The Economics of Real Estate Investment PDF

2 The Economics of Real Estate Investment Learning Objectives After completing this lesson, students should be able to… Distinguish between debt investments and ownership investments, and identify a type of return tha...

2 The Economics of Real Estate Investment Learning Objectives After completing this lesson, students should be able to… Distinguish between debt investments and ownership investments, and identify a type of return that’s only possible with an ownership investment Describe the three key investment characteristics of safety, liquidity, and yield, and explain how they affect each other Identify some of the advantages and disadvantages of investing in real estate Describe the income approach to value, and discuss the considerations involved in applying a suitable cap rate Compare business cycles and real estate cycles Discuss the main factors that affect real estate supply and demand, and distinguish between the business trends and the government factors that impact real estate markets Suggested Lesson Plan. 1. Give students Exercise 2.1 to review the previous chapter, “Property Management: an Overview.” 2. Provide a brief overview of Chapter 2, “The Economics of Real Estate Investment,” and review the learning objectives for the chapter. © 2021 Rockwell Publishing  Property Management Instructor Materials 3. Present lesson content: Investment Basics – Debt investments and ownership investments – Key investment characteristics – Diversification EXERCISE 2.2 Classifying investments EXERCISE 2.3 Safety, liquidity, and yield EXERCISE 2.4 Portfolio diversification Investing in Real Estate – Advantages of real estate investment – Disadvantages of real estate investment – Determining how much to pay for a property EXERCISE 2.5 Advantages and disadvantages of investing in real estate Economic Forces and Business Cycles – Markets – Principle of supply and demand – Business cycles – Real estate cycles Factors Affecting Real Estate Supply and Demand – Social and business trends – Government factors EXERCISE 2.6 Government influence on the housing market 4. End lesson with Chapter 2 Quiz. Chapter 2 Outline: The Economics of Real Estate Investment I. Investment Basics A. Investment: any allocation of funds expected to generate a profit for the owner 1. Different types of investments include real estate, stocks, bonds, commodities (oil, gold, wheat, etc.), and CDs and savings accounts 2. Return: money earned on an investment, which can take the form of interest, dividends, or appreciation 2  Chapter 2: The Economics of Real Estate Investment a. Dividend: a pro rata share of the corporation’s earnings distributed to each shareholder b. Appreciation: an increase in an investment’s value over time B. Investments come in two forms: debt investments and ownership investments 1. Debt investment: an investment in which an investor lends money to an individu- al or business entity a. The investor allows the borrower to use his funds in exchange for interest 2. Ownership investment: an investment in which the investor acquires an asset or an ownership interest in an asset a. An ownership investment can provide two types of returns: income (divi- dends, rent) and appreciation (if the value of the investment increases) 3. Security: any instrument representing either a debt or ownership investment that does not carry with it the right to direct managerial control C. Investors analyze investment opportunities by examining three key characteristics: safety, liquidity, and yield 1. Safety: The degree of risk associated with an investment; in particular, the likeli- hood of losing money on an investment a. Safer investments offer lower returns; riskier ones offer higher returns b. Safe investments include T-bills and deposits in checking and savings ac- counts (because they are insured by the federal government) 2. Liquidity: the ability to convert an asset to cash quickly a. More liquid investments offer lower yields b. Liquid investments include savings and checking accounts c. Illiquid investments include art and real estate 3. Yield: the rate of return on an investment for the investor; a high-yield investment is one that is highly profitable a. Yield is usually expressed as a percentage D. Experts recommend that investors diversify: invest in a mix of stocks, bonds, real estate, and commodities 1. Portfolio: the various investments than an investor owns, plus cash reserves 2. An ideal portfolio includes very safe investments, somewhat safe investments with moderate yield, and risky but potentially high-yield investments EXERCISE 2.2 Classifying investments EXERCISE 2.3 Safety, liquidity, and yield EXERCISE 2.4 Portfolio diversification 3  Property Management Instructor Materials II. Investing in Real Estate A. The three biggest advantages of real estate investment are cash flow, appreciation, and leverage 1. Cash flow: the remainder of the rental income received by an investor after pay- ing the property’s operating expenses and mortgage payment 2. Appreciation: an increase in an investment’s value over time a. Equity: the difference between a property’s market value and the liens against the property; equity increases as the loans are paid off; real estate is not a liquid asset, but equity loans can be a source of cash for investors 3. Leverage: using borrowed money to invest in an asset 4. Tax advantages: real estate investors may be able to take tax deductions that are not available for other kinds of investments, such as deductions for mortgage interest and operating expenses B. The disadvantages of real estate investment include illiquidity, high risk, high cost, the need for expert knowledge, and immobility C. In general, investors will pay more for a property that generates a larger income 1. Income approach to value: the appraiser takes the property’s net operating income and divides it by the rate of return that the investor expects (the capitalization or “cap” rate) a. Net operating income (NOI): the amount of income left over after paying for the property’s operational expenses b. The cap rate will vary depending on both the rate of return for similar invest- ments in the current market, and the investor’s tolerance for risk EXERCISE 2.5 Advantages and disadvantages of investing in real estate III. Economic forces and business cycles A. Market: any arena in which buyers and sellers exchange a product; markets can be local, regional, national, or international 1. In the real estate market, the product is rental space and the geographical area is usually local B. Prices in a local market are most affected by the principle of supply and demand: supply is the quantity of a particular product in a market, and demand is the desire among potential purchasers for a particular product in a market 1. Seller’s market: when demand exceeds supply and prices increase 2. Buyer’s market: when supply exceeds demand and prices drop 3. Supply and demand can be measured by studying the absorption rate: the length of time, usually expressed in months, that it takes for the existing amount of va- cant space to be rented at the current rental rate 4  Chapter 2: The Economics of Real Estate Investment C. Business cycle: a pattern of repeated waves of growth and decline that characterizes the movement of the economy 1. Prosperity: the phase in the business cycle where growth is sustained and stable 2. Recession: the phase in the business cycle where the economy is contracting, characterized by increased unemployment and falling prices 3. Recovery: the phase in a business cycle where growth starts to resume after a recession has bottomed out D. Real estate cycles: cycles of growth and contraction that occur specifically within the real estate sector; these often closely track broader business cycles 1. Prosperity: developers jump onboard with an abundance of projects, trying to take advantage of big profits 2. Overbuilding: the number of new units eventually exceeds demand, and prices drop 3. Adjustment: developers end up having to cut rents on new buildings and abandon further development; corresponds to recession phase of business cycle 4. Stabilization: a new phase of development that begins after the adjustment phase is complete; corresponds to the recovery phase of the business cycle IV. Factors Affecting Real Estate Supply and Demand A. Social and business trends affect the supply of and demand for real estate in a par- ticular market 1. Population changes affect demand for real estate; rental markets may be affected by seasonal population changes 2. Business cycles can have a big impact on a local real estate market, as expansion may lead to new construction, while contraction leads to high vacancy rates; em- ployment opportunities and wages also play a role in demand 3. Demographic changes affect demand for various types of housing units (such as number of bedrooms per unit) 4. Technological changes create new patterns of demand; increase in online retailing decreases demand for retail space; increased telecommuting decreases demand for office space 5. Social trends that affect supply and demand include migration from urban to suburban areas, environmental concerns, and consumer preferences in retail shop- ping B. Government factors that affect the real estate market include monetary policy, regulation of lending institutions, mortgage industry involvement, tax policy, and environmental and land use laws 1. Monetary policy: the federal government’s control over the size of the money supply; implemented primarily through the Federal Reserve’s control of key in- terest rates 5  Property Management Instructor Materials a. Reserve requirements: the Federal Reserve also implements monetary policy by changing the percentage of deposits commercial banks must keep on re- serve with the Federal Reserve Bank b. Open market operations: the Federal Reserve’s manipulation of the money supply through the purchase and sale of government securities 2. Lending institution regulation affects availability of credit; strict regulations tend to decrease the availability of credit 3. The federal government is heavily involved in the mortgage industry in order to promote homeownership a. Fannie Mae and Freddie Mac were created to help strengthen the housing market, by buying mortgage loans from lenders, packaging them as mort- gage-backed-securities, and selling the loans in the secondary market b. The Federal Housing Administration (FHA) and the Department of Veterans Affairs insure or guarantee home loans in order to encourage lenders to lend to borrowers 4. Tax policies vary from one area to another, affecting the desirability of certain places to invest; the federal government’s income tax code includes exemptions and deductions that are designed to encourage real estate investment 5. Environmental and land use laws impact the amount and types of land available for development, as well as types of buildings that can be constructed (through zoning) EXERCISE 2.6 Government influence on the housing market Exercises EXERCISE 2.1 Review exercise To review Chapter 1, “Professional Property Management: an Overview,” read the following True/False questions aloud to students and have them jot their answers down on a piece of paper; discuss the answers together. 1. Managed properties are typically classified as either commercial, multi-residential, single-family, manufacturing, or retail. 2. Professional property management did not really get its start until the 1980s. 3. BOMA® stands for the Building Office Managers Association. 4. In most states, a property manager must hold a real estate license or property manager’s license. 5. The Institute of Real Estate Management (IREM®) confers the Certified Property Manager (CPM®) designation. 6  Chapter 2: The Economics of Real Estate Investment Answers: 1. FALSE. The traditional categories of property are: residential, retail, office, indus- trial, or mixed-use. 2. FALSE. Professional property management became well established in the first few decades of 20th century. 3. FALSE. BOMA stands for the Building Owners and Managers Association. 4. TRUE. Most states impose a license requirement on property managers. 5. TRUE. The Institute of Real Estate Management offers the CPM credential. EXERCISE 2.2 Classifying investments Which of the following are ownership investments? Which are debt investments? 1. Shares of Facebook stock 2. Bonds issued by the city to fund a new library 3. A rental condo in Palm Springs 4. Mortgage loans by banks 5. A certificate of deposit paying one-half percent interest 6. A savings account 7. A fine art collection including prints by Andy Warhol 8. Gold coins Answers: 1. Ownership 2. Debt 3. Ownership 4. Debt 5. Debt 6. Debt 7. Ownership 8. Ownership 7  Property Management Instructor Materials EXERCISE 2.3 Safety, liquidity, and yield Fill in the blank with the proper term: Safety Liquidity Yield 1. The ____________ of an investment refers to how easily an investor can convert that investment into cash. 2. The ____________ of an investment refers to likelihood of losing money on the investment. 3. The ____________ of an investment refers to how much money an investor makes from the investment. Answers: 1. LIQUIDITY. Publicly traded stock is quite liquid (easy to sell); real estate is not. 2. SAFETY. An FDIC-insured savings account poses almost no risk of losing money; other investments, such as real estate, are much less safe. 3. YIELD. Yield is the amount of money an investment returns. EXERCISE 2.4 Portfolio diversification Roberto, Sheila, and Jim own the investment assets described below. Whose portfolio seems the most diversified? Roberto owns: a rental duplex, a modest-sized certificate of deposit, a mutual fund (with both stocks and bonds), and a large savings account. Sheila owns: a very large certificate of deposit, a large savings account, an invest- ment in a Broadway musical, and a large number of shares of stock in a small manufacturing company she works for. Jim owns: 60% of the stock of a local cement company, a large amount of cash (which he keeps in a safe at home), shares in a gambling syndicate that places legal bets on sporting events and in casinos, and a collection of vintage luxury cars. Answer: The purpose of diversity in a portfolio is to reduce the risk of being wiped out by a downturn in a particular type of asset. All three investors have adequate cash reserves, a non-risky type of asset. Sheila’s investment in a musical and concentrat- ing all her stock-type investments in the company she happens to work for would be classified as risky. Similarly Jim’s stock investments are concentrated in one local company. His other investments also seem risky. Both these investors lack the more stable approach to stock ownership offered by mutual fund investments, which 8  Chapter 2: The Economics of Real Estate Investment Roberto has. Real estate, while risky, adds diversity to cash and stock investments. Most financial experts would classify Roberto’s portfolio as the best diversified. EXERCISE 2.5 Advantages and disadvantages of investing in real estate The real estate market is doing reasonably well in Tompkins County. Classify each of the following as either an advantage or disadvantage of investing in real estate in this kind of location. 1. Cash flow 2. Illiquidity 3. Appreciation 4. Degree of risk 5. Principle of leverage 6. Tax deductions 7. Cash outlay required 8. Degree of expertise needed 9. Immobility of land Answers: 1. ADVANTAGE. Not all types of assets generate cash flow; some stocks don’t pay dividends, for example. 2. DISADVANTAGE. The expense and time necessary to sell a piece of real estate is a significant drawback to owning this kind of asset. 3. ADVANTAGE. Not all investment assets can appreciate; bonds, for example, do not gain in value. 4. DISADVANTAGE. Real estate tends to go through cycles and there is a risk that values may fall. 5. ADVANTAGE. In a rising market, the borrower does not have to share the ap- preciation with her lender; using borrowed funds to invest is known as leverage. 6. ADVANTAGE. The government offers tax incentives to owners of investment real estate. 7. DISADVANTAGE. Generally borrowers have to come up with their own downpay- ment and the amount required can be large. 8. DISADVANTAGE. Understanding the local real estate market well enough to rec- ognize a fairly priced investment property isn’t easy, nor is managing the property afterwards. 9. DISADVANTAGE. Despite the investor’s best efforts, local values may fall; the investor cannot move the property to a more suitable location. 9  Property Management Instructor Materials EXERCISE 2.6 Government influence on the housing market Discussion Prompt: Imagine that the housing market is hot. Overheated, in fact. The government fears that lower- and even middle-income buyers are getting priced out of the market. Officials also fear a bursting bubble could drive down the na- tional economy. What steps might the government take to cool the housing sector? Answer: The federal government could raise bank reserve requirements, meaning that banks would have less money to lend for mortgages. That would drive up inter- est rates, making home loans less attractive. The government could also act to increase key interest rates directly. Generally, rising interest rates put downward pressure on home prices. In addition, the government could step up the selling of its securities such as Treasury bonds. (This kind of activity is called “open market operations.”) When the government stockpiles the money from the bond sales, there is less money in circulation, and fewer loans can be made. Again, this causes interest rates to rise. Another step the government could take to dampen the housing market would be to decrease the role of government-managed agencies, such as Fannie Mae and Freddie Mac. These agencies normally help support the housing market. 10  Chapter 2: The Economics of Real Estate Investment Chapter 2 Quiz 1. An investment increases in value over time, 6. A manufacturing company needs capital, so it because of increased demand for it. This in- sells a factory to an investor and proceeds to creased value is known as: lease the building from the investor to continue a) a dividend its operations there. This transaction is known b) a return as a: c) appreciation a) cash-on-cash transaction d) Both B and C b) leveraged buyout c) sale-leaseback d) straw-man transaction 2. A type of investment is considered both a debt investment and a security. This investment would therefore be a: 7. All of the following are disadvantages inherent a) bond to investment in real estate, except for: b) mortgage loan a) illiquidity c) savings account b) immobility d) stock c) leverage d) risk of loss 3. As an investment’s _____ increases, its _____ also increases. 8. The rate of return that an investor expects to a) liquidity; yield earn from a real estate investment (as used in b) safety; leverage the income approach to value) is the: c) safety; liquidity a) capital gain d) safety; yield b) capitalization rate c) cash-on-cash rate d) net operating income 4. Which of the following has the potential for the highest yield? a) Bond 9. Ivan finds that he can buy an Acme Widget at b) Certificate of deposit Shop-O-Mart for $1. He also finds that he can c) Savings account buy an identical Acme Widget for $1.50 at d) Real estate Mom & Pop’s Mercantile, which is also located nearby. He opts to buy his widget at Shop-O- Mart. This illustrates the principle of: 5. An apartment building has a market value of a) anticipation $2,000,000; there is a lien against it for the b) diminishing returns owner’s purchase loan, for $800,000. The c) substitution $1,200,000 disparity is known as the prop- d) supply and demand erty’s: a) appreciation b) cash flow c) equity d) leverage 11  Property Management Instructor Materials 10. A new advertising campaign has convinced 14. The problem of overbuilding, in real estate many people that they need Acme Widgets, and cycles, tends to coincide with which phase of suddenly there aren’t enough Acme Widgets to the larger business cycle? satisfy the needs of everyone who wants to buy a) Prosperity one. Prices for Acme Widgets skyrocket. This b) Recession would be considered a: c) Recovery a) balanced market d) Stabilization b) buyer’s market c) perfect market 15. A resort community has high demand for rental d) seller’s market properties during the summer, and low demand for rental properties at other times in the year. 11. A property manager is calculating the local Which of the following categories of social market’s absorption rate for apartments. She and business trends would encompass this finds that there are currently 120 units available phenomenon? locally, and that the usual rate of apartment a) Business expansion/contraction leasing throughout the market is 360 units per b) Demographic change year. How long would it take to absorb the c) Population change current supply of apartments? d) Technological change a) 3 months b) 4 months 16. Which of the following examples would de- c) 6 months scribe how trends in demographic changes can d) 9 months affect supply and demand? a) Fewer families with more than two children 12. Which of the following is the correct order for means less demand for apartments with typical business cycles? three bedrooms or more a) Prosperity, recession, recovery b) Higher unemployment leads to more de- b) Prosperity, recovery, recession mand for rentals because fewer people are c) Recession, prosperity, recovery becoming homeowners d) Recovery, recession, prosperity c) Increasing use of online shopping leads to a decline in demand for retail property d) There is low demand for apartments during 13. There aren’t enough apartments in a small town summers in a college town where a large new employer has just opened up. What will happen next? a) Prices will continue to go down, until more 17. Which of the following is not a way in which apartments are constructed the Federal Reserve implements monetary b) Prices will continue to go down, until more policy? apartments are taken off the market a) Changing reserve requirements c) Prices will continue to go up, until more b) Controlling key interest rates apartments are constructed c) Engaging in open market operations d) Prices will continue to go up, until more d) Passing appropriations bills apartments are taken off the market 12  Chapter 2: The Economics of Real Estate Investment 18. In order to stimulate a weak economy, the Federal Reserve might: a) lower interest rates b) raise interest rates c) raise reserve requirements d) sell Treasury securities through open mar- ket operations 19. Fannie Mae and Freddie Mac: a) buy mortgage loans from lenders and re- package and sell them b) guarantee home loans c) insure home loans d) sell Treasury securities 20. The housing market in Forest Hills enters into a buyer’s market. This most likely means: a) demand is high, relative to supply b) demand is low, relative to supply c) prices are rising d) supply is low, relative to demand 13  Property Management Instructor Materials Answer Key 1. c) Appreciation is an increase in an 8. b) To estimate a property’s value using investment’s value over time. Appre- the income approach to value, divide ciation is one way in which an investor the net operating income by the inves- may get a return on her investment. tor’s capitalization rate (which is the investor’s desired rate of return). 2. a) Only a bond is both a debt investment (one where an investor lends money to 9. c) The principle of substitution is a prin- a business or individual) and a security ciple of value that states that a buyer (an investment instrument that does won’t pay more for a similar item that not include a right to managerial con- he could get from another seller for a trol over a business). lower price, unless there is unreason- able delay or difficulty in acquiring the 3. c) Safety and liquidity generally go hand substitute item. in hand (for instance, savings accounts are both very safe and very liquid); on 10. d) In a seller’s market, prices go up as the other hand, safety and yield do not buyers compete with each other for correlate (a savings account is likely to a scarce product. This works to the have a very low yield). seller’s benefit (at least until there’s an increase in supply). 4. d) While real estate is certainly not guar- anteed to provide the highest yield, it 11. b) Absorption rate is determined by di- is likely to provide a higher yield than viding the total space available by the safe and/or liquid investments like current rate of demand for that type of bonds, CDs, and savings accounts, space. In this case, divide 120 units by most of which have fixed returns. 360 units per year, to find that the rate is one-third of a year, or four months. 5. c) Equity is the difference between a property’s value and the liens against 12. a) A business cycle moves through three it. Equity in a property is considered stages: prosperity (sustained growth), part of an investor’s net worth. recession (contraction), and recovery (renewed growth). 6. c) A sale-leaseback involves selling a property to an investor and then 13. c) If demand exceeds supply, prices will leasing the property back from that in- go up. This will eventually stimulate vestor. new entrants into the market, at which point supply will catch up with de- 7. c) Leverage—using borrowed funds to mand and prices will be balanced. invest in an asset, and earning returns on those borrowed funds—is not a disadvantage; in fact, it is a potential advantage to real estate investment. 14  Chapter 2: The Economics of Real Estate Investment 14. a) During the prosperity phase of the broader business cycle, real estate de- velopers tend to see high demand and big profits, and launch new projects. This turns into overbuilding. 15. c) Data concerning the number of people living in a community, or moving in or out of a community, would describe population change. 16. a) Demographic change describes chang- es in the makeup of the population, such as changes in age, race, or house- hold size. 17. d) The Fed’s three tools for implement- ing monetary policy are interest rates, reserve requirements, and open market operations. The Fed cannot pass bills; only Congress can do that. 18. a) Lowering interest rates stimulates more borrowing and more consump- tion. Raising reserve requirements and selling Treasury securities take more money out of circulation, which drives up interest rates and discourages bor- rowing and consumption. 19. a) Fannie Mae and Freddie Mac are secondary market agencies, meaning that they buy loans, package them as mortgage-backed securities, and sell them to investors. 20. b) In a buyer’s market, supply exceeds demand. Prices are low, as sellers com- pete with each other to attract scarce buyers. 15  Property Management Instructor Materials PowerPoint Thumbnails Use the following thumbnails of our PowerPoint presentation to make your lecture notes. Property Management Lesson 2: The Economics of Real Estate Investment © 2021 Rockwell Publishing 1 Introduction This lesson discusses: ⚫ investment basics ⚫ investing in real estate ⚫ economic forces and business cycles ⚫ factors affecting real estate supply and demand © 2021 Rockwell Publishing 2 Investment Basics Investment: Any allocation of funds that’s expected to generate a profit for the investor. Examples: ⚫ real estate ⚫ stocks ⚫ bonds ⚫ commodities (oil, gold, wheat) ⚫ CDs and savings accounts © 2021 Rockwell Publishing 3 16  Chapter 2: The Economics of Real Estate Investment Investment Basics Return: The money earned on an investment. Includes: ⚫ interest ⚫ dividends ⚫ appreciation Dividend: Pro-rata share of company’s earnings. Appreciation: Increase in investment’s value over time. © 2021 Rockwell Publishing 4 Investment Basics Two types of investments: ⚫ debt investments ⚫ ownership investments © 2021 Rockwell Publishing 5 Investment Basics Debt Debt investment: Investor lends money to an individual or business entity in exchange for interest. Examples: ⚫ mortgage ⚫ bank’s debt investment; borrower pays interest ⚫ savings account ⚫ depositor’s debt investment; bank pays interest © 2021 Rockwell Publishing 6 17  Property Management Instructor Materials Investment Basics Ownership Ownership investment: Investor uses money to acquire title in an asset. Includes: ⚫ real estate ⚫ shares of stock © 2021 Rockwell Publishing 7 Investment Basics Ownership Two types of return on ownership investments: ⚫ income (rent or dividends) ⚫ appreciation © 2021 Rockwell Publishing 8 Investment Basics Securities Security: An instrument that represents an ownership or debt investment without the right of direct control over the business. Examples: ⚫ stocks ⚫ bonds Sale of securities is strictly regulated. © 2021 Rockwell Publishing 9 18  Chapter 2: The Economics of Real Estate Investment Summary Investment Basics – Investment – Return – Debt investment – Ownership investment – Income – Appreciation – Security © 2021 Rockwell Publishing 10 Investment Basics Key investment characteristics Three main characteristics of investments: ⚫ safety ⚫ liquidity ⚫ yield These three characteristics have an effect on each other. © 2021 Rockwell Publishing 11 Key Investment Characteristics Safety Safety: The investor’s risk of losing the money originally invested. Safe investments include: ⚫ savings accounts (insured by federal government) ⚫ T-bills (backed by federal government) Generally, high safety = low return (yield). © 2021 Rockwell Publishing 12 19  Property Management Instructor Materials Key Investment Characteristics Liquidity Liquidity: Ability to convert investment to cash quickly and easily. Examples: ⚫ savings accounts (very liquid) ⚫ CDs, stocks, mutual funds (less liquid) ⚫ real estate (least liquid) Generally, high liquidity = low return (yield). © 2021 Rockwell Publishing 13 Key Investment Characteristics Yield Yield: Return on investment, such as interest, dividend, and rent; usually expressed as a percentage. ⚫ High-risk investments need high yields to attract investors. ⚫ Low-yield investments need to be safer and/or more liquid to attract investors. Generally, high yield = illiquid or high risk. © 2021 Rockwell Publishing 14 Investment Basics Diversification Diversification: Distributing investments across a variety of levels of safety, liquidity, and risk. ⚫ Often referred to as having a diversified portfolio. Portfolio: The mix of investments that a person owns, plus cash reserves. © 2021 Rockwell Publishing 15 20  Chapter 2: The Economics of Real Estate Investment Summary Key Investment Characteristics – Safety – Liquidity – Yield – Diversification – Portfolio © 2021 Rockwell Publishing 16 Investing in Real Estate Advantages of real estate investment Three main advantages to investing in real estate: ⚫ cash flow ⚫ appreciation ⚫ leverage © 2021 Rockwell Publishing 17 Advantages: Investing in RE Cash flow Cash flow: Remainder of rental income received by investor after payment of operating expenses. ⚫ Income property usually produces some cash flow after expenses and mortgage payments. ⚫ Many other investments require sale of asset to realize any income. © 2021 Rockwell Publishing 18 21  Property Management Instructor Materials Advantages: Investing in RE Appreciation Appreciation: Increase in an investment’s value over time. ⚫ Real estate generally appreciates over time, increasing owner’s equity. Equity: Difference between value of a property and the liens against it. © 2021 Rockwell Publishing 19 Advantages: Investing in RE Leverage Leverage: Using borrowed money to invest in an asset. ⚫ When investor borrows money to buy property, and entire property appreciates in value, investor gets return on both the cash invested and the money borrowed. ⚫ Results in much higher yield on cash invested compared to other investments. © 2021 Rockwell Publishing 20 Advantages: Investing in RE Tax deductions Investor also benefits from tax deductions on owning and operating property. Examples: ⚫ mortgage interest ⚫ depreciation ⚫ operating expenses © 2021 Rockwell Publishing 21 22  Chapter 2: The Economics of Real Estate Investment Advantages: Investing in RE Tax deferral When investor sells property, she can defer taxes on any gains. Two common methods: ⚫ installment sale ⚫ 1031 exchange © 2021 Rockwell Publishing 22 Disadvantages: Investing in RE Illiquidity One disadvantage with real estate is time needed to sell the asset (illiquidity). ⚫ Easier to convert other assets (stocks, mutual funds) into cash. © 2021 Rockwell Publishing 23 Disadvantages: Investing in RE Risk of loss Many things can go wrong with real estate. Two main types of causes for economic loss: ⚫ property loses value due to external factors (chiefly economic downturns) ⚫ property develops unexpected expenses © 2021 Rockwell Publishing 24 23  Property Management Instructor Materials Disadvantages: Investing in RE Cash outlay Majority of purchase price is usually financed, but required downpayment still large amount for any one investment. ⚫ Can result in lack of diversification. © 2021 Rockwell Publishing 25 Disadvantages: Investing in RE Expert knowledge To do well with real estate as investment, investor needs expert knowledge of: ⚫ local, regional market forces ⚫ anticipated demand for given property ⚫ management of property ⚫ income ⚫ expenses ⚫ proper maintenance © 2021 Rockwell Publishing 26 Disadvantages: Investing in RE Immobility and permanence Real estate is immovable and heavily affected by its environment, yet investor has little or no control over that environment. © 2021 Rockwell Publishing 27 24  Chapter 2: The Economics of Real Estate Investment Determining What to Pay Income approach to value Income approach to value: Estimate of a property’s value based on the income it produces. ⚫ Divide annual net operating income by rate of return investor expects (capitalization rate, or “cap rate”). Net operating income (NOI) ÷ Capitalization rate = Value © 2021 Rockwell Publishing 28 Determining What to Pay Income approach to value Net operating income (NOI) ÷ Capitalization rate = Value Net operating income (NOI): Amount of income left over after paying property’s operating expenses. © 2021 Rockwell Publishing 29 Determining What to Pay Income approach to value Example: Property earns $100,000 NOI, investor wants 7% return. Net operating income (NOI) ÷ Capitalization rate = Value 100,000 ÷.07 = 1,428,571 Value = $1,428,571 © 2021 Rockwell Publishing 30 25  Property Management Instructor Materials Summary Investing in Real Estate – Cash flow – Appreciation – Leverage – Tax deductions – Illiquidity – Risk of loss – Immobility and permanence – Income approach to value © 2021 Rockwell Publishing 31 Economic Forces & Cycles Returns on real estate investment sometimes unpredictable because subject to external forces: ⚫ economic forces ⚫ social trends © 2021 Rockwell Publishing 32 Economic Forces & Cycles Markets Market: Any arena in which buyers and sellers exchange a product. Can be: ⚫ local ⚫ regional ⚫ national ⚫ international © 2021 Rockwell Publishing 33 26  Chapter 2: The Economics of Real Estate Investment Economic Forces & Cycles Markets Real estate rental markets nearly always local. ⚫ But local markets influenced by national and regional factors such as: ⚫ state/federal spending ⚫ tax rates © 2021 Rockwell Publishing 34 Economic Forces & Cycles Supply and demand Price of an item is determined by supply and demand. Supply: The quantity of goods available in a market. Demand: The desire among potential purchasers for particular goods. © 2021 Rockwell Publishing 35 Economic Forces & Cycles Supply and demand Supply and demand have inverse relationship, creating a cycle: Demand increases → Supply decreases Supply increases → Demand decreases © 2021 Rockwell Publishing 36 27  Property Management Instructor Materials Economic Forces & Cycles Supply and demand Seller’s market: When demand exceeds supply and prices go up. ⚫ High prices encourage increase in production, which increases supply. ⚫ As supply increases, market price begins to fall. © 2021 Rockwell Publishing 37 Economic Forces & Cycles Supply and demand Buyer’s market: When supply exceeds demand and prices go down. ⚫ Bargain prices attract buyers, increasing demand. ⚫ As demand increases, market prices begin to rise. © 2021 Rockwell Publishing 38 Economic Forces & Cycles Supply and demand Supply and demand measured by absorption rate. Absorption rate: Length of time for existing vacant space to be rented under current conditions; expressed in months. ⚫ Total space available for lease in market ÷ current rate of demand = absorption rate. ⚫ 240,000 sq. ft. available ÷ 80,000 sq. ft. current demand = 36 months to absorb. © 2021 Rockwell Publishing 39 28  Chapter 2: The Economics of Real Estate Investment Economic Forces & Cycles Business cycles As with supply and demand, overall economy goes through business cycles. Business cycles: Pattern of repeated waves of growth and decline in an economy. © 2021 Rockwell Publishing 40 Economic Forces & Cycles Business cycles Business cycle has three different stages: ⚫ prosperity ⚫ recession ⚫ recovery © 2021 Rockwell Publishing 41 Economic Forces & Cycles Business cycles Prosperity: Growth is sustained and stable. Recession: Economy is contracting; characterized by increased unemployment and falling prices. Recovery: Growth starts to resume after recession has bottomed out. © 2021 Rockwell Publishing 42 29  Property Management Instructor Materials Economic Forces & Cycles Real estate cycles Business cycles affect whole economy; real estate cycles generally more local. ⚫ Commercial properties most affected. Real estate cycles correspond to three-stage pattern of business cycles: ⚫ prosperity (prosperity) ⚫ adjustment (recession) ⚫ stabilization (recovery) © 2021 Rockwell Publishing 43 Economic Forces & Cycles Real estate cycles Overbuilding: Prosperous market leads to building; supply eventually exceeds demand. Adjustment: Because of overbuilding, developers forced to cut rents on existing buildings and abandon new projects. Stabilization: After adjustment, cycle bottoms out and new development begins again. © 2021 Rockwell Publishing 44 Summary Economic Forces and Cycles – Markets – Supply and demand – Absorption rate – Business cycles – Real estate cycles – Prosperity/Overbuilding – Recession/Adjustment – Recovery/Stabilization © 2021 Rockwell Publishing 45 30  Chapter 2: The Economics of Real Estate Investment Real Estate Supply and Demand Supply and demand also affected by: ⚫ social and business trends ⚫ government factors © 2021 Rockwell Publishing 46 Real Estate Supply and Demand Social and business trends Social and business trends include: ⚫ population changes ⚫ business cycles ⚫ demographic changes ⚫ technological changes ⚫ social trends © 2021 Rockwell Publishing 47 Social and Business Trends Population changes Population of area may change because of: ⚫ fluctuations in local birthrate ⚫ people moving into or out of area Increase in population prolongs prosperity phase. Decrease in population drives down property values. © 2021 Rockwell Publishing 48 31  Property Management Instructor Materials Social and Business Trends Population changes Rental market may be heavily affected by seasonal population changes: ⚫ college town ⚫ summer vacation properties © 2021 Rockwell Publishing 49 Social and Business Trends Business cycles Business cycles usually affect local real estate market. ⚫ Commercial: ⚫ expansion: new construction ⚫ contraction: high vacancy rates ⚫ Residential: employment opportunities (or lack of them) affect demand for rental housing. © 2021 Rockwell Publishing 50 Social and Business Trends Business cycles Residential: increase in local wages leads to: ⚫ greater demand for upper end rental units, OR ⚫ less demand for rentals as more residents able to buy homes © 2021 Rockwell Publishing 51 32  Chapter 2: The Economics of Real Estate Investment Social and Business Trends Business cycles Residential: decrease in local wages leads to: ⚫ more demand for rentals since fewer residents able to buy, OR ⚫ less rental demand because more roommates or living with family © 2021 Rockwell Publishing 52 Social and Business Trends Demographic changes Changes in household size or average age of residents affect demand for different types of units. ⚫ More families with children = higher demand for multiple bedroom units. ⚫ More young professionals or retirees = higher demand for smaller, low maintenance units. © 2021 Rockwell Publishing 53 Social and Business Trends Technological changes Technological changes can lead to: ⚫ more online shopping ⚫ less demand for retail space ⚫ more telecommuting ⚫ less need for office space © 2021 Rockwell Publishing 54 33  Property Management Instructor Materials Social and Business Trends Social trends Social trends affect supply and demand, including migration from urban to suburban areas (and vice versa). Other trends: ⚫ Environmental concerns: ⚫ commuting ⚫ desire for garden ⚫ Changes in shopping style: ⚫ upscale stores clustered around outdoor plaza vs. older shopping malls © 2021 Rockwell Publishing 55 Real Estate Supply and Demand Government factors Government factors include: ⚫ monetary policy (interest rates/money supply) ⚫ lending institution regulation ⚫ mortgage industry involvement ⚫ tax policy ⚫ environmental and land use laws © 2021 Rockwell Publishing 56 Government Factors Monetary policy Monetary policy: Federal government’s control over interest rates and size of the money supply, implemented primarily through Federal Reserve. Three main tools: ⚫ key interest rates ⚫ reserve requirements ⚫ open market operations © 2021 Rockwell Publishing 57 34  Chapter 2: The Economics of Real Estate Investment Government Factors Monetary policy Fed’s control of key interest rates affects rates banks charge customers. ⚫ If Fed wants to stimulate economy, it lowers the rate. ⚫ If Fed wants to control inflation, it raises the rate. © 2021 Rockwell Publishing 58 Government Factors Monetary policy Reserve requirements: Percentage of deposits commercial banks must keep on reserve with Federal Reserve Bank. ⚫ If Fed wants to shrink the money supply (thereby increasing interest rates), it raises reserve requirements. ⚫ If Fed wants to enlarge the money supply (thereby decreasing interest rates), it lowers reserve requirements. © 2021 Rockwell Publishing 59 Government Factors Monetary policy Open market operations: Federal Reserve’s control of money supply through purchase and sale of government securities. ⚫ If Fed wants to shrink the money supply (thereby increasing interest rates), it sells securities to investors. ⚫ If Fed wants to enlarge the money supply (thereby decreasing rates), it buys securities. © 2021 Rockwell Publishing 60 35  Property Management Instructor Materials Government Factors Lending institution regulations Federal government oversees lending and investment practices of nation’s largest financial institutions. ⚫ Degree of strictness affects availability of credit. ⚫ Loose regulations can make credit more available. ⚫ Strict regulations can make credit harder to get. © 2021 Rockwell Publishing 61 Government Factors Mortgage industry involvement Availability of mortgage financing influences investor demand for real estate. Government goal: promote home ownership. ⚫ Fannie Mae, Freddie Mac buy mortgages from lenders, package them as mortgage- backed securities. ⚫ Securities sold on secondary market. ⚫ Provides smooth flow of money for mortgages throughout country. © 2021 Rockwell Publishing 62 Government Factors Mortgage industry involvement Two other agencies also play role: ⚫ FHA insures loans for qualified buyers ⚫ VA guarantees loans for qualified veterans ⚫ encourages lenders to lend to borrowers whose income might not qualify for conventional loans ⚫ stricter underwriting since bubble, resulting in fewer of these loans © 2021 Rockwell Publishing 63 36  Chapter 2: The Economics of Real Estate Investment Government Factors Tax policy State and local governments tax real estate to fund their operations. ⚫ Tax rates vary widely from area to area. ⚫ High property taxes tend to discourage investment and development. ⚫ Low property taxes tend to encourage investment and development. ⚫ But if taxes used to pay for high-quality schools & roads, may attract developers. © 2021 Rockwell Publishing 64 Government Factors Tax policy Federal government’s main source of funds is income tax. Income tax code includes some exemptions and deductions designed to encourage real estate investment: ⚫ depreciation deductions ⚫ mortgage interest deductions ⚫ deductions for operating expenses © 2021 Rockwell Publishing 65 Government Factors Environmental and land use laws Environmental and land use laws affect amount of land available for development. ⚫ Example: regulations that limit building on shorelines or lakefronts. © 2021 Rockwell Publishing 66 37  Property Management Instructor Materials Government Factors Environmental and land use laws Zoning and other land use laws can restrict development or open it up. Example: ⚫ property zoned for single-family homes limits development ⚫ multifamily and/or mixed zoning may encourage development When zoning changes to allow for wider range of uses, it’s known as upzoning. © 2021 Rockwell Publishing 67 Summary Real Estate Supply and Demand – Monetary policy – Reserve requirements – Open market operations – Lending regulations – Mortgage industry involvement – Tax policy – Environmental, land use laws © 2021 Rockwell Publishing 68 38