Real Estate Investment I. Benefits of Investing-most people invest to ‘hit it big’ through the upside potential in real estate. This upside might come through appreciation, or through cash flow. Investment decisions are typically made after investment analysis is performed, with object to measure expected benefits based on investor’s criteria. Advantages and Disadvantages of investing: A. Advantages: 1. Cash Flow from Operations-either before or after tax, gross effective income less expenses. 2. Appreciation-increase in value over time, before or after taxes.
3. Leverage-use other people's money to make money. If return greater than cost of debt, magnifies return: a. Buy property for $100,000 and earn $15,000, for a 15% return. b. Buy $1,000,000 with $100,000 that generates $150,000 net income. If cost of debt is $63,000 ($900,000 @ 7%/yr.), then return is: $150,000-$63,000 =$87,000/100,000 or 87% return!!! 4. Tax Benefits-both during operations (depreciation, deductibility of interest, special credits, etc.) and at sale (capital gains treatment, deferring taxes through exchanges, etc.). 5. Intrinsic-Diversification, Pride of Ownership, etc. B. Disadvantages of Investment:
1. Large amounts of capital required. 2. Risky - does return justify risk?? a. Business Risk – risk of loss due to fluctuations in economic activity. b. Financial Risk – use of debt financing can magnify gains or losses. c. Inflation Risk – reduction of returns due to unexpected inflation. d. Liquidity Risk – Inability to quickly sell a property. 3. Lack of liquidity. 4. Changing economic conditions II. Elements of Investment Analysis-many different elements enter into investment analysis, most involving comparing the anticipated future benefits with the present cost of the investment. A. Two-part Return-typically analyze real estate returns relative to cash flow from operations, and then from sale. Both have a role, each providing a source of
return that may be more or less important to specific investors: 1. Cash flow from Operations-format*: Potential Gross Income plus Misc. Income less Vacancy & Bad Debts equals Effective Gross Income less Operating Expenses equals Net Operating Income less Debt Service equals Before Tax Cash Flow less Depreciation plus Principal equals Taxable Income less Taxes equals After Tax Income less Principal plus Depreciation equals After Tax Cash Flow PGI +MI -VBD EGI -OE NOI -DS BTCF -DEPR +PRIN TI -Taxes ATI -PRIN +DEPR ATCF
2. After Tax Equity Reversion-format: Selling Price less Selling Expenses equals Net Sales Proceeds less Mort. Balance Remaining less Taxes on Sale equals After Tax Eq. Rever. and Taxes are calculated as: Net Sales Proceeds less Adjusted Basis equals Taxable Gain times Capital Gains Rate equals Taxes Due NSP -AB GAIN xRate Taxes SP -SE NSP -MBR -Taxes ATER
B. Accounting Framework for Analysis-can use ratio analysis, discounted cash flow analysis, or both. When using discounted cash flow analysis, will incorporate both net present value (NPV) and internal rate of return (IRR) concepts. These concepts
recognize that the timing of the flows is important, i.e. the further out the flows are to be received, the lower their present value. III. Introduction to Investment Analysis ultimately the question to be answered in investment analysis is should a property be purchased, and if so at what price? Correspondingly, if a certain price is asked for a property and it is purchased at that price, what return will the investment yield? A. Ratio Analysis - quality of investment can be ascertained using ratios of various measurements: 1. Price per square foot or per unit - relative comparative measures with other projects. 2. Capitalization Rate - relationship of NOI divided by Value in first year - again a comparative measure with other projects
in the market. Obviously this is a static measure that ignores future cash flows, reversion, time-value of money, etc. 3. Equity Dividend Rate (Cash on Cash Ratio) - calculated by dividing the BTCF by the initial equity investment. This provides a measure of cash flow to equity, and is very common in a comparative analysis, although still a static ratio that ignores future cash flows, reversion, etc. 4. Debt Coverage Ratio - measure of the riskiness of the loan, and is of interest to both the investor and the lender. DCR is the ratio of the NOI to the Debt Service, and provides a measure of the cushion the cash flow of the property has in covering mortgage payment. Most lenders require at least a 1.25 ratio (i.e. 25% cushion). B.Discounted Cash Flow Analysis - an alternative to static ratio analysis is to
project after tax cash flows for each year of the investment, and then estimate a reversionary value and corresponding after tax equity reversion. Several different analyses can be undertaken with this information: 1. Net Present Value - done on a before or after tax basis, where initial equity investment is related to the anticipated future flows. The future flows are effectively discounted back to the present at the required rate of return, and then compared to the initial equity investment. If the present value of the flows is greater than the initial investment, then a positive net present value exists, meaning the investment exceeds the required rate of return. 2. Internal Rate of Return (IRR) - similar concept to NPV, but now the initial equity investment is equated with the discounted
future flows. That rate that equates to the two is the IRR. Problems with the IRR exist - primarily in the reinvestment assumption and the fact that multiple IRRs can result if investment has greater than one sign change. 3. FMRR - adjusted IRR that deals with the reinvestment assumption (assumes a realistic reinvestment rate) plus can stabilize variable cash flows that swing from positive to negative (or vice versa).
* Explanation of each variable: A. Gross Possible Income - comes from market rents. In estimating gross possible income, must assess whether rents to be used are contract or market rents (always use market rents unless have a long-term contract). Market rents (both current and future) will be dependent on supply and demand of property in the current market, as well as location and condition of the property, past trends in rents, underlying economic conditions (income and population changes), etc. Obviously income will vary over time as market conditions change, which adds to the risk inherent in real estate investment. Income also will vary based on how lease is structured, and how much of market risk is transfered to the lessee. 1. Lease structure - leases will include a variety of items that impact on rent as well as responsibilities of lessor/lessee.
These things will include lease term, use of property, finish-out allowance, rent terms and structure, who is responsible for expenses, concessions (i.e. free rent periods), renewal options, etc. All of these elements are negotiable, and ultimate package will affect total cost to the tenant (income to the owner) of the lease. Typical factors affecting risk and price of lease: a. Calculation of rent - several alternatives, including fixed rent, percentage rent (base plus overage as a percent of sales), index rent (tied to changes in an underlying indes, such as CPI), graduated payment lease. b. Payment of expenses - typically classify leases by extent of expenses paid by tenant. If none of the expenses are paid by tenant (i.e. all expenses are paid by lessor) - called a gross lease (aka full
service). If all expenses are paid by tenant, called a triple-net lease. If expenses split, typically referred to as a net (lessee pays taxes) or net-net (lessee pays taxes and insurance) lease. Very common arrangement today is a fixed amount of expenses being paid by the lessor, with any overage passed through to the tenant - referred to as an expense stop. Example, tenant pays $10 per square foot annual rent, with a $5 per square foot expense stop. This means that on a 1,000 square foot space, the monthly rent would be $833.33 ($10 x 1,000 / 12), with the lessor responsible for $416.66 ($5 x 1,000 / 12) per month of expenses. Anything over that amount would be paid by the tenant, typically on a pro-rata basis with any other tenants. c. Concessions - if supply exceeds demand, fairly common for lessor to
offer concessions as an inducement to get tenants to sign long-term lease. Usually reduced or free rent for an initial period, but may also be a larger finish-out or payment of expenses. Owner may also offer tenant a small equity participation in the ownership of the building to get them to commit to a long-term lease as an anchor tenant. d. Renewal and Relocation Options another item of negotiation that typically give the tenants the right to renew their leases at relatively low rates in the future, or relocate in the event more desireable space in the same building comes available, or a new building is constructed by the owner, etc. B.Vacancy Allowance - Unfortunately, lessor will not always be able to have all space rented and paying rent all of the
time. So investor must provide an allowance for vacancy and bad debts. This can be based on historical information, or can be taken from current market standards. Published sources available for income, vacancy and expense estimates for most property types for most major markets (downtown and suburban). Even new or 100% occupied buildings need to allow for a vacancy allowance due to normal turnover. C. Operating Expenses - typically two types of expenses, fixed and variable: 1. Fixed - expenses of the property regardless of the level of occupancy: a. b. c. d. property taxes insurance advertising and promotion repairs and maintenance
2. Variable - expenses vary based on the occupancy: a. utilities b. management expense c. cleaning D. Net Operating Income (NOI) - result of subtracting operating expenses from Effective Gross Income (Gross Possible less Vacancy). Note that Operating Expenses do not include depreciation or financing. The reason is that NOI is the cash flow to the property, before taxes. Financing is not considered an expense of the property, but rather an expense of the owner. E. Before Tax Cash Flow (BTCF) - when financing is incorporated in the analysis, it is done in two ways. The first is to take out the entire annual debt service (i.e. principal and interest payment). This is subtracted
from the NOI to arrive at BTCF. The second way financing is incorporated is to take out interest payments only to find taxable income, and then ultimately to take out the principal portion from after tax income to arrive at After Tax Cash Flow.