Chapter 10: Investment and Risk Analysis

1
Chapter 10 Investment and Risk Analysis

• Motivations for R/E Investment
• Return (cash flow)
• Appreciation (inflation hedge)
• Diversification
• Tax Benefits

2
Investment Styles or Strategies

• Sector Investing
• Contrarian Investing
• Market Timing
• Growth Investing
• Value Investing
• Strategy as to Size of Type
• Strategy as to Tenants
• Arbitrage Investing
• Turnaround Investing
• Trophy of Blue Chip Investing

3

• Projecting Cash Flows
• Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
• Rents 100 102 104 106
  108
• Vacancy 5 5 5 5
  5
• Net Rent 95 97 99
  101 103
• Op. Exp. 38 39 40 40 41
• NOI 57 58 59 61 62
• Usually include the debt service
• Debt Ser. 30 30 30 30 30
• Eq Div(BTCF) 27 28 29 31 32
• Equity Dividend Before Tax Cash Flow (BTCF)

4

• Common Investment Ratios
• Price per square foot (or price per acre)
• Capitalization Ratio NOI/Price
• Eq. Dividend Ratio Equity Dividend/Eq. Inv.
• Debt Coverage Ratio NOI/Debt Service
• Estimating the future sales price
• Projected inflation rate
• Projected cap rate
• Final Cash Flow
• Sales Price (estimated)
• Less Mortgage Balance
• Before Tax Cash Flow from Sale

5

• Measures of Investment Performance
• Net Present Value (NPV)
• Profitability Index PV of Cash Flow/EQ Inv.
• Internal Rate of Return (IRR)
• Adjusted (Modified) IRR Makes assumptions about
  how the cash flows are reinvested

6

• Example of Modified IRR
• Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
• NOI 57 58 59 61 62
• Debt Ser. 30 30 30 30 30
• BTCF 27 28 29 31 32
• Eq. Inv. -60
• IRR 38.2
• NPV(15) 50.5
• Calculate what each BTCF grows to _at_6
• - BTCFs 34 33 32.5 33 32
• - Total _at_ end of 5 yrs 164.5
• I 22.3 n5, PMT0 PV-60 FV 164.5
• Modified IRR (_at_6) 22.3

7
Risk Analysis

• Types of Risk in R/E Investment
• Business Risk
• Financial Risk Leverage risk
• Liquidity Risk cant sell the project
• Inflation Risk
• Management Risk
• Interest-Rate Risk
• Legislative Risk
• Environmental Risk

8
Sensitivity Analysis

• Change a single assumption at a time
• Scenarios
• Partitioning of IRR How much of return is due
  to operations and how much from capital gains
• Risk vs. Return

9
Real Estate Taxes

• Real Estate Taxes Interest are Deductible
• Principle residence and second home.
• Investment real estate
• Gain on Sale of Principle Residence is excluded
  from tax up to a max. of 250K (or 500K if MFJ).
  A principle residence may be sold no more than
  once every 2 years.

10
Calculation of Gain on Sale

• Sales Price
• Less Selling Expenses
• Net Selling Price
• Original Cost (or Basis)
• Plus Improvements
• Less Accumulated Depreciation
• Adjusted Basis
• Net Selling Price
• Less Adjusted Basis
• Gain on Sale

11

• Calculating Depreciation
• Residential Property 27.5 years, straight line
• Commercial Property 39 years, straight line
• Depreciate only building costs, not land.
• Passive loss rules
• Real estate income is defined by the tax laws as
  passive income.
• Passive losses can be offset only against passive
  gains.
• Exception 1 Middle income taxpayers (AGIlt120K)
  can deduct up to 25,000 of rental losses against
  regular income if they actively manage the
  property.
• Exception 2 R/E professionals can deduct
  passive rental losses against regular income.

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• Maximum capital gain rate on federal taxes is 20
  for assets held for at least 1 year.
• Investment Analysis Example
• Consider the purchase of an Apartment
  House
• (in 1.000s)
• Purchase Price 3,300
• Mortgage 2,600
• Equity 700
• NOI 570
• Cap Rate 17

13

• Calculating Before-Tax Cash Flows
• Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
• NOI 570 580 590 610 620
• Debt Ser. 500 500 500 500 500
• BTCF 70 80 90 110 120
• Sales Price 3,100
• Less Mortgage Balance (1,000)
• BTCF (from sale) 2,100

14

• After-Tax Cash Flows from Operations
• Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
• NOI 570 580 590 610 620
• - Interest 500 500 500 500 500
• - Dep. 60 60 60 60 60
• Taxable Inc. 10 20 30 50 60
• Tax (50) 5 10 15 25
  30
• BTCF 70 80 90 110 120
• Less Tax 5 10 15
  25 30
• ATCF 65 70 75 85 90

15

• Calculating After-Tax Cash Flow from Sale
• Yr 1 Yr 2 Yr 3 Yr 4 Yr 5
• Sales Price 3,100
• Less Mortgage Balance
  (1,000)
• BTCF (from sale) 2,100
• Now Calculate Taxable Gain
• Sales Price 3,100
• Original Cost Basis 3,300
• Less Accumulated Depreciation 300
• Adjusted Basis 3,000
• Taxable Gain (Price Adj Basis) 100
• Tax (20) 20
• After-Tax Cash Flow from Sale 2,080

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• Investment Analysis
• Yr 0 Yr 1 Yr 2 Yr 3
  Yr 4 Yr 5
• BTCF -700 70 80 90 110
  2,220
• ATCF -700 65 70 75 85 2,170
• Before-Tax IRR (BTIRR) 33.2
• After-Tax IRR (ATIRR) 31.6
• NPV Before-Tax (_at_15) 647
• NPV After-Tax IRR (_at_15) 586
• After-Tax Present Value of Equity _at_15 1,286
• Value of the Debt (Mortgage) 1,000
• Total Value of the Property 2,286

17
Homework

• Problems 10-2, 10-6 (pages 330 331)