Ch 19 Analyzing Income Producing Properties

2 Outline  I. Advantages of Real Estate Investment  II. Disadvantages of Real Estate Investment  III. Capital Budgeting Decision Making  IV. The Discounted CF Model Applied to Real Estate  V. Example Analysis of an Income Producing Property

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

4 II. Disadvantages of Real Estate Investment  Large initial capital requirements  Carrying costs  Active management  Risk Business risk Financial risk Purchasing power risk Liquidity risk

5 III. Capital Budgeting Decision Making  Estimate CFs  Apply Investment Criteria - NPV - IRR (note: IRR cannot be used when) 1. 2.

6 Mutually Exclusive Projects Which project would you choose? Project A: 012 -$300$200$170 Project B: 012 -$400$250$230

7 IV. The Discounted Cash Flow Model Applied to Real Estate  4 Ingredients: 1. Initial equity = Purchase Price – Loan Amount 2. ATCF = After-Tax Cash Flow from Operations 3. ATER = After-Tax Equity Reversion 4. i = the investor’s required rate of return

8 The Discounted Cash Flow Model 2. after-tax cash flow (ATCF): potential gross income (PGI) - vacancy and collect losses (VCL) effective gross income (EGI) - operating expenses (OE) net operating income (NOI) - annual debt service (ADS) before-tax CF - taxes from operations ATCF taxes from operations: NOI - interest (Int) - depreciation (Dep) taxable income (TI) x income tax rate taxes from operations

9 The Discounted Cash Flow Model 3. after-tax equity reversion (ATER): gross sale price - selling expenses net sales price - loan payoff (AO) before tax equity reversion (BTER) - taxes (due on sale) ATER taxes due on sale: net sales price - purchase price + accumulated depreciation taxable gain x capital gain tax rate taxes due on sale

10 V. Example of the DCF Model  Consider a four-unit apartment complex that is offered for sale at $455,000. The land value is assumed to be $160,000.  The units are expected to rent for $1,325 per month in the first year (increasing at 3.5% per year) with an annual vacancy rate of 5%.  The property is expected to have operating expenses of $25,420 in the first year, which increase at 3.5% per year.  A loan is available at 75% of the purchase price for 7% interest with monthly payments over 25 years.  Selling expenses at the end of the 5 th year are 6% of gross selling price.  Assume the property is depreciated over 27.5 years and it is bought in the middle of Jan (Year 1) and sold in the middle of Dec (Year5).  The investor believes property values will increase at the annual rate of 2% per year.  The investor faces an ordinary income tax rate of 28% and a capital gain tax rate of 18%.  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 10%?