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Chapter 11

Introduction to Investment Concepts

Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Major Topics
Investor Objectives Sources of real estate returns Introduction to Cash Flow Analysis What we mean by direct and indirect real estate investment Returns on labor versus returns on investments Sources of real estate risk Measuring real estate risk Investment alternatives within the real estate asset class Creative advantages of partnerships and investment structuring
Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Introduction: What do Investors Want?


Investors seek current or future income or
sometimes both

Future income might be used for personal


consumption at a later date or for future generations

Aggressiveness of investor depends on risk


preferences

Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Sources of Real Estate Returns


Cash Flow Comes from the collected rents less the operating expenses and debt service Usually received monthly

Tax Shelter or Postponement Deductible non-cash items include depreciation, amortization of points paid for financing and possibly tax credits for specialized government programs
Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Sources of Real Estate Returns (Contd.)


Equity Buildup from Mortgage Repayment Can occur from mortgage principal repayment

Equity Gains from Price Appreciation


Sources of appreciation: - Inflation - Real price changes
Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Timing of Returns
From a timing perspective, we can take the four types of returns listed above and reduce these to only two:

Cash Flow (after tax)

The before tax cash flow plus or minus tax savings or taxes due can be treated as one final source of returns during the operational stage of ownership The appreciation and equity buildup from mortgage repayment both result in before tax proceeds at the time of sale
Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Residual Cash Flow (after tax)

Introduction to Cash Flow Analysis


Gross Rent or Potential Gross Income
Effective Gross Income

Operating Expenses
Net Operating Income or NOI

Debt Service

Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Important Terms (Contd.)

Gross Rent Less Vacancy = Effective Gross Income Less Operating Expenses = Net Operating Income Less Debt Service = Cash Flow (before tax)

Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Current Yield and Total Return


Current Period Return Periodic Returns IRR (Internal rate of Return)

Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Levered versus Unlevered Investments


The term levered or leveraged refers to
the ability of an investor to increase the returns on equity through the use of debt less than the total return on the asset, known as positive leverage debt

This occurs whenever the cost of debt is

Most investors buy stock without direct When debt is used, it is known as buying

on margin and more aggressive investors do use margin accounts


Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Sources of Real Estate Risk


In general, the risk and returns are greater
for real estate than bonds, and less for real estate than stocks There may be times when stock returns are less than real estate/ bond returns

Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Sources of Risk (Contd.)


Economic Risks - Extremely Important! - No control Business Risk or Management Risks - More controllable than economic risks Financial Risk - Leverage - most controllable decision Liquidity Risks - Significant for all direct investments Political Risks - Over time has become more significant - No control
Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Risk Analysis at the Property Level


Sensitivity Analysis: Cash flow pro-formas
are developed and then ranges of uncertain variables are tested for their impact on key financial ratios and cash flow

Simulation Analysis: When an entire range

of probable estimates are tested for several variables at one time, and the resulting distributions of probable results generated

Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Managing Risk
Risk management is accomplished through
negotiation and contracting, or in some cases the purchase of insurance or hedge investments demand and supply, are for the most part uncontrollable lease that expires in the future might be managed through negotiation the use of more or less leverage

Economic risks, based on expected market

Yet, the risk of a given tenant renewing a

Financial risks might also be managed by


Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Managing Risk (Contd.)


More leverage or debt as a proportion of
the total purchase price will result in greater variability of returns priced

Risks that cannot be shifted must simply be That is, the investor must figure out how

much extra expected return they require in order to take on the additional risk, known as risk premiums

Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Risk Premiums Example


Assume the following current capital market rates and investment specific required premia: Risk free short term real rate (prior to inflation) = .015 or 1.5% = Rf Expected annual inflation = .03 or 3.0% = EI Liquidity risk premium = .015 or 1.5% = LP (for the difficulty of quickly selling real estate) Economic, business and political risks = .04 or 4.0% Total Return: R = Rf+EI+LP+other risk premia = 10%

Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Portfolio Perspectives
Portfolio risk is based on the estimate of
return volatility for an entire basket or investments generally will lower total portfolio risk

Combining two or more risky investments This is a result of the less then perfect

correlation of the individual asset returns, correlations over specific investment horizons then the total portfolio risk can be drastically reduced
Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

When the individual assets show negative

Market Efficiency and Real Estate


Markets are efficient to the extent that all of the available information is reflected in the current market prices Efficient markets have no trading (buying or selling) based on inside information It is still possible to achieve above average market returns

Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner

Creative Advantages of Partnership and Investment Structuring


One advantage of real estate versus other types of assets is that even a single investment can be structured to achieve individual investor objectives

Example: one investor may want current returns and another may want future wealth By structuring an investment with various contractual interests (securities or mortgages) that direct the return priorities to different investors multiple investors can achieve their objectives G. Miller and David M. Geltner Real Estate Principles for the New Economy: Norman

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Real Estate Principles for the New Economy: Norman G. Miller and David M. Geltner