Chapter 16
Analyzing Income- Producing
Properties
Why forecasting?
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Forecast – not guess
Maximize investment
dollars
Locate profits in projects
that others overlook
Advantages of Real
Estate Investment
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Cash Flow from Operations
(After Tax Cash Flow – ATCF)
Appreciation (After Tax Equity
Reversion – ATER)
Portfolio Diversification
Financial Leverage
Tax Benefits
Cash Flow
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After Tax Cash Flow (ATCF)
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Income
 Revenue minus Costs
 Revenue Includes:
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Rent
Extras
 e.g. laundry services,
covered parking
Expense Escalators
 In commercial real estate
 Tenant contracted to pay
increase in costs (e.g.
utilities)
Costs Include:

Debt, insurance, taxes,
maintenance, etc.
Appreciation
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After Tax Equity Reversion
(ATER)
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“Equity reversion” = return
of funds originally invested
in the property plus any
increase in property value.
Portfolio Diversification
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Real Estate investments
can diversify your entire
portfolio of investments
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- Stocks, bonds, etc.
Spread investment risk
over different investment
vehicles.
Some like Real Estate
because it is tangible and
long-term.
Financial Leverage
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“Other people’s money”
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- Down payment and borrow the
remainder
Magnifies investment returns
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A. Purchase a $100,000 office
with 100% equity or
B. Use the $100,000 to put
down 10% on a $1,000,000
office building and borrow
$900,000.
*assume income=costs
After 1 year, both properties
increase 10% and are sold.
A) $110,000-$100,000 = $10,000
profit / $100,000 investment =
10% return
B) $1,100,000 - $1,000,000 =
$100,000 profit / $100,000
investment = 100% return
Tax Benefits
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Write losses against other
income
Disadvantages of Real
Estate Investment
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large capital requirements
risk
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Financial risk (Large Capital
requirements)
Liquidity risk: Discounts on
quick sales.
Purchasing power risk: Tie
money up for large periods of
time.
Business risk (Changing
market conditions): R.E.
requires specialized
knowledge of markets and
transactions affecting specific
sectors.
The Wealth Maximization
Objective
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investment can be defined as present
sacrifice in anticipation of future benefit
investment decision making involves
comparison of the expected future
benefits with the costs of the investment
investors’ ultimate goal is to maximize
their wealth by choosing investments that
are worth more than they cost
the NPV decision rule employs the wealth
maximization concept
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If faced with two competing projects, one
that offers an NPV of $1,501 and another
that offers a NPV of $703, the investor
would prefer the one with the largest NPV.
The Discounted Cash
Flow Model
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To apply the NPV rule in
practice, real estate investors
may use the following
discounted cash flow model.
After Tax Cash Flow
(ATCF)
Potential Gross Income
-Vacancy & Collection Loss
-Operating Expenses
-Debt Service
-Taxes
After Tax Cash Flow (ATCF)
After Tax Equity
Reversion (ATER)
Gross Sale Price
-Selling Expenses
-Loan Payoff
-Taxes
After Tax Equity Reversion
(ATER)
Discounted Cash Flow
Model
T
NPV=Σ + ATCFt + ATERT - Initial
t=1
(1+i)t
(1+i)T
Equity
Highlights of Property
Search (from p.358-359)
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Individual Investor
Limited Funds
Familiar Neighborhood
Rental & Expense
Knowledge
Talk to lenders
Estimate future increases
in expenses and income
After Tax Cash Flow
(ATCF)
Potential Gross Income (PGI)
-Vacancy & Credit Losses (VCL)
Effective Gross Income (EGI)
-Operating Expenses (OE)
Net Operating Income (NOI)
-Annual Debt Service (ADS)
Before Tax Cash Flow (BTCF)
-Taxes
After Tax Cash Flow (ATCF)
Calculating Taxes for
ATCF
Net Operating Income (NOI)
-Interest Expense (INT)
-Depreciation Deduction (DEP)
Taxable Income (TI)
x Marginal Tax Rate (MTR)
Taxes from Operations (Taxes)
After Tax Equity
Reversion (ATER)
Sale Price
-Sale Expenses
Net Sale Price
-Loan Balance
Before Tax Equity Reversion
-Taxes
After Tax Equity Reversion
Calculating Taxes for
ATER
Net Sale Price
-Purchase Price
+ Accumulated Depreciation
Taxable Gain
x Marginal Tax Rate
Taxes
Example of the DCF
Model
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Consider a four-unit apartment complex that is
offered for sale at $255,000.
The units are expected to rent for $725 per month
in the first year (increasing at 5% per year) with an
annual vacancy rate of 4%.
The property is expected to have operating
expenses of $9,900 in the first year (increases at
3% per year).
A loan is available at 70% of the purchase price for
9% interest with monthly payments over 25 years.
The investor believes property value will increase at
the annual rate of 5% per year.
The investor faces a tax rate of 28%.
The investor expects a five year holding period.
Is this a good deal based on the NPV rule at a
required rate of return of 16%?
See cash flow calculations in Tables 16.3 and 16.4
End Chapter 16
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Questions?