Investment Analysis for Real Estate Decisions (PDF)

Investment Analysis for Real Estate Decisions, Ninth Edition Unit 1: The Real Estate Investment Decision Unit Outline This first unit introduces investment analysis, differentiates between real estate assets and real estate services, and looks at the...

Investment Analysis for Real Estate Decisions, Ninth Edition Unit 1: The Real Estate Investment Decision Unit Outline This first unit introduces investment analysis, differentiates between real estate assets and real estate services, and looks at the historical record of real estate as an investment medium. A. Investment Analysis: Art and Science 1. Real estate investment analysis has consistently lagged behind mainstream finance and investment thought. However, great strides have been made in recent years. 2. Modern real estate investment analysis treats real estate as a capital asset desired for the stream of benefits it is expected to produce; real estate investment analysis as a special case of modern capital budgeting. B. Who Invests in Real Estate? 1. Real estate investment by institutions such as real estate investment trusts (REITs) and pension funds has been stimulated by federal law. a. The Internal Revenue Code exempts distributed income real estate investment trust earnings from taxation at the corporate level. The National Association of Real Estate Investment Trusts reported in 2018 that 184 member REITs owned real estate assets with a collective capitalization of more than $960 billion. b. The Employee Retirement Income Security Act of 1974 (ERISA) directed pension fund managers to diversify their portfolios. Many responded by moving aggressively into real estate. In 2016, aggregate pension fund capital in real estate equities exceeded $3.1 trillion. 2. Foreigners directly own a very small portion (about eight percent) of U.S. real estate, but their holdings tend to be concentrated in certain geographic locales and specific types of properties. 3. Foreign direct investment in U.S. realty surged during the early 1980s and again in the early 1990s. 4. Two key factors heavily influence the level of foreign investment in U.S. realty: a. When shifts in foreign exchange rates make dollars less costly in terms of a foreign currency, U.S. real estate becomes relatively less expensive to holders of that country's currency, and thus more attractive. b. A disparity in long-term interest rates between the U.S. and a foreign country tends to depress real estate prices in the high-interest-rate country and make real ©2019 Kaplan, Inc. May be reproduced for educational uses only.  Investment Analysis for Real Estate Decisions, Ninth Edition estate there relatively more attractive to investors in the low-interest-rate country. C. Why Invest in Real Estate? 1. Investors can be conveniently characterized as passive or active. a. Many investors acquire direct title to real property in which they invest. They either oversee the property themselves or hire professional management firms to handle day-to-day management chores. They are said to be active investors. b. Others place assets with professional money managers who in turn acquire interests in real property. Investors also frequently acquire shares in corporations or partnerships that hold extensive real property interests. These passive investors make no operating decisions. 2. Investors can also be usefully classified according to whether they take an equity or a debt position. a. A distinction is usually made between investment in real assets, such as land and buildings and investment in financial assets, such as mortgage-backed promissory notes. In this text we define real estate investment as acquiring an ownership or a leasehold interest in real property. b. In a strict sense, both the institutional lender and the individual who contributes personal resources are investors. But as a matter of analytical convenience, we will exclude the mortgage lender from our discussion of investment analysis and decision making. D. How Have Real Estate Investments Performed 1. A scarcity of real estate yield data has made comparisons between real estate and alternative assets unreliable. Findings varied widely, due to different premises employed by researchers; but the most frequent conclusion was that over an extended period real estate tends to generate returns roughly comparable to those available from common stocks, while offering significantly greater predictability of returns. 2. More recently, an increase in institutional holdings of real estate and the requirement that institutional investment yields be reported on a regular basis have permitted more precise comparisons of real estate returns with those available from other investments. Findings are heavily influenced, however, by the period from which data are drawn. 3. Brueggeman, Chen and Thibodeau analyzed performance data from commingled real estate funds (CREFs) from 1972 through 1983. They concluded that real estate funds ©2019 Kaplan, Inc. May be reproduced for educational uses only.  Investment Analysis for Real Estate Decisions, Ninth Edition outperformed the Standard and Poor's 500 stock index and the Ibbotson Associates bond index for the entire period and for each sub-period analyzed. 4. Michael Giliberto compared REIT yields with the Standard and Poor's 500 stock index for 1978 through 1989 and concluded that the advantage had swung decisively to common stocks. 5. In a 1984 analysis of 17 previous studies, Robert Zerbst and Barbara Cambon concluded that long-term yields of real estate and common stocks have been very similar since 1950, but that real estate tends to outperform stocks during periods of inflation. 6. The recent study (2001) by Clayton and MacKinnon indicated that the relationship has changed over time and REI returns are less related to returns on large capitalization stocks than they were in earlier years. The REIT returns now more closely correspond to returns on small capitalization stocks. E. Definitions and Concepts 1. Investment Value. The value of a property as an investment to a present or prospective owner is frequently referred to as investment value. It reflects the individual investor's assumptions about the future ability of a property to produce revenue, about the likely holding period, selling price, tax consequences, risk, available financing, and all other factors that affect expected net benefits of ownership. Because many of these assumptions are subjective, each individual's investment value perspective is unique. 2. Most Probable Selling Price. Most probable selling price is a probabilistic estimate of the price at which a future transaction will occur. 3. Transaction Range. Investment value from the present owner's perspective sets the lower end of the range of possible transaction prices. Investment value from the perspective of the most likely buyer determines the upper end of the range. a. Investment value from a prospective seller's point of view is the minimum acceptable price, based upon assumptions about the remaining future benefits of ownership. To be motivated to sell, an owner must conclude that the most probable selling price is greater than investment value. b. From a prospective buyer's point of view, investment value is the maximum amount he or she is justified in paying for the property, based on assumptions about the future benefits of ownership. To be motivated to buy, the prospective purchaser must conclude that investment value is greater than the most probable selling price. ©2019 Kaplan, Inc. May be reproduced for educational uses only.  Investment Analysis for Real Estate Decisions, Ninth Edition c. For a transaction to be possible, investment value from the prospective buyer's point of view must be greater than from the prospective seller's point of view. The actual transaction price will fall somewhere within this range. The exact price within this range will depend upon the relative bargaining strengths and skills of the participants to the transaction. 4. Market Value. Market value is the most probable price at which the property would sell in a competitive market if it had been exposed to the market for a reasonable time. It assumes reasonably informed parties, each acting in his or her own best interest and with neither subject to undue influence. F. Estimating Investment Value: An Overview 1. An investor who buys a particular property is in effect buying a set of assumptions about the ability of the property to generate cash flows over the expected holding period and the likely market value of the property at the end of the proposed holding period. The analysis proceeds in four distinct steps: a. Estimate the stream of expected benefits. An investor who buys a particular property is in effect buying a set of assumptions about the ability of the property to generate cash flows over the expected holding period and the likely market value of the property at the end of the proposed holding period. b. Adjust for timing differences in expected streams of benefits from investment alternatives. Of equal concern is when the benefits are to be received. Those expected to be received in the far distant future add less to a property's investment value than do those whose anticipated receipt is more imminent. c. Adjust for differences in perceived risk associated with alternatives. Expected benefits that are viewed with a greater degree of certainty will be more highly valued, other things being equal, than will those considered problematical. d. Rank alternatives according to the relative desirability of the perceived risk- return combinations they embody. 2. Financial analysts have long recognized that the value of a business enterprise is the sum of the value of the outstanding debt plus the value of the equity. Real estate valuation theory also recognizes the value of an investment property as the sum of the debt and equity positions. a. Investment value can, therefore, be expressed as the present value of the equity position plus the present value of the debt position. b. Present value of debt is the amount of available mortgage financing or the outstanding mortgage loan balance. ©2019 Kaplan, Inc. May be reproduced for educational uses only.  Investment Analysis for Real Estate Decisions, Ninth Edition c. Present value of the equity position is the value today of the anticipated after-tax cash flow during a prospective ownership period and of the anticipated after-tax proceeds from disposal. 3. Even if all the considerations are incorporated appropriately, it is unlikely that investors will arrive at the same investment value conclusion. Agreement between market participants will be largely coincidental. a. There will likely be disagreement about the future stream of rental revenue and operating expenses associated with a property. b. Individuals will also differ in the degree of certainty with which they hold their expectations; they will perceive differing levels of risk associated with expected outcomes. c. Investors in high income tax brackets benefit more from tax-deductible losses, which can be used to offset otherwise taxable income from other sources. d. People also differ in their willingness to defer immediate consumption in the interest of even greater benefits in future years. e. Those who are less bothered by the possibility of variance between expected and actual investment outcomes will be inclined to place a greater investment value on risky ventures than are those who prefer a more precisely determinable future. 4. Investor Objectives and Risk. Investors are diverse, and they will have a variety of different objectives. Yet all rational investors seek financial return as a reward for committing resources and as compensation for bearing risk. a. Emotional temperament plays a large role in an investor's attitude toward risk. Authorities generally agree that, to the extent they are motivated by rational financial considerations, most investors have similar attitudes toward risk and expected return. b. They prefer a higher return for a given perceived risk, they prefer less risk for a given expected return, and they accept additional perceived risk only if accompanied by additional expected return. c. They tend to become increasingly averse to additional risk as total perceived risk increases. ©2019 Kaplan, Inc. May be reproduced for educational uses only.