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Investments: Analysis and Behavior Chapter 20- Real Estate and Tangible Assets ©2008 McGraw-Hill/Irwin.

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Presentation on theme: "Investments: Analysis and Behavior Chapter 20- Real Estate and Tangible Assets ©2008 McGraw-Hill/Irwin."— Presentation transcript:

1 Investments: Analysis and Behavior Chapter 20- Real Estate and Tangible Assets ©2008 McGraw-Hill/Irwin

2 20-2 Learning Objectives Understand the investment characteristics of owning real property. Know the risks of income property. Be able to appraise real estate value. Utilize real estate securities in a portfolio. Learn how to invest in gold.

3 20-3 Real Property Financial Assets Investment instrument issued by a corporation, government, or other organization which offers legal rights to debt or equity cash flow. Real Property Land and the buildings or other objects permanently affixed to the land. U.S. Household Assets… Year-end 2004 (in billions) % of Total Assets Tangible Assets $ 25, % Real Estate21, % Consumer durable goods3, % Financial Assets$ 29, % Deposits5, % Bonds2, % Stocks and mutual funds10, % Pension funds10, % Equity in noncorporate business$ 6, % Total Assets$ 61, %

4 20-4 Real Estate Characteristics Income property Real estate bought for the purposes of generating rental income. Raw land Unused land with no improvements Improvements The buildings and structures constructed on a property. Buying and Selling Illiquid Real estate agent 6% commission

5 20-5 Home Ownership House Price Index (HPI) US Office of Federal Housing Enterprise Oversight How do you create an index with heterogeneous assets that trade infrequently? Sale and refinance data bases of Fannie Mae and Freddie Mac US (5.97%), California (8.6%), Kansas (4.3%)

6 20-6 Income Property Cash flow is important for income property investing! Know the revenue determinants Rental income, vacancies, collection losses Know the cost determinants Expenses, utilities, insurance, property taxes Assessed value (% of market value) Tax rate

7 20-7 Cash Flow Determinates of Income Property Revenue Ideal Rental Income IRI Vacancy and Collections Losses- VC Miscellaneous Income+ MI Gross Income GI Costs Operating Expenses OE Maintenance Expenditures ME Utilities U Insurance I Property Taxes PT Total Costs TC Net Operating Income (GI – TC) NOI Financing Mortgage Payment MP Cash Flow (GI – TC – MP) CF

8 20-8 Example: An investor is examining a rental property listed for sale. The investor is mostly concerned about the cash flow of the property. The property has five apartments that can each be rented for $750 per month. A 10% vacancy and collection loss rate is expected. Operating expenses and maintenance expenses are estimated to be $3,000 and $3,800, respectively. Utilities paid by the owner will be $2,600 and insurance and taxes are predicted to be $7,100. If the investor can put 20% down on the $250,000 and obtain a 30-year mortgage at 7.5%, what is the cash flow of property?

9 20-9 The annual mortgage payment can be computed with a financial calculator. Use the number of periods as 360 (=30 × 12), interest rate of (=7.5% ÷ 12), present value of $200,000 (=0.80 × $250,000), and future value of 0. The monthly payment solution is $1,398. This is $16,781 annually. The cash flow of the property is therefore: Cash FlowComputation Ideal Rental Income$45,000= $750×5×12 – Vacancy and Collection Loss $4,500= $45,000×0.10 = Gross Income$40,500 – Operating Expenses $3,000 – Maintenance Expenses $3,800 – Utilities $2,600 – Insurance & Taxes $7,100 = Total Costs$16,500 = Net Operating Income (NOI)$24,000 – Mortgage Payment$16,781 = Cash Flow $7,219

10 20-10 Real Estate Valuation Valuing real estate is called appraisal. Discounted Cash Flow Method Converts expected cash flow and price appreciation to a present value Comparable Transactions Method Uses the transaction prices of similar properties to estimate value.

11 20-11 Quick estimate of income property value Direct capitalization Similar to using the P/E ratio to evaluate a stocks value Find the capitalization rate, R, from recent property sales and the first year NOI: Then use it to estimate the propertys value:

12 20-12 Discounted Cash Flow Method Net Operating Income (NOI) is used as the annual cash flows. Discount rate, k, uses the capitalization rate and property growth rate, g: Terminal value: Discount equation:

13 20-13 Example: An investor with a five year holding period, estimates the NOI each year as $20,770, $22,001, $23,300, $24,671, and $26,116. The capitalization rate for similar properties was computed to be 10.5%. If real estate is expected to appreciate at 4% per year, what is the discounted cash flow value of the property? Solution First compute the discount rate: k = R + g = 10.5% + 4% = 14.5%. Second, compute the terminal value. Remember that selling a property involves a 6% commission: TV = (NOI5 / R) × (1 – 0.06) = ($26,115 / 0.105) × (1 – 0.06) = $233,791.

14 20-14 Lastly, compute the discounted cash flow value: If the property is listed for less, it is undervalued and would be a good value to purchase.

15 20-15 Comparable Transactions Method 3 steps Find sale transactions of comparable properties Similar location, location, location Compute the final adjusted comparable price for each transaction Adjust for differences in bedrooms, bathrooms, lot size, time from sale, etc. Reconcile final adjusted prices to estimate the indicated value Average, median, etc.

16 20-16 Real Estate Securities Securities can be issued that represent ownership in portfolios of real estate properties: Real Estate Investment Trusts (REITs) Equity REITs Mortgage REITs Hybrid REITs Real Estate Mutual Funds Real Estate oriented companies

17 20-17 Table 20.5 Return Characteristics of REIT Categories, 1972 to 2005 Equity REITsMortgage REITsHybrid REITs Average Annual Return =14.66%10.95%12.06% Standard Deviation =16.72%30.43%26.84% Minimum =-21.40%-45.32%-52.22% Median =17.18%13.36%16.92% Maximum =47.59%77.34%56.19%

18 20-18 Investing in Gold U.S. individuals were banned from owning hold until Except jewelry Now you can invest in gold: Gold coins Gold bars Gold mining stocks Gold mutual funds Gold Exchange Traded Fund

19 20-19

20 20-20 Gold has not been a very good investment, but it has been uncorrelated with stock returns. Table 20.6 Gold Returns and Stock Returns, 1976 to 2005 Annual Gold ReturnS&P500 Return Average =6.2%14.6% Standard deviation = 27.60%15.96% Coefficient of variation = Correlation =-0.089

21 20-21 Trading Gold Coins One ounce gold coins Other sizes available too Gold quality (22 karat versus 24 karat) Gold coin price: Coin price = value of gold + numismatic value + dealer spread Numismatic value is the amount of premium attributed to collector attributes. The scarcity of the coin and its appearance (fine, extra fine, proof, etc.) are the attributes that coin collectors evaluate. Gold investors have little interest in paying premiums for obtaining gold. Therefore, gold bugs tend to buy common gold coins with no numismatic value. British Sovereign (0.235 Troy oz.)

22 20-22 Art and Collectibles Art derives its value from the demand of people who want to own it. Supply is fixed No new Rembrandts or Van Gogh's Supply is increasing New artists and new works Art and collectibles are traded in auctions

23 20-23 Auctions Two largest international auction firms: Christies Sothebys Hundreds of millions of dollars in art and collectibles are sold every day.

24 20-24 Auction Costs Buyers premium Commonly 20% Sellers commission costs Variable 10% fee on the first $100,000 of the sale, 8% fee on the next $150,000 of value, 7% on the next $250,000, 5% on the next $500,000, and so on

25 20-25 Beware the Fad Investment Beanie Baby craze of the late 1990s Beanie Babies are small beanbag animals made by Ty Inc. Cute names like Roary the lion and Bucky the beaver Beanies cost less than a dollar to make and retailed for about $5. As they became popular, children tried to collect them all. Adults insisted that one day their collections would be valuable. Collectors bought retired Beanies for $10 or $20 dollars and resold them for $50. Rare Beanies such as Peanut, the Royal Blue Elephant, sold for over $4,000 at online auctions. And Derby, the Horse, was once valued at $4,500. Parents planned to send their children to college on the their investment in Beanie Babies. Then, one day the demand dried up. People who had bought dozens of beanies at inflated prices all tried to sell at once. As collectors became sellers, the price of the toys plummeted. In 2005, a search for Beanie Babies on eBay produced nearly 15,000 auctions of retired Beanies. Many were being sold in groups. A group of 19 animals were offered at a minimum bid of $7.49––there were no bids. A mint condition Peanut was offered for $2.99there were no takers. From a price of $5, up to thousands, and back down to $3. The great Beanie Baby bubble had burst! Baseball cards, Beatle memorabilia, POGs, etc.

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