©2011 Cengage Learning

Chapter 16 ©2011 Cengage Learning SUMMARY OF REAL ESTATE INVESTMENT PRINCIPLES

Investing is defined as giving up present consumption in exchange for future benefits. Investing is opposite of consumption ©2011 Cengage Learning Basic Investment Principles

Key Investment Factors Return Management Taxability Liquidity Risk ©2011 Cengage Learning

Major Economic Characteristics of an Investment Return can be in the form of money or amenities. It may also vary over time & include reversion at transfer A series of payments over a period of time. A series of payments plus a large single payment. A large single payment. Management of the investment over the holding period. Investors are interested in the after tax return. Liquidity - real estate is considered illiquid. Property may be sold or borrowed against. ©2011 Cengage Learning

Investment Risks a) Financial b) Interest Rate c) Purchasing Power d) Social Change e) Legal Change ©2011 Cengage Learning

Real Estate as an Investment Normally produces slow recovery of profit & initial investment over a period of years. The process of forecasting money received annually, including resale, is called cash flow analysis. ©2011 Cengage Learning

Cash Flow The income received from an investment over a period of time. ©2011 Cengage Learning

Before-Tax Cash Flow—Economic Cash Flow Gross Scheduled Income Less Vacancy & Rent Cost Equals Gross Operating Income Less Operating Expenses Equals Net Operating Income (NOI) Less Debt Service Equals Before-Tax Cash Flow ©2011 Cengage Learning

Net Spendable Income = Before Tax Cash Flow - Taxes ©2011 Cengage Learning

Annual Cash Flow Analysis 1. Gross Scheduled Income ($800 X 20 units X 12 mos.) $192, Plus: Other Income ($300 X 12 mos.)+ 3, Equals: Total Gross Income$195, Less: Vacancy/Credit Loss (5%)- 9, Equals: Gross Operating Income$185, Less: Annual Operating Expenses- 43, Equals: Net Operating Expenses$142, Less: Annual Debt Service-126, Equals: Before-Tax Cash Flow$16,350

©2011 Cengage Learning Tax Benefit Analysis 10. Net Operating Income (Line 7)$142, Less: Interest (Loan 1)-119, Less: Interest (Loan 2)0 13. Less: Cost Recovery (Depreciation)- 38, Equals: Real Estate Taxable Income or$ Equals: Estimated Allowable Loss (If Loss)$ 16. Times: Tax Bracket (times Line 14 or 15)X Equals: Taxes Saved or Paid$ 5,981 Net Spendable Income 18. Before- Tax Cash Flow (Line 9)$ 16, Plus/Less Taxes Saved or Paid (Line 17)+ 5, Equals: Net Spendable Income (After- Tax Cash Flow)$ 22,331

Rental Real Estate Taxable income can represent an income or loss Passive income and loss rules ©2011 Cengage Learning

After Tax Cash Flow Net spendable income Plus or minus the taxes saved or paid ©2011 Cengage Learning

Ownership Period Analysis Investment in large properties means a higher degree of analysis. Multiyear analysis is used with the cash flow projected for each year of the estimated holding period. ©2011 Cengage Learning

Net Spendable Income Includes the Net Sale Proceeds Called reversion by appraisers ©2011 Cengage Learning

Estimated Net Sales Proceeds Resale price Minus seller closing costs Minus loan balances Minus capital gain taxes Equals Net Sale Proceeds ©2011 Cengage Learning

Cash Flow Analysis Estimate the first year’s Net Spendable Income (After- Tax Cash Flow). Estimate each subsequent year’s Net Spendable Income for the holding period Estimate the net sale proceeds. ©2011 Cengage Learning

Key Economic Issues Offering price Amount of the cash investment Rate of return on the cash investment ©2011 Cengage Learning

Techniques of Investors to Determine Purchase Price Gross Rent Multiplier Asking Price / Gross Scheduled Income =Gross Rent Multiplier Capitalization Rate Net Operating Income (NOI) / Asking Price = Capitalization Rate Price Per Square Foot ©2011 Cengage Learning

Rate of Return on cash invested Rate of Return for the first year cash flow Rate of Return for the holding period – Internal Rate of Return (IRR) – Financial Management Rate of Return (FMMR) ©2011 Cengage Learning

First-year before-tax cash on cash rate First-Year Before-Tax Cash Flow Cash Invested First-Year Before-Tax Cash-on-Cash Rate = Refer to the 20-Unit apartment case study shown as figure 16.1; the Before-Tax Cash Flow is $16,350, and the cash invested is $500,000; thus: $16,350 Before-Tax Cash Flow $500,000 Cash Invested 3.27% Before-Tax Cash-on-Cash Rate =

©2011 Cengage Learning After-tax cash rate First-Year Net Spendable Income Cash Invested First-Year After-Tax Cash-on-Cash Rate = Refer to the 20-Unit apartment case study; the Net Spendable Income is $22,331, and the cash invested is still $500,000; therefore, the After-Tax Cash-on-Cash Rate is: Net Spendable Income $22,331 Cash Invested $500, % After- Tax Cash on Cash Rate =

©2011 Cengage Learning Investing is defined as giving up present consumption in exchange for future benefits. Give it a try. You might like it or better explain it to others!