Chapter 11:Investment Analysis and Taxation

of Income Properties

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

11-2

Investment AnalysisInvestment Analysis

Equity Investment Motivations for Investing in Income

Properties– Rate of Return– Price Appreciation– Diversification– Tax Benefits

11-3

Market CharacteristicsMarket Characteristics

Real Estate Cycle– Large Market in number and size of properties– Competitive– Fragmented Ownership– Overdevelopment Potential– The cycle differs for different property types.

11-4

Exhibit 11-1Exhibit 11-1The “Real Estate Cycle”The “Real Estate Cycle”

11-5

Investment StrategiesInvestment Strategies

Investing in Core Properties Investing in Core Properties with a “Value

Add” Strategy Property Sector Investing Contrarian Investing Market Timing Growth Investing Value Investing

11-6

Investment StrategiesInvestment Strategies

Strategy as to Size of Property Strategy as to Tenants Arbitrage Investing Turnaround/Special Situations Opportunistic Investing Investing in “Trophy” or “Blue Chip”

Properties Development

11-7

Market AnalysisMarket Analysis

Evaluation of supply and demand for a type of property

Absorption Supply of Space Market Rents Forecasting Supply, Demand, Market

Rents, and Occupancy

11-8

Investment AnalysisInvestment Analysis

Internal Rate of Return (IRR)– The discount rate at which the net present

value of the cash flows is equal to 0. – If IRR >= r; accept Project– If IRR < r; reject Project– Where r is the discount rate, or more

colloquially, the “hurdle rate”

11-9

Investment AnalysisInvestment Analysis

Net Present Value– A way to solve for the initial price that an investor may

pay given a specified discount rate. – Discounted value of the cash flows. – The discount rate is the rate of return that an investor

will require in order to make this investment. – If we include the initial equity investment in this

calculation, we can solve for the difference and see how much more or less the investor may pay and still receive a rate that is equivalent to their discount rate.

11-10

Debt FinancingDebt Financing

Equity Dividend = NOI - DS– NOI = Net Operating Income – DS = Debt Service

The equity dividend is also referred to as the before-tax cash flow from operations (BTCF0)

11-11

Debt FinancingDebt Financing

Equity Dividend Rate =

Equity Dividend/Initial Equity Investment– Sometimes referred to as “unleveraged cash on cash”

rate.

Debt Coverage Ratio (DCR) = NOI/DS– The DCR is a vital ratio for lenders.– If the DCR is less than 1, the borrower will not be able

to service the debt. – Generally, lenders want a DCR greater than 1 so the

borrower has a cushion and can repay.

11-12

Debt FinancingDebt Financing

Example 11-1: – $1,000,000 Property; – 95% allocated to building and 5% to land– 70% LTV; 7% Interest Rate, 30 Years– $700,000 debt; $300,000 equity– Monthly Payment = $4657.11– DS = 12 x $4657.11 = $55,885

– NOI1 = $85,000

11-13

Before-Tax Cash FlowBefore-Tax Cash Flow

Equity Dividend = NOI-DS– $85,000 - $55,885 = $29,115 – This is also the BTCFo for this year.

Equity Dividend Rate = EQDIV/Equity– $29,115/$300,000 = 9.71%

Debt Coverage Ratio = – $85,000/$55,885 = 1.52

These ratios all pertain to the first year of operations.

11-14

Before-Tax Cash FlowBefore-Tax Cash Flow Before-Tax Cash Flow from the Property

Sale (BTCFs):

– BTCFs = Sales Price – Mortgage Balance

– In Example 11-1, if the property were sold in Year 4 for $1,100,000 then

– BTCF = $1,100,000 - $668,322 = $421,678The mortgage loan balance ($668,322) is

computed as previously. See Chapter 4.

11-15

Four Classes of Real Property– Real Estate held as a “personal

residence”– Real Estate held for sale to others –

“dealer” property”– Real Estate held for use in a trade or

business – “trade or business property”– Real Estate held as an investment for the

production of income – “investment property”

TaxationTaxation

11-16

Active Income– Salaries, wages, bonuses, and

commissions

Portfolio Income– Interest, dividends, and capital gains

Passive Income– Rents from real estate, and royalties from

oil and gas rights

Types of Taxable IncomeTypes of Taxable Income

11-17

Passive Activity Loss Passive Activity Loss RestrictionsRestrictions

Passive losses cannot be used to reduce active or portfolio income

Passive losses may be used to reduce other passive income

Passive losses not used may be used in future years or at the same time of sale

11-18

Passive Activity Loss RestrictionsPassive Activity Loss Restrictions

1st Exception– Active participants may deduct up to $25,000 in

passive losses against other non-passive income, subject to limitations such as their adjusted gross income

2nd Exception– Broad exception for real estate professionals

from the Passive Activity Loss rules. – For many of you, if you enter the real estate

business, this will apply to you.

11-19

Depreciation BasisDepreciation Basis The original cost basis includes all costs

associated with acquiring the property and transferring the title

Land value cannot be depreciated The depreciable basis is the total value

that can be depreciated over the recovery period

Depreciable Basis = Cost Basis – Land Amount

11-20

DepreciationDepreciation Depreciation

– Depreciable Basis / Recovery Period

Recovery Period is different based on property type– Residential income producing property (27.5

Years)– Non-residential income producing property (39

Years)– Note that the recovery period is a product of the

tax code. It will vary based on the country that the real estate is located in.

11-21

After-Tax Cash FlowsAfter-Tax Cash Flows

Calculating the after-tax cash flow from operations

Step 1: Compute taxable income

Net Operating Income- Depreciation- Interest

Taxable Income

11-22

After-Tax Cash FlowsAfter-Tax Cash Flows

From Slide 11-10, depreciation is based on a building value of $950,000 over 27.5 years. – Depreciation = $950,000/27.5 = $34,545– Interest = $48,775 using the “amort” function

on the financial calculator.– The depreciation schedule will vary. It is not

always 27.5 years.

11-23

After-Tax Cash FlowsAfter-Tax Cash Flows

From Example 11-1, year 1 taxable income would be:

NOI $85,000

Depreciation - $34,545

Interest - $48,775

Taxable Income $ 1,680

11-24

After-Tax Cash FlowsAfter-Tax Cash Flows

Step 2: Compute Taxes

Taxes (at 28%) = 0.28 x 1,680 = $470 Step 3: Compute after-tax cash flow from

operations for year 1

ATCF1 = BTCF1 – Taxes

= 29,115 - 470

= $28,645

11-25

After-Tax Cash FlowsAfter-Tax Cash Flows

Taxes on the property sale

– Gain from price appreciationThe maximum is 15%

– Gain from accumulated depreciationTaxed at 25%

– Note that these rates have changed and will change in the future as the tax code is updated and modified.

11-26

After-Tax Cash FlowsAfter-Tax Cash Flows

From Example 11-1, Slide 11-12 Before-tax cash flow from the property

sale = $421,678 Step 1: Compute tax on property value

increase:$1,100,000 - $1,000,000 = $100,000

Taxed at 15% capital gains rate = $15,000

11-27

After-Tax Cash FlowsAfter-Tax Cash Flows

Step 2: Compute tax on prior depreciation:

4 Years at $34,545 = $138,180

Taxed at 25% = $34,545

Step 3: Compute total taxes from sale:

$34,545 + $15,000 = $49,545

11-28

After-Tax Cash FlowsAfter-Tax Cash Flows

Step 4: Compute after-tax cash flow from the property sale

ATCFs = BTCFs – Taxes

ATCFs = $431,678 - $49,545 = $382,133

Analysis– Compute After-Tax Internal Rate of Return– Compute After-Tax Net Present Value