1. Chapter 16 Analyzing Income- Producing Properties

2. Why forecasting?  Forecast – not guess  Maximize investment dollars  Locate profits in projects that others overlook

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

4. Cash Flow  After Tax Cash Flow (ATCF) Income  Revenue minus Costs  Revenue Includes: Rent Extras  e.g. laundry services, covered parking Expense Escalators  In commercial real estate  Tenant contracted to pay increase in costs (e.g. utilities)  Costs Include: Debt, insurance, taxes, maintenance, etc.

5. Appreciation  After Tax Equity Reversion (ATER) “Equity reversion” = return of funds originally invested in the property plus any increase in property value.

6. Portfolio Diversification  Real Estate investments can diversify your entire portfolio of investments - Stocks, bonds, etc.  Spread investment risk over different investment vehicles.  Some like Real Estate because it is tangible and long-term.

7. Financial Leverage  “Other people’s money” - Down payment and borrow the remainder  Magnifies investment returns A. Purchase a $100,000 office with 100% equity or B. Use the $100,000 to put down 10% on a $1,000,000 office building and borrow $900,000. *assume income=costs - After 1 year, both properties increase 10% and are sold. A) $110,000-$100,000 = $10,000 profit / $100,000 investment = 10% return B) $1,100,000 - $1,000,000 = $100,000 profit / $100,000 investment = 100% return

8. Tax Benefits  Write losses against other income

9. Disadvantages of Real Estate Investment  large capital requirements  risk Financial risk (Large Capital requirements) Liquidity risk: Discounts on quick sales. Purchasing power risk: Tie money up for large periods of time. Business risk (Changing market conditions): R.E. requires specialized knowledge of markets and transactions affecting specific sectors.

10. The Wealth Maximization Objective  investment can be defined as present sacrifice in anticipation of future benefit  investment decision making involves comparison of the expected future benefits with the costs of the investment  investors’ ultimate goal is to maximize their wealth by choosing investments that are worth more than they cost  the NPV decision rule employs the wealth maximization concept If faced with two competing projects, one that offers an NPV of $1,501 and another that offers a NPV of $703, the investor would prefer the one with the largest NPV.

11. The Discounted Cash Flow Model  To apply the NPV rule in practice, real estate investors may use the following discounted cash flow model.

12. After Tax Cash Flow (ATCF) Potential Gross Income -Vacancy & Collection Loss -Operating Expenses -Debt Service -Taxes After Tax Cash Flow (ATCF)

13. After Tax Equity Reversion (ATER) Gross Sale Price -Selling Expenses -Loan Payoff -Taxes After Tax Equity Reversion (ATER)

14. Discounted Cash Flow Model T NPV=Σ + ATCF t + ATER T - Initial t=1 (1+i) t (1+i) T Equity

15. Highlights of Property Search (from p.358-359)  Individual Investor  Limited Funds  Familiar Neighborhood  Rental & Expense Knowledge  Talk to lenders  Estimate future increases in expenses and income

16. After Tax Cash Flow (ATCF) Potential Gross Income (PGI) -Vacancy & Credit Losses (VCL) Effective Gross Income (EGI) -Operating Expenses (OE) Net Operating Income (NOI) -Annual Debt Service (ADS) Before Tax Cash Flow (BTCF) -Taxes After Tax Cash Flow (ATCF)

17. Calculating Taxes for ATCF Net Operating Income (NOI) -Interest Expense (INT) -Depreciation Deduction (DEP) Taxable Income (TI) x Marginal Tax Rate (MTR) Taxes from Operations (Taxes)

18. After Tax Equity Reversion (ATER) Sale Price -Sale Expenses Net Sale Price -Loan Balance Before Tax Equity Reversion -Taxes After Tax Equity Reversion

19. Calculating Taxes for ATER Net Sale Price -Purchase Price + Accumulated Depreciation Taxable Gain x Marginal Tax Rate Taxes

20. Example of the DCF Model  Consider a four-unit apartment complex that is offered for sale at $255,000.  The units are expected to rent for $725 per month in the first year (increasing at 5% per year) with an annual vacancy rate of 4%.  The property is expected to have operating expenses of $9,900 in the first year (increases at 3% per year).  A loan is available at 70% of the purchase price for 9% interest with monthly payments over 25 years.  The investor believes property value will increase at the annual rate of 5% per year.  The investor faces a tax rate of 28%.  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 16%?  See cash flow calculations in Tables 16.3 and 16.4

21. End Chapter 16  Questions?