Chapter 16 Real Estate and High-Risk Investments

Copyright © Houghton Mifflin Company. All rights reserved.16 | 2 Learning Objectives 1.Demonstrate how you can make money investing in real estate. 2.Recognize how to take advantage of beneficial tax treatments in real estate investing. 3.Calculate the right price to pay real estate investment and how to finance your purchase. 4.Assess the disadvantages of investing in real estate. 5.Summarize the risks and challenges of investing in collectibles, precious metals, and gems. 6.Explain why options and futures are high-risk investments.

Copyright © Houghton Mifflin Company. All rights reserved.16 | 3 Making Money Investing in Real Estate Real Estate: property consisting of land, structures attached to the land, and accompanying rights and privileges Direct Ownership: actual legal title to a property

Copyright © Houghton Mifflin Company. All rights reserved.16 | 4 Making Money Investing in Real Estate Current income and capital gains –Rental yield – computation of how much income the investor might pocket from rent each year before mortgage payments as a percentage of the purchase price. Average = 4 % Values range from 2% - 9% Current income results from positive cash flow. Capital gains when property is sold.

Copyright © Houghton Mifflin Company. All rights reserved.16 | 5 Sample Rental Yield Calculation Assumes 50% of rental income goes for expenses (not debt)

Copyright © Houghton Mifflin Company. All rights reserved.16 | 6 Making Money Investing in Real Estate Price appreciation leads to capital gains. –Capital improvements – costs in making value- enhancing changes beyond normal maintenance and repairs. –Repairs – costs necessary to maintain property value Leverage can increase an investor’s return. –Loan-to-value ratio – measures the amount of leverage in a real estate investment project by dividing the total amount of debt by the market price of the investment.

Copyright © Houghton Mifflin Company. All rights reserved.16 | 7 Making Money Investing in Real Estate Beneficial tax treatments: 1.Depreciation Is tax deductible. 2.Interest is tax deductible. 3.Rental income tax regulations on vacation homes. (Ex: <15 days = no tax) 4.Capital gains are taxed at reduced rates. (15% vs. ordinary tax rates up to 35%) 5.Tax-free exchanges

Copyright © Houghton Mifflin Company. All rights reserved.16 | 8 Effect of Depreciation on Income Taxes and Return

Copyright © Houghton Mifflin Company. All rights reserved.16 | 9 Additional Effect of Interest Paid on Income Taxes on Return

Copyright © Houghton Mifflin Company. All rights reserved.16 | 10 Pricing and Financing Real Estate Investments Pay the right price. –Discounted cash-flow method Financing a real estate investment –Conventional, fixed-rate mortgage –Seller financing (or owner financing) –Sweat equity property

Copyright © Houghton Mifflin Company. All rights reserved.16 | 11 Discounted Cash Flow to Estimate Price If required rate of return is 10% and purchase price is $200,000: Investor should negotiate lower price to be $181K Accept less than 10% return on investment Hope sales price is higher than $265K in 5 years

Copyright © Houghton Mifflin Company. All rights reserved.16 | 12 Disadvantages of Real Estate Investing Business risk Complexity Large initial investment Lack of Diversification Dealing with tenants Time-consuming management demands

Copyright © Houghton Mifflin Company. All rights reserved.16 | 13 Disadvantages of Real Estate Investing Low current income Unpredictable costs Interest rate risk Legal fees High Transfer Fees Illiquidity

Copyright © Houghton Mifflin Company. All rights reserved.16 | 14 Investing in Collectibles, Precious Metals, and Gems Collectibles: cultural artifacts that have value because of their age, scarcity, etc. Making a profit on collectibles is not easy. Buying and selling collectibles on the ‘Net: easy and convenient, but not always safe! Gold and other metals: –Gold bullion, gold coins –Gold stocks and mutual funds –Silver, platinum, palladium, rhodium Precious stones and gems: diamonds, sapphires, rubies, etc.

Copyright © Houghton Mifflin Company. All rights reserved.16 | 15 Investing in Options and Future Contracts Derivative (or Derivative Security) – an instrument who’s value is based upon another underlying asset. –Ex: Mortgage backed securities, stock options, etc. Options allow you to buy or sell an asset at a predetermined price. –Stock Option – Security that gives the holder the right to buy or sell a specific number of shares of a certain stock at a specified (strike) price before an expiration date.

Copyright © Houghton Mifflin Company. All rights reserved.16 | 16 Investing in Options and Future Contracts Options are created by an option writer. –Option premium – the price of the option –Option holder – person who buys option –Call option – the right to buy the option asset at a strike price at any time before expiration –Put option – the right to sell the option asset at a strike price at any time before expiration Conservative writers profit by selling covered calls. –Covered Option, Naked Option – The option owned by the writer who can settle a contract with minimal risk. Naked option is not owned by the writer and is speculative with regard to risk.

Copyright © Houghton Mifflin Company. All rights reserved.16 | 17 How to Make Sense of Option Contracts

Copyright © Houghton Mifflin Company. All rights reserved.16 | 18 Commodities Futures Contracts Futures Contract – Type of exchange traded forward contract that specifies the size of the contract, quality of product to be delivered and delivery date. –Agricultural, commercial and mining products Economic need creates futures markets. Speculators may trade in futures markets. Futures are a zero-sum game. – The wealth of investors remains the same; the trading simply redistributes the wealth among the traders. Each profit is offset by an equal loss.

Copyright © Houghton Mifflin Company. All rights reserved.16 | 19 The Top 3 Financial Missteps In Real Estate and Investing People experience challenges in investing in real estate and high risk investments when they do the following: 1.Fail to factor in income lost due to vacancies and collection costs for tenants who do not pay. 2.Fail to set enough money aside for maintenance, repairs, unanticipated capital improvements, and rising real estate taxes. 3.Assume that real estate prices will go up and interest rates will not increase.

Copyright © Houghton Mifflin Company. All rights reserved.16 | 20 Good Money Habits in Real Estate and High-Risk Investments Consider the disadvantages before investing in real estate. Invest only in real estate properties that have a positive cash flow. Finance real estate investments with conventional mortgages, not mortgages with adjustable interest terms. Use the discounted cash-flow method to help determine the right price to pay. If you put money into high-risk assets, limit your investment to no more than 10 percent of your portfolio.