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The Real Estate


The Real Estate
!nvestment Decision
!nvestment Decision
HOMEBUD
HOMEBUD
Franklin Templeton Asset Group
Franklin Templeton Asset Group
2 2
State of the !nvestment
State of the !nvestment
Analysis Art
Analysis Art

Historically lagged behind


Historically lagged behind
mainstream finance and
mainstream finance and
investment thought; great
investment thought; great
strides recently
strides recently

Treats real estate as capital


Treats real estate as capital
asset desired for stream of
asset desired for stream of
benefits
benefits
-
-
Real estate investment as
Real estate investment as
special case of modern capital
special case of modern capital
budgeting
budgeting
3 3
Real Estate as an
Real Estate as an
!nvestment
!nvestment

nvestors Passive or Active


nvestors Passive or Active
-
-
Active investors
Active investors
acquire direct
acquire direct
title to real property; either
title to real property; either
oversee property themselves or
oversee property themselves or
hire management firms
hire management firms
-
-
Passive investors
Passive investors
place assets
place assets
with professional money
with professional money
managers who acquire interests
managers who acquire interests
in real property; may acquire
in real property; may acquire
shares in corporations or
shares in corporations or
partnerships that hold real
partnerships that hold real
property interests; make no
property interests; make no
operating decisions
operating decisions
4 4
Real Estate as an
Real Estate as an
!nvestment
!nvestment
-
-
!nvestors take equity or debt
!nvestors take equity or debt
position
position
-
-
Distinction between investors in
Distinction between investors in
real assets and investors in
real assets and investors in
financial assets
financial assets
-
-
While both are investors, exclude
While both are investors, exclude
mortgage lenders from this study
mortgage lenders from this study
of investment analysis and
of investment analysis and
decision making
decision making
5 5
Figure 1.1
Figure 1.1
6 6
Who Are the !nvestors?
Who Are the !nvestors?

Private investors
Private investors

nstitutions, such as RETs and


nstitutions, such as RETs and
pension funds
pension funds

Small level of foreign holdings


Small level of foreign holdings
-
-
Concentrated in locales and
Concentrated in locales and
types of properties
types of properties
-
-
Surged during early 1980s and
Surged during early 1980s and
later moderated
later moderated
-
-
Level shifts with foreign
Level shifts with foreign
exchange rates
exchange rates
-
-
Level impacted by relative
Level impacted by relative
interest rates
interest rates
7 7
Figure 1.2
Figure 1.2
8 8
Real Estate !nvestment
Real Estate !nvestment
Performance
Performance

Data for investment comparisons


Data for investment comparisons
scarce, but frequently concluded
scarce, but frequently concluded
that real estate generates returns
that real estate generates returns
roughly comparable to common
roughly comparable to common
stock, with greater predictability of
stock, with greater predictability of
returns
returns

More data for investment return


More data for investment return
comparisons available recently, but
comparisons available recently, but
heavily influenced by period from
heavily influenced by period from
which data are drawn
which data are drawn

Brueggeman, Chen and Thibodeau


Brueggeman, Chen and Thibodeau
analysis
analysis
--
--
real estate funds
real estate funds
outperformed Standard
outperformed Standard
'
'
s and
s and
Poor
Poor
'
'
s 500 stock index and
s 500 stock index and
bbotson Associates bond index
bbotson Associates bond index
9 9
Real Estate !nvestment
Real Estate !nvestment
Performance
Performance

Giliberto compared RET yields


Giliberto compared RET yields
with Standard and Poor
with Standard and Poor
'
'
s 500 stock
s 500 stock
index, 1978
index, 1978

1989; found
1989; found
advantage in common stocks
advantage in common stocks

Zerbst and Cambon (1984)


Zerbst and Cambon (1984)
analyzed earlier studies; found real
analyzed earlier studies; found real
estate tends to outperform stocks
estate tends to outperform stocks
during periods of inflation
during periods of inflation

Clayton and MacKinnon (2001) find


Clayton and MacKinnon (2001) find
RET returns now closely
RET returns now closely
correspond to returns on small
correspond to returns on small
capitalization stocks
capitalization stocks
10 10
Concepts and
Concepts and
Definitions
Definitions

Most Probable Selling Price


Most Probable Selling Price

Probabilistic estimate of the


Probabilistic estimate of the
price at which a future
price at which a future
transaction will occur
transaction will occur

Investment Value
Investment Value

Value of a
Value of a
property as an investment to a
property as an investment to a
present or prospective owner
present or prospective owner
11 11
Concepts and
Concepts and
Definitions
Definitions

Transaction nvestment value from the Transaction nvestment value from the
present owner present owner' 's perspective sets the s perspective sets the
lower end of the range of possible lower end of the range of possible
transaction prices. nvestment value from transaction prices. nvestment value from
the perspective of the most likely buyer the perspective of the most likely buyer
determines the upper end of the range. determines the upper end of the range.
- - To be motivated to sell, seller must conclude To be motivated to sell, seller must conclude
most probable selling price is greater than most probable selling price is greater than
investment value investment value
- - To be motivated to buy, buyer must conclude To be motivated to buy, buyer must conclude
investment value is greater than most investment value is greater than most
probable selling price probable selling price
- - For transaction to be possible, investment For transaction to be possible, investment
value from prospective buyer value from prospective buyer' 's point of view s point of view
must be greater than from the prospective must be greater than from the prospective
seller seller' 's point of view s point of view
12 12
Figure 1.3
Figure 1.3
13 13
Figure 1.+
Figure 1.+
14 14
Figure 1.S
Figure 1.S
15 15
Estimating !nvestment
Estimating !nvestment
value: An Overview
value: An Overview

nvestor who buys property buys set of nvestor who buys property buys set of
assumptions about ability of property to assumptions about ability of property to
generate cash flows over the expected generate cash flows over the expected
holding period and likely market value of holding period and likely market value of
property at end of proposed holding property at end of proposed holding
period. Analysis: period. Analysis:
- - Estimate the stream of expected benefits Estimate the stream of expected benefits
- - Adjust for timing differences in expected Adjust for timing differences in expected
streams of benefits from investment streams of benefits from investment
alternatives alternatives
- - Adjust for differences in perceived risk Adjust for differences in perceived risk
associated with alternatives associated with alternatives
- - Rank alternatives according to relative Rank alternatives according to relative
desirability of the perceived risk desirability of the perceived risk- -return return
combinations they embody combinations they embody
16 16
Estimating !nvestment
Estimating !nvestment
value: An Overview
value: An Overview

Value of an investment
Value of an investment
property is sum of the debt and
property is sum of the debt and
equity positions
equity positions
-
-
nvestment can be expressed as
nvestment can be expressed as
present value of the equity
present value of the equity
position
position
plus the
plus the
present value of
present value of
debt position
debt position
17 17
Figure 1.6
Figure 1.6
18 18
Figure 1.7
Figure 1.7
19 19
!nvestors Disagree on
!nvestors Disagree on
!nvestment values
!nvestment values

nvestors unlikely to arrive at


nvestors unlikely to arrive at
same investment value
same investment value
conclusions as they differ on:
conclusions as they differ on:
-
-
Future stream of rental revenue
Future stream of rental revenue
and operating expenses
and operating expenses
-
-
Perceived levels of risks
Perceived levels of risks
-
-
Willingness to defer immediate
Willingness to defer immediate
consumption in interest of future
consumption in interest of future
benefits
benefits
-
-
Desire for precisely determinable
Desire for precisely determinable
future
future
-
-
nvestors in higher
nvestors in higher
-
-
income
income
brackets benefit more from tax
brackets benefit more from tax
-
-
deductible losses
deductible losses
20 20
!nvestor Objectives and
!nvestor Objectives and
Risk
Risk
- - Seek financial return as reward for Seek financial return as reward for
committing resources and as committing resources and as
compensation for bearing risk compensation for bearing risk
- - Emotional temperament plays a large Emotional temperament plays a large
role in an investor role in an investor' 's attitude s attitude
- - Relate expected return to risk; accept Relate expected return to risk; accept
additional perceived risk only if additional perceived risk only if
accompanied by additional expected accompanied by additional expected
return return
- - Tend to become increasingly averse to Tend to become increasingly averse to
additional risk as total perceived risk additional risk as total perceived risk
increases increases
21 21
Figure 1.8
Figure 1.8
22 22
Figure 1.9
Figure 1.9
23 23
!nvestment Strategy
!nvestment Strategy
and the Concept of
and the Concept of
Narket Efficiency
Narket Efficiency
24 24
Supply, Demand, and the
Supply, Demand, and the
Price of Real Estate Assets
Price of Real Estate Assets

Demand
Demand
-
-
Relationship between market
Relationship between market
price and the quantity of a good
price and the quantity of a good
or service that will be bought per
or service that will be bought per
time period, over the entire
time period, over the entire
range of possible prices
range of possible prices
-
-
For real estate assets, demand
For real estate assets, demand
is inversely related to their price
is inversely related to their price
25 25
Figure 2.1
Figure 2.1
26 26
Supply, Demand, and the
Supply, Demand, and the
Price of Real Estate Assets
Price of Real Estate Assets

Demand Schedule
Demand Schedule
is the
is the
relationship between price and
relationship between price and
quantity;
quantity;
demand curve
demand curve
is the
is the
graphic form of the same
graphic form of the same
information
information
-
-
A specific demand schedule
A specific demand schedule
applies only to a defined
applies only to a defined
population vying for a particular
population vying for a particular
class of property
class of property
27 27
Supply, Demand, and the
Supply, Demand, and the
Price of Real Estate Assets
Price of Real Estate Assets

Shift in demand
Shift in demand

the entire
the entire
range of relationships between
range of relationships between
price and quantity demanded
price and quantity demanded
changes. Among determinants
changes. Among determinants
of location and shape of
of location and shape of
demand curves for real estate
demand curves for real estate
assets, and of changes in
assets, and of changes in
demand are:
demand are:
-
-
Number of prospective tenants
Number of prospective tenants
-
-
Changes in operating expenses
Changes in operating expenses
-
-
Yields available on other assets
Yields available on other assets
-
-
Technology
Technology
-
-
Tastes
Tastes
28 28
Figure 2.2
Figure 2.2
29 29
Supply, Demand, and the
Supply, Demand, and the
Price of Real Estate Assets
Price of Real Estate Assets

Example
Example
-
-
demand schedule
demand schedule
for downtown office space
for downtown office space
-
-
Price changes alter quantity
Price changes alter quantity
demanded
demanded
-
-
Decline in after
Decline in after
-
-
tax cash flow
tax cash flow

Market areas become relatively Market areas become relatively


more desirable, drop bidding for more desirable, drop bidding for
downtown property downtown property

Less downtown space purchased Less downtown space purchased


at each possible price per square at each possible price per square
foot foot
30 30
Figure 2.3
Figure 2.3
31 31
Supply, Demand, and the
Supply, Demand, and the
Price of Real Estate Assets
Price of Real Estate Assets

Relative Scarcity
Relative Scarcity
-
-
Property in abundance
Property in abundance
commands no substantial value
commands no substantial value
-
-
Supply is defined as the
Supply is defined as the
relationship between price and
relationship between price and
the quantity of a product
the quantity of a product
suppliers place on the market
suppliers place on the market
during a specified time period,
during a specified time period,
for all possible prices
for all possible prices
32 32
Supply, Demand, and the
Supply, Demand, and the
Price of Real Estate Assets
Price of Real Estate Assets

Supply function differs as


Supply function differs as
specified time period is
specified time period is
lengthened or shortened
lengthened or shortened
-
-
Short run
Short run

variations in the
variations in the
supply of real estate placed on
supply of real estate placed on
the market are an individuals
the market are an individuals
'
'
perceptions of the relationship
perceptions of the relationship
between market value and
between market value and
investment value
investment value
-
-
Long run
Long run

the supply curve of


the supply curve of
real estate is influenced by cost
real estate is influenced by cost
of construction
of construction
33 33
Supply, Demand, and the
Supply, Demand, and the
Price of Real Estate Assets
Price of Real Estate Assets

Quantity supplied
Quantity supplied

refers to
refers to
amount of product that will be
amount of product that will be
placed on the market per
placed on the market per
period of time at a specified
period of time at a specified
price
price

Supply
Supply

the relationship
the relationship
between price and quantity
between price and quantity
supplied over the entire range
supplied over the entire range
of possible prices
of possible prices
34 34
Supply, Demand, and the
Supply, Demand, and the
Price of Real Estate Assets
Price of Real Estate Assets

Equilibrium price
Equilibrium price

price at
price at
which there will be sufficient
which there will be sufficient
quantity of a product to satisfy
quantity of a product to satisfy
desires of all consumers at that
desires of all consumers at that
price, but with no surplus
price, but with no surplus
remaining on the market.
remaining on the market.
Quantity demanded and
Quantity demanded and
quantity supplied meet at the
quantity supplied meet at the
point where the supply and
point where the supply and
demand functions intersect.
demand functions intersect.
35 35
Figure 2.+
Figure 2.+
36 36
Figure 2.S
Figure 2.S
37 37
Figure 2.6
Figure 2.6
38 38
Narket Efficiency and
Narket Efficiency and
Profit Opportunities
Profit Opportunities

Markets
Markets

institutional
institutional
arrangements or mechanisms
arrangements or mechanisms
whereby buyers and sellers are
whereby buyers and sellers are
brought into contact with each
brought into contact with each
other. There are not
other. There are not
necessarily physical entities or
necessarily physical entities or
geographical location
geographical location
39 39
Narket Efficiency and
Narket Efficiency and
Profit Opportunities
Profit Opportunities

Markets
Markets

commonality of
commonality of
product
product
-
-
Owner
Owner
-
-
occupant market
occupant market
-
-
Renter
Renter
-
-
occupant market
occupant market
-
-
Multifamily investment
Multifamily investment
-
-
Nonresidential market
Nonresidential market
40 40
Figure 2.7
Figure 2.7
41 41
Narket Efficiency and
Narket Efficiency and
Profit Opportunities
Profit Opportunities

Range of Markets
Range of Markets
-
-
n an
n an
atomistic market,
atomistic market,
each
each
participant is so insignificant
participant is so insignificant
relative to the size of the total
relative to the size of the total
market that he has no
market that he has no
perceptible effect on price, Every
perceptible effect on price, Every
buyer can purchase as much as
buyer can purchase as much as
desired, every seller can sell as
desired, every seller can sell as
much as desired.
much as desired.
-
-
n an
n an
absolute monopoly
absolute monopoly
, there
, there
is only one supplier or a good or
is only one supplier or a good or
service for which there are not
service for which there are not
reasonably acceptable
reasonably acceptable
substitutes
substitutes
42 42
Figure 2.8
Figure 2.8
43 43
Narket Efficiency and
Narket Efficiency and
Profit Opportunities
Profit Opportunities

Price Searchers and Market


Price Searchers and Market
Efficiency
Efficiency
-
-
n an
n an
efficient market
efficient market
,
,
information is transmitted quickly
information is transmitted quickly
and without cost, eliminating
and without cost, eliminating
above average profit
above average profit
-
-
Time required for information to
Time required for information to
be reflected in price is a
be reflected in price is a
measure of market efficiency
measure of market efficiency
-
-
n less efficient market,
n less efficient market,
information is scarce and costly;
information is scarce and costly;
greater degree of price
greater degree of price
searching
searching
44 44
Narket Efficiency and
Narket Efficiency and
Profit Opportunities
Profit Opportunities

Sources of Market nefficiency


Sources of Market nefficiency
-
-
nformation costly and difficult to
nformation costly and difficult to
obtain; comparison shopping
obtain; comparison shopping
expensive and time consuming
expensive and time consuming
-
-
High transaction costs prohibit
High transaction costs prohibit
portfolio adjustment
portfolio adjustment
-
-
No two properties exactly alike
No two properties exactly alike
45 45
Strategy !mplications
Strategy !mplications

n atomistic markets,
n atomistic markets,
economic
economic
rent
rent
will be rare and short
will be rare and short
-
-
lived
lived

Less efficient the market,


Less efficient the market,
longer the adjustment process
longer the adjustment process
takes
takes
46 46
Figure 2.9
Figure 2.9
47 47
Land Utilization and the
Land Utilization and the
Rental value of Real
Rental value of Real
Estate
Estate
48 48
Economic Factors in
Economic Factors in
Land Use Decisions
Land Use Decisions

Location choice is primarily


Location choice is primarily
economic decision
economic decision

Economic models investigate


Economic models investigate
land development patterns
land development patterns

Market imperfections create


Market imperfections create
deviations, yet systematic
deviations, yet systematic
pattern is discernible
pattern is discernible

Clusters of stores for multiple


Clusters of stores for multiple
nuclei that create peaks in
nuclei that create peaks in
local land values
local land values
49 49
Economic Factors in
Economic Factors in
Land Use Decisions
Land Use Decisions

Friction of space
Friction of space

Linkages
Linkages

Transfer costs
Transfer costs

Processing costs
Processing costs
50 50
Figure 3.2
Figure 3.2
51 51
Figure 3.3
Figure 3.3
52 52
Figure 3.+
Figure 3.+
53 53
Figure 3.S
Figure 3.S
54 54
The Narket for Rental
The Narket for Rental
Space
Space

Competitive bids for best


Competitive bids for best
space create highest rents;
space create highest rents;
rents tend to decline as
rents tend to decline as
distance from 100 percent
distance from 100 percent
location increases
location increases

Overlapping of uses
Overlapping of uses
55 55
Narket Structure and the
Narket Structure and the
Need for Narket Research
Need for Narket Research

Atomistic markets (price takers) have Atomistic markets (price takers) have
little need for market research; sellers little need for market research; sellers
deliver homogeneous product to deliver homogeneous product to
whatever buyer is currently in the market whatever buyer is currently in the market
and sell for established and sell for established market price market price

Price searchers (those who operate in Price searchers (those who operate in
monopolistically competitive or monopolistically competitive or
oligopolistic markets) face more complex oligopolistic markets) face more complex
problem; control over market price is problem; control over market price is
closely related to the extent that their closely related to the extent that their
product is distinguished from closest product is distinguished from closest
substitute substitute

Each piece of real estate is unique with Each piece of real estate is unique with
respect to exact location respect to exact location

Product differences desensitize buyers to Product differences desensitize buyers to


price differentials price differentials

Price searchers with access to market Price searchers with access to market
intelligence benefit intelligence benefit
56 56
Narket Research Tools
Narket Research Tools
and Techniques
and Techniques
57 57
The Need for Narket
The Need for Narket
Research
Research

nvestment analysts and portfolio managers nvestment analysts and portfolio managers
need market information at every stage in need market information at every stage in
their decision their decision- -making efforts making efforts

Market information is required not only for Market information is required not only for
rational acquisition decisions, but for rational acquisition decisions, but for
managing the existing investment portfolio managing the existing investment portfolio

Market research is also need to facilitate Market research is also need to facilitate
operating management decisions operating management decisions
58 58
How Nuch Narket
How Nuch Narket
Research?
Research?

Justified by market stability and


Justified by market stability and
degree of investment
degree of investment
complexity
complexity

Maximum net benefit from


Maximum net benefit from
research occurs when pursued
research occurs when pursued
to point where marginal
to point where marginal
benefits equal marginal cost
benefits equal marginal cost

Decision makers must identify


Decision makers must identify
point of maximum benefit
point of maximum benefit
59 59
Figure +.1
Figure +.1
60 60
A Design for Narket
A Design for Narket
Research
Research

Formulate nature of problem


Formulate nature of problem

Proceed from general to


Proceed from general to
specific
specific

Four quadrant forecasting


Four quadrant forecasting
matrix
matrix
61 61
Figure +.2
Figure +.2
62 62
Preparing the Research
Preparing the Research
Report
Report

Summarizes procedures
Summarizes procedures
employed and describes
employed and describes
conclusions reached
conclusions reached

Everything in research report


Everything in research report
should be explained in terms of
should be explained in terms of
its bearing on the conclusion
its bearing on the conclusion

Report format is determined by


Report format is determined by
nature of research problem
nature of research problem
and needs of user
and needs of user
63 63
Data Sources
Data Sources

Primary data
Primary data

Secondary data
Secondary data
64 64
Primary data
Primary data

Statistics gathered by
Statistics gathered by
researcher precisely for
researcher precisely for
problem at hand
problem at hand

Can be gathered by
Can be gathered by
communication or by
communication or by
observation
observation
65 65
Secondary data
Secondary data

Less costly and time


Less costly and time
consuming to generate
consuming to generate

Never precisely in desired form


Never precisely in desired form

Available from agencies


Available from agencies
66 66
Descriptive Research
Descriptive Research

Examples
Examples
-
-
Describing profile of typical
Describing profile of typical
tenants
tenants
-
-
Estimating proportion of people
Estimating proportion of people
in a specific population who
in a specific population who
behave in a particular manner
behave in a particular manner

Describes aspect of problem


Describes aspect of problem

Requires planning and catalog


Requires planning and catalog
system
system

Cross
Cross
-
-
sectional
sectional
or
or
time series
time series
67 67
Statistical Research
Statistical Research

Permit reliable generalizations


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

Descriptive statistics
Descriptive statistics

nferential statistics
nferential statistics
68 68
Geographic !nformation
Geographic !nformation
Systems
Systems

(GS) relate information to


(GS) relate information to
geographic location; series of
geographic location; series of
map overlays
map overlays

Computerized systems
Computerized systems
69 69
Figure +.3
Figure +.3
70 70
Reconstructing the
Reconstructing the
Operating History
Operating History
71 71
Overview of Operating
Overview of Operating
Statement
Statement

Concerned with actual cash


Concerned with actual cash
flows into and out of investor
flows into and out of investor
'
'
s
s
funds
funds

Present cash inflows and


Present cash inflows and
outflows from operations and
outflows from operations and
extend the presentation to
extend the presentation to
include non
include non
-
-
operating cash
operating cash
flows such as those from debt
flows such as those from debt
service, income taxes and
service, income taxes and
capital expenditures
capital expenditures
72 72
Table S.1
Table S.1
73 73
Overview of Operating
Overview of Operating
Statement
Statement

Potential gross rent


Potential gross rent

amount of
amount of
rental revenue a property would
rental revenue a property would
generate with no vacancies
generate with no vacancies

Operating expenses
Operating expenses

include all
include all
cash expenditures required to
cash expenditures required to
maintain and operate the property
maintain and operate the property
so as to generate the gross rent
so as to generate the gross rent

Net operating income


Net operating income

the
the
difference between effective gross
difference between effective gross
income and operating expenses
income and operating expenses

Debt service
Debt service

consequence of
consequence of
using borrowed money to acquire
using borrowed money to acquire
property
property

After
After
-
-
tax cash flow= bottom line
tax cash flow= bottom line

the amount of cash remaining at


the amount of cash remaining at
the end of the reporting period
the end of the reporting period
74 74
Estimating Ability to
Estimating Ability to
Command Rent
Command Rent

History of recent operations


History of recent operations

Verify records of comparable


Verify records of comparable
properties
properties

Estimate recent gross income


Estimate recent gross income
through research
through research

Find comparable properties


Find comparable properties
-
-
Define market area
Define market area
-
-
dentify properties that
dentify properties that
prospective tenants would
prospective tenants would
consider as close substitutes
consider as close substitutes
75 75
Figure S.1
Figure S.1
76 76
Figure S.2
Figure S.2
77 77
Estimating Operating
Estimating Operating
Expenses
Expenses

Subject property
Subject property
'
'
s operating
s operating
history
history

Recent expense history of


Recent expense history of
comparable properties
comparable properties

Published compendiums of
Published compendiums of
similar properties as
similar properties as
benchmarks
benchmarks
78 78
Table S.2
Table S.2
79 79
Table S.3
Table S.3
80 80
Table S.+
Table S.+
81 81
Table S.S
Table S.S
82 82
Table S.6
Table S.6
83 83
Forecasting !ncome and
Forecasting !ncome and
Property value
Property value
84 84
Forecasting Gross
Forecasting Gross
!ncome
!ncome

Desirability of space, attractiveness,


Desirability of space, attractiveness,
price of competing space
price of competing space

Prospects for continued income


Prospects for continued income
-
-
generating ability
generating ability

Physical (natural and man


Physical (natural and man
-
-
made)
made)
and location characteristics
and location characteristics

Forecast changes in physical and


Forecast changes in physical and
location characteristics
location characteristics

Linkages and transfer costs


Linkages and transfer costs

nharmonious or incompatible land


nharmonious or incompatible land
usage
usage

Changes in supply of comparable


Changes in supply of comparable
rental space
rental space
85 85
Forecasting Operating
Forecasting Operating
Expenses
Expenses

Extend prior years


Extend prior years
'
'
trend into
trend into
future (simple straight
future (simple straight
-
-
line
line
extrapolation)
extrapolation)

Alter trend line based on


Alter trend line based on
predicted changes during
predicted changes during
forecast period
forecast period
86 86
The Net Operating
The Net Operating
!ncome Forecast
!ncome Forecast

Difference between forecast of


Difference between forecast of
rental revenue and forecast of
rental revenue and forecast of
operating expenses
operating expenses
87 87
Table 6.1
Table 6.1
88 88
Table 6.2
Table 6.2
89 89
Estimating Future
Estimating Future
Narket value
Narket value

Cash flow from eventual


Cash flow from eventual
disposal
disposal

Capitalization rate
Capitalization rate

ratio
ratio
between operating income and
between operating income and
market value
market value

Note current capitalization rate


Note current capitalization rate
applicable to comparable
applicable to comparable
properties and estimate how
properties and estimate how
rate might change over
rate might change over
forecasting period
forecasting period
90 90
Financial Leverage and
Financial Leverage and
!nvestment Analysis
!nvestment Analysis
91 91
Why Leverage is So
Why Leverage is So
Popular
Popular

Financial leverage
Financial leverage

using
using
borrowed funds to amplify the
borrowed funds to amplify the
outcome of equity investment
outcome of equity investment

Greater ratio of borrowed funds


Greater ratio of borrowed funds
to equity, greater degree of
to equity, greater degree of
financial leverage
financial leverage

Leverage is favorable so long


Leverage is favorable so long
as the rate of return on assets
as the rate of return on assets
exceeds the cost of borrowing
exceeds the cost of borrowing
92 92
Why Leverage is So
Why Leverage is So
Popular
Popular

Spread
Spread

difference between
difference between
rate of return on assets and
rate of return on assets and
cost of borrowing
cost of borrowing

Favorable spread magnifies


Favorable spread magnifies
return on equity of highly
return on equity of highly
leveraged investment
leveraged investment

When
When
debt service constant
debt service constant
is
is
less than the rate of return on
less than the rate of return on
total assets, additional financial
total assets, additional financial
leverage increases cash flow
leverage increases cash flow
to the equity position
to the equity position
93 93
Table 7.1
Table 7.1
94 94
Why Leverage is So
Why Leverage is So
Popular
Popular

Federal income tax law creates


Federal income tax law creates
major incentive to use financial
major incentive to use financial
leverage
leverage
-
-
nterest payments generally tax
nterest payments generally tax
deductible
deductible
-
-
Depreciation allowance to
Depreciation allowance to
recover costs
recover costs
-
-
Gains on disposal treated as
Gains on disposal treated as
capital gains
capital gains
95 95
Neasuring Financial
Neasuring Financial
Leverage
Leverage

Debt/equity ratio
Debt/equity ratio

ratio
ratio
between borrowed funds and
between borrowed funds and
equity funds
equity funds

Loan/value ratio
Loan/value ratio

ratio
ratio
between borrowed funds and
between borrowed funds and
market value of asset being
market value of asset being
financed
financed
96 96
Neasuring Financial
Neasuring Financial
Leverage
Leverage

Greater leverage increases risk that


Greater leverage increases risk that
cash flow from investment will be
cash flow from investment will be
insufficient to meet debt service
insufficient to meet debt service
obligation (
obligation (
financial risk
financial risk
)
)

Debt coverage ratio


Debt coverage ratio

degree to
degree to
which actual net operating income
which actual net operating income
can fall below expectations and still
can fall below expectations and still
be sufficient to meet debt service
be sufficient to meet debt service
obligation
obligation
97 97
How Nuch is Enough
How Nuch is Enough
Financial Leverage?
Financial Leverage?

Lenders frequently express


Lenders frequently express
maximum amount of loan in terms
maximum amount of loan in terms
of minimum permissible debt
of minimum permissible debt
coverage ratio
coverage ratio

Lenders specify maximum


Lenders specify maximum
permissible loan
permissible loan
-
-
to
to
-
-
value ratio
value ratio

As more money is borrowed to


As more money is borrowed to
finance an investment, the venture
finance an investment, the venture
becomes increasingly risky
becomes increasingly risky

ncreasing amount of borrowed


ncreasing amount of borrowed
funds relative to equity funds drive
funds relative to equity funds drive
up cost of borrowing
up cost of borrowing
98 98
Table 7.3
Table 7.3
99 99
Who Are the Lenders?
Who Are the Lenders?

Commercial banks
Commercial banks

Life insurance companies


Life insurance companies

Pension funds
Pension funds

Commercial mortgage
Commercial mortgage
-
-
backed
backed
securities (CMBs)
securities (CMBs)
100 100
Credit !nstruments and
Credit !nstruments and
Borrowing Arrangements
Borrowing Arrangements
101 101
Credit and Security
Credit and Security
!nstruments
!nstruments

Promissory notes
Promissory notes

Mortgages
Mortgages
-
-
Purchase
Purchase
-
-
money mortgages
money mortgages
-
-
Blanket mortgages
Blanket mortgages
-
-
Open
Open
-
-
ended mortgage
ended mortgage

Deed of trust
Deed of trust
102 102
Credit Terms
Credit Terms

Fully amortizing
Fully amortizing

Partially amortizing
Partially amortizing

Straight/term/bullet
Straight/term/bullet

Portion of interest deferred


Portion of interest deferred

Fluctuating interest rates


Fluctuating interest rates
103 103
Alternative Financing
Alternative Financing
Nethods
Nethods

nstallment sales contracts


nstallment sales contracts

Sale and leaseback


Sale and leaseback

Junior mortgages
Junior mortgages
104 104
Government
Government
-
-
Sponsored
Sponsored
Credit Arrangements
Credit Arrangements

Department of Housing and


Department of Housing and
Urban Development
Urban Development

State and local government


State and local government
private activity bonds
private activity bonds

Redevelopment bonds
Redevelopment bonds
105 105
The Cost of Borrowed
The Cost of Borrowed
Noney
Noney
106 106
The Nany Faces of
The Nany Faces of
!nterest Expense
!nterest Expense

Nominal rate
Nominal rate
or
or
contract rate
contract rate

interest rate based on face


interest rate based on face
amount of promissory note
amount of promissory note

Effective rate
Effective rate

rate actually
rate actually
paid
paid

After
After
-
-
tax borrowing costs are
tax borrowing costs are
usually lower than before
usually lower than before
-
-
tax
tax
costs
costs

Real rate
Real rate
of interest
of interest

effective
effective
rate, adjusted for price inflation
rate, adjusted for price inflation
107 107
Table 9.1
Table 9.1
108 108
Comparing Financing
Comparing Financing
Alternatives
Alternatives

Effective interest rates differ


Effective interest rates differ
- - Different contract rates Different contract rates
- - Differences in effective rates due to Differences in effective rates due to
differences in loan origination fees or differences in loan origination fees or
discount fees discount fees

Lenders often refuse to quote rate


Lenders often refuse to quote rate
until late in loan approval process
until late in loan approval process
109 109
Table 9.S
Table 9.S
110 110
Basic !ncome Tax
Basic !ncome Tax
!ssues
!ssues
111 111
Nature and Significance
Nature and Significance
of the Tax Basis
of the Tax Basis

Newly acquired property


Newly acquired property
'
'
s
s
initial tax basis is starting point
initial tax basis is starting point
in determining income tax
in determining income tax
consequences of operating the
consequences of operating the
property and, ultimately, the
property and, ultimately, the
tax consequence of disposal
tax consequence of disposal

During holding period, tax


During holding period, tax
basis is adjusted to reflect
basis is adjusted to reflect
disinvestment or additional
disinvestment or additional
capital investment
capital investment
112 112
Nature and Significance
Nature and Significance
of the Tax Basis
of the Tax Basis

Selling or exchanging a
Selling or exchanging a
property generates a gain or
property generates a gain or
loss equal to the difference
loss equal to the difference
between the sales price and
between the sales price and
the adjusted basis of the
the adjusted basis of the
property at the time of disposal
property at the time of disposal
113 113
The !nitial Tax Basis
The !nitial Tax Basis

Property acquired as gift, initial


Property acquired as gift, initial
tax basis the same as donor
tax basis the same as donor
'
'
s,
s,
unless donor incurs gift tax
unless donor incurs gift tax
liability
liability

Property acquired by
Property acquired by
inheritance, initial tax basis is
inheritance, initial tax basis is
market value as determined for
market value as determined for
estate tax purposes
estate tax purposes

Property acquired by purchase,


Property acquired by purchase,
cost forms buyer
cost forms buyer
'
'
s initial tax
s initial tax
basis
basis
114 114
Allocating the !nitial Tax
Allocating the !nitial Tax
Basis
Basis

Two or more assets acquired


Two or more assets acquired
together, initial tax basis must
together, initial tax basis must
be allocated between them
be allocated between them
using ratio of their relative
using ratio of their relative
market value
market value
-
-
Specify price of each in original
Specify price of each in original
purchase contract
purchase contract
-
-
Use ratio of land value to
Use ratio of land value to
building value estimated by tax
building value estimated by tax
assessor
assessor
-
-
Have independent appraiser
Have independent appraiser
estimate relative value of land
estimate relative value of land
and buildings
and buildings
115 115
Adjusting the Basis in
Adjusting the Basis in
Cost Recovery
Cost Recovery

Depreciation allowance
Depreciation allowance

An
An
allowance of capital invested in
allowance of capital invested in
improvements of property held for
improvements of property held for
business or investment purposes.
business or investment purposes.
- - Does not apply to property held for Does not apply to property held for
personal use or primarily for resale personal use or primarily for resale
- - Land, considered virtually Land, considered virtually
indestructible, is not included in indestructible, is not included in
depreciation allowance computation depreciation allowance computation
116 116
Adjusting the Basis in
Adjusting the Basis in
Cost Recovery
Cost Recovery

Claiming tax deduction for cost


Claiming tax deduction for cost
recovery allowances reduces a
recovery allowances reduces a
property
property
'
'
s tax basis
s tax basis

Lower the adjusted tax basis when


Lower the adjusted tax basis when
property is sold, the greater the
property is sold, the greater the
taxable gain on disposal
taxable gain on disposal
117 117
Recovery of Building
Recovery of Building
and Other
and Other
!mprovements
!mprovements

27.5 years for buildings


27.5 years for buildings
intended for residential rental
intended for residential rental
purposes
purposes

39 years for buildings intended


39 years for buildings intended
for other allowable purposes
for other allowable purposes

15 years for land


15 years for land
improvements such as walks,
improvements such as walks,
roads, sewers, and fences
roads, sewers, and fences
118 118
Recovery of Building
Recovery of Building
and Other
and Other
!mprovements
!mprovements

Allowance for buildings are


Allowance for buildings are
computed using straight
computed using straight
-
-
line
line
method
method

Allowances for improvements


Allowances for improvements
on and to the land may be
on and to the land may be
computed using the 150
computed using the 150
percent declining balance
percent declining balance
method
method
119 119
Other Adjustments to
Other Adjustments to
the Tax Basis
the Tax Basis

Basis is reduced when portion


Basis is reduced when portion
of asset is sold or destroyed by
of asset is sold or destroyed by
casualties such as fire, flood,
casualties such as fire, flood,
or storm
or storm

Owner
Owner
'
'
s tax basis is increased
s tax basis is increased
by expenditures that materially
by expenditures that materially
increase the property
increase the property
'
'
s value
s value
or useful life
or useful life

Transaction costs are added to


Transaction costs are added to
the tax basis
the tax basis
120 120
Table 10.2
Table 10.2
121 121
Tax Consequences of
Tax Consequences of
Ownership Form
Ownership Form

Title may vest in owners as


Title may vest in owners as
individuals
individuals

Title may vest in a corporation


Title may vest in a corporation

Tax Option Corporations


Tax Option Corporations

nvestors may form a general


nvestors may form a general
partnership
partnership

Limited partnership may hold


Limited partnership may hold
title
title

Limited liability company


Limited liability company
122 122
Tax Consequence of
Tax Consequence of
Property Sales
Property Sales

Adjusted tax basis at time of sale is


Adjusted tax basis at time of sale is
the initial tax basis plus all
the initial tax basis plus all
additional capital investments,
additional capital investments,
minus cumulative depreciation
minus cumulative depreciation
allowances, plus
allowances, plus
-
-
or
or
-
-
minus certain
minus certain
other adjustments that may
other adjustments that may
sometimes apply
sometimes apply

Gain or loss on property


Gain or loss on property
'
'
s sale is
s sale is
difference between the value of
difference between the value of
consideration received and the
consideration received and the
adjusted tax basis at the time of the
adjusted tax basis at the time of the
transaction
transaction
123 123
Tax Consequences of
Tax Consequences of
Financial Leverage
Financial Leverage

Borrowing or repaying debts


Borrowing or repaying debts
are not taxable events
are not taxable events

nterest expense is usually tax


nterest expense is usually tax
-
-
deductible in the year the
deductible in the year the
interest is paid
interest is paid

Exception
Exception
--
--
prepaid interest is
prepaid interest is
not deductible until actually
not deductible until actually
earned by the lender
earned by the lender
124 124
Tax Consequences of
Tax Consequences of
Financial Leverage
Financial Leverage

Construction period interest is


Construction period interest is
special exception
special exception

must be
must be
capitalized; reflected in annual
capitalized; reflected in annual
depreciation allowances
depreciation allowances

Deductibility of mortgage
Deductibility of mortgage
interest is limited by passive
interest is limited by passive
asset loss limitation rules
asset loss limitation rules

Strategy
Strategy

borrow against
borrow against
equity rather than selling, as
equity rather than selling, as
selling will trigger a taxable
selling will trigger a taxable
gain
gain
125 125
!ncome Tax Credits for
!ncome Tax Credits for
Property Rehabilitation
Property Rehabilitation

Tax credits
Tax credits

direct, dollar
direct, dollar
-
-
for
for
-
-
dollar offsets against one
dollar offsets against one
'
'
s
s
income tax obligation
income tax obligation

Expenditures to rehabilitate
Expenditures to rehabilitate
certain buildings qualify for a
certain buildings qualify for a
10 percent
10 percent
rehabilitation tax
rehabilitation tax
credit
credit
126 126
Limitations on
Limitations on
Deductibility of Losses
Deductibility of Losses
-
-
Limited partner
Limited partner
'
'
s income and
s income and
expenses from a partnership are
expenses from a partnership are
always considered passive asset
always considered passive asset
items
items
-
-
Real estate held for rental
Real estate held for rental
purposes is passive unless it is
purposes is passive unless it is
incidental to the primary
incidental to the primary
business activity
business activity
-
-
Special exception for real estate
Special exception for real estate
investors who are not actively
investors who are not actively
engaged in a real estate trade or
engaged in a real estate trade or
business to deduct up to
business to deduct up to
$25,000 of passive asset losses
$25,000 of passive asset losses
each year
each year
127 127
Figure 10.1
Figure 10.1
128 128
Taxation of Foreign
Taxation of Foreign
!nvestors
!nvestors

Taxpayer who acquires a U.S. real


Taxpayer who acquires a U.S. real
estate interest from a foreign owner
estate interest from a foreign owner
must withhold and remit to the RS
must withhold and remit to the RS
10 percent of the gross sales price,
10 percent of the gross sales price,
unless
unless
- - Property is worth no more than Property is worth no more than
$300,000 and is to be used by $300,000 and is to be used by
purchaser as personal residence purchaser as personal residence
- - Transaction is protected from taxation Transaction is protected from taxation
pursuant to a U.S. tax treaty pursuant to a U.S. tax treaty
- - Seller or buyer obtains a certificate Seller or buyer obtains a certificate
form the RS that reduces the amount form the RS that reduces the amount
to be withheld to be withheld
129 129
Taxation of Foreign
Taxation of Foreign
!nvestors
!nvestors

Buyer who fails to withhold the


Buyer who fails to withhold the
correct amount may be liable
correct amount may be liable
for the under
for the under
-
-
withheld amount,
withheld amount,
plus interest and penalties
plus interest and penalties
130 130
Alternative Ninimum
Alternative Ninimum
Tax
Tax

After figuring tax liability the


After figuring tax liability the
regular way, taxpayers must
regular way, taxpayers must
perform an alternative
perform an alternative
computation, and pay taxes on
computation, and pay taxes on
whichever computation method
whichever computation method
results in the greater liability
results in the greater liability

Alternative computation tax


Alternative computation tax
credits, and many tax
credits, and many tax
deductions, that are permitted
deductions, that are permitted
in the regular computation
in the regular computation
must be excluded
must be excluded
131 131
Tax Consequence of
Tax Consequence of
Property Disposal
Property Disposal
132 132
Computing the Realized
Computing the Realized
Gain or Loss
Gain or Loss

Everything of economic value


Everything of economic value
received in exchange for a property
received in exchange for a property
comprises the
comprises the
consideration
consideration

f seller receives other property or


f seller receives other property or
services as part of the transaction,
services as part of the transaction,
these must be included at their fair
these must be included at their fair
market value
market value

Difference between consideration


Difference between consideration
received and the adjusted tax basis
received and the adjusted tax basis
at the time of the transaction is the
at the time of the transaction is the
realized gain
realized gain
or
or
loss
loss
on disposal
on disposal
133 133
Tax Treatment of
Tax Treatment of
Realized Gains or
Realized Gains or
Losses
Losses
-
-
Gains are ordinary income when
Gains are ordinary income when
they result from recapture of
they result from recapture of
depreciation allowances.
depreciation allowances.
-
-
Gains are also ordinary income
Gains are also ordinary income
when they result from selling real
when they result from selling real
estate that has been held for
estate that has been held for
resale in the normal course of
resale in the normal course of
business (dealer property).
business (dealer property).
-
-
Gains on the sale or exchange of
Gains on the sale or exchange of
real estate held for business or
real estate held for business or
investment purposes are capital
investment purposes are capital
gains. f the holding period
gains. f the holding period
exceeds one year, the gain is a
exceeds one year, the gain is a
long
long
-
-
term capital gain.
term capital gain.
134 134
Tax Treatment of
Tax Treatment of
Realized Losses
Realized Losses

Real estate used in a trade or


Real estate used in a trade or
business (includes actively
business (includes actively
managed rental property) and held
managed rental property) and held
for more than one year are called
for more than one year are called
Section 1231
Section 1231
assets. Gains on their
assets. Gains on their
disposal are treated as capital
disposal are treated as capital
gains, losses are treated as offsets
gains, losses are treated as offsets
against ordinary income.
against ordinary income.

Losses on real estate held for


Losses on real estate held for
investment purposes are capital
investment purposes are capital
losses. f the real estate is held for
losses. f the real estate is held for
more than one year, the loss is a
more than one year, the loss is a
long
long
-
-
term capital loss
term capital loss
135 135
Computing Net Gain or
Computing Net Gain or
Loss on Sale of Assets
Loss on Sale of Assets
Held for Use in Trade or
Held for Use in Trade or
Business
Business

Offset Section 1231 gains and


Offset Section 1231 gains and
losses against each other.
losses against each other.

Offset long
Offset long
-
-
term capital gains
term capital gains
against long
against long
-
-
term capital
term capital
losses
losses

Offset short
Offset short
-
-
term capital
term capital
against against short
against against short
-
-
term
term
capital losses
capital losses

f there are net losses in one


f there are net losses in one
category and gains in the
category and gains in the
other, offset the two
other, offset the two
136 136
Tax Consequences
Tax Consequences
Depends Upon Outcome
Depends Upon Outcome
of Offsetting Gains and
of Offsetting Gains and
Losses
Losses

f outcome is net short


f outcome is net short
-
-
term
term
gains, lump them with ordinary
gains, lump them with ordinary
income
income

f outcome is net long


f outcome is net long
-
-
term
term
gains, they are taxed at the
gains, they are taxed at the
maximum rate of 20%,
maximum rate of 20%,
regardless of taxpayer
regardless of taxpayer
'
'
s
s
marginal tax bracket.
marginal tax bracket.

f outcome is net losses, they


f outcome is net losses, they
are offset against ordinary
are offset against ordinary
income on a dollar
income on a dollar
-
-
for
for
-
-
dollar
dollar
basis, but only to the extent of
basis, but only to the extent of
$3,000 per year
$3,000 per year
137 137
When Realized Gains or
When Realized Gains or
Losses Are Recognized
Losses Are Recognized

Gains are
Gains are
realized
realized
when a
when a
transaction is completed
transaction is completed

They may be
They may be
recognized
recognized
(and
(and
tax consequences
tax consequences
experienced) in that year or at
experienced) in that year or at
another time
another time
138 138
Using the !nstallment
Using the !nstallment
Nethod
Nethod

f seller takes back a promissory


f seller takes back a promissory
note in part payment for property, it
note in part payment for property, it
may be possible to defer
may be possible to defer
recognition of part of the taxable
recognition of part of the taxable
gain until principal amount of the
gain until principal amount of the
note is collected
note is collected

Gain that may be deferred is the


Gain that may be deferred is the
installment method gain
installment method gain

total gain
total gain
minus any portion that represents
minus any portion that represents
recapture of accelerated
recapture of accelerated
depreciation allowances
depreciation allowances
139 139
Using the !nstallment
Using the !nstallment
Nethod
Nethod

Contract price
Contract price
is total selling
is total selling
price, less balance of any
price, less balance of any
mortgage note payable by the
mortgage note payable by the
purchaser to a third party
purchaser to a third party

Each year, recognized gain is


Each year, recognized gain is
determined by multiplying the
determined by multiplying the
amount of the sales price
amount of the sales price
actually collected by the seller,
actually collected by the seller,
multiplied by the ratio of the
multiplied by the ratio of the
installment method gain to the
installment method gain to the
contract price
contract price
140 140
Using the !nstallment
Using the !nstallment
Nethod
Nethod

nstallment note must include a


nstallment note must include a
provision for reasonable rate of
provision for reasonable rate of
interest
interest

otherwise, RS imputes a
otherwise, RS imputes a
reasonable rate and recalculates
reasonable rate and recalculates
the tax consequences of the
the tax consequences of the
transaction
transaction

Complex tax rules limit the extent to


Complex tax rules limit the extent to
which a taxpayer can defer a gain
which a taxpayer can defer a gain
by using the installment method
by using the installment method
when they themselves own
when they themselves own
substantial amount of mortgage
substantial amount of mortgage
indebtedness
indebtedness
141 141
Like
Like
-
-
Kind Exchanges
Kind Exchanges

An otherwise taxable gain


An otherwise taxable gain
realized on an exchange of
realized on an exchange of
like
like
-
-
kind assets need not be
kind assets need not be
recognized in the year of the
recognized in the year of the
transaction. Tax liability is
transaction. Tax liability is
postponed until a future,
postponed until a future,
taxable transaction occurs with
taxable transaction occurs with
respect to the newly acquired
respect to the newly acquired
property.
property.
142 142
Like
Like
-
-
Kind Exchanges
Kind Exchanges

Enabling legislation for like


Enabling legislation for like
-
-
kind exchanges (called tax
kind exchanges (called tax
-
-
free
free
exchanges) is contained in
exchanges) is contained in
Section 1031 of the nternal
Section 1031 of the nternal
Revenue Code.
Revenue Code.
143 143
Like
Like
-
-
Kind Exchanges
Kind Exchanges

To qualify under Section 1031:


To qualify under Section 1031:
-
-
Must have been bona fide
Must have been bona fide
exchange of assets involved
exchange of assets involved
-
-
Property conveyed must have
Property conveyed must have
been held for productive use in a
been held for productive use in a
trade or business or an
trade or business or an
investment and must be
investment and must be
exchanged for like
exchanged for like
-
-
kind property
kind property
that is also to be used in a trade
that is also to be used in a trade
or business or held as an
or business or held as an
investment
investment
-
-
Property must be of like
Property must be of like
-
-
kind
kind
144 144
Like
Like
-
-
Kind Exchanges
Kind Exchanges

Certain types of property are


Certain types of property are
specifically excluded form
specifically excluded form
Section 1031
Section 1031

Foreign real estate is never


Foreign real estate is never
considered like
considered like
-
-
kind with
kind with
domestic real estate
domestic real estate
145 145
Tax Consequences of
Tax Consequences of
Like
Like
-
-
Kind Exchanges
Kind Exchanges

f all property involved in an


f all property involved in an
exchange qualifies as like
exchange qualifies as like
-
-
kind and
kind and
all parties qualify, then no party to
all parties qualify, then no party to
the exchange may recognize any
the exchange may recognize any
gain or loss on the transaction.
gain or loss on the transaction.

Should some of the property


Should some of the property
involved in an exchange fail the
involved in an exchange fail the
like
like
-
-
kind test, then some portion of
kind test, then some portion of
a gain must be recognized in the
a gain must be recognized in the
year of the transaction.
year of the transaction.

Receipt of property that does not


Receipt of property that does not
meet the like
meet the like
-
-
kind definition has the
kind definition has the
effect of partially disqualifying a
effect of partially disqualifying a
gain from deferral under Section
gain from deferral under Section
1031.
1031.
146 146
Giving Property Away
Giving Property Away

Gifts and legacies are


Gifts and legacies are
subjected to a unified,
subjected to a unified,
graduated gift and estate tax
graduated gift and estate tax
that is imposed on the person
that is imposed on the person
who makes a gift or to the
who makes a gift or to the
estate of a decedent
estate of a decedent
147 147
Giving Property Away
Giving Property Away

Exemptions and exclusions


Exemptions and exclusions
from the gift and estate tax:
from the gift and estate tax:
-
-
One may give as much as
One may give as much as
$11,000 each to as man persons
$11,000 each to as man persons
as one wishes each year with no
as one wishes each year with no
gift tax implications ($22,000 for
gift tax implications ($22,000 for
spouses)
spouses)
-
-
Unlimited exemption for gifts or
Unlimited exemption for gifts or
legacies to a spouse who is a
legacies to a spouse who is a
United States citizen
United States citizen
-
-
Unlimited exemption for payment
Unlimited exemption for payment
of tuition and medical expenses
of tuition and medical expenses
for others
for others
148 148
Giving Property Away
Giving Property Away

Gifts are cumulative over the


Gifts are cumulative over the
giver
giver
'
'
s lifetime for purposes of
s lifetime for purposes of
determining the graduated tax
determining the graduated tax
rate, but gift taxes are due in
rate, but gift taxes are due in
the year the gift is made
the year the gift is made

Each taxpayer has a lifetime


Each taxpayer has a lifetime
credit against the unified gift
credit against the unified gift
and estate tax. The amount of
and estate tax. The amount of
the credit will shelter
the credit will shelter
$1,000,000
$1,000,000
149 149
Giving Property Away
Giving Property Away

Gift of property that is subject


Gift of property that is subject
to a mortgage will have
to a mortgage will have
sale
sale
as
as
well as
well as
gift
gift
elements
elements

The tax basis of a recipient


The tax basis of a recipient
'
'
s
s
interest in property received as
interest in property received as
a gift is the same as the basis
a gift is the same as the basis
of the giver
of the giver
'
'
s, unless the giver
s, unless the giver
incurred a gift tax liability.
incurred a gift tax liability.

Letting title pass as a legacy


Letting title pass as a legacy
rather than a gift works better
rather than a gift works better
for highly appreciated property
for highly appreciated property
150 150
Traditional Neasures of
Traditional Neasures of
!nvestment Worth
!nvestment Worth
151 151
Ratio Analysis
Ratio Analysis

Ratios are employed to gauge


Ratios are employed to gauge
the reasonableness of
the reasonableness of
relationships between various
relationships between various
measures of value and
measures of value and
performance:
performance:
-
-
ncome multipliers
ncome multipliers
-
-
Financial ratios
Financial ratios
152 152
!ncome Nultipliers
!ncome Nultipliers

Express the relationship


Express the relationship
between price and either gross
between price and either gross
or net income
or net income

Multiplier analysis permits


Multiplier analysis permits
obviously unacceptable
obviously unacceptable
opportunities to be weeded out
opportunities to be weeded out

Gross income multipliers


Gross income multipliers

Net income multipliers


Net income multipliers
153 153
Financial Ratio Analysis
Financial Ratio Analysis

Frequently employed to
Frequently employed to
facilitate inter
facilitate inter
-
-
property
property
comparisons.
comparisons.

Operating ratio
Operating ratio

Break
Break
-
-
even ratio
even ratio

Debt coverage ratio


Debt coverage ratio
154 154
Traditional Profitability
Traditional Profitability
Neasures
Neasures

Attempt to relate cash


Attempt to relate cash
investment to expected cash
investment to expected cash
returns in some systematic
returns in some systematic
fashion
fashion

not equally
not equally
successful
successful

Overall capitalization rate (free


Overall capitalization rate (free
-
-
and
and
-
-
clear rate of return)
clear rate of return)

Equity dividend rate (Cash


Equity dividend rate (Cash
-
-
on
on
-
-
Cash rate of return)
Cash rate of return)
155 155
Traditional Profitability
Traditional Profitability
Neasures
Neasures

Broker
Broker
'
'
s rate of return
s rate of return

Payback period
Payback period
156 156
Traditional Profitability
Traditional Profitability
Neasures
Neasures

Shortcomings of traditional
Shortcomings of traditional
measures of investment
measures of investment
performances:
performances:
-
-
gnore cash
gnore cash
-
-
flow expectations
flow expectations
during the later years of the
during the later years of the
holding period
holding period
-
-
gnore cash
gnore cash
-
-
flow expectations
flow expectations
from disposal
from disposal
157 157
Toward Nore Rational
Toward Nore Rational
Analysis
Analysis

Five major factors governing


Five major factors governing
the relative attractiveness of a
the relative attractiveness of a
real estate investment must be
real estate investment must be
incorporated into rational real
incorporated into rational real
estate investment analysis
estate investment analysis
158 158
Toward Nore Rational
Toward Nore Rational
Analysis
Analysis
-
-
Najor Factors
Najor Factors

Anticipated stream of net cash


Anticipated stream of net cash
flow to the investor
flow to the investor

Expected timing of cash


Expected timing of cash
receipts
receipts

Degree of certainty with which


Degree of certainty with which
expectations are held
expectations are held

Yields available from


Yields available from
alternative investment
alternative investment
opportunities
opportunities

nvestor
nvestor
'
'
s attitude toward risk
s attitude toward risk
159 159
Toward Nore Rational
Toward Nore Rational
Analysis
Analysis

Time
Time
-
-
adjusted investment
adjusted investment
evaluation measures
evaluation measures
-
-
Discount expected future cash
Discount expected future cash
flows to make them more nearly
flows to make them more nearly
comparable to those receivable
comparable to those receivable
in the present
in the present
160 160
Discounted Cash
Discounted Cash
-
-
Flow
Flow
Analysis
Analysis
161 161
Present value
Present value

Present value
Present value
is the value today of
is the value today of
benefits that are expected to
benefits that are expected to
accrue in the future
accrue in the future

When discounting is done at the


When discounting is done at the
minimum acceptable rate of return
minimum acceptable rate of return
on equity:
on equity:
- - Present value in excess of the Present value in excess of the
required initial equity cash outlay required initial equity cash outlay
implies that a project is worthy of implies that a project is worthy of
further considerations further considerations
- - A present value totaling less than the A present value totaling less than the
required initial equity expenditure required initial equity expenditure
results in automatic rejection results in automatic rejection
162 162
Present value
Present value

To use this approach, discount all


To use this approach, discount all
anticipated future cash flows at the
anticipated future cash flows at the
minimum acceptable rate of return.
minimum acceptable rate of return.
The result is the present value of
The result is the present value of
expected cash flows.
expected cash flows.
PV=CF PV=CF
1 1
/(1+i)+CF /(1+i)+CF
2 2
(1+i) (1+i)
2 2
+CF +CF
3 3
/(1+i) /(1+i)
3 3
+ +. ..+(CF .+(CF
n n
/(1+i) /(1+i)
n n
163 163
Net Present value
Net Present value

Subtracting the required initial


Subtracting the required initial
equity expenditure from the present
equity expenditure from the present
value yields net present value
value yields net present value
- - A positive net present value means a A positive net present value means a
project is expected to yield a rate of project is expected to yield a rate of
return in excess of the discount rate, return in excess of the discount rate,
and therefore merits further and therefore merits further
consideration consideration
- - A net present value of less than zero A net present value of less than zero
means the project is expected to yield means the project is expected to yield
a rate of return less than the minimum a rate of return less than the minimum
acceptable rate, and therefore should acceptable rate, and therefore should
be rejected be rejected
164 164
!nternal Rate of Return
!nternal Rate of Return

There is an inverse relationship


There is an inverse relationship
between discount rates and
between discount rates and
present value
present value

The rate that will exactly


The rate that will exactly
equate the present value of a
equate the present value of a
projected stream of cash flows
projected stream of cash flows
with any positive initial cash
with any positive initial cash
investment is the
investment is the
internal rate
internal rate
of return
of return
165 165
!nternal Rate of Return
!nternal Rate of Return
n n

Cost =
Cost =

CF
CF
1 1
/(1+k)
/(1+k)
t t
t=1 t=1

Where CF is the cash flow


Where CF is the cash flow
projected for year t, cost is
projected for year t, cost is
defined as the initial cash
defined as the initial cash
outlay, and k is the discount
outlay, and k is the discount
rate that makes the present
rate that makes the present
value of the expected future
value of the expected future
cash flows exactly equal to the
cash flows exactly equal to the
initial cash outlay
initial cash outlay
166 166
!nternal Rate of Return
!nternal Rate of Return

Decision criteria using the RR


Decision criteria using the RR
is:
is:

f the internal rate of return is


f the internal rate of return is
equal to or greater than an
equal to or greater than an
investor
investor
'
'
s required rate of
s required rate of
return, a project is considered
return, a project is considered
further
further

f the internal rate of return is


f the internal rate of return is
less than the minimum
less than the minimum
acceptable rate of return, the
acceptable rate of return, the
project is rejected
project is rejected
167 167
Problems with the
Problems with the
!nternal Rate of Return
!nternal Rate of Return

Can result in conflicting


Can result in conflicting
decision signals
decision signals

Might result in investment error


Might result in investment error
168 168
Reinvestment
Reinvestment
-
-
Rate
Rate
Problem
Problem

nterproject comparison using


nterproject comparison using
internal rate of return analysis
internal rate of return analysis
involves an implicit assumption
involves an implicit assumption
that funds are reinvested at the
that funds are reinvested at the
internal rate of return. The
internal rate of return. The
internal rate of return method
internal rate of return method
reliably discriminates between
reliably discriminates between
alternatives only if there are
alternatives only if there are
available other acceptable
available other acceptable
opportunities expected to yield
opportunities expected to yield
an equally high rate.
an equally high rate.
169 169
The Nultiple
The Nultiple
-
-
Solutions
Solutions
Problem
Problem

Generally, a project
Generally, a project
'
'
s net
s net
present value is a decreasing
present value is a decreasing
function of the discount rate
function of the discount rate
employed. Thus, with
employed. Thus, with
successively a higher discount
successively a higher discount
rates, a point is reached where
rates, a point is reached where
the net present value is zero.
the net present value is zero.
This is the internal rate of
This is the internal rate of
return, and any greater
return, and any greater
discount rate will result in a
discount rate will result in a
negative net present value.
negative net present value.
170 170
The Nultiple
The Nultiple
-
-
Solutions
Solutions
Problem
Problem

Not all cash


Not all cash
-
-
flow forecasts
flow forecasts
have one internal rate of return
have one internal rate of return
equating all cash inflows with
equating all cash inflows with
all cash outflows.
all cash outflows.

nvestment proposals may


nvestment proposals may
have any number of internal
have any number of internal
rates of return, depending on
rates of return, depending on
the cash
the cash
-
-
flow pattern.
flow pattern.
171 171
Comparing Net Present
Comparing Net Present
value and !RR
value and !RR

When using internal rate of


When using internal rate of
return, reject all projects whose
return, reject all projects whose
internal rate of return is less
internal rate of return is less
than the minimum required rate
than the minimum required rate
of return. Projects with an
of return. Projects with an
internal rate of return equal to
internal rate of return equal to
or greater than the minimum
or greater than the minimum
acceptable rate are considered
acceptable rate are considered
further.
further.
172 172
Comparing Net Present
Comparing Net Present
value and !RR
value and !RR

When using net present value,


When using net present value,
discount at the minimum
discount at the minimum
acceptable rate of return and
acceptable rate of return and
reject all projects with a net
reject all projects with a net
present value of less than zero.
present value of less than zero.
Projects with a net present
Projects with a net present
value of zero or greater are
value of zero or greater are
considered further.
considered further.
173 173
Comparing Net Present
Comparing Net Present
value and !RR
value and !RR

Under most circumstances, the


Under most circumstances, the
internal rate of return and net
internal rate of return and net
present value approaches will
present value approaches will
give the same decision signals
give the same decision signals

n some conditions,
n some conditions,
contradictory signals emerge
contradictory signals emerge

Given different decision


Given different decision
signals, results of net present
signals, results of net present
value are usually preferred
value are usually preferred
174 174
Nodified !nternal Rate
Nodified !nternal Rate
of Return
of Return

Discounts all negative cash


Discounts all negative cash
flows back to the time at
flows back to the time at
which the investment is
which the investment is
acquired, and compounds all
acquired, and compounds all
positive cash flows forward to
positive cash flows forward to
the end of the final year of the
the end of the final year of the
holding period.
holding period.
175 175
Financial Nanagement
Financial Nanagement
Rate of Return
Rate of Return

Findley and Messner have


Findley and Messner have
developed a variation on the
developed a variation on the
internal rate of return called
internal rate of return called
financial management rate of
financial management rate of
return which incorporates two
return which incorporates two
intermediate rates:
intermediate rates:
-
-
Cost of capital rate employed to
Cost of capital rate employed to
discount negative cash flows
discount negative cash flows
back to year zero
back to year zero
-
-
Specified reinvestment rate for
Specified reinvestment rate for
compounding positive cash
compounding positive cash
flows to the end of the
flows to the end of the
projection period
projection period
176 176
!nvestment Goals and
!nvestment Goals and
Decision Criteria
Decision Criteria
177 177
Choosing a Discount
Choosing a Discount
Rate
Rate

Choice is critical in selecting


Choice is critical in selecting
between alternative opportunities
between alternative opportunities
and deciding what opportunities
and deciding what opportunities
merit additional considerations
merit additional considerations

Summation technique
Summation technique

Risk
Risk
-
-
adjusted discount rate
adjusted discount rate
178 178
!nvestment Decisions
!nvestment Decisions
and Decision Rules
and Decision Rules

Precise rules for making investment


Precise rules for making investment
decisions depend of the nature of
decisions depend of the nature of
the problem
the problem

Net present value does not give an


Net present value does not give an
unambiguous decision signal when
unambiguous decision signal when
projects require different levels of
projects require different levels of
initial cash outlay
initial cash outlay
- - Profitability index (P) is calculated by Profitability index (P) is calculated by
dividing the present value of expected dividing the present value of expected
future cash flows by the amount of the future cash flows by the amount of the
initial cash outlay. The quotient initial cash outlay. The quotient
represents present value per dollar of represents present value per dollar of
initial cash expenditure initial cash expenditure
179 179
!nvestment Decisions
!nvestment Decisions
and Decision Rules
and Decision Rules

General decision rule is to


General decision rule is to
accept the project with the
accept the project with the
greatest profitability index
greatest profitability index
(assuming there is no
(assuming there is no
difference in the risk profile of
difference in the risk profile of
competing opportunities)
competing opportunities)
180 180
!nvestment Decisions
!nvestment Decisions
and Decision Rules
and Decision Rules

nvestors must select from between


nvestors must select from between
investment alternatives, all of which
investment alternatives, all of which
are considered desirable.
are considered desirable.
- - nvestors constantly face mutually nvestors constantly face mutually
exclusive investment decisions exclusive investment decisions
- - The most appropriate technique for The most appropriate technique for
deciding between mutually exclusive deciding between mutually exclusive
alternatives when using the net alternatives when using the net
present value approach is to accept present value approach is to accept
the alternative producing greater the alternative producing greater
(positive) net present value. (positive) net present value.
- - When using the internal rate of return, When using the internal rate of return,
the most appropriate approach is to the most appropriate approach is to
accept the proposal having the higher accept the proposal having the higher
internal rate of return, providing it is internal rate of return, providing it is
greater than the predetermined rate. greater than the predetermined rate.
181 181
!nvestment Decisions and
!nvestment Decisions and
Decision Rules
Decision Rules
-
-
Nutually
Nutually
Dependent Proposals
Dependent Proposals

nvestment proposals are


nvestment proposals are
mutually dependent
mutually dependent
if
if
acceptance of one forces the
acceptance of one forces the
investor to accept the other.
investor to accept the other.
Acquisition of more than one
Acquisition of more than one
property at a time requires
property at a time requires
consideration of results from
consideration of results from
alternative combinations.
alternative combinations.
182 182
!nvestment Decisions and
!nvestment Decisions and
Decision Rules
Decision Rules
-
-
Nutually
Nutually
Dependent Proposals
Dependent Proposals
- - Group mutually dependent ventures Group mutually dependent ventures
into consolidated units, and treat each into consolidated units, and treat each
unit as a single investment venture unit as a single investment venture
- - Accept mutually dependent Accept mutually dependent
combination having the highest net combination having the highest net
present value present value
- - f f packages packages differ in amount of initial differ in amount of initial
equity cash expenditure, compare the equity cash expenditure, compare the
profitability indexes of the profitability indexes of the
combinations combinations
- - f internal rate of return method is f internal rate of return method is
being used, accept the combination being used, accept the combination
having the highest calculated return having the highest calculated return
183 183
!nvestment value and
!nvestment value and
!nvestment Strategy
!nvestment Strategy

nvestment value is value of an


nvestment value is value of an
income producing property to a
income producing property to a
particular investor
particular investor

Prospective investors will be


Prospective investors will be
motivated to buy if they believe
motivated to buy if they believe
their subjective investment
their subjective investment
value is greater than the
value is greater than the
amount they will have to pay
amount they will have to pay
for a property
for a property
184 184
!nvestment value and
!nvestment value and
!nvestment Strategy
!nvestment Strategy

Owners will be motivated to


Owners will be motivated to
sell if they believe they will
sell if they believe they will
receive more than their
receive more than their
properties are worth to them as
properties are worth to them as
elements in their personal
elements in their personal
investment portfolios
investment portfolios

The greater the spread


The greater the spread
between investment value and
between investment value and
transaction price for both buyer
transaction price for both buyer
and seller, the greater the
and seller, the greater the
possible increase in both
possible increase in both
investors
investors
'
'
wealth
wealth
185 185
Risk in Real Estate
Risk in Real Estate
!nvestment
!nvestment
186 186
Najor Risk Elements
Najor Risk Elements

Financial risk
Financial risk

nsurable risk
nsurable risk

Business risk
Business risk
187 187
Figure 1S.1
Figure 1S.1
188 188
Controlling Risk
Controlling Risk

Risk analysis
Risk analysis

nvest in less risky projects


nvest in less risky projects
-
-
Eliminates opportunities for
Eliminates opportunities for
extraordinary profits
extraordinary profits
-
-
Financial market assigns
Financial market assigns
appropriate level of return to
appropriate level of return to
each opportunity, commensurate
each opportunity, commensurate
with level of risk perceived
with level of risk perceived
-
-
n an efficient market, the only
n an efficient market, the only
way to reduce risk associated
way to reduce risk associated
with single investment ventures
with single investment ventures
is to choose a venture with a
is to choose a venture with a
lower expected return
lower expected return
189 189
Figure 1S.+
Figure 1S.+
190 190
Controlling Risk
Controlling Risk

Real estate markets tend to be


Real estate markets tend to be
somewhat less efficient than
somewhat less efficient than
are organized securities
are organized securities
markets. Real estate investors
markets. Real estate investors
who can exploit market
who can exploit market
inefficiencies are able to reap
inefficiencies are able to reap
extraordinary profits without
extraordinary profits without
shouldering commensurately
shouldering commensurately
greater risk.
greater risk.
191 191
Controlling Risk
Controlling Risk

nvestors can control risk


nvestors can control risk
exposure by considering the
exposure by considering the
relationship between assets
relationship between assets
already held and potential new
already held and potential new
acquisitions.
acquisitions.
192 192
Controlling Risk
Controlling Risk

Real estate investors are


Real estate investors are
forced to make assumptions
forced to make assumptions
about a venture
about a venture
'
'
s ability to
s ability to
generate income over an
generate income over an
extended period. Risk is often
extended period. Risk is often
viewed as the possibility of
viewed as the possibility of
variance between assumptions
variance between assumptions
and actual outcomes.
and actual outcomes.
193 193
Controlling Risk
Controlling Risk

Lease agreements often permit


Lease agreements often permit
landlords to shift some risk to
landlords to shift some risk to
tenants.
tenants.

Hedging may also reduce risk.


Hedging may also reduce risk.
194 194
Risk Preferences and
Risk Preferences and
Profit Expectations
Profit Expectations

Rational investors prefer a


Rational investors prefer a
higher to a lower return for a
higher to a lower return for a
given level of risk; for a
given level of risk; for a
specified level of return they
specified level of return they
prefer less risk to more risk
prefer less risk to more risk

They accept additional risk


They accept additional risk
only if accompanied by
only if accompanied by
additional expected investment
additional expected investment
rewards
rewards
195 195
Figure 1S.6
Figure 1S.6
196 196
Risk Preferences and
Risk Preferences and
Profit Expectations
Profit Expectations
-
-
Configuration of risk
Configuration of risk
-
-
reward
reward
indifference curves will depend
indifference curves will depend
upon the individual investor
upon the individual investor
'
'
s
s
personal attitude toward risk.
personal attitude toward risk.
197 197
Risk Preferences and
Risk Preferences and
Profit Expectations
Profit Expectations
-
-
The more risk averse the
The more risk averse the
individual, the more steeply
individual, the more steeply
sloped the indifference curve
sloped the indifference curve
showing that person
showing that person
'
'
s
s
preference
preference
-
-
The indifference curve of an
The indifference curve of an
investor who is indifferent toward
investor who is indifferent toward
risk has no curvature at all
risk has no curvature at all
-
-
Some investors may be willing to
Some investors may be willing to
trade expected return for the
trade expected return for the
opportunity to bear greater risk,
opportunity to bear greater risk,
and will therefore have a
and will therefore have a
downward
downward
-
-
sloping risk reward
sloping risk reward
indifference curve
indifference curve
198 198
Successful !nsurance
Successful !nsurance
Firms as Rational Risk
Firms as Rational Risk
Takers
Takers

Allow insured parties to


Allow insured parties to
substitute the certainty of a
substitute the certainty of a
small loss for the uncertainty of
small loss for the uncertainty of
a larger, possibly catastrophic
a larger, possibly catastrophic
loss
loss

Astute risk management


Astute risk management

Risk takers by design


Risk takers by design
199 199
Neasuring Risk
Neasuring Risk
-
-
Rational investors will seek to
Rational investors will seek to
determine the amount of risk
determine the amount of risk
associated with an investment
associated with an investment
opportunity and will decide
opportunity and will decide
upon a minimum expected
upon a minimum expected
return that will justify the
return that will justify the
perceived risk
perceived risk
200 200
Neasuring Risk
Neasuring Risk
-
-
Traditional approaches to
Traditional approaches to
incorporating a risk premium
incorporating a risk premium
have included:
have included:
-
-
Using a shorter payback period
Using a shorter payback period
-
-
Higher required rate of return
Higher required rate of return
-
-
Downward adjustment to
Downward adjustment to
projected cash flows
projected cash flows
201 201
Neasuring Risk
Neasuring Risk
-
-
Traditional risk
Traditional risk
-
-
adjustment
adjustment
techniques share a serious
techniques share a serious
shortcoming
shortcoming
-
-
they do not
they do not
permit quantification of the risk
permit quantification of the risk
element.
element.
202 202
Traditional Risk
Traditional Risk
-
-
Adjustment Nethods
Adjustment Nethods
203 203
The Payback
The Payback
-
-
Period
Period
Approach
Approach

Payback period is the time


Payback period is the time
required for cash inflows from
required for cash inflows from
an investment to equal the
an investment to equal the
original cash outlay.
original cash outlay.
-
-
Proponents of this technique
Proponents of this technique
adjust for risk by varying the
adjust for risk by varying the
minimum acceptable payback
minimum acceptable payback
period.
period.
-
-
nadequate method
nadequate method
-
-
Desirability of real estate
Desirability of real estate
opportunities often depend
opportunities often depend
heavily upon expected gain from
heavily upon expected gain from
disposal
disposal
204 204
Risk
Risk
-
-
Adjusted Discount
Adjusted Discount
Rate
Rate

nvolves varying the discount


nvolves varying the discount
rate to reflect risk perception;
rate to reflect risk perception;
the higher the perceived risk,
the higher the perceived risk,
the greater the size of the
the greater the size of the
discount rate.
discount rate.
-
-
Risk
Risk
-
-
adjusted discount rate is
adjusted discount rate is
composed of a risk
composed of a risk
-
-
free rate plus
free rate plus
a risk premium
a risk premium
-
-
Probably most commonly used
Probably most commonly used
approach, but fatally flawed
approach, but fatally flawed
205 205
Certainty
Certainty
-
-
Equivalent
Equivalent
Technique
Technique

nstead of
nstead of

best estimate
best estimate

of
of
future cash flows, substitutes
future cash flows, substitutes
an amount that leaves the
an amount that leaves the
client indifferent between
client indifferent between
expected receipt of the best
expected receipt of the best
estimate and absolute certainty
estimate and absolute certainty
of receiving the substitute
of receiving the substitute
amount. Substitute amount
amount. Substitute amount
(certainty equivalent) is
(certainty equivalent) is
discounted at the risk
discounted at the risk
-
-
free rate.
free rate.
206 206
Partitioning Present
Partitioning Present
values
values

Real estate investments are


Real estate investments are
valued solely for the
valued solely for the
anticipated future stream of
anticipated future stream of
benefits ownership bestows.
benefits ownership bestows.
Real estate investment can be
Real estate investment can be
seen as the purchase of a set
seen as the purchase of a set
of assumptions about a
of assumptions about a
property
property
'
'
s ability to produce a
s ability to produce a
benefit stream (after
benefit stream (after
-
-
tax cash
tax cash
flow).
flow).
207 207
Partitioning Present
Partitioning Present
values
values

Factors contributing to flow


Factors contributing to flow
include:
include:
-
-
income tax consequences
income tax consequences
-
-
loan amortization
loan amortization
-
-
change in property value over
change in property value over
projected holding period
projected holding period
208 208
Partitioning Present
Partitioning Present
values
values

nvestment value can be divided


nvestment value can be divided
into present value of equity and
into present value of equity and
present value of debt. Present
present value of debt. Present
value of equity position can also be
value of equity position can also be
partitioned into its component parts.
partitioned into its component parts.
- - Expressing each component as a Expressing each component as a
percentage of total permits the relative percentage of total permits the relative
importance of each to be assessed. importance of each to be assessed.
- - Components that comprise major Components that comprise major
segments of the total present vale of segments of the total present vale of
the equity position will merit extended the equity position will merit extended
analysis. analysis.
209 209
Sensitivity Analysis
Sensitivity Analysis

Sensitivity analysis is a logical


Sensitivity analysis is a logical
extension of partitioning to
extension of partitioning to
determine what portions of the
determine what portions of the
forecast merit further
forecast merit further
refinement.
refinement.
-
-
Revels how possible forecasting
Revels how possible forecasting
error will affect the present value
error will affect the present value
of actual after
of actual after
-
-
cash flows.
cash flows.
-
-
Consists of altering components
Consists of altering components
of the forecast one at a time, and
of the forecast one at a time, and
studying the impact on
studying the impact on
investment value or present
investment value or present
value of the equity position.
value of the equity position.
210 210
Contemporary Risk
Contemporary Risk
Neasures
Neasures
211 211
Probability as a Risk
Probability as a Risk
Neasure
Neasure

Probability
Probability

the chance of
the chance of
occurrence associated with
occurrence associated with
any possible outcome.
any possible outcome.
Probabilities associated with
Probabilities associated with
any possible occurrence range
any possible occurrence range
from zero to one.
from zero to one.
-
-
f probability equals
f probability equals
zero
zero
, event
, event
certainly will not occur
certainly will not occur
-
-
A probability of
A probability of
one
one
indicates
indicates
certainty of occurrence
certainty of occurrence
212 212
Probability as a Risk
Probability as a Risk
Neasure
Neasure

Decisions are divisible:


Decisions are divisible:
-
-
Certainty
Certainty

only one possible


only one possible
outcome; decisions based solely
outcome; decisions based solely
on the decision maker
on the decision maker
'
'
s
s
preference between certain
preference between certain
alternatives
alternatives
-
-
Risk
Risk
-
-
probabilities associated
probabilities associated
with various possible outcomes
with various possible outcomes
are either known or can be
are either known or can be
estimated
estimated
-
-
Uncertainty
Uncertainty

probabilities are
probabilities are
neither known or estimable;
neither known or estimable;
implies unknown number of
implies unknown number of
possible outcomes
possible outcomes
213 213
Probability as a Risk
Probability as a Risk
Neasure
Neasure

Uncertainty is not measurable


Uncertainty is not measurable

As better information becomes


As better information becomes
available, uncertain elements
available, uncertain elements
can be converted to risk factors
can be converted to risk factors
by incorporating into analysis
by incorporating into analysis
their associated probability
their associated probability
distributions
distributions

Analysts generate information


Analysts generate information
to estimate the probability of
to estimate the probability of
occurrence of each risk
occurrence of each risk
214 214
Probability as a Risk
Probability as a Risk
Neasure
Neasure

Estimating future cash flows


Estimating future cash flows
from real estate ventures is
from real estate ventures is
part art and part science.
part art and part science.
-
-
No way to determine future,
No way to determine future,
instead develop informed
instead develop informed
estimates
estimates
-
-
Couple estimates with probability
Couple estimates with probability
estimate
estimate
-
-
Multiple law of probability
Multiple law of probability
used
used
to determine the probability of
to determine the probability of
occurrence of an event whose
occurrence of an event whose
outcome depends in turn on the
outcome depends in turn on the
outcome of some prior event
outcome of some prior event
215 215
!nterpreting Risk
!nterpreting Risk
Neasures
Neasures

Probabilistic estimates of
Probabilistic estimates of
possible investment outcomes
possible investment outcomes
provide valuable intelligence
provide valuable intelligence
about relative risk
about relative risk

Probability distribution
Probability distribution

array
array
of all possible outcomes and
of all possible outcomes and
their related probabilities of
their related probabilities of
occurrence
occurrence
-
-
Discrete probability distribution
Discrete probability distribution
-
-
Continuous probability
Continuous probability
distribution
distribution
216 216
Figure 17.1
Figure 17.1
217 217
!nterpreting Risk
!nterpreting Risk
Neasures
Neasures

Expected Value of probability


Expected Value of probability
distribution of possible cash flows is
distribution of possible cash flows is
the weighted average of the
the weighted average of the
possible cash flows making up the
possible cash flows making up the
distribution, with each value
distribution, with each value
weighted by its attendant
weighted by its attendant
probability of occurrence:
probability of occurrence:
n
n

CF
CF
=
=

CFiPi
CFiPi
i=1
i=1

Where CF is the expected value of


Where CF is the expected value of
cash flow distribution, CFi
cash flow distribution, CFi
x x
is the
is the
value of the ith probability, and , Pi is
value of the ith probability, and , Pi is
the probability associated with that
the probability associated with that
value.
value.
218 218
!nterpreting Risk
!nterpreting Risk
Neasures
Neasures

Variance
Variance

weighted average
weighted average
of the squared differences
of the squared differences
between each possible
between each possible
outcome and the expected
outcome and the expected
outcome:
outcome:
n
n

V =
V =

(
(
CF
CF
x x

CF
CF
)
)
2 2
P
P
x x
x=1
x=1
219 219
!nterpreting Risk
!nterpreting Risk
Neasures
Neasures

V is variance
V is variance

CF
CF
x x
is value of the xth possible
is value of the xth possible
outcome
outcome

CF
CF
is expected value
is expected value

P
P
x x
is related probability
is related probability
220 220
!nterpreting Risk
!nterpreting Risk
Neasures
Neasures

Square root of variance is


Square root of variance is
standard deviation
standard deviation

Standard deviation has other


Standard deviation has other
mathematical properties that
mathematical properties that
make it useful as a measure of
make it useful as a measure of
risk
risk

Once the mean and standard


Once the mean and standard
deviation are established, it is
deviation are established, it is
possible to determine the
possible to determine the
probability of occurrence of
probability of occurrence of
values over any desired
values over any desired
interval within the distribution
interval within the distribution
221 221
Figure 17.2
Figure 17.2
222 222
Figure 17.3
Figure 17.3
223 223
Figure 17.+
Figure 17.+
224 224
Figure 17.S
Figure 17.S
225 225
Figure 17.6
Figure 17.6
226 226
Risk Nanagement in a
Risk Nanagement in a
Portfolio Context
Portfolio Context
227 227
Nodern Portfolio Theory
Nodern Portfolio Theory
and Risk Nanagement
and Risk Nanagement

Among the universe of


Among the universe of
possible portfolios, there is a
possible portfolios, there is a
subset of combinations that
subset of combinations that
represent optimum
represent optimum
combinations of expected
combinations of expected
return and risk.
return and risk.

Precise choice from among the


Precise choice from among the
subset depends upon the
subset depends upon the
investor
investor
'
'
s attitude toward risk.
s attitude toward risk.
228 228
Nodern Portfolio Theory
Nodern Portfolio Theory
and Risk Nanagement
and Risk Nanagement

Systematic market risk


Systematic market risk

reflection of market prices; can


reflection of market prices; can
only by reduced in efficient
only by reduced in efficient
market by accepting lower
market by accepting lower
expected returns
expected returns

Unsystematic risk
Unsystematic risk

function of
function of
characteristics of particular
characteristics of particular
properties, such as location
properties, such as location
and design; can be eliminated
and design; can be eliminated
by diversifying the assets in a
by diversifying the assets in a
portfolio
portfolio
229 229
Figure 18.1
Figure 18.1
230 230
Nodern Portfolio Theory
Nodern Portfolio Theory
and Risk Nanagement
and Risk Nanagement

Among universe of possible


Among universe of possible
portfolios, the subset that
portfolios, the subset that
represents the best
represents the best
-
-
obtainable
obtainable
combinations of risk and return
combinations of risk and return
represent the
represent the
efficient frontier,
efficient frontier,
which can be altered by:
which can be altered by:
-
-
Mixing a risk
Mixing a risk
-
-
free asset into the
free asset into the
risky portfolio
risky portfolio
-
-
ncorporating borrowing into the
ncorporating borrowing into the
analysis
analysis
231 231
Figure 18.2
Figure 18.2
232 232
Real Estate
Real Estate
'
'
s Role in the
s Role in the
Efficient Portfolio
Efficient Portfolio

Efficient frontier is a theoretical


Efficient frontier is a theoretical
model which moves as the market
model which moves as the market
changes
changes

Studies indicate that real estate


Studies indicate that real estate
should be 10 to 20 percent of an
should be 10 to 20 percent of an
efficient portfolio, which is
efficient portfolio, which is
substantially above the average
substantially above the average
amount of real estate in institutional
amount of real estate in institutional
investor
investor
'
'
s portfolios
s portfolios
233 233
Figure 18.+
Figure 18.+
234 234
Real Estate
Real Estate
Diversification
Diversification
Strategies
Strategies

Geographic locale
Geographic locale

picking locales
picking locales
where the real estate cycle is not
where the real estate cycle is not
highly correlated
highly correlated

Product type
Product type

including a range of
including a range of
buildings such as apartments,
buildings such as apartments,
retail, industrial, office
retail, industrial, office

Product
Product
-
-
life cycle
life cycle

including some
including some
properties that are near the end of
properties that are near the end of
their life
their life
-
-
cycle, some that have
cycle, some that have
reached a stabilized growth path,
reached a stabilized growth path,
and others that are in the early
and others that are in the early
stages of development and growth
stages of development and growth
235 235
!nvestment Feasibility
!nvestment Feasibility
Analysis
Analysis
236 236
The Nature of the
The Nature of the
Feasibility Question
Feasibility Question

Feasibility analysis attempts to


Feasibility analysis attempts to
estimate the probability of
estimate the probability of
success of a specific proposed
success of a specific proposed
course of action
course of action
-
-
Formal or informal
Formal or informal
-
-
Early step in investment or
Early step in investment or
development process
development process
-
-
nvolves estimating the amount
nvolves estimating the amount
and timing of required cash
and timing of required cash
expenditures and expected cash
expenditures and expected cash
inflows, and an assessment of
inflows, and an assessment of
the degree of confidence that
the degree of confidence that
attaches to the estimates
attaches to the estimates
237 237
The Nature of the
The Nature of the
Feasibility Question
Feasibility Question

Feasible project must be:


Feasible project must be:
-
-
Physically possible
Physically possible
-
-
Legally feasible
Legally feasible
-
-
Financially feasible
Financially feasible
238 238
Figure 19.1
Figure 19.1
239 239
The Nature of the
The Nature of the
Feasibility Question
Feasibility Question

Feasibility analysis problems:


Feasibility analysis problems:
-
-
With a predetermined site,
With a predetermined site,
investigate alternative uses
investigate alternative uses
-
-
With a predetermined use,
With a predetermined use,
investigate alternative sites
investigate alternative sites
-
-
With predetermined funds,
With predetermined funds,
investigate alternative
investigate alternative
investment opportunities
investment opportunities
240 240
The Nature of the
The Nature of the
Feasibility Question
Feasibility Question

Limitations should be identified


Limitations should be identified
and defined in analysis
and defined in analysis
-
-
Limits of resources
Limits of resources
-
-
Values, goals, and objectives
Values, goals, and objectives
-
-
Physical characteristics of sites
Physical characteristics of sites
-
-
Society, through ordinances and
Society, through ordinances and
regulatory oversight
regulatory oversight
241 241
Steps in Feasibility
Steps in Feasibility
Analysis Process
Analysis Process
1. 1. Assess physical and legal aspects of the site. Assess physical and legal aspects of the site.
2. 2. Estimate demand for the proposed real estate Estimate demand for the proposed real estate
services. services.
3. 3. Analyze competitive space. Analyze competitive space.
4. 4. Estimate the cost of constructions, alteration, Estimate the cost of constructions, alteration,
rehabilitation or fix rehabilitation or fix- -up, as proposed in the initial up, as proposed in the initial
concept, and the cost of facility operations. concept, and the cost of facility operations.
5. 5. Estimate the cost of financing various possible Estimate the cost of financing various possible
combinations of equity and debt financing combinations of equity and debt financing
packages. packages.
6. 6. Estimate the rate at which vacant units will be Estimate the rate at which vacant units will be
rented. rented.
7. 7. Develop a schedule of cash inflows and outflows. Develop a schedule of cash inflows and outflows.
8. 8. Evaluate the anticipated cash flows for adequacy, Evaluate the anticipated cash flows for adequacy,
given the investor given the investor' 's minimum acceptable rate of s minimum acceptable rate of
return and the degree of risk the investor is return and the degree of risk the investor is
prepared to accept. prepared to accept.
242 242
Preliminary Financial
Preliminary Financial
Feasibility
Feasibility

Analysis should be viewed as


Analysis should be viewed as
continuous process
continuous process

To be feasible, project must be


To be feasible, project must be
attractive both to equity
attractive both to equity
investors and to mortgage
investors and to mortgage
lenders
lenders

Preliminary financial feasibility


Preliminary financial feasibility
deals with the threshold
deals with the threshold
questions concerning a
questions concerning a
proposed venture (solvency
proposed venture (solvency
testing)
testing)
243 243
Figure 19.2
Figure 19.2
244 244
Figure 19.3
Figure 19.3
245 245
Format for a Feasibility
Format for a Feasibility
Report
Report

Organization should reflect


Organization should reflect
purpose; designed to facilitate use.
purpose; designed to facilitate use.

Common format:
Common format:
Title page Title page
Table of contents Table of contents
List of tables and exhibits List of tables and exhibits
Executive summary Executive summary
Scope and limitations Scope and limitations
Regional and city analysis Regional and city analysis
Location and site analysis Location and site analysis
Market analysis Market analysis
Financial analysis and cash flow projections Financial analysis and cash flow projections
Conclusions and recommendations Conclusions and recommendations
246 246
Analyzing Subdivision
Analyzing Subdivision
Proposals
Proposals
247 247
Overview of the
Overview of the
Subdivision Process
Subdivision Process

Subdivision ventures grow out of Subdivision ventures grow out of


developer developer' 's perception of unsatisfied s perception of unsatisfied
demand for certain types of buildable demand for certain types of buildable
sites. sites.

mplement site acquisition strategy mplement site acquisition strategy

Title acquisition, land planning, land Title acquisition, land planning, land
survey survey

Physical improvements follow surveying Physical improvements follow surveying


process process

Sale Sale
248 248
Location Decisions
Location Decisions

Subdivision location decisions


Subdivision location decisions
must be responsive to needs of
must be responsive to needs of
ultimate users
ultimate users

Subdividers also need to


Subdividers also need to
consider current and potential
consider current and potential
uses of abutting sites
uses of abutting sites
249 249
Coping with Regulatory
Coping with Regulatory
Requirements
Requirements

Governmental land use control is


Governmental land use control is
exercised through zoning laws and
exercised through zoning laws and
master land use plans.
master land use plans.
- - Small Small- -scale subdividers may limit land scale subdividers may limit land
acquisition to appropriately zoned acquisition to appropriately zoned
tracts tracts
- - Large Large- -scale subdividers frequently scale subdividers frequently
develop plans requiring extensive develop plans requiring extensive
rezoning and government approvals rezoning and government approvals

Municipalities seek to influence


Municipalities seek to influence
level of subdivision activity through
level of subdivision activity through
control over public utilities
control over public utilities
- - Capacity Capacity
- - Special assessments Special assessments
250 250
Creating the Subdivision
Creating the Subdivision
Plan
Plan

Contents of land plans vary with


Contents of land plans vary with
size of developments
size of developments
- - Large Large- -scale plans divide area by scale plans divide area by
specialized use categories specialized use categories
- - Modest subdivision plans may simply Modest subdivision plans may simply
plot individual sites and make plot individual sites and make
provision for utility easements provision for utility easements
251 251
Financing the Project
Financing the Project

Subdividers use land acquisition and Subdividers use land acquisition and
development loans to raise capital development loans to raise capital

Lenders usually disburse loan proceeds Lenders usually disburse loan proceeds
on piecemeal basis as improvements are on piecemeal basis as improvements are
completed completed

Most lenders view subdivision loans as Most lenders view subdivision loans as
more risky than construction loans more risky than construction loans
- - Subdividers depend upon proceeds form land Subdividers depend upon proceeds form land
sales for funds to repay loans sales for funds to repay loans
- - Project marketability is vital Project marketability is vital
252 252
Development and
Development and
Rehabilitation
Rehabilitation
253 253
Overview of
Overview of
Development
Development

Real estate development


Real estate development
projects range in complexity
projects range in complexity
and size
and size

Ventures often originate with a


Ventures often originate with a
concept for finished urban
concept for finished urban
space; a perception of unmet
space; a perception of unmet
demand
demand

Development project may be


Development project may be
investor
investor
'
'
s desire to use
s desire to use
previously acquired site (
previously acquired site (

a site
a site
in search of an idea
in search of an idea

)
)
254 254
Feasibility Analysis
Feasibility Analysis

Two sections of feasibility


Two sections of feasibility
study:
study:
-
-
Market research and attempts to
Market research and attempts to
determine physical and location
determine physical and location
characteristics that will have the
characteristics that will have the
greatest consumer appeal
greatest consumer appeal
-
-
Economics of proposed project
Economics of proposed project
255 255
Feasibility Analysis
Feasibility Analysis
Steps: Steps:
- - Completion of feasibility study Completion of feasibility study
- - Market research Market research
- - Search for site Search for site
- - Estimate costs Estimate costs
- - Estimate value Estimate value
- - Estimate operating expenses Estimate operating expenses
256 256
Financing Real Estate
Financing Real Estate
Development
Development

Construction lenders
Construction lenders

Lender risk reduced by


Lender risk reduced by
requiring that developers
requiring that developers
acquire end
acquire end
-
-
loan commitments
loan commitments

f developer cannot obtain an


f developer cannot obtain an
end
end
-
-
loan commitment prior to
loan commitment prior to
arranging a construction loan,
arranging a construction loan,
standby or gap financing may
standby or gap financing may
be used
be used
257 257
Construction Phase
Construction Phase

Construction projects are


Construction projects are
carried out on either a custom
carried out on either a custom
or speculative basis.
or speculative basis.
-
-
Custom
Custom
-
-
Speculative
Speculative
258 258
Construction Phase
Construction Phase

Construction companies
Construction companies
expand and contract size in
expand and contract size in
response to economic
response to economic
conditions and differences in
conditions and differences in
scale of projects
scale of projects

General contractors
General contractors
-
-
Subcontract tasks
Subcontract tasks
-
-
Contract with user; General
Contract with user; General
contractors contract with
contractors contract with
subcontractors
subcontractors
-
-
General contractors coordinate
General contractors coordinate
work and oversees progress
work and oversees progress
259 259
Overview of
Overview of
Rehabilitation
Rehabilitation

Begins with existing structures


Begins with existing structures
in need of extensive renovation
in need of extensive renovation
-
-
Takes deteriorated or
Takes deteriorated or
functionally obsolete building
functionally obsolete building
and improves its physical
and improves its physical
condition or brings it up to
condition or brings it up to
modern design standards
modern design standards
-
-
Gentrification impetus for much
Gentrification impetus for much
rehabilitation activity
rehabilitation activity
-
-
Prime areas seem to be older
Prime areas seem to be older
inner
inner
-
-
city neighborhoods with
city neighborhoods with
convenient transportation links
convenient transportation links
260 260
!ncentive for
!ncentive for
Rehabilitation
Rehabilitation

Profit expectations
Profit expectations

Tax legislation rewards


Tax legislation rewards
261 261
Judging Feasibility of
Judging Feasibility of
Rehabilitation Proposals
Rehabilitation Proposals

Analysis of rehabilitation
Analysis of rehabilitation
proposals
proposals

Cost estimates
Cost estimates

Subtracting all costs and


Subtracting all costs and
expected profit from estimated
expected profit from estimated
value as completed leaves the
value as completed leaves the
amount available for purchase
amount available for purchase
of property
of property

f property can be purchased


f property can be purchased
for less, project is feasible; if
for less, project is feasible; if
cost is greater, project not
cost is greater, project not
feasible
feasible
262 262
!ndustrial Property, Office
!ndustrial Property, Office
Building and Shopping
Building and Shopping
Center Analysis
Center Analysis
263 263
!nvesting in !ndustrial
!nvesting in !ndustrial
Buildings
Buildings

ndustrial buildings have the


ndustrial buildings have the
advantages of reliable, credit
advantages of reliable, credit
-
-
worthy tenants, long
worthy tenants, long
-
-
term
term
leases, and opportunities to
leases, and opportunities to
shift many operating expenses
shift many operating expenses
to tenants
to tenants

Business operators, short on


Business operators, short on
capital, prefer to channel
capital, prefer to channel
resources into business
resources into business
expansion rather than real
expansion rather than real
estate ownership
estate ownership
264 264
Demand for !ndustrial
Demand for !ndustrial
Space
Space

Largely a function of demand


Largely a function of demand
for products produced by
for products produced by
industrial sector
industrial sector

Periodic shifts in demand for


Periodic shifts in demand for
industrial space of various
industrial space of various
types and in different locations
types and in different locations
reflect alterations in
reflect alterations in
composition of the industrial
composition of the industrial
sector
sector
-
-
Growth in service and
Growth in service and
technology
technology
-
-
Decrease for products of heavy
Decrease for products of heavy
industry
industry
265 265
Locations Factors
Locations Factors

Near fuel or power supply


Near fuel or power supply

Near markets
Near markets

Footlose ndustries
Footlose ndustries
266 266
Types of !ndustrial
Types of !ndustrial
Buildings
Buildings

No official classification system


No official classification system
for industrial buildings. Can be
for industrial buildings. Can be
characterized by nature of
characterized by nature of
building
building
'
'
s construction or type
s construction or type
of tenant it attracts:
of tenant it attracts:
-
-
Heavy industrial buildings
Heavy industrial buildings
-
-
Loft buildings
Loft buildings
-
-
Modern one
Modern one
-
-
story structures
story structures
-
-
ncubator Buildings
ncubator Buildings
267 267
!nvesting in Office
!nvesting in Office
Buildings
Buildings

Dramatic growth in service sector has Dramatic growth in service sector has
increased demand increased demand

Demand for office space is a Demand for office space is a derived derived
demand demand related to demand for services related to demand for services
supplied by occupants of office buildings supplied by occupants of office buildings

Unlike owner Unlike owner- -owned office buildings, owned office buildings,
investor investor- -owned buildings tend to be more owned buildings tend to be more
functional and less luxurious functional and less luxurious

Multi Multi- -year leases year leases

Options to renew on occupied space Options to renew on occupied space


268 268
!nvesting in Shopping
!nvesting in Shopping
Centers
Centers

nvestors and developers have


nvestors and developers have
long provided favorable lease
long provided favorable lease
terms to anchor tenants
terms to anchor tenants

major stores that attract


major stores that attract
customers
customers

Recently, developers have


Recently, developers have
allowed major tenants to
allowed major tenants to
construct their own buildings
construct their own buildings
on sites leased from owners
on sites leased from owners
269 269
Lease Arrangement in
Lease Arrangement in
Shopping Centers
Shopping Centers

Owners set base rental rate and


Owners set base rental rate and
increase rental rates as tenant
increase rental rates as tenant
'
'
s
s
sales volume increases
sales volume increases
(percentage clause)
(percentage clause)

Large shopping center tenants


Large shopping center tenants
typically lease space on net basis,
typically lease space on net basis,
paying all expenses associated
paying all expenses associated
with operation of their space;
with operation of their space;
smaller tenants often pay own utility
smaller tenants often pay own utility
expenses
expenses

Shopping center tenants often pay


Shopping center tenants often pay
common area maintenance fee
common area maintenance fee
270 270
Types of Shopping
Types of Shopping
Centers
Centers

Neighborhood shopping
Neighborhood shopping
centers
centers

Community shopping centers


Community shopping centers

Regional shopping malls


Regional shopping malls

Super regional shopping malls


Super regional shopping malls

Lifestyle centers
Lifestyle centers
271 271
Real Estate !nvestment
Real Estate !nvestment
Trusts
Trusts
272 272
RE!T Regulations
RE!T Regulations

RETS are organized as


RETS are organized as
corporations or trusts; each
corporations or trusts; each
RET is chartered in the state
RET is chartered in the state
in which it is headquartered
in which it is headquartered
and is subject to regulations
and is subject to regulations
and statutes of that state
and statutes of that state
273 273
RE!T Regulations
RE!T Regulations

RETS are subject to


RETS are subject to
provisions of RS code, which
provisions of RS code, which
specify minimum conditions
specify minimum conditions
under which they will be
under which they will be
granted the special income tax
granted the special income tax
status to which they owe their
status to which they owe their
popularity with investors
popularity with investors
274 274
RE!T Regulations
RE!T Regulations
--
--
!RS
!RS
- - Shares must be held by at least 100 Shares must be held by at least 100
persons, and five or fewer shareholders persons, and five or fewer shareholders
cannot own 50 percent or more of the cannot own 50 percent or more of the
shares during the last half of any tax shares during the last half of any tax
year year
- - RET must be a passive investor rather RET must be a passive investor rather
than active participant in property than active participant in property
operations operations
- - At least 75 percent of assets must At least 75 percent of assets must
consist of real estate, mortgage notes, consist of real estate, mortgage notes,
cash, cash items, or government cash, cash items, or government
securities, and at least 75 percent of securities, and at least 75 percent of
gross income must come from rents, gross income must come from rents,
mortgage investment income, and gains mortgage investment income, and gains
on the sale of real estate on the sale of real estate
- - At least 90 percent of At least 90 percent of ordinary income ordinary income
must be distributed to shareholders must be distributed to shareholders
275 275
RE!T Ownership
RE!T Ownership
-
-
Shareholders have approximately
Shareholders have approximately
same rights as stockholders in
same rights as stockholders in
any other corporation
any other corporation
-
-
Shareholders elect trustees or
Shareholders elect trustees or
directors to conduct RET
directors to conduct RET
investment and business activities
investment and business activities
-
-
Trustees and directors hire
Trustees and directors hire
managers to conduct general
managers to conduct general
affairs
affairs
276 276
RE!T Nanagement
RE!T Nanagement
-
-
Some RETs hire internal
Some RETs hire internal
managers, or external advisors
managers, or external advisors
-
-
Advisors may select property
Advisors may select property
managers to oversee operation of
managers to oversee operation of
rental property
rental property
-
-
North American Securities
North American Securities
Administrators Association, in a
Administrators Association, in a
Statement of Policy on Real
Statement of Policy on Real
Estate Investment Trusts
Estate Investment Trusts
that was
that was
adopted April 28, 1981, provides
adopted April 28, 1981, provides
guidelines for setting advisory
guidelines for setting advisory
fees
fees
277 277
RE!T Assets
RE!T Assets
-
-
Equities accounted for
Equities accounted for
approximately 72 percent of total
approximately 72 percent of total
RET assets in 2001; mortgage
RET assets in 2001; mortgage
loans accounted for about 11
loans accounted for about 11
percent; balance held as cash or
percent; balance held as cash or
miscellaneous other assets
miscellaneous other assets
-
-
Equity REITs
Equity REITs
invest primarily in
invest primarily in
real estate equities;
real estate equities;
mortgage
mortgage
REITs
REITs
invest primarily in mortgage
invest primarily in mortgage
secured loans;
secured loans;
hybrid REITs
hybrid REITs
favor
favor
a balance between equities and
a balance between equities and
mortgage loans
mortgage loans
278 278
RE!T as !nvestment
RE!T as !nvestment
vehicles
vehicles
- - Shareholders benefit from: Shareholders benefit from:
Limited liability Limited liability
Centralized management Centralized management
Continuity of entity life Continuity of entity life
Free transferability of interests Free transferability of interests
- - Tax consequences of RET investment: Tax consequences of RET investment:
Shareholders are taxed directly on Shareholders are taxed directly on
distributed earnings distributed earnings no double taxation as no double taxation as
with corporations with corporations
Losses do not flow through to shareholders Losses do not flow through to shareholders
RETs permit diversification on limited RETs permit diversification on limited
budget budget
RETs low RETs low- -cost way to benefit from cost way to benefit from
professional management professional management
279 279
RE!T as !nvestment
RE!T as !nvestment
vehicles
vehicles
-
-
RET ownership entails the risk
RET ownership entails the risk
associated with stock market
associated with stock market
fluctuations
fluctuations
280 280
RE!T as !nvestment
RE!T as !nvestment
vehicles
vehicles
-
-
RET Mutual Funds permit
RET Mutual Funds permit
investors to hold a diversified
investors to hold a diversified
portfolio with a relatively modest
portfolio with a relatively modest
total investment
total investment