1. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 1 CHAPTER ELEVEN INVESTMENT ANALYSIS AND TAXATION OF INCOME PROPERTIES

2. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 2 Motivation For Investing Rate of return Price appreciation Diversification Tax benefits

3. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 3 Hierarchy of Investment Strategies 1. Sector or Industry 2. Type of property in the industry

4. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 4 Investment Strategies A. Property sector investing B. Contrarian investing Major economic, technological and other factors would make a property of poor type. C. Market timing D. Growth investing E. Value investing A. Overlooked by investors

5. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 5 Investment Strategies F. Size of property G. Strategy as to tenants H. Arbitrage investing I. Turn around/ special situation J. Blue chip properties

6. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 6 Real Estate Investment Analysis Investment Strategy Investment philosophy Investment objectives Investment policies

7. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 7 Investment Decisions A. Forecast cash flows from operations B. Forecast cash flow from sale C. Determine present value of expected cash flows D. Apply an investment decision criterion

8. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 8 A.Forecasting Cash Flows From Operations Potential Gross Income Effective Gross Income Operating Expenses Net Operating Income Non-Recurring Expenses

9. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 9 Net Operating Income Calculation Income/Expense ItemSymbol Potential Gross Income(PGI) - vacancy and collection losses(VCL) + Other Miscellaneous Income(MI) = Effective Gross Income(EGI) - Operating Expenses(OE) = Net Operating Income(NOI)

10. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 10 Net Operating Income Example ItemTotal Potential Gross Income$ 180,000 - Vacancy and Collection Losses18,000 + Other Miscellaneous Income______0 = Effective Gross Income162,000 - Operating Expenses_72,900 = Net Operating Income$ 89,100

11. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 11 Forecasted Cash Flows From Net Operating Income ItemYear1Year2Year3Year4Year5 PGI$180,000$185,400$190,962$196,691$202,592 - V&C18,00018,54019,09619,66920,259 = EGI162,000166,860171,866177,022182,333 - OE72,90075,08777,34079,66082,050 = NOI$89,100$91,773$94,526$97,362$100,283

12. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 12 B- Forecasted Cash Proceeds From Sale ItemSymbolYear5 Expected Sales Price(SP)$1,026,000 - Selling Expenses(SE)51,300 = Net Sales Proceeds(NSP)$974,700

13. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 13 C- Present Value Calculation YRInvest.NOINSPPV@12% 0$0$0 $0$0 189,10079,554 291,77373,161 394,52667,282 497,36261,875 5100,283974,700609,974 PV=PV=$891,846

14. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 14 Net Present Value (NPV) The net present value is the present value of a project’s cash inflows, minus the present value of the cash outflows. The cash flows are discounted at the investor’s required rate of return– in the example 12 percent.

15. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 15 Net Present Value Calculation YRInvest.NOINSPPV@12% 0$-885,000 189,10079,554 291,77373,161 394,52667,282 497,36261,875 5100,283974,700609,974 PV = NPV= $891,846 $ 6,846

16. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 16 Net Present Value Calculation YRInvest.NOINSPPV@12% 0$-885,000 189,10079,554 291,77373,161 394,52667,282 497,36261,875 5100,283974,700609,974 NPV=$ 6,846

17. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 17 NPV Decision Criteria If NPV>0, the project exceeds the investor’s required rate of return. If NPV<0, the project does not meet the investor’s required rate of return. If NPV=0, the project’s expected return equals the investor’s required rate of return.

18. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 18 Internal Rate of Return (IRR) The internal rate of return is the discount rate at which NPV=0, the rate of return at which the present value of the cash inflows equals the present value of the cash outflows.

19. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 19 IRR Decision Criteria If IRR> the required rate of return, then accept. If IRR< the required rate of return, then reject. If IRR= the project’s expected return equals the investor’s required rate of return.

20. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 20 NPV and the IRR NPV: cash flows assumed reinvested at discount rate Generally preferred to IRR for making decisions IRR: cash flows assumed reinvested at the IRR rate May provide inferior wealth maximizing ranking of alternative opportunities to the NPV Multiple solutions possible Easily compared to other investments and widely used

21. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 21 Debt Financing 1. Capitalization Rate 2. Equity Dividend Rate 3. Mortgage Constant 4. Operating Expense Ratio 5. Loan-to-Value Ratio 6. Debt Coverage Ratio 7. Debt Service 8. Max debt service

22. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 22 Debt Financing: Investment Criteria: Profitability Ratios Capitalization Rate: R o = NOI/ Acquisition Price Equity Dividend Rate: R e = EDR= BTCF/ Initial Equity Mortgage Constant: R m = MC= Debt Service (DS)/ Initial Loan Amount Debt service is the cash required over a given period for the repayment of interest and principal on a debt.

23. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 23 Investment Criteria: Financial Ratios Operating Expense Ratio: OER= Operating Expenses/ EGI Loan-to-Value Ratio: LTV= Mortgage Balance/ Property Value Debt Coverage Ratio: DCR= Net Operating Income/ Debt Service Max debt service: NOI/Desired DCR

24. © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 24 End of chapter!