Chapter 11 Investment, Taxation

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Chapter 11Investment, Taxation Risk Analysis
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Motivations for Investing in Income Properties

• Returns from operation of cash flows
• Returns from reversional cash flows
• Diversification
• Tax benefits

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Income Potential-R.E. Assets
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Operating Statement

• GPI Gross Potential Income
• - VC - Vacancy Collection Losses
• EGI Effective Gross Income
• - O.E. - Operating Expenses
• NOI Net Operating Income
• Cash Flow from Operations
• NOI Net Operating Income
• - DS -Debt Service
• BTCF Before Tax Cash Flow
• - T -Taxes
• ATCF After Tax Cash Flow

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Tax Calculation

• NOI Net Operating Income
• - I - Interest Expense
• - D - Depreciation
• TI (loss) Taxable Income
• x MTR x Marginal Tax Rate
• T (TS) Taxes (Tax Savings)

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Financial Ratio Analysis

• Loan to Value Ratio (LTV)
• Loan Amount/Market Value of Property
• Determine the degree of financial
  leverage equity investor has
• (normally lt 80)

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• Debt Service Coverage (DSC)
• NOI/Total Mortgage Payment
• Indicate the propertys ability to service
  debt (normally gt 1.2)
• Operating Expense Ratio (OER)
• Operating expenses/Effective gross
  income or Gross potential income
• A higher operating ratio will leave very
  little NOI to cover debt service. (norm
  depends on property type (i.e.., Apts. 35-40
  of PGI)

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• Break-Even Rate (BER)
• Operating Expenses Debt Services
• GPI or EGI
• Sometimes is referred to as the default
  ratio. Indicates the occupancy required
  for a project to meet all cash outlays
  associated with operations debt service
  (lower ratio is better for lender borrower)

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• Return on Assets (ROA)
• NOI/Total property investment
• An indication of a propertys total
  return. Compare to similar properties.
• Return on Equity (ROE)
• BTCF/Equity
• Also referred to as cash on cash return
  or equity dividend rate. Shows the effect of
  borrowing. Compare to similar properties.

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Weaknesses of Rule of Thumb Ratio Analysis

• Time value of money isnt considered.
• Ignores changes in operational CFs.
• Ignores properties appreciation potential.
• Before-Tax vs. After-Tax
• Use the ratios as a quick test of propertys
  return or value.
• ATCF Analysis is far more important to the
  equity investor
• Commonly used source of industry data is the
  National Association of Realtors, Institute of
  Real Estate Management. Income Expense
  Analysis Reports.

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Measures of Investment Performance Based on Cash
Flow Projection

• NPV PV of all CFs - Initial Cash Outlay
• Profitability Index __PV of all CFs___
• Equity Investment
• IRR Discount rate that causes PV of all CFs to
  equal initial cash outlay.
• MIRR IRR when cash inflows have been reinvested
  at a safe rate

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Abuses of DCF Analysis

• Mismatched growth rates between rental income and
  expenses.
• Failure to consider rental concessions and
  effective rents.
• Absence of lease-by-lease analysis in properties
  encumbered by long-term leases.
• Figures that project that expense recovery income
  will increase at the same growth rate as other
  expenses in a property encumbered by gross leases
  with expense stops.

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• Projections for vacancy and collection losses
  that are not synchronized with market conditions.
• Use of operating expense categories that do not
  include all cost items. Common omissions are
  tenant improvements and leasing commissions.
• Use of ending capitalization rates that are lower
  than starting capitalization rates. Reversion
  capitalization rates should be related to the
  propertys age and remaining economic life.
• Underestimation of sales and other reversion
  costs.
• Use of an inappropriate internal rate of return
  (discount rate).

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Risk AnalysisAll real estate investment
analysis is risk analysis.

• Types of risk
• Business risk
• Financial risk
• Liquidity risk
• Inflation risk
• Management risk
• Interest Rate risk
• Legislative risk
• Environmental risk

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Risk Analysis Techniques

• Sensitivity Analysis What if Analysis?
• Change one assumption at a time
• Consider scenarios (but, most likely, worst case)
• Partitioning the IRR
• Monte Carlo Simulation

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TAXES

• Most income-producing real estate investments are
  Held for use in trade or business - Section 1 2
  3 1 Assets.
• Taxable IncomeNOI-Interest-Depreciation,
• isnt equal to
• BTCF NOI - Debt Service

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Depreciation

• A method of allocating the cost of a wasting
  asset over its estimated useful life.
• Depreciation deductions can be claimed as a tax
  deduction on real estate improvements (not land),
  regardless of whether the market indicates an
  increase in the value of the property.
• The deductions reduce taxable income without any
  real cash payment.
• Depreciation deductions serve to reduce the
  adjusted tax basis of property so, upon a
  resale, there will be a greater capital gain on
  which a tax is due.

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Capital Gain

• Net Sales Proceeds - Adjusted Basis Taxable
  Gain (loss)
• Adjusted Basis Original Basis (cost of land,
  improvements, acq. installation fees)
  Capital Improvements - Accumulated Depreciation.

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Current Capital Gain Tax Rates

• Essentially, the new law reduces the top tax rate
  on capital gains to 20 (from 28) for
  investments you hold more than 5 yrs.
  Investments you hold more than 5 yrs. will be
  taxed at 18 if you acquire them after 2000, or
  if they are marked to the market.

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Passive Losses

• Since 1986 income loss from all sources,
  including Real Estate, are divided into 3
  categories
• Active Income
• Wages
• Salaries
• Portfolio Income
• Interest
• Dividends
• Passive Income
• Trade or business in which the investor does not
  materially participate
• Rental activities
• Limited partnership activities

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Passive Activity Loss Limitation (PALL)

• These income classifications are very important
  because in general, passive losses cannot be used
  to offset income from another category.
• One special exception applies to individual
  rental property owners (other than limited
  partners). These investors are allowed to offset
  active income with up to 25,000 of passive
  activity losses (to the extent such losses exceed
  income from passive activities) from rental real
  estate activities in which the individual
  actively participates. (cont.)

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• (cont.)
• In general, the individual must own a 10 or
  greater interest in the activity and be involved
  in management decisions, such as selection of
  tenants and determination of rents, or must
  arrange for others to provide services (e.g. a
  property manager to manage the property on a
  day-to-day basis). The TRA phases out this
  special rule for individuals with adjusted gross
  incomes between 100,000 and 150,000. An
  individual with adjusted gross income in excess
  of 150,000 would receive no loss allowance

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• The Tax Act of 1993 provides some easing of the
  passive loss rules for real estate brokers,
  salespersons, and other real estate
  professionals.
• The major benefit is that eligible taxpayers can
  deduct unlimited real estate activity losses from
  active income and portfolio income.
• Under the new law, individuals must meet these
  requirements
• 1. More than half of all personal services they
  perform during the year are for real property
  trades or business in which they materially
  participate and
• 2. They perform more than 750 hours of service
  per year in those real estate activities.

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GATRE

• Real Estate Investment Analysis Computer Program
  can be found on the internet at
  http//www.mtsu.edu/jtimmons/gatre2000.xls
• Type in this address and save file to a disk,
  then open in Excel.