Real Estate Investment & Finance (Key Concepts)

• There are seven valuation criteria specific to real property.
• -location and construction
• -production of growth capital
• -production of income
• -durability
• -response to change
• -enhancement of activities within a building
• -productivity

The first four criteria are the financial considerations that go into purchasing or leasing real estate. The last three criteria are associated more with facilities management of existing buildings.

A capital investment is one in which monies are invested to produce or increase asset value. Whereas income generated from the rental of a building is recognized on an income statement in the period it was earned, capital or value growth is usually not recognized until an asset is sold (except in the case of certain institutions, such as banks and insurance companies, where real property is carried on the books at its estimated fair market value). Instead, capital invested in real estate is carried on the balance sheet as either its historical cost or its net of accumulated depreciation (net book value). When real estate is sold for more than its net book value, a capital gain is recognized on the income statement in the period during which the transaction took place.

In other words, real property investments produce capital gains when they yield more when sold than they cost to acquire. In practice, these numbers must be adjusted for the effects of inflation and the cost of borrowing money. Of course, other factors may also be considered.

Churn rate is the annual rate of reconfiguration, relocation, or other physical change in a facility. It is expressed as a percentage of square feet or population involved in the change.

While most real estate is considered static and subject to minimal change over time, the interiors of most office buildings are constantly changing to keep up with businesses that reconfigure their organizations to better position themselves in highly competitive marketplaces. This physical change is called the churn rate. Churn is stated in terms of the percentage of a space inventory that is reconfigured in some way (walls, furniture, finishes, utilities) in a year. Churn rates average 30-35% in most companies.

Churn costs can be very substantial and should be considered an operating expense because they do not add value to the property as an asset.

Property managers are focused on the financial and physical management of the building. Their goal is to keep the building full of tenants and running efficiently, maximizing net income for the owner while minimizing risks. They represent the owner in dealing with vendors and services and they also market and lease available space.

Depending on the type of investment and the goal of the investors, consideration is given to investment ROI (the return on the investment while it is being held) and/or to capital ROI (the return on the investment when they are done with it). Investment ROI may be considered cash flow, such as monies received as interest on a savings account of from a stock dividend. Capital ROI results from an investment's appreciation in value; art or sculpture, for example, would not have a cash flow but may increase significantly in value over a period of time.

Investment ROI - The return on an investment while it is being held.

Capital ROI - The return on an investment as appreciation in value over a period of time.

• The standard financial evaluation techniques typically applied to investment/production decisions include:
• -break-even analysis
• -payback analysis
• -net present value analysis
• -internal rate of return

Utility: Real estate has the power of an economic good. It fills a human need or provides a desired service.

Scarcity: Real estate is limited. The quantity of land on planet Earth is fixed with little possibility of creating more.

The relative utility and individual uniqueness of each real estate parcel results in dramatic differences in the value of individual locations. It is said that there are only three important factors when considering an investment in real estate: location, location, and location.

Ad valorem levies are taxes on real estate based on value.

Eminent domain is the right of a government or properly authorized entity to take private proeprty for public use. The right of eminent domain is exercised through a condemnation process, and the owner must be justly compensated for the taking of the property.

Escheat is the right of government to take title to private property in the absence of legal heirs.

The Rule of 72 is an approximation of how many years will be required to double a capital investment. It is determined by dividing the yield into the number 72.

Assume that you intend to make an investment and that you will leave the interest earned on that investment to accumulate as capital, that is, to compound. An example might be a certificate of deposit with a yield of 8% per annum. By dividing the yield (8 in this case) into the number 72, you will have an approximation of how many years (9 in this example)will be required to double the amount of your original capital. Although the results are approximate, the effect of compounding is readily apparent.

6 years (72 / 12 = 6)

Yield is the total return on an investment during the period it is held.

The ability to sell an investment quickly for cash determines its liquidity. Liquidity is often an anticipated or perceived investment quality. Liquidity is highly dependent on orderliness and stability in the secondary marketplace. Unexpected events often play a role in the liquidity of a particular investment. The closure of a lender, a bankruptcy, or a wekening in the real estate or securities markets can affect both price and liquidity. To be liquid, an investment must have a recognized market and there must be a pool of willing purchasers.

Every individual, business, and political entity experiences periods of prosperity and deprivation, and periods of economic ascent and decline. Alternating periods of expansion and decline in economic activity make up a business cycle. Business activity cycles and recycles throught the life of a market-driven economy. These cycles take place on a microeconomic and macroeconomic level.

Risk is the potential for injury or loss. Risk, in the statistical sense, is the likelihood that a possible outcome will take place. Risk, in the human sense, is taking a chance that involves the possibility of reward if a decision is correct and loss if it is incorrect. Economic risk involves aspects of both stastitical and human risk. Economic uncertainty and expectations, clouded by prejudice and corporate mission or political issues, give rise to increased risk.

When a commercial bank is not able to immediately meet an increased reserve requirement with cash or equivalents, the affected bank can borrow the necessary additional resesrves from the district Federal Reserve Bank itself. This borrowing actiivty is known as discount window operations.

When securities are purchased for cash from the market makers, it results in an increased amount of cash available for loans. The more cash that is available for lending, the lower the interest rates will tend to become.

When securities are sold to market makers, cash is withdrawn from the pool of funds available for lending and interest rates rise.

Tangibles are classified into two general types: those that produce an income stream during the holding period and those that do not.

Owning real estate requires a specific method of description. Every tract of land has boundaries that make it distinct from other parcels, adn these demarcations legally describe the land. Legal descriptions of land are used in formal documents, especially deeds and mortgages in which informal descriptions, such as mailing addresses, are not sufficient.

The metes and bounds system measures distnace and direction from an arbitrary reference point.

A warranty deed, or a general warranty deed, contains covenants that guarantee the seller will make good any defects in the title that he or she transfers. This warranty extends through the entire title chain of the property.

The formation of a partnership does not require governmental approval or registration.

Two or more parties combine for potentially greater borrowign power. With several individuals participating in the venture, the financial assets of the individuals are combined to provide the firm with a greater financial footing. In theory, an association of this type should make lenders more willing to make funds available to a partnership.

Two or more parties share the financial impact of failure. The caveat to this risk-spreading aspect is that all the partnersare jointly and severally liabile for all obligations. Therefore, if one partner conducted him- or herself improperly to the detriment of the other partner(s), the outcome of a failure may be even greater to the remaining partners.

Two or more individuals share time requirements so that duties and responsibilities can be assigned among the partners.

Knowledge and expertise increase with several individuals participating in ownership of the firm.

Sometimes called a general and limited partnership, this ownership form consists of two classes of partners who have unequal ownership interests and differing responsibilities. Limited partnership features one or more individuals who act as general partners. These general partners are responsible for the operation of the firm and are liable for the financial obligations of the partnership. The general partner(s) may own a majority interest in the venture or may own virtually none of it. Regardless, the operational control of the partnership rests solely with the general partner(s).

Limited partners are so called because their financial liabliity is limited to the amount of their investment. Should the partnership fail, these partners have no further obligation unless they are specifically obligated to owe additional money. Limited partners may not participate in the management of the enterprise. If a limited partner becomes actively involved in the management of theifm, he or she is then deemed a general partner and, as such, is liable for the financial obligations of the firm.

Limited partnerships must be registered with the secretary of state in the state where they conduct business.

In the past, US tax laws provided significant advantages for the limited partners. The Tax Reform Act of 1986 and subsequent changes have eliminated most of these advantages, however, particularly with respect to real estate investment.

Double Taxation: FCorporate profits are taxed at the federal, state, and often at the local level. This income is taxed at the prevailing corporate rate and, when part of the after-tax income is paid to shareholders as dividents, taxes must again be paid on dividends received by the stockholders.

Limitations on Capital Accumulation: The federal taxing authority will not allow some smaller corporations to accumulate excess capital, such as reserve funds, beyond a certain level. These regulations are stringently applied to companies with a small number of shareholders.

Extensive Administrative Paperwork: Additional reporting and disclosure requirements tend to icnrease the operating costs of a corporation above levels that would be expected in a proprietorship or partnership.

Subchapter S Corporations may only issue common stock.

Subchapter S Corporations are limited to more than 75 stockholders. For the purpose of counting, married couples are considered a single stockholder.

A syndication can take any ownership form, but it is unique in the way it is formed. An individual or firm, called the syndicator, identifies, locates, or creates an investment opportunity and attracts investors to provide equity for the project. Additional funding is often sought using the investor funds as equity to leverage the remainder of the necessary funding. When the funding is in place and the investment is secured, the syndicator often assumes management of the project.

One distinct advantage to establishing a trust is that assets placed in trust cannot be seized by creditors for payment of debts.

There are two basic forms of REITs: equity trusts and mortgage trusts. Equity trusts are created for real estate ownership. This type of trust may use leverage or it may remain unleveraged. Mortgage trust REITs are organized to provide real estate financing of virtually all types, including long-term mortgages.

REITS must issue 95% of trust net income (profits) to holders of beneficial interest annually.

Tenancies are real estate multiple ownership forms that typically occur among related parties (family members). These co-owners are generally fewer in number than are found in business relationships, and these tenancies are often used to hold title to personal residences.

Tenancy by the entirety is essentially the same as joint tenancy except that it is only available to married couples. In this form, tenancy by the entirety carries with it the right of survivorship; the couple is considered to co-own the property.

Tenancy in common provides for fractional ownership by two or more individuals. Each tenant holds the title individually, and the ownership fractions need not be equal in amount. In the event of the death of a tenant in common, the interest is passed on to his or her heirs, who need not have a prior existing interest in the property.

Joint tenants are similar in character to tenants in common, with one significant difference - the right of survivorship. In the event that one of the joint tenants dies, title passes to the survivor rather than an heir. Death terminates the tenancy, and the survivor holds sole title to the ownership interest.

Public data, also called composite data, includes information from federal, regional, and state agencies, chambers of commerce, local planning departments, regulatory agencies, county assessors, treasurers, and recording offices.

Information from private sources can be very difficult to gather. This type of information, known as specific data, is regarded as private by the individuals, groups, or institutions involved in the transactions. Private sources generally require confidentiality and such information often cannot be verified.

Market Data

• Architectural Plans
• As-Built Drawings
• Assessment of Property ConditionConstruction Cost Data
• Electrical Plans
• Foundation Plans
• Mechanical Plans
• Observed Obsolescense
• Observed Physical Condition
• Project Specifications
• Renovation Costs
• Site & Soil Surveys
• Structural Plans

Most handheld calculators operate with the algebraic logic system. The algebraic logic system operates in a sequential format similar to the sequence of a typical addition or subtraction problem. Each numeric value is entered and then followed by an operator such as +, -, x, / . The result is obtained by entereing the equal sign.

This logic system takes into account the algebraic axiom known as the power of operation. This axiom assigns a higher power to operations such as multiplication and division than addition and subraction. This requires that the operation of the igher power be performed before the operation of the lower power.

Many financial calculators, including the HP 10bII and its predecessor, the HP 10b, use the chaining logic system. Chaining logic is similar to Algebraic logic except it does not use the power of operation axiom. It operates in a strict sequential format, essentially obtaining a result after each operation. Each operation is performed based on teh result of the previous operation.

• The variables that affect the principal and interest portion of each loan payment are:
• 1. Amortization Term [N]
• 2. Interest Rate [I/YR]
• 3. Principal Amount [PV]
• 4. Periodic Payment [PMT]

$4,387.86

$49,874.89

$2,779.43

$497,220.57

Book value is an accounting term that refers to the value used for financial statements. Generally, the book value is the original price, plus any capital improvements, less accounting depreciation. Book value is often used to determine income tax liability and investment return.

Assewssed value is an administrative, government-imposed valuation. It is made by a county assessor to prepare a property tax schedule (ad valorem taxation). Assessed value is generally a percentage (sometimes as low as 30%) of the estimated market value. The assessed value is then multiplied by the current mill levy to produce the actual tax bill.

Utility is the ability of a product to satisfy a human want, need, or desire. Thus, utility is the ability to render services to satisfy a demand. Utility can refer to all items, such as gold, cars, merchandise, services, and real estate. A product must have utility to possess value.

The reason is the desire of certain individuals to have a commodity that meets mroe than a physical need (food, shelter, and work space); it must meet a psychological need. Desiring a product or property we see others enjoying is a well-documented aspect of human nature. Thus, desiring a unique object is part of value. When many people desire a certain item, there is said to be a demand for that product.

Highest and best use is that use of land or improved real property that produces the greatest return. The true value of real estate is based on the market's perception of its most proper, probable, and profitable use. Also referred to as typical and most probable use, highest and best use is the appraiser's opinion of how the proeprty may be used to create the highest value.

• 1. Legality
• 2. Profitability
• 3. Financial Feasibility
• 4. Physical Feasibilty
• 5. Reasonableness
• 6. Environmental Acceptance
• 7. Appropriateness
• 8. Compatibility
• 9. Possibility
• 10. Competitive Uses

The highest and best use estimate must be physically probable. High-rise offices may rent rapidly if they are located near an international airport, but height limitations in airport flight corridors prevent constructino of such properties. Also, such items as topography or soil conditions may preclude a desired development. A facility manage rmust gather adequate information concerning physical restrictions and conditions to determine the physical appropriateness of a use in any analysis.

Environmental acceptance is an extremely important consideration affecting highest and best use decisions. Examples include noise ordinances and strict enforcement of pollution regulations.

Appropriateness is simply a judgment as to whether the subject proeprty fits into its environment and neighborhood. As with reasonableness, consider the values, priorities, and sensibilities of the project's potential neighbors.

Gross leases require that the lessee pay a fixed rent to the landlord, and that the landlord then pay all operating expenses related to the property.

Net leases require that the tenant pay some or all of the operating expenses of the property.

In a triple-net lease, rental payments cover debt service (mortgage principal plus interest) and lessor's (owner's) basic profit.

The triple-net lease is commonly used for unique single-tenant buildings.

Percentage leases are fairly standard for retail space. In this type of lease, the landlropd is fully or partially compensated for rent by a percentage of the tenant's sales. Typically, there is a fixed minimum rent, called the base rent, in percentage leases. When sales of the tenant exceed a specified level, the landlord receives a part of the sales as additional rent. Leases of this type often have maximum specified rentals as well.

When a tenant leases a parcel of vacant land and pays for all improvements made on the site, the tenant does this in accordance with a ground lease. Typically, the rent received by the landowner also covers operating expenses.

Related to the concept of highest and best use is the principle of contribution. Contribution theory looks at individual portions of the whole property and measures their relative worth. For example, owners of a suburban office building in Phoenix that has no parking shelter may determine that they could charge a monthly parking fee to tenants if a shelter was cosntructed. The resulting income would be sufficient to amortize the cost of the parkign shelter as well as to provide a reasonable return.

The concept of contribution then tries to measure the relative worth of each agent of production or the amount that its absence would detract from the value of the entire property.

General data refers to social, economic, governmental, and environmental trends that affect property value. This includes information on job growth or decline, changes in population, housing starts, and occupancy statistics.

The concept of substitution states that for comparable goods, the product with the lowest price will enjoy the highest level of demand and the widest distribution.

The market comparison approach of valuing a property uses information on sales of comparable properties. It is especially useful when there have been recent transactions for similar buildings. The principle of substitution influences value because it assumes that a purchaser will pay no more for a property than for the cost of a similar one with equal utility.

The market comparison approach is frequently used for single-family residences, condominium units, and vacant lots. It is not useful for markets where there is an insufficient amount of sales data.

Sale prices vary based on the amount of down payment and the financing terms. An investor may pay a higher price for a property if the amount of down payment were reduced and the seller would loan the balance of the price at a below-market interest rate. To view all whole-property comparable sales in the same light - on a cash-equivalent basis - you must discount those sales that had favorable seller financing.

The land-to-building ratio adjustment may be made either under the category of site characteristics or under improvement characteristics. Because of the probability of future expansion of buildings, the need for adequate parking, and other site uses, it is appropriately considered here. The land-to-building ratio is determined by dividing the land area by the building area.

Topography for each comparable may require adjustment due to terrain - depressions, excess soil, steep slopes - or difficult soils. Topography adjustments are varied and could include razing an old building foundation. Topography adjustment would also include unusual soil conditions, such as soft soil, which would require extra foundations under a typical structure, or soil which would require blasting or jackhammering in order to place the foundation footings and utility lines.

The gross rent multiplier (GRM) is a rule of thumb frequently used by some individuals in the real estate community, particularly for apartment and hotel properties. Although GRM does not take into account such factors as management, vacancy, and operating ratio, it does have market acceptance and thus should not be ignored.

This method of arriving at an estimate of fair market value involves multiplying gross rental income by a factor that varies with the type of property and its location. An example might be an eight-story building that has a value equal to six times gross rentals.

The risk involved in using this rule of thumb is that the features and condition of the building, in addition to the other factors cited above, are not given any consideration.

• Three basic components are used to calculate value with the cost approach:
• 1. Determine the value of the vacant land.
• 2. Estimate construction costs of the physical structure(s).
• 3. Subtract actual depreciation of the physical structure(s).

Outdated lighting fixtures are an example of functional obsolescence.

Economic or external obsolescence includes market changes, such as population shifts, plant closings, and highway construction.

Capitalization Rate = NOI / Value

9.5%

• Equity = 25% down (.25) x 11% return rate (.11) = 0.0275
• Mortgage = 75% financing (.75) x Mortgage Constant 0.144550 = 0.1084125

• Equity Rate + Mortgage Rate = Mortgage Equity Rate
• 0.0275 + 0.1084124 = 0.1359125

Mortgage Equity Rate = 13.6%

$800,000

An income rate that reflects an ivnestor's analysis of risk. It is used to convert a single year's net operating income expectancy into a price or value. An investor's cap rate is also considered the desired rate of return. Also called the cap rate.

Selection of a rate requires knowledge of market indicators and attitudes, analysis of specific market data such as sales of comparable properties, current interest rates, alternative yields, and good judgment by the investor.

One real estate appraisal technique attempts to evaluate the income stream produced by a parcel of land and the improvements on it as separate entities. This process is called the residual technique. The building residual technique is used when an income stream attributable to the land is deducted from the property's NOI. In this case, the remaining income is the residual income attributable to the improvements. Conversely, the land residual is what remains after income attributable to the improvements is deducted from the property's NOI.

• Proportion (in %) Equity x Return on Equity Rate = Equity Weight
• Proportion (in %) Loan x Interest Rate = Mortgage Rate

Total Proportions must = 100%

Equity Weight + Mortgage Weight = Blended Capitalization Rate

The first step in developing a firm or project cap rate is to fully evaluate your actual cost of investment funds. This model, called the WACC (weighted average cost of capital), is capable of evaluating the cost and tax implications of borrowed funds. It is also capable of calculating the cost of using equity funds and the impact of flotation costs upon the firm or a specific project.

The WACC model treats the investment components in the same manner as the blended rate approach. The difference is that taxation and flotation impacts can be included.

• 1. Proportion of Debt = Wd
• 2. Pretax Rate (Cost) of Debt = Kd
• 3. Marginal Tax Rate of the Firm = T
• 4. Proportional Weight of Equity = We
• 5. Cost (or Opportunity Cost) of Equity = Ke
• 6. Flotation Costs = F

The WACC is less than either the loan interest rate or the expected investor rate of return. The reason for this seeming disparity is the tax effect - interest and flotation costs are deductible from ordinary income for tax purposes.

You must make subjective judgments concerning the probability of economic conditions and market interest rates; however, examination of historical rates (market research) will provide you with a sound initial point of analysis.

Economic conditions such as recession, growth, decline, or boom periods should be compared with mortgage rates should be compared.

• Every properly trained loan officer knows the importance of the five C's of credit. When they are forgotten or ignored, the loan is generally in trouble before it is made. The five C's are:
• 1. Character: The borrower's moral commitment and willingness to repay the funds that are loaned.
• 2. Capacity: The ability of the borrower to repay the loan from normal and typical business sources.
• 3. Capital: The fundamental financial strength of the borrower.
• 4. Conditions: The condition of the ecomony as a whole and the present condition of the borrower's industry and market niche.
• 5. Collateral: The value of assets pledged to the lender as protection from loss in the event of default or conditions not anticipated when the loan was made.

Amortized loans include both principal reduction and interest in monthly payments.

4%

Loan Constant = 9.15% or 0.9148

In a Shared Appreciation Mortgage (SAM) the lender is allowed the opportunity to participate in future appreciation of the property. Udner the terms of such mortgages, the borrower is obligated to pay the lender a percentage of the appreciated value at some set time in the future.

The debt service coverage ratio is a measure of the ability of a project to meet its debt service requirement. This ratio is determined by dividing the NOI during any given time period by the debt service for the same period of time. If the ratio is 1:1, there is exactly enough NOI to meet thedebt service with no margin for reduced income or greater than anticipated expenses. Similarly, a debt service coverage ratio less than 1:1 indicates thre is not sufficient income to service the project debt.

This debt service coverage ratio indicates that there is sufficient income after expenses to service tehd ebt and provide positive cash flow on the project. The greater this ratio becvomes, the greater the cash flow and the margin for unexpected expenses. Furthermore, the greater the ratio becomes, the more comfortable the loan officer becomes. Lenders and regulators may specify a minimum debtg service coverage ratio in order to approve a loan.

The debt service coverage ratio is 1.107.

Construction loans are extended to finance construction of a real estate project. Typically, construction loans are made only after project feasibility studies are completed and plans and specifications have been made. The demonstrated ability to secure a commitment for permanent financing for the project may also be a condition for approving a construction loan. Such loans are interim in character; that is, they are made for the length of time that is required to complete construction of the project, and, perhaps, to meet a certain minimum level of leasing. Such loans are usually made in a series of advances, called draws, as construction progresses. These loans use the building under construction and the site itself as collateral.

Typically, construction loans are made only after project feasibility studies have been made. The demonstrated ability to secure a commitment for permanent financing for the proejct may also be a condition for approving a construction loan.

The Federal Reserve Systme regulates, through the Federal Open Market Committee, the amount of money and credit available to the US economy.

The Government National Mortgage Association (GNMA) was created in 1968 as an arm of HUD. This agency, known as Ginnie Mae, was organized to support the mortgage activities of the FHA and the VA (the US Veterans Administration). The agency sells packages of mortgages in the secondary investment market with the full faith and credit guarantee of the US Government.

Real estate contracts must be in writing to be enforceable.

Real estate contracts are subject to the provisions of the Statute of Frauds in the governing state.

Covenants are the rights and obligations of both the lender and the borrower. Covenants can include clauses with regards to payment, applications of payments, late charges, maintenance, insurance, additional liens or encumbrances, protection of the lender, binding of successors, acceleration, assignments of rents, and defeasance.

Under the acceleration clause, the lender has the right, at its option, to make the remainder of the entire debt due and payable immediately if the mortgagor fails to fulfill any of the covenants.

Under the assignment of rents clause, the lender has the right, at its option, to directly collect rents or other compensation from the property in the event the borrower fails to meet his or her obligations. You should note that assignments are not enforceable in some states.

Under the defeasance clause, the lender is obligated to discharge the mortgage to the borrower once full payment has been made.

Tax liens, judgments, and mechanic's liens are examples of involuntary liens; mortgages are examples of voluntary liens.

There are three participants to a deed of trust: the borrower, called the trustor or grantor; the lender, called the beneficiary or grantee; and the trustee.

• -Fee simple interests
• -Leasehold interests
• -Fee estate and leased fee interests
• -Air rights
• -Subsurface rights

The kicker loan, also called a participation loan, is defined as an additional interest payment benefit for the lender. In return for making a first mortgage loan at a favorable interest rate, the borrower agrees to pay the lender a portion of the cash flow from the property, but in the form of interest. The lender has a mortgage investment that provides higher than typical returns. The lender may also receive a portion of the increase in property value upon sale or refinance.

the convertible mortgage enables the lender, at its option, to convert all or part of the mortgage debt into equity in the project. The conversion may not encompass all of the ownership, but the lender might be given a prearranged option to purchase the developer's total interest.

The secondary market purchases loans from banks or savings & loan associations and then resells these mortgages to investors. These secondary market operations provide vast sums of additional mortgage funds for homeowners and excellent investor yields. The market for such securities is very well organized and is regulated through federal government policy and supervision.

The Bureauf of Labor Statistics is the principal fact-finding agency for the Federal Government in the broad field of labor economics and statistics. This agency publishes the monthly Consumer Price Index, a survey statistically reporting on the effect of inflation on the purchasing power of the US dollar.

The Consumer Price Index is a monthly survey issued by the US Deparment of Labor's Bureau of Labor Statistics to statistically report the effect of inflation on the purchasing power of the US dollar.

Contract rent is the actual rent agreed upon under the terms of a lease.

Examples of fixed expenses include insurance premiums and property taxes.

Variable expenses are influenced by occupancy levels and your professional management.

The sum of fixed and variable expenses represents the operating expenses for the facility. Be very careful to note that these expenses do not include any debt service, income taxes, capital improvement expenditures, or noncash items such as goodwill oramortization. Operating expenses are directly related to the physical condition of your property. In both the operational and accounting senses, you must concern yourself with the fixed and variable expenses.

The sum of all actual and probable income, less all operating expenses, is called NOI (net operating income). you must be careful to note that depreciation expense, income taxes, capital expenditures, and debt service are not considered when determining or forecasting NOI,.

Compounding is the calculation of interest on a principal amount, plus interest on the interested accrued during a previous period, which is combined at specific intervals. In actuality, this is interest earned upon interest that is left to accumulate.

$8,874.89

$49,672.36

$937,566.17

The process used to reduce a future benefit to its present value is called discounting. The size of a discount depends on the rate necesary to satisfy an investor, the perceived risk of repayment, and the length of time the investor must wait to receive the future benefit. A payment in the future can be discounted by determining the amount that must be invested today to grow at a compounding interest rate equal to the future benefit when it is due.

$261,255.43

$284,233.22

$324.25

$249,999.86

$100,000.06

The term annuity means an annual income. However, it is taken into present usage to mean an agreement for payment of a specific amount paid at specific intervals. Annutiy payments can be level, decreasing, or increasing; however, the amount and time of payments must be certain.

The time value of money is the value of money figuring in a given amount of interest earned over a given amount of time. The time value of money refers to the fact that a dollar in hand today is worth more than a dollar promised at some future time.

Internal rate of return (IRR) is the actual rate of return of a series of cash flows generated by an investment.

If we want to kjnow the actual rate of return on the investment, we must solve for IRR. In this calculation, the present value components of the future cash flows match the initial investment. The calculation then determines the interest rate based on the remaining earned interest components of the future cash flows. In the present value calculation, we obtain a dolalr value for the total present value components; in teh IRR calculation, we obtain an interest percentage from the earned interest components.

An IRR attempts to measure investment performance. It can be used to measure the performance of any investment during its holding period. This method of measurement is particularly adaptazble to evaluating irregular income sreams and periods when income is negative, such as during initial years of a venture requirings substantial front-end investment.

If the present value component is greater than the initial investment, the expected rate of return will not only be achieved, but exceeded. Correspondingly, if the present value component is leass than the initial investment, the expected rate of return will not be achieved.

IRR is particularly adaptable to evaluating irregular income streams and periods when income is negative, such as during initial years of a venture requiring substantial front-end investment.

Net Present Value is the difference between teh present value of capital outlays and the present value of all future cash flow benefits. When the initial investment is subracted from the present value, the result is known as the net present value (NPV).

$-32,107.76

The present value of the future cash flows is weell bewlo the initial investment, indicating that the expected rate of return was not achieved.

17.59%

When the equity contribution to a project is small relative to the level of financing, the IRR becomes disproportionately large and is not a fair measure of performance.

A single investment with a simple interest rate in which interest is not compounded would generate uniform, conservative cash flows.

One of the advantages of a real estate investment is that it allows the investor to adjsut the initial investment without substantially affecting the stream of future cash flows. A real estate investor may limit or increase the amount of the initial investment by adjusting the amount of the loan on the ivnestment.

NPV would be less that if the sales price had not increased and IRR would be lower.

Investors expect a higher IRR to justify selection of a high risk investment.

Gross Income - Itemized Deductions x Tax Rate - Tax Credits = Net Tax Liability

Operating costs are deductions allowed for investment property, such as maintenance, repairs, utilities, and insurance.

In real estate investment, the most significant deductible expense is depreciation expense. Theoretically, depreciation systematically allocates the cost of a revenue-generating asset as an expense over an estimated useful life.

Tax credits reduce the amount of taxes to be paid, rather than reducing taxable income.

• Some buildings may qualify for annual tax credits if they meet the requirements of low-income housing. Residential rental property must meet criteria in the areas of:
• -Low-income tenant occupancy
• -Gross rent restrictions
• -State credit authority
• -IRS certification

In addition, the facility must operate for 15 years as low-income housing. Low-income housing credits are unique in that they do not reduce the depreciable basis, whereas both rehabilitation credits and certified historic credits must reduce the depreciable basis.

Net Capital Gain = Sales Price - Adjusted Basis

Adjusted Basis = Purchase Price + Improvements - Depreciation - Tax Credits

$100,000 + $20,000 - $40,000 = $80,000

The cost of any capital improvements made to the property must be depreciated, commencing in the year those improvements are expensed. Improvements are also depreciated over 39 years (commercial property) and 27.5 years (residential investment property).

A tax-deferred exchange is a transaction in which property is exchanged and the resulting gain is not taxed. Internal Revenue Code 1031 allows a taxpayer the ability to defer capital gains taxes that become due as a result of the sale of real property until the new property is sold or disposed of. The property being sold is referred to as the relinquished property. This relinquished property is exchanged for the property being purchased, known as the replacement property. Tax-deferred exchanges have many conditions and take various forms.

Often, corporations will own their own plant, warehouse, or office building. This property may have been purchased several years in the past. Depreciation allowed under earlier accelerated depreciation methods has probably exhausted higher depreciation write-offs, while at the same time the property may have substantially appreciated in value. Sometimes in this situation, a corporation will sell its plant, warehouse, or office building but continue to occupy the facility and pay rent to the buyer. This is known as a sale and leaseback transaction.

When the market value of a property has dropped below the current mortgage balance, and the owner has likely exhausted all financial remedies and is faced with an unfavorable sale or foreclosure, the first mortgage may be written off as nonrecourse to the holder and the deficit may not be recoverable by the lender. For tax purposes, the debt is said to be forgiven and the obligation extinguished, generating a phantom income to the foreclosed borrower. Some of these forgiven debts can be rather substantial. Besides losing the property, the foreclosed borrower must pay income taxes on the portion of the debt that was forgiven by the lender.

• General-use properties can be further divided into six main categories:
• 1. apartment buildings
• 2. freestanding retail stores
• 3. shopping centers
• 4. multi-tenant industrial buildings
• 5. multi-tenant office buildings
• 6. warehouses

• Examples of special-use properties include:
• -airport facilties
• -automobile showrooms and facilities
• -banks
• -bowling alleys
• -car washes
• -data cetners
• -drive-in restaurants
• -hospitals
• -hotels
• -mobile home parks
• -mortuaries
• -motels
• -nursing homes
• -oil refineries and tank farms
• -parking garages
• -piers and wharfs
• -service stations
• -supermarkets

A company that intends to occupy a building it owns will most likely be there a long time. In this case, long-term interest loans and heavy front-end investments can be justified and may yield handsome returns. Financial decisions can include a consideration of long-term paybacks, lower IRRs, and greater use of soft-cost and intangible items in justifications. The viability of this owner/occupant posture depends on where a company is in its overall business cycle and the durability of its market presence. The essence of this appraoch is contained in one simple analogy: We tend to invest more in a house we plan to live in for a long time than in an apartment that will merely tide us over for a short period of time.

As a landlord renting space to others, your priorities are vastly different from those of an owner/occupant, even if you intend to own the building for a long time. You are l ikely to invest heavily in base building systems, especially adequate HVAC, electrical, and communications capacities. You are also likely to try to minimize the investment of in-house cash, which may be needed to cover building operations when cost increases cannot be passed on to tenants. In this case, the property will probably be financed, resulting in tighter controls by the lender trying to preserve its investment and financing agreements.

Although long building life may be desirable, your ability to attract and retain tenants may take priority over long-term investments, especially in depressed markets. A landlord will generally set life cycles to depreciation schedules permitted by tax laws. Flexibility is achieved more by strategically planning a good tenant mix and staggering leas terms than by installing special building components, such as demountable partitions. In other words, business flexibility is more important than physical flexibility.

To determine physical feasibility, you must systematically evaluate the site and improvements of any proeprty be acquired, developed, or renovated. This evaluation examines the site and its improvements separately, because the legal and tax consequences of a site and a building are different. In performing a physical analysis, remember that almost every physical factor or characteristic has some financial consequence or ramification.

1. Legal / regulatory factors: zoning, building codes, insurance requirements, approval processes in government bodies, and environmental impact of site activity.

2. Base building factors: HVAC, historical patterns of building maintenance, condition of building envelope (especially the roof), electrical system capacity, telephone signal network, lighting system, finsihes, and type of sprinkler system.

3. Tenant space factors: Floor plate size and shape, space measurement systems, mullion spacing, usable/rentable/gross efficiency, and accessibilty to systems via raised flooring or demountable walls.

4. Organizational Characteristics of Tenants or Occupants: Growth rates and patterns, churn rates and patterns, historical patterns of how space has been funded and acquired, space standards, adaptability of workforce to hoteling and telecommuting, in-house decision-making responsiveness, degree of technology intensiveness, and stance of real property organization.

• 1. Marketability
• 2. Functionality
• 3. Age
• 4. Renovation
• 5. Appropriateness

One of the most helpful tools to use when inspecting a property is a civil engineer's or a land surveyor's scaled survey as-built drawing of the site and improvements. The drawing should indicate where the land and improvements are and what they should include. A good drawing should show site shape, dimensions, boundary bearings and distances, a legal description (including acreage to four decimal places), paved areas, parking space designations, landscaping, and the outline of the building foundation. It should also show encroachments and easements (if any), ingress and egress points, location of drainage catch basins, and location of utility lines. By using a made-to-scale drawing, the analyst can estimate the correct land-to-building ratio and make a judgment about the adequacy of the land use.

• During the proces of improvement analysis, you should keep the following considerations in mind:
• -regulations and code compliance
• -the quality of materials, workmanship, and design of the improvement

Local trends have a stronger impact on improved real property than national trends. Although this may seem to be an oversimplification, a proeprty that is subject to local problems, such as a high rate of unemployment, will suffer regardless of the state of the economy in the rest of the country.

Demolition is the final phase of a building's life cycle.

The rate at whic hproperties for sale or lease can be marketed in your locality is called the absorption rate. Low or negative absorption indicates an unhealthy prospect for new development. Conversely, high absorption rates indicate the existence of development opportunities.

The period of routine administration of a property typically represents the longest single phase of the property life cycle. It is a period of stabilized investment. If properly managed during this life cycle phase, the investment will operate at maximum efficiency. A rule of thumb is that building efficiency tends to follow ten-year cycles. During its first few years, a new structure is considered to be stabilized; it is performing the functions for which it was intended. In later years, the cost of maintaining the property rises as building components wear out. This cycle also generally exists durin gthe yeras immediately following a major rehabilitiation.

Strictly speaking, capital expenditures are those costs incurred by acquiring or upgrading assets that produce revenues. Capital expenditures are expected to produce a return in the form of increased value that appears ona corporate balance sheet. You should note that a capital expenditure is intended to be long-term in its contribution to revenue enhancement.

It can be difficult to distinguish between an operating expense and a capital expenditure. The ultimate test of the nature of expenditures rests with the original definition. If the expenditure enhances a company's balance sheet, extends the life or productivity of the building, or creates a new source of revenue for the firm, it is a capital expenditure.

• 1. Change in the volume of production
• 2. Change to a new plant site
• 3. Damage to equpiment from outside causes
• 4. Expansion
• 5. Inadequacy of present equipment for production of product improvements
• 6. Obsolescence
• 7. Wear
• 8. Worker skill and learning time
• 9. Working conditions and morale

Life cycle costing is the application of systems analysis to compare alternative capital expenditures that are expected to produce benefits over a period of time greater than one year. Life cycle costing takes into account all of the current and future financial implications ofa capital project, which include:

• -acquisition cost
• -annual expenses or savings
• -operating costs
• -maintenance costs
• -personnel expenses
• -one-time future expenses or income
• -overhaul costs
• -salvage costs
• -present value

A critical element of life cycle costing is the application of the principles of present value analysis.

A critical element of life cycle costing is the application of the principles of present value analysis.

Historically, real interest has been approximately 3%, but when a firm reclassifies a project as high risk, or the cost of borrowing is high, it is appropriate to use higher rates.

By using a spreadsheet program, you can easilyi see the effect of slight changes in assumptions while life cycle costing.

• One-time costs are usually tracked by work orders for specific jobs and can include the following:
• -moving
• -furniture rearrangement
• -space redesign
• -above-building-standard alterations to prepare the space for occupancy (especially remodeling for an incumbent occupant who intends to stay)
• -extra design services for above-standard alterations (extra detailing, millwork shop drawings, installation drawings, and specification of a systems furniture)
• -master planning, master space programming, and development of space standards
• -environmental studies and quality assessments
• -improvements (as opposed to repairs or maintenance) tha tadd new capability and net asset value to the building

A well-designed chargeback system can help a company become more fiscally responsible. This is primarily achieved through the tww primary benefits of chargeback systems - cost awareness and the elimination of the cookie-jar mentality. The more customer departments know about what their service requests cost, the more prudent they will be about requesting them. Cost awareness can benefit the company as a whole by reducing costs, and can help the facilities department avoid unnecessary work by allocating resources more closely in line with their original, budgeted purpose.

• Several hurdles stand in the way of implementing such a system where one does not already exist. They include:
• -additional staff requirements
• -compatibility with existing policies
• -consumer education

Costs for major replacements or renovations are factored into some chargeback systems to develop a general fund from which all major projects will be funded. History has shown that almost all such systems have experienced greater ongoing costs than anticipated, prompting raids on the replacment fund and compromising the capital improvement plan. This leaves users disgruntled for having allocated resources to a long-term investment that did not pay off.

The most critical element of any investment decision is the willingness to accept the risks involved. The acceptance of such rissks is based on the owner's business objectives. Each investor, whether an individual or a firm, uses a set of crieteria to judge whether or not an investment is suitable in teh context of these objectives.

The first step in successfully managing an investment is developing a concept of the business and establishing a vision of the firm's direction - establishing the mission.

Any successful business is created as a result of an idea or technique that produces a competitive advantage for the firm's owners and investors. The owner has learned something that others either had not realized or had failed to exploit - a niche in his or her marketplace - and capitalized on the opportunity. Such underpinnings of a firm ar its core competencies.

Firms with diffuse leadership possess few management layers, but decision-making authority is sometimes so dispersed that investment decisions must be made by committees. By definition, committees are collaborative and labor intensive. Work can be slow and tedious. If market conditions require an immediate response, committee meetings may make the organization too cumbersome to respond quickly to opportunities and the firm may lose out. Committee work detracts from immediately profitable operations, and there may be long, costly delays in the decision process. However, committee decisions tend to favor analytical approaches to decisions and are not clouded by the judgments and prejudices of a single decision maker.

There is no single best way to make either a general or specific investment decision. The approach must be specific to each company,multifaceted, and combine all of the best analysis, planning, direction, and patience to see the investment through to a successful conclusion. An element of sheer courage is also involved in decision making. That is, taking a chance when you wish you had more information but there is no time to get it.

In recent years, businesses have failed because of their fixation on short-term profits.

A number of techniques can be applied to most situations in an effort to increase property value. Some of these strategies are obvious; others may not be quite so apparent. Two of the approaches you might take are to develop greater financial performance and make better management decisions.

Providing good service to tenants is the primary basis for tenant retention.

A satisfied tenant can contribute greatly to the manager's success by referring prospective tenants. This is a major resource for developing new leasing leads, especially in soft markets.

Effective managers can best demonstrate creative problem-solving abilities by making nonprogrammed decisions. Most significant decisions are nonprogrammed ones, and strong skills in this area may be one of the most distinguishing qualities between effective and ineffective managers. Such decisions require more highly developed problem solving and creative abilities - the art and science of management.

The distinguishing feature between risk and uncertainty is that in dealing with uncertainty, one does not know the probabilities of each alternative. Most management decisions must be reached under conditions of uncertainty, where definite probabilities have not been established because there are too many unknown factors and the situation involves too many variables. Therefore, managers must estimate the probability for each alternative based on their own or others' experience, judgment, and intuition.