1 / 50

Investments in Real Assets

Investments in Real Assets. Chapter 20. Prof. Hagen Sinodoru, MBA • Banking and Finance • www.sinodoru.com St. Petersburg State University of Economics and Finance. Objectives. Understand the advantages and disadvantages of real assets

alma-perkins
Download Presentation

Investments in Real Assets

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Investments in Real Assets Chapter 20 Prof. Hagen Sinodoru, MBA • Banking and Finance • www.sinodoru.com St. Petersburg State University of Economics and Finance

  2. Objectives Understand the advantages and disadvantages of real assets Explain the portfolio significance of the correlations between real estate and other assets Explain the characteristics of investing in real estate Discuss the various forms of financing for real estate investments Explain the traditional appeal of precious metals as a form of investments Understand the factors that influence the value of collectibles

  3. Investments in Real Assets Advantages and Disadvantages of Real Assets Real Estate as an Investment Real Estate Returns and Correlations Valuation of Real Estate Forms of Real Estate Ownership Gold and Silver Precious Gems Other Collectibles Appendix 20A: A Comprehensive Analysis for Real Estate Investment Decisions

  4. Real Assets Real assets are tangible assets that may be: Seen Felt Held Collected Real assets during inflationary environments have at times outperformed financial assets. • Examples: • Real estate • Gold and silver • Diamonds • Coins, stamps, and antiques

  5. Wealth Indices of Investments in Equity REITs and Basic Series Index (Year-End 1971= $1)

  6. Real Assets - Advantages An inflation hedge Hedge against unknowns, fears Effective vehicle for diversification Improves portfolio risk-return alternatives Low correlation with monetary assets May provide psychic pleasure

  7. Real Assets - Disadvantages Lack of large, liquid, efficient markets Larger commissions & spreads compared to securities No current income except from real estate Storage and insurance costs Unit costs may be high Cyclical hysteria or overreactions periodically occur (timing may be tricky)

  8. Real Estate as an Investment About half of U.S. households own real estate as a home or investment Brokerage and investment firms have entered the market to: Buy Sell Finance Syndicate property Real estate has increased to 10% of pension fund portfolios today

  9. Real Estate as an Investment Investments may include: Homes Duplexes Apartments Offices Industrial buildings Shopping centers Hotels and motels Undeveloped land

  10. Real Estate Returns and Correlations The Tax Reform Act of 1986 Substantially increased wait time to take full advantage of real estate tax deductions Severely restricted writing-off of paper real estate losses by passive investors against other forms of income • Made real estate • investment less attractive

  11. Real Estate Returns and Correlations Negative impact of tax reform on real estate blamed for declining economic conditions of late 1980s and early 1990s 1. Fewer new properties were developed 2. Gluts in office space/apartments shrank 3. Rents increased on existing properties 4. Eventual higher real estate evaluations

  12. Real Estate Returns and Correlations • Less supply plus higher demand equals higher real estate values • Historically low interest rates also contributed to an increase in demand • Bubble eventually burst in 2007 • An 18 month recession followed • Second worse since Great Depression • 10% unemployment

  13. Real Estate Returns and Correlations • What are the long-term portfolio implications of holding real estate? • Real estate has a low correlation with stocks/bonds • Low correlations could increase portfolio return and reduce portfolio standard deviation • Historically, only small cap stocks have out performed real estate on a risk-adjusted basis • Real estate also provides steady cash flow

  14. Valuation of Real Estate The Cost Approach Comparative Sales Value The Income Approach • In most cases, a final value may • be determined from a combination • of the three approaches.

  15. Valuation of Real Estate:The Cost Approach Easy for new property Harder for older buildings Poor location makes building worth less than its replacement cost Economic conditions influence value Cost to replace an asset at current prices used as the value of real estate

  16. Valuation of Real Estate:Comparative Sales Value True comparables may be difficult to find Combine sale values of several comparable properties to “average” out differences Find value using comparable property prices in the neighborhood

  17. Valuation of Real Estate:The Income Approach The stream of net earnings generated by an income-producing property capitalized as a measure of that property’s worth Annual net operating income Capitalization rate (Cap rate) = Valuation

  18. Valuation of Real Estate:The Income Approach = Valuation Annual net operating income Capitalization rate (Cap rate) Future realistic values of annual rentals minus expenses such as property taxes, insurance,… The rate of return required by investors in similar-type investments

  19. Valuation of Real Estate:The Income Approach Example: Projected annual net operating income = $17,500 Market capitalization rate = 10% Value based on this approach: $17,500 0.10 = $175,000

  20. Valuation of Real Estate:The Income Approach • Income approach helpful but overly simplistic: • Annual NOI* changes over time • Difficulty of choosing a capitalization rate * NOI = Net operating income

  21. Valuation of Real Estate Benefits of combining the 3 approaches: Can use insights provided by each individual approach Can overcome some limitations involved in using only single approach

  22. Financing of Real EstateTypes of Mortgages Fixed-Payment Mortgage Most frequently used Adjustable Rate Mortgage (ARM) Graduated Payment Mortgage (GPM) Shared Appreciation Mortgage (SAM) Other Forms of Mortgages (equity participation arrangement)

  23. Forms of Real Estate Ownership Ownership of real estate can take many forms: Individual or Regular Partnership Syndicate or Limited Partnership Real estate investment trust (REIT)

  24. Forms of Real Estate Ownership Individual ownership or regular partnership Simplest way from a legal viewpoint Take advantage of personal knowledge of local markets and changing conditions to enhance returns Well-defined center of responsibility often leads to quick corrective actions Often lacks ability to pool adequate capital to engage in large-scale investments Often lacks expertise to develop wide range of investments Unlimited liability for the investor

  25. Forms of Real Estate Ownership Syndicate or Limited Partnership General partner forms partnership Unlimited liability Responsible for managing property Limited partners purchase participation units Liability limited to initial investment No responsibilities – merely investors Front-end fees to General Partner 5-25% Blind poolor are specific projects identified? Public offering Involves larger total amounts SEC registration Private offering Local in scope Maximum 35 investors Secondary (resale) markets exist but dealer spreads and commissions high

  26. Forms of Real Estate Ownership Real Estate Investment Trust Similar to mutual funds or investment companies Trade on organized exchanges or over-the-counter Pool investor funds No minimum investment other than cost of share Most liquid type of real estate investment Large secondary market

  27. Forms of Real Estate Ownership Real Estate Investment Trust (continued) To qualify, trust must receive 75% of income from real estate Rents Interest on mortgage loans Must distribute at least 95% of income as cash dividend Equity Trusts Buy, operate, and sell real estate as investment Mortgage Trusts Make long-term loans to real estate investors Hybrid Trusts Engage in activities of both equity and mortgage trusts There are more than 400 REITS in existence

  28. Gold and Silver Precious metals Most volatile of real asset investments Historically, gold and silver: Move up in value during troubled times Decline in value during stable & predictable periods

  29. Gold Major factors that drive up gold prices are: Fear of war Political instability Inflation • Different forms of gold ownership: • Gold Bullion • Gold Coins • Gold Stocks • Gold Futures Contracts • Gold ETF (GLD)

  30. Movement in Gold Prices

  31. Silver Many of the same investment characteristics as gold Hedge against inflation Potential safe haven investment during troubled times

  32. Silver Used for: Heavy industrial and commercial applications Photography Electronic Electrical manufacturing Electroplating Silverware and jewelry Different forms of silver ownership: Silver Bullion Silver Coins Silver Futures Contract Silver Mining Stocks

  33. Precious Gems Diamonds Rubies Sapphires Emeralds Gems appeal to investors because of their: Small size Easy concealment Great durability

  34. Precious Gems Market knowledge is most important Must either be an expert or deal with “honest” expert Better to buy higher quality, smaller-carat diamond than lesser quality, higher-carat diamond

  35. Other Collectibles Art Antiques Stamps Chinese ceramics Rare books Psychic pleasure as well as opportunity for profit

  36. A Comprehensive Analysis for Real Estate Investment Decisions Appendix 20A

  37. Valuation of Real Estate: A More Comprehensive Analysis Any asset’s ultimate worth is based on the present value of its future cash flows

  38. A More Comprehensive Analysis • Determine purchase price, size of mortgage, annual mortgage payment • Compute the net operating income for each year of the anticipated holding period • Translate this to annual cash flow during the holding period • Project the selling price of the property after the holding period • Discount the annual cash flows and the anticipated selling price after the holding period back to the present to determine the present value of the future benefits • Compare the upfront cash commitment to the present value of future benefits to determine if the property provides a positive net present value

  39. 1. Determine the Purchase Price & Financing • Assume: • Six-unit apartment complex • Purchased for $180,000 • Loan 80% of the value at 12% for 20 years • The loan would be for $144,000 ($180,000 x 80%) • Balance of $36,000 ($180,000 - $144,000) put up in cash • From table below, annual mortgage payment for 20 years at 12% is $19,280

  40. 2. Determine Net Operating Income (NOI) for each year • Assume buyer intends to hold property for 4 years and then sell it. We can determine the value each year from the table below:

  41. 3. Determine the Annual Cash Flow • Income from operations must be adjusted by nonoperating factors such as: • Interest expense • Depreciation • Taxable income/losses • Related taxes or tax shield benefits • Repayment of the mortgage

  42. Table 20A-3 Subtracts depreciation and interest expense from net operating income to find taxable income or loss for each year 3. Determine the Annual Cash Flow (cont.)

  43. To the extent the investor is actively involved with the property, the losses during the first two years can be used as a tax shield (shelter) for other income as reflected in Table 20A-4 3. Determine the Annual Cash Flow (cont.)

  44. Net Operating Income is combined with annual tax shield benefits or taxes owed & the annual mortgage payments to determine the total annual value of cash flow in Table 20A-5 3. Determine the Annual Cash Flow (cont.)

  45. 4. Project the Sales Price • Property purchased for $180,000 • Appreciates 6% per year over 4 year period • Sales value: $180,000 x 1.262* = $227,160 • Net proceeds from selling the property after subtracting sales commission & fees of 7%  • = $277,160 – (0.07 x $227,160) = $211,259 *Appendix A – Compound sum 4 periods at 6% the factor is 1.262

  46. 4. Project the Sales Price (cont.) • To the extent that the net proceeds exceed the book value of the property, a capital gains tax has to be paid: • Book value = Purchase price of $180,000 • minus [4 years of depreciation: 4 x $5,096] $ 20,384 • = $159,616 • Capital gain = Net proceeds of sale $211,259 • minus book value $159,616 • = $ 51,643

  47. 4. Project the Sales Price (cont.) • Funds from sale = Net Proceeds $211,259 • minus Capital gains tax [15% x $51,643] $ 7,746 • = $203,513 • From the funds from the sale, the investor must pay off the mortgage balance of $134,432 that exists after four years of repayments of principal: • Funds from sale $203,513 • Payoff of mortgage - $134,432 • Net cash flow (from sale) = $ 69,081

  48. 5. Determine Present Value of All Benefits If investor’s required rate of return on real estate investments is 12%, the present value of the future cash flows is $52,461.

  49. 6. Compare Upfront Cash Payment to Benefits The Net Present Value of the Investment: $52,461 Present value of future cash flows - $36,000 Upfront cash investment = $16,461 Net present value Investment earns more than the required return of 12% and is attractive, earning about 22%. Caveat: Real estate is illiquid investment and almost the entire return here is based on the assumption of a 6% yearly increase in value

  50. Financing of Real Estate An essential consideration in a real estate investment analysis is the cost of financing Prior example: Loan of $144,000 Over 20 years At 12% interest Payments $19,280 Table 20–1 page 542 shows the effects of various interest rates on annual payments

More Related