Chapter 10: Investment and Risk Analysis Motivations for R/E Investment Return (cash flow) Appreciation (inflation hedge) Diversification Tax Benefits

Investment Styles or Strategies 1.Sector Investing 2.Contrarian Investing 3.Market Timing 4.Growth Investing 5.Value Investing 6.Strategy as to Size of Type 7.Strategy as to Tenants 8.Arbitrage Investing 9.Turnaround Investing 10.Trophy of Blue Chip Investing

Projecting Cash Flows Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Rents Vacancy Net Rent Op. Exp NOI Usually include the debt service Debt Ser Eq Div(BTCF) Equity Dividend = Before Tax Cash Flow (BTCF)

Common Investment Ratios: 1.Price per square foot (or price per acre) 2.Capitalization Ratio = NOI/Price 3.Eq. Dividend Ratio = Equity Dividend/Eq. Inv. 4.Debt Coverage Ratio = NOI/Debt Service Estimating the future sales price 1.Projected inflation rate 2.Projected cap rate Final Cash Flow: Sales Price (estimated) Less: Mortgage Balance Before Tax Cash Flow from Sale

Measures of Investment Performance 1.Net Present Value (NPV) 2.Profitability Index = PV of Cash Flow/EQ Inv. 3.Internal Rate of Return (IRR) 4.Adjusted (Modified) IRR: Makes assumptions about how the cash flows are reinvested

Example of Modified IRR Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 NOI Debt Ser BTCF Eq. Inv. -60 IRR 38.2% NPV(15%) $50.5 Calculate what each BTCF grows - BTCFs end of 5 yrs = I = 22.3%; n=5, PMT=0; PV=-60; FV = Modified IRR = 22.3%

Risk Analysis Types of Risk in R/E Investment Business Risk Financial Risk – Leverage risk Liquidity Risk – cant sell the project Inflation Risk Management Risk Interest-Rate Risk Legislative Risk Environmental Risk

Sensitivity Analysis Change a single assumption at a time Scenarios Partitioning of IRR: How much of return is due to operations and how much from capital gains Risk vs. Return

Real Estate Taxes Real Estate Taxes & Interest are Deductible Principle residence and second home. Investment real estate Gain on Sale of Principle Residence is excluded from tax up to a max. of $250K (or $500K if MFJ). A principle residence may be sold no more than once every 2 years.

Calculation of Gain on Sale Sales Price Less: Selling Expenses Net Selling Price Original Cost (or Basis) Plus: Improvements Less: Accumulated Depreciation Adjusted Basis Net Selling Price Less: Adjusted Basis Gain on Sale

Calculating Depreciation: 1.Residential Property: 27.5 years, straight line 2.Commercial Property: 39 years, straight line Depreciate only building costs, not land. Passive loss rules: Real estate income is defined by the tax laws as passive income. Passive losses can be offset only against passive gains. Exception 1: Middle income taxpayers (AGI<120K) can deduct up to 25,000 of rental losses against regular income if they actively manage the property. Exception 2: R/E professionals can deduct passive rental losses against regular income.

Maximum capital gain rate on federal taxes is 20% for assets held for at least 1 year. Investment Analysis Example Consider the purchase of an Apartment House (in $1.000s) Purchase Price$3,300 Mortgage 2,600 Equity 700 NOI 570 Cap Rate 17%

Calculating Before-Tax Cash Flows Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 NOI Debt Ser BTCF Sales Price 3,100 Less: Mortgage Balance (1,000) BTCF (from sale)2,100

After-Tax Cash Flows from Operations Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 NOI Interest Dep Taxable Inc Tax (50%) BTCF Less: Tax ATCF

Calculating After-Tax Cash Flow from Sale Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Sales Price 3,100 Less: Mortgage Balance (1,000) BTCF (from sale) 2,100 Now Calculate Taxable Gain: Sales Price 3,100 Original Cost Basis 3,300 Less: Accumulated Depreciation 300 Adjusted Basis 3,000 Taxable Gain (Price – Adj Basis) 100 Tax (20%) 20 After-Tax Cash Flow from Sale 2,080

Investment Analysis Yr 0 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 BTCF ,220 ATCF ,170 Before-Tax IRR (BTIRR)33.2% After-Tax IRR (ATIRR)31.6% NPV Before-Tax NPV After-Tax IRR After-Tax Present Value of Value of the Debt (Mortgage)$1,000 Total Value of the Property$2,286

Homework Problems: 10-2, 10-6 (pages 330 – 331)