DISCLAIMER: Copyright: 2011

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1 DISLAIMER: This publication is intended for EDUATIONAL purposes only. The information contained herein is subject to change with no notice, and while a great deal of care has been taken to provide accurate and current information, UB, their affiliates, authors, editors and staff (collectively, the "UB Group") makes no claims, representations, or warranties as to accuracy, completeness, usefulness or adequacy of any of the information contained herein. Under no circumstances shall the UB Group be liable for any losses or damages whatsoever, whether in contract, tort or otherwise, from the use of, or reliance on, the information contained herein. Further, the general principles and conclusions presented in this text are subject to local, provincial, and federal laws and regulations, court cases, and any revisions of the same. This publication is sold for educational purposes only and is not intended to provide, and does not constitute, legal, accounting, or other professional advice. Professional advice should be consulted regarding every specific circumstance before acting on the information presented in these materials. opyright: 2011 by the UB Real Estate Division, Sauder School of Business, The University of British olumbia. Printed in anada. ALL RIGHTS RESERVED. No part of this work covered by the copyright hereon may be reproduced, transcribed, modified, distributed, republished, or used in any form or by any means graphic, electronic, or mechanical, including photocopying, recording, taping, web distribution, or used in any information storage and retrieval system without the prior written permission of the publisher.

2 FUNDAMENTALS OF INVESTMENT ANALYSIS, PART I: SINGLE PERIOD ANALYSIS After studying this chapter, a student should be able to: Learning Objectives # describe the various objectives to investment, including wealth maximization, tax shelter, inflation hedge, and diversification; # explain the process of estimating future gross potential income and effective gross income; # describe how net operating income and beforetax and after-tax cash flows are calculated; # describe the various single-period risk and return measures and investment decision rules; and # discuss the resale issue including appreciation. Introduction Defining Investment Analysis Real Estate Investment Opportunity Waterfront ondo Property apital Gain and ash Flow Potential Although we see advertisements similar to this all the time and, while we are familiar with the process of investment analysis and probably have participated in the process on several occasions, we seldom pause to analyze and reflect on this activity. In the simplest form, investment implies a process of sacrificing current consumption in the expectation that we can increase future consumption. Just as farmers decide not to eat some grain but rather sow the fields so they can enjoy more grain in the future, so too do investors "plant" their money today, in the expectation they will have more money later. Similarly, many individuals may buy anada Savings Bonds or mutual funds in order to increase their wealth for greater future consumption. Generally, investors face a variety of investment alternatives, and investment analysis refers to the process of selecting one or more investments from this menu of alternative investments. Generally the process of investment analysis involves an obvious selection from alternatives: one need only consult the "For Sale" advertisements to see the range of alternative real estate investments. In some cases, however, the alternative investment choices may not be so clear. For example, a government may decide to invest in an improved transportation system between the north and south shores of a river. The alternative investment choices could include a bridge, a ferry, a tunnel, or even a helicopter system. While most individuals do not participate on a regular basis in such major investment decisions, they do illustrate the need to explore carefully the range of alternative investments from which a choice is to be made. At the other extreme, 18.1

3 hapter 18 investors often have to decide between only two investments: select Alternative "A", or leave your money where it is right now. In other words, do nothing. But even doing nothing is an investment decision. Most individuals make their investment choices from a set of common investment alternatives. An investor plans to invest $20,000 and may consider using: bonds mutual funds stocks jewellery or art real estate other investments But even among these basic categories of investments, an investor will face an extensive range of alternative investment opportunities with differing durations, risks, scale (or size), and liquidity (marketability). Investment Analysis: Some Key Issues Whatever the particulars of the investment alternatives, four common points must be considered: In all investments it is the future or expected costs and benefits that are important. Investment implies buying future events, not past events. All investments will involve some degree of risk that expectations are not realized. The amount of risk associated with any particular class of assets may differ significantly (i.e., there are significant differences between the amount of risk in "blue chip" and "penny" stocks). Investment analysis implies some expected costs and benefits which must be measured or quantified in order to make a decision. Investment analysis implies that some criteria does exist to help the investor decide among several alternatives. These criteria should lead to unbiased decisions. The purpose of this and the following chapter is to develop a framework for making investment decisions, particularly as they apply to real estate assets. These chapters will outline the problems associated with measuring the expected costs and benefits from real estate investments and analyzing the various investment decision criteria available and used in the marketplace. ALERT! Investment analysis involves forecasting future events and comparing expected performances for alternative investments. There are many ways to generate the forecasts and to arrive at an investment choice. The purpose of this and the following chapter is to provide a foundation so that brokerages and managing brokers are able to understand the wide variety of approaches which investors may use, and to comment on their strengths and weaknesses. The emphasis is on developing an understanding, not on promoting a particular forecasting model or investment criteria. 18.2

4 Fundamentals of Investment Analysis, Part I: Single Period Analysis Investment Objectives A Menu of Investors' Objectives: Just why do investors elect to sacrifice current consumption and invest in real estate (or any other asset for that matter)? The list of objectives can be extensive, but they can generally be distilled to the following: Maximize expected income Maximize expected wealth Minimize expected risk Provide tax sheltering Provide inflation hedge Provide diversification Satisfy other reasons such as prestige, job creation, and so on The first three objectives listed are quite interrelated. Maximizing income over time will result in maximizing individual wealth. However, one finds that higher expected returns are associated with higher risks; hence, to maximize expected incomes or wealth, investors must be prepared to take on more risk. Since investors generally reach some point beyond which they will not knowingly accept more risk, it is necessary to carefully restate the objectives as follows: Maximize expected income or wealth subject to risk being at or below the acceptable maximum; or Minimize expected risk providing the expected income or wealth is at least equal to the investor's minimum requirement. These restated objectives recognize the relationship between expected risk and return that prevails in the marketplace. This relationship is illustrated in Figure 1. While no one believes expected returns will increase linearly with risks as illustrated, we do anticipate that higher expected returns will generally be associated with higher expected risks. It will be helpful to explore more fully each of these investment objectives, especially as they pertain to real estate investments. Figure 1 Risk-Return Relationship 18.3

5 hapter 18 Wealth Maximization If the returns on real estate investments are generally higher than the yields on other investments, does this fact mean that real estate is a superior investment? In other words, are these real estate yields abnormal returns? In order to answer this question we must consider the concept of a competitive and efficient market. The competitive and efficient markets framework is an extension of the perfect competition model from microeconomics. Under perfect competition, there is such a large number of buyers and sellers in the market that each participant is so small in relation to the entire market that he or she cannot individually affect market prices. Perfect competition also assumes free entry and exit of resources and participants. There are no capital or information barriers to participating in a real estate market. Finally, perfect competition requires that investors have complete information flows; all market participants have access to all available information affecting the returns and risks of properties in a real estate market. In a competitive real estate market, prices fully capitalize any information affecting the value of real estate assets. Higher returns can only exist in a market if either: the investments have greater risk; or the market is uncompetitive or inefficient. In a competitive market, an investor can earn higher returns only by choosing more risky investments. Even though real estate returns during the past decade have been higher than the bond and stock market returns, they should not be considered superior or abnormal if real estate investments have more risk than the other investment alternatives. When looking at results, one should take the mean and standard deviation into account. The mean or expected value is a measure of central tendency and is equal to the sum of the numbers in a set divided by the number of individual data parts in the set. The standard deviation measures the spread of the data around the mean of a distribution (risk level). Tax Shelters To some investors, inherent in the idea of investing in real estate assets is the concept of tax sheltering. A tax shelter is simply an investment which reduces or defers the income tax liability of an investor. Tax shelter benefits in a real estate investment can result from the investor being able to deduct certain expenses which do not represent a cash outlay in the investment (e.g., capital cost allowance), from taxable income. A primary source of tax shelter for real estate investors is the capital cost allowance (A) deduction. This tax-deductible expense is allowed under income tax provisions to recognize the loss to the investor resulting from the physical depreciation of the structure. However, the rate at which the tax regulations state that a building is losing value (the A rate) is generally greater than the rate of actual depreciation. In fact, often the property as a whole may increase in market value despite any physical depreciation of the structure. These A deductions are non-cash expenses which may not necessarily reflect actual economic losses. Given the tax shelter available in real estate investment (which has been reduced by the anada Revenue Agency), an important question is whether tax shelter benefits are a source of abnormal returns for real estate investors. If the tax treatment of real estate is relatively favourable when compared to other investments, are the comparative after-tax returns higher for real estate due to the tax shelter benefits? We can apply a competitive market framework to the analysis of this question. In competitive investment markets, you would expect the price of properties to be affected by any tax shelter benefits available in real estate investment. If investors recognize and respond to the additional shelter benefits, they would increase their demand for real estate assets and bid up the prices of these investments. Acquisition prices would rise by an amount equal to the present value of the tax shelter. Real estate investors should not be able to earn abnormal or superior returns from the benefits of publicly known tax regulations. ompetitive real estate markets would be expected to capitalize into property values any tax shelter benefits, and the rate of return of real estate investors would be the same as the rate expected on other investments of similar risk. 18.4

6 Fundamentals of Investment Analysis, Part I: Single Period Analysis Inflation Hedge Real estate investment is widely perceived to be an excellent inflation hedge. Real estate offers an investor protection against the loss of purchasing power resulting from the rising prices of goods and services to the degree that the investor's equity increases in value at a rate equal to or greater than inflation. Research studies have observed that, historically, real estate values have grown at a faster rate than inflation and, therefore, real estate investments have provided a hedge against the effects of inflation on investors' returns. Why have real estate investments been such good inflation hedges? As you may recall, the market value of a property is equal to the present value of expected future benefit flows. Under conditions of inflation brought on by rising demand for goods and services, the demand for spatial services increases and, given the short run price inelasticity of supply (i.e., the supply is fixed in the short run), inflation results in higher expected rental incomes. These increases in benefit flows cause higher market values of real estate assets. A key characteristic of real estate (or any other asset) which enables it to be a potential inflation hedge is supply inelasticity. If the supply of real estate assets could expand rapidly with rising demand, there would be smaller increases in future benefit flows and less growth of real estate values in response to the inflationary pressures. To illustrate the analysis, consider the example of a neighbourhood shopping centre containing a grocery store and two other retail outlets. It is common real estate practice for the leases of these three tenants to consist of a base rent and a percentage of their gross sales. With inflation and rising nominal incomes of households, there would be increases in retail sales and higher rental incomes of the shopping centre. The growth of operating income and property appreciation would provide the investors in the centre with protection against the possibility of a decrease in the real value of their investment. This protection against inflation is illustrated in Table 1. Table 1 Number of Years over Which a Property Must Double in Price Inflation Years 5% 14 10% 7 15% 5 As an example, at a 10% rate of inflation, land prices must double within about seven years for investors to protect their equity against inflation. These figures assume no net operating income from undeveloped land; i.e., any revenue from uses such as agriculture are offset by expenses such as property taxes. Finally, inflation has an important adverse effect on debt financing in a real estate investment. Historically, the standard mortgage instrument in anada has been a constant-payment loan with nominal interest rates. Under inflationary conditions, the investor financing a property with such an instrument is affected by a phenomenon known as the tilt problem. When inflation is expected, nominal mortgage rates rise because of higher inflationary premiums embedded in interest rates. These premiums compensate lending institutions for the fact that they are being paid back in money which is worth less in terms of its purchasing power. While the costs of the higher interest rates caused by inflation may be offset over time by rising rental income and property appreciation, greater financing costs can create cash flow problems for an investor in the early years of the holding period with the after-financing, operating income being negative. Investors in these cases must either contribute additional equity during the investment or arrange supplemental debt financing. 18.5

7 hapter 18 Diversification: Spreading Your Risk Diversification is sometimes naïvely defined as the spreading of risk or, more colloquially, as "not putting all of your eggs in one basket". The idea being that by dividing your wealth over a number of different investments rather than holding just one, the chances of substantial loss of your investment funds is lowered. Through diversification, an investor's portfolio cannot be wiped out by the total failure of any single investment. Such a concept of diversification is rather incomplete. Under certain conditions, adding new investments to a portfolio may not reduce overall risk or may only reduce it by a small amount. If the returns on two investments are directly related to one another in a close association (i.e., if the return of one rises, the return of the other goes up by approximately the same amount), the combination of these two investments in a portfolio does not lower the risk of the investor. An example might be the acquisition of two similar apartment buildings in the West End of Vancouver. Since these two investments are basically affected by similar market forces, the returns on these investments would tend to move together and investors would not necessarily reduce their portfolio risk by holding both properties. Further, if real estate investors wish to reduce their portfolio risk, they can usually fulfill their goals by adding to their portfolios assets which have lower project risk levels (e.g., government savings bonds); but investors face the trade-off of also reducing the overall portfolio return. A more complete definition of diversification is the combining of investments whose returns are less than perfectly positively correlated in order to reduce portfolio risk without sacrificing portfolio returns. The key relationship is the correlation (relationship) between investment returns. If the returns are perfectly correlated, then diversification provides no risk reduction. If the investment returns are weakly correlated or, better yet, negatively correlated, diversification can substantially reduce overall portfolio risk. The possibility of real estate investors reducing their risk exposure through diversification creates a new consideration in real estate investment analysis. While analysis may centre on the individual returns and project risk characteristics of prospective investments, it is clear that attention must also be given to the relationships among the returns of alternative real and financial assets. Investors should seek properties whose returns have a negative correlation or only a weak positive correlation with other assets in their portfolios. Investors consider diversification characteristics of real estate investments when they make investment decisions. As rational and informed investors, equity participants in real estate markets can be expected to attempt to minimize their risk exposure through diversification. By judicious selection of investments to increase the level of diversification within their portfolios, real estate investors can reduce their portfolio risk. However, not all of the risk can be eliminated. A portion of investment risk relates to common economic factors that affect the overall performance of all investments. This overall or market-related risk cannot be diversified. Portfolio risk therefore is generally considered to have two components: Diversifiable risk: The risk that can be offset through the acquisition of assets with less than a perfect positive relationship among themselves Non-diversifiable risk (market-related risk): The portion of the risk that cannot be offset through diversification The connection between these two risk components is illustrated in Figure 2. It shows total portfolio risk declining as the number of investments increases. At some level of diversified portfolio holdings the only remaining risk for an investor will be the non-diversifiable or market-related risk. While real estate markets obviously have not reached the point where all participants are fully diversified, the illustration does suggest the importance of diversification to real estate investors. If investors can potentially reduce their overall risk exposure without sacrificing return, they would be foolish to ignore diversification considerations in their investment decisions. 18.6

8 Fundamentals of Investment Analysis, Part I: Single Period Analysis Figure 2 Diversification and Portfolio Risk Measuring osts and Benefits The basic premise underlying investment analysis is that the goal of any investor is to form an investment portfolio which has the highest possible expected return for a given level of risk. Or, put another way, the investor seeks the lowest possible investment risk for a given expected return. Investors are assumed to be risk averse, meaning that they must be compensated with higher returns in order to get them to accept greater risks. The first step in investment analysis, therefore, is to measure real estate investment risk and return. Two types of return measures are generally applied to individual real estate investments: single-period rates of return; and multiple period rates of return. Single-period measures evaluate the investment return on the basis of the benefit and cost flows over a time period of one year (or less). Multiple-period measures are used to summarize the investor's benefit and cost flows over a holding period that spans more than one year. This section explores the first step in measuring returns, namely, measuring expected future costs and benefits which is an essential step in the undertaking of either investment analysis or appraisal assignments. While the non-financial characteristics of real estate assets may be important to investors, it is the amount, timing, and certainty of future costs and benefits associated with the ownership of an interest in real property which forms the starting point for financial analysis. Estimates of these costs and benefits are made using pro forma financial statements, which are financial statements prepared using projected future cash flows. The measurement of costs and benefits will depend to some extent upon the purpose of the analysis (see Figure 3). The appraiser is generally interested in forecasting the future net operating income from the property for use in the income or investment method of appraisal (see the chapter on appraisal). The investment analyst is generally interested in extending this analysis to the cash flow statement, either before or after tax. In some cases the analyst may also be interested in the impact an investment will have on the annual financial statements, particularly the income statement and balance sheet. 18.7

9 hapter 18 Figure 3 Types of Financial Data Both the appraiser and the investment analyst are concerned with forecasting future events: the benefits and costs expected to be generated by the real property (or company). In this regard, they are concerned with a projected income statement (with some modifications to suit their particular needs). Readers will note that the traditional income statement (see Figure 4) may be prepared on an accrual basis and hence the reported net income after tax need not necessarily equal the cash generated by the firm. One major reason why the reported after-tax income may not equal the cash generated is due to the extension of short term credit (accounts receivable and payable). In forecasting revenues and expenses, the real estate analyst generally ignores the short term credit and assumes all revenues and expenses are received or paid when they are incurred. Hence, in making forecasts for real estate appraisal and investment analysis, there is an implicit assumption that all transactions for revenues and expenses are on a cash, not accrual, basis. (Refer to the accounting chapters for a review of these terms.) An analyst may want to forecast a traditional income statement, but this occurs infrequently because it would necessitate not only a forecast of revenues and expenses but also a forecast of the use of short term credit (accounts receivable and payable). The more common practice in real estate analysis is to forecast periodic cash flows and ignore the problems of short term credit. However, major long term financing decisions and major capital expenditures are usually included in the forecasts, but only when they represent cash flows. We can get some insights into how the experts measure the costs and benefits associated with real estate investments. The data collected on the MLS listing form for income producing properties (shown in Appendix 1) reflects the data commonly used at least as a starting point to measure annual benefits. To arrive at a reasonable forecast of the future revenues and expenses, a real estate analyst (or appraiser) may elect to start from the most recent known data: the current income statement. However, it must be noted that the current income statement may not be representative of the future, either because the current year is not typical or because the analyst (appraiser) is forecasting some changes in the market or in the lease contracts governing the property. Given that the task of the investment analyst (or appraiser) is to forecast a cash flow statement, the initial steps involve: a forecast of the rental revenue for the property rented under lease conditions expected to prevail for the subject property; a forecast of expenses borne by the landlord under the lease contracts; a forecast of debt servicing costs and income taxes; a forecast of capital expenditures (as opposed to operating expenses); and an analysis of refinancing decisions. 18.8

10 Fundamentals of Investment Analysis, Part I: Single Period Analysis Figure 4 Garden Warehouse Limited Income Statement For the Year January 1, 20 to December 31, 20 Rental Revenues $102,000 Miscellaneous Revenues 3,600 Total Revenue $105,600 Expenses: Management $ 5,100 Maintenance 17,200 Utilities 500 Property Taxes 6,300 Interest 47,520 Depreciation expense - buildings 9,000 - fixtures 2,333 Insurance 600 Miscellaneous 2,400 90,953 Net Income Before Income Tax $ 14,647 Income Tax Expense 5,615 After-Tax Net Income for Year $ 9,032 Less Dividends Declared 4,000 Retained Earnings, End of First Year $ 5,032 Estimation of Gross Potential Rental Income and Effective Gross Income Annual gross potential rental income is the expected rent at which the property can be leased on the assumed specified lease terms and at 100% occupancy. In the case of a building in multi-occupancy, gross potential rental income will be the sum of the gross rental value of each part that is separately leased. Gross potential rental income will be determined by the appraiser making a rental valuation, almost invariably using the comparative method to estimate current leasing terms. With reference to an apartment building, the suites would be inspected and the rental value would be ascertained from evidence of rents being paid for similar accommodation. In making such a rental valuation, it might be noted that there are two kinds of evidence of value: direct evidence and indirect evidence. Direct evidence is the rent at which the suites in the property under consideration are currently leased. Indirect evidence is the rent obtained for similar suites in comparable buildings. If the appraiser is satisfied that rents currently being paid in the subject property represent market value, under the lease terms, then direct evidence is stronger than indirect evidence. Note that any existing lease contract which continues into the future may result in a level of gross potential income less than the market level of rents, at least until the existing lease contract expires. In the case of existing lease contracts, two forecasts are necessary: the gross potential income given the existing leases and the gross potential rental income of the property if it could be leased at market level rents. If no existing leases continue into the future or if the existing leases provide for market level rents, then only one forecast is necessary: the market rents. 18.9

11 hapter 18 In undertaking this market rental appraisal and evaluation of existing leases, the analyst must be familiar with the types of rental covenants in order to find comparable lettings so that future rents can be forecast. The parties to the lease must negotiate at arm's length to drive the best possible bargain. This condition is sometimes not satisfied when a tenant renews a lease. In such circumstances, the tenant may (if pressed) pay a higher rent than anyone else would pay because, if obliged to move, he or she is likely to pay moving costs. In other circumstances, the landlord may be willing to take a somewhat lower rent because he or she is dealing with an established, known tenant. This is not to say that all rents fixed on renewal are unrepresentative of market value, but rather that the current rents may vary with 10% of the market under these circumstances. A further condition of leasing which may exist is a requirement that the tenant shall carry out certain work to the premises. The benefit of such work will endure for the landlord after the lease has expired. Other things being equal, the profits of a business will vary with management skill. onsequently, the quality of management will affect the net income derived from revenue producing real estate. Thus, in determining gross potential rental income, the criterion to use is that level of rent which will produce the greatest net income over the period of the investment. Such rents might be termed the optimum rental value. The optimum rent per suite will not necessarily be the highest rent paid for that type of accommodation. Obviously, there is no formula to calculate the level of optimum rent, and the decision rests on the judgment of the analyst (i.e., knowledge of a market). In practice, there will be no difference, in many cases, between the rents actually being paid and optimum rental value. But it is necessary to ensure that different levels of management skill do not give rise to variations in the yields obtained from analysis. In other words, analysis proceeds on the basis of constant management skill and the analyst's judgment determines that constant level of management skills. There will be times when the adoption of actual operating figures at the date of analysis would lead to a distortion in the results of the analysis owing to mistaken management policies. Having established gross potential rental income, the next step is to derive effective gross income. Effective gross income is the gross potential rental income less a suitable allowance for vacancies and bad debts (collection loss) during the year. Normally, some loss of revenue is to be expected through vacancies and bad debts, particularly if the property is in multioccupation or if a property with single occupation is leased for a short term. Estimating the allowance for vacancies and bad debts is not quite as simple as one might expect since the level of rents charged will influence the vacancy rate and bad debts. Rents which are relatively higher than other similar suites are conducive to higher vacancy rates. The additional income obtained when a suite is leased at such a high rent may be more than offset by the loss during the additional periods it is vacant. When the expenses of ownership are calculated, the analyst will adopt those costs which are appropriate to the optimum rent because the quality of services supplied to the tenants will also affect vacancy rates. The actual amount of the vacancy allowance must be determined according to market conditions. The allowance will vary at different periods of time. It must be emphasized that the figure to use is not necessarily the vacancy rate actually existing at the date of the analysis but that which, according to estimates, will exist over the period of the investment (if the rents charged were those on which the amount of gross potential rental value is based). Illustration 1: Swift Apartments omplex An investor, Joe Smith, is considering the purchase of a small apartment building at a cost of $585,000. In order to analyze the virtues of this investment, the investor has asked that a forecast of future incomes and expenses be made. The property contains 15 suites which you estimate can be let at approximately $622 per month. Your evidence suggests that the current vacancy rate for such properties is 2% and that you can expect to experience 1% loss in bad debts

12 Gross Potential Rental Income (100% Occupancy) $ 112,000 + Other Income + 0! Allowance for Bad Debts (1%)! 1,120! Allowance for Vacancy (2%)! 2,240 = Effective Gross Income $ 108,640 Fundamentals of Investment Analysis, Part I: Single Period Analysis This item of effective gross income corresponds to an estimate of the total revenue which appears on the traditional income statement. There may be other sources of income for which the analyst would elect to provide a separate vacancy and bad debt allowance. For example, the analyst may use 2% vacancy on the rental from the building and 10% vacancy for parking. Net Operating Income The estimated cost of the landlord's operating expenses (necessary to maintain the security and stability of income and invested capital) must be subtracted from the forecasted effective gross income. In carrying out the analysis, the investor may not have available any figures of actual operating expenses for the subject property. Therefore, it will be necessary to derive his or her own estimates from analysis of such outgoings in other similar buildings. Even if actual figures of operating expenses are available, they must be checked against the figures which are estimated to result from competent management in order to ensure that the net operating income calculated is at the optimum level. In principle, checking actual expenses is exactly the same as checking the rents actually being paid. Wherever possible, an expense analysis should be made on a per unit basis in order to give flexibility in application. For example, expenses might be expressed as annual cost per room or per square or cubic foot. Expenses or outgoings may be divided into two categories according to the frequency with which they arise. onstant outgoings are those which are of the same relative magnitude each year (e.g., taxes, wages, lighting, and insurance), whereas cyclical outgoings are those items of expense which do not arise every year or which vary substantially in amount from one year to another. Such cyclical items include repairs to the building and repairs and renewals to equipment such as refrigerators, stoves, and so on. Operating expenses may also be classified as fixed expenses and variable expenses. The fixed expenses are costs that, in the short run, remain constant throughout the period, independent of the level of occupancy. Variable expenses are defined as outlays that vary directly with the level of occupancy. Obviously, some components of a given expense may be both fixed and variable. For example, fuel expense may represent both fixed (to maintain some minimum temperature in the building and common area) and variable (as the occupancy level increases). For our purposes, we will identify expenses according to their most representative classification. Figure 5 demonstrates a detailed breakdown of a net operating income statement. The list of variable and fixed expenses shown is fairly typical for an apartment building. These items, if incurred during a period of time, would also appear on an income statement. Moreover, except for accounts payable and prepaid items carried over from period to period, these items would also represent cash outflows. One other element that is typically deducted from effective gross income is replacement reserves (also referred to as replacement allowances). Replacement reserves represent the amount of funds set aside for the periodic replacement of building components (such as appliances) that wear out more rapidly than the building itself and must be replaced during the building's economic life. Reserves are not deducted in Figure 5 as they are treated as capital expenditures, not expenses. However, in preparing a forecast of net operating income, particularly for appraisal purposes, it is customary to include an annual reserve requirement. The forecasts necessary for the income statement for income tax purposes, and for cash flow analysis, also extend beyond the estimated net operating income. Two further operating items are to be considered: debt servicing and income taxes

13 hapter 18 Figure 5 Swift Apartments omplex Forecasted Net Operating Income For One Year Period Potential Gross Rental Income $112,000 - Bad Debt Allowance (1%) 1,120 - Vacancy Allowance (2%) 2,240 = Effective Gross Income $108,640 Variable Expenses: Utilities $ 6,000 Repairs and Maintenance 4,000 Services 2,000 Administration and Payroll 2,400 Supplies 1,500 Decorating 2,500 Management 6,000 Miscellaneous 800 Total Variable Expenses $ 25,200 Fixed Expenses: Real Estate Taxes $ 10,000 Insurance 1,500 Other Taxes and Fees 300 Total Fixed Expenses $ 11,800 Total Expenses $ 37,000 Net Operating Income (Before Reserves) $ 71,640 Before-Tax Flows The analyst may be interested in before-tax flows for two reasons: to forecast before-tax income and to forecast the before-tax cash flows. Both of these forecasts will start from the estimate of net operating income before replacement reserves. The net operating income is taken before reserves for replacement since these reserves are not a cash outflow; hence will not affect the before- or after-tax cash flows. In the case of the income statement, only the interest component of the debt is deducted to arrive at an estimate of income before tax. Principal is not deducted because it is treated as a capital contribution (i.e., funds put up to purchase the property). The depreciation expense must also be deducted. In the case of estimating before-tax cash flows (BTFs), both the principal and interest components of the debt are deducted but no depreciation expense is deducted since depreciation expense is not a cash item. Using our example, the income and cash flows on a before-tax basis would be calculated in a manner shown in Figures 6 and

14 Fundamentals of Investment Analysis, Part I: Single Period Analysis Figure 6 Before-Tax Income and Before-Tax ash Flow Net Operating Income (Before Reserves) For Income Statement Analysis For ash Flow Analysis! Interest Expense! Interest! Depreciation Expense! Principal = Before-Tax Income = Before-Tax ash Flow Figure 7 Swift Apartment omplex Sample Before-Tax Income and Before-Tax ash Flow Gross Potential Income $ 112,000 + Other Income 0! Vacancy Allowance 2,240! Bad Debt Allowance 1,120 = Effective Gross Income $ 108,640! Variable Expenses 25,200! Fixed Expenses 11,800 = Net Operating Income $ 71,640 For Income Statement Analysis For ash Flow Analysis For Appraisal! Interest $ 47,521! Interest $ 47,521! Reserves $ 9,080! Depreciation Exp. 10,000! Principal 1,782 = Before-Tax Income $ 14,119 = BTF $ 22,337 = Stabilized NOI $ 62,560 Depreciation expense is taken on a straight line basis for the example. Depreciation expense is based on a 45 year building life and $450,000 building cost. Depreciation expense = $10,000 (450,000 45)

15 hapter 18 In this example, the original mortgage is for $350,000 at 14% per annum, compounded semi-annually. The amortization period is 25 years and payments are made monthly. The interest/principal payment calculation follows: 14 O NOM% 14 j rate 2 O P/YR 2 O EFF% j rate 12 O P/YR 12 O NOM% j rate PV 350, N FV 0 alculation Press Display omments PMT -4, Monthly payment %/& PMT -4, Rounded payment 1 INPUT 12 O AMORT PER 1-12 Range of payments to be amortized = -1, Principal Year 1 = -47, Interest Year 1 Two points should be noted regarding the analysis to this point. First, it was assumed that in making these forecasts the analyst ignores short term credit (accounts receivable and payable). Hence the forecasts from gross potential rental income through to net operating income before reserves are all cash equivalent values. Moreover, the payments on debt, both principal and interest, are assumed to be made when incurred. The only non-cash items considered thus far are the reserves for replacement (used in analysis for appraisal) and the depreciation expenses (used in the income statement). Second, only the interest component of debt payments is included in the income statement but the entire payment (principal and interest) is included in the cash flow statement. After-Tax ash Flows The final step in the analysis of the operating income and cash flows is the determination of the after-tax income and after-tax cash flows (ATF). Note that income tax is treated as a cash expense and deducted from both the before-tax income and before-tax cash flows. Just how the income tax is calculated will be addressed in the next chapter. For now, assume the accountant has provided the information. The complete forecasting analysis, starting with gross potential income through to after-tax cash flows, for all major purposes, is shown in Figure 8. Seven quite different forecasted amounts are determined to represent the expected performance of this asset: Gross potential income = $112,000 Net operating income = $71,640 Net operating income after reserves = $62,

16 Fundamentals of Investment Analysis, Part I: Single Period Analysis Before-tax income = $14,119 After-tax income = $6,559 Before-tax cash flow = $22,337 After-tax cash flow = $14,777 Each of these estimates will be used in the analysis of real estate investments, but the last two are most commonly required. The forecasting of after-tax income is less frequently required for investment purposes. The after-tax income forecast will be of interest to an investor who is concerned with the impact that ownership of the asset will have on the financial statements. It is not, however, used for analysis of the merits of the investment. Note that different investors may elect to use quite different measures of benefits and costs. For example, some investors prefer to exclude financing from their investment analysis and use a before-tax, before-financing cash flow (e.g., net operating income). Other investors prefer an after-tax, after-financing return measure (e.g., after-tax cash flow). The preferences are diverse but no matter what measure of benefits is used, the investor must then take their preferred measures of costs and benefits and use these to measure the "investment worth" of the asset: these represent the decision criteria used to select one investment from the menu of alternatives. Figure 8 Swift Apartment omplex Forecasting Income and ash Flows Gross Potential Income $ 112,000 + Other Income 0! Vacancy Allowance 2,240! Bad Debt Allowance 1,120 = Effective Gross Income $ 108,640! Variable Expenses 25,200! Fixed Expenses 11,800 = Net Operating Income $ 71,640 For Income Statement For ash Flows For Appraisal! Interest $ 47,521! Interest $ 47,521! Reserves $ 9,080! Depreciation 10,000! Principal 1,782 = Stabilized NOI $ 62,560 = Before-Tax Income $ 14,119 = BTF $ 22,337! Income Tax 7,560! Income Tax 7,560 = After-Tax Income $ 6,559 = ATF $ 14,777 A wide range of decision criteria is used in the marketplace, ranging from a "coin flip" to a sophisticated statistical analysis

17 hapter 18 The single period measures of return are covered in the next section of this chapter and the multi-period measures of return are covered in the next chapter. Basic Return and Risk Measures One Year Measures There are a number of one period (one year) ratios that have traditionally been applied to measure the profitability of a real estate investment. These single period measures have the common characteristic of being relatively easy to calculate. Unlike the multi-period measures in the analysis of a prospective investment, they do not require the forecasting of the future values over a long holding period. In situations where investment information is so sketchy that future flows during an investor's holding period cannot be reasonably estimated, these basic measures may be the best available criteria for making an investment decision. We will consider five single period measures, two of which were introduced in the previous chapter. Gross Rent Multipliers While gross rent multipliers (GRMs) are more commonly thought to be an appraisal tool, these can be used for investment decision making. The gross rent multiplier is a one period measure equal to: GRM = Investment ost Effective Gross Income and, in the case of the Swift Apartments omplex, the gross rent multiplier is: GRM = $585,000 $108,640 = times Sometimes, especially for residential rental properties, the gross rent multiplier is expressed as monthly rather than annual rental. For example, the monthly effective gross income for the Swift Apartment omplex is approximately $9,050 and the (monthly) gross rent multiplier is: GRM = $585,000 $9,050 = 64.6 times The investment decision rule using gross rent multipliers: Decision Rule If you are to select one investment, select the investment with the lowest gross rent multiplier. If you are deciding whether or not to invest, invest providing the gross rent multiplier is less than your personally determined gross rent multiplier (e.g., invest providing the gross rent multiplier is less than 6.0). While the gross rent multiplier looks like a trivial investment decision criteria, it is important to note that, under a different name, it was for many years the single most common investment decision rule in industry. Outside of real estate it is called the payback period: the number of years (or periods) it takes to recover the purchase price. In the case of our Swift Apartments omplex it takes 5.39 years to recoup invested capital

18 Fundamentals of Investment Analysis, Part I: Single Period Analysis Net Rent Multipliers The gross rent multiplier suffers from a number of weaknesses, one of which is an assumption that all investment properties will have similar operating expense ratios (the ratio of operating expenses to gross potential incomes). This assumption may not always be warranted. Although not a common practice (but useful for comparison purposes), one way to overcome the possible error in this assumption is to use a net rent (or, more specifically, net operating income) multiplier (NRM): NRM = Investment ost Net Operating Income and, in the case of the Swift Apartments omplex, the net rent multiplier is: NRM = $585,000 $71,640 = times The net rent multiplier can then be used to select the "best" investment from among the menu of investment alternatives. Decision Rule Select the investment with the lowest net rent multiplier. If you are deciding whether or not to invest, invest if the net rent multiplier is less than your personally determined NRM. Again this net rent multiplier, under a different name, is commonly used in the stock brokerage industry: it is known as the price-to-earnings ratio (P/E ratio): the ratio of the stock price to the earnings of the company. The common rule of thumb is to buy when the P/E ratio falls below some specific standard. Return on Investment A popular return measure is the return on investment (ROI). The return on investment is calculated as the ratio of an asset's net operating income (NOI) in a given year to its total investment cost. This is simply the reciprocal of the net rent multiplier: ROI = NOI Investment ost This measure is also called the overall capitalization rate or the broker's yield. When considering a prospective investment, the net operating income figure is usually the projected net operating income in the first year of the holding period and the investment cost is the purchase price of the property. The return on investment is in essence the free and clear rate of return, the investor's return on a before-tax, before-financing basis. In the case of the Swift Apartments omplex, the property has an estimated cost of $585,000 and it is projected to generate a net operating income in the first year of $71,640. Given these figures the investment's return on investment is: $71,640 ROI = = or 12.24% $585,000 Decision Rule If you are selecting one investment alternative, choose the investment with the highest return on investment. If you are deciding whether or not to invest, invest if the return on investment equals or exceeds your own requirement for this type of investment (e.g., invest if the return on investment equals or exceeds 10.75%)

19 hapter 18 Equity Dividend Rate A third measure of investment worth often utilized in real estate investment analysis is the equity dividend rate (EDR). The equity dividend rate is the ratio of the property's before-tax cash flow (BTF) to the investor's initial equity investment. EDR = BTF Equity Investment This ratio is also known in appraisal circles as the cash throw-off return. The equity dividend rate is often employed by real estate investors because it measures the realized or projected return of investors on their equity invested in a property. It also allows for easy comparison with alternative investments such as government or corporate bonds where the interest return is quoted on a before-tax basis. The investor buying the Swift Apartments omplex is expecting a before-tax cash flow in the first year of $22,337. Given the equity investment of $235,000 ($585,000 - $350,000), the equity dividend rate in the first year of the holding period is: $22,337 EDR = = or 9.50% $235,000 Decision Rule If you are selecting one investment from a menu of investments, select the one with the highest equity dividend rate. If you are deciding whether or not to invest, invest if the equity dividend rate equals or exceeds your minimum required equity dividend rate for this type of investment. ash on ash Return With the tax shelter benefits available in real estate investment, some investors prefer an equity return measure derived on an after-tax basis. Such a measure is the cash on cash return ( on ). The cash on cash return is the ratio of the annual after-tax cash flow (ATF) to the investor's original equity investment: on = ATF Equity Investment The cash on cash return ( on ) for the first year of the Swift Apartments omplex is: $14,777 on = = or 6.3% $235,000 If income tax payable is zero, the cash on cash return would be equal to the equity dividend rate. Decision Rule If you are selecting one investment from a menu of investments, select the one with the highest cash on cash return. If you are deciding whether or not to invest, invest if the cash on cash return equals or exceeds your minimum required cash on cash return for this type of investment

20 Summary of One Period Investment Decision Rules Fundamentals of Investment Analysis, Part I: Single Period Analysis The five decision rules outlined above can be summarized according to the type of investment problem the investor faces. We have described two investment situations: select one investment project from among a menu of investment alternatives; and decide whether or not to make a particular investment. The application of the investment decision criteria are then as follows: Decision riteria Select "A" from Menu if it has the: Invest if: 1. Gross Rent Multiplier lowest GRM GRM lower than "X" 2. Net Rent Multiplier lowest NRM NRM lower than "X" 3. Return on Investment highest ROI ROI greater than "X%" 4. Equity Dividend Rate highest EDR EDR greater than "X%" 5. ash on ash Return highest on on greater than "X%" Note: "X" and "X%" are set by the investor and vary depending on the risk. Resale Value and Residual ash The one period investment returns illustrated thus far all share one common weakness: they do not include the allimportant capital gain or appreciation. One reason for buying real estate is to realize a capital gain. Using a one year holding period, the analyst could forecast the expected sale price of the asset at the end of this holding period. From this forecasted sale price, the analyst could deduct those costs and expenditures occasioned by the sale to arrive at a before- and after-tax cash residual and use this to estimate the appreciation. If you purchased common stock (assume all cash purchase for the moment), then you might calculate the one year rate of return as: and Return = Dividend + Appreciation Rate of Return = Dividend % Appreciation ost And "appreciation" can be measured as: Appreciation = Value Year End! ost Therefore, the rate of return is: Rate of Return = Dividend % (Value Year End & ost) ost In the case of real estate investments we substitute some other measure of annual benefit for the stock dividend (e.g., gross rent, net rent, BTF, ATF). We can now address the problem of how to incorporate appreciation into the one period investment decision rules

21 hapter 18 Net Forecasted Sale Price The starting point in the analysis is to forecast the sale data. At this stage, we used a one year horizon; hence we need to estimate the property value one year in the future. For purposes of illustration, assume that property values are increasing at 6% per annum. The Swift Apartments omplex property was purchased for $585,000, held for one year, and disposed of at the end of the first year. Therefore the expected sale price at the end of year is: Expected Sale Price = $585,000 (1.06) = $620,100 On the assumption that the property is sold for $620,100 at the end of the year, the investor would experience some sale costs (i.e., legal and commission fees), be required to prepay the outstanding mortgage on the property (or permit the purchaser to assume the debt), and be subject to some form of income tax on the sale. If one assumes the investor will pay a real estate commission of $18,402 and legal fees of $2,500, the net sale price can be found as: Gross Sale Price $ 620,100! Real Estate ommission 18,402! Legal Fees (losing) 2,500 = Net Sale Price (before tax) $ 599,198 Before-Tax ash Reversion The analyst must deduct from the net sale price the outstanding balance on all mortgages at year end. If any prepayment penalties apply, they must also be deducted. In this example the original mortgage was in the amount of $350,000 at 14% per annum, compounded semi-annually. The amortization period was 25 years with monthly payments of $4, The outstanding balance after one year or 12 months would be: alculation Press Display omments 14 NOM% 14 j rate 2 P/YR 2 EFF% j rate 12 P/YR 12 NOM% j rate PV 350, N FV %/& PMT -4, Monthly Payment 1 INPUT 12 AMORT PER 1-12 Range of payments to be amortized = -1, Principal Year 1 = -47, Interest Year 1 = 348, OSB

22 Fundamentals of Investment Analysis, Part I: Single Period Analysis Assuming there are no prepayment penalties, the before-tax cash reversion would be: Gross Sale Price $ 620,100! ommission 18,402! Legal Fees 2,500 = Net Sale Price $ 599,198! Outstanding Balance on Debt 348,218 = Before-Tax ash Reversion $ 250,980 The original purchase price for this property was $585,000 involving a mortgage in the amount of $350,000 and initial equity of $235,000. The mortgage balance has declined by $1,782 ($350,000 - OSB 12) and the equity (on a pre-tax basis) has increased from $235,000 to $250,980, an increase of $15,980. Two factors have contributed to this growth in equity: net capital appreciation and principal repayment on the loan as illustrated in Figure 9. Single Period Investment Decision Rules with Appreciation It is possible to incorporate the one period appreciation into some of the single period decision rules. This property need not be sold at year end (e.g., the gain can be a book gain not a realized gain). For example, using the Swift Apartments omplex we might suggest a one year estimated return of: Overall Return = Overall Return = NOI % Appreciation ost NOI % (Net Sale Price & ost) ost OR Overall Return = Overall Return = $71,640 % ($599,198 & $585,000) $585,000 $71,640 % $14,198 $585,000 Overall Return = 14.67% This would be an overall return, before financing and before income tax considerations. Similarly we could incorporate appreciation into a before income tax return on equity: Equity Return = Overall Equity Return = Overall Equity Return = Overall Equity Return = BTF % Gain in Equity Original Equity BTF % (losing Equity & Original Equity) Original Equity $22,337 % ($250,980 & $235,000) $235,000 $22,337 % $15,980 $235,000 Overall Equity Return = 16.3% 18.21

23 hapter 18 Recall that the gain in equity of $15,980 includes $1,782 principal repaid and $14,198 in property appreciation net of expected sales costs. Figure 9 Before-Tax Reversion Analysis While it is possible to calculate a single period return measure including appreciation and use this as an investment criteria, the more common practice is to extend the analysis over a number of years. The next chapter explores multiperiod return measures and investment criteria. Summary: Single Period Analysis The one period return calculations provide a series of quick, easy to calculate performance measures. We identified seven such measures for our illustrative Swift Apartments omplex: Gross Rent Multiplier (GRM) Net Rent Multiplier (NRM) Return on Investment (ROI) 12.24% Equity Dividend Rate (EDR) 9.5% ash on ash Return ( on ) 6.3% Overall Return 14.67% Overall Equity Return 16.3% Which measure is best? They all apply to the same property and property circumstances. There is no one "best" measure: they all suffer from some weaknesses. However, all of these single period measures share one common weakness: they assume that the one year used in the analysis is typical of all years. If this is not the case (e.g., if year one is not typical), then all the single period measures will be weak. The multi-period measures in the next chapter are designed to overcome this weakness

24 Fundamentals of Investment Analysis, Part I: Single Period Analysis APPENDIX 1 MLSLink: Multi-Family ommercial Data Input Form 18.23

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