Analyzing Income Producing Properties

1
Chapter 16

• Analyzing Income- Producing Properties

2
Why forecasting?

• Forecast not guess
• Maximize investment dollars
• Locate profits in projects that others overlook

3
Advantages of Real Estate Investment

• Cash Flow from Operations (After Tax Cash Flow
  ATCF)
• Appreciation (After Tax Equity Reversion ATER)
• Portfolio Diversification
• Financial Leverage
• Tax Benefits

4
Cash Flow

• After Tax Cash Flow (ATCF)
• Income
• Revenue minus Costs
• Revenue Includes
• Rent
• Extras
• e.g. laundry services, covered parking
• Expense Escalators
• In commercial real estate
• Tenant contracted to pay increase in costs (e.g.
  utilities)
• Costs Include
• Debt, insurance, taxes, maintenance, etc.

5
Appreciation

• After Tax Equity Reversion (ATER)
• Equity reversion return of funds originally
  invested in the property plus any increase in
  property value.

6
Portfolio Diversification

• Real Estate investments can diversify your entire
  portfolio of investments
• - Stocks, bonds, etc.
• Spread investment risk over different investment
  vehicles.
• Some like Real Estate because it is tangible and
  long-term.

7
Financial Leverage

• Other peoples money
• - Down payment and borrow the remainder
• Magnifies investment returns
• A. Purchase a 100,000 office with 100 equity or
• B. Use the 100,000 to put down 10 on a
  1,000,000 office building and borrow 900,000.
• assume incomecosts
• After 1 year, both properties increase 10 and
  are sold.
• 110,000-100,000 10,000 profit / 100,000
  investment 10 return
• 1,100,000 - 1,000,000 100,000 profit /
  100,000 investment 100 return

8
Tax Benefits

• Write losses against other income

9
Disadvantages of Real Estate Investment

• large capital requirements
• risk
• Financial risk (Large Capital requirements)
• Liquidity risk Discounts on quick sales.
• Purchasing power risk Tie money up for large
  periods of time.
• Business risk (Changing market conditions) R.E.
  requires specialized knowledge of markets and
  transactions affecting specific sectors.

10
The Wealth Maximization Objective

• investment can be defined as present sacrifice in
  anticipation of future benefit
• investment decision making involves comparison of
  the expected future benefits with the costs of
  the investment
• investors ultimate goal is to maximize their
  wealth by choosing investments that are worth
  more than they cost
• the NPV decision rule employs the wealth
  maximization concept
• If faced with two competing projects, one that
  offers an NPV of 1,501 and another that offers a
  NPV of 703, the investor would prefer the one
  with the largest NPV.

11
The Discounted Cash Flow Model

• To apply the NPV rule in practice, real estate
  investors may use the following discounted cash
  flow model.

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After Tax Cash Flow (ATCF)

• Potential Gross Income
• -Vacancy Collection Loss
• -Operating Expenses
• -Debt Service
• -Taxes
• After Tax Cash Flow (ATCF)

13
After Tax Equity Reversion (ATER)

• Gross Sale Price
• -Selling Expenses
• -Loan Payoff
• -Taxes
• After Tax Equity Reversion (ATER)

14
Discounted Cash Flow Model

• T
• NPVS ATCFt ATERT - Initial
• t1 (1i)t (1i)T Equity

15
Highlights of Property Search (from p.358-359)

• Individual Investor
• Limited Funds
• Familiar Neighborhood
• Rental Expense Knowledge
• Talk to lenders
• Estimate future increases in expenses and income

16
After Tax Cash Flow (ATCF)

• Potential Gross Income (PGI)
• -Vacancy Credit Losses (VCL)
• Effective Gross Income (EGI)
• -Operating Expenses (OE)
• Net Operating Income (NOI)
• -Annual Debt Service (ADS)
• Before Tax Cash Flow (BTCF)
• -Taxes
• After Tax Cash Flow (ATCF)

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Calculating Taxes for ATCF

• Net Operating Income (NOI)
• -Interest Expense (INT)
• -Depreciation Deduction (DEP)
• Taxable Income (TI)
• x Marginal Tax Rate (MTR)
• Taxes from Operations (Taxes)

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After Tax Equity Reversion (ATER)

• Sale Price
• -Sale Expenses
• Net Sale Price
• -Loan Balance
• Before Tax Equity Reversion
• -Taxes
• After Tax Equity Reversion

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Calculating Taxes for ATER

• Net Sale Price
• -Purchase Price
• Accumulated Depreciation
• Taxable Gain
• x Marginal Tax Rate
• Taxes

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Example of the DCF Model

• Consider a four-unit apartment complex that is
  offered for sale at 255,000.
• The units are expected to rent for 725 per month
  in the first year (increasing at 5 per year)
  with an annual vacancy rate of 4.
• The property is expected to have operating
  expenses of 9,900 in the first year (increases
  at 3 per year).
• A loan is available at 70 of the purchase price
  for 9 interest with monthly payments over 25
  years.
• The investor believes property value will
  increase at the annual rate of 5 per year.
• The investor faces a tax rate of 28.
• The investor expects a five year holding period.
• Is this a good deal based on the NPV rule at a
  required rate of return of 16?
• See cash flow calculations in Tables 16.3 and 16.4

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End Chapter 16

• Questions?