealing with Purchase Offers Chapter Summary (cont.) Noneconomic Decisions Fair Housing Laws Civil Rights Act of 1866 Civil Rights Act of 1968 State Fair Housing Laws Equal Credit Opportunity Act Americans with Disabilities Act NAR Code of Ethics 57