Chapter 11 Introduction to Investment Concepts

“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

Chapter 11

Introduction to Investment Concepts


Major Topics

Investor Objectives Sources of real estate returns Introduction to Cash Flow Analysis What we mean by direct and indirect real

estate investment Returns on labor versus returns on

investments Sources of real estate risk Measuring real estate risk Investment alternatives within the real

estate asset class Creative advantages of partnerships and

investment structuring


Introduction: What do Investors Want?

Investors seek current or future income or sometimes both

Future income might be used for personal consumption at a later date or for future generations

Aggressiveness of investor depends on risk preferences


Sources of Real Estate Returns

Cash Flow

- Comes from the collected rents less the operating expenses and debt service

- Usually received monthly

Tax Shelter or Postponement

- Deductible non-cash items include depreciation, amortization of points paid for financing and possibly tax credits for specialized government programs


Sources of Real Estate Returns (Contd.)

Equity Buildup from Mortgage Repayment

- Can occur from mortgage principal repayment

Equity Gains from Price Appreciation

Sources of appreciation:- Inflation- “Real” price changes


Timing of Returns

From a timing perspective, we can take the four types of returns listed above and reduce these to only two:

Cash Flow (after tax)The before tax cash flow plus or minus tax savings or taxes due can be treated as one final source of returns during the operational stage of ownership

Residual Cash Flow (after tax)The appreciation and equity buildup from mortgage repayment both result in before tax proceeds at the time of sale


Introduction to Cash Flow Analysis

Gross Rent or Potential Gross Income

Effective Gross Income

Operating Expenses

Net Operating Income or NOI

Debt Service


Important Terms (Contd.)

Gross RentLess Vacancy = Effective Gross IncomeLess Operating Expenses= Net Operating IncomeLess Debt Service= Cash Flow (before tax)


Current Yield and Total Return

Current Period Return

Periodic Returns

IRR (Internal rate of Return)


Levered versus Unlevered Investments

The term “levered” or “leveraged” refers to the ability of an investor to increase the returns on equity through the use of debt

This occurs whenever the cost of debt is less than the total return on the asset, known as “positive leverage”

Most investors buy stock without direct debt

When debt is used, it is known as “buying on margin” and more aggressive investors do use margin accounts


Sources of Real Estate Risk

In general, the risk and returns are greater for real estate than bonds, and less for real estate than stocks

There may be times when stock returns are less than real estate/ bond returns


Sources of Risk (Contd.)

Economic Risks- Extremely Important!- No control

Business Risk or Management Risks- More controllable than economic risks

Financial Risk- Leverage - most controllable decision

Liquidity Risks- Significant for all direct investments

Political Risks- Over time has become more significant - No control


Risk Analysis at the Property Level

Sensitivity Analysis: Cash flow pro-formas are developed and then ranges of uncertain variables are tested for their impact on key financial ratios and cash flow

Simulation Analysis: When an entire range of probable estimates are tested for several variables at one time, and the resulting distributions of probable results generated


Managing Risk

Risk management is accomplished through negotiation and contracting, or in some cases the purchase of insurance or hedge investments

Economic risks, based on expected market demand and supply, are for the most part uncontrollable

Yet, the risk of a given tenant renewing a lease that expires in the future might be managed through negotiation

Financial risks might also be managed by the use of more or less leverage


Managing Risk (Contd.)

More leverage or debt as a proportion of the total purchase price will result in greater variability of returns

Risks that cannot be shifted must simply be priced

That is, the investor must figure out how much extra expected return they require in order to take on the additional risk, known as “risk premiums”


Risk Premiums Example

Assume the following current capital market rates and investment specific required premia:

Risk free short term real rate (prior to inflation) = .015 or 1.5% = Rf

Expected annual inflation = .03 or 3.0% = EI Liquidity risk premium = .015 or 1.5% = LP (for

the difficulty of quickly selling real estate) Economic, business and political risks = .04 or

4.0%

Total Return:R = Rf+EI+LP+other risk premia = 10%


Portfolio Perspectives

Portfolio risk is based on the estimate of return volatility for an entire basket or investments

Combining two or more risky investments generally will lower total portfolio risk

This is a result of the less then perfect correlation of the individual asset returns,

When the individual assets show negative correlations over specific investment horizons then the total portfolio risk can be drastically reduced


Market Efficiency and Real Estate

Markets are efficient to the extent that all of the available information is reflected in the current market prices

Efficient markets have no trading (buying or selling) based on inside information

It is still possible to achieve above average market returns


Creative Advantages of Partnership and Investment Structuring

One advantage of real estate versus other types of assets is that even a single investment can be structured to achieve individual investor objectives

Example: one investor may want current returns and another may want future wealth

By structuring an investment with various contractual interests (securities or mortgages) that direct the return priorities to different investors multiple investors can achieve their objectives


END

Chapter 11 Introduction to Investment Concepts

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