Chapter 11 Introduction to Investment Concepts

1. Chapter 11Introduction to Investment Concepts “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. Creative Advantages of Partnership and Investment Structuring • One advantage of real estate versus other types of assets is that even a single investment can be structured to achieve individual investor objectives • Example: one investor may want current returns and another may want future wealth • By structuring an investment with various contractual interests (securities or mortgages) that direct the return priorities to different investors multiple investors can achieve their objectives “Real Estate Principles for the New Economy”: Norman G. Miller and David M. Geltner

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