Property Types PDF

Because learning changes everything. Property Types...

Because learning changes everything. Property Types ® Residential – properties that provide residences for individuals or families. Single-family houses – individual, detached units developed in subdivision tracts. Multifamily properties – differentiated by location and size of structure. Non-Residential. Office – range from major multitenant buildings to single tenant buildings. Chapter 9 Retail – vary from large regional shopping centers to small stores. Income-Producing Hotel/Motel – vary considerably in size and facilities. Properties: Leases, Rents, and the Market for Space Industrial/Warehouse – includes property used for light or heavy manufacturing as well as associated warehouse space. Recreational – includes country clubs, marinas, sports complexes, etc. Institutional – government, hospital, or university. Mixed Use. Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. © McGraw Hill 2 Local Market Studies of Supply and Supply and Demand Analysis Demand 1 Equilibrium Market Rental Rate – Demand for space. determined by the intersection of Quality of job creation. the supply and demand curves. Nature and kinds of employment. Implications for Risk – Changes in market rental rates Supply side. affect the risk and return Costs of financing. associated with investing in a Economic benefits of acquiring land and undertaking development. property. Leases can be structured to shift Demand Influences: some of the risk from the owner/lessor to the user/lessee. Apartments: Number of households. age of persons in households, size of household incomes, interest rates, home ownership, affordability, apartment rents, housing prices. Access the text alternative for slide images. © McGraw Hill 3 © McGraw Hill 4  Local Market Studies of Supply and Local Market Studies of Supply and Demand 2 Demand 3 Office Space: Categories of employment with very high proportions of office use include service Property Type Typical Construction and professional employment, including attorneys. accountants, engineers, Periods insurance. real estate brokerages and related activity, banking, financial services. Apartments Suburban garden walkup 6 to 18 months consultants. medical-dental, pharmaceutical, and so on. Urban mid -, high-rise 18 to 24 months Warehouse Space: Office Buildings Suburban low - rise 18 to 24 months CBD mid -, high - rise 24 to 48 months Categories of employment with high concentrations in warehouse use include Retail Strip/standalone 6 to 12 months wholesaling. trucking, distribution, assembly, manufacturing, sales/service. and so Neighborhood/community 12 to 24 months Enclosed malls 36 to 48 months on. Warehouse Suburban, single level 9 to 12+ months Retail Space: Demand indicators include household incomes, age, gender, population, size. and tastes /preferences. Supply Influences: Vacancy rates. interest rates and financing availability, age and combination of existing supply stock, construction costs, land costs. © McGraw Hill 5 © McGraw Hill 6 Location and User-Tenants The Business of Real Estate Concerns Results Most business real estate is leased and not owned because: 1. Increasing sales 1. Competition for space results in Most tenants find leasing to be more cost-effective than owning revenue. the highest rents for the most due to space requirements. 2. Reducing the cost of profitable locations. Tenants with greater space needs may also prefer to lease operations. 2. Locations will be dominated by users with similar revenue or because: 3. Some combination of 1 expense structures. Owning reduces operating flexibility. and 2. 3. The most appealing locations will Owners incur operating, maintenance, and repair expenses. produce the highest rents and spatial densities. Statistics. 4. Some competing firms are cost- 80% of office space is leased. sensitive. 63% of industrial/warehouse space is leased. © McGraw Hill 7 © McGraw Hill 8  The “Market” for Income-Producing Income Potential – Real Estate Assets Real Estate Tenants are searching for locations that provide the highest Market Rent – the price that must be paid by a potential profit. tenant to use (lease) a particular type of space under then- Investor-owners assume the risks of developing and/or current market conditions. Depends on: leasing and operating real estate for tenant-users in Outlook for the national economy. exchange for rent. Economic base of the area in which the property is located. Demand for the type of space provided by the property in the location being analyzed. Supply of similar competitive space. Vacancy – must be projected in order to project income. © McGraw Hill 9 © McGraw Hill 10 Underwriting Tenants General Contents of Leases Parties to the lease. Lease document assigns rights, duties, and responsibilities Base or minimum rent – the initial rent that must be paid under the lease contract. between: Deposits. Lessor – owner. Condition of the leased premises. Lessee – tenant. Allowable uses of the property. When evaluating a prospective tenant, the owner considers: Restrictions on subletting. Use of common areas. Financial statements. Responsibility for maintenance and repair. Credit ratings. Restrictions on alterations or improvements. Analyst reports. Construction of any expansion in the future. Eminent domain. Bank relationships. Responsibility for specific expenses. Existing obligations. Fire and casualty insurance. Renewal options. Estoppels. © McGraw Hill 11 © McGraw Hill 12  Methods for Recovering Operating Leases and Rental Income Expenses: Base rent – the initial rent that must be paid under the lease Gross (full-service) leases – the tenant pays rent only and the property contract. owner provides all services and pays all operating expenses. Modified (full-service) leases – the tenant pays rent that is lower than rent Methods to adjust rents. payable under a full-service lease. The owner provides all services but Flat rent – rents remain the same for the term of the lease. recovers from the tenant specific expenses identified in the lease. Step-up rent – based on a lease clause that provide that rent will Direct pass throughs. increase at the end of specified time intervals and in specific Nonoperating expense pass throughs – such as taxes and insurance. amounts during the time of the lease. Leases with operating expense recoveries – the tenant agrees to pay Indexed rent – adjusts rents using a specified index as a basis lower rents than would be the case for a full-service or modified full- for the adjustment. service lease in exchange for agreeing to pay a greater range of operating expenses. Rents adjusted based on revenue/sales performance – ties some portion of retail leases to sales. © McGraw Hill 13 © McGraw Hill 14 Service Arrangements for Large Comparing Leases: Effective Rent Users of Leased Space 1 Single net leases – the tenant pays rent and pays for all Effective rent can be used for comparison of individual operating expenses identified in the lease. leasing alternatives. Double net (net, net) leases – the tenant pays rent and Calculation procedure: pays all operating expenses directly plus the owner passes Calculate the present value of the expected net rental stream. through nonoperating expenses. Calculate an equivalent level annuity over the term of the lease. Triple net (net, net, net) leases – the tenant pays rent, all operating expenses, nonoperating expenses and certain recurring capital outlays for repairs, alterations, and modifications to the interior of the leased building space. Common area maintenance – tenants pay a pro rata share of expenses required to maintain common areas in the campus. © McGraw Hill 15 © McGraw Hill 16  Comparing Leases: Effective Rent Other Financial Considerations: Concessions and/or TI Allowances 2 Year (0) (1) (2) (3) (4) (5) 1. Gross Lease–Flat Rents Moving allowances. Gross rent – 40.00 40.00 40.00 40.00 40.00 Less: Operating expense Add: Recoveries – – 20.00 – 21.00 – 22.00 – 23.00 - 24.00 - Free or discounted rent. Not rent 20.00 19.00 18.00 17.00 16.00 Average net rent $18.00 – – – - - Buyouts of existing leases or lease termination fees. Present value $76.31 – – – - - Effective net rent $18.12 – – – - - 2. Gross Lease–Flat Rents with Expense stop Other inducements. Gross rent – 38.00 38.00 38.00 38.00 38.00 Less: Operating expense – 20.00 21.00 22.00 23.00 24.00 Add: Recoveries – – 1.00 2.00 3.00 4.00 Not rent – 18.00 18.00 18.00 18.00 18.00 Average net rent $18.00 – – – - Present value $75.82 – – – - Effective net rent $18.00 – – –- - 3. Gross Lease with 6 mo. Free rent and steps Gross rent – 20.00 40.00 49.00 49.00 49.00 Less: Operating expense – 20.00 21.00 22.00 23.00 24.00 Add: Recoveries – – – – - - Not rent – 00.00 19.00 27.00 26.00 25.00 Average net rent $19.40 – – – - - Present value $78.86 – – – - - Effective net rent $18.72 – – – - - © McGraw Hill 17 © McGraw Hill 18 Developing Statements of Operating Cash Flow Case Example: Office Properties 1 Rental Income. Rent Premiums and Discounts for Office Space. Add: Determining Lease Revenue. Other Income. Expense Recoveries. Rentable Area in a Building. Multiple Tenants – Rentable Area per Floor – Load Factors. Less: Vacancy and Collection Losses. Rentable area per floor Load factor per floor = Concessions. Usable area per floor Equals. Webster Office Plaza Effective Gross Income. Property Description Webster Office Plaza Less: Rentable Area (RA): 459,295 sq., ft., 17 stories Parking: 2,000 spaces Operating Expenses. Occupancy: 95% Site Area: 10 acres CAPEX/Improve Allowance. # Tenants: 65 # Elevators: 12 Rentables sq.ft., per Tenant (avg): 7,000 Equals. NOI (Net Cash Flow). © McGraw Hill 19 © McGraw Hill 20  Case Example: Industrial and Warehouse Case Example: Office Properties 2 Properties 1 Revenue Gross Rent ($25.65 base per sq., ft,*RA) $11,780,917 Pro Forma Statement of Cash Flow – Industrial/Warehouse Add: Expense Recoveries from Tenants $1,139,051 Add: Other Revenues Retail Services (Lobby) 10,000 Properties. Cell Tower Rents 54,301 Storage Fees 9,186 Parking Less: Vacancy (5% of Gross Rent) 381,215 589,046 Hellis Distribution Facility Less: Concessions (Free Rent, etc) 101,045 Effective Gross Income $12,303,364 Property Description Less: Operating Expenses Property Taxes 931,997 Hellis Distribution Facility/office/Showroom Building Mgmt/Admin/Leasing Expenses 982,891 Insurance Maintenance/Operations 638,420 987,484 Rentable Area (RA): 100,000 sq.ft/10% office/showroom space Utilities 1,731,542 Janitorial/Cleaning Business & Other Taxes 725,686 169,939 Lease: Single Tenant – 5 years Term – Net , Net Total Operating Expenses CAPEX/Improve Allowance 6,149,959 2,549,087 8,699,046 Rent per sq.ft:. 55 per Month, $6.60 per year Net Operating Income (NOI) $3,603,318 Operating Expense Recovery from Tenant: $1.00 per sq. ft. per Year *Rounded. © McGraw Hill 21 © McGraw Hill 22 Case Example: Industrial and Warehouse Properties 2 Case Example: Retail Properties 1 Revenue The Retail Leasing Environment. Rent (Base of $6.60 per sq. ft × RA) $660,000 Anchor Tenants versus In-line Tenants. Add: Expense Recovery from Tenant $100,000 Rents. Pass Throughs Property Taxes 125,000 Percentage rent clause. Insurance 50,000 1 Breakpoint sales level. Effective Gross Income $398,000 Less: Operating Expense CAM Charges – Recoveries. Maint/Repair/Other Expenses 150,000 Property Taxes 125,000 CAM charges per square foot of rentablein- line space = total CAM expenses - contribution expenses paid by anchor tenants total rentable area occupied by in - line tenant Insurance 50,000 Total Operating Expense 325,000 Shady Elm Community Shopping Center CAPEX/Improve Allowance 69,000 394,000 Property Description Shady Elm Community Shopping Center Net Operating Income (N OI) $544,000 Rentable Area (RA): 245,000 sq., ft., 17 Anchor Tenants: (2) Grocery/Home Furnishing Common Area: 80,000 sq.ft In-line/Shop Tenants: (30) Parking 2,500 spaces Site Area: 19 acres © McGraw Hill 23 © McGraw Hill 24  Case Example: Retail Properties 2 Case Example: Apartment Properties 1 Loss to lease – reflects the fact that leases on several units may have been made Revenue in previous periods and are different from current market rents being negotiated on Rent (Base of $16.73 per sq., ft,× RA) $4,080,850 new leases. Add: Overage Rent (from % leases) $ 308,700 CAM and other Expenses Recoveries from Tenants 1,139,250 Other income (kiosks, Outbuildings) 159,250 Name of Property Principal Amenities: Less: Vacancy (15% × RA × Base ) 204,942 Concessions – Waterfall Court Apartment Direct-access garages with automatic garage door openers. Washer/dryer Effective Gross Income $5,501,108 connections (full-size) in some units, Less: Operating Expenses Location swimming pool, limited access gates, Maintenance/Repair 584,700 Suburbia, USA parking spaces (400/some covered) Mgmt/Admin/Leasing Expenses 340,000 Improvement Description Land Area Density: Property Taxes 1,050,000 A 232-unit garden apartment community located Insurance 66,484 on a major north-south arterial road. The property Other 35,000 was well construct with a high level of amenities, Unit mix: Total Operating Expenses 2,075,700 including 100% direct-access garages. All building 1 bedroom - 1 bath CAPEX/Improve Allowance 315,000 (2,390,700) are two story construction with 90% brick exteriors 2 bedroom - 2 baths 104 units Avg. 1,000 sq.ft, per unit 128 units Net Operating Income (NOI) $3,110,408 Averages monthly rent: Age: Seven years old $885.65 per unit/.88 per square foot © McGraw Hill 25 © McGraw Hill 26 Case Example: Apartment Properties 2 End of Main Content Gross Potential Rental Income (GPRI) $2,465,649 Less: Loss to Lease* 61,036 Gross Rental Income $2,404,613 Less: Vacancy and Collection Loss Concession and Adjustments 285,013 181,739 1,937,861 Net Rental Income Add: Other Income 111,080 Recovery of expenses from tenants 200,000 311,080 Total Income 2,248,941 Less: Operating and Leasing Expenses 990,380 Capex/Improve Allowance 246,095 Because learning changes everything. ® Net Operating Income (NOI) 1,012,466 * Loss to lease could be positive if current market rents have fallen relative to rents on older leases made prior to the present time. www.mheducation.com Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. © McGraw Hill 27  Because learning changes everything. Valuation Fundamentals ® Market value is “the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller acting prudently and knowledgeably, and assuming the price is not Chapter 10 affected by undue stimulus. Implicit in this Valuation of Income definition is the consummation of a sale as of a Properties: Appraisal and the Market for Capital specified date and the passing of title from the seller to the buyer under conditions...” Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. © McGraw Hill 2 Appraisal Process and Approaches to Valuation Sales Comparison Approach 1. Ascertain the physical and legal identification of Based on data provided from recent sales of highly the property. comparable properties. 2. Identify property rights to be valued. Must be arms-length transactions. 3. Specify the purpose of the appraisal. Should be normal market transactions. 4. Specify effective date of value estimate. The rationale lies in the principle that an informed 5. Gather and analyze market data. investor would never pay more for a property than what other investors have recently paid for 6. Apply techniques to estimate value. comparable properties. © McGraw Hill 3 © McGraw Hill 4  Income Approach Gross Income Multiplier Method sales price Gross Income Multiplier Method – is based on GIM  Gross income relationships between gross income and sale prices for all comparable properties that are Interpreted that comparable properties are sold at applied to the subject property. GIM × the current gross income. Direct Capitalization Method – should be used in Potential gross income − assumes all the space is cases where it is suspected that differences in occupied. operating expenses exist between comparables. Effective gross income − is based on occupied Discounted Present Value Method – is based on space (potential gross income less vacancies). the principle that investors will pay no more for a property than the present value of all future N OIs. © McGraw Hill 5 © McGraw Hill 6 Direct Capitalization Method Discounted Cash Flow Techniques Capitalization Rate (R) – NOI divided by transaction price. Based on the principle that investors will pay no more for a property than the present value of all future NOIs. Value = NOI ÷ R Steps. Further Interpretation – Application and Limitations. 1. Forecast NOI. This approach does not assure that this property will be a good 2. Select a relevant holding period for the investment. investment if purchased. 3. Select a Discount Rate (r) for the period. It only assures the buyer that it is a competitive market price. 4. Using Approximations to Estimate Reversion Values (REV) or resale Whether or not it is a good investment will depend on the future prices using one of the following methods: growth in rents, income, and property values. Estimate REV by developing a terminal cap rate based on required rate of Capitalization Rates – A Note of Caution. return and expected long-term cash flows. Estimate REV with a terminal cap rate from sales of older comparable Properties chosen must be truly comparable or competitive. properties. Nonrecurring outlays for nonoperating expenses must be accounted Estimate the resale price based on an expected change in property values. for. © McGraw Hill 7 © McGraw Hill 8  Land Values: Highest and Best Use Mortgage-Equity Capitalization Analysis Residual Land Value – the difference between the total This method estimates the value of a property by property value and the cost of constructing an taking into consideration the requirements of the improvement on a given site. mortgage lender and equity investor. Volatility in Land Prices is typically caused by changes PV = M + E. in expected NOI and/or expected values for r and/or g. Where: “Highest and Best Use” Analysis – determines what use PV = property value. will provide the highest total land value. M = present value of expected mortgage financing. Vacant Site - it is the expected use of the land and its future income that determine its value. E = present value of equity investment made by investors. Improved Property – demolition and other costs must be considered. © McGraw Hill 9 © McGraw Hill 10 Reconciliation: Sales Comparison and Income Capitalization Approaches Cap Rates and Market Conditions It is a good policy to use both the sales comparison Lower market cap rates (higher property values) tend to be and income approaches to valuing properties when brought about by: possible. 1. Unanticipated increases in the demand for real estate relative to supply. When the sales comparison method is used, cap rates 2. Unanticipated decreases in interest rates. reflect what investors are currently paying for Both 1 and 2. comparable properties. However, properties that have sold recently are often Higher market cap rates (lower property values) tend to be not truly comparable to properties available for brought about by: purchase. 1. Unanticipated increases in the supply of real estate relative to demand. 2. Unanticipated increases in interest rates. Both 1 and 2. © McGraw Hill 11 © McGraw Hill 12  Word of Caution – Simultaneous Effects of Real Leases: Valuation of a Leased Fee Market Forces and Interest Rates on Property Values Estate When valuing specific properties, the investors must Leased fee estates – when properties being consider: considered for purchases and existing leases are 1. Current market supply and demand conditions and how long in place that have below (or above) market rents. such conditions will last. 2. The effects of such conditions on rents and NOI. 3. The future course of interest rates that may be affected by more global, non-real estate specific influences such as global economic growth and inflationary pressures. 4. The contents of leases that have been executed on the property being evaluated and whether conditions in 1, 2, and 3 will materially affect rents, expenses, and tenant default rates. © McGraw Hill 13 © McGraw Hill 14 Cost Approach End of Main Content Is based on the rationale that any informed buyer of real estate would not pay more for a property than what it would cost to buy the land and build the structure. Involves determining the construction cost of building a given improvement then adding the market value of the land. Estimates on existing buildings are reduced by Because learning changes everything. ® estimating any physical deterioration, functional obsolescence, or external obsolescence. This approach is more reliable when the structure is www.mheducation.com relatively new and depreciation does not present serious complications. Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. © McGraw Hill 15  Because learning changes everything. Motivations for Investing ® Rate of return – based on the net income after collecting rents and paying operating expenses. Price appreciation – in anticipation of selling properties after some holding period. Diversification – most investors want to hold a Chapter 11 variety of investment types. Investment Analysis and Taxation of Income Properties Tax benefits – historically, investors have paid little or no taxes on returns from real estate investments for many years. Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. 2 © McGraw Hill Real Estate Market Characteristics General Investment Strategies The Real Estate Cycle – the cyclical nature of the Core – acquiring existing, seasoned, relatively low-risk real estate industry. properties that are at least 80 percent leased to tenants with low credit risk. Core “Plus” – combines core investment with a strategy to make minor changes in the management of the property with a releasing program. Value Added – used to focus on some aspect of properties that are not being optimized. Opportunistic Investing – involves acquiring properties from investors in financial difficulty or properties needing renovation, upgrading, or repositioning. Access the text alternative for slide images. © McGraw Hill 3 © McGraw Hill 4  Specialized Investment Strategies Market Analysis Property Sector Investing – over the long term, one property type will outperform other Demand for space – comes from potential tenants who desire to property sectors. use the space for their business. Contrarian Investing – some major economic, technological or other event will make the investment outlook for a given property type poor and out of favor among investors. Supply of Space – comes from investors who have purchased or Market Timing – some investors can predict when to buy or sell properties. developed building and are willing to make that space available for Growth Investing – discovering those property types and markets that are likely to rent. experience significant or above average appreciation in value. Market Rents – rental rates and the growth in rents are highly Value Investing – research is directed toward finding those properties that have been overlooked by investors. correlated with occupancy rates. “Trophy” or “Blue Chip” Properties – only very visible, well-located properties should be Forecasting Supply, Demand, Market Rents, and Occupancy – the targets for acquisition. We can estimate demand based on expected employment growth for Size of Property – a preference for a subsector within a property type. the foreseeable future. Tenants – a preference for properties leased to multiple tenants or a single or very few tenants. We can estimate supply as the expected amount of new space likely to Arbitrage Investing – recognizing differences in prices that buyers are willing to pay for be added to the market. the same real estate investments in different markets. We also consider any likely changes to the amount of space per Turnaround Investing – changing or modifying the use of existing properties. employee. © McGraw Hill 5 © McGraw Hill 6 Making Investments: Projecting Cash Flows Introduction to Investment Analysis Base Rent. Investment analysis – analyzing a particular Market Rent. property to evaluate its investment potential. Expense Stops – place an upper limit on the amount of Internal Rate of Return (IRR) – the rate that operating expenses that will have to be paid by the owner. makes the present value of the projected cash Net Operating Income – projected revenues less projected flows equal to the initial investment. operating expenses. Present Value – the price that an investor should Expected Outlays for Replacements and Capital be willing to pay for a property given its projected Improvements – outlays of a recurring nature for the replacement of items that wear out in the normal operating cash flows. cycle of a property. Estimated Sale Price – an estimate of what the property might sell for. © McGraw Hill 7 © McGraw Hill 8  Taxation of Income-Producing Real Introduction to Debt Financing Estate Measures of Investment Performance Using Ratios. Does not include real estate held as a personal Equity Dividend Rate – calculated by dividing the B TCF residence by individuals. in the first year by the initial equity investment. Personal residences cannot be depreciated for tax Debt Coverage Ratio – the ratio of NOI to the mortgage purposes. payment. We assume that the property is not held for resale to others. Before-Tax Cash Flow from Sale. Individuals holding property for resale to others in the Internal Rate of Return to Equity Investor. ordinary course of business are referred to as dealers. Summary of Investment Analysis Calculations. Real property held for resale by a dealer is not depreciable for tax purposes. © McGraw Hill 9 © McGraw Hill 10 Taxable Income from Operation of Real Estate Adjustments to Taxable Income Taxable income from operating income property ≠ Depreciation Allowances. BTCF because: Depreciable Basis – generally equal to the cost of the improvements where cost is generally defined to include the Only the interest portion of a loan payment is acquisition price of the improvements plus any installation costs deductible from the NOI for tax purposes. associated with placing them into service. The tax code allows owners to deduct a depreciation Loan Points – must be deducted ratably over the term of the allowance from NOI. loan. Taxable Income = NOI − Interest − Depreciation Tax Liability and After-Tax Cash Flow – calculated by multiplying the taxable income by the investor’s marginal tax rate. Allowance. Marginal tax rate - the rate which the additional income from the investment under consideration will be taxed. © McGraw Hill 11 © McGraw Hill 12  Taxable Income from Disposal of After-Tax Investment Analysis Depreciable Real Property Gross sales price - any cash or other property After-Tax Cash Flow from Operations – BTCF less taxes. received in payment for the property sold, pus any Depreciation – lowers taxable income. liabilities against the property assumed by the After-Tax Cash Flow from Sale. buyer. Total capital gain results from. Net sales proceeds – gross sales price minus Price appreciation which has a maximum capital gain tax rate of 15%. selling expenses Accumulated depreciation which has a maximum tax rate of 25%. Gain or loss – net sales proceeds minus adjusted After-Tax IRR – based on the after-tax cash flow. basis which is original basis plus the cost of any Effective Tax Rate – the difference between the before-tax capital improvements, alterations, or additions IRR and the after-tax IRR. made during the period of ownership, less accumulated depreciation taken to date. © McGraw Hill 13 © McGraw Hill 14 A Note about Passive Losses End of Main Content Income and Loss Categories: Passive income or loss – income or loss from a trade or business where the investor does not materially participate in the management or operation of the property. Active income or loss – salaries, wages, fees for services, and income from a trade or business in which the investor materially participates. Portfolio income or loss – interest and dividend income from stocks, bonds, and some categories of real estate that are classified as capital assets. Because learning changes everything. ® Special Exceptions to PAL Rules – applies to individual rental property owners. Can offset active income with up to $25,000 of passive activity losses www.mheducation.com from rental real estate activities in which the individual actively participates. Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. © McGraw Hill 15  Because learning changes everything. Introduction to Financial Leverage ® Conditions for Positive Conditions for Positive Leverage – Before Tax Leverage – After Tax BTIRRP  BTIRRD. ATIRRP  ATIRRD Unleveraged BTIRR is greater than the interest ATIRRE  ATIRR P  rate paid on the debt.  ATIRRP   E ATIRRD  D Chapter 12 Financial Leverage and BTIRRE BTIRR PP  The after-tax return on total Financing Alternatives BTIRRP  BTIRRDD  D E  funds invested must exceed the after-tax cost of debt. Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. © McGraw Hill 2 Break-Even Interest Rate Risk and Leverage Break-even interest rate – the maximum interest rate that There is an implicit cost associated with the use of could be paid on the debt before the leverage becomes financial leverage. unfavorable. This cost is higher risk. ATIRR P BEIR  The decision to use leverage cannot be made by only 1 t looking at BTIRRP and BTIRREE. Leverage and the Incremental Cost of Debt. As the amount of debt increases, lenders may charge a higher The investor must ask whether the higher expected interest rate to obtain additional financing. return with leverage is commensurate with the higher risk. The investor should also ask if there is a way to realize the higher return with less risk. © McGraw Hill 3 © McGraw Hill 4  Underwriting Loans on Income Properties Market Study Elements Market Study and Appraisal – lenders usually require Analysis of the economic base. a market study and an appraisal by a third party. Prospective employment growth for the city or Borrower Financials – the borrower will provide loan region. security in the form of personal liability on the note. Analysis of the submarket showing vacancy Loan-to-Value Ratio - most lenders require that the rates and rents on competing properties. loan amount shall not exceed 75 to 80 percent of the value of the property. New construction and renter demand. Debt Coverage Ratio – measures the extent that the NOI from the property is expected to exceed the mortgage payments. © McGraw Hill 5 © McGraw Hill 6 Borrower Financials The Debt Coverage Ratio NOI Non-recourse clause – releases the borrower from = Max debt service personal liability and makes the property the sole Desired DCR target source of security for the loan. NOI Non-recourse clause may be viewed as a put DCR  mortgage payment option held by the borrower. © McGraw Hill 7 © McGraw Hill 8  Common Mortgage Covenants Other Loan Terms Lender must approve all new major leases. Lockout Period – prohibits the borrower from prepaying the loan within a specified period. Lender must approve any modification to existing leases. Yield maintenance fee (YMF). Lender and borrower agree that in the event of prepayment, the Lender must approve any additional construction. lender must continue to earn a certain yield for the remaining Borrower must supply periodic updates. term. Borrower must supply annual appraisal. The borrower must pay the difference between the lender’s lowest potential reinvestment rate and the original yield. Borrower must notify lender of any lawsuits. Borrower must notify lender of any major capital expenditures to correct structural defects. © McGraw Hill 9 © McGraw Hill 10 Alternatives to Fixed Rate Loan Participation Loans Structures Mortgage payments increase over time (like Lender Motivations. Investor Motivations. graduated payment mortgage). Lender’s rate of return The borrower pays less Lender receives a portion of the proceeds from is at least comparable initially than they would to what the return have with a straight loan. sale of the property (like a shared appreciation would have been with The investor may have mortgage). a fixed interest rate more cash flow during the Lender receives an option to purchase the loan. early years. property at a specified exercise price. The lender gets a Debt coverage ratio may be hedge against higher in the early years. unanticipated inflation. © McGraw Hill 11 © McGraw Hill 12  Sale-Leaseback of the Land Interest-Only Loans Investor owns the land and sells it with an agreement to lease the Interest-only loan – no amortization is required for land back from the purchaser. a specified period. Benefits: Balloon payment – lump sum payment due at the A way of obtaining 100 percent financing on the land. Lease payments are tax deductible. end of the interest-only period if the loan is not Investor may have the option to purchase the land back at the end of amortized. the lease. Bullet loans – short-term loans that require little or Effective cost of the sale-leaseback. no amortization. Assume land is sold for $100,000 (PV), held for five years (N), leased back for $3,500 per year (PMT), and repurchased for $110,408 less than without the sale-leaseback (FV). The resulting yield is 5.32% (I/Y). © McGraw Hill 13 © McGraw Hill 14 Accrual Loans Convertible Mortgages Accrual loans – payments for a specified number of years Convertible mortgage – gives the lender an option to purchase a full or a are lower than the amount that would be required to cover partial interest in the property at the end of some specified period. the monthly interest charge. Assume: Pay rate – the rate used to calculate the loan payment that A $700,000 convertible mortgage that allows the lender to acquire 55% of the equity ownership in the property at the end of the fifth year when the property is is different from the rate used to calculate the interest valued at $1,104,080. Loan is amortized over 20 years with monthly payments. charged. Interest rate is 4.25% compared to 5% on a conventional loan. Accrual rate – the rate used to calculate the interest Effective yield: charged. N = 5 × 12 = 60. PV = $700,000. Negative amortization – when a loan payment is less than the amount of interest due on the outstanding loan PMT = 52,016/12 = 4,334.67. balance. FV = $1,104,080 × 55% = $607,244. Solve for I = 5.10%. © McGraw Hill 15 © McGraw Hill 16  Comparison of Financing Alternatives Other Financing Alternatives The table ranks the six financing alternatives Mezzanine Loan – bridges the gap between the compare regarding before- and after-tax returns, first mortgage debt on the property and the equity debt coverage, and lender’s yield (IRR D ). investment. Preferred Equity – an equity interest in the BTI RRE ATI RRE D CR IRRD property but has debt like characteristics because Convertible 5 4 5 4 Participating 6 6 3 1 preferred equity investors have a claim on cash Sale-Leaseback 1 3 5 2 flows from the property that comes before that of Interest-Only 2 1 1 4 the regular equity investors. Accrual 3 2 2 4 Convertible 4 5 4 3 © McGraw Hill 17 © McGraw Hill 18 End of Main Content Because learning changes everything. ® www.mheducation.com Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.  Because learning changes everything. Comparing Investment Returns ® Will the investment provide an adequate or competitive return? This depends on: The nature of alternative real estate investments; Other investments that are available to the investor; The respective returns that those alternatives are expected to yield; and Chapter 13 Differences in risk between the investment being Risk Analysis considered relative to those alternative investments available to the investor. Copyright 2022 © McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC. © McGraw Hill 2 Types of Risk Due Diligence Overview Business Risk – loss due to fluctuations in economic activity that affect Due diligence describes the investigation that an the variability of income produced by the property. investor should undertake when considering the Financial Risk – the risk of bankruptcy. acquisition of a property. Liquidity Risk – the inability to convert an asset into cash without significant loss in value. Due diligence is the process of discovering Inflation Risk – rise in prices unrelated to improvements in technology. information needed to assess whether or not Management Risk – the competency of management. investment risk is suitable given a set of Interest Rate Risk – changes in interest rates. investment objectives. Legislative Risk – results from the fact that changes in regulations can adversely affect the profitability of the investment. Environmental Risk – changes in the value of real estate due to changes in its environment or sudden awareness that the existing environment is potentially hazardous. © McGraw Hill 3 © McGraw Hill 4  General checklist of the areas that Sensitivity Analysis should be investigated: Rent roll analysis. Change a Single Assumption at a Time – allows Lease agreement review. the analyst to isolate the impact of a specific input Review of service and maintenance agreements. assumption. Pending or threatened matters review. Review of title/deed documents to determine nature and extent of easements. Scenarios – alternatively, the analyst can identify Property survey. likely scenarios such as base case, best case, Government compliance. and worst case. Physical inspection. Tax matters. Insurance policies. Engineering studies. Market studies. List of personal property. © McGraw Hill 5 © McGraw Hill 6 Partitioning the IRR Variation in Returns and Risk Internal rate of return on equity investment in real Measures of Variance and Risk – standard deviation estate comprises of two sources of cash flow: gives a specific range within which we can expect the actual return for each investment to fall in relation to 1. Cash flow from operations. its expected return. 2. Cash flow from the sale of the investment. Risk and Return – coefficient of variation measures risk per unit of expected return. This is important because it helps the investor to determine how much of the return depends on Portfolio Considerations – by developing a portfolio of different investment properties, the investor can annual operating cash flow and how much depends significantly reduce risk through diversification. on the projected cash flow from resale. © McGraw Hill 7 © McGraw Hill 8  Market Leasing Assumptions with Lease Rollover Risk Renewal Probabilities There is uncertainty as to whether the existing Market Rent – when a renewal probability is less than 100% and there is a difference between market rent for ne