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Chapter 11:

Investment Analysis and Taxation


of Income Properties
McGraw-Hill/Irwin

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Investment Analysis
Equity Investment
Motivations for Investing in Income
Properties
Rate of Return
Price Appreciation
Diversification
Tax Benefits

11-2

Market Characteristics
Real Estate Cycle
Large Market in number and size of properties
Competitive
Fragmented Ownership
Overdevelopment Potential
The cycle differs for different property types.

11-3

Exhibit 11-1
The Real Estate Cycle

11-4

Investment Strategies
Investing in Core Properties
Investing in Core Properties with a Value
Add Strategy
Property Sector Investing
Contrarian Investing
Market Timing
Growth Investing
Value Investing
11-5

Investment Strategies
Strategy as to Size of Property
Strategy as to Tenants
Arbitrage Investing
Turnaround/Special Situations
Opportunistic Investing
Investing in Trophy or Blue Chip
Properties
Development

11-6

Market Analysis
Evaluation of supply and demand for a
type of property
Absorption
Supply of Space
Market Rents
Forecasting Supply, Demand, Market
Rents, and Occupancy

11-7

Investment Analysis
Internal Rate of Return (IRR)
The discount rate at which the net present
value of the cash flows is equal to 0.
If IRR >= r; accept Project
If IRR < r; reject Project
Where r is the discount rate, or more
colloquially, the hurdle rate

11-8

Investment Analysis
Net Present Value
A way to solve for the initial price that an investor may
pay given a specified discount rate.
Discounted value of the cash flows.
The discount rate is the rate of return that an investor
will require in order to make this investment.
If we include the initial equity investment in this
calculation, we can solve for the difference and see
how much more or less the investor may pay and still
receive a rate that is equivalent to their discount rate.

11-9

Debt Financing
Equity Dividend = NOI - DS
NOI = Net Operating Income
DS = Debt Service

The equity dividend is also referred to as


the before-tax cash flow from operations
(BTCF0)

11-10

Debt Financing
Equity Dividend Rate =
Equity Dividend/Initial Equity Investment
Sometimes referred to as unleveraged cash on cash
rate.

Debt Coverage Ratio (DCR) = NOI/DS


The DCR is a vital ratio for lenders.
If the DCR is less than 1, the borrower will not be able
to service the debt.
Generally, lenders want a DCR greater than 1 so the
borrower has a cushion and can repay.
11-11

Debt Financing
Example 11-1:
$1,000,000 Property;
95% allocated to building and 5% to land
70% LTV; 7% Interest Rate, 30 Years
$700,000 debt; $300,000 equity
Monthly Payment = $4657.11
DS = 12 x $4657.11 = $55,885
NOI1 = $85,000
11-12

Before-Tax Cash Flow


Equity Dividend = NOI-DS
$85,000 - $55,885 = $29,115
This is also the BTCFo for this year.

Equity Dividend Rate = EQDIV/Equity


$29,115/$300,000 = 9.71%

Debt Coverage Ratio =


$85,000/$55,885 = 1.52

These ratios all pertain to the first year of


operations.
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Before-Tax Cash Flow


Before-Tax Cash Flow from the Property
Sale (BTCFs):
BTCFs = Sales Price Mortgage Balance
In Example 11-1, if the property were sold in
Year 4 for $1,100,000 then
BTCF = $1,100,000 - $668,322 = $421,678
The mortgage loan balance ($668,322) is
computed as previously. See Chapter 4.

11-14

Taxation
Four Classes of Real Property
Real Estate held as a personal
residence
Real Estate held for sale to others
dealer property
Real Estate held for use in a trade or
business trade or business property
Real Estate held as an investment for the
production of income investment
property
11-15

Types of Taxable Income


Active Income
Salaries, wages, bonuses, and
commissions

Portfolio Income
Interest, dividends, and capital gains

Passive Income
Rents from real estate, and royalties from
oil and gas rights
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Passive Activity Loss


Restrictions
Passive losses cannot be used to reduce
active or portfolio income
Passive losses may be used to reduce
other passive income
Passive losses not used may be used in
future years or at the same time of sale

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Passive Activity Loss Restrictions


1st Exception
Active participants may deduct up to $25,000 in
passive losses against other non-passive income,
subject to limitations such as their adjusted gross
income

2nd Exception
Broad exception for real estate professionals from
the Passive Activity Loss rules.
For many of you, if you enter the real estate
business, this will apply to you.
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Depreciation Basis
The original cost basis includes all costs
associated with acquiring the property and
transferring the title
Land value cannot be depreciated
The depreciable basis is the total value
that can be depreciated over the recovery
period
Depreciable Basis = Cost Basis Land
Amount
11-19

Depreciation
Depreciation
Depreciable Basis / Recovery Period

Recovery Period is different based on property


type
Residential income producing property (27.5 Years)
Non-residential income producing property (39
Years)
Note that the recovery period is a product of the tax
code. It will vary based on the country that the real
estate is located in.
11-20

After-Tax Cash Flows


Calculating the after-tax cash flow from
operations
Step 1: Compute taxable income
Net Operating Income
- Depreciation
- Interest
Taxable Income
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After-Tax Cash Flows


From Slide 11-10, depreciation is based
on a building value of $950,000 over 27.5
years.
Depreciation = $950,000/27.5 = $34,545
Interest = $48,775 using the amort function
on the financial calculator.
The depreciation schedule will vary. It is not
always 27.5 years.

11-22

After-Tax Cash Flows


From Example 11-1, year 1 taxable
income would be:
NOI
Depreciation
$34,545
Interest
Taxable Income

$85,000
- $48,775
$ 1,680
11-23

After-Tax Cash Flows


Step 2: Compute Taxes
Taxes (at 28%) = 0.28 x 1,680 = $470
Step 3: Compute after-tax cash flow from
operations for year 1
ATCF1 = BTCF1 Taxes
= 29,115 - 470
= $28,645
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After-Tax Cash Flows


Taxes on the property sale
Gain from price appreciation
The maximum is 15%

Gain from accumulated depreciation


Taxed at 25%

Note that these rates have changed and


will change in the future as the tax code
is updated and modified.
11-25

After-Tax Cash Flows


From Example 11-1, Slide 11-12
Before-tax cash flow from the property
sale = $421,678
Step 1: Compute tax on property value
increase:
$1,100,000 - $1,000,000 = $100,000
Taxed at 15% capital gains rate = $15,000

11-26

After-Tax Cash Flows


Step 2: Compute tax on prior depreciation:
4 Years at $34,545 = $138,180
Taxed at 25% = $34,545
Step 3: Compute total taxes from sale:
$34,545 + $15,000 = $49,545

11-27

After-Tax Cash Flows


Step 4: Compute after-tax cash flow from
the property sale
ATCFs = BTCFs Taxes
ATCFs = $431,678 - $49,545 = $382,133
Analysis
Compute After-Tax Internal Rate of Return
Compute After-Tax Net Present Value

11-28