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Chapter 16

Chapter 16. Analyzing Income- Producing Properties. Why forecasting?. Forecast – not guess Maximize investment dollars Locate profits in projects that others overlook. Advantages of Real Estate Investment. Cash Flow from Operations (After Tax Cash Flow – ATCF)

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Chapter 16

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  1. Chapter 16 Analyzing Income- Producing Properties

  2. Why forecasting? • Forecast – not guess • Maximize investment dollars • Locate profits in projects that others overlook

  3. Advantages of Real Estate Investment • Cash Flow from Operations (After Tax Cash Flow – ATCF) • Appreciation (After Tax Equity Reversion – ATER) • Portfolio Diversification • Financial Leverage • Tax Benefits

  4. Cash Flow • After Tax Cash Flow (ATCF) • Income • Revenue minus Costs • Revenue Includes: • Rent • Extras • e.g. laundry services, covered parking • Expense Escalators • In commercial real estate • Tenant contracted to pay increase in costs (e.g. utilities) • Costs Include: • Debt, insurance, taxes, maintenance, etc.

  5. Appreciation • After Tax Equity Reversion (ATER) • “Equity reversion” = return of funds originally invested in the property plus any increase in property value.

  6. Portfolio Diversification • Real Estate investments can diversify your entire portfolio of investments • - Stocks, bonds, etc. • Spread investment risk over different investment vehicles. • Some like Real Estate because it is tangible and long-term.

  7. Financial Leverage • “Other people’s money” • - Down payment and borrow the remainder • Magnifies investment returns • A. Purchase a $100,000 office with 100% equity or • B. Use the $100,000 to put down 10% on a $1,000,000 office building and borrow $900,000. *assume income=costs • After 1 year, both properties increase 10% and are sold. • $110,000-$100,000 = $10,000 profit / $100,000 investment = 10% return • $1,100,000 - $1,000,000 = $100,000 profit / $100,000 investment = 100% return

  8. Tax Benefits • Write losses against other income

  9. Disadvantages of Real Estate Investment • large capital requirements • risk • Financial risk (Large Capital requirements) • Liquidity risk: Discounts on quick sales. • Purchasing power risk: Tie money up for large periods of time. • Business risk (Changing market conditions): R.E. requires specialized knowledge of markets and transactions affecting specific sectors.

  10. The Wealth Maximization Objective • investment can be defined as present sacrifice in anticipation of future benefit • investment decision making involves comparison of the expected future benefits with the costs of the investment • investors’ ultimate goal is to maximize their wealth by choosing investments that are worth more than they cost • the NPV decision rule employs the wealth maximization concept • If faced with two competing projects, one that offers an NPV of $1,501 and another that offers a NPV of $703, the investor would prefer the one with the largest NPV.

  11. The Discounted Cash Flow Model • To apply the NPV rule in practice, real estate investors may use the following discounted cash flow model.

  12. After Tax Cash Flow (ATCF) Potential Gross Income -Vacancy & Collection Loss -Operating Expenses -Debt Service -Taxes After Tax Cash Flow (ATCF)

  13. After Tax Equity Reversion (ATER) Gross Sale Price -Selling Expenses -Loan Payoff -Taxes After Tax Equity Reversion (ATER)

  14. Discounted Cash Flow Model T NPV=Σ + ATCFt + ATERT - Initial t=1 (1+i)t (1+i)T Equity

  15. Highlights of Property Search (from p.358-359) • Individual Investor • Limited Funds • Familiar Neighborhood • Rental & Expense Knowledge • Talk to lenders • Estimate future increases in expenses and income

  16. After Tax Cash Flow (ATCF) Potential Gross Income (PGI) -Vacancy & Credit Losses (VCL) Effective Gross Income (EGI) -Operating Expenses (OE) Net Operating Income (NOI) -Annual Debt Service (ADS) Before Tax Cash Flow (BTCF) -Taxes After Tax Cash Flow (ATCF)

  17. Calculating Taxes for ATCF Net Operating Income (NOI) -Interest Expense (INT) -Depreciation Deduction (DEP) Taxable Income (TI) x Marginal Tax Rate (MTR) Taxes from Operations (Taxes)

  18. After Tax Equity Reversion (ATER) Sale Price -Sale Expenses Net Sale Price -Loan Balance Before Tax Equity Reversion -Taxes After Tax Equity Reversion

  19. Calculating Taxes for ATER Net Sale Price -Purchase Price + Accumulated Depreciation Taxable Gain x Marginal Tax Rate Taxes

  20. Example of the DCF Model • Consider a four-unit apartment complex that is offered for sale at $255,000. • The units are expected to rent for $725 per month in the first year (increasing at 5% per year) with an annual vacancy rate of 4%. • The property is expected to have operating expenses of $9,900 in the first year (increases at 3% per year). • A loan is available at 70% of the purchase price for 9% interest with monthly payments over 25 years. • The investor believes property value will increase at the annual rate of 5% per year. • The investor faces a tax rate of 28%. • The investor expects a five year holding period. • Is this a good deal based on the NPV rule at a required rate of return of 16%? • See cash flow calculations in Tables 16.3 and 16.4

  21. End Chapter 16 • Questions?

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