Investment Analysis and Taxation of Income Properties

McGraw-Hill/Irwin

Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

Investment Analysis

Equity Investment

Motivations for Investing in Income

Properties

– Rate of Return

– Price Appreciation

– Diversification

– Tax Benefits

11-2

Market Characteristics

Real Estate Cycle

– Large Market in number and size of properties

– Competitive

– Fragmented Ownership

– Overdevelopment Potential

– The cycle differs for different property types.

11-3

Exhibit 11-1

The “Real Estate Cycle”

11-4

Investment Strategies

Investing in Core Properties

Investing in Core Properties with a “Value

Add” Strategy

Property Sector Investing

Contrarian Investing

Market Timing

Growth Investing

Value Investing

11-5

Investment Strategies

Strategy as to Size of Property

Strategy as to Tenants

Arbitrage Investing

Turnaround/Special Situations

Opportunistic Investing

Investing in “Trophy” or “Blue Chip”

Properties

Development

11-6

Market Analysis

Evaluation of supply and demand for a type of property

Absorption

Supply of Space

Market Rents

Forecasting Supply, Demand, Market

Rents, and Occupancy

11-7

Investment Analysis

Internal Rate of Return (IRR)

– The discount rate at which the net present value of the cash flows is equal to 0.

– If IRR >= r; accept Project

– If IRR < r; reject Project

– Where r is the discount rate, or more colloquially, the “hurdle rate”

11-8

Investment Analysis

Net Present Value

– A way to solve for the initial price that an investor may pay given a specified discount rate.

– Discounted value of the cash flows.

– The discount rate is the rate of return that an investor will require in order to make this investment.

– If we include the initial equity investment in this calculation, we can solve for the difference and see how much more or less the investor may pay and still receive a rate that is equivalent to their discount rate.

11-9

Debt Financing

Equity Dividend = NOI - DS

– NOI = Net Operating Income

– DS = Debt Service

The equity dividend is also referred to as the before-tax cash flow from operations

(BTCF0)

11-10

Debt Financing

Equity Dividend Rate =

Equity Dividend/Initial Equity Investment

– Sometimes referred to as “unleveraged cash on cash” rate. Debt Coverage Ratio (DCR) = NOI/DS

– The DCR is a vital ratio for lenders.

– If the DCR is less than 1, the borrower will not be able to service the debt.

– Generally, lenders want a DCR greater than 1 so the borrower has a cushion and can repay.

11-11

Debt Financing

Example 11-1:

– $1,000,000 Property;

– 95% allocated to building and 5% to land

– 70% LTV; 7% Interest Rate, 30 Years

– $700,000 debt; $300,000 equity

– Monthly Payment = $4657.11

– DS = 12 x $4657.11 = $55,885

– NOI1 = $85,000

11-12

Before-Tax Cash Flow

Equity Dividend = NOI-DS

– $85,000 - $55,885 = $29,115

– This is also the BTCFo for this year.

Equity Dividend Rate = EQDIV/Equity

– $29,115/$300,000 = 9.71%

Debt Coverage Ratio =

– $85,000/$55,885 = 1.52

These ratios all pertain to the first year of operations. 11-13

Before-Tax Cash Flow

Before-Tax Cash Flow from the Property

Sale (BTCFs):

– BTCFs = Sales Price – Mortgage Balance

– In Example 11-1, if the property were sold in

Year 4 for $1,100,000 then

– BTCF = $1,100,000 - $668,322 = $421,678

The mortgage loan balance ($668,322) is computed as previously. See Chapter 4.

11-14

Taxation

Four Classes of Real Property

– Real Estate held as a “personal residence” – Real Estate held for sale to others –

“dealer” property”

– Real Estate held for use in a trade or business – “trade or business property”

– Real Estate held as an investment for the production of income – “investment property” 11-15

Types of Taxable Income

Active Income

– Salaries, wages, bonuses, and commissions Portfolio Income

– Interest, dividends, and capital gains

Passive Income

– Rents from real estate,…