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Chapter 16 Analyzing Income- Producing Properties
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Why forecasting? Forecast – not guess Maximize investment dollars Locate profits in projects that others overlook
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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
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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.
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Appreciation After Tax Equity Reversion (ATER) “Equity reversion” = return of funds originally invested in the property plus any increase in property value.
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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.
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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
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Tax Benefits Write losses against other income
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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.
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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.
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The Discounted Cash Flow Model To apply the NPV rule in practice, real estate investors may use the following discounted cash flow model.
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After Tax Cash Flow (ATCF) Potential Gross Income -Vacancy & Collection Loss -Operating Expenses -Debt Service -Taxes After Tax Cash Flow (ATCF)
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After Tax Equity Reversion (ATER) Gross Sale Price -Selling Expenses -Loan Payoff -Taxes After Tax Equity Reversion (ATER)
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Discounted Cash Flow Model T NPV=Σ + ATCF t + ATER T - Initial t=1 (1+i) t (1+i) T Equity
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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
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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)
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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)
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After Tax Equity Reversion (ATER) Sale Price -Sale Expenses Net Sale Price -Loan Balance Before Tax Equity Reversion -Taxes After Tax Equity Reversion
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Calculating Taxes for ATER Net Sale Price -Purchase Price + Accumulated Depreciation Taxable Gain x Marginal Tax Rate Taxes
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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
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End Chapter 16 Questions?
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