Chapter 11 Introduction to Investment Concepts

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Chapter 11Introduction to Investment Concepts
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Major Topics

• Investor Objectives
• Sources of real estate returns
• Introduction to Cash Flow Analysis
• What we mean by direct and indirect real estate
  investment
• Returns on labor versus returns on investments
• Sources of real estate risk
• Measuring real estate risk
• Investment alternatives within the real estate
  asset class
• Creative advantages of partnerships and
  investment structuring

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Introduction What do Investors Want?

• Investors seek current or future income or
  sometimes both
• Future income might be used for personal
  consumption at a later date or for future
  generations
• Aggressiveness of investor depends on risk
  preferences

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Sources of Real Estate Returns

• Cash Flow
• Comes from the collected rents less the operating
  expenses and debt service
• Usually received monthly
• Tax Shelter or Postponement
• Deductible non-cash items include depreciation,
  amortization of points paid for financing and
  possibly tax credits for specialized government
  programs

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Sources of Real Estate Returns (Contd.)

• Equity Buildup from Mortgage Repayment
• Can occur from mortgage principal repayment
• Equity Gains from Price Appreciation
• Sources of appreciation
• Inflation
• Real price changes

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Timing of Returns

• From a timing perspective, we can take the
• four types of returns listed above and reduce
• these to only two
• Cash Flow (after tax)
• The before tax cash flow plus or minus tax
  savings or taxes due can be treated as one final
  source of returns during the operational stage of
  ownership
• Residual Cash Flow (after tax)
• The appreciation and equity buildup from
  mortgage repayment both result in before tax
  proceeds at the time of sale

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Introduction to Cash Flow Analysis

• Gross Rent or Potential Gross Income
• Effective Gross Income
• Operating Expenses
• Net Operating Income or NOI
• Debt Service

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Important Terms (Contd.)
Gross Rent Less Vacancy Effective Gross
Income Less Operating Expenses Net Operating
Income Less Debt Service Cash Flow (before tax)

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Current Yield and Total Return

• Current Period Return
• Periodic Returns
• IRR (Internal rate of Return)

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Levered versus Unlevered Investments

• The term levered or leveraged refers to the
  ability of an investor to increase the returns on
  equity through the use of debt
• This occurs whenever the cost of debt is less
  than the total return on the asset, known as
  positive leverage
• Most investors buy stock without direct debt
• When debt is used, it is known as buying on
  margin and more aggressive investors do use
  margin accounts

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Sources of Real Estate Risk

• In general, the risk and returns are greater for
  real estate than bonds, and less for real estate
  than stocks
• There may be times when stock returns are less
  than real estate/ bond returns

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Sources of Risk (Contd.)

• Economic Risks
• Extremely Important!
• No control
• Business Risk or Management Risks
• More controllable than economic risks
• Financial Risk
• Leverage - most controllable decision
• Liquidity Risks
• Significant for all direct investments
• Political Risks
• Over time has become more significant
• No control

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Risk Analysis at the Property Level

• Sensitivity Analysis Cash flow pro-formas are
  developed and then ranges of uncertain variables
  are tested for their impact on key financial
  ratios and cash flow
• Simulation Analysis When an entire range of
  probable estimates are tested for several
  variables at one time, and the resulting
  distributions of probable results generated

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Managing Risk

• Risk management is accomplished through
  negotiation and contracting, or in some cases the
  purchase of insurance or hedge investments
• Economic risks, based on expected market demand
  and supply, are for the most part uncontrollable
  
• Yet, the risk of a given tenant renewing a lease
  that expires in the future might be managed
  through negotiation
• Financial risks might also be managed by the use
  of more or less leverage

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Managing Risk (Contd.)

• More leverage or debt as a proportion of the
  total purchase price will result in greater
  variability of returns
• Risks that cannot be shifted must simply be
  priced
• That is, the investor must figure out how much
  extra expected return they require in order to
  take on the additional risk, known as risk
  premiums

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Risk Premiums Example

• Assume the following current capital market
• rates and investment specific required premia
• Risk free short term real rate (prior to
  inflation) .015 or 1.5 Rf
• Expected annual inflation .03 or 3.0 EI
• Liquidity risk premium .015 or 1.5 LP (for
  the difficulty of quickly selling real estate)
• Economic, business and political risks .04 or
  4.0
• Total Return
• R RfEILPother risk premia 10

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Portfolio Perspectives

• Portfolio risk is based on the estimate of return
  volatility for an entire basket or investments
• Combining two or more risky investments generally
  will lower total portfolio risk
• This is a result of the less then perfect
  correlation of the individual asset returns,
• When the individual assets show negative
  correlations over specific investment horizons
  then the total portfolio risk can be drastically
  reduced

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Market Efficiency and Real Estate

• Markets are efficient to the extent that all of
  the available information is reflected in the
  current market prices
• Efficient markets have no trading (buying or
  selling) based on inside information
• It is still possible to achieve above average
  market returns

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Creative Advantages of Partnership and Investment
Structuring

• One advantage of real estate versus other types
  of assets is that even a single investment can be
  structured to achieve individual investor
  objectives
• Example one investor may want current returns
  and another may want future wealth
• By structuring an investment with various
  contractual interests (securities or mortgages)
  that direct the return priorities to different
  investors multiple investors can achieve their
  objectives

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END