Slide 1
CHAPTER ELEVEN
INVESTMENT ANALYSIS AND
TAXATION OF INCOME
PROPERTIES
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Slide 2
Motivation For Investing
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Rate of return
Price appreciation
Diversification
Tax benefits
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Slide 3
Investment Strategies
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•
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•
•
•
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•
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•
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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
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Slide 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
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Slide 5
Real Estate Investment Analysis
• Investment Strategy
– Investment philosophy
– Investment objectives
– Investment policies
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Slide 6
Forecasting Cash Flows From
Operations
•
•
•
•
•
McGraw-Hill/Irwin
Potential Gross Income
Effective Gross Income
Operating Expenses
Net Operating Income
Non-Recurring Expenses
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Slide 7
Net Operating Income
Calculation
Income/Expense Item
Symbol
Potential Gross Income
(PGI)
- vacancy and collection losses
(VCL)
+ Other Miscellaneous Income
(MI)
= Effective Gross Income
(EGI)
- Operating Expenses
(OE)
= Net Operating Income
(NOI)
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Slide 8
Net Operating Income Example
Item
Total
Potential Gross Income
$ 180,000
- Vacancy and Collection Losses
18,000
+ Other Miscellaneous Income
______0
= Effective Gross Income
162,000
- Operating Expenses
_72,900
= Net Operating Income
McGraw-Hill/Irwin
$ 89,100
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Slide 9
Forecasted Cash Flows From Net
Operating Income
Item
Year2
Year3
Year4
Year5
$180,000
$185,400
$190,962
$196,691
$202,592
- V&C
18,000
18,540
19,096
19,669
20,259
= EGI
162,000
166,860
171,866
177,022
182,333
- OE
72,900
75,087
77,340
79,660
82,050
$89,100
$91,773
$94,526
$97,362
$100,283
PGI
= NOI
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Year1
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Slide 10
Forecasted Cash Proceeds
From Sale
Item
Symbol
Expected Sales Price (SP)
- Selling Expenses
(SE)
= Net Sales Proceeds (NSP)
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Year5
$1,026,000
51,300
$974,700
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Slide 11
Present Value Calculation
YR
0
1
2
3
4
5
McGraw-Hill/Irwin
Invest.
$
0
NOI
NSP
89,100
91,773
94,526
97,362
100,283 974,700
PV=
PV@12%
$
0
79,554
73,161
67,282
61,875
605,974
$891,846
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Slide 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.
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Slide 13
Net Present Value Calculation
YR
0
1
2
3
4
5
McGraw-Hill/Irwin
Invest.
$-885,000
NOI
NSP
89,100
91,773
94,526
97,362
100,283 974,700
NPV=
IRR=
PV@12%
$-885,000
79,554
73,161
67,282
61,875
609,974
$ 6,846
12.2%
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Slide 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.
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Slide 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.
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Slide 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.
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Slide 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
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Slide 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
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Slide 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
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Slide 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
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Slide 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.)
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Slide 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
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Slide 23
Tax on Operations
Item
Net Operating Income
- Depreciation
- Interest Expense
- Amortized Financing Costs
= Taxable Income
x Tax Rate
= Tax Liability
McGraw-Hill/Irwin
Symbol
(NOI)
(DEP)
(INT)
(AFC)
(TI)
(TR)
(TAX)
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Slide 24
After Tax Cash Flow
From Operations
McGraw-Hill/Irwin
Item
Symbol
Net Operating Income
(NOI)
- Interest Expense
(INT)
- Principal Amortization
(PA)
= Before- Tax Cash Flow
(BTCF)
- Tax Liability
(TAX)
= After- Tax Cash Flow
(ATCF)
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Slide 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
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Slide 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
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Slide 27
Annual Depreciation Deduction
• Annual Depreciation=
• Depreciable Basis/ Recovery Period
– mid- month convention
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Slide 28
Cost Recovery Period
• Residential income Property (27.5
years)
• Other commercial income property (39
years)
• Personal property (3-15 years)
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Slide 29
Original Cost Basis and
Depreciation
The original cost
basis is affected
by depreciation
and substantial
(capital)
improvements
Original Cost Basis
-Total Annual Depreciation
+ Total Capital Improvements
= Adjusted Basis
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Slide 30
Tax Due on Sale
Item
= Net sale Proceeds
- Adjusted Basis
= Total Taxable Gain
- Depreciation Recapture
= Capital Gain
Capital Gain Tax
+ Depreciation Recapture Tax
= Tax Due on Sale
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Symbol
(NSP)
(AB)
(TG)
(DR)
(CG)
(CGTAX)
(DRTAX)
(TDS)
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Slide 31
After Tax Cash Flow From Sale
Item
Gross Sale Price
- Selling Expenses
= Net Sale Proceeds
- Remaining Mortgage Balance
= Before- Tax Equity Reversion
- Tax Due on Sale
= After- Tax Equity Reversion
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Symbol
(GSP)
(SE)
(NSP)
(RMB)
(BTER)
(TDS)
(ATER)
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