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Chapter 2:

Chapter 2:. Value and Real Estate Decisions. Value and Investment Decisions. An investment decision is one that entails significant costs now in return for benefits in the future Significant time into the future Significant, irreversible costs now. Elements of an Investment Decision.

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Chapter 2:

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  1. Chapter 2: Value and Real Estate Decisions

  2. Value and Investment Decisions • An investment decision is one that entails significant costs now in return for benefits in the future • Significant time into the future • Significant, irreversible costs now

  3. Elements of an Investment Decision Future Benefits Financial Time Initial Cost Non-Financial

  4. Normal Business Decisions vs. Real Estate Decisions • Normal business decisions • Recruit Personnel • Choose ways to generate business • Choose marketing strategies or channels • Select an organizational structure • Select equipment • Real estate decisions • Choose the location • Rent or buy • Expand or not • Renovate or not • Hold or sell • How to finance or refinance

  5. Initial Cost Cash Flow at Sale Cash Flow From Operations The Cash Flows of a Real Estate Investment Future Net Cash Flows Time

  6. Nonfinancial Factors in Real Estate Decisions • Example: choice of a personal residence • Important to “internalize” information on the nonfinancial factors • Decision is intuitive, but no less of a valuation decision • Proof: Houses do have prices

  7. The Spectrum of Risk in Investments

  8. Four Combinations of Investment Risk

  9. Significance of Cost Risk vs Cash Flow Risk • Cost risk is immediate, and therefore can have greater impact on value. • Each risk requires special expertise. • Cost risk is evaluated by engineers and building contractors. • Cash flow risk is evaluated by brokers, market researchers or appraisers.

  10. The Spectrum of Cost Uncertainty

  11. The Spectrum of Cash Flow Uncertainty

  12. Risk, Investment, and Yield • Two investment choices: • Vacant residential lot which can sell in one year for $50,000 • Treasury bonds that will mature in one year, paying $50,000 • Which would you pay the most for? • Why?

  13. Risk, Investment, and Yield (continued) • If you purchase the lot for $40,000, and sell in a year for $50,000, how much has your money grown? • If you purchase the Treasury securities for $48,000, how much does your money grow? • What do we call these growth rates?

  14. Ways of Managing Real Estate Risk • Avoid risky ventures • Study real estate as an ongoing interest • Do not accept advice on an uninformed basis • Get experience in a type of investment: • Work for experienced persons • Make only small-scale investments • Assure a long holding period • Price risk • Cash flow (or benefit stream) risk

  15. Two Concepts of Real Estate Value • Investment value: Value to a particular individual • Appraised value: Value to a “typical” investor, or probable selling price

  16. A Condo Conversion Story: Rent or Buy • Price: $157,000 • Financing • 90 percent of price • 30 years, 5.75 percent • $824.59 • Closing costs: $9,420 • Property taxes: App. $2,400 • Monthly Association fee: $160.00 • Current apartment rent: $1,010 month

  17. A Condo Conversion Story: Rent or Buy

  18. A Condo Conversion Story: Rent or Buy

  19. A Condo Conversion Story: Rent or Buy

  20. A Condo Conversion Story: Rent or Buy • Do Jennifer’s assumed appreciation rates of 2.5 percent to 7.5 percent seem reasonable? • Why does she believe she needs to “compound” the initial cost figure when considering sale in the future? • Does she appear to be forgetting anything important in her analysis of the rent or purchase decision?

  21. End of Chapter 2

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