Investments: Analysis and Behavior

Chapter 20- Real Estate and

Tangible Assets

©2008 McGraw-Hill/Irwin

20-2

Learning Objectives

Understand the investment characteristics of owning real property.

Know the risks of income property. Be able to appraise real estate value. Utilize real estate securities in a portfolio. Learn how to invest in gold.

20-3

Real Property Financial Assets

Investment instrument issued by a corporation, government, or other organization which offers legal rights to debt or equity cash flow.

Real Property Land and the buildings or other objects permanently affixed to the land. U.S. Household Assets…

Year-end 2004(in billions)

% of Total Assets

Tangible Assets $ 25,340.9 41.1%

Real Estate 21,579.7 35.0%

Consumer durable goods 3,761.2 6.1%

Financial Assets $ 29,564.1 48.0%

Deposits 5,887.6 9.6%

Bonds 2,733.4 4.4%

Stocks and mutual funds 10,296.4 16.7%

Pension funds 10,646.7 17.3%

Equity in noncorporate business $ 6,677.1 10.8%

Total Assets $ 61,582.1 100.0%

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Real Estate Characteristics Income property

Real estate bought for the purposes of generating rental income.

Raw land Unused land with no improvements

Improvements The buildings and structures constructed on a property.

Buying and Selling Illiquid Real estate agent

6% commission

20-5

Home OwnershipHouse Price Index (HPI)

US Office of Federal Housing Enterprise Oversight How do you create an index with heterogeneous assets that trade infrequently?

Sale and refinance data bases of Fannie Mae and Freddie Mac US (5.97%), California (8.6%), Kansas (4.3%)

Figure 20.1 Some Markets for Homes are Hotter than Others

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Data Source: U.S. Office of Federal Housing Enterprise Oversight (w w w .ofheo.gov)

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Income Property Cash flow is important for income property

investing! Know the revenue determinants

Rental income, vacancies, collection losses

Know the cost determinants Expenses, utilities, insurance, property taxes

Assessed value (% of market value) Tax rate

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Cash Flow Determinates of Income Property

RevenueIdeal Rental Income IRIVacancy and Collections Losses - VCMiscellaneous Income + MIGross Income GI

CostsOperating Expenses OEMaintenance Expenditures MEUtilities UInsurance IProperty Taxes PTTotal Costs TC

Net Operating Income (GI – TC) NOI

FinancingMortgage Payment MP

Cash Flow (GI – TC – MP) CF

20-8

Example: An investor is examining a rental property listed

for sale. The investor is mostly concerned about the cash flow of the property. The property has five apartments that can each be

rented for $750 per month. A 10% vacancy and collection loss rate is expected.

Operating expenses and maintenance expenses are estimated to be $3,000 and $3,800, respectively. Utilities paid by the owner will be $2,600 and insurance and taxes are predicted to be $7,100.

If the investor can put 20% down on the $250,000 and obtain a 30-year mortgage at 7.5%, what is the cash flow of property?

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The annual mortgage payment can be computed with a financial calculator. Use the number of periods as 360 (=30 × 12), interest rate of 0.625

(=7.5% ÷ 12), present value of $200,000 (=0.80 × $250,000), and future value of 0. The monthly payment solution is $1,398. This is $16,781 annually.

The cash flow of the property is therefore: Cash Flow Computation

Ideal Rental Income $45,000 = $750×5×12

– Vacancy and Collection Loss $4,500 = $45,000×0.10

= Gross Income $40,500

– Operating Expenses $3,000

– Maintenance Expenses $3,800

– Utilities $2,600

– Insurance & Taxes $7,100

= Total Costs $16,500

= Net Operating Income (NOI) $24,000

– Mortgage Payment $16,781

= Cash Flow $7,219

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Real Estate Valuation Valuing real estate is called

appraisal.

Discounted Cash Flow Method Converts expected cash flow and

price appreciation to a present value

Comparable Transactions Method Uses the transaction prices of

similar properties to estimate value.

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Quick estimate of income property value Direct capitalization

Similar to using the P/E ratio to evaluate a stock’s value

Find the capitalization rate, R, from recent property sales and the first year NOI:

Then use it to estimate the property’s value:

V

NOIR

R

NOIV

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Discounted Cash Flow Method Net Operating Income (NOI) is used as the

annual cash flows. Discount rate, k, uses the capitalization

rate and property growth rate, g:

Terminal value:

Discount equation:

gRk

R

NOITV n

n

n

tt

t

k

TV

k

NOIV

111

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Example: An investor with a five year holding period, estimates the NOI

each year as $20,770, $22,001, $23,300, $24,671, and $26,116. The capitalization rate for similar properties was computed to be 10.5%. If real estate is expected to appreciate at 4% per year, what is the discounted cash flow value of the property?

Solution First compute the discount rate:

k = R + g = 10.5% + 4% = 14.5%. Second, compute the terminal value. Remember that selling a

property involves a 6% commission:

TV = (NOI5 / R) × (1 – 0.06)

= ($26,115 / 0.105) × (1 – 0.06) = $233,791.

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Lastly, compute the discounted cash flow value:

If the property is listed for less, it is undervalued and would be a good value to purchase.

55432 145.1

791,233$

145.1

115,26$

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670,24$

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300,23$

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002,22$

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770,20$V

863,196$796,118$270,13$353,14$522,15$782,16$140,18$

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Comparable Transactions Method

3 steps Find sale transactions of comparable properties

Similar location, location, location

Compute the final adjusted comparable price for each transaction

Adjust for differences in bedrooms, bathrooms, lot size, time from sale, etc.

Reconcile final adjusted prices to estimate the indicated value

Average, median, etc.

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Real Estate Securities Securities can be issued that represent ownership in

portfolios of real estate properties:

Real Estate Investment Trusts (REITs) Equity REITs Mortgage REITs Hybrid REITs

Real Estate Mutual Funds

Real Estate oriented companies

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Table 20.5 Return Characteristics of REIT Categories, 1972 to 2005

Equity REITs Mortgage REITs Hybrid REITs

Average Annual Return = 14.66% 10.95% 12.06%

Standard Deviation = 16.72% 30.43% 26.84%

Minimum = -21.40% -45.32% -52.22%

Median = 17.18% 13.36% 16.92%

Maximum = 47.59% 77.34% 56.19%

Figure 20.4 REIT Sector Value in $ billions (# of REITS in category)

Industrial/Office (37), $93.5

Retail (33), $89.4 Residential (27), $55.1

Diversified (17), $22.9

Lodging/Resorts (19), $20.3

Self Storage (5), $14.9

Health Care (14), $15.7

Specialty (9), $17.9

Mortgage (36), $24.2

Data Source: National Association of Real Estate Investment Trusts (w w w .nareit.com), February 28, 2006

20-18

Investing in Gold

U.S. individuals were banned from owning hold until 1974. Except jewelry

Now you can invest in gold: Gold coins Gold bars Gold mining stocks Gold mutual funds Gold Exchange Traded Fund

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Figure 20.5 Gold Prices can Dramatically Change

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Gold peaked at $870.00 during trading on January 21, 1980.

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Data Source: Kitco (w w w .kitco.com)

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Gold has not been a very good investment, but it has been uncorrelated with stock returns.

Table 20.6 Gold Returns and Stock Returns, 1976 to 2005

Annual Annual

Gold Return S&P500 Return

Average = 6.2% 14.6%

Standard deviation = 27.60% 15.96%

Coefficient of variation = 4.46 1.09

Correlation = -0.089

20-21

Trading Gold Coins One ounce gold coins

Other sizes available too

Gold quality (22 karat versus 24 karat)

Gold coin price:Coin price = value of gold + numismatic value + dealer spread

Numismatic value is the amount of premium attributed to collector attributes. The scarcity of the coin and its appearance (fine, extra fine, proof, etc.) are the attributes that coin collectors evaluate.

Gold investors have little interest in paying premiums for obtaining gold. Therefore, gold bugs tend to buy common gold coins with no numismatic value.

British Sovereign (0.235 Troy oz.)

20-22

Art and Collectibles

Art derives its value from the demand of people who want to own it. Supply is fixed

No new Rembrandts or Van Gogh's

Supply is increasing New artists and new works

Art and collectibles are traded in auctions

20-23

Auctions Two largest international

auction firms:

Christie’swww.christies.com

Sotheby’swww.sothebys.com

Hundreds of millions of dollars in art and collectibles are sold every day.

20-24

Auction Costs

Buyer’s premium Commonly 20%

Seller’s commission costs Variable

10% fee on the first $100,000 of the sale,

8% fee on the next $150,000 of value,

7% on the next $250,000, 5% on the next $500,000, and

so on

20-25

Beware the Fad “Investment” Beanie Baby craze of the late 1990s

Beanie Babies are small beanbag animals made by Ty Inc.

Cute names like “Roary” the lion and “Bucky” the beaver

Beanies cost less than a dollar to make and retailed for about $5.

As they became popular, children tried to collect them all.

Adults insisted that one day their collections would be valuable.

Collectors bought “retired” Beanie’s for $10 or $20 dollars and resold them for $50.

Rare Beanies such as Peanut, the Royal Blue Elephant, sold for over $4,000 at online auctions. And Derby, the Horse, was once valued at $4,500. Parents planned to send their children to college on the their “investment” in Beanie Babies.

Then, one day the demand dried up. People who had bought dozens of beanies at inflated prices all tried to sell at once.

As collectors became sellers, the price of the toys plummeted. In 2005, a search for Beanie Babies on eBay produced nearly 15,000 auctions of retired

Beanies. Many were being sold in groups. A group of 19 animals were offered at a minimum bid of $7.49––there were no bids. A mint condition Peanut was offered for $2.99—there were no takers.

From a price of $5, up to thousands, and back down to $3. The great Beanie Baby bubble had burst!

Baseball cards, Beatle memorabilia, POGs, etc.