Chapter 1 The Real Estate Investment Decision

Investment Analysis: Art and Science Historically lagged behind mainstream finance and investment thought; great strides recently Treats real estate as capital asset desired for stream of benefits Real estate investment as special case of modern capital budgeting

Why Invest in Real Estate? Investors take equity or debt position Distinction between investors in real assets and investors in financial assets While both are investors, exclude mortgage lenders from this study of investment analysis and decision making

Figure 1.1 7

Who Invests in Real Estate? Private investors Institutions, such as REITs and pension funds Small level of foreign holdings Concentrated in locales and types of properties Surged during early 1980s and again in the 1990s Level shifts with foreign exchange rates Level impacted by relative interest rates

Figure 1.2 Source: Based on data from National Association of Real Estate Investment Trusts 4 4

How Have Real Estate Investments Performed? Data for investment comparisons scarce, but frequently concluded that real estate generates returns roughly comparable to common stock, with greater predictability of returns More data for investment return comparisons available recently, but heavily influenced by period from which data are drawn Brueggeman, Chen and Thibodeau analysis--real estate funds outperformed Standard’s and Poor’s 500 stock index and Ibbotson Associates bond index

How Have Real Estate Investments Performed? Giliberto compared REIT yields with Standard and Poor’s 500 stock index, 1978 – 1989; found advantage in common stocks Zerbst and Cambon (1984) analyzed earlier studies; found real estate tends to outperform stocks during periods of inflation Clayton and MacKinnon (2001) find REIT returns now closely correspond to returns on small capitalization stocks

Definitions and Concepts Investment Value – Value of a property as an investment to a present or prospective owner Most Probable Selling Price – Probabilistic estimate of the price at which a future transaction will occur

Definitions and Concepts Transaction Investment value from the present owner’s perspective sets the lower end of the range of possible transaction prices. Investment value from the perspective of the most likely buyer determines the upper end of the range. To be motivated to sell, seller must conclude most probable selling price is greater than investment value To be motivated to buy, buyer must conclude investment value is greater than most probable selling price For transaction to be possible, investment value from prospective buyer’s point of view must be greater than from the prospective seller’s point of view Market Value – the most probable price at which the property would sell in a competitive market as of the date of the appraisal, if it had been exposed to the market for a reasonable time. The estimate assumes reasonably informed parties, each acting in his or her own best interest and with neither subject to undue influence.

Figure 1.3

Figure 1.4

Figure 1.5

Investment Value: An Overview Investor who buys property buys set of assumptions about ability of property to generate cash flows over the expected holding period and likely market value of property at end of proposed holding period. Analysis: Estimate the stream of expected benefits Adjust for timing differences in expected streams of benefits from investment alternatives Adjust for differences in perceived risk associated with alternatives Rank alternatives according to relative desirability of the perceived risk-return combinations they embody

Estimating Investment Value: An Overview Value of an investment property is sum of the debt and equity positions Investment can be expressed as present value of the equity position plus the present value of debt position

Figure 1.6

Figure 1.7

Investors Disagree on Investment Values Investors unlikely to arrive at same investment value conclusions as they differ on: Future stream of rental revenue and operating expenses Perceived levels of risks Willingness to defer immediate consumption in interest of future benefits Desire for precisely determinable future Investors in higher-income brackets benefit more from tax-deductible losses

Investor Objectives and Risk Seek financial return as reward for committing resources and as compensation for bearing risk Emotional temperament plays a large role in an investor’s attitude Relate expected return to risk; accept additional perceived risk only if accompanied by additional expected return Tend to become increasingly averse to additional risk as total perceived risk increases

Figure 1.8

Figure 1.9