The Real Estate Investment Decision

1
The Real Estate Investment Decision

• Chapter 1

2
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

3
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

4
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

5
Figure 1.1
6
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

7
Figure 1.2
8
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 Standards and Poors
  500 stock index and Ibbotson Associates bond index

9
Real Estate Investment Performance

• Giliberto compared REIT yields with Standard and
  Poors 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

10
Concepts and Definitions

• Most Probable Selling PriceProbabilistic
  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

11
Concepts and Definitions

• Transaction Investment value from the present
  owners 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 buyers point of view must be
  greater than from the prospective sellers point
  of view

12
Figure 1.3
13
Figure 1.4
14
Figure 1.5
15
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

16
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

17
Figure 1.6
18
Figure 1.7
19
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

20
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
  investors 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

21
Figure 1.8
22
Figure 1.9
23
Investment Strategy and the Concept of Market
Efficiency

• Chapter 2

24
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

25
Figure 2.1
26
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

27
Supply, Demand, and the Price of Real Estate
Assets

• Shift in demandthe 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

28
Figure 2.2
29
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

30
Figure 2.3
31
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

32
Supply, Demand, and the Price of Real Estate
Assets

• Supply function differs as specified time period
  is lengthened or shortened
• Short runvariations in the supply of real estate
  placed on the market are an individuals
  perceptions of the relationship between market
  value and investment value
• Long runthe supply curve of real estate is
  influenced by cost of construction

33
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

34
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.

35
Figure 2.4
36
Figure 2.5
37
Figure 2.6
38
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

39
Market Efficiency and Profit Opportunities

• Marketscommonality of product
• Owner-occupant market
• Renter-occupant market
• Multifamily investment
• Nonresidential market

40
Figure 2.7
41
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

42
Figure 2.8
43
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

44
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

45
Strategy Implications

• In atomistic markets, economic rent will be rare
  and short-lived
• Less efficient the market, longer the adjustment
  process takes

46
Figure 2.9
47
Land Utilization and the Rental Value of Real
Estate

• Chapter 3

48
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

49
Economic Factors in Land Use Decisions

• Friction of space
• Linkages
• Transfer costs
• Processing costs

50
Figure 3.2
51
Figure 3.3
52
Figure 3.4
53
Figure 3.5
54
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

55
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

56
Market Research Tools and Techniques

• Chapter 4

57
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

58
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

59
Figure 4.1
60
A Design for Market Research

• Formulate nature of problem
• Proceed from general to specific
• Four quadrant forecasting matrix

61
Figure 4.2
62
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

63
Data Sources

• Primary data
• Secondary data

64
Primary data

• Statistics gathered by researcher precisely for
  problem at hand
• Can be gathered by communication or by
  observation

65
Secondary data

• Less costly and time consuming to generate
• Never precisely in desired form
• Available from agencies

66
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

67
Statistical Research

• Permit reliable generalizations to be drawn after
  examination of a limited portion of the total
  pool of information
• Descriptive statistics
• Inferential statistics

68
Geographic Information Systems

• (GIS) relate information to geographic location
  series of map overlays
• Computerized systems

69
Figure 4.3
70
Reconstructing the Operating History

• Chapter 5

71
Overview of Operating Statement

• Concerned with actual cash flows into and out of
  investors 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

72
Table 5.1
73
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 linethe amount of
  cash remaining at the end of the reporting period

74
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

75
Figure 5.1
76
Figure 5.2
77
Estimating Operating Expenses

• Subject propertys operating history
• Recent expense history of comparable properties
• Published compendiums of similar properties as
  benchmarks

78
Table 5.2
79
Table 5.3
80
Table 5.4
81
Table 5.5
82
Table 5.6
83
Forecasting Income and Property Value

• Chapter 6

84
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

85
Forecasting Operating Expenses

• Extend prior years trend into future (simple
  straight-line extrapolation)
• Alter trend line based on predicted changes
  during forecast period

86
The Net Operating Income Forecast

• Difference between forecast of rental revenue and
  forecast of operating expenses

87
Table 6.1
88
Table 6.2
89
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

90
Financial Leverage and Investment Analysis

• Chapter 7

91
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

92
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

93
Table 7.1
94
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

95
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

96
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

97
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

98
Table 7.3
99
Who Are the Lenders?

• Commercial banks
• Life insurance companies
• Pension funds
• Commercial mortgage-backed securities (CMBs)

100
Credit Instruments and Borrowing Arrangements

• Chapter 8

101
Credit and Security Instruments

• Promissory notes
• Mortgages
• Purchase-money mortgages
• Blanket mortgages
• Open-ended mortgage
• Deed of trust

102
Credit Terms

• Fully amortizing
• Partially amortizing
• Straight/term/bullet
• Portion of interest deferred
• Fluctuating interest rates

103
Alternative Financing Methods

• Installment sales contracts
• Sale and leaseback
• Junior mortgages

104
Government-Sponsored Credit Arrangements

• Department of Housing and Urban Development
• State and local government private activity bonds
• Redevelopment bonds

105
The Cost of Borrowed Money

• Chapter 9

106
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

107
Table 9.1
108
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

109
Table 9.5
110
Basic Income Tax Issues

• Chapter 10

111
Nature and Significance of the Tax Basis

• Newly acquired propertys 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

112
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

113
The Initial Tax Basis

• Property acquired as gift, initial tax basis the
  same as donors, 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 buyers
  initial tax basis

114
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

115
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

116
Adjusting the Basis in Cost Recovery

• Claiming tax deduction for cost recovery
  allowances reduces a propertys tax basis
• Lower the adjusted tax basis when property is
  sold, the greater the taxable gain on disposal

117
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

118
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

119
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
• Owners tax basis is increased by expenditures
  that materially increase the propertys value or
  useful life
• Transaction costs are added to the tax basis

120
Table 10.2
121
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

122
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 propertys sale is difference
  between the value of consideration received and
  the adjusted tax basis at the time of the
  transaction

123
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

124
Tax Consequences of Financial Leverage

• Construction period interest is special
  exceptionmust be capitalized reflected in
  annual depreciation allowances
• Deductibility of mortgage interest is limited by
  passive asset loss limitation rules
• Strategyborrow against equity rather than
  selling, as selling will trigger a taxable gain

125
Income Tax Credits for Property Rehabilitation

• Tax credits direct, dollar-for-dollar offsets
  against ones income tax obligation
• Expenditures to rehabilitate certain buildings
  qualify for a 10 percent rehabilitation tax credit

126
Limitations on Deductibility of Losses

• Limited partners 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

127
Figure 10.1
128
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

129
Taxation of Foreign Investors

• Buyer who fails to withhold the correct amount
  may be liable for the under-withheld amount, plus
  interest and penalties

130
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

131
Tax Consequence of Property Disposal

• Chapter 11

132
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

133
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.

134
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

135
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

136
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
  taxpayers 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

137
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

138
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

139
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

140
Using the Installment Method

• Installment note must include a provision for
  reasonable rate of interestotherwise, 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

141
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.

142
Like-Kind Exchanges

• Enabling legislation for like-kind exchanges
  (called tax-free exchanges) is contained in
  Section 1031 of the Internal Revenue Code.

143
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

144
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

145
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.

146
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

147
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

148
Giving Property Away

• Gifts are cumulative over the givers 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

149
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 recipients interest in
  property received as a gift is the same as the
  basis of the givers, unless the giver incurred a
  gift tax liability.
• Letting title pass as a legacy rather than a gift
  works better for highly appreciated property

150
Traditional Measures of Investment Worth

• Chapter 12

151
Ratio Analysis

• Ratios are employed to gauge the reasonableness
  of relationships between various measures of
  value and performance
• Income multipliers
• Financial ratios

152
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

153
Financial Ratio Analysis

• Frequently employed to facilitate inter-property
  comparisons.
• Operating ratio
• Break-even ratio
• Debt coverage ratio

154
Traditional Profitability Measures

• Attempt to relate cash investment to expected
  cash returns in some systematic fashionnot
  equally successful
• Overall capitalization rate (free-and-clear rate
  of return)
• Equity dividend rate (Cash-on-Cash rate of
  return)

155
Traditional Profitability Measures

• Brokers rate of return
• Payback period

156
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

157
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

158
Toward More Rational AnalysisMajor 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
• Investors attitude toward risk

159
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

160
Discounted Cash-Flow Analysis

• Chapter 13

161
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

162
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.
• PVCF1/(1i)CF2(1i)2CF3/(1i)3.(CFn/(1i)n

163
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

164
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

165
Internal Rate of Return

• n
• Cost S CF1/(1k)t
• t1
• 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

166
Internal Rate of Return

• Decision criteria using the IRR is
• If the internal rate of return is equal to or
  greater than an investors 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

167
Problems with the Internal Rate of Return

• Can result in conflicting decision signals
• Might result in investment error

168
ReinvestmentRate 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.

169
The Multiple-Solutions Problem

• Generally, a projects 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.

170
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.

171
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.

172
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.

173
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

174
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.

175
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

176
Investment Goals and Decision Criteria

• Chapter 14

177
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

178
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

179
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)

180
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.

181
Investment Decisions and Decision RulesMutually
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.

182
Investment Decisions and Decision RulesMutually
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

183
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

184
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

185
Risk in Real Estate Investment

• Chapter 15

186
Major Risk Elements

• Financial risk
• Insurable risk
• Business risk

187
Figure 15.1
188
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

189
Figure 15.4
190
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.

191
Controlling Risk

• Investors can control risk exposure by
  considering the relationship between assets
  already held and potential new acquisitions.

192
Controlling Risk

• Real estate investors are forced to make
  assumptions about a ventures ability to generate
  income over an extended period. Risk is often
  viewed as the possibility of variance between
  assumptions and actual outcomes.

193
Controlling Risk

• Lease agreements often permit landlords to shift
  some risk to tenants.
• Hedging may also reduce risk.

194
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

195
Figure 15.6
196
Risk Preferences and Profit Expectations

• Configuration of risk-reward indifference curves
  will depend upon the individual investors
  personal attitude toward risk.

197
Risk Preferences and Profit Expectations

• The more risk averse the individual, the more
  steeply sloped the indifference curve showing
  that persons 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

198
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

199
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

200
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

201
Measuring Risk

• Traditional risk-adjustment techniques share a
  serious shortcomingthey do not permit
  quantification of the risk element.

202
Traditional Risk-Adjustment Methods

• Chapter 16

203
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

204
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

205
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.

206
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
  propertys ability to produce a benefit stream
  (after-tax cash flow).

207
Partitioning Present Values

• Factors contributing to flow include
• income tax consequences
• loan amortization
• change in property value over projected holding
  period

208
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.

209
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.

210
Contemporary Risk Measures

• Chapter 17

211
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

212
Probability as a Risk Measure

• Decisions are divisible
• Certaintyonly one possible outcome decisions
  based solely on the decision makers preference
  between certain alternatives
• Risk-probabilities associated with various
  possible outcomes are either known or can be
  estimated
• Uncertaintyprobabilities are neither known or
  estimable implies unknown number of possible
  outcomes

213
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

214
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

215
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

216
Figure 17.1
217
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 S CFiPi
• i1
• 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.

218
Interpreting Risk Measures

• Variance weighted average of the squared
  differences between each possible outcome and the
  expected outcome
• n
• V S (CFx CF)2 Px
• x1

219
Interpreting Risk Measures

• V is variance
• CFx is value of the xth possible outcome
• CF is expected value
• Px is related probability

220
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

221
Figure 17.2
222
Figure 17.3
223
Figure 17.4
224
Figure 17.5
225
Figure 17.6
226
Risk Management in a Portfolio Context

• Chapter 18

227
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 investors attitude toward risk.

228
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

229
Figure 18.1
230
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

231
Figure 18.2
232
Real Estates 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 investors portfolios

233
Figure 18.4
234
Real Estate Diversification Strategies

• Geographic localepic