Lecture 11 Introduction to Real Estate Investing

Types of Investment Opportunities Ownership of Income-Earning Assets – Savings Accounts – Corporate Bonds – Gov’t Bonds – Common/Preferred Stock Non-Financial Assets – Commodities – Business Ventures – Luxury Items

Real Estate Investment Real Estate Mortgage Investment – Interest payments derive rates of return – S & L’s, Lending Institutions, Brokerages – Owner Financing Real Estate Equity Investment – Income-earning capacity based on factors such as NOI, EGI, PGI, expenses, etc. – Specific to individual investor’s return requirements

Specific Investor Objectives Periodic Cash Flow Liquidity Price Appreciation Increase in Equity Through Mortgage Reduction Tax Shelter High Rate of Return Equity Leverage Estate Building Inflation Hedging Psychological Factors

Risks in Real Estate Investment Business or Income Risk – Unanticipated changes in the economy Financial Risk – Expenses exceed income Principal Risk – Property value expected to increase when market values for the property in fact decline Interest/Money Market Risk – Changes in Capitalization Rates Purchasing Power Risk – Inflationary changes in the economy

Obstacles in Real Estate Investment Objective information sources about the Subject are difficult to obtain Comparable property data is limited Reliable price quotations are not available on a frequent basis Typically only a select amount of buyers/sellers in a market Transactions are cumbersome, time-consuming, inefficient, etc. Time-consuming negotiating and bargaining Legal factors and tax considerations Relatively illiquid market

Lecture 11 Investment Analysis

Purpose of Investment Analysis Analyze property- and investor-specific items that derive property value – Income and Expense Factors (historical and forecasted) – Specific investor/investment (return) objectives

Income Items in Investment Analysis Contract rents (NOT market rents) for leased periods Vacancy and collections based on lease contracts

Expense Items in Investment Analysis Considers debt obligations Before-Tax Cash Flow and After-Tax Cash Flow – Considers ad Valorem property taxes, operating expenses, depreciation allowances, capital improvement expenditures (replacement reserves)

Before-Tax Operating Income Potential Gross Income (PGI) Less: Vacancy/Collection Loss Allowance Effective Gross Income (EGI) Less: Operating Expenses/Management Fees Before Debt Net Operating Income (NOI) Less: Debt Service Before-Tax Cash Flow (BTCF)

Lecture 11 Value Determination from Cash Flow

Discount Rate v. Capitalization Rate Capitalization Rate – Converts one cash flow into a value determinant Discount Rate – “Discounts” streams of cash flows into present values based on the theory of “Time Value of Money” – Used for highly-volatile streams of cash flows

Lecture 11 Example: Apartment Building