Transcript Chapter 11 Introduction to Investment Concepts

Chapter 11
Introduction to Investment
Concepts
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Major Topics
 Investor Objectives
 Sources of real estate returns
 Introduction to Cash Flow Analysis
 What we mean by direct and indirect
real estate investment
 Returns on labor versus returns on
investments
 Sources of real estate risk
 Measuring real estate risk
 Investment alternatives within the
real estate asset class
 Creative advantages of partnerships
and investment structuring
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Introduction: What do Investors Want?
 Investors seek current or future income or
sometimes both
 Future income might be used for personal
consumption at a later date or for future
generations
 Aggressiveness of investor depends on risk
preferences
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Sources of Real Estate Returns
 Cash Flow
-
Comes from the collected rents less the
operating expenses and debt service
Usually received monthly
 Tax Shelter or Postponement
-
Deductible non-cash items include
depreciation, amortization of points paid
for financing and possibly tax credits for
specialized government programs
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Sources of Real Estate Returns
(Contd.)
 Equity Buildup from Mortgage Repayment
-
Can occur from mortgage principal
repayment
 Equity Gains from Price Appreciation
Sources of appreciation:
- Inflation
- “Real” price changes
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Timing of Returns
From a timing perspective, we can take the
four types of returns listed above and reduce
these to only two:
 Cash Flow (after tax)
The before tax cash flow plus or minus tax
savings or taxes due can be treated as
one final source of returns during the
operational stage of ownership
 Residual Cash Flow (after tax)
The appreciation and equity buildup from
mortgage repayment both result in before
tax proceeds at the time of sale
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Introduction to Cash Flow
Analysis
 Gross Rent or Potential Gross Income
 Effective Gross Income
 Operating Expenses
 Net Operating Income or NOI
 Debt Service
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Important Terms (Contd.)
Gross Rent
Less Vacancy
= Effective Gross Income
Less Operating Expenses
= Net Operating Income
Less Debt Service
= Cash Flow (before tax)
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Current Yield and Total Return
 Current Period Return
 Periodic Returns
 IRR (Internal rate of Return)
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Levered versus Unlevered
Investments
 The term “levered” or “leveraged” refers to
the ability of an investor to increase the
returns on equity through the use of debt
 This occurs whenever the cost of debt is
less than the total return on the asset,
known as “positive leverage”
 Most investors buy stock without direct
debt
 When debt is used, it is known as “buying
on margin” and more aggressive investors
do use margin accounts
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Sources of Real Estate Risk
 In general, the risk and returns are greater
for real estate than bonds, and less for real
estate than stocks
 There may be times when stock returns are
less than real estate/ bond returns
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Sources of Risk (Contd.)
 Economic Risks
- Extremely Important!
- No control
 Business Risk or Management Risks
- More controllable than economic risks
 Financial Risk
- Leverage - most controllable decision
 Liquidity Risks
- Significant for all direct investments
 Political Risks
- Over time has become more significant
- No control
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Risk Analysis at the Property Level
 Sensitivity Analysis: Cash flow pro-formas
are developed and then ranges of uncertain
variables are tested for their impact on key
financial ratios and cash flow
 Simulation Analysis: When an entire range
of probable estimates are tested for several
variables at one time, and the resulting
distributions of probable results generated
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Managing Risk
 Risk management is accomplished through
negotiation and contracting, or in some
cases the purchase of insurance or hedge
investments
 Economic risks, based on expected market
demand and supply, are for the most part
uncontrollable
 Yet, the risk of a given tenant renewing a
lease that expires in the future might be
managed through negotiation
 Financial risks might also be managed by
the use of more or less leverage
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Managing Risk (Contd.)
 More leverage or debt as a proportion of
the total purchase price will result in
greater variability of returns
 Risks that cannot be shifted must simply be
priced
 That is, the investor must figure out how
much extra expected return they require in
order to take on the additional risk, known
as “risk premiums”
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Risk Premiums Example
Assume the following current capital market
rates and investment specific required premia:
 Risk free short term real rate (prior to
inflation) = .015 or 1.5% = Rf
 Expected annual inflation = .03 or 3.0% = EI
 Liquidity risk premium = .015 or 1.5% = LP
(for the difficulty of quickly selling real
estate)
 Economic, business and political risks = .04
or 4.0%
Total Return:
R = Rf+EI+LP+other risk premia = 10%
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Portfolio Perspectives
 Portfolio risk is based on the estimate of
return volatility for an entire basket or
investments
 Combining two or more risky investments
generally will lower total portfolio risk
 This is a result of the less then perfect
correlation of the individual asset returns,
 When the individual assets show negative
correlations over specific investment
horizons then the total portfolio risk can be
drastically reduced
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Market Efficiency and Real Estate
 Markets are efficient to the extent that all
of the available information is reflected in
the current market prices
 Efficient markets have no trading (buying or
selling) based on inside information
 It is still possible to achieve above average
market returns
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner
Creative Advantages of Partnership
and Investment Structuring
 One advantage of real estate versus other
types of assets is that even a single
investment can be structured to achieve
individual investor objectives
 Example: one investor may want current
returns and another may want future
wealth
 By structuring an investment with various
contractual interests (securities or
mortgages) that direct the return priorities
to different investors multiple investors can
achieve“Realtheir
Estate Principlesobjectives
for the New Economy”: Norman G. Miller and David M. Geltner
END
“Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner