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CHAPTER ELEVEN

CHAPTER ELEVEN. INVESTMENT ANALYSIS AND TAXATION OF INCOME PROPERTIES. Motivation For Investing. Rate of return Price appreciation Diversification Tax benefits. Investment Strategies. Property sector investing Contrarian investing Market timing Growth investing Value investing

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CHAPTER ELEVEN

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  1. CHAPTER ELEVEN INVESTMENT ANALYSIS AND TAXATION OF INCOME PROPERTIES

  2. Motivation For Investing • Rate of return • Price appreciation • Diversification • Tax benefits

  3. Investment Strategies • Property sector investing • Contrarian investing • Market timing • Growth investing • Value investing • Size of property • Strategy as to tenants • Arbitrage investing • Turn around/ special situation • Blue chip properties

  4. Investment Decisions • Forecast cash flows from operations • Forecast cash flow from sale • Determine present value of expected cash flows • Apply an investment decision criterion

  5. Real Estate Investment Analysis • Investment Strategy • Investment philosophy • Investment objectives • Investment policies

  6. Forecasting Cash Flows From Operations • Potential Gross Income • Effective Gross Income • Operating Expenses • Net Operating Income • Non-Recurring Expenses

  7. Net Operating Income Calculation

  8. Net Operating Income Example

  9. Forecasted Cash Flows From Net Operating Income

  10. Forecasted Cash Proceeds From Sale

  11. Present Value Calculation

  12. Net Present Value (NPV) • The net present value is the present value of a project’s cash inflows, minus the present value of the cash outflows. • The cash flows are discounted at the investor’s required rate of return– in the example 12 percent.

  13. Net Present Value Calculation

  14. NPV Decision Criteria • If NPV>0, the project exceeds the investor’s required rate of return. • If NPV<0, the project does not meet the investor’s required rate of return. • If NPV=0, the project’s expected return equals the investor’s required rate of return.

  15. Internal Rate of Return (IRR) • The internal rate of return is the discount rate at which NPV=0, the rate of return at which the present value of the cash inflows equals the present value of the cash outflows.

  16. IRR Decision Criteria • If IRR> the required rate of return, then accept. • If IRR< the required rate of return, then reject. • If IRR= the project’s expected return equals the investor’s required rate of return.

  17. NPV and the IRR • NPV: cash flows assumed reinvested at discount rate • Generally preferred to IRR for making decisions • IRR: cash flows assumed reinvested at the IRR rate • May provide inferior wealth maximizing ranking of alternative opportunities to the NPV • Multiple solutions possible • Easily compared to other investments and widely used

  18. Investment Criteria: Profitability Ratios • Capitalization Rate: • Ro= NOI/ Acquisition Price • Equity Dividend Rate: • Re= EDR= BTCF/ Initial Equity • Mortgage Constant: • Rm= MC= DS/ Initial Loan Amount

  19. Investment Criteria:Financial Ratios • Operating Expense Ratio: • OER= Operating Expenses/ EGI • Loan-to-Value Ratio: • LTV= Mortgage Balance/ Property Value • Debt Coverage Ratio: • DCR= Net Operating Income/ Debt Service

  20. 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 of business property • Real estate held as an investment for the production of income– investment property

  21. Types of Taxable Income • Active Income (e.g., salaries, wages, bonuses, and commissions.) • Portfolio Income (e.g., interest, dividends, and capital gains.) • Passive Income (e.g., rents from real estate, and royalties from oil and gas rights.)

  22. Passive Activity Loss Restrictions • Passive losses cannot be used to reduce active or portfolio income • Passive losses may be used to reduce other passive income • Passive losses not used may be used in future years or at the same time of sale • Active participants may deduct up to $25,000 in passive losses against other non-passive income, subject to limitations

  23. Tax on Operations

  24. After Tax Cash Flow From Operations

  25. Interest Expense and Amortized Financing Costs • Interest and prepaid interest • Costs of financing • Financing costs amortized over the term of the loan • Unused balance taken in the year sold

  26. Depreciation Basis • The original cost basis includes all costs associated with acquiring the property and transferring the title • Land value cannot be depreciated • The depreciable basis is the total value that can be depreciated over the recovery period • Depreciable Basis= Cost Basis- Land Amount

  27. Annual Depreciation Deduction • Annual Depreciation= • Depreciable Basis/ Recovery Period • mid- month convention

  28. Cost Recovery Period • Residential income Property (27.5 years) • Other commercial income property (39 years) • Personal property (3-15 years)

  29. Original Cost Basis and Depreciation

  30. Tax Due on Sale

  31. After Tax Cash Flow From Sale

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