Chapter 17Investing in Income-Producing Real Estate

• Advantages of Real Estate Investment– Attractions of real estate as an investment • Cash flow from operations

• Appreciation

• Portfolio diversification

• Financial leverage

Chapter 17Investing in Income-Producing Real Estate

• Disadvantages of Real Estate as an Investment– Large amount of capital required

– Risk, particularly liquidity risk

– Changing market conditions (overbuilding)

Chapter 17Investing in Income-Producing Real Estate

• Financial Decision Making– Goal is wealth maximization– Using the NPV rule– Using the IRR rule

Chapter 17Investing in Income-Producing Real Estate

• The Discounted Cash Flow Model– Initial equity investment– Forecasting after-tax cash flow (ATCF)• Calculating net operating income

– Potential gross income (PGI)

– Vacancy and credit losses (VCL)

– Effective gross income (EGI)

– Operating expenses (OE)

– Net operating income (NOI)

Chapter 17Investing in Income-Producing Real Estate

• The Discounted Cash Flow Model– Before-tax cash flow (BTCF)

• NOI less Debt Service– Taxes from Operation

• NOI• Interest Expense• Depreciation (DEP)

– 27.5 years for residential, and 39 years for nonresidential

• Taxable Income• Marginal Tax Rate

– After-tax cash flow (ATCF)

Chapter 17Investing in Income-Producing Real Estate

• After Tax Equity Reversion (ATER)– Gross sale price– Less Selling expenses– = Net sale proceeds– Mortgage Balance outstanding– Before-tax equity reversion (BTER)

Chapter 17Investing in Income-Producing Real Estate

• After Tax Equity Reversion (ATER)– Before-tax equity reversion (BTER)– Book value– Taxable gain– Taxes due on sale (TDS)– After-tax cash on sale

Chapter 17Investing in Income-Producing Real Estate

• Other Performance Measures– Cash-on-cash return– Operating expense ratio– Debt coverage ratio

Chapter 17Investing in Income-Producing Real Estate

• REITs– As an alternative to direct investment in real

estate