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McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Investments in Real Assets Chapter 20 Prof. Hagen Sinodoru,

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Presentation on theme: "McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Investments in Real Assets Chapter 20 Prof. Hagen Sinodoru,"— Presentation transcript:

1 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Investments in Real Assets Chapter 20 Prof. Hagen Sinodoru, MBA Banking and Finance www.sinodoru.com St. Petersburg State University of Economics and Finance

2 20-2 Objectives Understand the advantages and disadvantages of real assets Understand the advantages and disadvantages of real assets Explain the portfolio significance of the correlations between real estate and other assets Explain the portfolio significance of the correlations between real estate and other assets Explain the characteristics of investing in real estate Explain the characteristics of investing in real estate Discuss the various forms of financing for real estate investments Discuss the various forms of financing for real estate investments Explain the traditional appeal of precious metals as a form of investments Explain the traditional appeal of precious metals as a form of investments Understand the factors that influence the value of collectibles Understand the factors that influence the value of collectibles

3 20-3 Investments in Real Assets Advantages and Disadvantages of Real Assets Advantages and Disadvantages of Real Assets Real Estate as an Investment Real Estate as an Investment Real Estate Returns and Correlations Real Estate Returns and Correlations Valuation of Real Estate Valuation of Real Estate Forms of Real Estate Ownership Forms of Real Estate Ownership Gold and Silver Gold and Silver Precious Gems Precious Gems Other Collectibles Other Collectibles Appendix 20A: A Comprehensive Analysis for Real Estate Investment Decisions Appendix 20A: A Comprehensive Analysis for Real Estate Investment Decisions

4 20-4 Real Assets Real assets are tangible assets that may be: Seen Seen Felt Felt Held Held Collected Collected Real assets during inflationary environments have at times outperformed financial assets. Examples: Real estate Real estate Gold and silver Gold and silver Diamonds Diamonds Coins, stamps, and antiques Coins, stamps, and antiques

5 20-5 Wealth Indices of Investments in Equity REITs and Basic Series Index (Year-End 1971= $1)

6 20-6 Real Assets - Advantages An inflation hedge An inflation hedge Hedge against unknowns, fears Hedge against unknowns, fears Effective vehicle for diversification Effective vehicle for diversification Improves portfolio risk-return alternatives Improves portfolio risk-return alternatives Low correlation with monetary assets Low correlation with monetary assets May provide psychic pleasure May provide psychic pleasure

7 20-7 Real Assets - Disadvantages Lack of large, liquid, efficient markets Lack of large, liquid, efficient markets Larger commissions & spreads compared to securities Larger commissions & spreads compared to securities No current income except from real estate No current income except from real estate Storage and insurance costs Storage and insurance costs Unit costs may be high Unit costs may be high Cyclical hysteria or overreactions periodically occur (timing may be tricky) Cyclical hysteria or overreactions periodically occur (timing may be tricky)

8 20-8 Real Estate as an Investment About half of U.S. households own real estate as a home or investment About half of U.S. households own real estate as a home or investment Brokerage and investment firms have entered the market to: Brokerage and investment firms have entered the market to: Buy Buy Sell Sell Finance Finance Syndicate property Syndicate property Real estate has increased to 10% of pension fund portfolios today Real estate has increased to 10% of pension fund portfolios today

9 20-9 Real Estate as an Investment Investments may include: Homes Homes Duplexes Duplexes Apartments Apartments Offices Offices Industrial buildings Industrial buildings Shopping centers Shopping centers Hotels and motels Hotels and motels Undeveloped land Undeveloped land

10 20-10 Real Estate Returns and Correlations The Tax Reform Act of 1986 Substantially increased wait time to take full advantage of real estate tax deductions Substantially increased wait time to take full advantage of real estate tax deductions Severely restricted writing-off of paper real estate losses by passive investors against other forms of income Severely restricted writing-off of paper real estate losses by passive investors against other forms of income Made real estate investment less attractive

11 20-11 Real Estate Returns and Correlations Negative impact of tax reform on real estate blamed for declining economic conditions of late 1980s and early 1990s 1. Fewer new properties were developed 2. Gluts in office space/apartments shrank 3. Rents increased on existing properties 4. Eventual higher real estate evaluations

12 20-12 Real Estate Returns and Correlations Less supply plus higher demand equals higher real estate values Less supply plus higher demand equals higher real estate values Historically low interest rates also contributed to an increase in demand Historically low interest rates also contributed to an increase in demand Bubble eventually burst in 2007 Bubble eventually burst in 2007 An 18 month recession followed An 18 month recession followed Second worse since Great Depression Second worse since Great Depression 10% unemployment 10% unemployment

13 20-13 Real Estate Returns and Correlations What are the long-term portfolio implications of holding real estate? What are the long-term portfolio implications of holding real estate? Real estate has a low correlation with stocks/bonds Real estate has a low correlation with stocks/bonds Low correlations could increase portfolio return and reduce portfolio standard deviation Low correlations could increase portfolio return and reduce portfolio standard deviation Historically, only small cap stocks have out performed real estate on a risk-adjusted basis Historically, only small cap stocks have out performed real estate on a risk-adjusted basis Real estate also provides steady cash flow Real estate also provides steady cash flow

14 20-14 Valuation of Real Estate The Cost Approach The Cost Approach Comparative Sales Value Comparative Sales Value The Income Approach The Income Approach In most cases, a final value may be determined from a combination of the three approaches.

15 20-15 Valuation of Real Estate: The Cost Approach Easy for new property Easy for new property Harder for older buildings Harder for older buildings Poor location makes building worth less than its replacement cost Poor location makes building worth less than its replacement cost Economic conditions influence value Economic conditions influence value Cost to replace an asset at current prices used as the value of real estate

16 20-16 Valuation of Real Estate: Comparative Sales Value True comparables may be difficult to find True comparables may be difficult to find Combine sale values of several comparable properties to average out differences Combine sale values of several comparable properties to average out differences Find value using comparable property prices in the neighborhood

17 20-17 Valuation of Real Estate: The Income Approach Annual net operating income Capitalization rate (Cap rate) = Valuation The stream of net earnings generated by an income-producing property capitalized as a measure of that propertys worth

18 20-18 Valuation of Real Estate: The Income Approach Annual net operating income Capitalization rate (Cap rate) = Valuation Future realistic values of annual rentals minus expenses such as property taxes, insurance, … The rate of return required by investors in similar-type investments

19 20-19 Valuation of Real Estate: The Income Approach Example: Projected annual net operating income = $17,500 Market capitalization rate = 10% Value based on this approach: $17,500 0.10 0.10 = $175,000

20 20-20 Valuation of Real Estate: The Income Approach Income approach helpful but overly simplistic: Annual NOI* changes over time Annual NOI* changes over time Difficulty of choosing a capitalization rate Difficulty of choosing a capitalization rate * NOI = Net operating income

21 20-21 Valuation of Real Estate Benefits of combining the 3 approaches: Can use insights provided by each individual approach Can use insights provided by each individual approach Can overcome some limitations involved in using only single approach Can overcome some limitations involved in using only single approach

22 20-22 Financing of Real Estate Types of Mortgages Fixed-Payment Mortgage Most frequently used Adjustable Rate Mortgage (ARM) Graduated Payment Mortgage (GPM) Shared Appreciation Mortgage (SAM) Other Forms of Mortgages (equity participation arrangement)

23 20-23 Forms of Real Estate Ownership Ownership of real estate can take many forms: Individual or Regular Partnership Individual or Regular Partnership Syndicate or Limited Partnership Syndicate or Limited Partnership Real estate investment trust (REIT) Real estate investment trust (REIT)

24 20-24 Forms of Real Estate Ownership Individual ownership or regular partnership Simplest way from a legal viewpoint Simplest way from a legal viewpoint Take advantage of personal knowledge of local markets and changing conditions to enhance returns Take advantage of personal knowledge of local markets and changing conditions to enhance returns Well-defined center of responsibility often leads to quick corrective actions Well-defined center of responsibility often leads to quick corrective actions Often lacks ability to pool adequate capital to engage in large-scale investments Often lacks ability to pool adequate capital to engage in large-scale investments Often lacks expertise to develop wide range of investments Often lacks expertise to develop wide range of investments Unlimited liability for the investor Unlimited liability for the investor

25 20-25 Forms of Real Estate Ownership Syndicate or Limited Partnership General partner forms partnership General partner forms partnership Unlimited liability Unlimited liability Responsible for managing property Responsible for managing property Limited partners purchase participation units Limited partners purchase participation units Liability limited to initial investment Liability limited to initial investment No responsibilities – merely investors No responsibilities – merely investors Front-end fees to General Partner Front-end fees to General Partner 5-25% 5-25% Blind pool or are specific projects identified? Blind pool or are specific projects identified? Public offering Public offering Involves larger total amounts Involves larger total amounts SEC registration SEC registration Private offering Private offering Local in scope Local in scope Maximum 35 investors Maximum 35 investors Secondary (resale) markets exist but dealer spreads and commissions high Secondary (resale) markets exist but dealer spreads and commissions high

26 20-26 Forms of Real Estate Ownership Real Estate Investment Trust Similar to mutual funds or investment companies Similar to mutual funds or investment companies Trade on organized exchanges or over-the-counter Trade on organized exchanges or over-the-counter Pool investor funds Pool investor funds No minimum investment other than cost of share No minimum investment other than cost of share Most liquid type of real estate investment Most liquid type of real estate investment Large secondary market Large secondary market

27 20-27 Forms of Real Estate Ownership Real Estate Investment Trust (continued) To qualify, trust must receive 75% of income from real estate To qualify, trust must receive 75% of income from real estate Rents Rents Interest on mortgage loans Interest on mortgage loans Must distribute at least 95% of income as cash dividend Must distribute at least 95% of income as cash dividend Equity Trusts Equity Trusts Buy, operate, and sell real estate as investment Buy, operate, and sell real estate as investment Mortgage Trusts Mortgage Trusts Make long-term loans to real estate investors Make long-term loans to real estate investors Hybrid Trusts Hybrid Trusts Engage in activities of both equity and mortgage trusts Engage in activities of both equity and mortgage trusts There are more than 400 REITS in existence There are more than 400 REITS in existence

28 20-28 Gold and Silver Precious metals Precious metals Most volatile of real asset investments Most volatile of real asset investments Historically, gold and silver: Historically, gold and silver: Move up in value during troubled times Move up in value during troubled times Decline in value during stable & predictable periods Decline in value during stable & predictable periods

29 20-29 Gold Major factors that drive up gold prices are: Fear of war Fear of war Political instability Political instability Inflation Inflation Different forms of gold ownership: Gold Bullion Gold Coins Gold Stocks Gold Futures Contracts Gold ETF (GLD)

30 20-30 Movement in Gold Prices

31 20-31 Silver Many of the same investment characteristics as gold Many of the same investment characteristics as gold Hedge against inflation Hedge against inflation Potential safe haven investment during troubled times Potential safe haven investment during troubled times Silvers1976198020062010 price per ounce$5$50$12$29

32 20-32 Silver Used for: Used for: Heavy industrial and commercial applications Heavy industrial and commercial applications Photography Photography Electronic Electronic Electrical manufacturing Electrical manufacturing Electroplating Electroplating Silverware and jewelry Silverware and jewelry Different forms of silver ownership: Different forms of silver ownership: Silver Bullion Silver Bullion Silver Coins Silver Coins Silver Futures Contract Silver Futures Contract Silver Mining Stocks Silver Mining Stocks

33 20-33 Precious Gems Diamonds Diamonds Rubies Rubies Sapphires Sapphires Emeralds Emeralds Gems appeal to investors because of their: Gems appeal to investors because of their: Small size Small size Easy concealment Easy concealment Great durability Great durability

34 20-34 Precious Gems Market knowledge is most important Market knowledge is most important Must either be an expert or deal with honest expert Must either be an expert or deal with honest expert Better to buy higher quality, smaller-carat diamond than lesser quality, higher-carat diamond Better to buy higher quality, smaller-carat diamond than lesser quality, higher-carat diamond

35 20-35 Other Collectibles Art Art Antiques Antiques Stamps Stamps Chinese ceramics Chinese ceramics Rare books Rare books Psychic pleasure as well as opportunity for profit Psychic pleasure as well as opportunity for profit

36 20-36 A Comprehensive Analysis for Real Estate Investment Decisions Appendix 20A

37 20-37 Valuation of Real Estate: A More Comprehensive Analysis Valuation of Real Estate: A More Comprehensive Analysis Any assets ultimate worth is based on the present value of its future cash flows

38 20-38 A More Comprehensive Analysis 1.Determine purchase price, size of mortgage, annual mortgage payment 2.Compute the net operating income for each year of the anticipated holding period 3.Translate this to annual cash flow during the holding period 4.Project the selling price of the property after the holding period 5.Discount the annual cash flows and the anticipated selling price after the holding period back to the present to determine the present value of the future benefits 6.Compare the upfront cash commitment to the present value of future benefits to determine if the property provides a positive net present value

39 20-39 1. Determine the Purchase Price & Financing Assume: Six-unit apartment complex Six-unit apartment complex Purchased for $180,000 Purchased for $180,000 Loan 80% of the value at 12% for 20 years Loan 80% of the value at 12% for 20 years The loan would be for $144,000 ($180,000 x 80%) The loan would be for $144,000 ($180,000 x 80%) Balance of $36,000 ($180,000 - $144,000) put up in cash Balance of $36,000 ($180,000 - $144,000) put up in cash From table below, annual mortgage payment for 20 years at 12% is $19,280 From table below, annual mortgage payment for 20 years at 12% is $19,280

40 20-40 2. Determine Net Operating Income (NOI) for each year Assume buyer intends to hold property for 4 years and then sell it. We can determine the value each year from the table below:

41 20-41 3. Determine the Annual Cash Flow Income from operations must be adjusted by nonoperating factors such as: Interest expense Interest expense Depreciation Depreciation Taxable income/losses Taxable income/losses Related taxes or tax shield benefits Related taxes or tax shield benefits Repayment of the mortgage Repayment of the mortgage

42 20-42 Table 20A-3 Subtracts depreciation and interest expense from net operating income to find taxable income or loss for each year Table 20A-3 Subtracts depreciation and interest expense from net operating income to find taxable income or loss for each year 3. Determine the Annual Cash Flow (cont.)

43 20-43 To the extent the investor is actively involved with the property, the losses during the first two years can be used as a tax shield (shelter) for other income as reflected in Table 20A-4 To the extent the investor is actively involved with the property, the losses during the first two years can be used as a tax shield (shelter) for other income as reflected in Table 20A-4 3. Determine the Annual Cash Flow (cont.)

44 20-44 Net Operating Income is combined with annual tax shield benefits or taxes owed & the annual mortgage payments to determine the total annual value of cash flow in Table 20A-5 Net Operating Income is combined with annual tax shield benefits or taxes owed & the annual mortgage payments to determine the total annual value of cash flow in Table 20A-5 3. Determine the Annual Cash Flow (cont.)

45 20-45 4. Project the Sales Price Property purchased for $180,000 Property purchased for $180,000 Appreciates 6% per year over 4 year period Appreciates 6% per year over 4 year period Sales value: $180,000 x 1.262* = $227,160 Sales value: $180,000 x 1.262* = $227,160 Net proceeds from selling the property after subtracting sales commission & fees of 7% Net proceeds from selling the property after subtracting sales commission & fees of 7% = $277,160 – (0.07 x $227,160) = $211,259 *Appendix A – Compound sum 4 periods at 6% the factor is 1.262

46 20-46 To the extent that the net proceeds exceed the book value of the property, a capital gains tax has to be paid: Book value =Purchase price of $180,000 Book value =Purchase price of $180,000 minus [4 years of depreciation: 4 x $5,096] $ 20,384 =$159,616 =$159,616 Capital gain = Net proceeds of sale $211,259 Capital gain = Net proceeds of sale $211,259 minus book value $159,616 = $ 51,643 = $ 51,643 4. Project the Sales Price (cont.)

47 20-47 Funds from sale = Net Proceeds $211,259 Funds from sale = Net Proceeds $211,259 minus Capital gains tax [15% x $51,643]$ 7,746 minus Capital gains tax [15% x $51,643]$ 7,746 = $203,513 = $203,513 From the funds from the sale, the investor must pay off the mortgage balance of $134,432 that exists after four years of repayments of principal: From the funds from the sale, the investor must pay off the mortgage balance of $134,432 that exists after four years of repayments of principal: Funds from sale$203,513 Payoff of mortgage - $134,432 Net cash flow (from sale) =$ 69,081 4. Project the Sales Price (cont.)

48 20-48 5. Determine Present Value of All Benefits If investors required rate of return on real estate investments is 12%, the present value of the future cash flows is $52,461. If investors required rate of return on real estate investments is 12%, the present value of the future cash flows is $52,461.

49 20-49 6. Compare Upfront Cash Payment to Benefits The Net Present Value of the Investment: $52,461Present value of future cash flows $52,461Present value of future cash flows - $36,000 Upfront cash investment - $36,000 Upfront cash investment = $16,461 Net present value Investment earns more than the required return of 12% and is attractive, earning about 22%. Caveat: Real estate is illiquid investment and almost the entire return here is based on the assumption of a 6% yearly increase in value

50 20-50 Financing of Real Estate An essential consideration in a real estate investment analysis is the cost of financing An essential consideration in a real estate investment analysis is the cost of financing Prior example: Prior example: Loan of $144,000 Loan of $144,000 Over 20 years Over 20 years At 12% interest At 12% interest Payments $19,280 Payments $19,280 Table 20–1 page 542 shows the effects of various interest rates on annual payments Table 20–1 page 542 shows the effects of various interest rates on annual payments


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