Fundamentals of Real Estate

Lecture 8

Spring, 2003

Copyright © Joseph A. Petry

www.cba.uiuc.edu/jpetry/Fin_264_sp03

2

Exam Wednesday, 2/19 MC, 30-40 questions, similar to homework, class

examples. Exam will cover ch. 1-4. You should read each chapter carefully as well

as know lecture and homework material.

Today, we are going to put all of the financial analysis we have learned to work. Divide into your groups and work out the answers to example #2.

Housekeeping Issues

Input AssumptionsInput Assumption

Asking Purchase PriceLand value % of total price

Number of residential units sq ft eachResidential Rents per unit, per monthNumber of rental parking spaces spacesParking Rents per monthProjected Rental Increase per yearVacancy and Collection Losses per yearOperating Expenses of gross rentsExpected Holding Period yearsExpected Selling Price % per yearSelling Expenses of sale priceMortgage Financing:

Loan-to-Value ratioInterest RateMaturity yearsUp-front Financing Costs points

Personal Income Tax RateStraight Line Depreciation Over years %Depreciation Recapture Tax RateCapital Gain Tax Rate

4

Taxation at Sale of Property

Reconstructed Operating Statement Potential Gross Income (PGI)

- Vacancy & Collection Losses (VC)= Effective Gross Income (EGI)- Fixed Operating Expenses- Variable Operating Expenses= Net Operating Income (NOI)

5

Taxation at Sale of Property

After Tax Cash FlowsNet operating income (NOI)

- Interest expense (INT)- Principal amortization (PA)= Before-tax cash flow (BTCF)- Tax liability (TAX)= After-tax cash flow (ATCF)

6

Taxation at Sale of Property

Taxable Liability from OperationsNet Operating Income (NOI)

- Depreciation (DEP)- Interest expense (INT)- Amortized financing costs (AFC)= Taxable income (TI)x Tax rate (TR)= Tax liability (TAX)

7

Calculating Cash Flow from Sale

Gross Sales Price (GSP)- Selling Expenses (SE)= Net Sale Proceeds (NSP)- Remaining Mortgage Balance (RMB)= Before-Tax Equity Reversion (BTER)- Taxes Due on Sale (TDS)= After-Tax Equity Reversion (ATER)

Taxation at Sale of Property

8

Taxation at Sale of Property

Calculating Taxes Due on Sale Calculating Taxes Due on Sale

Net Sales Proceeds- Adjusted Basis (AB)= Total Taxable Gain (TG)- Depreciation Recapture (DR)= Capital Gain (CG)

Capital Gain Tax Liability (CGTAX)+ Depreciation Recapture Tax (DRTAX)= Taxes Due on Sale (TDS)

9

Federal Income Taxation

Depreciation Calculations Calculating Cash Flow from SaleAcquisition Price (AP=OCB)

+ Acquisition Costs (AC)- Land Value (LV)= Depreciable Cost Basis (DCB)

Acquisition Price (AP)+ Acquisition Costs (AC)+ Capital Improvements (CI)= Undepreciated Cost Basis (UCB)- Depreciation Expenses (DE)= Adjusted Basis (AB) Calculating Taxes Due on Sale

C o m m o n R e t u r n s & R a t i o s U s e d I n R e a l E s t a t e A n a l y s i sR a t i o F o r m U s e C o m m e n t

N e t p r e s e n t v a l u e T o i n d i c a t e d o l l a r v a l u e o f i n v e s t m e n t A l o n g w i t h I R R m o s t a p p r o p r i a t e( N P V ) i n c l u d i n g n e t s a l e p r o c e e d s ; a s s u m e s m e a s u r e o f t o t a l r e t u r n o v e r e n t i r e

a r e q u i r e d r a t e o f r e t u r n f o r i n v e s t o r i n v e s t m e n t h o r i z o nI n t e r n a l r a t e o f T o i n d i c a t e t o t a l r a t e o f r e t u r n , i n c l u d i n g N P V p r o v i d e s d o l l a r v a l u e a t r e q u i r e dr e t u r n ( I R R ) n e t s a l e p r o c e e d s ; a s s u m e s a t o u t s e t r a t e o f r e t u r n , I R R p r o v i d e s r a t e o f

a n a c q u i s i t i o n p r i c e f o r i n v e s t m e n t r e t u r n a t a s s u m e d a c q u i s i t i o n p r i c eO v e r a l l c a p N O I T o i n d i c a t e t h e r a t e o f r e t u r n o n t o t a l D o e s n o t i n c o r p o r a t e f u t u r e c a s h f l o w sr a t e ( O R ) A c q u i s i t i o n P r i c e i n v e s t m e n t ( b o t h l e n d e r a n d e q u i t y i n t h i s f o r m

p o s i t i o n ) f o r f i r s t p e r i o dD i r e c t c a p i t a l i z a t i o n R = y - g C o m m o n l y u s e d i n a p p r a i s a l s I n c o r p o r a t e s f u t u r e c a s h f l o w s p r o v i d e dr a t e ( R ) y = r e q u i r e d r a t e o f r e t u r n R a n g e s f r o m 8 . 0 % - 1 3 % ; l o w = s a f e N O I g r o w s a t c o n s t a n t r a t e ( g )E q u i t y d i v i d e n d B T C F T o i n d i c a t e t h e i n v e s o t r ' s o n e - p e r i o d T h i s r a t i o a c c o u n t s o n l y f o r t h er a t e ( E D R ) I n i t i a l E q u i t y I n v e s t m e n t r a t e o f r e t u r n i n c o m e b e n e f i t s ; i t i g n o r e s t a x a n d

a p p r e c i a t i o n a d v a n t a g e sN e t i n c o m e A c q u i s i t i o n P r i c e T o i n d i c a t e t h e r e l a t i o n s h i p b e t w e e n A q u i c k m e t h o d o f c o m p a r i n g t h em u l t i p l i e r ( N I M ) N O I N O I a n d t o t a l i n v e s t m e n t t o t a l i n v e s t m e n t t o i n c o m e o f

o n e p r o p e r t y t o o t h e r s i n t h e m a r k e tG r o s s i n c o m e A c q u i s i t i o n P r i c e T o i n d i c a t e t h e r e l a t i o n s h i p b e t w e e n A q u i c k m e t h o d o f c o m p a r i n g t h em u l t i p l i e r ( G I M ) E G I g r o s s i n c o m e a n d t o t a l i n v e s t m e n t t o t a l i n v e s t m e n t t o i n c o m e o f

o n e p r o p e r t y t o o t h e r s i n t h e m a r k e tG r o s s r e n t A c q u i s i t i o n P r i c e T o i n d i c a t e t h e r e l a t i o n s h i p b e t w e e n M o s t c o m m o n m e t h o d o f c o m p a r i n gm u l t i p l i e r ( G R M ) P G I g r o s s i n c o m e a n d t o t a l i n v e s t m e n t t h e t o t a l i n v e s t m e n t t o i n c o m e o f

o n e p r o p e r t y t o o t h e r s i n t h e m a r k e tO p e r a t i n g e x p e n s e O E T o i n d i c a t e t h e p o r t i o n o f r e n t a l N o r m a l r a n g e i s 2 5 - 5 0 % p e r c e n tr a t i o ( O E R ) E G I i n c o m e c o n s u m e d b y e x p e n s e s o f E G I

L o a n - t o - v a l u e M o r t g a g e B a l a n c e L i m i t e d b y l e n d e r s t o p r o t e c t t h e i r M a x i m u m a l l o w a b l e o n i n c o m er a t i o ( L T V ) P r o p e r t y V a l u e c a p i t a l f r o m d e f a u l t a n d f o r e c l o s u r e p r o p e r t y u s u a l l y 7 5 - 8 0 p e r c e n t

l o s s e sD e b t c o v e r a g e N O I U s e d b y l e n d e r s t o s e e h o w m u c h L e n d e r s u s u a l l y s e e k 1 . 2 0 t o 1 . 3 0r a t i o ( D C R ) D S N O I c a n d e c l i n e b e f o r e i t w i l l n o t c o v e r a g e r a t i o b u t m a y v a r y t h e i r

c o v e r d e b t s e r v i c e r e q u i r e m e n t s

nn

n

tt

t

r

NSP

r

NOIAP

)1()1(1

nn

n

tt

t

y

NSP

y

NOIIV

)1()1(10

11

Example #1 (from last time): Assume the following regarding a non-residential building: The purchase price is 450,000. The investor obtains a 360,000 loan. There are no financing costs. The investor expects the market value of the property to increase to $472,500 over the anticipated two-year holding period. Selling costs are expected to be 6% of the estimated sales price. The investor is in the 28% ordinary tax bracket. Capital gains will be taxed at 20%. Assume that the balance of the loan at the time of sale will be $354,276. Also assume that 15% of the purchase price represents the value of the land, and that improvements (the building) are depreciated over 31.5 years using straight line depreciation. A) compute the annual depreciation deduction, B) compute the adjusted basis at the time of the sale (after two years); C) Compute the tax liability from sale; D) Compute the after-tax cash flow (equity reversion) from sale.

Taxation at Sale of Property

12

Example #2: Assume the following regarding a residential building: The purchase price is 800,000. The investor obtains a 80% LTV loan, at 7.5% over 20 years, amortized monthly. There are no financing costs. There are 14 apartments, which rent at 850 per month. You expect it to take 3 months to fill a vacant apartment, and you assume that you will have 3 apartments change hands each year. You expect the market value of the property to increase 4% a year over the anticipated two-year holding period. Selling costs are expected to be 1.5% of the estimated sales price. Capital gains will be taxed at 20%. Depreciation Recapture is taxed at 25%. Also assume that 12% of the purchase price represents the value of the land. Construct proforma operating statements and tax tables to analyze this investment during its lifetime and upon disposition.

Taxation at Sale of Property