Investment and Before-tax Cash Flow Essay

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Chapter 11:
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,
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