Chapter 11 Investment, Taxation & Risk Analysis

1. Chapter 11Investment, Taxation & Risk Analysis

2. Motivations for Investing in Income Properties: • Returns from operation of cash flows • Returns from reversional cash flows • Diversification • Tax benefits

3. Income Potential-R.E. Assets

5. Operating Statement: GPI Gross Potential Income - V&C - Vacancy & Collection Losses = EGI = Effective Gross Income - O.E. - Operating Expenses = NOI = Net Operating Income Cash Flow from Operations: NOI Net Operating Income - DS -Debt Service = BTCF =Before Tax Cash Flow - T -Taxes* = ATCF =After Tax Cash Flow

6. TaxCalculation* NOI Net Operating Income - I - Interest Expense - D - Depreciation = TI (loss) =Taxable Income x MTR x Marginal Tax Rate = T (TS) = Taxes (Tax Savings)

7. Financial Ratio Analysis: • Loan to Value Ratio (LTV) = Loan Amount/Market Value of Property *Determine the degree of financial leverage equity investor has (normally < 80%)

8. Debt Service Coverage (DSC) =NOI/Total Mortgage Payment *Indicate the property’s ability to service debt (normally > 1.2) • Operating Expense Ratio (OER) = Operating expenses/Effective gross income or Gross potential income *A higher operating ratio will leave very little NOI to cover debt service. (norm depends on property type (i.e.., Apts. 35-40% of PGI)

9. Break-Even Rate (BER) = Operating Expenses + Debt Services GPI or EGI * Sometimes is referred to as the default ratio. Indicates the occupancy required for a project to meet all cash outlays associated with operations & debt service (lower ratio is better for lender & borrower)

10. Return on Assets (ROA) = NOI/Total property investment * An indication of a property’s total return. Compare to similar properties. • Return on Equity (ROE) = BTCF/Equity * Also referred to as “cash on cash” return or equity dividend rate. Shows the effect of borrowing. Compare to similar properties.

11. Weaknesses of “Rule of Thumb” Ratio Analysis: • Time value of money isn’t considered. • Ignores changes in operational CF’s. • Ignores properties appreciation potential. • Before-Tax vs. After-Tax Use the ratios as a quick test of property’s return or value. ATCF Analysis is far more important to the equity investor Commonly used source of industry data is the National Association of Realtors, Institute of Real Estate Management. Income & Expense Analysis Reports.

12. Measures of Investment Performance Based on Cash Flow Projection • NPV = PV of all CFs - Initial Cash Outlay • Profitability Index =__PV of all CFs___ Equity Investment • IRR = Discount rate that causes PV of all CFs to equal initial cash outlay. • MIRR = IRR when cash inflows have been reinvested at a “safe rate”

13. Abuses of DCF Analysis: • Mismatched growth rates between rental income and expenses. • Failure to consider rental concessions and effective rents. • Absence of lease-by-lease analysis in properties encumbered by long-term leases. • Figures that project that expense recovery income will increase at the same growth rate as other expenses in a property encumbered by gross leases with expense stops.

14. Projections for vacancy and collection losses that are not synchronized with market conditions. • Use of operating expense categories that do not include all cost items. Common omissions are tenant improvements and leasing commissions. • Use of ending capitalization rates that are lower than starting capitalization rates. Reversion capitalization rates should be related to the property’s age and remaining economic life. • Underestimation of sales and other reversion costs. • Use of an inappropriate internal rate of return (discount rate).

15. Risk Analysis*All real estate investment analysis is risk analysis. • Types of risk: • Business risk • Financial risk • Liquidity risk • Inflation risk • Management risk • Interest Rate risk • Legislative risk • Environmental risk

16. Risk Analysis Techniques: • Sensitivity Analysis “What if Analysis?” • Change one assumption at a time • Consider scenarios (but, most likely, worst case) • Partitioning the IRR • Monte Carlo Simulation

18. TAXES: • Most income-producing real estate investments are “Held for use in trade or business” - Section 1 2 3 1 Assets. • Taxable Income=NOI-Interest-Depreciation, isn’t equal to: BTCF = NOI - Debt Service

19. Depreciation: • A method of allocating the cost of a wasting asset over its estimated useful life. • Depreciation deductions can be claimed as a tax deduction on real estate improvements (not land), regardless of whether the market indicates an increase in the value of the property. • The deductions reduce taxable income without any real cash payment. • Depreciation deductions serve to reduce the adjusted tax basis of property; so, upon a resale, there will be a greater capital gain on which a tax is due.

20. Capital Gain: • Net Sales Proceeds - Adjusted Basis* = Taxable Gain (loss) *Adjusted Basis = Original Basis (cost of land, improvements, acq. & installation fees) + Capital Improvements - Accumulated Depreciation.

21. Current Capital Gain Tax Rates: • Essentially, the new law reduces the top tax rate on capital gains to 20% (from 28%) for investments you hold more than 5 yrs. Investments you hold more than 5 yrs. will be taxed at 18% if you acquire them after 2000, or if they are marked to the market.

22. Passive Losses: • Since 1986 income & loss from all sources, including Real Estate, are divided into 3 categories: • Active Income • Wages • Salaries • Portfolio Income • Interest • Dividends • Passive Income • Trade or business in which the investor does not materially participate • Rental activities • Limited partnership activities

23. Passive Activity Loss Limitation (PALL): • These income classifications are very important because in general, passive losses cannot be used to offset income from another category. • One special exception applies to individual rental property owners (other than limited partners). These investors are allowed to offset active income with up to $25,000 of passive activity losses (to the extent such losses exceed income from passive activities) from rental real estate activities in which the individual actively participates. (cont.)

24. (cont.) • In general, the individual must own a 10% or greater interest in the activity and be involved in management decisions, such as selection of tenants and determination of rents, or must arrange for others to provide services (e.g. a property manager to manage the property on a day-to-day basis). The TRA phases out this special rule for individuals with adjusted gross incomes between $100,000 and $150,000. An individual with adjusted gross income in excess of $150,000 would receive no loss allowance

25. The Tax Act of 1993 provides some easing of the passive loss rules for real estate brokers, salespersons, and other real estate professionals. • The major benefit is that eligible taxpayers can deduct unlimited real estate activity losses from active income and portfolio income. • Under the new law, individuals must meet these requirements: • 1. More than half of all personal services they perform during the year are for real property trades or business in which they materially participate and • 2. They perform more than 750 hours of service per year in those real estate activities.

26. GATRE: • Real Estate Investment Analysis Computer Program can be found on the internet at http://www.mtsu.edu/~jtimmons/gatre2000.xls • Type in this address and save file to a disk, then open in Excel.