Chapter 11: Investment Analysis and Taxation of Income Properties McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

11-2 Investment Analysis  Equity Investment  Motivations for Investing in Income Properties –Rate of Return –Price Appreciation –Diversification –Tax Benefits

11-3 Market Characteristics  Real Estate Cycle –Large Market in number and size of properties –Competitive –Fragmented Ownership –Overdevelopment Potential –The cycle differs for different property types.

11-4 Exhibit 11-1 The “Real Estate Cycle”

11-5 Investment Strategies  Investing in Core Properties  Investing in Core Properties with a “Value Add” Strategy  Property Sector Investing  Contrarian Investing  Market Timing  Growth Investing  Value Investing

11-6 Investment Strategies  Strategy as to Size of Property  Strategy as to Tenants  Arbitrage Investing  Turnaround/Special Situations  Opportunistic Investing  Investing in “Trophy” or “Blue Chip” Properties  Development

11-7 Market Analysis  Evaluation of supply and demand for a type of property  Absorption  Supply of Space  Market Rents  Forecasting Supply, Demand, Market Rents, and Occupancy

11-8 Investment Analysis  Internal Rate of Return (IRR) –The discount rate at which the net present value of the cash flows is equal to 0. –If IRR >= r; accept Project –If IRR < r; reject Project –Where r is the discount rate, or more colloquially, the “hurdle rate”

11-9 Investment Analysis  Net Present Value –A way to solve for the initial price that an investor may pay given a specified discount rate. –Discounted value of the cash flows. –The discount rate is the rate of return that an investor will require in order to make this investment. –If we include the initial equity investment in this calculation, we can solve for the difference and see how much more or less the investor may pay and still receive a rate that is equivalent to their discount rate.

11-10 Debt Financing  Equity Dividend = NOI - DS –NOI = Net Operating Income –DS = Debt Service  The equity dividend is also referred to as the before-tax cash flow from operations (BTCF 0 )

11-11 Debt Financing  Equity Dividend Rate = Equity Dividend/Initial Equity Investment –Sometimes referred to as “unleveraged cash on cash” rate.  Debt Coverage Ratio (DCR) = NOI/DS –The DCR is a vital ratio for lenders. –If the DCR is less than 1, the borrower will not be able to service the debt. –Generally, lenders want a DCR greater than 1 so the borrower has a cushion and can repay.

11-12 Debt Financing  Example 11-1: –$1,000,000 Property; –95% allocated to building and 5% to land –70% LTV; 7% Interest Rate, 30 Years –$700,000 debt; $300,000 equity –Monthly Payment = $ –DS = 12 x $ = $55,885 –NOI 1 = $85,000

11-13 Before-Tax Cash Flow  Equity Dividend = NOI-DS –$85,000 - $55,885 = $29,115 –This is also the BTCF o for this year.  Equity Dividend Rate = EQDIV/Equity –$29,115/$300,000 = 9.71%  Debt Coverage Ratio = –$85,000/$55,885 = 1.52  These ratios all pertain to the first year of operations.

11-14 Before-Tax Cash Flow  Before-Tax Cash Flow from the Property Sale (BTCF s ): –BTCF s = Sales Price – Mortgage Balance –In Example 11-1, if the property were sold in Year 4 for $1,100,000 then –BTCF = $1,100,000 - $668,322 = $421,678  The mortgage loan balance ($668,322) is computed as previously. See Chapter 4.

11-15  Four Classes of Real Property –Real Estate held as a “personal residence” –Real Estate held for sale to others – “dealer” property” –Real Estate held for use in a trade or business – “trade or business property” –Real Estate held as an investment for the production of income – “investment property” Taxation

11-16  Active Income –Salaries, wages, bonuses, and commissions  Portfolio Income –Interest, dividends, and capital gains  Passive Income –Rents from real estate, and royalties from oil and gas rights Types of Taxable Income

11-17 Passive Activity Loss Restrictions  Passive losses cannot be used to reduce active or portfolio income  Passive losses may be used to reduce other passive income  Passive losses not used may be used in future years or at the same time of sale

11-18 Passive Activity Loss Restrictions  1 st Exception –Active participants may deduct up to $25,000 in passive losses against other non-passive income, subject to limitations such as their adjusted gross income  2 nd Exception –Broad exception for real estate professionals from the Passive Activity Loss rules. –For many of you, if you enter the real estate business, this will apply to you.

11-19 Depreciation Basis  The original cost basis includes all costs associated with acquiring the property and transferring the title  Land value cannot be depreciated  The depreciable basis is the total value that can be depreciated over the recovery period  Depreciable Basis = Cost Basis – Land Amount

11-20 Depreciation  Depreciation –Depreciable Basis / Recovery Period  Recovery Period is different based on property type –Residential income producing property (27.5 Years) –Non-residential income producing property (39 Years) –Note that the recovery period is a product of the tax code. It will vary based on the country that the real estate is located in.

11-21 After-Tax Cash Flows  Calculating the after-tax cash flow from operations  Step 1: Compute taxable income Net Operating Income - Depreciation - Interest Taxable Income

11-22 After-Tax Cash Flows  From Slide 11-10, depreciation is based on a building value of $950,000 over 27.5 years. –Depreciation = $950,000/27.5 = $34,545 –Interest = $48,775 using the “amort” function on the financial calculator. –The depreciation schedule will vary. It is not always 27.5 years.

11-23 After-Tax Cash Flows  From Example 11-1, year 1 taxable income would be: NOI $85,000 Depreciation - $34,545 Interest- $48,775 Taxable Income $ 1,680

11-24 After-Tax Cash Flows  Step 2: Compute Taxes Taxes (at 28%) = 0.28 x 1,680 = $470  Step 3: Compute after-tax cash flow from operations for year 1 ATCF 1 = BTCF 1 – Taxes = 29, = $28,645

11-25 After-Tax Cash Flows  Taxes on the property sale –Gain from price appreciation  The maximum is 15% –Gain from accumulated depreciation  Taxed at 25% –Note that these rates have changed and will change in the future as the tax code is updated and modified.

11-26 After-Tax Cash Flows  From Example 11-1, Slide  Before-tax cash flow from the property sale = $421,678  Step 1: Compute tax on property value increase: $1,100,000 - $1,000,000 = $100,000 Taxed at 15% capital gains rate = $15,000

11-27 After-Tax Cash Flows  Step 2: Compute tax on prior depreciation: 4 Years at $34,545 = $138,180 Taxed at 25% = $34,545  Step 3: Compute total taxes from sale: $34,545 + $15,000 = $49,545

11-28 After-Tax Cash Flows  Step 4: Compute after-tax cash flow from the property sale  ATCF s = BTCF s – Taxes ATCF s = $431,678 - $49,545 = $382,133  Analysis –Compute After-Tax Internal Rate of Return –Compute After-Tax Net Present Value