Essentials of

Eleventh Edition

Real Estate Investment

David Sirota, PhD • Karen Stefano, Contributing Editor

Unauthorized reproduction or resale of this product is in direct

violation of global copyright laws. Customized for use by CE Source.

Ess_RE_Investment_11e.indb 1 1/20/2016 3:43:48 PM

 This publication is designed to provide accurate and authoritative information
in regard to the subject matter covered. It is sold with the understanding that the
publisher is not engaged in rendering legal, accounting, or other professional
advice. If legal advice or other expert assistance is required, the services of a
competent professional should be sought.

President: Dr. Andrew Temte

Chief Learning Officer: Dr. Tim Smaby
Executive Director, Real Estate Education: Melissa Kleeman-Moy
Development Editor: Jennifer Brandt

ESSENTIALS OF REAL ESTATE INVESTMENT ELEVENTH EDITION

©2016 Kaplan, Inc.
Published by DF Institute, Inc., d/b/a Dearborn Real Estate Education
332 Front St. S., Suite 501
La Crosse, WI 54601

All rights reserved. The text of this publication, or any part thereof, may not be
reproduced in any manner whatsoever without written permission from the
publisher.

Printed in the United States of America

ISBN: 978-1-4754-3372-2
PPN: 1559-0111

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 Contents

Introduction vii
Acknowledgments ix

SECTION A: PRINCIPLES OF REAL ESTATE INVESTMENT 1

1 Introduction to Real Estate Investment 2

Introduction 2
The Nature of the Real Estate Market 3
Purposes of Investing in Real Estate 10
Advantages of Investing in Real Estate 11
Disadvantages of Investing in Real Estate 13
Sustainability 15
Summary 15
Discussion Topics 16

2 Ownership Interests in Real Property 18

Introduction 18
Individual Ownership 19
Group Ownership 24
Trust Ownership 33
Foreign Investors 38
Summary 39
Discussion Topics 40

iii

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 iv Essentials of Real Estate Investment Eleventh Edition

3 Feasibility Studies of Real Estate Investments 42

Introduction 42
Market Analysis 43
Property Analysis 56
Summary 59
Discussion Topics 60

4 Income Taxes and Real Estate Investments 62

Introduction 62
Income Subject to Tax 63
Income Tax Rates 66
Real Estate Investments as Tax Shelters for Active Income 66
Real Estate Investments as Tax Shelters for Capital Gains 69
Summary 74
Discussion Topics 75

5 Financial Analysis of Real Estate Investments 77

Introduction 77
Financial Analysis 78
Calculators and Financial Analysis Software Programs 96
Summary 99
Discussion Topics 99

6 Financing for Real Estate Investments 102

Introduction 102
Sources of Funds 104
Forms of Real Estate Finance 107
Types of Real Estate Finance 109
Special Provisions for Investment Financing 113
Defaults and Foreclosures 116
Summary 120
Discussion Topics 122

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 Contents
v

SECTION B: PRACTICES OF REAL ESTATE INVESTMENT 124

7 Investing in Land 125

Introduction 125
Essentials of Land Investment Feasibility Studies 126
Single-Lot Investments 129
Acreage 131
Evaluating Land 132
Summary 140
Discussion Topics 140

8 Investing in Residential Properties 142

Introduction 142
Single-Family Detached Homes 143
The Fair Housing Act 146
Multiunit Apartment Rentals 148
Cooperatives 154
Condominiums 157
Conversions to Condominiums 160
Summary 163
Discussion Topics 164

9 Investing in Office Buildings 166

Introduction 166
Office Building Management 167
Types of Office Investments 172
The Americans with Disabilities Act (ADA) 177
Summary 179
Discussion Topics 180

10 Investing in Commercial Real Estate 182

Introduction 182
Strip Store Buildings 183
Neighborhood Shopping Centers 185
Community Shopping Centers 192
Regional and Super-Regional Shopping Centers 194
E-Commerce Competition 197
Summary 197
Discussion Topics 198

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 vi Essentials of Real Estate Investment Eleventh Edition

11 Investing in Industrial Properties 200

Introduction 200
The Industrial Real Estate Market 201
Characteristics of Industrial Real Estate 202
Types of Industrial Investments 206
Summary 212
Discussion Topics 213

12 Investing in Special Real Estate 215

Introduction 215
Manufactured-Home Parks 215
Diverse Realty Investments 218
Alternate Investment Opportunities 222
Summary 226
Discussion Topics 227
Glossary 229
Answer Key 237
Index 241

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 Introduction

The introduction to the 9th edition of this text expressed optimism about an eco-
nomic recovery from the Great Recession. The introduction to the 10th edition of this
text declared it an excellent time to invest in real estate because prices and interest rates
were low, even if banks were being very selective screening potential borrowers.
That optimism proved to be warranted and the investment advice well-founded. As of
August 2015, the unemployment rate is down to 5.1% nationally, though in some states
it still hovers at 7% and in some cities it is still as high as 10%. Other economic indica-
tors are strong, and economists predict continued job creation, which will fuel consumer
spending, which will in turn entice businesses to hire and invest more.
All of this translates into optimistic news for the U.S. housing market. As of mid-
2015, existing home sales (which make a comparatively large proportion of all home sales)
had surged to their highest level since November 2009. According to the National Asso-
ciation of REALTORS®, existing sales climbed 5.1% month over month to an annual rate
of 5.35 million sales. As of mid-2015, sales have been up year-over-year for eight straight
months. Homes are selling quickly again, and price growth in many markets continues
to hover at or near double-digit appreciation. According to the National Association of
REALTORS®, as of mid-2015, the number of existing homes sales with a final selling price
between $250,000 to $500,000 rose 17.4% year over year. Transactions valued between
$500,000 and $750,000 were also up 14.5%, while the $750,000 to $1 million bracket
increased 12.5%.
However, in order to fuel sustained improvement in housing demand, consumers will
need a consistently improving ability to finance a home purchase. Rapidly rising home
prices juxtaposed against minimal wage growth will pose a barrier to entry into the hous-
ing market for many Americans.
Democracy as a political system, when coupled with capitalism as an economic sys-
tem, is based on the private ownership of real and personal property. Therefore, in the
United States, individuals and corporations may own real property under the laws of this
country. Such private ownership, called the allodial system, allows for fee simple owner-
ship, which expands the simple rights of property use and control during an owner’s life
to include the powerful right to designate to whom a property passes upon the owner’s
death. As a result, owners may effectively translate their work efforts into tangible real
and personal property assets and thus accumulate an estate to enjoy and control into the
future.
vii

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 viii Essentials of Real Estate Investment Eleventh Edition

The desire to accumulate a measurably valuable estate and to generate a revenue

stream is no doubt one major reason for the tremendous interest in the ownership of real
property in this country. It appears that almost everyone gives high priority to the owner-
ship of real estate, from the smallest condominium to the largest shopping center.
This 11th edition of Essentials of Real Estate Investment examines the current real
estate market and describes the various opportunities for real estate investors. Real estate
may provide a profitable alternative for an investor’s portfolio with much of the income
sheltered by deductions for operational costs, interest expenses, and depreciation.
This text is divided into two major sections—Principles and Practices—and the units
are presented as follows.
Section A: Principles of Real Estate Investment
●● Unit 1 introduces the nature of the real estate market and explores purposes for
investing in real estate as an alternative to other forms of investment. It also describes
the advantages and disadvantages of real estate investments.
●● Unit 2 provides an inventory of the various forms of real estate ownership, including
individuals, groups, partnerships, trusts, and leaseholds.
●● Unit 3 describes the market and property analyses necessary to determine the feasibil-
ity of a real estate investment.
●● Unit 4 reviews the current income tax laws governing real estate investments. Included
are a number of tax-sheltering alternatives.
●● Unit 5 examines the financial requirements necessary to measure the economic feasi-
bility of a real estate investment.
●● Unit 6 completes Section A and investigates the financing alternatives for leveraging
real estate investments. Included are discussions of the government’s role in finance,
sources of funds, types and forms of real estate loans, special loan provisions for
investment financing, and default and foreclosure consequences.
Section B: Practices of Real Estate Investment
●● Unit 7 begins a unit-by-unit examination of the various types of real estate available
for investments. Here, descriptions of single lots and acreage are presented together
with the special analyses these types of investments require.
●● Unit 8 examines the investment requirements for residential properties and includes
single-family homes, multi-unit apartments, cooperatives, and condominiums.
●● Unit 9 explores investing in office buildings, including management requirements.
●● Unit 10 describes investments in commercial properties, including strip store build-
ings and small and large shopping centers.
●● Unit 11 presents the opportunities for investing in industrial properties, including
industrial parks, warehouses, and lofts.
●● Unit 12 examines a variety of alternative real estate investments, including manu-
factured-home parks, motels, amusement parks, and housing for the elderly, among
others.

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 Acknowledgments

David Sirota received his Ph.D. in Real Estate from the University of Arizona in
1971. He taught real estate subjects at many universities, including the University of
Arizona in Tucson, Eastern Michigan University in Ypsilanti, National University in San
Diego, and California State University in Fullerton, and at one time headed the Depart-
ment of Real Estate at the University of Nebraska in Omaha. Dr. Sirota has also written
state licensing exam questions for the Arizona Department of Real Estate and ETS. He
was involved as a consultant in the development of a congregate care center in Green Val-
ley, Arizona, and acts in a consultant capacity for individuals and developers. He was a
founding member of the Real Estate Educators Association (REEA), securing one of its
first DREI designations.
Karen Stefano is the co-author of the how-to business writing and self-marketing
guide Before Hitting Send: Power Writing Skills For Real Estate Agents. She is a lawyer and
real estate broker in California.
Thanks also go out to those who have contributed to this and previous editions of this
textbook: Karen B. Abbott, Thurza B. Andrew, Donald G. Arsenault, Jack R. Bennett,
Paul S. Black, Richard Blyther, Robert Bond, William J. Cahaney, Gene Campbell, Ken
Combs, Bo Cooper, Gerald R. Cortesi, Larry B. Cowart, Valleri J. Crabtree, Samuel P.
DeRobertis, Jack Flynn, Peter C. Glover, Ronald Guiberson, Lloyd L. Hampton, Byron
B. Hinton, James E. Howze, Carla J. Keegan, Sam Kiamanesh, Rick Knowles, Craig Lara-
bee, Calvin Montgomery Sr., William E. Nix, William M. North Jr., Michael R. Phillips,
Donald L. Pietz, Richard P. Riendeau, Jerry Rutledge, Jeff Siebold, Teresa Sirico, Walstein
Smith Jr., James Sweetin, Steve Williamson, and Roger W. Zimmerman.

ix

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Ess_RE_Investment_11e.indb 10 1/20/2016 3:43:48 PM
 Section

A
Principles of Real Estate
Investment

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 Introduction to Real
Estate Investment
Unit

1
LEARNING OBJECTIVES
After successfully completing this unit, you will be able to
●● describe the nature of the real estate market,
●● discuss the purposes of investing in real estate,
●● list the advantages and disadvantages of investing in real estate, and
●● explain the concept of sustainability.

betterments leverage relative scarcity

bundle of rights liquidity risk
buyer’s market longevity seller’s market
cycle market segmentation sheltering
demand market value supply
discretionary funds permanence sweat equity
easy money personal property tight money
fixity property value in use
forgoing real estate
highest and best use real property

INTRODUCTION
Property is anything that can be owned. Real estate is defined as land and all natural
and human-made improvements permanently attached thereto, and the rights appurte-
nant, including air and mineral rights. All other property is personal property. To own
real estate is not only to possess the physical property but also to acquire certain legal
rights to its continual peaceful use and redistribution. When we acquire real estate, we
also acquire an accompanying bundle of rights in the property. These are the rights of
use, possession, control, enjoyment, exclusion, and disposition, including the right to
pass the property on by means of a will, and they change the definition of real estate to
real property.

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 Unit 1: Introduction to Real Estate Investment 3

The ownership and control of real estate is a fundamental part of our lives. We depend
on real property to provide us with shelter and to satisfy other basic needs. In our country
these essential needs are met in various ways. Because technological achievements have
advanced our living standards, we are no longer individually dependent on the ownership
of land for the fulfillment of our basic needs. We rent or own an apartment or a house that
is serviced by utility companies and financed by lending institutions. We work in office
buildings, manufacturing plants, and shops, and we purchase our goods in stores, play in
parks, and consume the products of far-off farms and ranches.
Many persons now have the financial capability to step beyond using real property to
supply only their basic necessities. These individuals also acquire real estate as an invest-
ment, a creator and a storehouse of value that represents the conversion of their work
efforts into a tangible, valuable asset.
A real estate investment can be described as the commitment of funds by an individual
with a view to preserving and increasing capital and earning a profit. We all make invest-
ments of various kinds throughout our lives. We invest time, energy, and money in educating
ourselves and our children, in purchasing cars, in obtaining good health care, in accumulat-
ing savings, and in pursuing other ventures necessary to ensure a better quality of life.
In many instances, investment also represents the forgoing of some present comforts in
anticipation of future benefits. Forgoing instant gratification, although often painful, is nec-
essary in the accumulation of the savings essential to the acquisition of investment property.
A real estate investment sometimes requires something as important as money—it
often involves the application of personal time and effort. This hands-on approach to an
investment is called sweat equity.
Investment in real estate, however, extends beyond our everyday activities and con-
cerns the commitment of free money, money accumulated in excess of funds required to
secure life’s necessities. This free money, often called discretionary funds, can be viewed
as money available for investment.

THE NATURE OF THE REAL ESTATE MARKET

Characteristics of Real Property Investments

Each parcel of real estate is unique and thus requires an individual investment anal-
ysis relevant to its specific locational attributes. However, all real property has certain
common characteristics that affect its value. These characteristics include fixity, longevity,
permanence, risk, and market segmentation.
Fixity.  Real estate is fixed in location, which greatly restricts the scope of its marketabil-
ity. As a result of this fixity, real estate values are affected by any political and economic
activities occurring in the immediate vicinity.
Longevity.  Real estate is generally considered to be a long-term investment because of
the durability of the improvements and the permanence of the land. This quality of lon-
gevity enables investors to estimate, with some degree of reliability, the present value of a
future stream of income from their properties.
Permanence.  It is the attribute of permanence that forms the basis for our system of
long-term mortgage-debt amortization. Investment in real estate usually involves rela-

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 4 Essentials of Real Estate Investment Eleventh Edition

tively large dollar amounts that require complex financial arrangements. These complexi-
ties, in turn, require the expertise of lawyers, accountants, brokers, property managers,
real estate consultants, and other specialists.
Risk.  Real estate investment is a risk —a relatively high-risk venture that reflects the
uncertainties of a somewhat unpredictable market. In fact, there is no readily identifiable,
organized national market for real estate as there is for stocks and bonds. The realty market
is a combination of local markets that react speedily to changes in local economic and polit-
ical activities and somewhat more slowly to regional, national, and international events.
Market segmentation.  The real estate industry also suffers from market segmenta-
tion. The fractured aspect of this unorganized and largely unregulated market is further
complicated by the lack of standardization of the product and the fact that many of the
market’s participants react intuitively, giving little attention to formal feasibility or mar-
keting studies. The real estate investment market is divided into submarkets such as retail,
warehouse, residential, and others, compounding the complexity of investing. However,
the investor who seeks qualified help and takes advantage of available protective measures
can often mitigate some of the risks.
Besides these inherent characteristics of real property, many government activities
also directly or indirectly influence property values. At the federal level, income tax laws
are often confusing and frustrating. So is the government’s regulation and control of
money. This power effectively dictates the extent of real estate activity through manipula-
tion of the supply as well as the cost of mortgage money.
Our various levels of government also function in numerous other ways to affect real
estate property values. Environmental controls and impact studies add time and costs to
the development of land—costs that are inevitably paid by consumers. Local political atti-
tudes regarding zoning and growth restrictions act to raise the prices of properties already
developed, effectively creating a monopolistic position for their owners.
Fueling these political attitudes is the antigrowth philosophy of citizens in some areas
where property taxes and other public costs are rising at an alarming rate to serve an ever-
increasing population. “Not in my backyard” has become the slogan in these troubled cities.

Decline of the Realty Market

In the early 2000s, the subprime mortgage market more than doubled its offerings of
hybrid ARMs with artificially low initial payment schedules and other very liberal qualify-
ing standards. Fannie Mae and Freddie Mac loans also became available in various forms
using very liberal qualifying standards, thereby creating many risky loan products.
The overall housing market boom began to decline in 2006. The subprime market
was the first to crash, but by 2007, Fannie Mae and Freddie Mac were also in trouble.
Borrowers found themselves unable to pay their sharply increased mortgage payments
as adjustable rate loans began to be reset at higher rates. Refinancing was no longer an
option because realty values were declining and a slow market made it very difficult to sell.
In September 2008, Fannie Mae and Freddie Mac were placed into conservatorship under
the newly formed Federal Housing Finance Agency.
On February 17, 2009, President Obama signed into law the American Recovery
and Reinvestment Act, the stimulus bill with the important elements of federal tax cuts,
expanded unemployment benefits, and other social welfare provisions. On February 18,
2009, the President announced the formation of the Homeowners Affordability and Sta-

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 Unit 1: Introduction to Real Estate Investment 5

bility Plan to help families avoid foreclosures by restructuring or refinancing their delin-
quent mortgages. As a result, the following programs were created:
●● The Home Affordable Modification Program (HAMP) is available to eligible hold-
ers of real estate that is either a residence or residential rental who are employed but
unable to make their mortgage payment. Loans may be modified to create affordable
payments in order for the lender to avoid foreclosure. In addition to modifications
of Freddie Mac and Fannie Mae, also available are FHA-HAMP and VA-HAMP
modifications.
●● The Home Affordable Refinance Program (HARP) and HARP 2.0 are available to
eligible Freddie Mac and Fannie Mae mortgage holders who are not behind on their
payments but are unable to refinance at a lower interest rate because the value of their
home has declined.
●● Other programs have been made available through the Financial Stability Improve-
ment Act of 2009 and include the following:
●● Principal Reduction Alternative (PRA)
●● Second Lien Modification Program (2MP)
●● FHA Home Affordable Modification Program (FHA-HAMP)
●● USDA’s Special Loan Servicing
●● Veteran’s Affairs Home Affordable Modification (VA-HAMP)
●● Home Affordable Foreclosure Alternatives Program (HAFA)
●● Second Lien Modification Program for Federal Housing Administration Loans
(FHA-2LP)
●● FHA Refinance for Borrowers with Negative Equity (FHA Short Refinance)
●● Home Affordable Unemployment Program (UP)
●● Housing Finance Agency Innovation Fund for the Hardest Hit Housing Markets
(HHF)
Programs such as these have allowed many borrowers to keep their homes in spite
of the financial conditions of the Great Recession. For more programs available to real
estate owners and for specific eligibility, visit https://www.makinghomeaffordable.gov
/steps/pages/step-2-all-programs.aspx.

Supply of and Demand for Real Estate

In the very broadest sense, the supply of land is unlimited. Although it is true that the
earth represents a fixed supply, it is also true that this supply can be extended indefinitely
by building under as well as over the land masses and the open seas. Still, there are huge
expanses of land that remain unusable in their present state or are uninhabitable because
of geophysical circumstances.
It is the relative scarcity of usable land, however, that is important to real estate as an
investment vehicle. Relative scarcity is what establishes the basic value for real estate. The
economic worth of property fluctuates with the effective demand for strategically located
and thus, by definition, relatively scarce parcels of land. Even more important than the
supply of and the demand for unimproved land are the interactions of these economic
factors as they affect the existing stock of improved real estate.

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 6

(Resident population as of July 1. Numbers in thousands)

Sex and age
2015 2020 2025 2030 2035 2040 2045 2050 2055 2060
BOTH SEXES

Ess_RE_Investment_11e.indb 6
321,363 333,896 346,407 358,471 369,662 380,016 389,934 399,803 409,873 420,268
.Under 18 years 74,518 76,159 78,190 80,348 81,509 82,621 84,084 85,918 87,744 89,288
.Under 5 years 21,051 21,808 22,115 22,252 22,516 23,004 23,591 24,115 24,479 24,748
.5 to 13 years 36,772 37,769 39,511 40,366 40,790 41,190 41,936 42,951 43,969 44,758
.14 to 17 years 16,695 16,582 16,565 17,730 18,203 18,427 18,558 18,852 19,296 19,782
.18 to 64 years 199,150 201,768 203,166 205,349 210,838 217,675 224,562 230,147 234,819 238,947
.18 to 24 years 30,983 30,028 30,180 30,605 32,125 33,199 33,680 33,967 34,469 35,239

Source: U.S. Census Bureau

.25 to 44 years 84,327 88,501 91,833 93,878 95,013 96,078 98,725 101,609 104,331 106,303
.45 to 64 years 83,839 83,238 81,152 80,865 83,700 88,398 92,157 94,570 96,020 97,404
.65 years and over 47,695 55,969 65,052 72,774 77,315 79,719 81,288 83,739 87,309 92,033
.85 years and over 6,306 6,693 7,389 8,946 11,579 14,115 16,512 17,978 18,201 18,187
.100 years and over 78 106 143 168 188 230 310 442 564 690

.16 years and over 255,161 266,024 276,558 286,967 297,259 306,634 315,152 323,314 331,770 340,868
.18 years and over 246,845 257,737 268,218 278,123 288,153 297,395 305,850 313,885 322,129 330,980
.15 to 44 years 127,847 130,958 134,451 137,764 140,793 143,114 146,337 149,714 153,263 156,374
MALE 158,362 164,812 171,196 177,323 183,013 188,335 193,525 198,770 204,147 209,663
.Under 18 years 38,089 38,937 39,989 41,104 41,700 42,269 43,018 43,955 44,889 45,677
.Under 5 years 10,763 11,150 11,307 11,377 11,512 11,761 12,061 12,329 12,515 12,652
.5 to 13 years 18,784 19,309 20,210 20,649 20,867 21,072 21,453 21,972 22,492 22,895
.14 to 17 years 8,541 8,478 8,472 9,078 9,321 9,436 9,504 9,655 9,882 10,130
.18 to 64 years 99,232 100,904 102,004 103,510 106,624 110,408 114,162 117,219 119,719 121,870
.18 to 24 years 15,908 15,396 15,479 15,720 16,515 17,069 17,319 17,468 17,726 18,120
.25 to 44 years 42,389 44,796 46,719 47,949 48,627 49,197 50,584 52,093 53,502 54,516
.45 to 64 years 40,934 40,712 39,806 39,841 41,481 44,142 46,259 47,658 48,491 49,233
Essentials of Real Estate Investment Eleventh Edition

.65 years and over 21,041 24,970 29,204 32,709 34,690 35,657 36,346 37,595 39,540 42,116
.85 years and over 2,163 2,382 2,716 3,366 4,418 5,378 6,299 6,854 6,941 6,944
.100 years and over 14 22 31 38 44 56 76 108 137 167

.16 years and over 124,529 130,110 135,472 140,749 145,978 150,799 155,273 159,645 164,199 169,051
.18 years and over 120,273 125,875 131,208 136,219 141,314 146,066 150,507 154,814 159,259 163,986
.15 to 44 years 64,714 66,545 68,558 70,470 72,136 73,354 75,039 76,802 78,637 80,233
FEMALE 163,001 169,084 175,211 181,148 186,649 191,681 196,409 201,034 205,725 210,605
.Under 18 years 36,429 37,222 38,201 39,244 39,809 40,352 41,067 41,963 42,855 43,610
.Under 5 years 10,288 10,658 10,807 10,875 11,004 11,243 11,530 11,786 11,964 12,096
.5 to 13 years 17,988 18,460 19,301 19,717 19,923 20,118 20,483 20,979 21,476 21,862
.14 to 17 years 8,153 8,104 8,093 8,653 8,882 8,991 9,054 9,197 9,414 9,652
.18 to 64 years 99,918 100,863 101,162 101,839 104,214 107,267 110,400 112,927 115,100 117,077
.18 to 24 years 15,075 14,632 14,702 14,886 15,610 16,130 16,361 16,499 16,743 17,119
.25 to 44 years 41,938 43,705 45,114 45,928 46,385 46,881 48,141 49,516 50,828 51,787
.45 to 64 years 42,905 42,527 41,346 41,025 42,219 44,256 45,897 46,912 47,529 48,171
.65 years and over 26,654 30,999 35,848 40,066 42,625 44,062 44,943 46,144 47,770 49,917
.85 years and over 4,143 4,311 4,673 5,580 7,160 8,736 10,213 11,124 11,259 11,243
.100 years and over 64 85 112 130 143 174 235 334 428 523
tion by Selected Age Groups and Sex for the United States: 2015 to 2050).

.16 years and over 130,631 135,914 141,085 146,218 151,281 155,835 159,879 163,669 167,572 171,817
.18 years and over 126,572 131,862 137,010 141,904 146,839 151,329 155,342 159,071 162,870 166,995
.15 to 44 years 63,133 64,412 65,894 67,294 68,657 69,760 71,298 72,911 74,627 76,141
numbers of people but also in terms of subgroupings according to age and income.

FIGURE 1.1  Projections of the Population by Selected Age Groups and Sex for the United States: 2015 to 2050
One of the principal components of demand is population, not only in terms of

more than 398 million people by the year 2050 (see Figure 1.1: Projections of the Popula-
The current U.S. population topped 320 million in 2015 and is expected to grow to

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 Unit 1: Introduction to Real Estate Investment 7

Migrational trends and locational economic base analyses can be developed to esti-
mate variations in the demand for real estate within a given area. Changes in location as
well as changes in living patterns determine where there will be growth in demand for real
property and what this demand will require in terms of housing and related real estate
developments.
A tight money market occurs when interest rates are high and loans are difficult to
find. An easy money market reflects low interest rates and lots of money available for real
estate loans.
Supply can sometimes be viewed as a function of demand when the bidding on
scarce properties forces prices upward. Serving effective demand and anticipating its
impact is a real estate supplier’s most important skill, one that industry professionals and
investors are vigorously pursuing with increasing degrees of sophistication in order to
perfect investment strategies. Because most real estate developments involve a time lag,
which exists because of the time it takes to prepare raw land and construct new buildings,
shrewd investors constantly study the market to anticipate demand.
Often, supply itself may be viewed as an accelerator of demand. The imposition of
growth controls, building moratoriums, and stringent environmental controls seriously
inhibits the increase of new housing stock and puts the full pressures of demand on exist-
ing property owners. These owners then enjoy a virtual monopoly which affects rental
rates and property prices. Thus, the available stock of improved real estate itself establishes
the design, quality, price, and terms for the consumer.

Real Estate Cycles

Keeping in mind the cause-and-effect relationship between supply and demand, we
can now examine the cyclical nature of the real estate market. A real estate cycle (see
Figure 1.2: Real Estate Cycles) is frequently described as either a buyer’s market or a sell-
er’s market. A buyer’s market indicates a surplus of supply and a downward price trend,
favoring the purchaser. In a seller’s market, supply is short and demand is high—prices are
forced upward by the competitive market situation.

FIGURE 1.2  Real Estate Cycles

Peak
Activity

Co
ntr
n io

act
ns
pa

ion
Ex

Time
Because the term cycle implies repetitive, ongoing fluctuations in price, the buyer’s
and seller’s markets are equal and opposite partners in the cycle. Thus, we can begin at any
stage of a real estate cycle to examine the total cycle’s fluctuation. If we enter a cycle some-

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 8 Essentials of Real Estate Investment Eleventh Edition

where near its peak, we can observe a shortage of supply, high prices as a result of com-
petitive bidding, and, logically, high concurrent profits for sellers. Such high profits act
to attract new investors who wish to capitalize on the opportunities, and it is reasonable
to assume that new construction will take place, regardless of costs. With new buildings
available as additional inventory to satisfy demand, the market cycle will level temporarily
and then start to fall until supply exceeds demand. At this point, the cycle has reached its
valley, and conditions are those of a buyer’s market.
Other catalysts can affect a cycle, acting to speed it up or slow it down, to raise or
lower its peaks and valleys. Included among these catalysts are tax reforms, interest rate
fluctuations, a depression or recession, or even a national crisis such as the tragedy of
9/11, to name only a few.
The inherent imperfections of the real estate market contribute to the perpetuation
of the cyclical trend. Lack of communication among real estate building contractors,
coupled with the time lag between the start-up and the completion of buildings, is a
major factor in this problem. Another problem arises when contractors base a decision
to build on gut feelings instead of market research. Real estate tends to have a longer
contraction phase than other types of industry. A manufacturer of appliances may lay off
workers and cut back production to ride out a contraction in the market. The owner of
an office building still has the same amount of space to lease and therefore may stay in
contraction longer.
Entering the market at the peak of a cycle involves planning, possible rezoning, and
financing, as well as labor and material acquisitions in anticipation of construction. When
building continues at a feverish pace to capture the profits of backlogged demand, little
thought is given to overbuilding until the inevitable occurs and supply exceeds demand.
Now the situation is reversed, with few buyers and many alternative properties from
which to choose. A concomitant lowering of prices results until little, if any, profits are
left. Building ceases and market conditions continue at a low point until the excess supply
is absorbed, at which time the market begins to move toward the peak again.
Despite the cyclical short-run fluctuations in any real estate market, property values,
in general, rise over the long term. However, this trend is based on a summarization
of activities involving many properties. Any individual property may react cyclically or
counter-cyclically to the general activities of the marketplace, much as individual stocks
gain or lose value within the stock exchange. Real estate investors are cautioned to con-
sider each purchase carefully from both its micro and macro positions in the realty mar-
ket. Investors must be aware of the long-term aspect of real estate investments.

Value Theory of Real Estate

Although all of the foregoing economic principles are important for potential real
estate investors to keep in mind, in the final analysis investors will be primarily concerned
with the value of one particular property. Real estate has value only as one in a series of
alternative investment opportunities. Value is, in reality, in the eye of the beholder, the
occupier, or the user.
A seller’s value is, more often than not, a reflection of personal and slightly sentimen-
tal feelings. Undoubtedly, the buyer or agent will have an entirely different opinion of
the value of that particular property. Likewise, an insurable value, a condemnation value,
and a taxable value, among others, may all indicate a different dollar amount for the same
property.

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 Unit 1: Introduction to Real Estate Investment 9

In theory, the value of a parcel of real estate is interpreted to be market value, or its
value as established in an exchange. As such, market value is defined as that price which
a knowledgeable buyer will pay and a knowledgeable seller will accept for a property that
has been exposed for sale to the market for a reasonable length of time and with neither
buyer nor seller acting under duress or enjoying any advantage, financial or otherwise.
Most real estate transactions will require an estimate of the market value of the property
involved.
However, market value, as estimated by the seller, appraiser, or perhaps a real estate
broker, may differ substantially from market price, which clearly is established by what
the buyer will actually pay for the property.
When determining the value of a particular property at a specific point in time, an
evaluator has several basic principles of value to use as guides. The principle of substitu-
tion contends that no rational, economical person would pay more for one property
than for another of like design, quality, and utility. This principle is the basis for the cost
approach and the comparable sales approach to estimating the market value of real prop-
erty and usually establishes the uppermost limit of a property’s market value.
The principle of balance identifies the problems that result from an oversupply or
undersupply of a particular type of real estate. For example, too many condominiums of
the same size, design, and price in one area would act to depress the values of all of these
properties within the market.
The principle of contribution states that the value of an addition to a property is a
function of its contribution to the overall profitability of the property, not just its con-
struction cost.
The principle of conformity states that homogeneity in design and quality creates the
most reasonable value for a property, while a property that is dramatically different from
or nonconforming to its surroundings is invariably lowered in value.
The principle of anticipation stipulates that most investors make their investment deci-
sions based on the measurement of the present value of an anticipated net income stream.
This principle is the basis of the income capitalization approach to realty evaluation.
The principle of highest and best use is fundamental to estimating the value in use
of a real estate investment. This principle is defined as that legal and possible use that is
most likely to produce the greatest net return from a property over a given period of time.
In addition to its market value, real estate also has a value in use. This is the value on
which a number of real estate investors rely and a value that could differ from the prop-
erty’s market value. For example, compare the market value of a property currently used as
a parking lot with its potential value as the site for a high-rise office building. Thus, value
in use is that use of the property that may or may not be its highest and best use.
As discussed earlier, value is primarily a function of the interactions of supply and
demand. A relatively scarce but desirable item’s value may increase specifically because of
its scarcity and desirability. It must also be remembered that change is ever-present, thus
affecting attitudes concerning desirability and value.
Real estate is considered to be just such a relatively scarce and desirable item. Its value
is in a constant state of change because of a myriad of continuously operating social and
economic forces. Estimators of real estate value must be acutely alert to three stages of
change in property values:
1. Integration—a condition of developing value when building new

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 10 Essentials of Real Estate Investment Eleventh Edition

2. Equilibrium—a condition of stable value during the holding period

3. Disintegration—a condition of declining value during the aging process
A property’s value is affected by the prevailing stage of change in its city or neighbor-
hood. Because property cannot be moved, it may go through this evolutionary cycle many
times during its economic life.

PURPOSES OF INVESTING IN REAL ESTATE

To Preserve Capital
A primary reason for investing in real estate is the preservation and possible enhance-
ment of the capital invested. Generally, owners have enjoyed rising property values over
the years. Consequently, the capital value of the investment is preserved or increased by
appreciation. It is precisely for this reason that real estate investments are described as
hedges against inflation. Theoretically, the values of real estate fluctuate with local market
cycles, but real estate values tend to rise over the long term.
A real estate investment may build up additional equity for its owner through reduc-
tion of the mortgage debt. The periodic repayments of the principal amounts owed on
existing financing increase equity in property. This increasing equity can be secured for
reinvestment either by refinancing the mortgage or by selling the property, depending on
the market. In fact, one of the more important benefits of investing in real estate is this
ability to reuse the capital through periodic, tax-free refinancing, while at the same time
preserving the value of the investment. In addition, the owner’s equity in an investment
may be raised by increasing the amount of the net operating income (NOI), which invari-
ably raises the total value of the investment.
Although the problems associated with tenants are legendary as well as endless, ten-
ants often improve the properties they occupy to enhance their living environment. These
betterments tend to increase a property’s value and are often left behind when the tenant
moves. This not only preserves an owner’s capital investment but actually enhances it,
sometimes substantially.

To Earn a Profit
Fundamentally, all investors in real estate seek a profit on the money they invest. By
definition, an investment of any kind is a commitment of funds with the intention of
preserving capital and earning a profit. For real estate investors, these profits assume two
forms. The income stream from the tenants’ rents should generate one kind of profit. The
gross amount of rent should be adequate to pay for all of the fixed and variable operating
expenses of the property, with enough remaining to show a return on the investment.
Thus, an investor anticipates that the income will provide a steady cash profit while the
invested capital remains protected over time. When the property is sold, this investment
will be recovered intact or, better still, a gain will be made. This gain reflects the increase
in the property’s value during the time it was held and is the second form of profit that
can be earned by a real estate investor.
Before committing any funds, an investor should analyze carefully the returns avail-
able from opportunities other than the purchase of real estate. For example, a viable alter-
native to investing in a real estate venture is to deposit money into a government security

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 Unit 1: Introduction to Real Estate Investment 11

paying interest each year. The annual interest or profit (before taxes) that is earned on
this investment becomes a benchmark against which to measure the anticipated profit-
ability of an alternative investment. The principal can be withdrawn from this security at
a specific time, so it meets the requirements of an investment: preservation of capital and
generation of a profit.
If we analyze a real estate investment that shows an annual return (before taxes),
with the possibility of recovering the full investment within some identifiable future time
period, we see a situation parallel to the government security. However, unlike this secu-
rity, there is a greater degree of risk associated with real estate investments. This risk
includes the likelihood of actually being able to collect the rents in the amounts and at
the times anticipated and the chances of fully recovering the investment in the future. In
addition, unforeseeable problems might occur over time.
Thus, the profit from a real estate investment should not be considered equal to this
same profit from a government security. Something extra must be earned to offset the
greater risks that are so much a part of realty ownership. In addition, to compensate for
lack of liquidity, real estate investments must develop even larger returns. Unlike other
investments, real estate is often difficult to sell at a specific point in time. Therefore, to be
viable, a real estate investment should be designed to develop a relatively higher rate of
return (profit) than is available from other safer, more liquid investment opportunities.

To Enjoy Tax Relief

Under the current income tax code, unlike many other investments, the income
derived from rental real estate can be sheltered substantially to diminish the income tax
liability and thus enhance the bottom-line return.
After all income from a rental property is accumulated for the year, the expenses
incurred to develop this income may be deducted, effectively sheltering this amount
from income taxes. Sheltering income simply means having the income deemed as either
nontaxable as in the deduction of expenses or as tax-deferred as in cost recovery (depre-
ciation) deductions. These expenses include all operating costs such as management fees,
property taxes, utility expenses, repairs, maintenance, advertising, bookkeeping, and oth-
ers as required. In addition, the interest paid on existing real estate loans is deductible,
as are allowable amounts of depreciation. Thus, the gross income derived from rentals is
effectively reduced to a net amount that is then subject to the imposition of income taxes
at the taxpayer’s bracket.
In addition, real estate tax investments are normally made for extended periods of
time and, as such, enjoy the tax advantages available under long-term capital gains (other
than depreciation recapture) when the investment is sold for a profit.
The full ramifications of the current tax laws, as they apply to investment decision
making, will be examined in later units.

ADVANTAGES OF INVESTING IN REAL ESTATE

Any list of available avenues of investment will include stocks, bonds, savings cer-
tificates, life insurance policies, commodities, consumer merchandise, and real estate.
The investment opportunities in real estate include open land, vacant lots, farm acre-
age, industrial properties, houses, apartment buildings, stores, shopping centers, office

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 12 Essentials of Real Estate Investment Eleventh Edition

buildings, clinics, recreational projects, mineral deposits, securities, manufactured-home

parks, condominiums, and airspace. Competition for the dollars available for investment
is high, and each opportunity has its own particular advantages and disadvantages. The
general advantages of investing in real estate, however, include its relatively high-yield
possibilities, leveraging opportunities, tax flexibilities, and the retention of a high degree
of personal control over the capital invested.

Relatively High Yields

Bottom-line yields in excess of 20% are not unusual for many real estate invest-
ments. Yields can even exceed this amount, reaching infinity in those cases where 100%
or more leverage—using borrowed funds to purchase property—has been achieved. More
common, though, are realty investments that regularly develop 10–15% annual returns
over the life of the investment. These profits reflect the opportunities that exist in real
estate and, when compared to average yields on other types of investments, explain its
popularity.
The return on a savings investment is the rate of interest paid by the bank or savings
association. These rates currently run up to 3%, depending on the type and duration of
deposit. These are before-tax yields, which are eroded by the taxes paid, in accordance
with the investor’s particular tax bracket. Stocks often pay dividends that average about
5% of the value of the investment; but unlike savings, for which the amount of deposit
remains constant over time, the value of the stocks fluctuates in the market. As a result, an
element of risk is introduced for a stock investor who analyzes yield in terms of dividends
received plus growth in value. If this growth is 5% per year and the shareholder receives
5% in dividends, the yield is 10% before taxes.
Bond yields fluctuate, sometimes dramatically, as a function of the money market. A
bond owner may earn 7% interest but may have to take a discount when selling in a mar-
ket at more than 7%. Some bonds, such as municipals, are tax exempt, and their yields
are commensurately lower, depending on the bond’s rating.
It is axiomatic in real estate investment that high profits are positively correlated
with high risk. Although yields on real estate investments do fluctuate from time to time
and from property to property, there are guidelines on which objective decisions may be
based. For example, despite the fractured quality of the general real estate market, there
are fairly definable submarkets. One such submarket is apartment projects. Depending
on location, number of apartments in the complex, and their size and decor, an investor
can usually find comparable projects, research competitive rents, and estimate the income
possible from an anticipated investment. This analysis and others will provide data on
which an objective decision concerning the profitability of the investment can be based.
There are similar submarkets for houses, stores, office buildings, shopping centers, and
other forms of real property.

Leveraging Opportunities
Although most lenders allow a purchaser to borrow up to 50% of the value of
securities such as stocks and bonds, real estate offers an investor the highest leveraging
opportunities of any investment alternative. Many realty transactions require 20–40%
of a property’s value as a cash down payment, while others have 10%, 5%, or even no
down payment requirements. A few investors, after completing some highly sophisticated
financing strategies, may even be able to enjoy the benefits of arranging their real estate

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 Unit 1: Introduction to Real Estate Investment 13

investment portfolios with greater than 100% leverage and end up with cash in their
pockets.
High-leverage situations include transactions involving carryback mortgages, land
leases, subordination, joint ventures, syndication, sale-leasebacks, wraparound mortgages,
participation mortgages, and other creative real estate ownership and financing arrange-
ments. These concepts and their applications, among others, will also be examined in
upcoming units.

Income Tax Flexibility

Real estate allows its owner a high degree of tax flexibility, due in large part to the
application of depreciation allowances and the ability to deduct the premises’ operating
costs from the gross income collected.

High Degree of Personal Control

Real estate investments provide the opportunity for a high degree of personal con-
trol. Purchase terms can be designed to reflect specific financial circumstances. Often,
rents can be arranged to anticipate changes in future realty cycles. Various bookkeeping
techniques can be adopted to reflect individual needs as they change over time. Property
can be periodically refinanced to capitalize on the equity accumulated. The investor usu-
ally retains the power to decide on when, how, and to whom the investment will be sold,
under terms that satisfy personal economic requirements.

DISADVANTAGES OF INVESTING IN REAL ESTATE

There are no perfect investments. An investor who prefers the guaranteed safety
offered by U.S. government securities is required to forgo high yields to achieve this safety.
An investor who is interested in the relatively high yields offered by real estate will have
to sacrifice a certain amount of safety and liquidity and be willing to take a more active
personal role in managing such an investment.
The disadvantages associated with real estate investments include relatively poor
liquidity, large capital requirements, constant management, being a “landlord,” and a
relatively high degree of risk.

Relatively Poor Liquidity

Although real estate is usually easy to purchase, it is sometimes difficult to sell, with
little certainty about the final sales price. Unlike the stock and bond markets, where there
are almost always buyers to be found if the price is low enough, sometimes real estate can-
not even be given away, let alone sold at a reasonable price. For example, in good times
owners are reluctant to sell, while in bad times everyone wants to sell at the same time,
significantly reducing the property’s marketability.

Large Capital Requirements

Contributing to the poor liquidity of real estate income property are the relatively
large sums of money needed for property acquisition, maintenance, and reserves. Despite
the high leveraging opportunities that exist in this field, a sound investment must be
backed by adequate operating capital to protect it in the event of unforeseen major cri-

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 14 Essentials of Real Estate Investment Eleventh Edition

ses. An unexpected reversal in the economic cycle of a community could result in a high
number of vacancies and, at the same time, eliminate any possible market for disposing of
the suddenly declining investment property.

Necessity of Constant Management

Everything about real estate, as in most other areas of present-day living, is expensive.
At current rates for repairs, everyday maintenance is costly, to say nothing of required
replacement of worn-out items. Major maintenance expenditures such as a new roof,
plumbing, or electrical systems can easily amount to thousands of dollars.
Constant property maintenance is an absolute necessity for improved real estate
investments. Buildings need careful attention, including perpetual nailing, patching,
painting, and replacement of worn parts to satisfy tenants and ensure continuing rental
cash flows. In addition, the hallways, elevators, and grounds also require routine upkeep.
In other words, a real estate investment requires more active participation on the part
of the individual investor than do most other investment opportunities. This manage-
ment activity may be passed along to a professional management agent or service, but
then the income from the property must be sufficient to justify the cash paid for these
services.

Being a Landlord
Most real estate investments require that the property owner enter into some form
of personal involvement with the professional manager, the tenants, or both. These inter-
personal relationships are often warm and rewarding, but they can also become distress-
ing, especially when a manager must be dismissed or a tenant evicted. People are often
deterred from investing in real estate because, as landlords, they are exposed to tenants’
complaints and the problems of managing property, and this factor should be included in
the acquisition decision.

Risk
Finally, it must be clearly understood that there are substantial risks involved when
investing in real estate. It is true that there are risks in every field of endeavor, even in our
daily activities. Still, it is important to reiterate that investing involves decision making: a
choice of what you should buy; when and where you should buy; and, most significantly,
whether you should invest at all.
What makes real estate investment so hazardous is the number of agencies and events
beyond the investor’s control that influence its success; for example, the unpredictability
of the income tax code may be enough of a detractor to discourage some investors. We
also cannot ignore the vicissitudes of the financial markets as interest rates fluctuate in
response to the natural laws of supply and demand, as well as to the imposition of mon-
etary controls by the Federal Reserve System (the Fed).
Add the other disadvantages, enumerated previously, and you can draw a clear warn-
ing that although real estate investment carries with it the potential for large rewards,
there are indeed substantial risks involved. Yet even in real estate there are varying degrees
of risk. Investing in an office building with a successful and profitable track record that
has a number of tenants on long-term leases presents less risk than investing in a proposed
building with no history to consider.

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 Unit 1: Introduction to Real Estate Investment 15

SUSTAINABILITY
In today’s world, sustainability is also a factor when developing real estate. According
to the U.S. Environmental Protection Agency (EPA), sustainability is based on a simple
principle: everything that we need for our survival and well-being depends, either directly
or indirectly, on our natural environment. The EPA is the government’s environmental
watchdog. To that end, many government contracts include sustainability clauses. The
Internal Revenue Code also includes incentives for energy efficiency. For more informa-
tion, visit https://www.fedcenter.gov/programs/sustainability/.

SUMMARY
In economic terms, land is considered a relatively scarce commodity, although from
a practical point of view, land is infinite in supply because it can be developed into the air
and underground. Still, most of the earth’s population gathers tightly in the great cities of
the world, congregating where the jobs are. Thus, there is an ever-increasing demand for a
limited supply of desirable real estate. This pressure of demand acts to force the prices of
available real estate to new heights.
Real estate market activities fluctuate as a function of supply and effective demand.
When the top of the cycle has been reached, with high prices reflecting high profits, the
entry of new builders acts to add to the supply and to reduce the prices and profits accord-
ingly, resulting in a reversal of the cycle. The microcycle is local in character, while the
long-term cycle shows an ever-increasing value for real estate over time.
In addition to the demands of a growing population, artificial limitations on the sup-
ply of real property add to the increasing costs of real estate. Concerns with pollution have
led to environmental controls that limit new construction. Political attitudes regarding
controlled growth have also inhibited construction in many areas of the country. Natural
gas and water shortages, sewer inadequacies, central city decline, and resultant suburban
expansions all have placed substantial burdens on current property owners to support
their local governments on an ever-shrinking tax base.
Despite all these obstacles, real estate investors continue to seek profitable projects.
Attempting to anticipate demand and, in some areas of this country, actually creating
demand by the very design of their projects, real estate developers are: adjusting the sizes
of homes; rethinking the frills in office buildings; providing the magnetism necessary to
attract customers to shopping centers; and creating new concepts in planned unit devel-
opments, manufactured-home parks, office parks, and industrial parks. All of this is in an
effort to bring a usable product to a receptive market.
The measurement of a property’s value is a function of its utility, its ability to gen-
erate income in the future, and its position in a spectrum of alternative investment
opportunities.
Value often is based on subjective intuitive interpretations, although a body of prin-
ciples has been developed to describe property value in more objective terms. These
principles include those of substitution, highest and best use, balance, contribution, con-
formity, and anticipation, and they describe the function of value in conjunction with the
activities of a rational, economic investor.

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 16 Essentials of Real Estate Investment Eleventh Edition

Basically, people invest in real estate with a view toward preserving capital and earn-
ing a profit. Real estate investments offer relatively higher yields, greater leveraging oppor-
tunity, greater income tax sheltering strategies, and a higher degree of personal control
than most other types of investments.
On the other hand, real estate is definitely illiquid when compared with stocks and
bonds. It also requires a commitment to personal involvement in management, either
with a professional manager or with the tenants themselves. The role of landlord has prob-
ably turned many away from the profit opportunities available in real estate investments.

DISCUSSION TOPICS
1. Investigate the economic conditions of your community and identify the point in the
real estate cycle at which you believe it to be.
2. Identify a specific neighborhood in your community and estimate where it is on the
development spectrum: integration, equilibrium, or disintegration.

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 Unit 1: Introduction to Real Estate Investment 17

UNIT EXAM 6. A buyer’s market indicates all of the following

EXCEPT
1. From a rational point of view, an investor in real
a. excess supply.
estate must consider all of the following analysis
b. lower prices.
aspects EXCEPT
c. high demand.
a. yield.
d. flexible terms.
b. risks.
c. pride. 7. Which of the following approaches to value
d. value. reflects the actual price that a knowledgeable
buyer will pay?
2. Real estate investments should be considered first
a. Value in use
and foremost from the viewpoint of the
b. Highest and best value
a. economic soundness of the project.
c. Appraised value
b. unique financing techniques available.
d. Market value
c. tax shelter opportunities.
d. unlimited growth potential. 8. To increase the use of leverage when buying a real
estate investment is to
3. Real estate investments have all of the following
a. decrease its yield.
advantages EXCEPT
b. increase its risk.
a. high yields.
c. decrease its operating expenses.
b. leverage.
d. increase its beginning book basis.
c. liquidity.
d. personal control. 9. Because of the fractured quality of the market,
a real estate investment is frequently considered
4. Which of the following is TRUE regarding the
highly
characteristics of real estate?
a. profitable.
a. It has a central and controlled market.
b. illiquid.
b. It is a short-term asset.
c. transferable.
c. Each parcel is similar to each other parcel.
d. valuable.
d. Its market condition is seldom in balance with
supply and demand. 10. When properties in blighted areas begin attract-
ing investors, they are entering a period of
5. Supply and demand theory indicates that if they
a. integration.
both increase at the same rate, prices will
b. equilibrium.
a. go up.
c. disintegration.
b. go down.
d. urban renewal.
c. first go up and then go down.
d. remain constant.

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 Ownership Interests in
Real Property
Unit

2
LEARNING OBJECTIVES
After successfully completing this unit, you will be able to
●● list and describe different types of individual ownership,
●● list and describe different types of group ownership,
●● describe trust ownership, and
●● explain the role played by foreign investors.

ancillary probate inheritability real estate mortgage trust (REMT)

blue sky laws investment trust regular corporation
collapsible corporation irrevocable trust right of first refusal
community property joint tenancy S corporation
curtesy rights joint venture severalty
discretionary trust limited liability company (LLC) sole and separate ownership
dower rights limited partnership syndicate
fee simple ownership living trust tenancy by the entirety
general partnership partnership tenancy in common
grantor retained income trust real estate investment trust (REIT) testamentary trust
(GRIT)

INTRODUCTION
How an investor holds title to real estate has a significant impact on the degree of
personal involvement in management and on the amount of profit to be earned, taxes to
be paid, and personal liability for debts and damages. This unit includes a review of the
major forms of interests in real property, including ownership by individuals and owner-
ship by groups such as corporations, collapsible corporations, partnerships, and trusts.

18

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 Unit 2: Ownership Interests in Real Property 19

INDIVIDUAL OWNERSHIP
Individuals may acquire legal interests in real property, called fee simple ownership.
An estate in fee simple implies that the owner has the greatest bundle of rights to the use
of the property. Included in this bundle is the right to use, possess, finance, lease, inherit,
and sell, among others. Without partners to please or shareholders to impress, individuals
may design their investment holdings to meet their own immediate and long-term goals.
On the other hand, individual owners assume a high degree of personal involve-
ment, responsibility, and liability for their investments and all the problems inherent in
such tight control. For example, legal suits for contributory negligence and consequential
damages can easily bankrupt an underinsured property owner. The eviction of nonpaying
tenants may well be anathema to another. Individual ownership of real estate demands
that the investor take an active role in investment management.
The various forms of individual ownership include tenancy by the entirety, tenancy
in common, community property, joint tenancy with the rights of survivorship, sole and
separate ownership, ownership in severalty, and dower and courtesy rights.
Prior to examining each of these forms, an important distinction must be made
concerning an individual owner’s rights of property control. An owner can hold a fee
simple title or an undivided interest in a fee subject to the right of either inheritability or
survivorship.
Inheritability implies that the control individuals have over their estates includes the
right to designate who will inherit their property. These designations are described in the
owner’s will, which requires a legal probate procedure before the estate can be distributed
to the heirs.
The purpose of the probate process is to provide creditors of the deceased with a rea-
sonable amount of notice and time in which to perfect their claims against the estate. To
this end, a primary probate is initiated in the deceased’s state of residency, and ancillary
probates are initiated in each state in which portions of the estate’s assets are situated.
Thus, for a deceased Michigan resident who owned property in Arizona, the primary
probate proceedings would take place in Michigan, and an attorney in Arizona would
supervise the ancillary proceedings in that state.
On the other hand, joint tenancy, also called survivorship, eliminates this personal
control over the distribution of an estate after death. When two or more persons enter
into a survivorship form of ownership, they give up their inheritable rights and designate
that on one owner’s death, the other(s) in the agreement will be the recipient(s) of the
deceased’s portion of the property. The interests of the deceased pass automatically and
immediately to the survivors in this form of survivorship ownership.
Holding title subject to the right of survivorship eliminates the necessity of probate
proceedings, with concomitant savings in time and costs. However, as we shall soon see,
the survivorship form may create inheritance tax problems for those estates large enough
to be subject to such a tax. See Figure 2.1: Real Property Ownership for inheritability and
survivorship interests.

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 20 Essentials of Real Estate Investment Eleventh Edition

FIGURE 2.1  Real Property Ownership

Type Relationship Consequences on Death
Tenancy by the entirety Husband and wife, only Automatic survivorship
Tenancy in common Anybody Inheritable
Community property Husband and wife, only Inheritable
Joint tenancy Anybody, although usually Automatic survivorship
family members
Sole and separate A married person in his or Inheritable
her own right, but implying
a living spouse
Severalty Unmarried or divorced Inheritable
persons, widows, and
widowers
Dower/courtesy Surviving spouses Inheritable

Tenancy by the Entirety

Tenancy by the entirety is an arrangement limited to husbands and wives that
includes the automatic right of survivorship and is not available in community property
states and some common law states. The owners are construed to be one entity, and when
one spouse dies, the other becomes the immediate sole owner. Neither spouse may uni-
laterally dispose of the interest.

Tenancy in Common
Recognized in all states, tenancy in common is an arrangement in which each of
several participants controls and has an interest in an undivided portion of the entire
property. This relationship can be established between any two or more persons. The basic
components of tenancy in common are the concepts of inheritability and undivided inter-
ests. Inheritability provides individual owners with the right to designate to whom their
proportionate share of the property will pass on their death. Undivided interests implies
that no single participant can identify a specific portion of the subject property but rather
has the rights to the entire property and its benefits as per the participant’s proportionate
share. Each tenant in common has an equal voice in the property’s management, unless
otherwise specified, and each assumes a proportionate share of the responsibilities, obliga-
tions, and profits of the tenancy.
Spouses would normally own an undivided one-half interest in a property. Four part-
ners might agree on an equal ownership arrangement of one-quarter interest each. How-
ever, any proportion is allowable. For example, one partner may have an undivided 12/20
interest, while another has a 5/20 undivided interest, and a third partner a 3/20 undivided
interest. In a $20,000 cash transaction, this would require the partners to contribute
$12,000, $5,000, and $3,000, respectively.
Anyone may own property as a tenant in common. It is a form of ownership whereby
each participant may dispose of one’s own interest at will unless there is a formal partner-
ship agreement to the contrary. Each participant’s undivided interest is inheritable and is
distributed by will to the deceased partner’s heirs. Thus, in a state that recognizes tenancy
by the entirety, if spouses wish to exercise control over their estate by will and designate

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 Unit 2: Ownership Interests in Real Property 21

some other party their heir, they should hold title to property as tenants in common so
that each will have an undivided one-half interest.
Should an owner die without a will ( intestate), the owner’s interest would pass to the
deceased’s heirs. Of course, if the owner dies with a will ( testate), the deceased’s property
passes to the devisees named in the will. Remember that these issues are legally complex
and will differ from state to state, which necessitates the input of a competent attorney.

Joint Tenancy with Rights of Survivorship

All but four states recognize joint tenancy, whereby participants, not necessarily
spouses, own equal undivided interests in property, subject to the rights of survivorship.
Any joint tenant may sell an interest, but the joint tenancy arrangement will be discon-
tinued and the new owner will assume a role as a tenant in common with the remaining
owners.
Although anyone may hold title in joint tenancy, it is unusual for persons other than
family members to enter into such an arrangement. Remember, survivorship effectively
eliminates an owner’s right to designate by will to whom property interests vest. They will
automatically vest in the surviving owners.
Thus, a father’s death in a joint-tenancy arrangement with his wife and son results
in the father’s one-third undivided interest automatically vesting in the surviving wife
and son, consequently raising each of their proportionate interests to an undivided one-
half. When the wife dies, the son automatically acquires the full interest in the property,
and probate proceedings are avoided each time. Again, legal counsel is needed for such
matters.

Community Property
Under community property, which applies only to married couples, monies earned
during marriage and property purchased with these community funds belong equally to
each spouse, who, simultaneously, maintains inheritable rights. Thus, the community
property spousal relationship is exactly opposite to the survivorship rights of spouses who
are tenants by the entirety.
Most agree, however, that the participants may maintain separate personal controls
under certain circumstances. For example, property inherited by one spouse can be main-
tained as separate property. Also, any funds flowing from this separate property may be
kept separate, as long as they are not commingled with community funds in the family
checking or savings accounts. If this income is deposited into a family account, the funds
become community property, but the inherited real estate can still be maintained as sepa-
rate property. On the other hand, if the income from separate property is kept apart from
community funds, any additional property purchased with these monies will also be con-
sidered separate property, even if the acquisition occurs during marriage. Texas, however,
considers any money earned during marriage to be community property, even those funds
earned from separate property, unless the couple has signed a contract stating otherwise.
As shown in Figure 2.2: Forms of Ownership in Each State, only nine states recognize
community property, each with differing interpretations of the various intricacies inher-
ent in this form of ownership.

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 22 Essentials of Real Estate Investment Eleventh Edition

FIGURE 2.2  Forms of Ownership in Each State

  Forms of Ownership      
  Sole Concurrent      
  Individual Tenancy in Common Joint Tenancy Tenancy by the Entirety Community Property
Alabama • • •
Alaska* • • •
Arizona • • • •
Arkansas • • • •
California • • • •
Colorado • • •
Connecticut • • •
Delaware • • • •
District of • • • •
Columbia
Florida • • • •
Georgia • • •
Hawaii • • • •
Idaho • • • • •
Illinois • • •
Indiana • • • •
Iowa • • •
Kansas • •
Kentucky • • • •
Louisiana** •
Maine • • • •
Maryland • • • •
Massachusetts • • • •
Michigan • • • •
Minnesota • • • •
Mississippi • • • •
Missouri • • • •
Montana • • • •
Nebraska • • • •
Nevada • • • •
New • • • •
Hampshire
New Jersey • • • •
New Mexico • • • •
New York • • • •
North • • • •
Carolina
North Dakota • • •
Oregon • • •
Pennsylvania • • • •

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 Unit 2: Ownership Interests in Real Property 23

FIGURE 2.2  Forms of Ownership in Each State (Continued)

  Forms of Ownership      
  Sole Concurrent      
  Individual Tenancy in Common Joint Tenancy Tenancy by the Entirety Community Property
Rhode Island • • • •
South Carolina • • •
South Dakota • • •
Tennessee • • • •
Texas • • • •
Utah • • •
Vermont • • • •
Virginia • • • •
Washington • • • •
West Virginia • • • •
Wisconsin ††
• • •
Wyoming • • • •
* Alaska does allow couples to opt into a community property arrangement; property is separate unless both parties agree to
make it community property.
** In Louisiana, real estate can be owned by one person and by two or more persons, but these ownership interests are created
by Louisiana statute. There is no estate comparable to those of joint tenancy, tenancy by the entirety, or community property, nor
is there any statutory estate giving surviving co-owners the right of survivorship. Two or more persons may be co-owners under
indivision, or joint, ownership.
†
Ohio does not recognize joint tenancy but does permit a special form of survivorship by deed through an instrument commonly
called a “joint and survivorship deed.”
††
Wisconsin recognizes “marital property,” which is similar to community property.

Community Property with Right of Survivorship

Community property with right of survivorship allows for the tax advantage of com-
munity property (step up in 100% of the basis of property upon death of a spouse) with
the outright ownership by the surviving spouse of the decedent’s one-half interest. Pro-
bate is also avoided. Married owners of real estate must proactively title property in this
manner.

Sole and Separate Ownership

All states recognize sole and separate ownership of property, which is an inheritable
estate. This form of ownership vests title to property in the name of one spouse while
implying that the other is still alive but has signed over the interest. Sole and separate
ownership can be used to take advantage of special property tax exemptions, simplify
property management, or avoid inheritance taxes.
For example, in Arizona and several other states, qualified veterans are eligible for
special tax exemptions on their portion of a property. If a non-veteran spouse quitclaims
interest to the veteran spouse, the veteran spouse can then claim the tax exemption for
the entire property, not just the veteran’s half. Although Arizona is a community property
state, the veteran would own this particular property as separate property because, as
described previously, property inherited or received as a gift by one spouse in a commu-
nity property state may be held as sole and separate property.

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 24 Essentials of Real Estate Investment Eleventh Edition

Often, one spouse will quitclaim the interest in a property to the other for ease of
management. This same purpose can be achieved if one spouse executes a power of attor-
ney legally granting the other full authority over the property.
In addition, sole and separate ownership is often used to transfer one spouse’s share
of a property to the other spouse as a gift to avoid probate costs and inheritance taxes.
However, a transfer of this nature may be subject to gift taxes. The impacts of inheritance
and gift taxes will be examined in Unit 4.

Severalty Ownership
All states acknowledge that single persons, whether unmarried or divorced, as well
as widows and widowers, own their real property in severalty, also called sole ownership.
Severalty is an inheritable estate because it is necessary to have two or more persons to
establish a survivorship estate. Thus, owners in severalty should designate by will to whom
they wish property to be distributed on their death. Corporate ownership is in the form
of severalty.

Dower and Curtesy Rights

Finally, most states recognize the legal rights of a surviving spouse in the real estate of
the deceased spouse. The rights of a widow in the property of her deceased husband are
called dower rights, while the rights of a widower in the property of his deceased wife
are called curtesy rights. The degree to which these rights are respected varies from state
to state. In some states, dower and curtesy rights were abolished and replaced by “elective
shares”—not distinguishing whether the surviving spouse is a widow or a widower.
Note that title companies are requiring the spouse who is not on the deed to sign the
contract and the deed to reduce any liability arising from dower or curtesy rights or “elec-
tive shares” in the future.
It is important that investors be familiar with the laws of the states in which they
anticipate purchasing real estate because these specific laws will prevail for all transactions
concerning property regardless of an investor’s principal state of residence. Any income
derived from property is subject to the laws of the state in which it is situated as well as to
federal income taxes. In addition, although a deceased’s main probate will be originated
in the state of primary residency, ancillary probate proceedings will be required in each
state where owned property is located. It is advisable to consult a real estate attorney in
every case.

GROUP OWNERSHIP
In addition to individuals who own real estate investments singly, with their spouses,
or with others as tenants in common, there are more formal arrangements for group
ownership of realty. Five important property ownership types are the corporation, the S
corporation, the collapsible corporation, formal partnerships, and limited liability com-
panies. It is important to carefully analyze from a tax and legal liability standpoint each of
the various titling and ownership structures.

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 Unit 2: Ownership Interests in Real Property 25

Corporations
A regular corporation, also called a C corporation, is a separate legal entity created
under the authority of the laws of the specific state of its incorporation. It is composed of
any number of persons who join together for mutual purposes and is considered to have
an existence distinct from that of its members. Corporations are endowed with the capac-
ity for continuous succession despite changes in ownership, and they act as individuals in
matters relating to the common purposes of the association. These actions must remain
within the bounds of its powers, as outlined in the corporate charter, and within the laws
of the various states in which it is licensed to operate. As a legal entity, a corporation can
hold title to real property in its own right.
Participation in a corporation is evidenced by stock certificates that are traded by
various means, mostly in organized stock exchanges. Certain classes of stock owners have
the right to vote but usually take a passive role in the activities of their corporations. The
actual operation of a corporation is often left to professional managers who serve together
with the company’s president and board of directors for the shareholders’ benefit.
Corporations formed for the purpose of investing in real estate are designed pri-
marily as capital-accumulating vehicles. Using a public stock offering, the organization
of a corporation may attract funds “looking for an investment,” giving smaller inves-
tors an opportunity to expand their participation far beyond their individual financial
capabilities.
Corporations have four general characteristics: continual life, centralized manage-
ment, limited personal liability, and easy transferability of interests.
Continual life.  Corporations “die” only when they are disbanded intentionally, are
absorbed into another company by merger or by a court order, or fail to file an annual
report with the secretary of state. (Note that due to the “continuity of life,” death or
bankruptcy will not terminate a corporation as long as someone continues to file the
annual report.) Otherwise they function perpetually, with new managers replacing those
who retire.
Centralized management.  Large corporations can afford to attract talented profes-
sional people. A corporation’s functional design lends itself to centralized management,
in which trained and experienced teams are directed by and held accountable to a board
of directors.
Limited personal liability.  One of the most important characteristics of a corporation
formed for real estate investments is its ability to shield a shareholder’s personal estate
from the debts of the corporation. Unlike a general partnership, in which participants are
personally responsible for their proportionate shares of a venture’s liabilities, corporate
shareholders’ risks are limited to the extent of their investment in the company. In the
event of a bankruptcy, other personal assets of the stock owners are not subject to attach-
ment for any of the corporation’s debts. Officers of the corporation are also protected by
the corporate form of ownership. There are exceptions to this protection for criminal acts
and trust fund liabilities such as employee FICA/Medicare and sales taxes. Also, it is pos-
sible for a court to “ pierce the corporate veil” in cases where the corporation was formed
simply to avoid liability. This immunity is also eliminated on those corporate loans where
officers are required to be held personally liable for the debt. Lenders may ask officers for
a personal guarantee of repayment of the debt when a corporation is newly formed or has
weak credit.

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 26 Essentials of Real Estate Investment Eleventh Edition

Easily transferable interests.  Because of the efficiency of the organized public

exchanges, corporate stock ownership is relatively easy to transfer. This characteristic is
particularly desirable for real estate investors who normally face a difficult situation when
they need to sell their holdings.

S Corporations
Clouding the efficiency of corporate ownership for real estate investments is the prob-
lem of double taxation. The corporation is subject to income taxes on the profits it gener-
ates, and the shareholders must pay taxes again when these profits are distributed to them
as dividends. This double tax has made corporations less desirable for real estate investors
and has led to the popularity of the S corporation, the limited partnership, limited liabil-
ity companies (LLCs), and the real estate investment trust as alternative ownership forms.
These forms of ownership act as investment conduits, bypassing double taxation.
The special form of corporation called an S corporation, also called an S corp or
Subchapter S corporation, is available for small businesses. It offsets the onerous double tax
while still preserving the advantage of limited personal liability intrinsic in the corporate
design. The major disadvantage of an S corporation is its limited ability to pass through
losses to individual investors. However, this disadvantage is significant only for a syndi-
cate that emphasizes tax shelter over current cash flows. The S corporation is a popular
vehicle for real estate investment.
S corporations are a creation of the tax laws. To qualify, a company must file an elec-
tion form with the IRS and meet the following criteria:
●● It must be a domestic corporation.
●● It must not have more than 100 shareholders. Married couples are treated as one
shareholder.
●● Nonresident aliens are not eligible to participate, although foreign corporations or
partnerships are allowed.
●● It must have only one class of stock, although designations for voting or nonvoting
stock may apply, making the S corporation as flexible as a limited partnership.
Until the passage of the Subchapter S Revision Act in 1982, S corporations could not
have more than 20% of gross receipts in the form of passive investment income, such as
rents. The elimination of this rule has broadened the scope of this ownership vehicle to
include income property investments as well as properties held for growth.
The major advantages of an S corporation include limited personal liability, ease of
transferability of ownership shares, centralized management, and comparative ease of
formation. Its basic disadvantage is that aggregate losses may be passed through to the
individual shareholders in an amount equal only to cash paid for the stock, plus any loans
made to the company. Thus, the S corporation’s most efficient application for real estate
investment is for projects designed for purposes other than tax shelters.

Collapsible Corporations
A corporation formed for a single purpose and then disbanded when the goal is
achieved is termed a collapsible corporation. For example, a corporation may be formed
for the specific purpose of owning a property from its unimproved state through the

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 Unit 2: Ownership Interests in Real Property 27

completion of building construction on the site. During the course of construction, cer-
tain operating expenses, such as management salaries, mortgage interest, placement fees,
and title insurance premiums, are treated as ordinary costs. Because there is no rental
income from the property until the building is completed, in effect, these expenses are
active losses and, as such, can be used to offset other active income. This usually results
in a substantial tax shelter for the corporation’s owners. However, when the building is
finally completed and the property is sold, profits from the sale of the improved property
are considered active income.

Partnerships
Operating under the aegis of the Federal Uniform Partnership Act, real estate may
be owned by individuals or corporations in partnership, with every partner considered
a tenant in common with each of the other partners. The various forms of this type
of ownership include full partnerships, syndicates, limited partnerships, limited liability
companies, and joint ventures. Because of the legal complexities involved in forming a
partnership, it is suggested that an attorney’s services be employed to prepare a partner-
ship agreement.
General partnerships.  Many general partnerships, also called full partnerships, are
relatively informal arrangements wherein some friends or family members join to pur-
chase an investment property as tenants in common. The only evidence of the partner-
ship is their names on a deed specifying their proportionate ownership interests in the
property. Other general partnerships can be designed with a formal contractual agree-
ment specifying in detail the various rights, duties, and obligations of each member and
whether their ownership interests are freely transferable. Some agreements require that a
participant’s interest first be offered to the remaining partners prior to being sold outside
the partnership. This condition is called a right of first refusal.
Under the general partnership form of ownership, each partner assumes an active
management role. As a result, there must be unanimous agreement each time a decision
is made, regardless of the proportions of ownership. Thus, a general partnership with
unequal shares still allows each of the owners a voice in management.
General partnerships are usually designed to unite compatible persons who have
similar goals for real estate investments, thereby enlarging their individual capabilities to
acquire property. Although the management votes are equal, the distribution of earnings
and the mortgage and property tax obligations are based on each participant’s propor-
tionate percentage of ownership. Partners are then personally responsible for their own
income tax liability.
In a general real estate partnership, members are personally liable for all debts and
obligations of the partnership, regardless of their proportionate share. In the event of
bankruptcy, other personal assets of the partners may be attached to satisfy creditors.
However, the partnership itself is not responsible for the private debts of any one partner.
In the event of a personal bankruptcy, only the proportionate interest of the troubled
partner may be attached by creditors.
A condition common of many formal general partnership agreements specifies what
the surviving partners’ relationship will be with the heirs of a deceased partner. Recogniz-
ing the need for continuing compatibility in a general partnership in which each par-

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 28 Essentials of Real Estate Investment Eleventh Edition

ticipant has an equal voice in management, most formal realty agreements will grant the
remaining partners an option to purchase the ownership interest of a deceased partner.
A buy-out formula is devised at the inception of the partnership, usually based on
the fair market value of the share at the time of death. The funds for the purchase option
may be secured from the proceeds of a partnership life insurance program or from con-
tributions made by each surviving partner. In the absence of a buy-out agreement, or if
the remaining partners do not exercise the option that does exist, the heirs assume the
deceased’s partnership position and the realty investment continues to function.
Syndicates.  A syndicate consists of two or more investors joining together for the pur-
pose of purchasing and operating a real estate investment. A syndicate may take the form
of a corporation, full partnership, LLC, or limited partnership. It is merely a description
of multiple ownership in real estate, not a form of legal ownership. Most syndicates are in
the limited partnership format, with the syndicator taking the role of the general partner
and the investors being limited partners.
Limited partnerships.  Unlike the general partnership, in which each participant takes
an active management role and is also subject to the personal liabilities involved, limited
partnerships and syndicates attract realty investors who prefer to take a passive role in
management and who wish to limit their personal liability to the extent of their specific
cash investments.
A limited partnership or syndicate is formed when a real estate promoter, assuming
the liability and responsibility of a general partner or syndicator, purchases or takes an
option to purchase an investment property. The public is then invited to participate as
limited partners by buying ownership shares in various denominations. The result is a
relatively large group of investors who rely on the management expertise of the general
partner for promised profits. The limited partners take a passive role in management and
enjoy the security of protecting their other personal assets from liabilities incurred by the
partnership. Any losses by the limited partners are limited to the extent of the individual’s
investment in the group. General partners retain full liability for all the debts of the
partnership.
Limited partnerships are investment conduits that pass the profits directly through
to the investors in proportion to their ownership shares. Any annual income tax liabili-
ties are thus imposed at the investor’s level. When the property is sold, the proceeds are
also distributed proportionately to each investor. Because excess losses cannot be passed
through to the passive investors in a syndicate or limited partnership, the popularity of
these ownership entities has diminished in favor of real estate investment trusts (REITs).
Each share in the limited partnership is the individual property of the investor and is
inheritable. The shares are evaluated according to current market prices at the time of the
owner’s death and then distributed to the heirs after payment of any required inheritance
and estate taxes.
Many smaller realty investors are attracted to this form of ownership. They can not
only limit their personal liability and avoid the burdens of active property management
but they can also expand their individual investment capabilities by becoming part of a
group that invests in larger, more efficient, and hence potentially more profitable, realty
ownership ventures.

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 Unit 2: Ownership Interests in Real Property 29

Limited partnerships are relatively popular vehicles for real estate ownership because
they offer a wide latitude of investment opportunities, the ability to attract large sums of
venture capital, and great flexibility in organizational design. Their organizational flex-
ibility stems from their ability to design investments that can fulfill individual investors’
requirements. To illustrate, one investment may be organized to attract persons interested
in receiving income in the form of regular cash flow from one single specific property,
such as an office building. Other limited partnerships can be designed to attract investors
who prefer to purchase shares in a diversified investment portfolio consisting of a variety
of properties, much like a mutual fund in the stock market.
As an investment conduit and to preserve its single-tax profile, a limited partnership
must actively avoid displaying, at any one time, the basic four characteristics of a corpora-
tion: continuity, central management, limited liability, and easy transfer of interests. In
fact, the IRS looks with disfavor on any limited partnership in which more than two of
these characteristics exist at any one time.
As a result, because centralized management and limited liability are absolutely basic
to limited partnerships, they are often designed to terminate at a specified time, and cer-
tain restrictions are placed on the transferability of ownership shares. In the first instance,
the termination date is often established in advance; in the second instance, the organi-
zational agreements usually include the general partner’s right of first refusal to purchase
any shares before they are offered to the public.
Because syndicates are concerned with selling units of ownership in an enterprise,
they come under the definition of a securities dealership and, as such, are subject to the
Uniform Partnership Act, more commonly called individual state laws called blue sky
laws. These blue sky laws require every syndicator or general partner to prepare a com-
prehensive prospectus to distribute to potential investors. In addition to describing the
physical property and the terms and conditions of the investment, full disclosure must be
made of the names and experience histories of each syndicator, as well as a clear indication
of all of the risks inherent in the proposition.
When investors consider forming or joining a syndicate, it is imperative that they
know precisely what is required in the way of organization, costs, and potential benefits.
A comprehensive outline for a syndicate offering is shown in Figure 2.3: Syndicate Offer-
ing (Limited Partnership).

FIGURE 2.3  Syndicate Offering (Limited Partnership)

Article I. General Provisions

Formation General partner
Name Certificate of limited partnership
Purposes Agent for service of process
Place of business Exhibit of limited partners
Term

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 30 Essentials of Real Estate Investment Eleventh Edition

FIGURE 2.3  Syndicate Offering (Limited Partnership) (Continued)

Article II. Definitions
Acquisition expenses Net proceeds
Acquisition fees Offering and organization expenses
Adjusted invested capital Offering memorandum
Affiliate Operation expenses
Assignee Original invested capital
Cash available for distribution from operations Partners
Cash from sales or refinancing Partnership
Closing date Partnership properties
Distribution Property management fee
Finders’ fees Sales commission
General partner(s) Subscription agreement
Gross offering proceeds Subordinated real estate commission
Gross property revenue Total outstanding units
Limited partners Unit
Managing general partner Unit holders
Majority vote Working capital reserve
Article III. Capital Contribution and Related Matters
Capital contributed by general partner(s) No priority
Capital contributed by limited partners Remedies for default in capital contributions
Payment for units Subscriptions and admissions
Subsequent offerings of additional units General partner(s) may purchase units
No action or consent necessary by limited partners for No assessments or additional contributions
admission of other limited partners No withdrawal of capital contributions
Return of capital Securities laws
No interest on capital Temporary investment of partnership capital
Article IV. Allocation of Distributions, Income, Losses, and Other Items Among the Partners
Distribution to the partners The general partner or partners' share of allocations and
Capital accounts distributions among themselves

Obligation of general partner(s) to make up negative Allocation between assignor and assignee
capital accounts Timing of distribution
Limitations on distributions Express consent of allocations
Allocation for tax purposes Special allocation for tax-exempt and foreign investors
The limited partners’ share of allocations and Tax withholding
distributions among themselves

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 Unit 2: Ownership Interests in Real Property 31

FIGURE 2.3  Syndicate Offering (Limited Partnership) (Continued)

Article V. Management of Partnership
The management powers of the general partner(s) General partner(s) may engage in other activities
Restrictions on powers of the general partner(s) Dealing with the partnership
Decisions Liability of the general partner(s) and their affiliates
Actions requiring consent of all general partners Consent of the limited partners not required
The limited partners have no management powers Liability of general partner(s) for capital contributions
Duty of the general partner(s) to devote time Reserves
Article VI. Compensation to the General Partner(s) or Affiliates
Property management fee Initial partnership, tax advice, and administration fee
Real estate brokerage commission on acquisition Farm property management fee
Partnership management fee Investment advisory fee
Real estate brokerage commission on resale of property Mortgage brokerage commission
Standby loan commitment fee Subordinated interest
Loan guaranty fee Sales commission
Fee for initial property management and marketing advice Incentive management fee
and rental marketing structure Rental consulting fee
Development supervision fee Fees payable on removal
Limitation on compensation to general partner(s)
Article VII. Books, Records, Accounts, and Reports
Books and records Reports Tax matters partner
Limited partners’ rights regarding books, records, and tax Bank accounts
information Designated person
Accounting basis and fiscal year
Article VIII. Assignment of Interests in the Partnership
Assignment of interest in the partnership of the general Substituted limited partner
partner(s) Death, insanity, incompetency, or bankruptcy of a limited
Assignment units partner
No assignment allowed under certain circumstances
Article IX. Dissolution and Termination of the Partnership
Dissolution Winding up and liquidation
Continuation of the business of the partnership No recourse against general partner(s)
Authority to wind up Claim of limited partners or assignees
Article X.Termination of a General Partner
General partner(s) ceasing to be a general partner(s) Removal of a general partner(s)
Termination of executory contracts with general Continuing interest of terminated general partner(s)
partner(s) or affiliates Reports after removal
Article XI. Meetings and Voting Rights
Notice of meetings Voting rights of the limited partners
One vote per unit Consents

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 32 Essentials of Real Estate Investment Eleventh Edition

FIGURE 2.3  Syndicate Offering (Limited Partnership) (Continued)

Article XII. Partnership Expenses
Reimbursement to general partner(s) Direct payment of partnership expenses
Expenses of general partner(s)—nonreimbursable Payment of expenses of the partnership
Article XIII. Amendments of Partnership Documents
Amendments in general Amendments by the general partner(s)
Amendments requiring greater than a majority rule
Article XIV. Borrowings
Loans by the general partner(s) to the partnership Commercial loans
Loans by the partnership to the general partner(s) or
others
Article XV. Representations and Warranties of the Partners
General partner(s) Indemnification by limited partners
Limited partners
Article XVI. Miscellaneous Provisions
Notices Waiver of action for partition
Article section headings Attorneys' fees
Construction Creditors
Severability Remedies
Choice of venue and law Authority
Counterparts Tax elections
Entire agreement Legends
Amended certificates of limited partnership Signatures
Power of attorney to the general partner(s) Election to be governed by successor or different limited
Further assurances partnership law

Successors and assigns Arbitration

Exhibits
Description of property to be acquired Name, address, number of limited partnership units, and
capital contributions of each limited partner
The dissolution of a syndicate occurs on the expiration of its term or on the first
occurrence of one of the following:
●● Election by the general partner(s) to dissolve or discontinue the partnership, which is
approved by a majority vote
●● Bankruptcy of the partnership
●● The sale or disposition of all or substantially all partnership assets, including the ces-
sation of active business, the distribution of all cash, and the termination of reserves
for liabilities
The benefits from the limited partnership form of ownership can extend beyond even
the more usual income, depreciation, and growth in value potentials of most real estate
investments. Because termination dates must be established in advance, promoters may
design a number of separate limited partnerships, each controlling an individual property.

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 Unit 2: Ownership Interests in Real Property 33

These partnership units can then be traded regularly, with each transfer resulting in new
increased depreciation levels for each unit.
Limited liability company.  The limited liability company (LLC) is an alternative to
the limited partnership. An LLC has a corporate form and the tax advantages of a partner-
ship without the restrictions of an S corp.
Resembling a corporation by limiting the personal liability of its shareholders and an
S corporation by having the tax impact at only the shareholder level, the LLC includes
these additional benefits for its owners:
●● Both gains and losses are passed through to individual shareholders.
●● It may be designed to dissolve on the death or bankruptcy of one or more of its
members.
●● It may include in its ownership nonresident aliens or foreign investors.
●● Its basis may be expanded to add the partnership’s debt to its investors’ capital, unlike
the S corporation, which limits the basis to the cash investment of its shareholders.
For example, an LLC is formed with $1 million contributed by its shareholders;
$500,000 is used to make a down payment on a $3 million office building. The LLC’s
basis is increased to $3.5 million to include the $2.5 million debt.
LLCs can be organized only in states with authorizing legislation. Ownership inter-
ests are not freely transferable. The IRS continues to rule favorably for LLCs and, under
Letter Ruling 9226035, has consented to allow conversions of existing limited and gen-
eral partnerships to LLCs. Many states (such as California and Texas) charge an extra tax
for the privilege of operating an LLC.
Joint venture.  A special form of a general partnership, the joint venture brings together
the skills and assets of a group of heterogeneous investors for a specific realty project. For
example, a joint venture might be formed by a landowner, a developer, and a financier,
each of whom contributes unique skills and assets to the overall project and receives, in
exchange, a proportionate share of ownership.
The scope of a joint venture can be broadened to include as partners not only those
persons mentioned above but also carpenters, electricians, plumbers, and other artisans
who contribute labor and materials as their share and who receive in return a proportion-
ate ownership.
Joint ventures must have a definite agreement setting forth the intentions of the
parties, including provisions for treatment of the cash flows. This form of ownership can
be entered into by individuals, corporations, and partnerships that become tenants in
common with each other and are subject to the conditions, privileges, obligations, and
liabilities of the full partnership discussed earlier.

TRUST OWNERSHIP
A trust is an arrangement whereby a person or legal entity holds title to a property and
manages it for the benefit of another. The creator of a trust is the trustor, the holder of
legal title is the trustee, and the receiver of the benefits of the trust is the beneficiary, who
may also be the trustor under some agreements.

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 34 Essentials of Real Estate Investment Eleventh Edition

Trusts may be described as discretionary trusts or irrevocable trusts. The former can
be altered or discontinued at the discretion of the participants. The latter are established
for a specific purpose and cannot be changed until this purpose is achieved.
Trust agreements pertinent to real estate investments include the testamentary trust,
the living trust, the grantor retained income trust (GRIT), and the investment trust.
These real estate trusts are created for many reasons, including to
●● provide continuity in ownership over several generations,
●● enlist the expertise of professional management,
●● eliminate repetitive probate costs, or
●● hide the identity of beneficiaries.

Testamentary Trust
A trust may be established by the provision of a decedent owner’s will specifying that
certain portions or all of the property in the estate be placed into a trust for the benefit
of designated heirs. This form of ownership is a testamentary trust and vests control and
management of a deceased’s property in the name of a trustee. In this manner, an estate
may be kept intact through one or more generations of heirs and may enjoy the benefits
of professional management during the intervening years until its final distribution per
the terms of the deceased’s will.

Living Trusts
In the living trust (also called the inter vivos trust) form of real estate ownership, a
trustor executes an agreement with a trustee to hold property in trust for the trustor’s
benefit and under the trustor’s direct control for a certain time until specific goals have
been attained. The living trust is terminated when these goals are achieved. Such a trust is
originated by naming the trustors as primary beneficiaries during their lifetimes. On their
death, the living trust changes to a testamentary trust, and the decedents’ heirs move from
a secondary beneficiary position into the primary position.
A living trust is often employed by land developers when acreage is purchased under
the terms of an installment contract. The seller of the land is required to place the receiv-
able contract in trust with a bank or title company together with instructions to release
certain portions of the collateral land as stipulated payments are made to the trustee
by the purchaser-developer. The trust ends when the contract is paid in full. Thus, the
land seller becomes the beneficiary of this living trust as well as the trustor. The trustee
is empowered to accept payments and to issue releases and sends the proceeds from the
payments to the beneficiary.
This trust arrangement guarantees the developer periodic releases of parcels from the
contract. These timely releases are vital to the success of the project because they maintain
a constant flow of land for development. In the absence of such a living trust agreement,
the developer would need to find the seller each time a payment was made to secure a
release of the needed property from the lien of the contract. Because the trustee, usually
a corporation, is the legal owner of the contract, the developer can quickly and efficiently
secure the periodic releases when needed.

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 Unit 2: Ownership Interests in Real Property 35

In the event that the seller dies during the term of the contract, the trust will continue
uninterrupted, with the benefits passing through to the heirs under the testamentary pro-
visions. Thus, the trust continues to function until the contract is satisfied, the property
fully distributed, and the goals achieved.
Investors sometimes make use of the anonymous ownership advantage of a living
trust to hide their names as beneficiaries. This technique is especially effective if the revela-
tion of a property owner’s name might have an adverse effect on the negotiations for the
purchase, sale, or refinancing of a specific property.
Living trusts established to become testamentary trusts and to control property over
several generations eliminate the costs of repetitive probate proceedings because the sec-
ondary beneficiaries automatically advance each time the primary beneficiary dies. Gen-
eration-skipping trusts have been eliminated under the tax laws, and currently the value
of a trust’s assets are included in the total value of an individual’s estate for inheritance tax
purposes. However, an irrevocable trust can still be established to avoid inheritance taxes.
To create such a trust, a property owner must make an irrevocable gift of property to a
trustee, with the property to be held on behalf of the named beneficiaries until the donor’s
demise. Thus, the donor may enjoy the income from the property and, at death, have the
income accrue to the benefit of the heirs. The gift is subject to appropriate gift taxes at the
time the trust is established but is exempt from inheritance taxes, unless it is made within
a period of three years prior to the trustor’s death. In that case, it will be included in the
total value of the estate.

Grantor Retained Income Trust

The grantor retained income trust (GRIT) is useful for a family with considerable
real estate assets. The grantors, usually the parents, transfer titles to income-producing
properties in trust to a trustee for the benefit of the grantee, usually the child or children,
for a period of years. During the term of the trust, the income flows to the grantors, but
at the end of the trust period, the property vests outright to the grantees.
The benefit of a GRIT is that all appreciation in the values of the properties after the
trust is created is removed from the estate of the grantors, provided they survive the trust
term.
The Technical and Miscellaneous Revenue Act of 1988 (TAMRA) imposed the fol-
lowing limitations on the use of a GRIT:
●● The grantor must be the beneficiary of the income from the trust, not anyone else.
●● The grantor must not be a trustee of the trust.
●● Only the grantor may receive income from the trust property.
●● The trust term must not exceed 10 years.
Other family and charitable trusts may be created to satisfy unique ownership require-
ments. An attorney and accountant thoroughly familiar with both federal and state tax
laws are strongly recommended to avoid the many pitfalls inherent in this relatively com-
plicated form of property ownership.

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 36 Essentials of Real Estate Investment Eleventh Edition

Investment Trusts
In addition to the individual trust forms for property ownership already described,
trusts can also be designed to act as investment conduits for small investors, enabling
them to pool resources to participate in the field of real estate. By subscribing to and
meeting specific IRS requirements, an investment trust avoids the double tax burden
imposed on corporate earnings. The IRS requirements follow:
●● Transferable beneficial shares must be issued to at least 100 persons.
●● More than five persons must own more than 50% of the beneficial shares of the trust.
●● At least 75% of the trust’s assets must be in real estate.
●● At least 75% of the gross income must be derived from rents from real property,
interest on obligations secured by mortgages on real property, gain from disposition
of real property that is not dealer property, and certain types of interest on dividends.
●● At least 90% of the trust’s earnings must be distributed to shareholders each year.
●● The trust itself must be a passive investor, hiring others to manage and operate its
investments.
The common types of investment trusts are the equity trusts called real estate invest-
ment trusts, real estate mortgage trusts, and a hybrid form of these two.
In addition to these basic real estate trust forms, special investment trusts can be
designed for the development and ownership of medical buildings, manufactured-home
parks, recreational condominiums, mini-warehouses, and other unique real estate devel-
opments. A synopsis of a trust offering is shown in Figure 2.4: Synopsis of a Trust Offering.

FIGURE 2.4  Synopsis of a Trust Offering

Synopsis of a Trust Offering
(Subject to State Securities Division Approval)
REGENCY APARTMENTS
100 Real Estate Investment Trust Units
Minimum Investment $30,000
This offer may be considered speculative, and there is no assurance that the property will increase in value or that the
Trust will realize a profit from the operation or upon the sale thereof. There is no public market for the Trust interests,
and none can be expected to develop.
The Regency Corporation shall be the manager of the Trust. No dealer, salesperson, or any other person has been
authorized to make any representations other than those contained herein. This publication does not constitute an
offer to sell or the solicitation of an offer to buy any of the securities offered hereby to any person to whom it is
unlawful to make such an offer. The Trust intends to sell only those number of interests described herein.
The Regency Investment Trust is acquiring the Regency Apartments under an agreement executed with Allied
Investment Corporation (the sellers). The purchase price is $3 million, to be paid in cash upon closing. It is the
intention of this Trust to generate positive cash-flow income to its investors for five years, then capital gains profits
when the project is converted to condominiums and sold.
The Property. The Regency Apartments consists of 100 one-bedroom, 1½ bathroom, unfurnished rental units. It is
located at the intersection of Bell and Center Streets, close to Monterey Plaza Shopping Center. The complex is
composed of 10 individual two-story red brick buildings on a three-acre lot. There are two heated swimming pools,
saunas, whirlpool baths, dressing rooms, and improved patios. Each apartment has its own carport and storage area, as
well as small private patios or balconies. The apartments are all 900 square feet and include built-in kitchens, paneling,
wallpaper, separate air-conditioning, drapes, and carpets.

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 Unit 2: Ownership Interests in Real Property 37

FIGURE 2.4  Synopsis of a Trust Offering (Continued)

Pro Forma Statement

Gross Potential Income:
100 apartments @ $500 per month $600,000
Contingencies:
Vacancies 5%
Reserves 10%
Operating Expenses:
Management 5%
Taxes 7%
Insurance 3%
Maintenance 20%
Total (50%) – 300,000
Net Operating Income (NOI) $300,000
(10% on $3 million invested)
(Note that projected growth in value is to $5 million in five years [$50,000 per apartment as a condominium]. This
reflects a 15% additional annual return for a total overall projected annual yield of 25% before income taxes.)
All books and records shall be housed at the office of the Regency Corporation and shall be open to inspection by
all members of the Trust during regular business hours. Monetary distributions shall be made monthly, and all profits
shall be distributed equally to each unit of the Trust (1⁄100). No unit owner shall bear any financial loss in excess of the
original contribution.

Real Estate Investment Trusts

A real estate investment trust (REIT) uses the accumulated funds of its investors to
earn real estate income via diverse properties as well as to create long-term investments. A
REIT is primarily an income generator for a group of small investors and is similar to the
stock market’s mutual funds. It may be publicly traded, publicly non-traded, or privately
invested in.
REITs give the small investor the opportunity for broad-based participation in real
estate equity investments, offering both regular income from rentals and long-term gains
in property value as incentives. Unlike other forms of real estate ownership, REITs may
not pass losses through to their beneficiaries. Thus, their use as tax shelters is limited.
Their greatest appeal is to those investors who can absorb additional active income but do
not have either the financial capability or the inclination to invest directly in real estate.
REITs may be equity, mortgage, or hybrid in nature; that is, they may hold real estate,
real estate mortgages, or both. Legislation authorizing REITs was signed into law by Presi-
dent Eisenhower in 1960, and REITs have enjoyed cyclical success over time. According
to www.reit.com, REITs are in position to sustain a solid performance at least through
2015. In 2014, publicly traded REITs had an average return of 27.2%, compared to a
return of 13.7% for the S&P 500 index. Although most commercial real estate is owned
via partnerships, REITs have once again become a popular investment vehicle as they are
more liquid and less capital intensive. Because there are tax advantages for foreign inves-
tors in real estate via REITs, there has been an increase in their popularity abroad.
Traditionally, REITs had to conform to rules that required that they receive income
primarily from rentals and could provide only those services customary from a landlord.

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 38 Essentials of Real Estate Investment Eleventh Edition

However, the Real Estate Modernization Act, effective January 1, 2000, allowed REITs
to create and own profitable subsidiary companies that provide noncustomary services to
REIT tenants without penalty. These services include, among others, management of the
buildings, land development activities, bulk purchasing discounts for tenants, and part-
nerships with other entities to provide other services such as rental insurance. The income
from these activities is taxable at the corporate level.
Real estate mortgage trusts.  Real estate mortgage trusts (REMTs) are a form of
investment that attracts participants who prefer the benefits offered by real property
financing activities, a somewhat more stabilized form of cash flow, rather than the often
volatile activities of the real estate equities market.
An REMT uses the monies secured from the sale of beneficial interests to establish a
substantial line of credit with its bank or a similar financial institution. Then the REMT
uses this credit to participate in the real estate financing market as a lender of junior
mortgages, wraparound loans, gap loans, participation loans, and other sophisticated and
often esoteric financing forms.
Hybrid trusts.  Often REITs and REMTs are established as interlocking trusts, with the
REIT dealing in property equities and the REMT financing these investments. In effect,
this combination creates a hybrid trust arrangement and offers beneficiaries a greater
opportunity for investment diversification.

FOREIGN INVESTORS
According to the National Association of REALTORS®, for the 12 months ending
March 2015, foreign investors purchased $104 billion worth of U.S. real estate, approxi-
mately 8% of total existing home sales dollar volume. Foreign clients are an upscale group
of buyers, paying on average nearly $500,000 for a house compared to the overall U.S.
average house price of approximately $256,000. However, unit sales of homes to foreign-
ers declined by 10% in the 2014–2015 period, possibly due to the strengthening of the
U.S. dollar in relation to foreign currencies and weakening foreign economies.
Any banks dealing with foreign investors must report cash payments of $10,000 or
more to the IRS. The Foreign Investment in Real Property Tax Act requires that the bro-
ker handling a sale for a foreign person withhold 10% of the gross proceeds to ensure the
proper taxes are paid to the IRS.
Generally, foreign investors purchase American property because of
●● perceived security of investments in the United States, based primarily on the stability
of our government;
●● the appreciation in the values of their own currency when compared to the dollar;
●● highly inflated values of real estate in their own countries; and
●● easing of restrictions by their own governments on foreign investments.
A 2015 survey of members representing 17 countries in the Association of Foreign
Investors in Real Estate indicated that the United States is viewed overwhelmingly as the
country providing the most stable and secure real estate investments and the best oppor-
tunity for capital appreciation.

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 Unit 2: Ownership Interests in Real Property 39

SUMMARY
This unit presented an overview of the various types of ownership interests in real
property. Ranging from individual ownership to corporate forms, partnerships, and trusts,
real estate investors have many formats to choose from to satisfy their specific preferences.
Individually, real estate can be owned with either survivorship or inheritability as a
goal. Although ownership forms can be changed during a lifetime with the agreement of
all parties, it is the distribution of property after death that dictates its lifetime owner-
ship design. Thus, in most states, married couples may own property as tenants by the
entirety, with the result that the deceased’s portion will automatically vest in the surviving
spouse. This eliminates the time and cost of probate, but it also eliminates the rights of
the deceased to designate an heir other than the spouse.
To preserve the prerogative of designating by will to whom an estate will pass, an
inheritable estate must be established. Toward this end, the community property form
of ownership is recognized in only eight states, while the tenancy in common format is
available in every state to provide spouses with an alternative to tenancy by the entirety.
For those who want to avoid probate costs in the community property states and also
in those states that do not recognize tenancy by the entirety, the available form of owner-
ship is joint tenancy with the rights of survivorship. This estate can be used by any two
or more persons, but because it effectively eliminates inheritability, it is usually limited to
use by family members.
For the married individual who wishes to maintain control over property, sole and
separate ownership is available. Finally, for the single person, ownership in severalty is the
format under which to own real estate. Each of these forms, sole and separate and sever-
alty, is inheritable because only one person is involved.
An alternative to the individual ownership of property is the establishment of a cor-
poration. Here, personal liability is limited to the corporation’s assets. In addition, the
corporate form provides a basis for attracting a pool of investment funds from many
smaller investors through the sale of stock. Its design guarantees continuity and affords
the means for hiring professional management. Corporate earnings are subject to double
taxation and, as such, are limited in use as real estate investment ownership formats.
However, S corps can be used as investment conduits to avoid double taxation.
Partnerships are used to join investors together to share in a potentially profitable
venture. A general partnership gives each participant an equal voice in the management,
despite the proportionate share of ownership. In addition, each partner is personally
responsible for the liabilities of the partnership.
On the other hand, limited partnerships and syndicates act to shelter passive inves-
tors’ individual liabilities. In this form of ownership, the general partner, or syndicator,
assumes full responsibility for management in addition to full liability for the success of
the investment.
Property ownership in the form of a trust is established to create continuity in the
management of an estate and to avoid repetitious probate costs. Living trusts, or inter
vivos trusts, which after death become testamentary trusts for the benefit of the heirs, can
be established to control property during the life of a beneficiary. This form of ownership
directs a trustee to hold the legal title to property in trust for specified beneficiaries and

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 40 Essentials of Real Estate Investment Eleventh Edition

to follow the directions established in the trust agreement for the management of the
properties involved.
Investment trusts such as REITs and REMTs are established on this living trust basis,
as are family and special trusts. However, REITs and REMTs act as investment conduits
for many smaller investors and qualify under specific IRS regulations to act as trustees
in purchasing, managing, and financing real properties. Because of these special require-
ments, profits from these activities are taxed only once at the beneficiary level, not twice
as in the corporate ownership form.

DISCUSSION TOPICS
1. Investigate your state laws regarding the distribution of the assets of an estate left by
a person who dies intestate and without any discoverable heirs.
2. Secure a copy of an offering on a syndicated property and compare its form and con-
tent with the outline provided in Figure 2.3: Syndicate Offering (Limited Partner-
ship). Would you recommend an investment in the enterprise?

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 Unit 2: Ownership Interests in Real Property 41

UNIT EXAM 6. Which of the following is NOT an attribute of a

limited partnership?
1. Automatic survivorship is intrinsic in which of
a. The personal liability of the limited partners is
the following forms of realty ownership?
limited to their investment.
a. Sole and separate
b. Taxes on profits are imposed at the investor’s
b. Tenancy in common
level.
c. Tenancy by the entirety
c. Each partner takes an active role in
d. Community property
management.
2. An S corporation d. Operating losses are passed through to the
a. requires 100 or more shareholders. partners.
b. is subject to double taxation.
7. A father, mother, and daughter own a property in
c. is available to foreign investors.
joint tenancy. The daughter sells her interest to a
d. limits the personal liability of its shareholders.
friend for cash. How is the ownership changed?
3. Tenancy in common includes which of the a. The friend becomes a joint tenant with the
following? parents.
a. Automatic survivorship b. All three parties now own as tenants in
b. Married persons only common.
c. Undivided ownership c. The friend is a tenant in common with the
d. Equal ownership shares only parents, who remain joint tenants.
4. Participants in a general partnership usually take d. The daughter cannot sell her joint tenancy
title as which of the following? interest.
a. Joint tenants 8. The right of survivorship refers to the fact that
b. Tenants in common when one owner dies, that owner’s share will pass
c. Tenants by the entirety a. according to the deceased’s will.
d. Tenants in severalty b. to the deceased’s family.
5. Corporations are formed to own real estate for all c. to the surviving spouse.
of the following reasons EXCEPT d. to the surviving owners.
a. to avoid double tax on profits. 9. A living trust usually evolves into
b. for broad-based capital accumulation. a. an inter vivos trust.
c. to limit shareholder personal liability. b. a testamentary trust.
d. to develop continuity of ownership. c. a collapsible trust.
d. a limited partnership.
10. The Uniform Partnership Act, or “blue sky laws,”
cover all of the following EXCEPT
a. the experience of the syndicators.
b. an indication of the potential risk of the
investment.
c. a guaranteed return on the investment.
d. a description of the property, terms, and con-
ditions of the investment.

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 Feasibility Studies of
Real Estate Investments
Unit

3
LEARNING OBJECTIVES
After successfully completing this unit, you will be able to
●● understand how government regulations affect the desirability of an investment property,
●● describe how a market analysis leads to important data, and
●● list the attributes of a property analysis and how this information affects the real estate investor.

deed restrictions feasibility study plat

due diligence market analysis setback requirement
Environmental Protection Agency minimum housing standards subdivision restrictions
(EPA)

INTRODUCTION
Many real estate investments are made in a relatively informal manner. A real estate
broker offers a particular property to a client, who inspects it and briefly analyzes its
income potentials using certain mathematical techniques to measure profitability. Usually
the services of an appraiser are sought to verify the market value of the property. If the
investment meets the buyer’s criteria and the terms of the purchase can be arranged to
satisfy the parties, the transaction is completed.
Under the responsibility of due diligence, a broker often insists on a more inten-
sive analysis of the possible financial success of an investment to satisfy the requirements
not only of the investor but also of the financier and potential tenants. These formal
feasibility studies are generally undertaken when large projects are contemplated, such
as subdivisions, office buildings, shopping centers, industrial parks, and manufactured-
home parks. Feasibility studies consist of three broad analyses: market analysis, property
analysis, and financial analysis. This unit examines the first two; Unit 5 examines financial
analysis.

42

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 Unit 3: Feasibility Studies of Real Estate Investments 43

MARKET ANALYSIS
Although each study is designed to meet the needs of a particular development, all
feasibility investigations include analyses of environmental impact, local government reg-
ulations, community profile, and the data accumulated. Each of these areas of investiga-
tion includes mathematical manipulations of various data and statistics as well as political
and sociological impact information.

Environmental Protection Agencies

Increased pollution of our natural environment led to the passage of the National
Environmental Policy Act of 1969. A federal administrative division, the Environmental
Protection Agency (EPA), was established by this act. Among its other duties, the EPA
determines environmental control guidelines for the development of real estate projects.
In practice, the EPA encourages the individual states to adopt and enforce local controls
of their own and steps in only when the states do not act to implement the minimum
federal guidelines.
To make sure that long-term protection of the environment is the guiding criterion
in public decisions, EPA guidelines require government agencies at all levels to consider
qualitative factors as well as economic and technical factors; long-term benefits and costs
in addition to short-term benefits and costs; and alternatives to proposed actions affecting
the environment.
In those states that have adopted environmental controls, the government agencies
are guided in their analyses by the results of individual environmental impact studies.
These impact studies include Phase I, which requires an exhaustive study of the past
uses of the property to reveal any possible contamination. In addition, the site itself is
carefully examined for traces of contamination, such as leaking tanks, dry wells, hazard-
ous waste, and so forth. In Phase II, more research is required if any contamination pos-
sibilities are revealed in Phase I. Finally, Phase III kicks in to clean up any contamination
revealed in the prior research. Most purchase contracts contain a provision whereby a
buyer may cancel a contract should there be any revelation of contamination. The reason
for this is that a buyer could become liable for damages and cleanup costs related to the
contamination. Under federal regulations there is a list of potentially responsible parties
(PRPs) that may be held liable. PRPs include the persons or entities that created, trans-
ported, or installed the contamination. PRPs also include the owner of the property at the
time the contamination appeared, subsequent owners, and even managers of the property.
A defense to this imputed liability is called the innocent landowner defense. This
defense does not simply mean that the purchaser of the property did not know of the con-
tamination but rather that the purchaser used all due diligence in an attempt to uncover
any problem (a Phase I assessment) and that nothing appeared in the research.
Each major political jurisdiction in these states has an environmental quality divi-
sion. As a prerequisite to the development of a new real estate project, an application for
environmental review must be filed by the developer with the appropriate agency. An
investigation is conducted, and an environmental impact report is released. Contribu-
tions to this report are made by the various government groups involved in the decision,
such as the local zoning board, building inspection department, sewer department, and
city transportation division.

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 44 Essentials of Real Estate Investment Eleventh Edition

If the application is approved, development proceeds to completion. If defects in the

plan are revealed in the impact study, the applicant is informed and may resubmit the
application together with proposed remedies. In situations where the project is categori-
cally denied because of potential serious damage to the environment, the applicant may
appeal through appropriate legal channels.
Figure 3.1: Environmental Review Process for City of San Diego outlines San Diego’s
environmental review process and time requirements for proposed real estate develop-
ments. In practice, the time requirements have proven to be seriously understated.

FIGURE 3.1  Environmental Review Process for City of San Diego

Application Submittal
and Processing
2 Work Days

Initial Staff Study

5–10 Work Days

Environmental Review
Committee Determination
1 Work Day

Project Analysis and Public Review

Report Preparation Period
5–10 Work Days 30 Calendar Days

Adverse Comments No Adverse Comments

Received

FINAL REPORT
Response to Public
Comment
1–5 Work Days

Publication of Legal Appeals Period

Notice
1–5 Work Days 10 Calendar Days

If Appealed If Not Appealed

Appeals Hearing by FINAL REPORT

Environmental Appeals
Board (EAB)
1 Work Day

Modification Requested If Approved

by EAB

Report Modified as FINAL REPORT (WHEN ACCEPTED BY EAB)

Required

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 Unit 3: Feasibility Studies of Real Estate Investments 45

Local Government Regulations

Just as the various agencies of the federal government have an impact on real estate
investment activities, so local agencies affect the investment process. Following are some
more specific ways in which the regulating bodies of local governments control the growth
and development of communities.
Subdivision regulations.  Most major communities in this country have adopted laws
to regulate the subdividing of land. The purpose of these laws is to prevent the unplanned
and haphazard division of large parcels of land into small building lots. City and county
officials are charged with the duty of supervising the orderly growth of their communities.
As a result, an investor who wishes to develop a parcel of land must present an applica-
tion for plat approval and required zoning changes to the special local agency established
for the purpose of subdivision control, such as a local planning and zoning department.
Plat approval.  To control the design of a new subdivision, a developer must submit
a plat for approval by all of the various departments involved in community services. A
plat is a drawing of the subdivision by an engineer or architect that shows lot sizes, street
widths, easements, and so on (see Figure 3.2: Sample Plat). The proposed lot sizes must
conform to acceptable standards. The street design must link up to existing roadways and
incorporate special safety features, such as proper widths, gradients for curves, access for
firefighting equipment, and turnarounds in cul-de-sac streets. This plat is recorded so that
the legal descriptions become effective.

FIGURE 3.2  Sample Plat

W. Line E 1/2
E 1/2 Lot 7 Well site
Fertile Acres Amended City of Glendale
35/38 Dkt 967-132
Corner of this
20 subdivision South Line of the North 230.34' of Lot 7 30
City of Glendale - Dkt 3019-108 30
20 20
East - 283.00
25 70 70 73 70 12

Corner of this
Easement for 1'

subdivision
Public Utilities
N 1 10' E

N 1 10' E

10' Easement for

100

100
80

85

1 2 3 4
125.00

125.00

R = 40
= 35 39'30" 1'
drainage

1
T = 20 25.7 62
.89
Fertile Acres Amended

Fertile Acres Amended

S 1 10'30" W - 250.66

2 4 .0
50 70 25.85 2
Dearing Lane

West "F" Street

25 25
N 1 10' E
35/38

35/38

East - 238.00 East -

191.36 46.64 29.98
25 25
R = 40
50 70 26.87 24. 5
8 9 .6
T = 20 24.08 63
125.66

R = 40
125.37

= 35 39'30"
Corner of this
80.39

subdivision
N 1 10' E

N 1 10' E

8 7 6 5
100.46

100.53

85.61

12
12

12

25 70 70 73 69.95
20 N. 89 56' W. - 282.95 12' Easement for
Corner of Public Utilities
this Subdn. North Line of the South 125.17' of
Found Bar. Lot 7 Fertile Acres Amended

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 46 Essentials of Real Estate Investment Eleventh Edition

Adequate drainage must be provided to avoid potential flood damage. Utility installa-
tions must be situated in proper easements and be readily accessible for continuing main-
tenance. Adequate solid and liquid waste-disposal systems must be developed to prevent
pollution of underground or surface water streams.
Prior to plat approval, any special circumstances surrounding each particular project
must be solved to the satisfaction not only of the community agencies but also of neigh-
bors and other citizens whose rights are involved.
Zoning codes.  In addition to subdivision regulations, most communities have local
zoning ordinances that designate allowable land usage for particular purposes. Histori-
cally, zones were separated according to types of use: single-family residential, multifamily
residential, commercial, industrial, and special purpose (such as an airport or hospital).
It was felt then, and still is in most parts of our country, that to maintain their separate
integrity, these different divisions should not be mixed. See Figure 3.3: Pima County,
Arizona, Summary of Zoning Classifications, Principal Uses, and Development Standards
for an example of one area’s land uses.

FIGURE 3.3  Pima County, Arizona, Summary of Zoning Classifications, Principal Uses, and Development Standards

Zone Principal Uses Minimum Lot Area Minimum Minimum Yards Building Other/
Area Width Area Per Front Side Rear Height/ Coverage
    Unit   Stories  
IR: Institutional Low-density 36 acres None 36 acres 50 50 50 access 34/2
Reserve residential; structure 50 10* access
agricultural 10* structure
24
*50 if animal use
RH: Rural Low-density 180,000 None 180,000 50 20 50 access 34/2 Option A
Homestead residential; (4.133 structure 50 10* access
limited acres) 10* structure
conditional 24
commercial *50 if animal use
use;
agricultural
use
GR-1: Rural Residential and 36,000 None 36,000 30 10 40 access 34/2 Option A
Residential agricultural; structure 30 10* access
(April 1972) limited 10* structure
conditional 24
commercial *50 if animal use
use
MLZ: Mount Single family 36,000 None 36,000 555 34/3 Option A;
Lemmon Zone residences access 50%
structure
19
SR: Suburban Single family 144,000 None 144,000 50 10 50 access 34 access Option A;
Ranch residences; (3.31 acres) structure 100 10* structure 30%
agriculture 10* 24
*100 if animal use

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 Unit 3: Feasibility Studies of Real Estate Investments 47

FIGURE 3.3  P
 ima County, Arizona, Summary of Zoning Classifications, Principal Uses, and Development
Standards (Continued)
Zone Principal Uses Minimum Lot Area Minimum Minimum Yards Building Other/
Area Width Area Per Front Side Rear Height/ Coverage
    Unit   Stories  
SR-2: Suburban Single family 72,000 120ft 72,000 30 10 40 access 34/2 Option A
Ranch Estate residences structure 60 10* access;
10* structure
24
*see 18.18.060
SH: Suburban SR uses; 36,000 100 18,000 30 10 40 access 34/2 Option A
Homestead manufactured structure 60 4* 4* access
homes (max. structure
2 per lot); *50 if animal use 24
duplexes
CR-1: Single Single family 36,000 100 36,000 30 10 40 access 34/2 Options A
Residence residences structure 60 4* 4* access and B
structure
*50 if animal use 24
CR-2: Single Single family 16,000 80 16,000 30 10 40 access 34/2 Options A, B,
Residence residences structure 60 4* 4* access and C
structure
*50 if animal use 24
CR-3: Single Single family 8,000 60 8,000 20 8 25 access 34/2 Options A, B,
Residence residences structure 50 4* 4* access and C; 40%
structure
*20 if animal use 12
CR-4: Mixed Single 7,000 (5 None SF: 7,000 Site Setbacks 20 34** Options C
Dwelling Type family and acre min. MF: 3500 10 10 Setbacks access and D; 50%
multi-family site Opt. D) on individual lots structure 60% (one
residences; (Opt. D: not on edge of 12 story)
duplexes SF: 3,500 site: zero-lot-line
Average) placement of bldg.
is subject to P.C.
Bldg. Code
CR-5 CR-4 uses 6,000 (5 None SF: 6,000 Site Setbacks 20 34** Options C
acre min MF: 2000 10 10 Setbacks access and D; 50%
site Opt. D) on individual lots structure 60% (one
(Opt. D: not on edge of 12 story)
SF: 2,000 site: zero-lot-line
Average) placement of bldg.
is subject to P.C.
Bldg. Code
TR: CR-3, CR-4, Res: 10,000 SF: 40 MF: 1,000 20 7 25* 20 0 10 34** 24
Transitional and CR-5 uses; Non-Res: 60 (SF detached)
offices; day none
care center;
motel/ hotel;
health care
center

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 48 Essentials of Real Estate Investment Eleventh Edition

FIGURE 3.3  P
 ima County, Arizona, Summary of Zoning Classifications, Principal Uses, and Development
Standards (Continued)
Zone Principal Uses Minimum Lot Area Minimum Minimum Yards Building Other/
Area Width Area Per Front Side Rear Height/ Coverage
    Unit   Stories  
CMH-1: Manufactured 8,000 60 8,000 20 8 25 34/2 24 Option A
Mobile Home or site built (subdivision
1 homes only)
CMH-2: Manufactured None None 3,500 15 10 15 (or if 34/2 24 Options E
Mobile Home or site built access is provided: and F
2 homes; mobile 25 10 25)
home park
TH: Trailer Trailer (RV) 18,000 None 2,000 30 10 30 access; 34/2 24
Homesite park (8,000 SF structure 60 4 4
prior to
1971)
MU: Multiple Site-built or Res: 7,000 Res: 60 Res: 20 7 25 access 34/2 Options C
Use manufactured Non-res: 3,500 structure 20 4 4 and E
homes None Non-res:
commercial or None
light industrial
if MU use
permit is
obtained
MR: Major Major resort Minimum 50 50 50 (from 34 Minimum site
Resort 20-acre site edge of site) cover 33%
area. One
guest room
per 4,356
square-foot
site area
RVC: Rural Retail Business Maximum None None 150 from center- 34/2 Architectural
Village Center 20-acre line of scenic route; review by
zoning 25 from TR zone; DRC; max
district 75 from residential site cover by
zone buildings: 25%
CB-1: Local Retail business, Res: 4,500 Res: 40 Duplex/ 20 0 10 Duplex/ Res: 34** Option C
Business all TR uses Duplex/ Duplex/ Condo: Condo
Condo: Condo: 60 1,000
10,000 20 7 25
CB-2: General CB-1 uses; Res: 4,500 Res: 40 Duplex/ 20 0 10 Duplex/ 39 Option C
Business wholesale; Duplex/ Duplex/ Condo: Condo
storage of Condo: Condo: 60 1,000
equipment 10,000 20 7 25
and household
goods; bars

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 Unit 3: Feasibility Studies of Real Estate Investments 49

FIGURE 3.3  P
 ima County, Arizona, Summary of Zoning Classifications, Principal Uses, and Development
Standards (Continued)
Zone Principal Uses Minimum Lot Area Minimum Minimum Yards Building Other/
Area Width Area Per Front Side Rear Height/ Coverage
    Unit   Stories  
CPI: Campus Manufacturing; Minimum None None 25 20 30 (also 100 36 Review by
Park Industrial research 10 acre site from any existing DRC; hrg.
or cond. Approved by Board of
residential zone) Sups. Max
site cover by
buildings: 33%
CI-1: Light/ Limited CI-2 None None None 15 0 10 (or buffer 39
Industrial and intensive req. by landscaping
Warehousing industrial uses chapter if greater)
CI-2: General Limited CB-2 None None None 15 0 10 Ind: 54
Industrial and CI-1 Non-ind:
uses; other 39
industrial uses
subject to
conditions and
performance
standards.
CI-3: Heavy Limited CI-2 43,560 None None 10% 35 30 lot None
Industrial and intensive depth (or buffer
industrial uses req. by landscaping
chapter, if greater)
NOTES
Option A = Cluster Development Option (refer to Section 18.09.040)
Option B = Lot Reduction Option (refer to Section 18.09.050, and to individual zones)
Option C = Lot Development Option (refer to Section 18.09.060)
Option D = Small Lot Subdivision Option (refer to Section 18.09.080, and to individual zones)
Option E = Mobile Home Subdivision Option (refer to Sections 18.35.060 and 18.37.060)
Option F = Mobile Home Park Option (refer to Section 18.35.060)
* On a corner lot in CR-3, CR-4, CR-5, TR, or CB-1, the minimum rear yard may be reduced to not less than 10
feet, provided the minimum side yard on the side street is increased by 10 feet and all parking requirements are met
(Section 18.07.050-G).
** Building heights subject to scenic route regulations (i.e., for properties adjacent to a scenic route, no building shall
exceed 24 feet within 200 feet of a property line). In CB-1, this restriction applies only to residential development.
Source: Pima County Development Services
Repeatedly, subdivisions have been designed with an inner core of space for single-
family housing surrounded by areas intended for more intensive uses, such as apartments
and store buildings. Industrial land is usually located along the highways and railroads to
facilitate shipping requirements and minimize the effects of pollution on residential areas.
Zoning designations usually are based on a system of code letters that stand for cer-
tain allowable uses and specify the required amount of land that can be used for construc-
tion. These zoning codes also include specifications for spaces that must be left vacant
between adjoining lots. This type of specification is called a setback requirement.

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 50 Essentials of Real Estate Investment Eleventh Edition

For example, a county CR-1 designation could indicate a single residence use requir-
ing a minimum of 36,000 square feet of total lot area per unit, construction setbacks of 30
feet from the front lot line, 40 feet from the rear lot line, 10 feet from each side lot line,
and not more than 34 feet building height.
These requirements vary from jurisdiction to jurisdiction and depend to a great degree
on the type of development anticipated for the specific location. It is important for a real
estate investor to be thoroughly familiar with local zoning codes.
Rezoning a property from its present use to a more intensive use, such as changing a
vacant lot zoned for a single house to a zoning that would permit four units, may result in
substantial profits for an investor, as we will discover in later units. The rezoning process
involves the submission of an application to the appropriate government agency, a review
of this application by the professional staff of this agency, and a public hearing in front of
a commission, city council, or county board of supervisors who will rule on the accept-
ability of the professional staff’s recommendations. Public hearings allow petitioners to
state their cases and also permit neighbors and other interested citizens to make their
feelings known. Participants have recourse to the courts if they feel rezoning decisions are
unfair.
Because each jurisdiction follows its own specific techniques for conducting the
rezoning process, investors interested in this form of activity are well-advised to know the
requirements in their particular area and seek professional legal help.
Deed and subdivision restrictions.  Restrictions are covenants that run with the
land—once recorded they remain in effect into the future or for a period of time speci-
fied in the restrictions. Each new owner of the property buys “subject to” the restrictions.
Restrictions specify what the property can or cannot be used for or what can or cannot be
built on the land. Restrictions supersede any zoning on the property.
Individual deed restrictions are usually imposed by a landowner on property to be
split off and sold separately from the main parcel. By restricting the new parcels, the origi-
nal owner can maintain the integrity of the main parcel.
Subdivision restrictions, on the other hand, are usually established by the developer
on all of the lots in a new subdivision in order to maintain their homogeneity of use as
well as value. Subdivision restrictions generally run for 50 years or longer. Thus, buyers
in the subdivision can rely on their investments maintaining their values for long periods
of time.
For example, restrictions may include a minimum number of square feet per resi-
dence and prohibit any use other than residential use in the subdivision. Other restric-
tions may also be included (see Unit 11).
Restrictions are only as strong as the persons who will be responsible for their enforce-
ment. In the case of deed restrictions, when the original owner dies or moves away, the
split property owners may stop observing the requirements. If the new owner of the main
property does not object within a reasonable period, the restrictions may be broken.
Similarly, with subdivision restrictions, their enforcement relies on a strong neighborhood
association that will not be afraid to sue those who do not observe the requirements. Some
courts have ruled that an association’s failure to enforce restrictions over time waives the
association right to enforcement.

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 Unit 3: Feasibility Studies of Real Estate Investments 51

Investors must not only be aware of what the zoning codes are but also must be alert
to check with a title company or lawyer about any existing restrictions on the property
in question.
Planned unit developments (PUDs).  Many communities use a form of subdivision
called the planned unit development (PUD). A PUD involves the elimination of the side-
yard setback requirements and allows mixed land uses. Thus, apartments and town houses
can be joined together with common walls, while retail businesses and “clean” industrial
plants can be incorporated right into the subdivision.

■■ FOR EXAMPLE  If a 100-acre tract can hold 400 individual single-family detached
houses under a zoning designation of four house lots to the acre, a PUD can be designed
to include four separate 100-unit complexes. Elimination of the side-yard setback require-
ment makes it possible to construct a 100-unit building that includes high-rise and low-
rise apartments joined by common walls. Each 100-unit building is surrounded by open
space that would contain lawn areas, playgrounds, swimming pools, bicycle and walking
paths, tennis courts, golf courses, and similar recreational facilities.
Mixed land-use PUDs incorporate residents, retail businesses, office buildings, and
even acceptable industrial plants into their designs. These PUDs become entirely self-
contained small communities. For example, Reston, Virginia, has store buildings, apart-
ments, a lake, and various employment centers built right into exclusive single-family
home areas. Residents of this type of community, also called a traditional neighborhood
development (TND), can walk or ride a bicycle to work, school, stores, or recreational
areas.
Minimum housing standards.  Many communities have adopted uniform building
and housing codes that designate minimum housing standards required for new con-
struction as well as for older homes.
Requirements for new housing include minimum specifications for foundations,
underflooring, wood framing, roofing, and weatherproofing, and general requirements
involving light, ventilation, and sanitation. Some jurisdictions also require provisions for
off-street parking facilities and fire warning systems.
For older structures, most cities maintain inspection staff charged with determining
the safety of existing properties. Where a building or a portion of a building (usually
more than 50%) is found to be unsanitary or unsafe, these inspectors have the power to
issue appropriate citations to the owner, specifying failings that need to be corrected and
penalties if they are not. At the same time, a sign is posted indicating that the building is
unsafe and advising against entry. Ultimately, if the faults are not corrected, the structure
may be condemned and destroyed as a public nuisance.
In great part, these minimum housing standards are a result of the activities of mort-
gage lenders. Historically, lenders have fought for better building codes for potential
enhancement of the value of their collateral. The Federal Housing Administration (FHA)
has been a pioneer in these efforts with its standardization of appraisal techniques, which
led to the establishment of new housing codes in the mid-1930s.
Planned growth.  Many communities throughout the country compete with each other
to attract new industry by offering tax waivers and other incentives. In some instances,
industrial development foundations are formed by local businesspeople and given large

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 52 Essentials of Real Estate Investment Eleventh Edition

budgets with which to lure desirable industries away from other communities. New
industry means new jobs; higher earnings; more taxes; and generally, growth, expansion,
and prosperity.
In some areas, community growth has become uncontrolled as a consequence of a
burgeoning population. City planners and citizens alike are displeased over these develop-
ments, and politicians move to a no-growth policy. However, some yield to pressure from
the construction industry and modify their views to form a policy of planned growth.
This vests more power in the bureaucratic agencies that control land use and development
and inhibits new construction.
As a direct consequence of slowing new building, values of existing properties tend
to rise. A case in point is the dramatic increase in values of coastal and lakeside properties
in areas that have imposed building moratoriums and that enforce severe controls on new
developments.

Community Profile
Most new real estate projects begin with an available piece of property, an investor
looking for a property, and a broker acting as a catalyst to unite the two. Thus, a project
starts with a predetermination of use—for example, a shopping center. The feasibility
study must then include an analysis of the market this center is intended to serve.
Market analysis is predominantly concentrated at the local level. To determine the
potential income that can be realized from an investment, a careful investigation must
first be made of the economic climate of the community and, more particularly, of the
neighborhood in which the project is located.
An analysis generally begins with an on-site tour of the area. The investor obtains all
available maps of the locale, zoning ordinances pertaining to the area, applicable building
codes, and statistical data concerning the population. The investor then examines at least
six major factors in the neighborhood: land usage, economic climate, occupancy rates,
transportation and utility services, facilities, and community acceptance.
Neighborhood boundaries and land use.  A neighborhood can be defined as an area
within which common characteristics of population and land use prevail. There is no
predetermined size for a neighborhood. In rural areas it may consist of three square miles,
while a city neighborhood may be five square blocks.
The investor must determine the boundaries of the area before a market analysis
can be made. Rivers, lakes, mountains, parks, railroad tracks, or major highways help
delineate the confines of a neighborhood. Particular note should be made of natural and
artificial boundaries that may curtail the future growth of a neighborhood.
In the absence of any obvious physical boundaries, an investor must determine the
extent of land that is under common usage and shares a similar population. Any vari-
ances or restrictions in zoning should also be noted. Depending on the type of property
involved, these zoning regulations may have a positive or negative effect. Commercial and
industrial enterprises are adversely affected by a zoning restriction that limits the area to
residential or multifamily use. On the other hand, the desirability of a residential neigh-
borhood could decline severely if a zoning ordinance favorable to industrial development
were granted for the area. A prudent investor will also review any studies performed for
the local planning commission or zoning board.

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 Unit 3: Feasibility Studies of Real Estate Investments 53

Neighborhood economy.  Various sources of statistical information are available to an

investor for assessing the economic climate of a neighborhood. The local chamber of com-
merce accumulates data concerning the number and types of businesses in the area, the
volume of their activity, and general trends in their growth or decline. A neighborhood
with a well-diversified business sector is usually more economically stable than an area
that depends on a single major industry for its support.
Information secured from local financial institutions also provides a reliable indica-
tion of the area’s economy. The volume of mortgage loans outstanding and being issued
reflects the overall confidence in the real estate market. Competitive rental prices cur-
rently charged for residential, commercial, and industrial space in the neighborhood also
offer an accurate measurement of the area’s economy. Low rents generally indicate an
oversupply of rentals relative to a limited demand, whereas high rents generally indicate
a shortage of rental space.
Occupancy rates.  The occupancy rates for a particular type of property also reflect the
relationship between supply and demand in the neighborhood. Occupancies constantly
change and vacancy rates fluctuate accordingly, and this affects rents and values.
A high occupancy rate indicates a shortage of space and the possibility for rent
increases. A low rate, as reflected by many For Lease signs posted in a neighborhood,
results in tenant demands for lower rents and other concessions on the part of the land-
lord. The oversupply of space that results in low occupancy rates can be either technical
or economic in origin. Technical oversupply occurs when there are more available units
than potential tenants. Economic oversupply reflects asking prices beyond the purchasing
power of potential tenants. Statistics on vacancy rates can be obtained from current hous-
ing reports, which are published by state departments of commerce and list vacancies by
region. Local utility companies often provide information regarding vacancies, with the
number of non-operating meters corresponding roughly to the number of vacant apart-
ments, stores, or offices, as the case may be.
The investor-developer must also be able to predict whether future occupancy levels
will rise or fall and how quickly these transitions will take place. To answer these ques-
tions, existing competitive space must be inventoried according to building type, age, size
of units, and rental schedules. In addition, careful attention should be devoted to securing
an inventory of all new construction, both under way and contemplated.
To a great extent, accurate prediction of occupancy rates depends on matching the
composition of the local populace to the available space. The investor-developer should
know the number of potential buyers or tenants and their ability and willingness to pur-
chase or rent the properties being developed. The stability and trends of their incomes
must also be determined.
Statistics issued by state departments of labor list the total number of employed per-
sons by region and also provide the investor with information regarding unemployment
ratios. Information obtained from the chamber of commerce can furnish investors a clear
picture of local employment opportunities and the median income of the community’s
population. In addition, local financial institutions can provide information about the
population’s savings habits as an indication of economic stability. These employment and
income data should develop some reliable benchmarks for establishing appropriate rental
schedules.

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 54 Essentials of Real Estate Investment Eleventh Edition

To plan efficiently for the number and type of housing units needed, investors in
residential rental properties must determine the most common individual family size and
composition, in addition to the total number of people within the area. For example, the
prospects for financial success of a high-rise apartment complex composed of studio and
one-bedroom units in an area composed mainly of families with two children are quite
different from those prospects for a similar property in a neighborhood of young singles
or childless couples. Local marriage, birth, and divorce records will provide investors with
information regarding the structure of family units within the area.
In addition to the family structure, investors in residential real estate must be aware
of current shifts in population. When changes in the composition of a neighborhood are
detected, these alterations must be carefully analyzed in terms of land use and income
level. An increase in population due to an influx of middle-income families into an
expanding community has a considerably different meaning from an increase in popula-
tion due to overcrowding in lower-rental areas. The implications for the future use of the
neighborhood are quite different in each case (see the discussion of population demo-
graphics in Unit 1).
Transportation and utilities.  Regardless of the type of development contemplated,
transportation facilities are of prime importance to future tenants and must be included
in the market analysis of the property. In large cities, close proximity to public transpor-
tation is vital to apartment dwellers who may not own cars. Employees in many office
buildings often rely on public transportation to get to work. Traffic patterns, street net-
works, and traffic counts in a neighborhood are significant to such commercial ventures
as strip stores or shopping centers.
Much of this type of information is readily available from the local chamber of com-
merce. Industrial developments require convenient access to railroads, expressways, or
airports for receiving and distributing goods.
In addition to public transportation facilities, access and linkage to various parts of
the community are essential components of the market analysis process. Here, not only
must the distance to work be examined but also the roads and freeway networks to deter-
mine the amount of time it takes to reach various destinations.
For example, a housing project constructed some distance from the center of a com-
munity on less-expensive land might be successful if a connecting freeway allows potential
homebuyers to get to work faster than if the project were built in town with only surface
transportation available. Thus, a time-distance study should be included in feasibility
reports.
Residential, commercial, and industrial property users are also deeply concerned with
the availability of adequate parking facilities. The aggravation of overcrowded curb space
in urban areas can be relieved by off-street tenant parking. Commercial enterprises need
adequate parking facilities for their customers, and industrial concerns require dockside
space for loading and areas for employee parking.
The costs and availability of utility services are becoming increasingly important in
their effect on profits from investment properties. Commercial and industrial users are
particularly concerned with heavy-duty power lines, separate sewerage systems, and other
unique services required by the nature of their businesses.

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 Unit 3: Feasibility Studies of Real Estate Investments 55

Neighborhood facilities.  Although the existence of neighborhood amenities is of great

significance to residential investors, any improvements that help to attract potential resi-
dents will indirectly benefit commercial and industrial developers by providing a local
pool of potential consumers and employees. When inspecting a neighborhood, an inves-
tor should note the location and number of parks, playgrounds, theaters, restaurants,
schools, colleges, houses of worship, and other social or cultural organizations and facili-
ties that will be attractive to future inhabitants.
Community acceptance.  Community involvement with any new real estate develop-
ment, especially if it involves rezoning, has become extremely important and should be
included in a feasibility study.
In one geographic area, it took Walmart many months and a good deal of money
to finally find acceptance within the community for one of their “super stores.” It was
built on the third location recommended because citizens owning properties around the
other two locations expressed too much opposition. The third location was approved
only after many concessions to the local neighborhoods, which raised the building costs
considerably.
In another area, a drugstore chain battled with the local historic preservation com-
mittee to build in a neighborhood where some houses were to be removed to make room
for the drugstore’s parking area.
As indicated earlier, environmental impact studies are required in many areas of the
country. These studies describe the effects of the project not only on the immediately sur-
rounding properties but also on the community and region as a whole. Project plans must
be approved by various government agencies, including street and road, water, sewer, fire,
building inspection, and other departments charged with protecting the health, safety,
and welfare of citizens.
Any time lags necessary to satisfy these requirements must be included in the study
for the investor to develop the strategy necessary to complete the project and enter the
market in a timely manner.

Evaluating the Data

Once the community profile is complete, the investor-analyst must combine the
information collected concerning transportation facilities, economic conditions, type and
number of similar spaces, rental schedules, and population composition and evaluate it as
a whole. When reviewing the data, the investor should remain aware of the special needs
of the particular type of property for which the investigation was made.
Industrial property developers should pay specific attention to the opportunity for
physical expansion, transportation facilities, special utility services, availability of raw
materials, and the quality and quantity of the potential labor pool in the area. Commer-
cial property developers must be informed about traffic patterns, car and pedestrian traffic
flows, location of competitors, public transportation facilities, adequate parking space,
and the income profile of the market-area populace. Of special interest to residential
property developers are the size of family units, median income levels, trends in family
composition and locational movements, and sociological and cultural compatibilities.
Reconciliation of the neighborhood survey data with the specific qualities of the
property to be developed allows the investor to estimate the optimum rental that can be
secured for the space offered. From this estimate, the investor will be able to calculate the

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 56 Essentials of Real Estate Investment Eleventh Edition

profitability of the project after deducting expected operating expenses, interest on loans,
and depreciation. Thus, a project will receive a “go” or “no go,” depending on the rate of
profitability and its acceptance by the investor.
The success of the market analysis is only as reliable as the judgment of the person
making the evaluation. In the absence of experience, an investor should seek the services
of a professional property analyst who is fully knowledgeable about the nature of business
and economic cycles and who can accurately assess their influences on the character and
future trends of the subject market area.

PROPERTY ANALYSIS
An investor needs to carefully examine the physical characteristics of the parcel of
land to be used in new construction or the nature and condition of the existing building
considered for purchase. In the first instance, the land’s geological and surface charac-
teristics are investigated, as well as the costs of their probable modification and of the
installation of utilities, roadways, and landscaping. In the second instance, the physical
condition of the existing building, its functional capability, and costs of modernization
must be analyzed for potential repair and maintenance expenses.

The Site
Besides the locational characteristics described in the market analysis, a site’s physical
attributes must be examined to determine its capacity to support the structures the inves-
tor intends to build.
Surface attributes.  The use of a parcel of real estate may be limited by its topography,
vegetation, size, shape, or exposure. These surface attributes include hilly terrain, the
absence of fertile topsoil, woods, boulders, irregular shapes, narrow dimensions, obnox-
ious odors, and oppressive sounds. To cure any of these problems and to prepare a parcel
of land for new construction involves expenditures that must be included in a feasibility
study for a complete picture of total investment costs.
While physical irregularities may be corrected with the services of landscaping engi-
neers, it is often more difficult to acquire the amount of land necessary to ensure adequate
areas for building and parking. Residential lots need ample frontage exposure to serve the
tastes of modern high-income homebuyers who also are seeking the quiet and protec-
tion of a suburban or rural location. Commercial property must be easily accessible to
people on foot or in cars. Industrial property must have access to railroads, highways, and
adequate utility services, including solid and liquid waste-disposal facilities.
Subsurface attributes.  The ability of a parcel of land to support new construction is
of paramount importance to developers of high-rise apartment or office buildings. Soft or
slippery subsoil conditions can result in high costs if a builder has to sink support piers to
firm bedrock, often far below the surface. New construction techniques are opening up
additional, formerly unusable, wet marshy lands for development, but the costs are high.
Where the land is rocky and the subsoil hard and impenetrable, there will be addi-
tional costs for excavation. In areas where basements are desired, these costs may adversely
affect the sale of houses. Where substantial foundations and a number of subsurface floors

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 Unit 3: Feasibility Studies of Real Estate Investments 57

are included in the building’s design, rocky subsoil creates physical barriers often difficult
to offset.
High subsurface water tables and areas subject to flooding often create difficulties
when providing for sanitary sewage disposal and adequate drainage runoff. Pollution of
underground water streams is a serious problem in these areas.
Hazardous waste.  As a result of our emerging awareness of the deterioration of our
environment, there is increasing pressure to preserve the integrity of our living space.
Many states have become stricter in enforcing EPA-suggested guidelines. California’s
Superfund Law is continually imposing new requirements on landowners, tenants, and
developers to ensure that their properties are free of contaminants and hazardous wastes.
The Comprehensive Environmental Response, Compensation, and Liability Act
(CERCLA) includes requirements to examine possibly polluted properties and to iden-
tify potentially responsible persons when making environmental site assessment studies.
Where we used to think only of commercial properties as having hazardous waste prob-
lems, there are a great many instances involving residential properties as well. Reasonable
inquiries must be made into a property’s past uses before purchase to determine if it is
contaminated. This is where a Phase I environmental site assessment should be performed.

The Property
The purpose of a property analysis is to familiarize the investor with the nature and
condition of the particular building under consideration and its position relative to simi-
lar properties in the neighborhood. On completion of the property analysis, the investor
should know what expenditures will be needed to make the property competitive with the
best units available in the area and what the average operating costs for the project will be.
Exterior attributes.  The visual image, or initial impression, created by a building is
of considerable importance to prospective tenants. Thus, an investor should note the age
and style of the property as well as the condition of the walkways, landscaping, and overall
exterior appearance of the building itself. Any improvements required should be noted.
In addition, the investor should be alert to any major repairs deferred by the previous
owner. The masonry, windows, eaves and trim, roof, porches, parking area, pool, other
amenities, and building parts must be carefully examined for defects that may require
immediate attention and capital outlay.
Interior attributes.  The investor should carefully examine the interior of the building,
including the number of individual apartments or offices and their layouts, size, number
of rooms, closets, bathrooms, and views. Also, property must be able to be renovated to
accommodate the diverse uses of the tenants. Securing optimum rents is a function of
desirability of design and location in the building as well as of physical quality.
When inspecting individual units, the investor should examine the condition of the
hardware, plumbing, walls, and electrical fixtures. In apartment units, appliances, carpets,
and drapes should be checked and an estimate made of the expense of repairing or replac-
ing worn or obsolete items.
The condition of entryways, halls, laundry rooms, storage rooms, and other com-
mon interior areas should be checked. Any redecorating and replacement that may be
required to improve the general appearance of the building should be noted. This inspec-
tion should include the heating and cooling systems, plumbing fixtures, water heaters,

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 58 Essentials of Real Estate Investment Eleventh Edition

elevators, swimming pools, and other tenant amenities, as well as the machinery required
for snow removal and lawn and pool maintenance.
Operating expenses.  The investor should verify the amount of property taxes with
the local tax assessor and the amount of insurance premiums with an agent. Constant
attention must be paid to adequate insurance coverage in the face of inflation and ever-
increasing legal settlements.
An investor must accurately estimate ongoing maintenance expenses, in addition to
monies earmarked for future replacement of major items, such as the roof, furniture,
carpets, and elevators.
Asbestos.  In addition to considering the condition of the site relative to the presence or
absence of hazardous waste, it is important for purchasers of existing structures to address
the possibility that construction materials containing asbestos may be present. The cost of
its removal could affect the profitability of the venture.
Repairs for the removal of asbestos can be deductible expenses only if it can be shown
that
●● they are necessary to keep the property in an ordinarily efficient operating condition,
and
●● the costs will not materially add to the value of the property or appreciably prolong
its life.
Otherwise,
●● the costs must be capitalized as a permanent addition to the existing basis of the
property, to be recovered at its sale;
●● the costs must be depreciated independently; or
●● the investor must identify which portion of the costs would increase the value of the
building and capitalize that portion. The balance can then be deducted as a repair
cost.
However, the hasty and careless removal of asbestos may cause more harm than leav-
ing it in place. Researchers have determined that when existing asbestos materials have
not been disturbed, the concentration of airborne asbestos is comparable to the level of
concentration in outdoor air. The EPA agrees that when asbestos is not damaged or dis-
turbed, it probably should not be removed. Often the asbestos may be contained in place
by encapsulating the asbestos with other material.
Toxic mold.  The property must be inspected carefully for the existence of toxic mold,
which must be removed to eliminate costly lawsuits. According to the American Bar
Association, prior to 2000, mold insurance claims settled for $5,000 or less. Today, com-
mercial developers and homeowner claims routinely exceed $100,000, and in 2011 the
largest reported verdict for a mold related claim was $7.7 million, awarded to the owners
of 216 condominium units in South Carolina. Most states have adopted notice require-
ments to tenants or purchasers of real estate (in some states, tenants must report mold
issues to landlords). Failure to disclose the existence of mold is likely to result in lawsuits.

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 Unit 3: Feasibility Studies of Real Estate Investments 59

Radon gas.  This is a colorless, odorless gas that is emitted by radioactive materials con-
tained in certain rock formations. In high enough concentrations it can cause lung cancer.
Typically, radon problems can be eliminated with proper ventilation of the structure.
Lead-based paint.  Federal lead-based paint regulations must be followed if the prop-
erty is a single-family or multifamily residential property built before 1978. There are six
basic requirements under these regulations:
1. The buyer must be given the EPA booklet, Protect Your Family From Lead in Your
Home.
2. The seller/landlord must disclose any known lead-based paint hazards.
3. Sales contracts and leases must contain a lead warning statement.
4. The seller/landlord must provide the buyer/tenant copies of any lead-based paint
reports concerning the property.
5. Buyers must be given a 10-day opportunity to conduct a lead-based paint inspection
by a qualified lead inspector.
6. As of April 2010, federal law requires anyone who is paid for work that disturbs paint
to be trained and certified by the Environmental Protection Agency.
More information on lead-based paint may be found at www.hud.gov.
Other environmental issues.  There are many other environmental issues that may
affect the investment, such as carbon monoxide, urea formaldehyde foam insulation,
polychlorinated biphenyls, groundwater contamination, electromagnetic fields, and
underground storage tanks. A wealth of information on these issues is available at www.
epa.gov.
Because of the many and varied problems that may exist within structures, investors
are advised to enlist the services of a qualified private building inspector for a professional
opinion of the structure’s condition.
Together with the payments necessary for debt service, the investor is then ready to
do a financial analysis to complete the feasibility study.

SUMMARY
Many real estate investments are made in a somewhat informal manner, with a buyer
purchasing a property after a cursory examination of its physical condition and a rudi-
mentary analysis of its profit potential. Other realty transactions require more defini-
tive feasibility studies, including analyses of the environmental impact, local government
regulations, and an analysis and market profile of the community where the property
is located. Then a complete, in-depth examination of the property itself, both land and
buildings, plus a financial analysis of the quantity and quality of the income stream need
to be derived.
A market analysis includes a description of where the property is located. Often,
there are no clear-cut physical boundaries, such as mountains, streams, or roadways, to
delineate a market neighborhood. Rather, the area is described as that which is under
common usage and shares a similar population. The economic climate of the neighbor-
hood is then examined to discover types of business activity, volume of sales, and general

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 60 Essentials of Real Estate Investment Eleventh Edition

trends in growth or decline. Included in the trend analyses is the availability of money for
mortgage and business loans and competitive rental prices charged for properties similar
to the projected investment.
Occupancy rates aid in measuring the economic quality of the market that a realty
project will serve. High current occupancy rates (low vacancy rates) indicate a shortage
of space and the possibility for rent increases. An oversupply of space, on the other hand,
indicates a weak market and the possibility of developing less cash flow from the project
than anticipated. Careful projections must be made of future trends in the development
of comparable rental space from new construction, both under way and contemplated.
A complete profile of the neighborhood’s population is included in the economic
analysis. In addition to the number of persons located in the area, their family structure
and financial positions can provide information that can be helpful in planning the num-
ber and types of housing units needed or the composition of a shopping center. Current
population shifts must be diagnosed for an indication of potential changes that may affect
the investment.
Once the economic profile of the market neighborhood is acquired, its locational
qualities should be identified. These attributes include the type and availability of trans-
portation facilities and utilities, as well as neighborhood amenities that would enhance a
contemplated project.
A careful investigation must be made of the community acceptance of a major new
realty development. In addition to the immediate neighbors’ attitudes, the requirements
of all the various public agencies that will be involved in the project’s supervision prior to
and during construction must be analyzed. Any substantial negative points of view will
have to be met forthrightly before the project is undertaken.
An in-depth study of the physical qualities of the land on which a project will be
constructed—or, in the case of a used property, of the building itself—must be coupled
with the economic analysis of the market the realty project will serve. Both surface and
underground attributes of the site must be analyzed in terms of its ability to support a
new project. An already existing building must be inspected in terms of its appearance
and functional efficiency so that the owner can learn of potential refurbishing costs and
ongoing operating expenses.

DISCUSSION TOPICS
1. Secure a copy of a recent feasibility study of a property in your area and examine it in
relation to the material in this unit.
2. An increasing awareness of the effects on our environment of uncontrolled growth
suggests an emerging trend toward a no-growth attitude. Investigate the attitudes in
your community from the points of view of both citizens and politicians.

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 Unit 3: Feasibility Studies of Real Estate Investments 61

UNIT EXAM 6. When examining a building included in a pro-

posed commercial investment, all of the following
1. The primary purpose of subdivision regulations
factors regarding the property must be considered
in most states is to
EXCEPT
a. enable developers to profit from rezoning.
a. appearance.
b. divide large parcels of land into small lots.
b. location.
c. prevent unplanned and haphazard
c. physical condition.
subdividing.
d. the appeals period following a city’s environ-
d. inhibit growth in developed areas.
mental review determination.
2. A mixed-use subdivision describes
7. How many units can be built on an apartment
a. properties having no deed or subdivision
site 220 feet wide by 385 feet deep, where the
restrictions.
zoning requires a total side-yard setback of 20
b. proportionate grouping by population age.
feet, a front yard of 25 feet, a rear yard of 10 feet,
c. a legally prohibited method of development.
a height limit of one story, and a minimum 3,500
d. different but compatible developments in one
square feet of usable lot area per unit?
designated area.
a. 16 units
3. Fundamentally, a planned unit development b. 20 units
(PUD) is designed to c. 24 units
a. eliminate deed and subdivision restrictions. d. 40 units
b. eliminate side-yards for more efficient land
8. Which of the following statements about residen-
use.
tial subdivision restrictions is FALSE ?
c. relegate housing developments to the suburbs.
a. They are enforceable only against the original
d. discourage mixed-use subdivisions.
homeowner.
4. In a market analysis, the occupancy rates for a b. They are covenants that run with the land.
particular type of property should be compared c. They are effective as long as they are enforced.
with the d. They are established to maintain the homoge-
a. community’s overall occupancy factor. neity of property use and value.
b. nation’s occupancy factor for that type of
9. A feasibility analysis is primarily designed to pro-
property.
vide an investor with information appropriate to
c. community’s occupancy factor for that type of
a. avoid paying income taxes.
property.
b. guarantee a profit on the investment.
d. U.S. Department of Labor’s employed persons
c. make an economically rational investment
list.
decision.
5. When analyzing the site of a new commercial d. satisfy various government regulatory
investment project, all of the following factors agencies.
must be considered EXCEPT the site’s
10. The Environmental Protection Agency (EPA)
a. surface attributes.
establishes guidelines for the prevention of all of
b. subsurface attributes.
the following EXCEPT
c. possible contamination.
a. air pollution.
d. fertility.
b. soil contamination.
c. water impurities.
d. property accessibility.

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 Income Taxes and Real
Estate Investments
Unit

4
LEARNING OBJECTIVES
After successfully completing this unit, you will be able to
●● calculate income subject to tax,
●● calculate income tax rates, and
●● describe tax shelter opportunities for real estate investors.

active income depreciation pyramiding

alternative minimum tax (AMT) exchange realized gain
boot installment factor recognized gain
capital gains income passive income taxable income
deferred exchange portfolio income tax shelter

INTRODUCTION
This unit examines the important income tax considerations for real estate investors,
whose handling of various tax alternatives has a direct effect on the profitability of their
investments. On one hand, the rents from investment property or the profits from the sale
of real estate increase the owner’s taxable income. On the other hand, operating expenses,
depreciation, refinancing, installment sales, and exchanging can all provide the investor
with a shelter for this income and profits. In addition, an appropriate management strat-
egy can develop a tax shelter for some of an investor’s income from other sources.

62

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 Unit 4: Income Taxes and Real Estate Investments 63

INCOME SUBJECT TO TAX

For federal income tax purposes, there are four categories of real property: residential,
investment, trade or business, and dealer. Each class of property has its own unique set of
tax rules. Also, since the Tax Reform Act of 1986, the Internal Revenue Service has further
separated income into three categories: active, portfolio, and passive.

Active Income
All monies earned in the normal course of working or conducting a trade or business
are identified as active income. The bulk of active income is derived from wages, salaries,
commissions, and annual operating profits from operating nonpassive businesses. Other
earnings also included in this category are tips, prizes, awards, alimony, gambling win-
nings, jury duty fees, and so on. Dealers in real property generate active income. Real
estate used in a trade or business may generate active income depending on facts and
circumstances. Investments in real estate may generate active income only if the investor
meets the definition of a real estate professional (when more than 50% of the taxpayer’s
personal services during the year are performed in real estate businesses and when more
than 750 hours of services in real property businesses are performed during the year).
A taxpayer who materially participates in a trade or business on a regular, continuous,
and substantial basis is defined as being active. A tax loss generated by an active trade or
business may be used to offset active income, such as salary. All real estate rental activity
is considered passive, no matter how involved the owners are, except corporation-owned
rentals and the operation of a hotel, motel, or inn, which are considered active.

Portfolio Income
Portfolio income includes interest, dividends, royalties, and annuity income, as well
as gains or losses from the sale or exchange of portfolio and certain investment assets.
Portfolio income is reduced by deductible expenses directly allocated to such income.
Portfolio activity of concern to real estate investors includes real estate investment
trust dividends, income from a real estate mortgage investment conduit, and certain gains
on investment real estate property, neither of which can be sheltered by passive losses.

Passive Income
Passive activities are trades or businesses in which a taxpayer does not materially par-
ticipate; that is, all activities carried on for a profit except an active trade or business or
portfolio activity.
Losses from passive trade or business activities each year may be used to offset income
from other passive activities for the year but cannot offset other active income or portfolio
income. Unused losses may be carried forward.
This passive income rule applies to individuals, estates, trusts, personal service corpo-
rations, partnerships, and S corporations. It does not apply to regular corporation-owned
real estate and equipment. Limited partnerships are intrinsically passive because limited
partners do not participate in management.
This provision attempts to match income with expenses and eliminates, to a large
degree, the tax sheltering aspects of real estate investments.

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 64 Essentials of Real Estate Investment Eleventh Edition

The $25,000 exception.  The single exception to the strict classification of real estate
rental activities as passive rather than active permits an individual taxpayer to use up to
$25,000 of real estate losses to offset other income—active or portfolio. However, the
investor must actively participate in the rental activity by engaging in management deci-
sions and maintaining or arranging for maintenance of the property. The taxpayer must
own more than 10% of the investment to qualify for this exception.
The $25,000 allowance will be reduced by 50% of the amount by which the taxpay-
er’s adjusted gross income (AGI) exceeds $100,000 ($200,000 for low-income housing).
The AGI is the total of all sources of income, each adjusted by its own allowable deduc-
tions, and is found on the last line of the first page of the IRS’s Form 1040, Individual
Income Tax Return. Thus, $125,000 AGI reduces the $25,000 allowance to $12,500, and
$150,000 AGI reduces it to zero, even though the taxpayer qualifies in every other manner.
Figure 4.1: Summary of Income Definitions summarizes the income definitions. All
expenses allocable to individual activities are deductible in that column only. No excess
losses in any one activity may be used to shelter income from other activities, except as to
the $25,000 rule and the $3,000 annual excess capital loss carryover.

FIGURE 4.1  Summary of Income Definitions

Active Income Passive Income Portfolio Income

Wages, salaries, profits from Profits from rental operations, limited Interest, dividends, royalties, annuities,
ownership of trade or business and partnerships, hobbies gains from sale or exchange of
operations of motels and hotels portfolio assets

Capital Gains Income

Monies earned as profits on investments made outside the ordinary course of work
and business are identified as capital gains income. Such income includes profits made
on the sale of real property, stocks, equipment, and other assets not held for regular busi-
ness purposes. In other words, noninventory assets produce capital gains income when
sold for a profit. This category also includes property held for the production of income,
such as apartment buildings and machinery in a plant, but specifically excludes all prop-
erty held as inventory stock for resale to customers. Capital gains profits are the difference
between the realized selling price of the property and its adjusted basis.
The realized selling price is most often the contract sales price (the actual price paid
on the sale of the property) less the allowed costs of sale such as:
●● Real estate commissions
●● Accountants’ fees
●● Settlement charges
●● Appraisal fees
●● Escrow fees
●● Document preparation
●● Surveys
●● Attorneys’ fees
●● Points paid by the seller to buyer’s lender

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 Unit 4: Income Taxes and Real Estate Investments 65

●● Closing fees
●● Advertising
●● Title insurance
●● Recording fees
●● Pest inspection
The adjusted basis of the property begins with the basis, which depends on the
method of acquisition. The three most common examples are as follows:
●● If the property was purchased, the basis is the purchase price.
●● If the property was inherited, the basis is the market value at the time of death.
●● If the property was received as a gift, the basis is simply the same as the giftor’s basis.
Once the basis is determined, certain adjustments (additions to and subtractions
from) are made to the basis over time. The most common of these adjustments include
the following:
●● Add the costs of purchase, which are very similar to the above-listed costs of sale
●● Add the cost of improvements to the property
●● Subtract depreciation on the improvements (land cannot be depreciated)
●● Subtract any casualty losses that are not reimbursed by insurance
●● Subtract any part of the property that has been sold
Consequently, the capital gains calculation is as follows:
1. Contract sales price less allowed costs of sale equals the realized selling price.
2. The basis plus allowed costs of purchase and improvements less depreciation, casualty
losses, and any part sold equals the adjusted basis.
3. Realized selling price less the adjusted basis equals the capital gain (or loss).

Capital Gains Taxes

Capital gains are taxed at a different rate than ordinary income. For capital gains, the
amount an investor is taxed depends upon both the investor’s tax bracket and the amount
of time the investment was held before being sold. If the asset is held for 12 months or
less, the gains are taxed at the taxpayer’s ordinary income tax rate. However, if the asset
was held for more than 12 months, the tax rate is 0% for the 10–15% brackets, 15% for
the 25–35% brackets, and 20% for the 39.6% bracket.
When the taxable gain or loss resulting from the sale of an asset is calculated, its cost
basis is subtracted from the amount realized on the sale. The cost basis is equal to the
purchase price, adjusted for factors such as fees paid (i.e., broker fees) and depreciation.

Estate and Gift Taxes

For 2015, the annual gift tax exclusion is $14,000 per person, per donee. This amount
changes from year to year as the federally imposed index (which is tied to inflation index-
ing) is applied. The nontaxable estate exclusion and the gift lifetime exclusion are $5.43
million for 2015 (up from $5.34 million in 2014).

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 66 Essentials of Real Estate Investment Eleventh Edition

INCOME TAX RATES

Taxes are imposed only on taxable income, which is the net amount remaining
after all allowable deductions and adjustments have been made from the gross amount of
income earned in a specific year. The tax rates are incremental; that is, all earnings listed
under a specified rate are taxed at that rate, whereas earnings over the stipulated amount
are taxed at the next rate, and so on.
Remember that corporate income is subject to double taxation, as described in Unit
2—once as corporate earnings and again as dividends distributed to shareholders. To
avoid this double tax, realty investments may be held by individuals as an S corporation
or in a trust.

Alternative Minimum Tax

The alternative minimum tax (AMT) is a special levy on investors and corporations
that take so many deductions and credits that they would pay little or no tax.
To calculate the AMT, follow these five steps:
1. Determine regular taxable income in accordance with current IRS regulations.
2. Add the tax preference items designated by law, such as excess accelerated deprecia-
tion over straight-line rates, defined excess passive losses, and interest received on tax-
exempt bonds issued for nongovernmental projects.
3. Deduct $37,225 for married couples filing separately, $22,500 for estates and trusts,
$48,450 for singles or heads of household, $74,450 for joint filers, and $40,000 for
corporations.
4. If the taxpayer’s alternative minimum taxable income exceeds $112,500 for single
individuals, $150,000 taxable income for joint filers and corporations, or $75,000
for married filing jointly and estates or trusts, then the deductions must be reduced
by 25% of the excess income until phased out. The exemption is totally phased out at
$310,000 for corporations, on a joint income of over $447,800, single $306,300, or
$223,900 married filing separately, and $165,000 for trusts.
5. Finally, the AMT rate is applied: 26% up to $175,000 ($87,500 for married persons
filing separately) and 28% on any excess AMT income. The taxpayer must pay the
higher of the regular tax amount or the alternative minimum tax amount. For corpo-
rations, the AMT rate is 20% of the AMT amount.

REAL ESTATE INVESTMENTS AS TAX SHELTERS FOR ACTIVE

INCOME
Real estate investments are defined as tax shelters where the operating costs, mort-
gage interest, and allowable depreciation are deducted from gross income to derive the net
income that is subject to tax.

Operating Costs and Interest Expenses

Investors in income-producing real property are allowed to deduct all operating
expenses and interest paid on property loans from the investment’s gross income. Every
real estate investment incurs operating expenses in one form or another and to varying

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 Unit 4: Income Taxes and Real Estate Investments 67

degrees. Vacant unimproved land is subject to property taxes; improved property develops
a multitude of operating costs, including property and sales taxes, insurance premiums,
maintenance charges, management fees, bookkeeping, advertising, pest control, and snow
removal. Any investment purchased with a loan also incurs interest expenses.
These and other charges are all deductible from the gross annual income when deter-
mining the net income, which is subject to tax at the owner’s rate. In addition to these
operating and interest expenses, improved income property may enjoy another deduc-
tion, depreciation of the improvements.

Depreciation
Appraisers describe depreciation as a loss in value from any cause. This loss can result
from a physical wearing out or from functional and economic obsolescence. The appraiser
attempts to measure this loss in value for a particular property.
On the other hand, depreciation from an accounting viewpoint is a recovery of
investment costs and makes no effort to reflect any real loss in the property value. It is a
theoretical loss of value for tax purposes. The following schedule provides the tax depre-
ciation schedule that has been allowed by the IRS.
●● Residential rental properties placed in service after January 1, 1987: 27.5 years
straight-line (3.63% per year)
●● Nonresidential real estate: 39 years straight-line (2.564% per year)
●● Autos and light trucks: Five-year write-off, 200% declining balance allowed
●● Personal property and manufacturing equipment: Seven-year write-off, 200% declin-
ing balance allowed
●● Land improvements (sidewalks, for example): 15-year write-off, 150% declining bal-
ance allowed
●● Rehabilitation tax credit for nonhistoric structures placed in service before 1936:
10%
●● Rehabilitation tax credit for certified historic structures: 20%

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 68 Essentials of Real Estate Investment Eleventh Edition

■■ FOR EXAMPLE  To illustrate how real estate investments act as tax shelters, con-
sider the following analysis:

$50,000 Gross annual income

–20,000 Annual operating expenses
30,000 Cash flow before debt service
–25,000 Interest paid on loan (limited to investment income)
5,000 Cash flow before depreciation
–10,000 Depreciation allowance
(5,000) Net paper loss

The gross annual income reflects income from all of the property’s sources, such as rents,
vending machines, and laundry.The operating costs include property taxes, insurance pre-
miums, maintenance, utilities, and management. The $30,000 cash flow is the net operat-
ing income (NOI) and is considered profit. This profit is sheltered from income tax by
allowable interest expenses and depreciation deductions. Thus, this investment generates
a $5,000 passive loss. This loss can be used to offset the owner’s other passive profits or,
if the owner qualifies, it can reduce other active or portfolio income accordingly, saving
tax dollars.

Note that this example does not include an amount for reserves for replacements in the
operating costs. Many prudent investors allocate a portion of the property’s income into
a reserve account each year toward future major repairs or replacements.These reserves
are not deductible operating expenses until they are actually spent.

Component depreciation.  Component depreciation is a method of depreciation in

which the individual parts of an asset are depreciated separately and not as a whole part
of the unit. For example, the plumbing, heating, and electrical systems in a building
could be depreciated separately from the structural part of the building because they have
shorter economic lives than the building itself. Prior to 1986, component depreciation
was a very popular method of maximizing depreciation allowances but was eliminated by
the Tax Reform Act of 1986.
However, this law applies only to IRS Section 1250, Real Property, not to Section
1245, Personal Property. This distinction allows a taxpayer to determine whether an item,
even if it otherwise appears to be a part of the real property, is in and of itself tangible
personal property for depreciation purposes. The art of separating out these components
is called cost segregation.
As guidelines for the definition of tangible personal property, the tax court in Whiteco
Industries Inc. v. Commissioner of IRS, 65 T.C.664 (1975) enumerated six factors to
consider:
1. Is the property capable of being moved or has it in fact been moved?
2. Is the property designed or constructed to remain permanently in place?
3. Do the circumstances show that the property may or will have to be moved?
4. Is the property readily movable?
5. How much damage will the property sustain upon its removal?
6. How is the property affixed to the land?

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 Unit 4: Income Taxes and Real Estate Investments 69

Thus, if the property satisfies the personal property quality under most, if not all, of
these guidelines, it may be eligible for a short-term recovery time period.
The potential applications of component depreciation include the following:
●● Restaurants and hotels that include significant machinery, fixtures, and specialized
food storage and handling facilities that might be considered separate from the
building
●● Office buildings where improvements can be constructed to be removable
●● Computer rooms and trading floors that are fitted with specialized telecommunica-
tions equipment, electrical service, and enhanced heating, ventilation, and air-condi-
tioning equipment
For more information regarding tax treatment of residential rental property, see IRS
Publication 527.

REAL ESTATE INVESTMENTS AS TAX SHELTERS FOR CAPITAL

GAINS
With the elimination in 1986 of preferred treatment of capital gains profits and accel-
erated depreciation allowances, real estate investments lost much of their glamour as tax
shelters. However, the tax laws have preserved other sheltering aspects, including tax-free
refinancing, pyramiding through refinancing, special exemptions for profits made from
the sale of principal residences, installment-sale deferments, exchanges, and inheritance
tax exemptions.

Tax-Free Refinancing
Refinancing involves the securing of a new loan to replace an old loan. Logically, the
new loan should be sufficient not only to satisfy the balance of the existing loan but also
to pay all of the placement costs involved and generate new cash the borrower can use
for additional investments. Any money acquired by refinancing is not subject to tax, even
if these funds exceed the original purchase price of the specific property. This money is
considered borrowed money and, as such, is not taxable.
In this regard, a distinction should be drawn between two types of gains: realized
gain is the actual profit derived from a transaction, such as the money received from
refinancing, and recognized gain is that portion of the profit subject to tax. In the case
of refinancing, a taxable capital gains income from this transaction exists only when the
realized gain becomes recognized gain upon the sale of the property. In the meantime,
property can be financed and refinanced repeatedly over time to generate tax-free cash
that can be invested and reinvested for additional profits.

Pyramiding through Refinancing

One way to acquire a substantial amount of real estate is to periodically refinance
those properties already owned and then use the proceeds to purchase new properties.
This procedure is pyramiding through refinancing.
Unlike pyramiding through selling (where an investor purchases a property, improves
it for resale at a higher price, and then purchases additional properties with gains from
the sale), pyramiding through refinancing is based on retaining all properties acquired.

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 70 Essentials of Real Estate Investment Eleventh Edition

By not selling, the investor is constantly increasing the refinancing base while avoiding
capital gains taxes.
Pyramiding through refinancing begins with the purchase of one property. If more
than one property can be purchased to start the plan, then the refinancing base will be
enhanced at the outset. The type of property to be purchased should be improved income
property that has the ability to generate at least enough cash flow to cover all operating
costs plus mortgage payments.
It is in the best interests of the investor to purchase better properties in stable or grow-
ing areas. An older property in a declining neighborhood would make a poor investment
with which to pyramid through refinancing. Rents and values of such buildings might
actually decrease and thus destroy the refinancing cycle.
With the appropriate application of deductible allowances, most, if not all, of the
net income earned during the years of ownership could be sheltered, while capital gains
taxes could be avoided through the refinancing process. The estate could then be left to
the investor’s heirs, at the stepped-up values determined at the date of death, without the
investor ever having to pay capital gains tax on any profits derived from ownership of this
property.
Although pyramiding to avoid capital gains taxes is a practical strategy, sometimes the
sale of a property is unavoidable. As indicated, any gains made in such a sale are subject
to income tax.
Principal Residence.  The income tax laws provide a special exclusion on the profits
earned from the sale of private residences. Since 1997, taxpayers have been allowed to
exclude from taxes up to $250,000 of the gain realized on the sale or exchange of a princi-
pal residence, and up to $500,000 for a married couple filing a joint return. To be eligible
to claim the exclusion, the residence must have been owned and used as the taxpayer’s
principal residence for a combined period of at least two years out of the five years prior to
the sale or exchange. The full exclusion is available only if the owner did not use the exclu-
sion on a prior home sale within a two-year period ending on the sale date. This exclusion
is also valid for properties owned in a living or revocable trust, as stated in a private letter
ruling by the IRS (PLR 199912026).
If the sale of the principal residence is considered an “ involuntary conversion,” such
as a health-related move or a move necessitated due to a divorce, this benefit may be pro-
rated. Thus, if a newly divorced couple has occupied the home as their principal residence
for just one out of the last five years, then a partial exclusion of one-half of the capital
gain is tax free.

Installment-Sale Deferment
Capital gains tax can be postponed by the application of an installment-sale plan,
available to both residential and commercial property owners, provided the outstanding
installment obligation at the end of the tax year is $5 million or less. For higher install-
ment obligations, special rules prevail. In general, dealers in real estate may not sell under
installment deferment but must pay any tax on gains at ordinary income rates at the time
of sale. Dealers are persons or companies who have real estate as their stock-in-trade (for
example, subdividers who sell lots or builders/developers who sell houses).
A gain on an installment sale is computed in the same manner as the net capital gain
on a cash sale: gross sale price minus costs of sale minus adjusted book basis equals net

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 Unit 4: Income Taxes and Real Estate Investments 71

capital gain. However, under an installment sale, the seller can elect either to pay the total
tax due in the year of the sale or to spread the tax obligation over the length of the install-
ment contract.
The installment-sale provision in the tax law is intended as a relief provision for own-
ers who can sell their property only by agreeing to accept payments in installments. A
seller might receive less cash in the year of the sale than the tax required on the total gain.
Therefore, the law allows tax payments to be made as installment payments are received.
For Example Consider a property sold for $100,000 net. On a noninstallment sale,
the buyer pays $40,000 cash and assumes an existing loan balance of $60,000. The
adjusted book basis on the date of the sale is $80,000. Given these facts, a cash transac-
tion would result in a taxpayer paying $3,000 tax on this property in the year of the sale
($100,000 – $80,000 = $20,000 capital gain × 15% tax rate = $3,000).
An installment sale can be designed to postpone portions of the seller’s tax liability.
For example, the sale can be structured to require $8,000 as a cash down payment and
$32,000 as a junior loan back to the seller. The buyer then assumes the $60,000 existing
loan. The installment contract is payable in four equal annual principal payments plus
interest at an agreed rate.
Computation of the seller’s tax liability under the installment contract first requires
a determination of the installment factor (gain divided by equity) to identify what por-
tion of the principal payment is profit and what portion is return of the equity buildup.
In this case, the seller’s gain is $20,000 ($100,000 – $80,000), and the equity is $40,000
($100,000 – $60,000). Thus, the installment factor is 50% ($20,000 gain ÷ $40,000
equity = 0.5).
The seller’s annual tax liability is $600 ($8,000 × 0.5 = $4,000 × 0.15 = $600), for a
total of $3,000 over five years ($600 × 5 = $3,000). This is exactly the same total tax that
is paid if the property were sold for cash. The installment treatment allows the seller to pay
this sum over the term of the contract as the principal is received. All interest received by
the seller is declared as portfolio income.
The installment plan allows a seller to pay tax in amounts proportional to the gain
collected each year. Thus, a seller whose tax bracket decreases over the term of an install-
ment contract will pay less tax than if the seller had elected to pay the full tax in the year
of the sale. This arrangement is particularly advantageous to a seller nearing retirement
age who will enter a lower tax bracket during the term of the installment contract. On the
other hand, there is the possibility that a seller’s tax bracket could rise over the installment
term, which would lead to the payment of more tax. Consequently, a seller is allowed to
pay the full amount of tax due on a capital gain any time it becomes expedient during the
installment-contract period.

Exchanges
An alternative method for tax-deferred pyramiding can also be accomplished by
upside trading or the property exchange technique. Section 1031 of the Internal Revenue
Code provides for the recognition of capital gain to be postponed under the following
conditions:
●● Properties to be exchanged must be held for productive use in a trade or business, or
for investment.

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 72 Essentials of Real Estate Investment Eleventh Edition

●● Properties to be exchanged must be of “ like kind” to each other: their nature or

character must be similar.
●● Properties must actually be exchanged.
Property held for productive use in a trade or business includes such things as
machinery, automobiles, factories, and rental apartments. Property held for investment
may include such items as vacant land and antiques. “Like kind” includes a machine
for a machine or real estate for real estate. Improvements on the land are considered to
be differences in the quality of the real estate, not in the type. Thus, a vacant lot can be
exchanged for a store property, or an industrial property may be exchanged for a high-rise
office building. Often, unlike property (called boot) is included in a real estate exchange
and must be accounted for separately. Boot may include cash, jewelry, or other personal
property. Since the value of the real properties being exchanged is often different, boot is
used to equalize the values.
There are at least six basic mathematical computations involved in the exchange
process:
1. Balancing the equities
2. Deriving realized gains
3. Deriving recognized gains
4. Determining tax impacts
5. Re-establishing book basis
6. Allocating the new basis
These computations are illustrated by the simple two-party exchange recorded in
Figure 4.2: Two-Party Exchange.

FIGURE 4.2  Two-Party Exchange

Property A Property B
STEP 1. Balancing the Equities
$100,000 Exchange price $150,000
– 60,000 Existing mortgage – 80,000
40,000 Owners’ equity $70,000
+ 30,000 Cash required
$70,000
STEP 2. Deriving Realized Gains
$100,000 Exchange price $150,000
– 70,000 Adjusted basis – 90,000
$30,000 Realized gain $60,000
STEP 3. Deriving Recognized Gains
(Recognized gain equals the sum of unlike properties.)
0 Cash required $30,000
0 Boot 0
0 Mortgage relief + 20,000
0 Recognized gain $50,000

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 Unit 4: Income Taxes and Real Estate Investments 73

FIGURE 4.2  Two-Party Exchange (Continued)

Property A Property B
STEP 4. Determining Tax Impacts
(Taxable income is the realized gain or the recognized gain, whichever is less.)
$30,000 Realized gain $60,000
0 Recognized gain 50,000
0 Taxable gain $50,000
(Note that Property B will pay income tax on $50,000. Property A will pay no tax.)
STEP 5. Re-establishing Book Basis
$70,000 Old basis $90,000
+ 80,000 New mortgage +60,000
+ 30,000 Cash and boot paid +0
+0 Recognized gain + 50,000
$180,000 Total $200,000
LESS
$60,000 Old mortgage $80,000
+0 Cash and boot received + 30,000
$60,000 Total $110,000
$120,000 New basis $90,000
STEP 6. Allocating the New Basis
(Each party will decide which portions of the new basis to allocate to land and to
improvements to establish new depreciation schedules.)
A two-party, like-kind property exchange will not qualify if
●● the parties are related,
●● either party sells the property within two years of the exchange, or
●● a property in the United States is exchanged for a property outside this country.
For purposes of this regulation, related persons are immediate family members, lineal
descendants, corporations in which the exchangers own more than 50% of the stock, two
corporations that are members of the same holding group, and a grantor or fiduciary of
a trust.
The two-year disposition rule is waived in the event of death or involuntary conversion.
It is not often that each of two potential exchangers owns property that is desired by
the other. More frequently, exchanges involve three or more property owners. To effec-
tively arrange these multiparty exchanges, the element of timing becomes an important
aspect to be considered. The process requires two contracts: one between the first two
parties, structuring the exchange, and a second contract in which the third party buys the
unwanted property. Each contract is conditional upon the closing of the other, and they
must be closed simultaneously.
Deferred exchange.  A federal court decision in 1979, Starker v. United States (602
F.2D 1341 (9th Circuit)), introduced the deferred exchange to expand the tax-free
exchange provisions in the tax law. Section 1031 of the tax code was amended to include
the deferred exchange, which, for the first time, allowed traders to set up an exchange for
properties not yet available but to be found within certain time constraints.

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 74 Essentials of Real Estate Investment Eleventh Edition

Tax-deferred exchanges of like-kind real estate became popular when Congress

amended the tax code to allow time-deferred exchanges. Now tax-free “Starker exchanges”
can be achieved, provided two time limits are met.
1. The property to be received by A must be identified no later than 45 days following
the date that A transfers property to B.
2. A must receive the exchange property from B no later than the earlier of (a) 180 days
after A transfers to B or (b) the due date of A ’s tax return for the year in which the
property is transferred to B.
Neither of these time periods can be extended; if they are not met, the exchange
becomes a fully taxable sale.
One suggested solution to the relatively short time periods allowed in the delayed
exchange is the reverse exchange developed by Louis Weller of Deloitte LLP real estate tax
service of Los Angeles. A reverse exchange involves the acquisition by a property owner
of a replacement property before the existing property is sold. An accommodating third-
party buyer acquires the replacement property and holds it until the exchanger sells the
relinquished property, at which time a conventional exchange is complete.
The IRS provides a safe harbor for reverse exchange participants, answering such
questions as whether an exchanger can fund the accommodating party’s purchase or hold
a fixed-price option on the replacement property.

Distribution to Heirs
The ultimate capital gains tax shelter is to maintain ownership of investment prop-
erty until death. At death, the property is appraised for inheritance tax purposes, and the
deceased’s heirs acquire title, with the new book value established at the time of death.
Although capital gains taxes can be avoided, certain estates are subject to the imposi-
tion of inheritance taxes. With the appropriate application of tax-free gift giving, even
these taxes can be avoided.
Estate tax.  The federal tax laws established exemptions for the values of estates subject
to federal estate taxes. As of 2015, this exemption is $5.43 million per person. In addi-
tion, many states have estate tax. These state rates vary and should be reviewed in con-
junction with investment planning.
Gift tax.  With proper planning, investors may be able to distribute their entire estates
by using tax-free gifts to avoid inheritance taxes.
The law provided gift exemptions of up to $14,000 for each donor per donee in
2015. Thus, a married couple could gift $28,000 tax free to each heir. The lifetime gift tax
exemption is $5.43 million. These exemptions are tied to inflation indexes and typically
change annually.

SUMMARY
Active income is derived from wages, salaries, commissions, interest, dividends, and
profits earned from year-to-year activities of businesses, in addition to other earnings.
Ordinary income in excess of allowable deductions is taxed at the federal and state levels
at progressive rates established by Congress and state legislatures.

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 Unit 4: Income Taxes and Real Estate Investments 75

Active income is sheltered to the extent of such allowable deductions as medical care,
state taxes, moving costs, and charitable donations, if itemized. The net income from real
estate investments is sheltered by operating expenses, interest charges, and depreciation
deductions. Operating expenses include management and maintenance fees plus charges
for utilities, advertising, property taxes, insurance premiums, bookkeeping services, and
similar costs. Interest charges are deducted from a property’s gross earnings before deriv-
ing the taxable income.
Current depreciation allowances are a 27.5-year straight-line rate for residential
income property and a 39-year straight-line rate for nonresidential property.
Capital gains income is composed of profits (or losses) on noninventory assets held as
investments for relatively long periods of time and then sold.
Losses from active trades or businesses can be used to shelter earnings from these
activities, while losses from passive activities are limited to sheltering earnings from pas-
sive activities.
All non-personal service real estate rentals are considered passive activities unless
owned by real estate professionals, and any losses are limited to the investment’s income.
The exception is a $25,000 excess loss carryover given those individuals who earn less than
$100,000 adjustable gross income and take a clearly defined active participation in a real
estate investment in which they own 10% or more by value.
Investors often capitalize on their equity by refinancing and securing tax-free dollars
from the new mortgage proceeds. Property equities grow through inflation and as a con-
sequence of the regular repayment of existing mortgages. Funds secured from refinancing
are not subject to income tax, even though these monies may exceed the original price
paid for the property. Thus, investors may refinance regularly and secure new cash assets
that enable them to acquire additional properties and expand their investment portfolios.
Taxes on profits from real estate capital gains can be deferred through installment
sales or the exchange process. When trading like properties, owners can carry their old
book values over to the new properties, effectively deferring taxes on any gains. Depend-
ing on the terms of the transaction, an up-trader can usually shelter the entire gain, while
the down-trader will have to pay taxes on the portion of the equity recovered.

DISCUSSION TOPICS
1. Check with a local real estate broker to review the benefits of a Starker exchange.
2. Secure a completed sample income tax form from a local accountant to examine the
actual tax impact of a Starker exchange.

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 76 Essentials of Real Estate Investment Eleventh Edition

UNIT EXAM 6. Under current tax law, long-term capital gains are
a. limited to $25,000.
1. By definition, portfolio income includes all of the
b. taxed at 15% maximum.
following EXCEPT
c. eliminated completely.
a. stock dividends.
d. applied only to commercial property.
b. oil and mineral royalties.
c. investment sales profits. 7. The losses sustained when selling an investment
d. savings account interest. property must first be deducted from any capital
gains made in the year, with any excess losses
2. Active income consists of earnings from all of the
a. allocated to shelter active income.
following EXCEPT
b. marked off the books.
a. wages.
c. carried forward to shelter any future capital
b. business profits.
gains at the rate of $3,000 per year.
c. stock dividends.
d. deducted as an operating expense.
d. capital gains.
8. Passive income is derived from which of the
3. On improved income property, all of the follow-
following?
ing are allowable expense deductions EXCEPT
a. Interest on savings
a. interest charges.
b. Dividends from stocks
b. principal payments.
c. Income from rentals
c. maintenance costs.
d. Royalties from oil leases
d. depreciation.
9. A commercial property was purchased for
4. When investment property is sold for less than its
$100,000 with 20% allocated to the land. At a
remaining book value, its depreciation was
straight-line depreciation rate of 2.564% per year,
a. approved by the IRS.
what is the adjusted basis of this property at the
b. underestimated.
end of the 10th year?
c. overestimated.
a. $2,051
d. estimated correctly.
b. $20,510
5. When an investment property purchased for c. $59,490
$150,000 is refinanced with a new loan for d. $79,488
$175,000, the $25,000 is
10. Which of the following is the installment factor
a. taxed as portfolio income.
for a property sold for $100,000 net subject to a
b. taxed as active income.
loan balance of exactly $40,000 with an adjusted
c. taxed as passive income.
basis of $60,000?
d. not taxed until the property is sold.
a. 33⅓%
b. 66⅔%
c. 100%
d. 150%

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 Financial Analysis of
Real Estate Investments
Unit

5
LEARNING OBJECTIVES
After successfully completing this unit, you will be able to
●● use interest, capitalization rates, and values to perform financial analyses,
●● understand profitability measures, and
●● appreciate the benefits and limitations of financial analysis software programs.

amortization discount rate opportunity cost

annual percentage rate (APR) effective gross income (EGI) present worth
annuity fixed costs reserves
before-tax cash flow fixed expenses return on investment (ROI)
breakeven point interest factor (IF) scheduled gross income (SGI)
capitalization rate internal rate of return (IRR) time value of money
compound interest net operating income (NOI) variable costs
debt service nominal interest rate variable expenses
discounted cash flow operating expenses

INTRODUCTION
After reviewing the market in which an investment is contemplated together with
the physical attributes of the property itself, an investor should undertake a thorough
financial analysis to attempt to estimate the investment’s value and potential profitability.
Although such a financial analysis appears to be a relatively simple matter of comparing
income with expenses to derive a net cash flow and a return on the investment, in reality
it requires a dedication to honestly examine all of the facts before deciding to purchase
the property.

77

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 78 Essentials of Real Estate Investment Eleventh Edition

FINANCIAL ANALYSIS
The most difficult part of a financial analysis is the gathering of complete and accurate
data pertinent to the project. No matter how sophisticated and complex, no analysis is
valid without clear and accurate inputs. Owners typically understate expenses and over-
state occupancy. Few include management fees or reserves for replacements, while others
brag about 100% occupancy when in reality their rents are too low. Deferred mainte-
nance is common.
Conservative investors recognize that due to credit losses and intervals between ten-
ants for normal maintenance, 95% occupancy is full occupancy. Also, depending on the
age and condition of the property, some portion of the gross income should actually be
set aside for reserves for replacement of major building components such as roofs, boilers,
and so on. Many investors have faced financial ruin because there were no reserves avail-
able for such expenses. A reasonable amount must also be allocated to management, no
matter who actually manages the property.
A financial analysis requires a diligent effort to gather real information about the
property in order to come as close as possible to an accurate opinion of the investment’s
potential.

Interest
An understanding of the principles of interest as they apply to real estate investment
is basic to any financial feasibility study for income property. Interest may be described
as rent paid for the use of money. Just as rent is paid for the use of an apartment, office,
or store, so interest, together with principal, is paid on a real estate mortgage as a condi-
tion of the terms of the loan agreement. The investor borrows (leases) money at a certain
interest rate (rent) for a specified time period, during which the amount borrowed is
systematically repaid (amortized).
The amount of rent that a landlord can charge for the use of property is a function of
the rental market for that particular type of real estate. Similarly, the rate of interest that
a lender can charge is a function of the money market as it affects that particular type
of loan. A rational borrower-investor will not pay a lender more interest than the low-
est interest rate available on a specific loan at a particular time. Unlike most credit card
account interest rates, which are based on monthly rates, real estate loans are established
at annual rates.
Simple interest.  Most loans made on real estate are established at a simple rate of inter-
est. Simple interest is paid only for the amount of money (principal) that is still owed as of
the date of computation; that is, interest is not paid on the money that has already been
repaid to the lender.
The formula for computing the amount of simple interest is as follows:
I = PRT
I = interest
P = principal
R = rate
T = time

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 Unit 5: Financial Analysis of Real Estate Investments 79

■■ FOR EXAMPLE  Using this formula, the interest on a $1,200 loan to be repaid in
one year at a 10% annual rate is $120:

I = PRT
I = $1,200 × 0.10 × 1
I = $120

If this $1,200 loan were to be repaid in 12 equal monthly payments of $100 plus simple
interest at the rate of 10% per annum, the interest portion of the first payment is com-
puted as follows:

I = PRT
I = $1,200 × 0.10 × 1⁄12
I = $120 ÷ 12
I = $10

The total amount of the first month’s payment in this sample is $110 ($1,200 ÷ 12 = $100
+ $10 interest = $110). The second month’s payment is $109.16 ($1,100 × 0.10 ÷ 12 =
$9.16 + $100 = $109.16). The amount of the third month’s payment is $108.33 ($1,000
× 0.10 ÷ 12 = $8.33 + $100 = $108.33), and so on until the loan is repaid when the last
payment of $100.83 is made ($100 × 0.10 ÷ 12 = $0.83 + $100). This illustrates the fact
that simple interest is charged only on the remaining amount of principal owed and only
for the time that the amount is unpaid.

Amortization.  The payment schedule just described is an illustration of amortization

—the systematic repayment of a loan. Most real estate mortgages are established for 15 to
30 years and require a regular payment to be made either annually, semiannually, quar-
terly, or, more usually, on a monthly basis (see Figure 5.1: The Mortgage Amortization
Triangle and Figure 5.2: Mortgage Factor Chart).

FIGURE 5.1  The Mortgage Amortization Triangle

If you know what the monthly payment and interest rate are, you can easily track how much of each month’s payment
is being applied toward principal and how much is applied toward interest.
Begin in the lower-left box and follow the arrows to perform the calculations described in each box for each month’s
calculation.Your result will show how much of a given month’s mortgage payment goes to pay principal and what
portion pays interest on the loan to the lender. For example, if you wanted to see how much the loan principal would
be reduced after three months, you would go around the triangle three times.

Monthly Payment (– Month’s interest) =

Amount paid toward principal

Principal balance Annual interest rate Principal balance (– Amount paid toward
÷ 12 = Month’s interest principal) = New principal balance

For example, using the Mortgage Factor Chart in Figure 5.2: Mortgage Factor Chart, assume a 30-year mortgage loan
for $170,000 at a 4.25% annual interest rate and a monthly payment of $836.40 (170,000 ÷ 1,000 × 4.92 = $836.40).
You can see how the triangle can help you determine the amount of principal and interest in each payment for the first
two months of the loan.

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 80 Essentials of Real Estate Investment Eleventh Edition

FIGURE 5.1  The Mortgage Amortization Triangle (Continued)

The principal balance on the loan at the end of the second month (the beginning of the third month) is $169,530.53.
What is the principal balance on this loan at the end of the third month?

Monthly Payment (– Month’s interest) =

Amount paid toward principal

Month 1: $836.40 – $602.08 = $234.32

Month 2: $836.40 – $601.25 = $235.15

Principal balance Annual interest rate ÷ Principal balance (– Amount paid toward
12 = Month’s interest principal) = New principal balance

Month 1: $170,000.00 × 4.25% ÷ 12 = $602.08 Month 1: $170,000.00 – $234.32 = $169,765.68

Month 2: $169,765.68 × 4.25% ÷ 12 = $601.25 Month 2: $169,765.68 – $235.15 = $169,530.53

Solution
Step 1: $169,530.53 × 4.25% ÷ 12 = $ 600.42
Step 2: $836.40 – $600.42 = $ 235.98
Step 3: $169,530.53 – $235.98 = $ 169,294.55
Principal balance at the end of the third month is $169,294.55.

FIGURE 5.2  Mortgage Factor Chart

Rate Term 10 Years Term 15 Years Term 20 Years Term 25 Years Term 30 Years
3 9.66 6.91 5.55 4.74 4.22
3⅛ 9.71 6.97 5.61 4.81 4.28
3¼ 9.77 7.03 5.67 4.87 4.35
3⅜ 9.83 7.09 5.74 4.94 4.42
3½ 9.89 7.15 5.80 5.01 4.49
3⅝ 9.95 7.21 5.86 5.07 4.56
3¾ 10.01 7.27 5.93 5.14 4.63
3⅞ 10.07 7.33 5.99 5.21 4.70
4 10.13 7.40 6.06 5.28 4.78
4⅛ 10.19 7.46 6.13 5.35 4.85
4¼ 10.25 7.53 6.20 5.42 4.92
4⅜ 10.31 7.59 6.26 5.49 5.00
4½ 10.37 7.65 6.33 5.56 5.07
4⅝ 10.43 7.72 6.40 5.63 5.15
4¾ 10.49 7.78 6.47 5.71 5.22
4⅞ 10.55 7.85 6.54 5.78 5.30
5 10.61 7.91 6.60 5.85 5.37
5⅛ 10.67 7.98 6.67 5.92 5.45
5¼ 10.73 8.04 6.74 6.00 5.53
5⅜ 10.80 8.11 6.81 6.07 5.60
5½ 10.86 8.18 6.88 6.15 5.68

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 Unit 5: Financial Analysis of Real Estate Investments 81

FIGURE 5.2  Mortgage Factor Chart (Continued)

Rate Term 10 Years Term 15 Years Term 20 Years Term 25 Years Term 30 Years
5⅝ 10.92 8.24 6.95 6.22 5.76
5¾ 10.98 8.31 7.03 6.30 5.84
5⅞ 11.04 8.38 7.10 6.37 5.92
6 11.10 8.44 7.16 6.44 6.00
6⅛ 11.16 8.51 7.24 6.52 6.08
6¼ 11.23 8.57 7.31 6.60 6.16
6⅜ 11.29 8.64 7.38 6.67 6.24
6½ 11.35 8.71 7.46 6.75 6.32
6⅝ 11.42 8.78 7.53 6.83 6.40
6¾ 11.48 8.85 7.60 6.91 6.49
6⅞ 11.55 8.92 7.68 6.99 6.57
7 11.61 8.98 7.75 7.06 6.65
7⅛ 11.68 9.06 7.83 7.15 6.74
7½ 11.74 9.12 7.90 7.22 6.82
7⅜ 11.81 9.20 7.98 7.31 6.91
7½ 11.87 9.27 8.05 7.38 6.99
7⅝ 11.94 9.34 8.13 7.47 7.08
7¾ 12.00 9.41 8.20 7.55 7.16
7⅞ 12.07 9.48 8.29 7.64 7.25
8 12.14 9.56 8.37 7.72 7.34

Add-on interest.  Although the simple interest rate is used for most real estate loans,
some lenders occasionally employ an add-on interest rate. This technique involves the
computation of interest on the total amount of the loan for the entire time period. This
amount of interest is then added onto the principal owed for repayment over the term
of the loan before the monthly payments are calculated. Add-on interest has the effect of
almost doubling the simple interest rate. This form of interest computation is used for
some home improvement loans and junior liens created by private mortgage companies.

■■ FOR EXAMPLE  In the case of a $1,200 loan for one year at an interest rate of
10%, if the add-on method of computation is employed, first the total interest on $1,200
for a one-year period is derived at the rate stated in the loan agreement ($1,200 × 0.10 =
$120). Next, this amount is added to the total principal owed ($120 + $1,200 = $1,320).
Finally, this sum is divided by the number of required payments to arrive at $110 as the
monthly amount due ($1,320 ÷ 12 = $110).

In formula form, the add-on interest rate is calculated as follows:

A = 2IC ÷ P (n + 1)
A = add-on interest rate
I = number of installment payments per year
C = total loan charges including all interest over contract term
P = principal
n = total number of installment payments in contract

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 82 Essentials of Real Estate Investment Eleventh Edition

Substituting figures from the example, the add-on interest rate is computed as follows:

A = 2IC ÷ P(n + 1)
A = 2(12) ($120) ÷ $1,200(12 + 1)
A = $2,880 ÷ $15,600
A = 0.1846 or 18.46%

At add-on interest rates, the borrower pays a level $110 per month for 12 months until
the loan is satisfied. An inspection of this schedule reveals that although the first month’s
payment is a true reflection of the 10% per annum simple interest charge, the second and
subsequent months’ payments are not. The interest charges in these months do not stop
on the portion of the principal that has been repaid. The accuracy of this observation is
illustrated by examining the sixth payment of $110. The $100 principal portion of this
payment repays exactly half the total loan ($100 × 6 = $600), but the 10% portion still
reflects the interest charged on the entire $1,200. Thus, the 10% add-on interest rate is
really about 18%, as seen from the formula calculations.
Note that a more accurate method for calculating the add-on interest rate (yield) is to
analyze the internal rate of return (IRR) with the use of a financial calculator, as discussed
later in this unit.
Nominal and effective rates of interest.  The relationship between simple interest
and add-on interest should now be quite clear. At a simple rate of 10% interest, the
nominal interest rate (the rate contracted for) is the same as the annual percentage
rate (APR) —the actual rate paid by the borrower. However, add-on interest, which has
a nominal (contracted) rate of 10%, results in an actual (effective) rate of approximately
18%.
Even with simple interest loan agreements, the nominal rate may not always be the
effective rate. For example, when a borrower executes a new mortgage loan for $100,000
and has to pay a one-point fee ($1,000) plus $500 of other costs, only $98,500 will be
received at the closing. However, this borrower will still have to pay interest on the full
$100,000 contracted for, which raises the APR.
Compound interest.  Compound interest is interest paid on interest earned. Annual
interest is often compounded monthly or even daily (as offered by many banks and sav-
ings associations). Then the effective rate of interest earnings is slightly higher than the
nominal rate.
The concept of compounding forms a basis for many investment decisions. A savings
account at the current interest rate is a constant investment alternative, and this interest
rate constitutes a safe return on such funds. In other words, the compound interest earned
on a savings account is a safe and viable investment yield against which potential earnings
from other investment opportunities can be measured.
Within this framework, an investor will measure the risk of alternative investments,
assigning a required return to each alternative as a function of its specific risk. Thus, an
investment in an apartment project might require at least a 15% return, or yield, as a
function of a 5% safe rate plus a 10% risk rate.

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 Unit 5: Financial Analysis of Real Estate Investments 83

■■ FOR EXAMPLE  At the beginning of a year, if $1 is deposited in a savings account

at 10% interest, the account will have a $1.10 balance at the end of that year ($1.00 ×
0.10 = $0.10 + $1.00 = $1.10). If this new $1.10 balance is allowed to remain on deposit
and the interest rate continues at 10%, then the balance in the account at the end of the
second year will be $1.10 × 0.10 = $0.11 + $1.10 = $1.21, and so on.

Compound interest may be computed using the following formula:

CS = BD(1 + i)n
CS = compound sum
BD = beginning deposit
i = interest rate per period
n = number of periods

■■ FOR EXAMPLE  At the end of 10 years, the balance of the savings account with
$1,000 deposited at the beginning of the period at 10% interest, compounded annually, is
computed as follows:

CS = BD(1 + i)n
CS = $1,000(1 + 0.10)10
CS = $1,000(1.10)10
CS = $1,000(2.59374)
CS = $2,593.74

Compound worth of an annuity.  The effects of compound interest on a single deposit

provide the investor with a fundamental basis for investment comparison. However, an
owner of income property is more concerned with the compounding of a series of depos-
its, which would more closely resemble a property’s cash flow in terms of rents. Any series
of regular annual receipts or payments is termed an annuity.
The formula for calculating the future compound worth of an annuity deposited into
an interest-earning account at the end of each period is as follows:
CS = RD[(1 + i)n – 1 + (1 + i)n – 2 + ... + (1 + i)n – n]
CS = compound sum
RD = regular deposit
i = interest rate per period
n = number of periods

■■ FOR EXAMPLE  A regular deposit of $1 made at the end of each year for three
years at 10% annual compound interest will be worth $3.31 at the beginning of the third
year, as shown:

CS = $1[(1 + 0.10)3 – 1 + (1 + 0.10)3 – 2 + ... + (1 + 0.10)3 – 3]

CS = $1[(1.10)2 + (1.10)1 + 1]
CS = $1[(3.31)]
CS = $3.31
Using the same formula, compare the future value of a 10-year series of $100 annual
deposits made at the end of each year at 10% annual compound interest with a single
$1,000 deposit made at the beginning of the period.

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 84 Essentials of Real Estate Investment Eleventh Edition

The difference of $1,000 represents the annual compounding effect on the whole
$1,000 deposit during the entire period versus the systematic $100 deposited at the end
of each year.
The mathematical calculations to determine the compound worth of a single sum of
money or of an annuity involve the use of an interest factor (IF). In the example of the
compound sum of a single amount of $1,000 at 10% annual interest for 10 years, the
beginning deposit ($1,000) is multiplied by an IF of 2.5937. Similarly, in the example of
a $100 annual annuity for 10 years at 10% per year, the regular deposit ($100) is multi-
plied by an IF of 15.9372. Thus, the portion of the equation represented by (1 + i)n equals
the IF.

■■ FOR EXAMPLE  CS = $100[(1.10)9 = 2.3579]

+ (1.10)8 = 2.1435
+ (1.10)7 = 1.9487
+ (1.10)6 = 1.7715
+ (1.10)5 = 1.6105
+ (1.10)4 = 1.4641
+ (1.10)3 = 1.3310
+ (1.10)2 = 1.2100
+ (1.10)1 = 1.1000
+ (1.10)0 = 1.0000
Total 15.9372 at the beginning of tenth year
CS = $100(15.9372)
CS = $1,594 (rounded)
and
CS = BD(1 + i)n
CS = $1,000(1.10)10
CS = $1,000(2.5937)
CS = $2,594 (rounded)

These interest factors are a function of interest rates and time and can be derived for
any combination of these inputs. Figure 5.3: Future Worth at Annual Compound Interest
Rate of 10% represents the interest factors for the future worth of $1 and of an annuity
of $1, compounded at an annual rate of 10%.
In Figure 5.3: Future Worth at Annual Compound Interest Rate of 10%, note the
10-year IF of 2.5937 for the future worth of a single sum of $1 and the interest factor of
15.9372 for the future worth of an annuity of $1, both compounded annually at the rate
of 10%. These are the interest factors developed algebraically in the previous examples.
Most interest factors are available in tabular form; still, a student of investments should
be familiar with the derivations of the information in the tables as well as with the use of
the tables themselves.

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 Unit 5: Financial Analysis of Real Estate Investments 85

FIGURE 5.3  Future Worth at Annual Compound Interest Rate of 10%

Years Future Worth of $1 (Deposited Future Worth of Annuity of $1
Beginning Period) (Deposited End of Period)
1 1.1000 1.0000
2 1.2000 2.1000
3 1.3310 3.3100
4 1.4641 4.6410
5 1.6105 6.1051
6 1.7715 7.7156
7 1.9487 9.4871
8 2.1436 11.4358
9 2.3579 13.5794
10 2.5937 15.9372
15 4.1772 31.7724
20 6.7275 57.2749
25 10.8347 98.3470
30 17.4494 164.4940

Time Value of Money

From the previous examples of compound interest, it can be seen that money grows
in worth over time if it is employed in an earning situation. The amount of growth is a
function of the rate of interest, or yield, earned on the deposit or investment. By the same
logic, money not received until some future time must be worth less today. How much
less it is worth is also a function of yield coupled with time.
The time value of money is particularly significant for real estate investors whose
yields are a function of rents to be received in the future. A lease, after all, is a promise to
make a series of payments (annuities) called rent. Because these monies are not immedi-
ately available for reinvestment, they are worth less now than they will be when they are
received.
For example, at a yield rate of 10%, a dollar that will not be received for one year is
really worth only $0.90 today. If the dollar could be deposited today at 10% per annum,
it would be worth $1.10 at the end of the year. Waiting a year to receive the dollar pre-
cludes the opportunity to earn $0.10.
Thus, the $0.10 can be interpreted as the opportunity cost, or discount rate, which
diminishes the present worth of the subject dollar to be received at the end of the year
to $0.90.
Present worth of a dollar.  The present worth of a dollar, or its net present value
(NPV), is, in mathematical terms, the reciprocal of its compound worth. The formula for
its derivation is
 1 
 
PW = A 
(1+ i)n 
PW = present worth
A = amount
i = interest rate per period
n = number of periods

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 86 Essentials of Real Estate Investment Eleventh Edition

■■ FOR EXAMPLE  The present worth of $1 to be received 10 years from today at

a discount rate of 10% is computed as follows:
 
 1 
PW = $1  
(1.10)10 
 1 
PW = $1  
 2.5937 
PW = $0.3855 or $0.39 rounded

To verify that the present worth of $1 to be received in 10 years at a discount rate of 10%
is worth only 39 cents today, reverse the situation and place this latter sum of money into
a 10% annually compounding savings account and observe its growth to $1 in 10 years
($0.3855 × 2.5937 = $1; see Figure 5.3: Future Worth at Annual Compound Interest Rate
of 10%).

Present worth of an annuity.  Just as the present worth of $1 is the reciprocal of its
compound rate, so the present worth of an annuity is reciprocally related to its compound
formula. The present worth of an annuity in which the payment is to be received at the
end of each period is expressed as follows:
 1 1 1 
PWA = RA  + + ... + 
 (1 + i )n (1 + i )n−1 (1 + i )n−n 
 
PWA = present worth annuity
RA = regular amount
i = interest
n = number of periods

■■ FOR EXAMPLE  The present worth of $1 to be received at the end of each year
for three years at a discount rate of 10% is $2.49:
 1 1 1 
PWA = $1 + +
3 (1.10 )2 (1.10 )1 
 (1.10 ) 
 1 1 1 
PWA = $1 + + 
 1 . 331 1 . 210 1 . 10 
PWA = $1[0.7513 + 0.8264 + 0.909]
PWA = $2.4868 or $2.49 rounded

Note in Figure 5.4: Present Worth at Annual Compound Interest Rate of 10% that
the present worth of $1, or its NPV, to be received in 10 years is $0.3855, and the present
worth of an annuity of $1 to be received over three years is $2.4868. These are the same
interest factors that were derived mathematically in the two previous examples.

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 Unit 5: Financial Analysis of Real Estate Investments 87

FIGURE 5.4  Present Worth at Annual Compound Interest Rate of 10%

Years Present Worth of $1 Present Worth of Annuity of $1 per Period

1 0.9091 0.9091
2 0.8264 1.7355
3 0.7513 2.4868
4 0.6830 3.1699
5 0.6209 3.7908
6 0.5645 4.3553
7 0.5132 4.8684
8 0.4665 5.3349
9 0.4241 5.7590
10 0.3855 6.1446
15 0.2394 7.6061
20 0.1486 8.5136
25 0.0923 9.0770
30 0.0573 9.4269

Profitability Measures
An estimate can be made of an investment’s value based on the anticipated amounts
of rent to be collected over a period of time. This estimate of value then forms the basis
for determining if the purchase price is competitive and the investment is economically
sound.
Most investors are primarily concerned with the relationship of the value of a prop-
erty to its ability to generate cash flows. They will consider purchasing only properties
that are self-supporting and also develop an acceptable return on the cash invested. The
required amount of this investment return is as personal a choice as is the type of property.
For example, some investors may be satisfied with a 10% return, while others insist on a
property that develops at least a 20% or higher yield. Some investors are content to derive
a lower return in exchange for the security of a long-term lease with a national tenant.
Others are willing to speculate with higher risks in anticipation of higher profits.
There is some confusion over the meaning of the term return on investment (ROI).
The confusion stems from a lack of agreement among investors and accountants regarding
a definition for the word investment. Is the investment the total price of the property? Is it
the cash down payment plus the growth in equity and value from year to year? Or is it just
the specific amount of money paid by the investor to purchase and develop the project?
For our purposes, we will define investment as the amount of cash used in the pur-
chase of the property plus the cash costs of any capital improvements made during its
ownership. All profits generated by the investment will then be used to measure the return
on this investment.
For example, if a property shows an after-tax cash flow of $10,000 on a $100,000
cash investment, it indicates a 10% cash-on-cash ROI ($10,000 ÷ $100,000). If the anal-
ysis is expanded to include a $3,000 pay down on the mortgage and a verifiable $5,000
increase in the property’s market value, then the bottom-line ROI is 18% ($10,000 +
$3,000 + $5,000 = $18,000 ÷ $100,000).

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 88 Essentials of Real Estate Investment Eleventh Edition

Notice that the investment did not increase by the amount of the equity buildup or
the rise in value. However, these profits are considered soft profits while they are being
earned. Only the cash profits are hard profits because they are real and in hand. However,
these same soft profits can be made hard when refinancing or selling the property.
The prudent investor will begin by reviewing the annual operating statements on the
property as far back as practical. A basic understanding of the major components of an
operating statement is essential to making intelligent investment decisions. See Figure
5.5: Sample Operating Statement for a sample operating statement. The various terms on
the statement are defined as follows:
●● Scheduled gross income (SGI), or potential gross income, is the amount of rental
income the property could produce with 100% occupancy and with all tenants pay-
ing full rent.
●● Vacancy loss is the amount of income lost due to empty units or space.
●● Credit loss, or rent loss, is the amount of income lost from tenants not paying some
or all of the rent.
●● Other income includes all nonrental income such as parking, laundry, or vending.
●● Effective gross income (EGI), or gross operating income, is the total income from
the property.
●● Operating expenses are the expenses necessary for the operation of the property and
are further broken down into the following:
●● Fixed expenses, which stay the same no matter what the occupancy level of the
property may be. Examples include property taxes, insurance, and landscaping.
●● Variable expenses, which will vary according to the occupancy level. Examples
include supplies, water, and any management fees that are tied to the amount of
rent collected.
●● Reserves, which are monies set aside for replacement of items such as carpet,
appliances, or roofs and for the unexpected circumstances that may arise.
●● Total operating expenses is simply the total of the three types of expenses just listed.
●● Net operating income (NOI) is the income left after all the operating expenses have
been paid. This income is what an investor is buying and what a lender is lending
against. This number is central to estimating the value of the property as will be cov-
ered later in this unit.
●● Debt service is the principal and interest payment on any mortgage loan on the
property. This is not considered an operating expense but rather a cost of financing.
●● Before-tax cash flow is the money left before income tax is paid.

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 Unit 5: Financial Analysis of Real Estate Investments 89

FIGURE 5.5  Sample Operating Statement

Annual Operating Statement
SCHEDULED GROSS INCOME $____________________
– Vacancy loss $____________________
– Credit loss $____________________
+ Other income $____________________
= EFFECTIVE GROSS INCOME $____________________
Operating expenses:
Fixed: $_______________
$_______________
$_______________
$_______________
Total fixed: $_______________
Variable: $_______________
$_______________
$_______________
$_______________
Total variable: $_______________
Reserves: $_______________
$_______________
$_______________
$_______________
Total reserves: $_______________
– TOTAL OPERATING EXPENSES $____________________
= NET OPERATING INCOME (NOI) $____________________
– Debt service $____________________
= BEFORE-TAX CASH FLOW $____________________

Capitalization Rate
The capitalization rate, also called the cap rate, is the rate of return, based on the
purchase price that would attract capital. In other words, it is the rate of return, based on
the purchase price that would make investors want to purchase the property. What con-
stitutes an acceptable capitalization rate is a judgment call on the part of the investor and
will vary depending upon the market location, type of property, and goals of the investor.

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 90 Essentials of Real Estate Investment Eleventh Edition

Value
Once the net operating income of the property is known, an investor or appraiser
may estimate the value of an income-producing property by dividing the NOI by the
capitalization rate.

■■ FOR EXAMPLE  A 100-unit apartment building is to be sold. Each unit rents for
$1,200 per month. The property often runs with a 10% vacancy and credit loss. There is
an additional $78,000 in other non-rent income, and the total operating expenses for the
year are $500,000. Capitalization rates in the marketplace are running between 5 and 8%.

100 units × $1,200 rent = $120,000 scheduled gross income per month
$120,000 ×12 = $1,440,000 scheduled gross income per year
$1,440,000 – $144,000 vacancy and rent loss = $1,296,000
$1,296,000 + $78,000 other income = $1,374,000 effective gross income
$1,374,000 – $500,000 operating expenses = $874,000 net operating income
Hence: $874,000 ÷ 5% capitalization rate = $17,480,000
$874,000 ÷ 6% capitalization rate = $14,566,667
$874,000 ÷ 7% capitalization rate = $12,485,714
$874,000 ÷ 8% capitalization rate = $10,925,000

Note that the higher the capitalization rate, the lower the indicated value. This is
because the higher the capitalization rate desired by the investors, the less they must pay
for the property to achieve their investment goal.
Breakeven analysis.  Whatever the investor’s personal profit orientation may be, a proj-
ect’s breakeven point is used as a primary indicator of potential profitability. Breakeven
is that point where gross income equals a total of fixed costs plus those variable costs
incurred to develop that particular gross income. Only when gross income exceeds the
amount needed to break even will a project begin to show a profit.
Every property has fixed costs that continue regardless of income. Such costs include
property taxes, insurance premiums, maintenance fees, utility charges, and mortgage
payments, all of which must be paid regularly. A property also incurs costs that vary
according to the income generated. Such variable costs include managerial fees, special
maintenance services, additional utility charges, bookkeeping, and advertising costs. For
ease of analysis, these variable costs are usually expressed as a ratio of rental income, such
as 20% of every rental dollar collected. This variable cost ratio is usually applied at a set
rate over all levels of income.
The formula for calculating a property’s breakeven point is expressed as follows:
FC
BE =
1− VCR
BE = breakeven
FC = fixed costs
VCR = variable cost ratio

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 Unit 5: Financial Analysis of Real Estate Investments 91

■■ FOR EXAMPLE  A breakeven point for a property that incurs $100,000 in fixed
costs and has a variable cost ratio of 20% is

BE = $100,000 ÷ (1 – 0.20)

BE = $100,000 ÷ 0.80

BE = $125,000

The occupancy rate required to generate the income necessary to break even can be
expressed as the ratio of the potential income to the breakeven point.

If the property consists of 30,000 square feet of rentable space at a fair-market rent of
$5 per square foot per year, 83% of the space will need to be rented if the breakeven
requirement is to be met (30,000 × $5 = $150,000 and $125,000 ÷ $150,000 = 0.8333).
The breakeven analysis provides an investor with a clear perspective to study the
financial feasibility of a particular project. If a reasonable breakeven point is determined,
such as the 83% calculated previously, then the property will be acquired by the investor.
If, on the other hand, it is estimated that 95% occupancy must be achieved just to break
even, an investor will probably decline the opportunity. In such a situation, the investor
should analyze the possibilities of reducing taxes, adjusting mortgage payments, and low-
ering variable costs before making a final decision.
Return on investment.  When establishing an ROI, the only absolute analysis is a
triple-net lease with an AAA-rated corporation for a specified period of time. Here the
rental income would truly be a net amount because the tenant-corporation is paying all
of the property’s operating expenses, taxes, and maintenance. Because the tenant is so
highly rated, the rental payment is a guaranteed income, all things being equal. Under
these circumstances, the ROI can be ascertained with a high degree of certainty, with little
left to guesswork.
The ROI analysis of other investments includes many educated guesses. The ques-
tions that permeate such analyses include, among others: Will the tenant remain in busi-
ness for the term of the lease? Will operating expenses rise? Will the tenant exercise the
renewal option? Does the operating statement reflect accurate data on which an informed
decision can be made?
It has been customary to carefully examine the income and expense statement for
one year’s operation to discern what the cash flows will be. This analysis then becomes the
benchmark for future years, with the investor hoping to offset any increase in operating
expenses with commensurate increases in rent.
This is where the risk factor enters into the financial analysis. Is it worth buying this
property to make a 10% return while being exposed to all of the risks and work the invest-
ment demands? Or should the return be 20%, 30%, or higher to make it worthwhile? Or
should the investor consider an alternative opportunity?
For example, consider an 18-unit apartment project generating $100,000 gross
annual income. Total operating expenses, including a vacancy factor, reserves for replace-
ments, property taxes, insurance premiums, utilities, maintenance, and management,
are estimated to be 50% of the gross income. This leaves $50,000 for debt service and
cash flow. The property is offered at $500,000 (a 10% capitalization rate) with $200,000
cash down and a loan for the balance for 30 years at 7.5% fixed interest. The mortgage

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 92 Essentials of Real Estate Investment Eleventh Edition

payment will be $25,200 per year principal and interest. The building is booked for
$400,000 for 27.5 years straight-line. The ROI analysis appears in Figure 5.6: Return on
an Investment of $200,000.

FIGURE 5.6  Return on an Investment of $200,000

$100,000 Gross annual income
– 50,000 50% operating expense ratio
50,000 Net operating income
– 25,200 Annual principal and interest
24,800 Net cash flow
+ 3,000 Principal add-back
27,800 Taxable before depreciation
– 14,500 Depreciation
13,300 Taxable income
× 0.31 Investor’s tax bracket
4,123 Income tax
24,800 Net cash flow
– 4,123 Income taxes
20,677 10.33% cash-on-cash ROI
+ 3,000 Equity growth
23,677 11.83% broker’s net ROI
+ 10,000 2% market value growth
$133,677 16.83% bottom-line ROI
Considering the facts presented in the example, should an investor buy this property?
This is not an easy question to answer. It depends on as many variables as there are inves-
tors. For example, does the investor want to put $200,000 in this one project or could two
projects be purchased for $100,000 down for each? (Analyze this same investment with
$100,000 cash down and observe the cash-on-cash ROI jump to 18.3% from 10.33%.)
Other questions might include the following, among others: Is this property located in an
area where the rents could be maintained and even improved? Are the improvements in
good shape? Is the ROI enough to warrant taking the risk?
Leverage.  Leverage is the use of borrowed funds to purchase a property. The degree of
leverage often affects the return on the investment. In the example above, the $500,000
property is purchased with a $200,000 cash down payment with a 60% loan-to-value
ratio (LTV) that develops a 10.33% cash-on-cash ROI. This jumps to an 18.3% cash-on-
cash ROI when the property is purchased for $100,000 cash with an 80% LTV. Thus,
leverage often can be applied to increase the return on equity.
Positive leverage.  Positive leverage occurs when the interest rate on the loan is less
than the capitalization rate, which is 10% in the example. Thus, positive leverage allows
the investor’s yield to increase as the LTV increases. Positive leverage also occurs when the
cost of the debt payment, expressed as a percentage, is lower than the annual return on
investment.
On the other hand, negative leverage is the reverse and occurs when the cost of the
debt payment is higher than the annual return on investment and when the loan interest

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 Unit 5: Financial Analysis of Real Estate Investments 93

rate is greater than the capitalization rate. Then negative leverage will lower the investor’s
return as the LTV increases.
Discounted cash flows.  A more sophisticated approach to estimating the return on an
investment is the discounted cash flow method. Unlike the traditional approach, which
assumes that rents will be received far into the future and that the property will probably
never be sold, the discounted cash flow procedure recognizes that income streams are
finite and end at a projected point in time.
Included in this approach is the recognition that income fluctuates from time to time
and that properties are usually sold or traded at an appropriate time. Even more impor-
tant, this method recognizes that monies to be received in the future are discounted to
their present value by a rate that reflects an investor’s required return on the investment.
Essentially, then, the discounted cash flow analysis is an application of the principle of the
present worth of an annuity, as described earlier.
A series of straight rental payments over the lease term creates an annuity for a prop-
erty owner-investor. The present worth of this annuity is calculated using the formula
given earlier in this unit.

■■ FOR EXAMPLE  Assume a regular net annual cash flow of $5,000 under a 15-year
lease, with a projected future net sales price for the property of $150,000 at the expira-
tion of the lease. At a 12% required annual return rate, the IF for this annuity is 6.8108,
and the IF for the residual value of the property, also called the “reversion,” is 0.1827
(these interest factors appear in Figure 5.7: Present Worth at Annual Compound Interest
Rate of 12%).

The present worth of the income stream is $34,054 ($5,000 × 6.8108 = $34,054), and
the present worth of the proceeds from the future sale is $27,405 ($150,000 × 0.1827 =
$27,405). Thus, the present worth of this investment is the total of the present worth of
the annuity and the present worth of the reversion, or $61,459.

FIGURE 5.7  Present Worth at Annual Compound Interest Rate of 12%

Period Present Worth of $1 Present Worth of Annuity of $1
1 0.8928 0.8928
2 0.7972 1.6900
3 0.7118 2.4018
4 0.6355 3.0373
5 0.5674 3.6048
6 0.5066 4.1114
7 0.4523 4.5637
8 0.4039 4.9676
9 0.3606 5.3282
10 0.3220 5.6502
11 0.2875 5.9376
12 0.2567 6.1943
13 0.2292 6.4235
14 0.2046 6.6281
15 0.1827 6.8108

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 94 Essentials of Real Estate Investment Eleventh Edition

In other words, an owner can invest approximately $60,000 in cash and earn 12%
annually on this money if the $5,000 net annual cash flow remains constant for 15 years
and the property is sold for $150,000 net at the expiration of the lease term.
Although rents can be fixed at a constant annual amount for the term of a net lease,
the basic weakness in this analysis is trying to estimate the value of the property at a point
in the future. Most investors use a capitalization rate for this purpose. A market capital-
ization rate is derived by dividing the net operating incomes of recently sold properties
similar to the subject property by their sales prices.
The present-worth analysis can also be employed to measure the value of a series of
irregular cash flows developed by a stepped-up, or graduated, lease.

■■ FOR EXAMPLE  Assume a 15-year lease with $4,000 net annual cash flows for the
first 5-year period, $5,000 for each of the next 5 years, and $6,000 annually for the final
5-year period. Again, assume that the property will be sold for $150,000 net cash at the
end of the lease term. The present worth of this investment is $59,014, at a 12% return
rate, derived as in Figure 5.8 15-Year Graduated Lease at the Rate of 12% Return.

The IF of 3.6048 shown in Figure 5.8: 15-Year Graduated Lease at the Rate of 12% Return
is the present worth of a 5-year annuity of $1 at 12%.The IF of 2.0454 is the 10-year IF of
5.6502 minus the 5-year IF of 3.6048. The IF of 1.1606 is the 15-year IF of 6.8108 minus
the 10-year IF of 5.6502. The IF of 0.1827 is the present worth of $1 to be received in
15 years at a 12% return (see Figure 5.8: 15-Year Graduated Lease at the Rate of 12%
Return).

FIGURE 5.8  15-Year Graduated Lease at the Rate of 12% Return

Period IF Annuity Amount
First 5 years 3.6048 $4,000 $14,419
Second 5 years 2.0454 5,000 10,227
Third 5 years 1.1606 6,000 6,963
Reversion 0.1827 150,000 27,405
      Total: $59,014
The sum total of $59,014 can also be derived by discounting each year’s net cash flow
by its appropriate IF, as illustrated in Figure 5.9: 15-Year Graduated Lease at the Rate of
12% Required Return.

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 Unit 5: Financial Analysis of Real Estate Investments 95

FIGURE 5.9  15-Year Graduated Lease at the Rate of 12% Required Return
Period Present Worth of $1 Present Worth of Annuity of $1
1 0.8928 0.8928
2 0.7972 1.6900
3 0.7118 2.4018
4 0.6355 3.0373
5 0.5674 3.6048
6 0.5066 4.1114
7 0.4523 4.5637
8 0.4039 4.9676
9 0.3606 5.3282
10 0.3220 5.6502
11 0.2875 5.9376
12 0.2567 6.1943
13 0.2292 6.4235
14 0.2046 6.6281
15 0.1827 6.8108

Internal rate of return.  Real estate investors place high reliance on internal rate of
return (IRR) analyses in their decision making. The IRR is a rate of discount at which
the present worth of future cash flows is exactly equal to the initial capital investment.
One way to measure the IRR is by calculating the present worth of each projected year’s
profits after assigning a specific opportunity rate to the analysis. This rate is fixed over the
investment term, a somewhat contrived unit of measurement. If the discount rate chosen
is too high or too low, it will bias the investment decision between an investment with an
early high yield and one having a high end-of-investment yield.
The IRR offsets these distortions by automatically making the NPV of the total cash
flows equal to zero. In other words, the return on one investment is compared with the
normal returns on all others.
The IRR process starts with the amount of cash investment required. The analyst then
takes the net returns projected over the term of the project and searches for the appropri-
ate interest rate that will discount these returns to zero. This is the project’s IRR.

■■ FOR EXAMPLE  Assume a $100,000 cash investment requirement, a $10,000 net

annual cash flow for 10 years, and a cash reversion of $100,000 at the end of the lease
period when the property is sold. The IRR is 10%.

$10,000 × 6.1446 (Figure 5.4) $61,446

$100,000 × 0.3855 (Figure 5.4) $38,550
Total: $100,000 (rounded)
Investment: $100,000
NPV: 0

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 96 Essentials of Real Estate Investment Eleventh Edition

If the project’s time frame is shortened to five years, the IRR will remain 10%.

$10,000 × 3.7908 (Figure 5.4) $37,900 CWA

$100,000 × 0.6209 (Figure 5.4) $62,090 PWR
Total: $99,990 (rounded $100,000)
Investment: $100,000
NPV: 0
Although the IRR is quickly reported via various software programs after making
the appropriate entries, it is not the final answer to all investment questions. The IRR
approach forces guesstimates of future net cash flows (it works best with a fixed net lease
with an AAA-rated tenant) and net sales proceeds. It also has built-in value deceptions.
For example, three different investments showing the same IRR may not be equal choices
for every investor. One investment shows high initial yields and another high end yields;
the third is balanced over the project’s holding period.
In other words, each investment must be analyzed individually to see how it fits into
the overall strategy of a specific investor. Thus, to maximize the use of computational
analysis software, the analyst should plug the IRR of the contemplated investment into
the client’s entire portfolio to see if the overall IRR is affected positively or negatively.
The example presented here can be modified to incorporate more complicated sce-
narios. For example, a modified IRR analysis will take into consideration the possibility of
negative cash flows for a number of years in a project’s start-up time. These out-of-pocket
amounts must be discounted appropriately and added to the investment amount to esti-
mate a more reliable IRR.

CALCULATORS AND FINANCIAL ANALYSIS SOFTWARE

PROGRAMS
The calculations involved in examining a potential real estate investment can be quite
complex. The purpose of this unit is to introduce the reader to the approaches used
by many investors. In addition to Microsoft Excel®, there are many advanced-function
calculators and other software programs available to assist you in this analysis. Popular
advanced-function calculators include the following:
●● HP 12C Financial Calculator
●● HP 17BII+ Financial Calculator
●● Calculated Industries 3415 Qualifier Plus IIIX Real Estate Finance Calculator
●● Calculated Industries 3430 Qualifier Plus IIIFX Real Estate Finance Calculator
Some of the more advanced software programs available today allow the analyst
almost unlimited latitude in treating the myriad of variables included in a real estate
investment. For example, most have provisions for handling changing tax brackets, mini-
mum tax impacts, and tax payables under almost every circumstance. Also available in
today’s market are hundreds of programs designed to do real estate investment studies and
forecasts, as well as property management software.
Despite the excitement surrounding the ever-evolving use of software programs
in real estate analysis, a word of caution is in order at this point. Notwithstanding the

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 Unit 5: Financial Analysis of Real Estate Investments 97

sophistication of the software, the hardware, or the programming, it’s the thinking behind
these tools that really counts. Tax brackets change over time, and after-tax sale proceeds
can be deceptive. Annual net cash flows can be affected dramatically by the new financial
arrangements available in today’s market. Negative amortization, variable interest rates,
multiple balloon payments, shared appreciation loans, and wraparounds are only a few of
the issues analysts must consider in their attempts to measure investment returns.
Today’s analyses are infinitely more sophisticated than the old six-times-gross
approach. With the addition of probability theory, giving the investor some good odds
that the analyst’s projections will be proved correct, more relevant decisions are being
made daily by those willing to take the time and trouble to check on their instincts.
Figure 5.10: Spreadsheet Analysis for IRR—Residential Income Property shows a
typical spreadsheet analysis for IRR. This program allows any single change to be reflected
automatically throughout the analysis.

FIGURE 5.10  Spreadsheet Analysis for IRR—Residential Income Property

Given: Purchase price = $5,000,000
Mortgage = $4,000,000 @ 12% interest, 20-year amortization
Mortgage payment = $44,043.45
5% growth in base rent and expenses
Sale at end of year 5 based on 10% capitalization rate on NOI
Land/Building allocation is $1,000,000/$4,000,000
Depreciation is straight-line for 27.5 years (use 0.03636)
Tax rate on ordinary income is currently 35% and on capital gain is 15%

Description Year 1 Year 2 Year 3 Year 4 Year 5

Income
Gross potential $600,000 $630,000 $661,500 $694,575 $729,304
Occupancy factor 85% 87% 90% 93% 95%
Adjusted gross 510,000 548,100 595,350 645,955 692,839
Recoverable expenses 12,750 13,703 14,884 16,149 17,321
Total income $522,750 $561,803 $610,234 $662,104 $710,160
Expenses
CAM expenses $15,000 $15,750 $16,538 $17,364 $18,233
Owner expenses + 5,000 + 5,250 + 5,512 + 5,788 + 6,078
Total expenses $20,000 $21,000 $22,050 $23,152 $24,311
NOI $502,750 $540,803 $588,184 $638,952 $685,849
Calculation of Tax
NOI $502,750 $540,803 $588,184 $638,952 $685,849
Less interest 477,240 470,737 463,408 455,150 445,845
Less depreciation 145,440 145,440 145,440 145,440 145,440
Taxable income ($119,930) ($75,374) ($20,664) $38,362 $94,564
Tax @ 36% (43,175) (27,135) (7,439) 13,810 34,043

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 98 Essentials of Real Estate Investment Eleventh Edition

FIGURE 5.10  Spreadsheet Analysis for IRR—Residential Income Property (Continued)

Description Year 1 Year 2 Year 3 Year 4 Year 5

Calculation of Cash Flow after Tax

NOI $502,750 $540,803 $588,184 $638,952 $685,849
Less interest 477,240 470,737 463,408 455,150 445,845
Less principal 51,281 57,785 65,113 73,371 82,677
Less tax @ 36% (43,175) (27,135) (7,439) 13,810 34,043
Cash flow after tax $17,404 $39,416 $67,102 $96,621 $123,284
ROI after taxes 1.740% 3.942% 6.710% 9.662% 12.328%
Sales Analysis
Year 5 NOI $685,849
10% Cap rate ÷ 0.10
Gross sales price $6,858,494
Closing expenses (10%) – 685,849
Net sales price $6,172,645
Less mortgage balance – 3,669,773
Cash proceeds before tax $2,502,872
Calculation of Tax Tax Rate Tax
Purchase price $5,000,000
Less accumulated depreciation – 727,200
Adjusted book basis $4,272,800
Net sales price $6,172,645
Less adjusted book basis – 4,272,800 0.15 $284,977
Taxable capital gain $1,899,845
Cash proceeds before tax $2,502,872
Less tax – 284,977
After-tax cash flow $2,217,895
ROI on the $1,000,000 invested in the project = 22.17%
Source: Allen B. Atkins, PhD, Northern Arizona University

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 Unit 5: Financial Analysis of Real Estate Investments 99

SUMMARY
The data collected in a financial study is used to estimate gross annual cash flows,
operating expenses, depreciation allowances, and returns on investment. These mathe-
matical analyses apply the concepts of interest, time value of money, and various measures
of profitability, and they complement the information secured in the feasibility study.
Interest is defined as rent paid or received for the use of money. Thus, a deposit in a
savings account earns the depositor interest, or rent. Similarly, an investment (deposit) in
an income property will generate a yield (interest), called a return on the investment.
Because interest, or yield, is earned on monies deposited or invested, those funds not
currently available for investments are then actually worth less than their face amounts.
How much less is a function of time and the rate of interest, or yield, desired by the inves-
tor. Thus, $100 to be received in one year is worth approximately $90 today at a 10%
yield, or discount rate. The $10 difference is the lost earnings or opportunity cost for not
having the $100 on deposit or invested for the year.
Many feasibility studies use a traditional approach for estimating returns on invest-
ment, while others use the discounted cash flow method, based on the concept of the
present worth of money. Traditionally, gross annual earnings are reduced by operating
costs, debt payments, and depreciation to arrive at a net income figure. Depending on the
owner’s tax bracket, this net amount is adjusted to develop a bottom-line return on the
owner’s cash investment. This traditional approach assumes that the income stream will
continue into perpetuity.
The discounted cash flow method, on the other hand, identifies a finite period for
rent flows and assumes that the property will be sold. Thus, the future net cash flows and
property sales receipts are discounted at the investor’s required yield rate to derive the
present worth of the investment. When the discounted amount equals the investment
amount, it is said that the property is generating the owner’s required internal rate of
return.

DISCUSSION TOPICS
1. What happens to the ROI if an investor refinances a positive cash flow property and
recaptures all of the original monies invested?
2. Investigate various software programs designed to assist with real estate investment
feasibility studies. What are the pros and cons of each program? Secure a copy of
a real estate investment analysis that employs one of these programs. Examine the
analysis for material presented in this unit.

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 100 Essentials of Real Estate Investment Eleventh Edition

UNIT EXAM 4. What single investment must be made in an

account earning 12% annual compound interest
Use the following information to answer questions 1
to accumulate $100,000 in 25 years?
through 3:
a. $4,000
An investor in the 28% bracket purchases a residential b. $5,882
income property for $350,000 with a $100,000 cash c. $12,750
down payment. The loan for $250,000 is payable at d. $17,000
10% interest-only for 10 years. The property generates
5. What regular annual payments must be made to
$50,000 annual gross income. Its operating expense
an account earning 12% annual compound inter-
ratio is 30%. The land is booked at $50,000 and the
est to accumulate $100,000 in 25 years?
improvements at $300,000 with depreciation using the
a. $750
39% straight-line rate.
b. $4,000
1. The annual cash-on-cash return on this invest- c. $5,880
ment is d. $12,750
a. 3.6%. 6. What regular annual payments must be made
b. 10%. to amortize a loan of $100,000 over 25 years at
c. 28%. 12% interest?
d. 30%. a. $4,000
2. The annual depreciation deduction is b. $5,880
a. $800. c. $12,750
b. $10,000. d. $17,000
c. $10,800. 7. At a 12% yield requirement, what is the present
d. $12,600. value of a $10,000 net annual income stream
3. Which of the following statements is FALSE ? to be received at the end of each year for 15
a. The investment throws off an $800 annual years plus the cash value reversion from the sale
loss. of the property at the end of the 15th year for
b. This is a fully tax-sheltered investment. $150,000?
c. This is a negative cash flow property. a. $82,141
d. The interest is a deductible expense. b. $95,514
c. $218,109
Use the information in Figure 5.11 to answer questions d. $400,202
4 through 8.
8. At a 12% yield requirement, what is the present
FIGURE 5.11  12% Annual Compound Interest value of an annual income stream to be received
Years Future Future Present Present at the rate of $5,000 at the end of each year for
Worth Worth Worth Worth five years, $10,000 for the next five years, and
$1 Ann. $1 $1 Ann. $1 $15,000 for the final five years, plus a net cash
5 1.7623 6.3528 0.5674 3.6048 reversion from the sale of the property at the end
of the 15th year of $87,500?
10 3.1058 17.5487 0.3220 5.6502
a. $43,391.25
15 5.4736 37.2797 0.1827 6.8109
b. $71,874.75
20 9.6463 72.0524 0.1037 7.4694 c. $192,675.75
25 17.0001 133.3339 0.0588 7.8431 d. $237,500.00
30 29.9599 241.3327 0.0334 8.0552

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 Unit 5: Financial Analysis of Real Estate Investments 101

9. When analyzing the expenses incurred in operat- 10. Most analyses of investment property profit
ing a commercial investment property, which of potentials are based on
the following is most often overlooked? a. dependable facts.
a. Maintenance b. educated guesses.
b. Reserves c. computer inputs.
c. Utilities d. verifiable information.
d. Management

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 Financing for Real
Estate Investments
Unit

6
LEARNING OBJECTIVES
After successfully completing this unit, you will be able to
●● list major sources of financing funds,
●● describe types and forms of real estate financing,
●● list special provisions for investment financing, and
●● describe different types of defaults and foreclosures.

adjustable-rate mortgage (ARM) deficiency judgment mortgage

assumable draws negative amortization
caps due-on-sale clause note
ceiling exculpatory clause partially amortized loan
collateral foreclosure sale-leaseback-buyback
construction loan graduated payment loan senior loan
contract for deed hypothecation split-fee financing
cosign index subject to
debt coverage ratio interim loan term loan
deed of trust junior loan variable interest rate
default lien wraparound loan

INTRODUCTION
The importance of finance in real estate investments is axiomatic. The profitability
of most transactions is based primarily on financial arrangements designed to enlarge the
returns on investments. The appropriate application of leverage may dramatically increase
investors’ profit margins but, often, their risks as well.

102

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 Unit 6: Financing for Real Estate Investments 103

In its simplest form, real estate finance includes the pledge of real property as col-
lateral to back up a borrower’s promise to repay a loan. If a default occurs, the lender is
legally entitled to force the sale of the pledged property to recover the balance owed.
In a broader sense, the financing relationship is described in terms of rights pledged as
collateral for a loan. Borrowers hypothecate (pledge) their rights to a lender but continue
to own and control the property throughout the term of the loan. In this relationship, the
lender holds equitable title (less than legal) to the property, which can be perfected into
full legal ownership if the borrower defaults.
Hypothecation implies that a borrower may acquire or continue occupancy and
control of the real estate pledged as collateral for a loan. Thus, a borrower may live in, rent
out, farm, and otherwise continue to use and benefit from property that is itself encum-
bered by the lien of a real estate loan.
This explains one of the basic attractions of real estate as an investment vehicle. An
owner may control a large, valuable property with relatively little amounts of money. The
process, called leverage, is the use of small amounts of money to control valuable proper-
ties through financing. Thus, with a 10% cash down payment, a purchaser might conceiv-
ably invest $10,000 and buy a $100,000 property if a $90,000 loan could be arranged.
The interest paid on this loan is deductible as an annual expense against the investment’s
income.
Leverage gives investors a powerful tool for the potential accumulation of large estates
in their lifetimes. In fact, many investors strive to apply leverage to the greatest extent pos-
sible in order to control many highly valued properties with a minimum amount of their
own money. This approach acts to preserve an investor’s liquid assets, which can then be
used to solve the specific problems that inevitably arise in the course of property owner-
ship and management.
For example, a property purchased for $100,000 cash and later sold for $120,000
shows a 20% return on the investment: $120,000 – $100,000 = $20,000 profit ÷
$100,000 invested = 20%. If this property were purchased using leverage with a $10,000
cash down payment and a mortgage of $90,000, it would show a 200% return on the
investment: $20,000 ÷ $10,000 = 200%. If it were purchased with a $20,000 down pay-
ment, the return would be 100%. If the investor had been able to buy the property with
zero down, the return would be infinite.
Leverage couples high returns with high risks. Because large mortgages require large
payments, rental cash flows need to be carefully maintained at levels adequate to meet
these obligations. Any slight rental decrease could adversely affect a highly leveraged
investor’s safety position.

Debt Coverage Ratio

There is a basic difference between lending for homeownership and for investment
purposes. In lending for homeownership the income to repay the loan comes from the
individual borrower. This is why lenders are concerned with the borrower’s credit standing
and job history. Commercial lending differs in that the funds to repay the loan come not
from the individual borrower but from the property. It is the net operating income of an
investment property that is used to repay the loan. This is why lenders are as concerned
with the property’s operating statement as with the individual borrower.

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 104 Essentials of Real Estate Investment Eleventh Edition

Commercial property lenders require that the net operating income from the prop-
erty “cover” the debt service (principal and interest payment) a specified number of times.
For example, a lender may require that the net operating income (NOI) cover the debt
service at least two times per year. This means that if the debt service is $100,000 per
year, then the net operating income must be at least $200,000. This ratio of NOI to debt
service is called a debt coverage ratio.
In the above example, a debt coverage ratio of 2 was required. In reality it is rare to
see a debt coverage ratio that high. Common debt coverage ratios often vary between 1.2
and 1.7. Using a 1.5 debt coverage ratio means that the NOI must be at least one-and-a-
half times the debt service. This insures that the property can repay the loan or provide an
income to the lender in case of foreclosure.

SOURCES OF FUNDS
Generally, our economy is based on the power of credit—using other people’s money.
The philosophy of buy now and pay later is precisely what real estate finance is all about.
However, despite the pressures for increased use of credit in this country, the need for
savings is also emphasized because without savings there is no credit! Most lending is
based on savings accumulated through accounts and certificates at banks and savings
institutions, premiums paid to life insurance companies, and pension and retirement
fund contributions.
The inventory of lenders for real estate finance may be divided into two general cat-
egories: institutional and noninstitutional lenders. They are distinguished by the degree
of responsibility exercised by the specific lenders in each category.

Institutional Lenders
Institutional lenders, charged with demonstrating the highest degree of responsibil-
ity to their principals, include commercial banks, savings institutions, and life insurance
companies. Displaying a generally conservative attitude toward real estate finance, these
lenders, also called financial intermediaries, are charged with preserving the quality and
quantity of their depositors’ and premium payers’ monies. This responsibility is manifest
in the careful screening of each loan applicant’s credit and the studious examination of
the collateral property’s value.
Commercial banks.  Originally designed to serve only the commercial checking needs
of their customers, these banks now offer a full spectrum of checking and savings accounts
as well as other services, including real estate loans. However, they prefer to participate in
relatively short-term loans to maximize their market position.
The short-term real estate mortgages that attract commercial banks include construc-
tion loans, home improvement loans, and equity loans. Construction loans, also called
interim loans, are designed to finance real estate development projects during their con-
struction stage. These interim loans are replaced by more permanent types of financing
secured on new buildings once construction is completed.
The contractor for a new building requires regular funding during the course of con-
struction to meet the payroll and purchase the materials necessary to the building process.
However, because the contractor has no building to pledge as collateral for a loan at the
outset of the development process, a lender cannot be expected to issue a check for the full

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 Unit 6: Financing for Real Estate Investments 105

amount of the loan until the collateral is actually constructed in the manner and quality
specified in the plans.
To solve this dilemma, the interim loan is funded through a series of draws. When-
ever a specified stage of construction has been completed to the lender’s satisfaction, a
portion of the entire loan is released to the contractor, providing the funds to pay for the
services and materials used to date. Each time another stage is completed, another draw is
issued, continuing to the building’s completion when the final draw is paid.
When construction is completed to everyone’s satisfaction, the interim loan is usually
replaced by a permanent long-term mortgage. In this manner, the increasing value of the
collateral matches the growing balance of the loan as draws are issued, thereby protect-
ing the lender. In the event of a default during the construction period, the lender will
foreclose on the collateral, even though it is unfinished at that point, and sell it to recover
the monies already distributed.
Home improvement loans are another short-term lending activity engaged in by
commercial banks, and these loans are of particular significance to those investors who
purchase rundown properties for repair and resale. Issued to cover the costs of room addi-
tions, swimming pool installations, or other remodeling requirements, home improve-
ment loans usually take a second mortgage position behind an existing first mortgage.
Some loans available today include an amount specified for rehabilitation as part of the
new loan.
Equity loans are a popular product for commercial banks because the interest on con-
sumer loans is no longer deductible for income tax purposes. To replace the diminishing
number of consumer loans, banks may promote loans on the equity that borrowers have
accumulated in their houses to provide those borrowers with cash for personal spending.
Home equity loans provide borrowers the benefit of deductible interest.
Savings institutions.  Consisting of mutual savings banks, savings associations, and
savings banks, these financial institutions provide many of the long-term loans for single-
family, owner-occupied housing. Dealing primarily in conventional loans, these institu-
tions invest most of their assets in real estate financing.
In the past, limitations imposed on savings institutions by federal and state regu-
lating agencies restricted their service areas. Savings institutions invariably developed as
neighborhood banks, with their lending capacity limited by the quantity of deposits they
attracted. In today’s real estate market, any limitations on area have been eliminated by
participation in the secondary mortgage market.
The Federal Reserve System has emerged as the governing body for most of these
lenders and has established a strong depositors’ insurance program under the Federal
Deposit Insurance Corporation (FDIC).
Life insurance companies.  The nation’s life insurance companies invest approximately
one-third of their assets in long-term mortgage loans and participate predominantly in
the financing of large commercial real estate developments. These companies provide
much of the funds needed to develop apartment and office buildings, as well as shopping
centers and industrial properties.

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 106 Essentials of Real Estate Investment Eleventh Edition

Noninstitutional Lenders
Noninstitutional lenders act somewhat independently from principal depositors and
premium payers. Included in these sources for real estate finance are retirement and pen-
sion funds, mortgage brokers and bankers, issuers of improvement district and industrial
development bonds, real estate investment and mortgage trusts, and credit unions. These
lenders retain a high degree of internal discretion regarding their investment decisions and
are not regulated as closely as the institutional lenders.
Retirement and pension funds.  Although federal legislation has imposed greater
controls over the financing activities of these entities, they still are able to make many
independent decisions regarding the kinds of real estate loans they issue. As a result, their
autonomy allows them to participate in financing speculative land-development projects
as well as to invest in more stable real estate ventures.
As with the institutional lenders, retirement and pension funds often invest in real
estate financing through the services of mortgage brokers and bankers.
Mortgage brokers and mortgage bankers.  Acting as representatives for their inves-
tors, mortgage brokers and mortgage bankers are important sources of real estate finance.
These companies are not primarily responsible to depositors or premium payers but are
directly accountable to their investors, who rely on these loan originators and servicers to
underwrite new loans carefully and according to established lending standards.
Mortgage brokers differ from mortgage bankers in that they bring together borrower
and lender, confirm the loan arrangement, charge the borrower a placement fee for their
services, and move on to the next transaction. Mortgage bankers, on the other hand, not
only originate loans and secure fees for these activities, they also service these loans by
collecting payments, periodically inspecting the collateral, and supervising any necessary
foreclosure actions. In effect, a mortgage banker becomes the lender’s local representative,
responsible for a loan from inception through satisfaction, whereas a mortgage broker
primarily acts as a catalyst in the creation of a new loan.
Real estate bonds.  Many communities finance municipal, industrial, and housing
developments with the issuance of bonds. These debts are repaid from property taxes,
rental receipts, and mortgage payments collected from tenants and owners of the various
properties.
Individual subdivision developers may also be eligible to finance the installation of
off-site improvements, including sewer and utility lines, street paving, sidewalks, and
similar items, by issuing improvement district bonds. In some areas of the country, these
bonds are the specific obligation of the property owners within the district. In other areas,
these bonds can become general obligation bonds.
Real estate investment and mortgage trusts.  REITs and REMTs are sources of
funds for real estate finance. Acquiring their money through the sale of beneficial interests
to the public, these trusts make loans for construction mortgages as well as for permanent
long-term mortgages on improved income properties. Acting mainly through the services
of mortgage brokers and bankers, the trusts provide the extra flexibility in loan place-
ments often vitally needed for the completion of complex realty projects.

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 Unit 6: Financing for Real Estate Investments 107

Credit unions.  Although credit unions are primarily active in financing personal prop-
erty acquisitions for their members, their increasing popularity is allowing them to expand
their investments to include short-term and long-term real estate loans.
Private loan companies.  Private loan companies range in size from the individual
entrepreneur and mom-and-pop operations to large national franchise organizations.
These companies deal primarily in junior loans, lending second mortgages on homeown-
ers’ equities. They make loans from their own funds or from monies borrowed from their
commercial banks.
Private real estate loan companies usually charge higher interest rates than other lend-
ers in an attempt to offset the risks inherent in their junior lien positions. They also
impose relatively high loan placement fees. Many states have developed laws regulating
the lending activities of private lenders. Besides requiring these companies to be licensed
and to post performance bonds, these laws limit the amount of fees that can be charged
by these lenders for their services.
Individuals.  When other financing is not available, the sellers of property often have to
provide the funds necessary to close the transaction. Arrangements for seller-financing are
usually made directly between the buyer and seller.
Some seller-financing involves first mortgages, usually when the property is owned
free and clear. More often it involves junior financing when the seller carries back a por-
tion of the equity as a second mortgage. In this arrangement an escrow collection service
is usually established. The buyer is then required to make regular monthly payments to
the escrow, adequate for both senior and junior loans. The escrow company then forwards
these payments to the respective lenders, keeping accurate records of each transaction.
Frequently, buyers of single-family homes need to borrow money for the down pay-
ment and closing costs from their parents or other family members. In some cases, the
donors are requested to cosign the new first mortgage documents to add their financial
resources as additional collateral to help the buyers qualify for the new loan.
To balance and manage an investment portfolio more efficiently, real estate inves-
tors should be fully acquainted with all the various mortgage loan opportunities in their
specific geographic areas, including lender attitudes, loan costs, and availability of funds.

FORMS OF REAL ESTATE FINANCE

When property is pledged as collateral for a loan, three basic forms are used to estab-
lish the desired lender-borrower relationship, depending on the area of the country. The
basic forms are the note and mortgage, deed of trust, and contract for deed.

Note and Mortgage

This form of financing requires that the borrower-mortgagor pledge the property and
all the rights therein to a lender-mortgagee in exchange for a loan. The borrower retains
legal fee simple ownership, while the lender secures an equitable interest in the collat-
eral, an interest that can be expanded into a full legal fee simple interest if the borrower
defaults.
Because borrowers retain legal fee simple title, in the event of a foreclosure action
they enjoy certain redemption privileges that depend on the laws of the state in which

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 108 Essentials of Real Estate Investment Eleventh Edition

the property is located. For example, in Alabama, a borrower may combine equitable and
statutory redemption periods for up to two years, during which time the property can be
redeemed and ownership continued. Other states have varying redemption periods under
the note and mortgage form, with most averaging approximately six months before a
defaulted borrower’s legal ownership is foreclosed.
In this form of finance, the note is the actual contract for the repayment of the debt,
while the mortgage is the pledge of real estate to secure the promise to pay. A note by
itself is legal evidence of a debt and stipulates the conditions of the loan and the terms of
repayment. A mortgage always needs a note to be legally enforceable, and it describes the
collateral and rights being pledged.

Deed of Trust
The note and deed used to establish a deed of trust financing relationship parallel
the note and mortgage, with one exception. With the deed of trust, the borrower-trustor
actually deeds the legal fee simple interest in the collateral to a third-party trustee to hold
in trust subject to the lien of the lender-beneficiary. When the loan is paid in full, the
trustee reconveys the property to the trustor. State laws vary regarding the use of the deed
of trust. In California, for example, it is not absolutely necessary for a note to accompany
the trust deed. In Washington, the trust deed arrangement is worded so that the property
vests in the trustee only in the event of a default.
The deed of trust financing arrangement acts to shorten a borrower’s redemption
period from as long as one year, under a note and mortgage, to as little as 90 days under
the trust deed. In the event of a default, the trustee is empowered by the terms of the trust
agreement to sell the collateral at public auction after having followed the letter of the law.
This procedure includes provisions for adequate notice to all concerned parties.
As with a mortgage, any proceeds from a foreclosure auction sale must first be applied
to pay any government tax liens or special assessments and the costs of the sale. The
remaining funds are then distributed first to the senior lender, then to all junior lienors,
and finally to the trustor.
The deed of trust is currently being used in the District of Columbia and the follow-
ing states:
●● Alaska
●● Arizona
●● California
●● Colorado
●● Georgia
●● Idaho
●● Mississippi
●● Missouri
●● Nevada
●● North Carolina
●● Tennessee

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 Unit 6: Financing for Real Estate Investments 109

●● Texas
●● Virginia
●● Washington
●● West Virginia

Contract for Deed

Also called a land contract, bond for deed, agreement of sale, or contract of sale, a con-
tract for deed is a form of financing instrument used primarily between individual lend-
ers and borrowers, not with banks or savings institutions. A contract for deed is not
accompanied by a note but is a single complete agreement, granting physical possession
to the buyer-borrower-vendee at the same time that it establishes the financing agreement
with the seller-lender-vendor.
Contracts for deed are usually employed in situations where the seller of a property
is helping the buyer complete the purchase by carrying back a loan for a portion of the
seller’s equity in the property. In such a case, a contract for deed is executed between the
buyer and seller for the amount of the seller’s equity. The legal fee simple interest remains
in the name of the seller, while the buyer secures an equitable title in the property as well
as its possession and control. When the terms of the loan contract are met, the seller
delivers a deed to the buyer, the recording of which is evidence of the loan’s satisfaction.
Some pitfalls of the contract for deed form of financing include
●● providing for transfer of title on seller’s demise prior to contract’s satisfaction,
●● providing for protection of title in case of litigation against seller, and
●● determining priority of intervening liens.
Maintaining legal title in the collateral during the term of the loan gives the seller cer-
tain foreclosure powers not available in either the mortgage or deed of trust forms. Basi-
cally, the buyer’s redemption periods are dramatically reduced, sometimes to as little as 30
days. Certain states, fearful that this foreclosure power may be used arbitrarily or capri-
ciously, prohibit or seriously inhibit the use of contracts for deed as a form of financing.

TYPES OF REAL ESTATE FINANCE

The three forms of finance—the note and mortgage, deed of trust, and contract for
deed—may be used to serve the particular needs of the principals in a real estate transac-
tion. Generally, the mortgage and trust deed forms are used by institutional lenders and
are designed to be in a senior loan position, with priority over any and all intervening
liens. The contract for deed can also be a senior loan when the seller-vendor owns the
property free and clear and carries back such a contract. However, most land contracts are
established as junior loans.
A lien is a legal claim against real or personal property, whereby the property is made
the security for the performance of some act, usually the repayment of a debt. A lien can
be either voluntary, such as a mortgage, or involuntary, such as a tax lien.
A mortgage loan becomes a voluntary lien as of the precise time of its recording at
the office of the recording official of the county in which the property is located. The
property’s recorded history will be carefully reviewed prior to the granting of a new loan,

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 110 Essentials of Real Estate Investment Eleventh Edition

and all prerecorded encumbrances will have to be satisfied. This procedure establishes that
the new lender’s rights are superior to the rights of any subsequent lienholders. Thus, the
legal doctrine of “first in time, first in right” acts to protect a lender’s senior lien position.

Senior Loans
The institutional lenders described previously—commercial banks, savings institu-
tions, and life insurance companies—are required by their licensing and regulating agen-
cies to practice the highest possible degree of financial responsibility. They are totally
prohibited from placing their customers’ funds in jeopardy when making investment
decisions. Consequently, the real estate financing activities of these lenders are normally
limited to senior mortgages and deeds of trust. They usually adopt a conservative approach
to lending, including a scrupulous analysis of a borrower’s credit and a thorough evalua-
tion of the property to be pledged as collateral.
In the event of a foreclosure, these lenders will seek to recover any funds still unpaid
through the sale of the collateral. To exercise their responsibility, these lenders must be in
senior lien position against the subject property at all times. The creation of any interven-
ing liens jeopardizes a lender’s chances of recovery at a foreclosure sale and constitutes a
breach of the loan contract. Generally, senior loans are conventional, insured, or guar-
anteed loans.
Conventional loans.  Although many conventional loans are insured by private mort-
gage insurance (PMI) companies, some do not have any insurance or guarantee by a third
party. On these uninsured conventional loans, complete reliance is placed on the bor-
rower to meet all obligations when due.
To offset the risk implicit in this arrangement, a conventional lender will not only
conscientiously qualify both borrower and property but will also require that a borrower
have a prescribed amount of personal funds invested in cash in the property. This equity
investment provides the lender a safety cushion in the event of a default.
The amount of this equity cushion establishes the loan-to-value ratios (LTVs)
employed by lenders to determine the amounts of the loans to be made. Historically,
lenders required that a borrower pay 50% of a property’s value as a cash down payment,
and then a loan for the balance would be issued. These equity requirements gradually
diminished from 50 to 33% to current requirements of between 20 and 25%, thus allow-
ing a conventional mortgage to be placed at about 80% of a property’s value. This equity
requirement acts to protect lenders by tying borrowers to their property ownership. A
borrower who has invested personal funds of 20 to 25% is less likely to undermine the
value of the property or “walk away” from it. Periodic decreases in the loan balance each
month, coupled with a possible rise in the property’s value due to inflation and physi-
cal improvements, increase an owner’s equity from the very first payment. Therefore, a
conventional senior first mortgage should be unlikely to go into default. In recent years,
however, many areas in the U.S. suffered substantial drops in value, causing borrowers
to choose to walk away from the property (and their loan obligations), leaving lenders to
assume massive losses.

Income Property Loans

When making loans on apartment, commercial, and industrial income properties,
lenders must evaluate many variables. In addition to the property’s value and the credit
characteristics of the borrowers, the lenders must consider the possibility that they may
wind up managing the property in the event of a foreclosure.

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 Unit 6: Financing for Real Estate Investments 111

Following guidelines established by Fannie Mae for purchase of commercial loans,

lenders will carefully examine the ability of the income from the property to support the
debt service required to amortize the loan. Thus, the amount of the loan will be estab-
lished as a function of the property’s net operating income and down payment, and debt
ratios will be adjusted accordingly.
To qualify for an income property loan, the following items will require examination:
●● Personal financial statements
●● Property income statements
●● Appraisals and feasibility studies
●● The borrower’s management track record

Junior Loans
Most real estate transactions are finalized when a buyer secures a new senior loan for
the major portion of the property’s value, with the balance paid as a cash down payment.
Sometimes, however, a buyer will require additional financing in the form of a second
mortgage or contract for deed to offset the burdens of heavy front-end cash requirements.
These junior loans are sometimes established between the individual parties to a real
estate transaction, with the seller carrying back a portion of the equity in the form of a
second mortgage.

Alternative Types of Finance

The three basic forms of real estate finance—the note and mortgage, trust deed, and
contract for deed—are employed as either senior or junior loans. The structures of these
instruments are somewhat flexible and therefore reasonably adaptable to fit various con-
tingencies. In addition, these instruments can be specially designed to finance unique real
estate situations, such as the wraparound, the sale-leaseback, and the joint venture.
Wraparound encumbrances.  A useful form of junior loan is the wraparound loan,
also called an all-inclusive loan. The unique feature of a wrap is that it creates a new loan
that encompasses any existing loan without disturbing the legal priority of the underlying
encumbrance. The wraparound loan cannot be used to bypass a due-on-sale clause, but it
can be drawn at a higher rate of interest than the underlying encumbrance.

■■ FOR EXAMPLE  Assume that a property is to be sold for $100,000, with a $10,000
(10%) cash down payment made by the buyer, and a $90,000 wraparound mortgage car-
ried back by the seller at 10% interest. The seller’s existing mortgage has a $70,000 bal-
ance, which is payable at 8.5% interest. Thus, the seller actually has a $20,000 equity in
the wrap and will be earning a full 10% on this amount plus a 1.5% override on the first
mortgage balance. This results in an effective annual earning rate of 15.25% [$20,000 ×
0.10 = $2,000 + ($70,000 × 0.015 = $1,050) = $3,050 ÷ $20,000 = 0.1525 or 15.25%].

Obviously this yield, being as high or higher than that offered by many alternative invest-
ments, may go a long way to relieve the reluctance of a seller who must carry back a
junior loan to complete a sale of a property.
A wrap can assume any of the three major financing forms—a mortgage, deed of
trust, or contract for deed. It can be designed to incorporate any and all of the special

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 112 Essentials of Real Estate Investment Eleventh Edition

clauses to be discussed later in this unit. Because of its relative simplicity, it allows for great
flexibility in its design.
Sale-leasebacks.  Another useful tool of real estate finance, the sale-leaseback, is used
primarily in large-project real estate transactions. In this situation, the owners of a prop-
erty sell it to investors and, simultaneously, lease it back, usually for long periods of
time—often from 30 to 40 years. The rents established in the lease are based on a fair and
prearranged return of the investment over the lease period. Thus, the investors are actually
purchasing a guaranteed return on their investment while insuring its recovery.
The advantages of this form of finance to the seller-tenant include the immediate
use of the cash proceeds from the sale and the opportunity to deduct the entire rental
amount as an operational business expense. This deduction is particularly advantageous
because the rent is based on the value of the land and the buildings. If the seller were to
retain ownership of the property, only depreciation on the buildings would be allowed as
a deductible business expense. Thus, the sale-leaseback technique is used most effectively
with properties already fully depreciated.
An additional advantage for the seller-tenant in this arrangement is that the obliga-
tion for the lease appears on the firm’s balance sheet as an indirect liability, whereas a
mortgage is considered a direct liability that adversely affects the firm’s debt ratio in terms
of obtaining future financing.
When the lease includes an option for the tenant to repurchase the property at the
end of the lease term, it is called a sale-leaseback-buyback. However, care must be taken
to establish the buyback price for a fair-market value at the time of sale. Otherwise the
arrangement is considered a long-term installment mortgage and any income tax benefits
that might have been enjoyed during the term of the lease will be disallowed. The buy-
back option is an important tool for the tenant because it effectively re-establishes a new
depreciable basis when the property is repurchased.
Joint ventures.  Also of great value as an investment-financing tool for acquiring real
estate is the joint venture. This technique is a form of equity participation that teams
lenders, who advance most or all of a project’s funds, with the developer, who contributes
time and expertise, as partners and co-owners. Some joint-venture participation arrange-
ments can be expanded to include the landowner and the construction contractor as well
as the financier and the developer.
A variation of this arrangement is split-fee financing. Here the lender purchases
the land under the project and leases it to the developer, while, at the same time, financ-
ing the improvements to be constructed on this leasehold. The land-lease payments are
established at an agreed-on base rate plus a percentage of the profits from the building’s
revenues. Under this arrangement, the lender-investor benefits by receiving a fixed return
(interest) on the loan investment, a flexible return on the land investment, and possible
residual benefits when the lease expires and clear ownership of the property is acquired.
The developer has the advantage of high leverage and a fully depreciable leasehold asset.

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 Unit 6: Financing for Real Estate Investments 113

SPECIAL PROVISIONS FOR INVESTMENT FINANCING

Creative Financing Arrangements

The variety of possible loan terms and conditions is virtually inexhaustible, comple-
menting the quality of high personal control usually acquired in real estate investments.
Some special financing clauses of particular importance to investors include prepayment
arrangements, due-on-sale provisions, assumption privileges, exculpatory clauses, and
what are often called creative financing arrangements.
Prepayment clauses.  Prepayment provisions in a real estate loan may include the right
to pay the debt in full before it is due, to impose penalties for any prepayment, to com-
pletely restrict prepayments for some designated time period, or various combinations of
these terms.
Prepayment privileges.  In the absence of any reference to prepayments in a loan con-
tract, a borrower may satisfy the balance of the debt at any time without restriction or
penalty. Some loans include a provision stipulating the total prepayments that may be
made in any one year without penalty. Such a clause establishes a partial prepayment
privilege.
Prepayment penalties.  Normally, a lender will not want a high-interest-rate loan to be
repaid prematurely. Hence, controls are established on prepayments of high-yield loans.
One form of control is the inclusion of a prepayment-penalty clause in the loan terms.
This clause imposes a penalty on any prepaid sums, thereby compensating a lender for any
loss in earnings due to early repayment. These penalties generally range from 3 to 5% of
the loan balance. In extreme cases, these percentages could be applied to the original loan
amount. Some states have laws restricting such penalties.
Lock-in clauses.  Some loans include a clause that prohibits any prepayment for a speci-
fied time period, often for as long as 10 years. This stringent form of control, called a
lock-in clause, is placed on very high-yield loans to preserve a lender’s earning position.
Often, combinations of prepayment conditions are incorporated into a single loan.
For example, a loan could restrict any prepayment for a certain time period, then allow
proportionate prepayments to be made annually, and finally allow the balance of the loan
to be repaid without restriction at the expiration of a specified term. Any deviations from
the agreed-on formula would result in the imposition of penalties.

Due-on-Sale Clauses
Lenders usually include a due-on-sale clause in their loan contracts. Also called a
call clause or transfer clause, this provision stipulates that a borrower may not sell, transfer,
encumber, assign, convey, or in any way dispose of the collateral property or any part
thereof without the express written consent of the lender. The due-on-sale clause goes
on to state that if any of the foregoing events should occur without the lender’s consent,
then the loan balance becomes immediately due in full, with true jeopardy of foreclosure
if not so paid.
The due-on-sale clause is designed to protect a lender from default by a subsequent
buyer of the property who assumes the original loan. Studies have shown that fewer
defaults and foreclosures occur against original borrowers than against second or third
owners, a testimony to the credit-underwriting procedures of most lenders.

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 114 Essentials of Real Estate Investment Eleventh Edition

Thus, in an assumption of an existing loan, the due-on-sale clause subjects the credit
of a potential new owner to the rigorous scrutiny of a credit analyzer. If the buyer’s credit
ability is found to be lacking, some adjustments in the loan provisions will be suggested.
If these adjustments are not acceptable to the parties involved, the lender simply calls in
the balance of the loan, requiring the parties to seek financing elsewhere.
A lender’s imposition of this call power can seriously affect the easy salability of an
encumbered property. The legality of due-on-sale clauses was challenged and, after con-
flicting high court decisions in many states, due-on-sale clauses were ruled legally enforce-
able by the U.S. Supreme Court in 1982. The case ruled upon, however, Fidelity Federal
Savings and Loan v. de la Cuesta, pertained only to federally chartered savings associations
and banks. Consequently, Congress passed the Garn–St. Germain Depository Institu-
tions Act which clearly stated that all due-on-sale clauses are enforceable for all real estate
loans.

Assumption vs. Subject-to Provisions

In the absence of a due-on-sale clause, existing financing is assumable by the buyers.
A buyer who assumes an existing mortgage agrees to sign the note and accept responsibil-
ity for repayment of the balance of the loan. In fact, the purchase of a property and the
assumption of the existing loan legally place the buyer in the same liability position as the
original makers of the note and mortgage and all intervening owners who had assumed
the same loan. In other words, a lender can look to any and all persons who have assumed
the loan for repayment and, in the event of a default, can hold them all personally liable
for complete satisfaction of the balance of the loan.
To avoid the imposition of this personal liability when buying a property with an
existing mortgage, and in the absence of a clause prohibiting such an approach, a pur-
chaser may stipulate in the contract that the purchase is being made subject to the exist-
ing loan balance. This approach effectively eliminates this particular buyer’s contingent
personal liability in the event of a future default. Only the original borrower and any
intervening assumers are liable.

Exculpatory Clauses
An effective technique used to minimize a borrower’s personal liability is to create
a nonrecourse loan with the inclusion of an exculpatory clause in the contract. This
clause is designed to limit a borrower’s personal liability exclusively to the property being
pledged as collateral, thus eliminating any possible attachment of other assets in the event
of a default. Most exculpatory clauses are included in construction loans but may be
added to real estate loans between individuals.

Alternative Financing Arrangements

Under most circumstances, a real estate loan is paid in regular monthly payments
of principal and interest over a specified time period. This system is called amortization.
Every payment is a function of the interaction among the loan amount, rate of interest,
and time of payments (see Figure 5.1 and Figure 5.2).
Economic conditions causing a lack of money for real estate loans and relatively high
interest rates on what money is available stimulate many innovative forms of finance.
These alternative financing techniques include variable payment schedules as well as vari-

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 Unit 6: Financing for Real Estate Investments 115

able interest rates. They attempt to satisfy both a lender’s desire to generate earnings and
borrowers’ desire to structure affordable payments. The following are some of the more
popular forms of creative financing.
Variable-payment schedules.  Under a loan contract, payments can be arranged to
reflect the specific needs of the parties thereto. For example, some borrowers require lower
payments in initial loan periods, while others prefer to pay higher amounts during the
early years. In the first instance, persons with limited earnings could enjoy the privilege of
lower payments for a few years, whereas in the second instance, higher wage earners might
choose to repay their loans earlier in anticipation of retirement.
Most variable-payment schedules are designed as graduated payment loans, also
called escalating loans, with lower early payments and later payments that gradually
increase to reflect a borrower’s improving economic status.
When a portion of the interest is deferred in addition to the principal, the loan
amount owed will increase from payment to payment. This is called negative amortiza-
tion, and unless some provisions are made for the payments to increase to include some
principal as well as interest, the final payment will be higher than the original face amount
of the loan. Negative amortization has fallen into disfavor and as a general rule should be
avoided.
Most loans are designed to amortize the amount owed over a prescribed period of
time. When payments are varied to reflect the needs of the loan participants, both interest
and principal can be adjusted. To the extent that the principal portion of the payment is
deferred, an interest-only amount can be derived. Under this arrangement, the amount
owed remains constant over time, and some provision must be made for this balance to be
paid in full as a balloon payment at a specified stop date. This loan is then called a term
loan. On the other hand, a partially amortized loan, where the payments are based on
a longer amortization schedule, requires that a balloon payment be made at the earlier
agreed-on stop date.
Variable interest rates.  Most real estate loans are arranged to be repaid over relatively
long periods of time at fixed interest rates. This procedure has proved to be somewhat
less than efficient because interest rates fluctuate over time, sometimes quite dramatically.
As a result, a number of lending institutions include variable interest rate clauses
in their mortgages. Also called an adjustable-rate mortgage (ARM), this technique
involves the development of a formula for interest computation based on an acceptable
measuring unit called an index, such as U.S. Treasury Bill rates, plus a fixed margin rate,
as an indication of current interest rates. If the index moves up a point, then the inter-
est rate on the loan will be adjusted upward 1%. Likewise, if the index drops, so will the
loan’s interest rate.
Obviously, there are faults in this program. Any substantial change in the index could
result in chaotic conditions for both the borrower and the lender. To offset the potential
problem of drastic changes in interest rates, certain conditions are usually included in the
contract to limit the amount of rate variability. For example, in some contracts the inter-
est change is limited to a maximum of 1% at any one time (caps), and then the new rate
must remain fixed for at least three years. Others have a ceiling, or limitation, on how
high the interest rate may be raised over the life of the loan. These types of limitations, or
any variation thereof, allows for a smoother transition between payment changes.

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 116 Essentials of Real Estate Investment Eleventh Edition

A participation mortgage allows a lender to participate in the income stream of an

income property as well as secure a share in the growing value of the property being
financed. Normally, a lender will reduce the interest rate on a new loan in exchange for
the share in the profits. Ownership remains in the borrower’s name, but the note recites
the partnership agreement.
A buy-down mortgage allows the seller, builder, buyer, buyer’s parents, or any third
party or combination of parties to make a lump-sum payment to the lender at the time
a loan is originated. In exchange, the interest rate is lowered, making the payments more
affordable.
A rollover loan is another effective technique for adjusting payments and interest.
Long-term payout schedules are established, but three-year, four-year, or five-year stop
dates are included. This forces the borrower to refinance accordingly and allows the lender
to adjust interest rates and payment amounts.
Zero-percent financing (ZPF) features loans at no interest. Offered by sellers who
agree to carry back these loans to sell their properties, only principal payments are required
until the loan amount is satisfied. The IRS imputes an interest rate on these transactions,
both to the borrower and the seller, allowing the borrower a commensurate income tax
deduction while charging the seller-lender tax on the imputed interest. The interest rate
imputed is the current U.S. Treasury Bill rate, adjusted twice a year.
A slight variation on this theme is the growing equity mortgage (GEM), where the
borrower increases the principal portion of the payment regularly, reducing the loan term
substantially.
The biweekly mortgage is an illustration of the GEM. By making one-half the loan
payment every two weeks, the borrower actually makes one full month’s extra payment
per year. This entire amount is applied to the principal and acts to reduce the amortization
period. Thus, a 30-year loan with this repayment method is reduced to 22 years.
A lease-purchase-option is still another form of creative financing. Here a lease is
designed to include the terms and conditions of a purchase option at the expiration of the
lease period. Often, portions of the rental payments are credited to the purchase price.
If the rental payments are considered option payments, a seller can postpone income
tax impacts until the option becomes due. If the option is exercised, the payments are
treated as capital gains. If the option is not exercised, the payments are considered ordi-
nary income (Koch v. Commissioner of IRS, 67 T. C. 71, (1976)).

DEFAULTS AND FORECLOSURES

The basic responsibilities of the parties to a real estate financial contract are clear-cut.
In exchange for money loaned, a borrower is obligated to
●● repay the loan according to the conditions stipulated,
●● preserve the value of the collateral, and
●● protect the priority lien position of the lender.
In the event the borrower breaches any of these obligations, the lender can exercise
the power of the acceleration clause and insist that the loan balance, plus accrued interest
and costs, be paid immediately and in full.

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 Unit 6: Financing for Real Estate Investments 117

Defaults
A default is the breach of one or more of the conditions or terms of a loan agreement.
When a default occurs, the acceleration clause found in all loan contracts is activated,
allowing the lender to begin foreclosure proceedings.
Payment delinquencies.  The most common default is the nonpayment of principal
and interest when due. Although most loan payments are due “on or before” a specified
date, most lenders respect a reasonable grace period, usually up to 10 days. Delinquencies
of longer than 10 days usually result in a reminder phone call or letter, and a continuing
lack of response will generally trigger the foreclosure process.
Property tax delinquency.  The nonpayment of property taxes is a technical default
under a real estate loan. Property taxes represent a priority lien over existing loans: if a tax
lien is imposed, the lender’s position as a priority lienholder is jeopardized. The collateral
property may be sold for taxes in some cases, eliminating the lender’s safe lien position. As
a consequence, all realty loans include a clause that stipulates the borrower’s responsibil-
ity to pay property taxes in the amount and on the date required. Many residential loans
include a portion of the taxes in the payments to be held in escrow until due. In accor-
dance with the Real Estate Settlement Protection Act (RESPA), only ¹/₁₂ of the taxes may
be collected each month. When the tax bill arrives, the lender must pay the bill in the full
amount even if the escrow account is short.
Other property liens.  Defaults also occur when a borrower allows federal, state, or
city income tax liens to vest against the property. In some jurisdictions, construction
(mechanics’ and materialmen’s) liens also take priority over pre-existing loans, and a bor-
rower is in default if these liens are recorded against the collateral property.
Hazard insurance premiums.  Nonpayment of hazard insurance premiums also con-
stitutes a default because the protection of the value of the collateral is paramount. Often,
the insurance premium is included in the loan payment. In accordance with RESPA, only
¹/₁₂ of the premium may be collected each month.
Neglected property maintenance.  Finally, a borrower is considered in default if the
property is allowed to physically deteriorate to the point where its value falls below the
balance of the loan.

Foreclosures
If any of the above defaults occur, most lenders would rather work out the problems
of a loan with the borrower before entering the foreclosure procedure. For example, if
the monthly payment is delinquent, some provision for a moratorium on a portion of the
payment, or even on the entire payment, might be offered to solve the problem in the
short run. If this is not successful, or if any of the other reasons for default are not curable,
then formal foreclosure is the only alternative.
Voluntary conveyance of deed (deed in lieu of foreclosure).  To avoid the compli-
cations and expenses of pursuing a formal foreclosure, a defaulting borrower may volun-
tarily convey the property to the lender. This strategy acts to keep the borrower’s credit
clear and puts the collateral into the hands of the lender quickly and efficiently. Depend-
ing on the circumstances, some lenders may not accept a voluntary conveyance. In a
distressed economy, lenders are more likely to be creative to avoid taking property back.

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 118 Essentials of Real Estate Investment Eleventh Edition

Instead of a foreclosure, the lender may agree to a “ short sale,” that is, a sale from the
delinquent owner to a new buyer at less than the loan balance. If the debt is nonrecourse,
the deemed sales price is the amount of the debt. If the debt is recourse, then the dif-
ference between the debt and the short sale price will be considered cancellation of debt
(COD) income and the short sale price minus the property’s adjusted basis will produce
gain or loss.
Judicial foreclosure and sale.  If the voluntary conveyance procedure is not possible,
as in cases of abandonment, then more formal procedures are followed. The most com-
mon foreclosure method under a note and mortgage format is the judicial procedure. A
complaint is filed in the court for the county in which the property is located, and a sum-
mons is issued to the mortgagor indicating the foreclosure action.
Simultaneously, a title search is made to determine the identities of all parties having
an interest in the collateral property, and a lis pendens is filed with the court, giving notice
to the world of the pending foreclosure. Notice is sent to all parties involved, allowing
them to defend their positions. If they do not do so, they will be forever foreclosed from
any future rights by judgment of the court.
After the appropriate number of days required by the jurisdiction for public notice, a
foreclosure suit is held before a presiding judge and a sale of the property at public auction
is ordered by means of a judgment decree.
A public sale is necessary to establish the actual market value of the property. If the
proceeds from the auction sale are not sufficient to recover the outstanding loan balance
plus costs, the lender may, in most states, sue on the note for a deficiency judgment,
which allows the lender to try and recapture any losses from the borrowers’ other assets.
Nonrecourse loans cannot have a deficiency judgment.
Power-of-sale foreclosure.  Under a deed of trust, the foreclosure process is the power-
of-sale method of collateral recovery. In the event of a default, the beneficiary (lender)
notifies the trustee of the trustor’s (borrower’s) default and instructs the trustee to foreclose.
Notice of default is recorded by the trustee at the county recorder’s office, and a
public notice is placed in the newspaper stating the total amount due and the date of the
public sale, usually 90 to 120 days from the recorded default.
Strict foreclosure.  Under a contract for deed, some states allow a strict foreclosure
process to prevail when the borrower’s equity is small. Designed to protect lenders under
low down payment transactions, strict foreclosures can take place in as little as 30 days
when the borrower has paid less than 20% of the purchase price.

Redemption Periods
A defaulted borrower has certain redemption rights under the law. In the judicial
foreclosure process, the borrower can bring the payments current, plus interest and pen-
alties, prior to the auction sale and redeem the property. This is called equitable redemp-
tion. In some states, the borrower has the right to pay the loan in full, plus interest and
expenses, for a certain period of time (varies from state to state) after the auction sale and
redeem the property. This is called statutory redemption.
Under the power-of-sale procedure, the borrower has the right to pay the balance in
full prior to the sale date to preserve ownership.

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 Unit 6: Financing for Real Estate Investments 119

Maximum Price
With a greater understanding of real estate financing and an appreciation of the lend-
er’s position, an investor may enter into a negotiation for the purchase of an investment
property with a distinct advantage. If the investor can calculate the most a lender will
lend on a property and add to that the most the investor can invest and still receive the
desired rate of return, then the investor can add the two to arrive at the most the investor
can pay for a property. Unlike buying a personal residence, there is no emotion involved.
The numbers either make sense and you have a deal, or they don’t and you move on to the
next potential investment property.
The calculations are as follows:
annual NOI ÷ debt coverage ratio = annual debt service ÷ loan factor = maxi-
mum loan
annual NOI – annual debt service = cash flow ÷ desired rate of return = maxi-
mum equity
maximum loan + maximum equity = maximum price

The debt coverage ratio is determined by asking the lender. The desired rate of return
is a judgment call on the part of the investor, and the loan factor comes from a chart and
depends on the interest rate and the term of the loan.

■■ FOR EXAMPLE  A property has an annual NOI of $100,000. The lender requires
a debt coverage ratio of 1.5. The lender will make a 30-year loan at 8.5%. The investor
wants a 12% return on the equity he invests. What is the maximum price the investor
can pay for this property? (Use Figure 6.1: Mortgage Constants to find the appropriate
mortgage constant.)

$100,000 ÷ 1.5 = $66,667 ÷ 0.09305 = $716,464 maximum loan

$100,000 – 66,667 = $33,333 ÷ 12% = $277,775 maximum equity
$716,464 maximum loan + $277,775 maximum equity = $994,239 maximum price
FIGURE 6.1  Mortgage Constants

(Annual Payments)
Years 8.5% 8.75% 9.0% 9.25% 9.5%
5 0.25377 0.25542 0.25709 0.25876 0.26044
10 0.15241 0.15411 0.15582 0.15754 0.15927
15 0.12042 0.12223 0.12406 0.12590 0.12774
20 0.10567 0.10760 0.10955 0.11151 0.11348
25 0.09771 0.09975 0.10181 0.10388 0.10596
30 0.09305 0.09519 0.09734 0.09950 0.10168

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 120 Essentials of Real Estate Investment Eleventh Edition

SUMMARY
The funds for financing real estate emanate from savings, both personal and corpo-
rate. These savings are held in the form of deposits in banks and savings institutions, and
as premiums paid for life insurance policies and into retirement and pension funds.
Basically, the funds for financing real estate investments originate from the financial
institutions in this country—the banks, savings associations, and life insurance compa-
nies. Either directly or through their correspondent mortgage bankers or representative
mortgage brokers, these intermediaries provide most of the monies for short-term con-
struction or home improvement loans; owner-occupied, single-family home mortgages;
and large-project, long-term financing, respectively.
Operating under a system of hypothecation, where the borrower pledges the subject
property as collateral to back up a promise to repay a loan while still retaining possession
and control of the property, the loans issued adopt the form of a note and mortgage, deed
of trust, or contract for deed. Under the note and mortgage, the borrower-mortgagor
has the longest periods of equitable and statutory redemption if the lender-mortgagee
forecloses. These redemption periods are shortened somewhat in the deed of trust format,
which requires that a borrower-trustor transfer the property’s title to a holder-in-due-
course trustee, who will maintain this title in trust for the lender-beneficiary. In the con-
tract for deed or land contract format, the buyer-borrower-vendee does not receive title
to the property from the seller-lender-vendor until the terms of the contract are met, thus
developing the possibility for even shorter redemption periods.
The mortgage, trust deed, or land contract can be used as either a senior or junior
loan. A senior loan is a lien in first priority position, with no other liens allowed to exist
or be created to jeopardize this protected position. The institutional lenders participate in
the senior loan market.
Junior loans are also sometimes used with increasing frequency by individuals to
arrange for the financing of the disparity between a new or an existing senior mortgage
and the price of the property being transferred. One of the more flexible types of junior
encumbrances is the wraparound contract, which encompasses existing liens. When the
wrap is drawn at a higher interest rate than the underlying mortgage, the wrap holder can
effectively raise the yield.
Among the variety of special provisions that may be included in a real estate loan
contract, those that are of primary importance to investors are the lock-in, right-to-sell,
assumption, and exculpatory clauses. Often, mortgages are established at interest rates
high enough so that a lender wishes to enjoy this yield for a prescribed time period. To
ensure this continuity, the borrower is prohibited from repaying the loan for the number
of years stipulated in the agreement.
In addition, a currently popular technique for lenders seeking to control their yields
is the due-on-sale provision. Here, the borrower must inform the lender in writing of the
possible sale of all or a portion of the collateral property and obtain the lender’s permis-
sion before the sale can be consummated. In this process, the lender may adjust the terms
of the loan to reflect more readily current money market conditions.
Investors may avoid any extended personal liability obligations when purchasing a
property by arranging the terms to include the words “subject to” rather than “assume and
agree to pay” when accepting responsibility for an existing loan. This format limits the

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 Unit 6: Financing for Real Estate Investments 121

investor-buyer’s personal liability to the collateral property, thus protecting other assets
from attachment in the event of foreclosure and a subsequent deficiency judgment.
This same limitation can be created by designing an exculpatory clause into the for-
mat of a new loan secured when purchasing a property.
Real estate loans can be established with an almost infinite variety of terms and condi-
tions, each loan being the final manifestation of the bargaining positions of the partici-
pants. Thus, payment schedules, interest rates, stop dates, balloon payments, discounts,
placement fees, and loan amounts reflect the status of the money market at the time a loan
is originated. And a borrower, given the personal control intrinsic in realty ownership, can
refinance property periodically to provide the cash flows necessary to pursue the highest
possible profit potentials.
Creative financing techniques, incorporating any number of versions of variable
interest rates and variable payment schedules, currently are available to finance real estate
purchases. Variable payment arrangements allow lenders and borrowers to manipulate
both interest and amortization rates. Variable interest rates protect lenders from holding
low-interest loans when rates are rising sharply. They are generally indexed to government
securities rates.
The participation mortgage and its variations, including the equity participation
mortgage, allow the borrower-buyer to pay lower interest rates or payments in return
for allowing the lender-seller a share in the property’s appreciation over a specific num-
ber of years. The rollover loan allows lenders to periodically alter interest and payment
terms, whereas zero-percent financing eliminates interest and acts as an inducement to
buy. The growing equity mortgage allows for regularly increasing proportions of princi-
pal in monthly payments, thereby reducing the term of the loan. The lease-option treats
monthly payments as rent with an option to buy at the expiration of the lease period.
A borrower is in default when regular payments are delinquent, property taxes are
not paid, income tax liens are allowed to vest, hazard insurance premiums are neglected,
or maintenance is ignored. If the borrower does not or cannot cure these problems in a
reasonable time and does not give the lender a voluntary deed in lieu of foreclosure, then
a formal foreclosure procedure is pursued.
Judicial foreclosure is used under a note and mortgage format. Here a lis pendens
is filed and a judgment sought to sell the collateral property at a public auction. If the
auction does not produce enough money to satisfy the balance of the debt plus costs, the
lender may secure a deficiency judgment. Under a trust deed, the power-of-sale foreclo-
sure allows the lender to record notice of default and schedule a public sale in 90 to 120
days. Some states allow strict foreclosure under a contract for deed when the borrower’s
equity is low and can be wiped out in as little as 30 days.
Some states provide a time prior to the foreclosure auction under a judicial sale to
bring the payments current. In addition to this equitable right of redemption, some states
allow an additional period of time after the sale, called a “statutory period of redemption,”
to redeem the property by paying the balance of the loan in full. Under the trust deed,
the borrower must pay the balance in full prior to the auction sale to maintain ownership.
A debt coverage ratio is the number of times that a property’s NOI can pay the debt
service. By using the debt coverage ratio, an investor can calculate the most a lender will
lend on a property and then add to that the most the investor can invest of the investor’s
own funds to receive the desired rate of return. By this calculation, investors know the
very most that they can pay and meet the desired goal.

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 122 Essentials of Real Estate Investment Eleventh Edition

DISCUSSION TOPICS
1. Check the interest rates, placement rates, and terms of real estate loans available in
your geographic area to finance real estate investment property.
2. Examine the laws in your state covering the redemption periods allowed a defaulted
borrower under the various real estate financing forms: mortgage, trust deed, and
land contract.

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 Unit 6: Financing for Real Estate Investments 123

UNIT EXAM 6. The real estate loan form under which the lender
maintains legal ownership is a
1. An adjustable-rate loan includes all of the follow-
a. deed of trust.
ing clauses EXCEPT
b. note and mortgage.
a. an index.
c. contract for deed.
b. a cap.
d. certificate of title.
c. a ceiling.
d. fixed monthly payments. 7. A negative amortization loan includes
a. a principal-only payment.
2. A basic difference between a deed of trust and a
b. an interest-only payment.
note and mortgage is the
c. a less than interest-only payment.
a. interest rate.
d. a principal-plus-interest payment.
b. redemption period.
c. length of loan. 8. A wraparound financial encumbrance implies all
d. size of loan. of the following EXCEPT
a. an existing underlying encumbrance.
3. A coverage ratio
b. a possible override profit.
a. establishes the amount of down payment.
c. an all-inclusive loan.
b. protects the lender from possible defaults.
d. a priority lien position.
c. establishes the amount of insurance required.
d. usually exceeds more than 3 to 1. 9. A seller under a sale-leaseback arrangement ben-
efits from all of the following EXCEPT
4. When assuming the balance of an existing loan,
a. immediate cash receipts.
the
b. release of liability under the existing assumed
a. original borrower is relieved of any further
mortgage.
personal liability on the loan.
c. tax deductible rent payments.
b. new borrower does not incur any personal
d. continued possession of the property.
liability on the loan.
c. new borrower is buying the property subject 10. With a $60,000 wrap loan payable at 10% inter-
to the terms of the loan. est-only around an existing $50,000 loan balance
d. original borrower and the new borrower are at 8%, the wrap holder’s annual yield is
jointly liable on the loan. a. 8%.
b. 10%.
5. All of the following refer to a real estate financing
c. 20%.
transaction EXCEPT
d. 56%.
a. collateralization.
b. agglomeration.
c. subordination.
d. hypothecation.

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 Section

B
Practices of Real Estate
Investment

124

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 Investing in Land
Unit

7
LEARNING OBJECTIVES
After successfully completing this unit, you will be able to
●● describe land investment feasibility studies and their essential elements,
●● list the types of single-lot investments,
●● describe the concept of acreage, and
●● describe the process of evaluating land.

assemblage land banking release clause

build to suit location rezoning
factoring plottage spot zoning
growth management recognition clause topography
hobby tax rules Regulation Z

INTRODUCTION
There are numerous and diverse investment opportunities in real estate, including
land, residential developments, office buildings, shopping centers, industrial projects, and
manufactured-home parks. In this portion of the book, the principles presented in the
prior units will be applied to an examination of these various types of investments.
Of all the forms of real estate ventures, investment in vacant land probably pro-
vides the greatest opportunity for creativity and profit. Simultaneously, it is no doubt the
riskiest real estate investment. Ranging from the simple purchase of an improved lot in a
subdivision by an individual who wishes to build a home, to the more complicated accu-
mulation of hundreds of unimproved acres to hold for future development and subdivid-
ing, to the acquisition of a tract of land in anticipation of rezoning for a more intensive
use, land is the real estate developer’s and speculator’s playground.
This unit examines methods for estimating the profitability of investing in vacant lots
and acreage as a portion of an investor’s total property-ownership portfolio. The goal of

125

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 126 Essentials of Real Estate Investment Eleventh Edition

most land buyers is to own the right property in the right place at the right time to com-
mand the highest possible return on an investment. Depending on an individual’s invest-
ment strategy, vacant land can provide a viable alternative to the ownership of improved
income property. Raw acreage presents the investor with an opportunity to diversify hold-
ings, earn high profits, and offset the risks of loss from other investments.
However, high profits are inevitably balanced by high risks, and vacant land invest-
ments are probably more affected by uncontrollable outside events than any other type of
real estate. Furthermore, land is not depreciable for tax purposes, and a beginning inves-
tor is well advised to start a portfolio with an improved income property. In this way, the
investor can maximize profits through the use of the tax shelters that improved property
provides. When income taxes have been somewhat minimized through investment tax
shelters, the investor is in a stronger financial position to speculate with vacant land.

ESSENTIALS OF LAND INVESTMENT FEASIBILITY STUDIES

Whether the investor in vacant land is a speculator or a developer of buildings, the
property’s location and physical quality will have a significant impact on the success of
the investment. Timing strategies, farming losses, development costs, and community
attitudes also affect the land investor’s potential profits.

Property Location
Primarily, the location of land determines its potential future growth in value.
Although some enterprising promoters have earned large profits from the sale of parcels
of relatively isolated land, well-situated property is more likely to increase in value. For
example, land lying within a three-mile area on either side of a major highway connecting
two neighboring communities is almost certain to increase in value over time. Generally,
communities tend to grow toward each other, developing increased demand and higher
values for intervening properties. As a rule, the closer to the highway a parcel of land is
situated, the higher its potential value.
Similarly, the purchase of raw acreage at the periphery of a community by an investor
who wishes to hold the land for appreciation requires an educated prediction of the direc-
tion in which the city will expand. An incorrect estimate of future growth patterns will
result in the investor’s waiting longer than expected for profit realization. As the waiting
period increases, the time value of money affects the average annual rate of return.
This relationship of location to value is equally applicable to single lots and large
tracts of land. For example, a lot purchased on a major arterial street in anticipation of
future rezoning for a more intensive use may prove to be an extremely profitable invest-
ment if the neighborhood grows in that direction. The reverse is also true. Another exam-
ple is a lot that is located on the exterior boundary of a subdivision and that overlooks a
large, vacant parcel of land. If the lot is to be used for the construction of a home, then
the development of a shopping center, office building, or other commercial activity on
the larger parcel may diminish the lot’s value. To a large degree, the value of land is based
on what can be built on that land.

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 Unit 7: Investing in Land 127

Property Features
The physical features of vacant land, such as topography and soil composition, are
as important as location in terms of future profitability. A parcel of land’s physical fea-
tures may be economically advantageous to one owner and disadvantageous to another.
For example, sloping foothill land is inefficient for farming but desirable for high-priced
homes with attractive views. Likewise, unimproved acreage near a large city may be less
useful for cattle grazing than for development as a suburban bedroom community.
Purchasers of single lots within a city must also be aware of the physical characteris-
tics of their land. A lot’s location, contours, drainage, soil quality, and rezoning potential
affect its value. Interior subdivision positions are essential to the buyer of a house lot,
while railroad tracks and highways are significant features of an industrial parcel. Retail
and office developments require access to major traffic arteries with high traffic counts,
while apartment and manufactured-home dwellers seek public transportation facilities
and neighborhood serenity.

Timing
“Buy low and sell high” is axiomatic to any investor seeking a profit, and proper tim-
ing has a great deal to do with both of these accomplishments. Timing is a particularly
important factor in real estate investments because, by their very nature, these invest-
ments are long term. In fact, real estate is often considered to be a nonliquid investment.
Often, it is easy to buy real estate but quite a bit more difficult to sell it; in some unfortu-
nate instances, it can become impossible even to give it away.
Land speculation requires a greater awareness of timing than many other real estate
investments because most land does not produce income during the holding period. It is
held by the investor pending a rise in value. The longer this interim holding period, the
lower the investment’s annual yield will be.
In addition to the land’s initial purchase price, the investor must make cash expen-
ditures for mortgage payments, property taxes, insurance, and improvements to the
land. Unless the property can be leased for some income-generating activity, vacant land
requires constant financial support during its investment life.
Depending on a lot’s location and characteristics, some owners will seek to minimize
their holding costs by renting their properties as parking or used-car lots during the wait-
ing period. Owners of larger parcels have found it expedient to develop farm or ranch
operations while waiting for the property to appreciate in value. Leasing the land to
tenant-farmers on a profit-sharing basis will often produce enough tax-sheltered income
to carry an investment.

Farming Losses
Although we have passed from a primarily agricultural society to a highly industrial-
ized one and are now in an era of services and informational systems, many parcels of
land in this country are still used for farming and ranching. When these activities are the
main occupations of their owners, the income acquired is treated as active income for tax
purposes.
Some land investors attempt to lease the land to a farmer or rancher to generate cash
flow and to keep the taxes low while they wait for the land to increase in value. Investors
who are not clearly defined as active farmers or ranchers will come under IRS Code Sec-

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 128 Essentials of Real Estate Investment Eleventh Edition

tion 183, which limits the deductions that can be taken by any individual or S corpora-
tion (active or passive) that is involved in these activities as so-called hobbies. Deductions
are limited to gross income. Any excess losses are not allowed to be carried forward to
future years but are lost forever. The IRS has additionally qualified the differences between
farming and ranching for a profit or for a hobby based on the following criteria:
●● The activity must be currently and clearly pointed to making a profit.
●● The owners/operators must have experience in the activity.
●● Considerable personal time and effort must be expended in the activity.
●● There must be legitimate hope for value appreciation.
●● The owner’s or operator’s other activities must be limited.
●● A continued series of annual losses cannot be tolerated.
●● Occasional minimum profits are not acceptable.
●● The activity must be the owner’s or operator’s main source of income.
●● Farming and ranching solely for enjoyment makes it a hobby.
The IRS is strict about enforcing these hobby tax rules in an effort to close the tax
loopholes that became prevalent in the 1970s and early 1980s. Some farming and ranch-
ing enterprises had been designed for large operating losses to allow their investors the
opportunities for abusive tax shelters.

Opportunity Costs
Whereas mortgage payments and property tax cash outlays during the holding period
are fairly obvious expenses, opportunity costs for the equity invested in the land are all
too often ignored. While the interest paid on a debt can be easily identified as a cost for
maintaining the investment, the interest not earned on the cash invested in the property
must also be included as a holding cost. The rationale for this practice is based on the
present-worth principle. If this money were invested, it would generate a profit. There-
fore, the money not earned on the capital invested should be considered as carrying costs.
For most real estate investors, the opportunity cost on invested capital forms the basic
measuring unit for determining their investment acquisitions. If, when sold, a property
cannot develop a return on the investment that substantially exceeds the loss of earnings
during the holding period, then these monies should be left on deposit or invested more
profitably elsewhere.

Community Acceptance
An investor in vacant land must become acutely aware of the legal and political atti-
tudes of local governing bodies. Local government may have a direct effect on the future
development of a specific parcel of land. Some communities have passed growth man-
agement legislation that requires developers to have their infrastructure (streets, sewers,
sidewalks, utility lines, and so forth) in place before they offer their properties for sale.
Others have raised other barriers to development. For example, if a community practices
a no-growth policy, it may be difficult, if not impossible, to secure the cooperation neces-
sary to have subdivision plans approved, or necessary utility services installed.

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The future value of land often depends greatly on the availability of gas, electricity,
and sewer services. Some communities control their growth by refusing to issue permits
for the installation of these utilities. Because a local moratorium on gas or sewer instal-
lations can destroy the timing strategy for a particular development, an investor in land
should carefully select those parcels that can be developed with as few potential difficulties
as possible. In the long run, growth management may result in ever-increasing prices for
developments and serious shortages of land for housing.
Land investors should be cognizant of the time involved in securing concurrency, a
meeting of the minds regarding appropriate land use. In addition, they should be aware of
the costs of impact fees charged by various government agencies for expanding pertinent
access roads and utility services.

SINGLE-LOT INVESTMENTS
The opportunities for single-lot investments include those individual parcels pur-
chased for residential construction and those that have the rezoning potential for more
intensive, and therefore more profitable, uses. In the first instance, the investor acts as a
developer, albeit on a small scale. In the second, the investor is a speculator seeking to
profit from the gain in value of the rezoned lot.

Residential Lots
Many people purchase a lot in anticipation of building a house on it in later years.
By acquiring a homesite at current costs, such a buyer hopes to profit from its growth in
value over time. Simultaneously, many of these buyers, unable to purchase a lot for cash,
enjoy the opportunity to make affordable payments over time so that the debt on the lot
will be paid in full prior to construction. The free and clear land then becomes the equity
necessary to secure a mortgage on the building.

Speculative Lots
In addition to residential lots purchased for future use, investors also buy strategically
located vacant lots in anticipation of a rise in value and profitable resale. Generally, these
speculative lot purchases are based on the possibility of a successful rezoning of the prop-
erty for a more intensive use than single-family residences. Included in this inventory are
lots physically suited for multifamily apartment projects and office structures as well as for
commercial and industrial developments.
Rezoning residential land to a more intensive use usually raises the value of the prop-
erty, sometimes quite dramatically. For example, in one community, when a 600-foot
block of residential property was rezoned to retail commercial use, its value changed
immediately from $200 per front foot to $500 per front foot. No physical changes were
required to make the land more usable, nor were any additional monies invested.
Successful rezoning requests are based largely on the subject property being located
in an area of use compatible with that being sought by the property owner. Good land-
control practices usually prevent any spot zoning and require that the applicant prove
conformity to the general land-use plan.
When purchasing vacant lots with possibilities for growth in value, an investor must
make a careful examination of the community to identify potential areas of expansion.

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 130 Essentials of Real Estate Investment Eleventh Edition

Once these neighborhoods are discovered, a meticulous search should be made to discover
the particular vacant parcels of land that have rezoning potential. The investor should be
aware that lots located on section and township lines often offer higher potential develop-
ment opportunities. Section and township lines are often used by land planners as major
roadway locations that develop the traffic needed by commercial developers to enhance
the profitability of the offices and stores to be located there.

Lease vs. Resale

It is important for investors who purchase lots for resale to carefully evaluate their
personal financial positions before actually selling. It may be more advantageous to lease,
rather than sell, the property.
A lease develops certain advantages for both the landowner and the tenant. The owner
benefits by securing an income stream into the future. In addition, at the expiration of
the lease, the reversionary rights to the land are retained, as well as any improvements
made thereon by the tenant. Long-term land leases also provide the landowner with an
asset—the lease—that can be capitalized on. By pledging the lease as collateral, the land-
lord can secure cash from a lender—tax-free cash that can be used to purchase additional
investments. Thus, the landlord continues to own the leased land and can expand the
investment portfolio accordingly.
The primary benefit to a land-leasing tenant is leverage: the leasehold interest acquired
under a long-term land lease can be pledged as collateral for a mortgage to construct a
new building. With a loan sufficient to pay for the costs of construction, the developer
may be able to leverage 100% and avoid investing personal funds in a project. In addition,
the rent paid by the tenant for the use of the land is considered an operating expense in
the year that it is incurred. Thus, by paying rent on land rather than owning it, a ten-
ant is effectively gaining the benefits of “depreciating” the land over the life of the lease.
Remember that land is not specifically depreciable.

Build to Suit
In an attempt to convert a vacant lot into income-producing improved property,
owners sometimes advertise that they will construct a building on a lot that will satisfy the
particular requirements of a potential tenant. On the signing of a long-term lease and the
construction of the building, the landowner becomes a landlord in the traditional sense.
At the expiration of the lease, the landlord continues to own both the land and the vacant
building, which can be re-rented or converted to a new use.
Building to suit generally refers to industrial, warehouse, office, or fast-food-res-
taurant facilities constructed for single users and designed specifically to meet individual
needs. The user may agree either to purchase the property when construction is com-
pleted or to become a tenant under a relatively long-term lease.
The build-to-suit market is currently being fueled by the rapid growth of high-tech
firms and life science businesses as well as by possible shortages of commercial space in
some areas of the country.
The difference in economic positions between an owner of a vacant parcel of land and
an owner of a vacant building is of critical importance to an investor in deciding whether
to build to suit. In the first instance, the property owner pays relatively low property taxes
and faces no continuing property-maintenance problems. In the second, the owner’s taxes

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 Unit 7: Investing in Land 131

are higher because they are based on the value of the building as well as the land. In addi-
tion, the building requires continuous care, repair, and protection.
Because the economic position of a building owner is more vulnerable than that of a
vacant lot owner, the landowner who solicits a tenant on a build-to-suit basis will negoti-
ate rather firmly for a lease that will completely satisfy investment requirements over the
term of the initial lease period. The rent will be arranged to develop an acceptable return
on the investment as well as a timely return of the investor’s cash outlay.

ACREAGE
Investors in raw acreage can be classified as either speculators or developers, as can
purchasers of small lots. A land parcel can be bought for resale as a single unit or for sub-
dividing into either improved or unimproved lots. In the former situation, the investor
acts as a speculator, holding the land for growth in value, and then selling the tract intact.
When raw acreage is subdivided, the investor who sells the land in small parcels after
few or no improvements have been made is speculating in land promotions, whereas the
subdivider who improves the raw acreage with roads, sewers, water, and other utilities and
amenities before selling lots is a land developer.
Land is often worth more as one wholly integrated and cohesive unit than it is as a
number of individually owned separate parcels. This concept is called plottage. To apply
this principle of ownership, a major farming or ranching enterprise would seek to control
as many adjoining acres as possible to attain more efficient production. Similarly, the
total of the individual values of lots in a block could be worth less than the value of the
entire block as a single site for a large shopping center. However, in this case, the value
increase is a function of a change in use as well as the efficiency of single ownership, called
assemblage.
Plottage can have a reverse effect on the value of acreage for speculators and develop-
ers. When quantities of land are accumulated for investment purposes, the total value
of the individual smaller parcels is usually less than the value of the total property when
finally acquired. However, if the speculator or developer decides to subdivide this wholly
owned property, the sum of the sales prices of the individual lots often greatly exceeds the
value of the property as a single unit. This concept will be examined in the next unit in a
discussion of conversion of rental apartments into condominiums.

Acreage for Resale in One Unit

In regions of the country where the land is fertile, very little acreage speculation takes
place. Productive land is usually held by individual farmers or ranchers. On the death of
the owner, the land is passed to family heirs. Speculation in acreage is most common in
areas of the country where the land is relatively unproductive.
The value of land is not based merely on its productive capacity. Depending on
intended use, location can become the key factor in determining value. Land specula-
tors are not as concerned with soil fertility as they are with locational advantages or dis-
advantages that will affect the future desirability of the land for developers or builders.
Accessibility to nearby major highways and communities; availability of water, gas, and
electricity; and proximity to natural and manmade amenities such as nearby lakes, woods,
golf courses, or ski slopes all increase the profit potential of investments in raw acreage.

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 132 Essentials of Real Estate Investment Eleventh Edition

Speculators in unimproved land range from the small investor, who buys 5 to 40 acres
located on the periphery of an expanding community, to the large investment syndicates,
which purchase thousands of acres to hold for future resale. Regardless of the size of the
investment, however, the philosophy is always to buy right to net a large profit.
Large profits are often less than they appear to be. For example, throughout its hold-
ing period, raw acreage requires the payment of such basic carrying charges as property
taxes, interest, and opportunity costs. Although taxes on vacant acreage are relatively low,
the compounding effects of opportunity costs must be included when analyzing the fea-
sibility of an investment in acreage. Remember, there is usually no cash flow to provide
offsetting income during the years between purchase and sale.
Assuming a property tax rate at a cost of 1% per year plus an opportunity (interest)
cost of 9% per year, the value of the land will have to increase at least 10% annually just
for the investor to break even when the property is sold. When an investor’s desired profit
rate and an appropriate percentage ratio to cover monies needed for the costs of a sale (for
example, commissions, title policy premiums, legal fees, income taxes) are added to this
10% rate, required annual increases in property value of 15 to 20% are often required.
This rate of increase means that the property must double in value every five to seven
years if the costs of investment plus a profit are to be earned. For example, even if the
value of the land increases 100% over a 10-year holding period and the property owner
sells for an amount twice what was originally paid, the annual rate of return is only 10%
(100% ÷ 10 years = 10% per year). At a 10% value increase annually, the investment may
not yield an amount of return adequate to cover both carrying costs and anticipated prof-
its. Thus, it is vital that an investor make an effort to identify future value-growth patterns
by carefully investigating trends in local property values.

EVALUATING LAND
The evaluation of raw land depends to a great degree on its future, rather than its
present, use. Thus, an investor must be able to predict the type of eventual use as well as
the time when this use will become feasible—not an easy task.
The most popular basis for evaluating land is the comparative approach, whereby
similarly zoned parcels of land that sold recently are said to establish the value. This is after
adjustments have been made for location, size, and date of sale.
A more comprehensive approach is advisable because the existing zoning of the land
may not be its highest and best future use. The time value of money also must be consid-
ered. Careful attention should be paid to an opinion of future use by analyzing the area’s
demographics, employment centers, and traffic counts. This information would form a
basis for projecting the number of acres that are in demand for each use classification (i.e.,
residential, business, industrial, and so forth).
In addition, a careful forecast should be made of when the property will be ready for
development. The factors to consider in this analysis include supply, demand, availability,
growth patterns, and distance from existing development. Some effort should be made
to project building costs and rents to estimate what a developer might pay for the land in
the future.
Finally, to derive the present value of the land, an appropriate investment return must
be established. When improved properties are being sold for close to a 10% capitaliza-

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 Unit 7: Investing in Land 133

tion rate on an all-cash basis, raw land requires that the investor double this figure to
account for the increased risks involved. Thus, a 20% annual return requirement should
be applied to project the future sale price.

■■ FOR EXAMPLE  Suppose a 15-acre tract of raw land is available for sale to an
investor who anticipates its use as a neighborhood shopping center within five years. The
present commercial rents in the area average $12 per square foot, and a 5% annual infla-
tion factor is anticipated.

If the land were ready for immediate development, its value would be worth approxi-
mately half the anticipated rents or, in this case, $6 per square foot. At 5% annual growth,
the land will be worth $7.66 (rounded) per square foot in five years. For an investor who
requires a 20% annual return, the price for the parcel today will be $3.08 (rounded) per
square foot:
$6 × (1.05)5 = $7.6577 per square foot, five years
$7.6577 × 0.4019 = $3.0777 or $3.08 present value

Subdividing for Speculation: Land Promotions

Some land-promotion projects are the consequence of speculation in raw acreage.
The promoter buys a large tract of vacant acreage, divides it into smaller parcels, and
resells these smaller, usually unimproved, lots to buyers scattered throughout this as well
as other countries.
These lots are marketed through various promotional plans and advertising media.
One of the more common marketing methods is to invite prospective buyers to a free
dinner during which salespeople extol the virtues of the property through lecture and
film. Often, these dinners are followed by an offer of a trip to the site, with any costs for
traveling reimbursed by the promoters after purchase of a lot. Generally, the various large
companies involved in such land promotions follow a format of marketing the individual
lots as second, or retirement, homesites.
The financing designs of both the original purchase of raw acreage by the promoter
and the subsequent sales of lots to individuals are the most important elements in this
form of real estate investment. A purchase of land for use in a sales promotion usually
requires the seller of the raw acreage to carry back a substantial portion of the sales price
as an installment land contract or purchase-money mortgage. Thus, after the promoter
makes a cash down payment, usually about 5 to 10% of the purchase price, the landowner
will accept a lien on the acreage involved for the remainder of the sales price. This bal-
ance is to be paid by the promoter on some regular amortization schedule. Under a land
contract, the seller retains legal title to the acreage until the terms of the contract are met,
usually the requirement that the balance be paid in full.
Most land-promotion property is sold to subsequent small-lot owners with any
underlying financial arrangements left intact. As a result, each individual sale is made sub-
ject to the lien of at least one existing encumbrance, the installment contract or purchase-
money mortgage between the promoter and the seller of the acreage. The existence of an
underlying encumbrance poses a serious threat to the purchaser of an individual lot if the
promoter does not make payments as required. The small-lot owner may be financially
hurt in a subsequent foreclosure of the master lien. To offset this problem, most legitimate

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 134 Essentials of Real Estate Investment Eleventh Edition

promoters will secure a recognition clause in their original financing agreement in which
the vendor or mortgagee agrees in advance that if the promoter should default during the
term of the agreement, the lender will respect the rights of subsequent lot owners and
honor their contracts.
Alternatively, a release clause may be inserted in the land contract under the terms
of which individual lots may be released from the master lien after a certain percentage of
its balance has been paid by the vendee.
The sales of lots to individual purchasers are generally designed as installment land
contracts. Most buyers of these promotional lots make small cash down payments, and
the balance is carried back by the selling company to be paid in regular monthly install-
ments. Frequently, the seller’s signature is not notarized, and, consequently, the contract
is unacceptable to the appropriate county office for recording.
A promoter hopes that the initial sales campaign will generate enough individual
sales to quickly develop the cash flows necessary to meet the required underlying contract
payments. Sometimes it takes a few years to reach this breakeven point, and the promoter
must be prepared to meet payments and operating costs with other funds. A promoter can
offset a cash shortage either by selling the individual contracts secured through early sales,
a process called factoring, or by pledging these contracts as collateral for a bank loan to
meet operating expenses. Once a breakeven point has been met, however, continued sales
will generally result in substantial profits.
Because they recognize the complexities and possible pitfalls for the consumer and
because of some past dishonesty in this form of land promotion, both federal and state
regulatory agencies carefully supervise such programs. All interstate land sales must con-
form to the requirements of the federal government’s Regulation Z. The promoters must
prepare and distribute to all prospective lot purchasers a full disclosure report describing
the subject property and the complete financial arrangements of the transaction. In addi-
tion, many states require that the promoter post bonds in amounts adequate to complete
any promised improvements to the land, such as roads, golf courses, clubhouses, and
lakes, before granting the promoter permission to market the lots (see Case Study 7.1).

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Case Study 7.1

1,280-Acre Land Promotion

The profit potentials in a land-promotion program can be illustrated by examining the case of
a two-section (1,280-acre) parcel of land, to be subdivided into 2,560 one-half-acre lots.These
lots will then be marketed within the state in which the property is located.

The purchase price of the raw acreage is $1,000 per acre, and it is estimated that it will cost
an additional $500 per acre to improve the land with roadways and basic utilities.An additional
$500 per acre will be needed for interest charges, carrying costs, and promotional fees. The
sales price of the half-acre lots will average $3,000 each, with 10% of the total sales to be
received as cash down payments. These monies will be allocated for sales commissions and
closing costs. The land contracts to be secured from the sales will be discounted and sold by
the promoter for 75% of their face value. It is anticipated that the project will take three years
to complete. The financial analysis appears below.

Costs:
1,280 acres @ $1,000 per acre $1,280,000
1,280 acres improvements @ $500 per acre + 640,000
1,280 acres carrying costs @ $500 per acre + 640,000
Total costs: $2,560,000
Income:
2,560 one-half-acre lots @ $3,000 each $7,680,000
Sales and closing @ 10% – 768,000
Sales contracts face amount $6,912,000
25% discount – 1,728,000
Net cash receipts $5,184,000
Less costs (above) – 2,560,000
Net profit before taxes $2,624,000
28% taxes (active income) – 734,720
Net profit after taxes $1,889,280
Return on total investment ($1,889,280 ÷ $2,560,000) 73.80%
Average annual return (73.80% ÷ 3 years) 24.60%

Note that this case includes discounting the contracts in an amount of $1,728,000, a substan-
tial sum of money. If the promoter were to hold the receivables, the returns would increase
dramatically. However, the face amount of those receivables would not be immediately avail-
able for reinvestment, as is the discounted sum. Thus, an opportunity cost would have to be
applied for the loss of earnings during the contracts’ holding periods, offsetting to a great
degree the higher profits.

However, note that the returns in this analysis are based on the full amount of the invest-
ment, assuming that they are paid in cash. More realistically, considering a leveraging investor,
the cash expended over the three years would include only the $1,280,000 costs for land
improvements and carrying charges plus a portion of the purchase price represented by an
acceptable down payment, such as 10%, or $128,000. The balance of $1,152,000 is carried
back by the seller of the raw acreage and is paid over time by the receipts collected from the
subsequent individual land contracts.

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 136 Essentials of Real Estate Investment Eleventh Edition

Therefore, the face amount total of the sales contracts, $6,912,000, must be decreased by
the $1,152,000 owed to reflect the promoter’s equity prior to discounting. The difference
is $5,760,000, and a 25% discount ($1,440,000) will result in a $4,320,000 cash flow before
costs and income taxes. Applying the more realistic cash investment figure of $1,408,000
($1,280,000 + $128,000 = $1,408,000), the returns are now as follows:

Total gross income $7,680,000

Sales and closing costs – 768,000
Sales contracts face amount $6,912,000
Less underlying encumbrance 1,152,000
Promoter’s equity in contracts $5,760,000
25% discount – 1,440,000
Net cash receipts $4,320,000
Less costs (adjusted) 1,408,000
Net profit before taxes $2,912,000
28% taxes – 815,360
Net profit after taxes $2,096,640
Return on cash invested ($2,096,640 ÷ $1,408,000) 148.90%
Average annual return (148.90% ÷ 3 years) 49.64%

Thus, leveraging actually doubles the bottom-line return of this investment.

Interstate Land Sales Regulations

The Department of Housing and Urban Development (HUD) engages in the regula-
tion of interstate land sales. HUD’s activities in connection with the Interstate Land Sales
Full Disclosure Act are of particular significance for those investors contemplating large-
scale land sales promotions.
Authorized under Title XIV of the Housing and Urban Development Act, the inter-
state land sales law is administered by the Office of RESPA and Interstate Land Sales. This
law requires that anyone engaged in the interstate sale or leasing of 25 or more improved
lots register the offering with HUD and make available to each prospective lot purchaser
or lessee all facts pertinent to the legitimate use of the land. The terms and conditions of
any financing in existence at the time of the sale or lease must be stated and the existence
of any other liens revealed. The probability for completion of promised off-site improve-
ments such as paving, parks, golf courses, and marinas must be given.
In addition to these data, the disclosure must also provide information about dis-
tances to nearby communities over paved or unpaved roads; provisions for placing con-
tract payments into a special escrow fund set aside for the purchase of the property; the
availability of recreation facilities; the availability of sewer and water services or septic
tanks and wells; the present and proposed utility services and charges; the number of
homes currently occupied; soil and foundation conditions that could cause problems in
construction or the use of septic tanks; and the type of title the buyer will receive.
A buyer is protected in several ways against failure to comply with the provisions of
the full disclosure requirements. If a prospective buyer has not been furnished a property

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 Unit 7: Investing in Land 137

report before signing, the contract may be canceled and a refund obtained. Furthermore,
the buyer must receive a property report at least 48 hours before a contract is signed and
must have seven calendar days after for a “cooling off” period. If the buyer wishes to can-
cel the contract during this period, a full refund of any payments will be made.
Criminal penalties of up to five years imprisonment, a fine of up to $5,000, or both
may be imposed if a developer willfully violates the law, makes an untrue statement, or
omits any material fact required in the statement of record or in the property report. In
addition, the purchaser may sue for damages not to exceed the purchase price of the lot,
plus any improvements made thereto, and reasonable court costs.
Complementing HUD’s requirements, a number of states have enacted their own
interstate land sales regulations as well. Administration of such state laws is usually placed
in the office of the state real estate or land commissioner. In Nebraska, for example, a
developer wishing to sell land located in other states must file an application for permis-
sion to sell with the Nebraska Real Estate Commission. The developer must pay a filing
fee commensurate with the number of lots in the subdivision and post a bond to guaran-
tee the timely completion of the off-site improvements promised in the sales.
Prior to granting approval for interstate land sales in Nebraska, the director of the
commission, or a deputy, visits the land at the developer’s expense to verify personally the
facts presented in the application.
Both the federal Interstate Land Sales Full Disclosure Act and the various state laws
regulating such sales have been developed to curb the fraudulent activities of unscrupu-
lous promoters of vacant land. Although land promoters invariably earn relatively high
profits, the purchasers of these lots often can barely recover their investments.

Subdividing for Development: Land Bankers

Speculation in acreage places an investor in a somewhat passive role while waiting for
values to rise to the point where profitable sales can be made. On the other hand, devel-
opment of acreage into subdivisions requires that an investor play a more active role to
effectively market the inventory of lots. Often, investors or builders purchase raw acreage
situated on the boundary of an expanding community, improve the property, subdivide
it, and sell lots or build houses, apartments, offices, or shopping centers on the land.
Every action of the subdivider creates value for the property including zoning, repair-
ing the land, installing the infrastructure, subdividing the land into lots, and constructing
houses.
A developer who improves raw land for construction purposes and maintains an
inventory of lots as a function of this ongoing business is called a land banker. Besides
the purchase price of the unimproved acreage, the costs of land banking include prop-
erty taxes, interest, off-site and on-site improvements, engineering, site development,
plat acceptance, sales commissions, insurance, and costs incurred because of timing con-
straints. The skills, risks, and responsibilities required of the land banker-developer make
this a very specialized segment of real estate investment.
To begin the development process, a land banker purchases a parcel of raw land,
usually 160 acres or more, and prepares plats and maps of the property designating street
locations, lot sizes, and the general plan for the entire proposed development.
These plats, usually drawn by licensed civil engineers, are submitted to the appropri-
ate community regulating agencies for approval of design and zoning. After meeting local

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 138 Essentials of Real Estate Investment Eleventh Edition

government requirements, including submission of a full environmental impact study,

the subdivider will proceed to physically prepare the land and sell lots to both individuals
and builders.
Depending on the amount of acreage involved in the development, the resulting
subdivision may follow the style of surrounding neighborhoods or may acquire a distinct
character of its own. Many large-scale developments include land designated for the loca-
tion of a school or a park, including a swimming pool, tennis courts, clubhouse, and,
perhaps, even a golf course.
Most well-planned subdivisions include a set of restrictions itemizing the type,
design, and quality of the improvements to be constructed on the lots therein. These
subdivision restrictions are recorded and become covenants that run with the land so that
each lot buyer and subsequent homeowner is required to observe these restrictions. Their
enforcement becomes the responsibility of the neighborhood association formed after the
project is completed. The restrictions are designed to create an economic and physical
homogeneity within a neighborhood, a condition important for maintaining property
values. By restricting lots to residential construction, incompatible uses are eliminated.
By requiring a minimum square or cubic footage for each house, an economic floor is
created, limiting the neighborhood residents to those who can afford to purchase a home
of the specified size.
Many builders do not have the financial capacity, the expertise, or the inclination
to become involved in land development. Such builders prefer to leave this type of real
estate investment opportunity to those with proven skill in the field. Smaller builders are
usually content to purchase lots from a developer-land banker, either singly or in packages
of from 5 to 50 lots, depending on their needs. The prices paid for these lots reflect the
developer’s cost of acquisition, preparation, and desired rate of return on the investment.
For smaller builders, this technique of land acquisition is much less costly and demanding
than an active entry into the field of subdividing (see Case Study 7.2).

Case Study 7.2

160-Acre Mixed-Use Subdivision

The profit potentials in land banking can be illustrated in the development of a 160-acre parcel
of land as a subdivision that will contain lots for a park, a school, apartments, offices, stores,
and houses.

Assume a purchase price of $1,120,000 ($7,000 per raw acre) plus $1 million allocated for
engineering, platting, rezoning, improvements, interest charges, and other carrying costs. The
project is expected to sell out in two years because of its strategic location and strong market
demand. Of the total parcel, 15 acres will be donated to the city for a park and roads, and 10
acres will be sold to the local school board for $100,000. This price reflects the developer’s
breakeven costs for the 10 acres and, together with the donated park site, establishes the
amenities necessary to attract potential home-buying families.

Anticipating a successful sellout of residential lots, contracts for the sale of a 10-acre apart-
ment site at $20,000 per acre, a 10-acre office site at $30,000 per acre, and a 15-acre shop-
ping center site at $40,000 per acre have been arranged in advance. The balance of the land,
100 acres, will be subdivided into 400 individual house lots to be sold for an average price of

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 Unit 7: Investing in Land 139

$6,500 each. Sales commissions and closing costs for all properties are estimated to be 10%
of the total receipts. The financial analysis follows:

Costs:
160 acres @ $7,000 per acre $1,120,000
Improvements + 1,000,000
Total: $2,120,000
Income:
15 acres donated for park 0
10 acres school site $100,000
10 acres apartment site @ $20,000 per acre + 200,000
10 acres office site @ $30,000 per acre + 300,000
15 acres commercial site @ $40,000 per acre + 600,000
100 acres @ 400 house lots @ $6,500 each + 2,600,000
Total $3,800,000
Less sales costs @ 10% 380,000
Net cash receipts $3,420,000
Less costs (above) – 2,120,000
Net profit before taxes $1,300,000
28% taxes – 364,000
Net profit after taxes $936,000
Return on total investment ($936,000 ÷ $2,120,000) 44.15%
Average annual return (44.15% ÷ 2 years) 22.08%

Note that in this case, as in Case 7.1, the bottom-line return is a function of the fact that
the entire investment has been paid in cash. With the appropriate application of leverage, the
returns for the mixed-use-subdivision developer can be increased substantially.

In this particular investment, the monies generated by the advance sales of the school site plus
the apartment, office, and commercial parcels ($1,200,000 total) would more than cover all of
the $1 million cost of the land improvements. Then, if the purchase could be arranged on an
installment basis, the investor’s cash outlay could be reduced to zero and the excess $200,000
used as a down payment.With this high leverage, the investor’s returns climb infinitely, creating
exciting possibilities for land-banking profits.

However, it must be clearly understood that investment in unimproved land is strictly a high-
stakes gamble. It is the most unpredictable of all types of real estate investment. No one can
accurately estimate when the land will sell or for what amount. In an economic slowdown, it
is the first to suffer and the last to recover.

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 140 Essentials of Real Estate Investment Eleventh Edition

SUMMARY
This unit examined some of the opportunities for investing in vacant land. Depending
on a property’s location, quality, purchase price, holding costs, and appropriate timing,
profitable speculative land investments can be acquired to enhance an investor’s portfolio.
Because most land holdings do not produce regular income, they are recommended for
the investor who has accumulated numerous improved income properties that will pro-
vide cash flows needed to carry the investment.
Land investments provide speculative opportunities that may generate relatively high
profits, depending on specific circumstances. Primarily, the location of the land deter-
mines the amount and timing of its future growth in value.
Investors must be aware of the opportunity costs, as well as the initial purchase price,
when estimating the profitability of purchasing raw land. In addition, careful attention
must be paid to the physical attributes of, and political attitudes toward, a specific land
parcel and the area in which it is located. These inputs must be positive to generate the
required growth in value within a reasonable time frame.
Single-parcel investments include residential lots purchased for the construction of a
home at some future time as well as speculative lots for resale.
More pertinent to the accumulation of a diversified real estate investment portfolio is
the purchase of residential lots with rezoning potentials. The rezoning of a parcel of land
to a more intensive use often substantially raises the property’s value. It is not unusual for
values to double or triple when a property is rezoned from residential to commercial use.
In the long run, it sometimes is more profitable to lease these rezoned parcels for new con-
struction rather than to sell them. The rental income developed from leasing establishes
an annuity for the landowner.
An alternative to leasing vacant land is to construct a building on the property and
thus convert the speculative quality of the investment to a more permanent income
stream. Care must be taken when erecting a single-purpose building, which may be dif-
ficult to re-rent when the initial lease expires or if the tenant defaults.
In addition to single-lot investments, many persons speculate in vacant acreage in
anticipation of profits through growth in value. Some investors purchase acreage to hold
until it increases in value to a point where the property can be sold profitably in one unit,
while others purchase acreage wholesale for subdivision purposes and then make a profit
by selling the smaller parcels at retail prices. It must be clearly recognized that investing in
vacant land is probably the highest risk of any real estate investment.

DISCUSSION TOPICS
1. Investigate the political attitude in your area regarding encouragement of growth,
no growth, or planned growth and examine the implications of this attitude for real
estate investors and developers.
2. Find a vacant site that is for sale on the periphery of your community and analyze its
present value using the information in this unit. How does your appraisal compare
to its asking price?

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 Unit 7: Investing in Land 141

UNIT EXAM 6. Excess loss carryover is disallowed by the IRS for

a. wheat farmers.
1. What is the value of acreage producing 6,000
b. horse ranchers.
bushels of grain per year worth $10 per bushel,
c. cow ranchers.
with a cost factor of 50% and a market capitaliza-
d. hobby farmers.
tion rate of 10%?
a. $30,000 7. Vacant lots are purchased by investors for all of
b. $60,000 the following reasons EXCEPT
c. $300,000 a. to build homes in the future.
d. $600,000 b. to resell them at higher prices.
c. to have them rezoned.
2. Of the factors affecting a parcel of land’s future
d. to shelter income taxes with depreciation
growth in value, the one that is generally consid-
allowances.
ered most important is
a. location. 8. Of the following, the property that will generally
b. price. develop the highest rental rate is
c. quality. a. an existing vacant store building.
d. timing. b. a newly constructed garden apartment.
c. a new store building constructed to suit a
3. From a locational point of view, a growth in value
specific tenant’s needs.
over time would most likely occur in land
d. a new store constructed as a speculative
a. adjoining a school.
investment.
b. near an interstate highway.
c. adjoining a manufacturing plant. 9. Plottage is based on the principle
d. near a railroad line. a. of buying low and selling high.
b. that the sum of the parts is more valuable
4. An analysis of the profitability of a vacant land
than the whole.
investment includes all of the following EXCEPT
c. that the whole is more valuable than the sum
a. income lost from unrented vacant land.
of the parts.
b. price and terms paid for initial purchase.
d. of buying wholesale and selling retail.
c. carrying costs, including interest and property
taxes. 10. Under the Interstate Land Sales Full Disclosure
d. opportunity costs on equity invested. Act, a buyer of a lot in a nationally promoted
subdivision has how many days after signing the
5. When discussing the quality of land, all of the
purchase agreement to cancel the deal?
following are included EXCEPT
a. Zero days
a. its topography and fertility.
b. Three days
b. the terms and conditions of its purchase and
c. Five days
sale.
d. Seven days
c. the availability of utilities.
d. the legal and political feasibility of its
development.

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 Investing in Residential
Properties
Unit

8
LEARNING OBJECTIVES
After successfully completing this unit, you will be able to
●● explain the options when investing in single-family detached homes,
●● describe the Fair Housing Act and how it affects residential properties,
●● explain the options when investing in multiunit apartments,
●● describe cooperatives and list the benefits of investing in them, and
●● describe condominiums and the procedure of converting other properties to condominiums.

common areas Fair Housing Act securities

condominium horizontal regime sinking fund
conversion lease tax credit
cooperative proprietary lease time-share
eviction

INTRODUCTION
More people invest in residential property than in any other form of real estate. Resi-
dential investments include ownership of a single-family detached house, an apartment
unit in a cooperative or condominium complex, and multiunit apartment buildings rang-
ing in size from duplexes to high-rise complexes.
An important feature of residential real estate ownership is the landlord-tenant rela-
tionship established when a house or apartment is rented. While these relationships are
usually amicable, unpleasant circumstances occasionally do arise. The necessary commit-
ment to active management, including the resultant interpersonal relationships, inhibits
many investors from participating in residential rental ownership.
This unit includes an examination of the various types of residential property invest-
ments, including management responsibilities and cash-flow analyses. A case describing
the profit possibilities in the conversion of a 100-unit apartment complex into a condo-

142

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 Unit 8: Investing in Residential Properties 143

minium association of individual ownerships is presented to broaden perspectives on the

field of residential property investment.

SINGLE-FAMILY DETACHED HOMES

Freestanding houses on single lots compose the greatest number of individual invest-
ments in the real estate inventory. According to the U.S. Census Bureau, in March 2015,
63.7% of this nation’s families owned their own homes. Included in this inventory, in
addition to the multitude of owner-occupied, detached single-family homes, condomini-
ums, and town homes, are houses purchased for rental, resale, rezoning, and conversion
into apartments. Investors also need to consider opportunities in affordable housing and
low-income housing tax credits.
In recent decades, suburban areas have been dominated by the single-family detached
house. This is changing to town homes and condominiums that offer housing with less
maintenance and lower costs. Condominiums have a median cost of approximately
$193,000 according to a March 2015 study by the National Association of REAL-
TORS® (NAR). This compares with a similar size single-family house costing a median of
$205,000, based on higher lot costs. This emerging market appeals to
●● divorced buyers who want to be near their children,
●● young professionals with no children,
●● empty-nest couples seeking freedom from maintenance responsibilities, and
●● senior citizens wanting to live near their children.

Owner-Occupied Homes
Technically, owner-occupied homes do not meet the full criteria for a real estate
investment. They are not income-producing properties and, therefore, are not eligible
for the complete range of deductions allowed for income properties. Only property taxes
and interest paid for mortgages on an owner-occupied home are deductible expenses for
income tax purposes. Additional deductions allowed for income property include main-
tenance costs, insurance premiums, and depreciation of the improvements. Most owner-
occupants, however, consider their houses as investments. For many people, buying a
home is the only real estate purchase they will make, and if they buy low and sell high, it
will come closer to an “investment” in the complete sense of the word.
The owner-occupied home has proved to be a successful means of enforced savings
for many people. A commitment to long-term mortgage payments generally results in the
accumulation of equity, which provides the basis for the measurable inheritable estates of
many owners. Frequently, homeowners find that they have relatively large equities in their
properties—equities that may be capitalized to acquire additional real estate holdings.
Furthermore, interest deductions may be taken on home equity loans.
Owner-occupied houses have also historically proven to be hedges against inflation
for those who wish to expand or improve their accommodations. Although the costs of
new construction have been rising, owners of existing houses have historically secured
enough funds from the sale of their older homes to enable them to purchase new homes.

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 144 Essentials of Real Estate Investment Eleventh Edition

Affordable Housing
The availability of affordable housing is an important social issue. Personal crises may
force America’s working poor to leave the safety and comfort of their homes and live on
the streets. Entire families are sometimes dispossessed and wander around looking for
jobs and shelter. There is a shortage of affordable homes and apartments for low-income
and no-income people. Cutbacks in national welfare programs have exacerbated the prob-
lem, while state and local agencies scramble to provide temporary shelters to preserve the
health and safety of the poor.

Low-Income Housing Tax Credits

One of the more socially redeeming current tax shelters is the tax credit available to
owners and developers of low-income housing. Low-income housing developed for the
purpose of obtaining these credits has created 2.6 million affordable homes since the 1986
passage of the U.S. Tax Reform Act. The Low-Income Housing Tax Credits (LIHTC)
program gives state and local LIHTC-allocating agencies the equivalent of nearly $8 bil-
lion in annual budget authority to issue tax credits for the acquisition, rehabilitation, or
new construction of rental housing targeted to lower-income households.
A tax credit is directly deductible from income taxes. Thus, it is a 100% tax benefit,
unlike other tax benefits, such as operating expenses, which are deducted from income.
For example, a $100 deduction at a 28% tax rate is worth only $28, whereas a $100 tax
credit can save the same taxpayer a full $100.
Low-income-housing tax credits provide an owner/developer with credits over a
10-year period on the following bases:
●● New construction and rehabilitation—a credit of 9% of costs is allowed each year
for the construction or rehabilitation of each qualifying low-income housing unit.
To qualify, the costs must exceed $6,000 per unit or 20% of the adjusted basis of
property purchased for rehabilitation.
●● New construction and rehabilitation financed with tax-exempt bonds or other federal
subsidies—a maximum credit of 4% is allowed each year, including projects financed
with Farm Service Agency loans.
●● Costs of acquiring existing housing—a maximum credit of 4% is allowed each year.
To qualify, the property must not have been used for low-income housing within the
previous 10 years.
●● Targeting requirements—to receive these credits, at least 20% of the units in a project
must be occupied by individuals with incomes of 50% or less of the area’s median
income, adjusted for family size, or at least 40% of the units must be occupied by
individuals with incomes of 60% or less of the area’s median income, adjusted for
family size. Units may not be used on a transient basis, thus eliminating hospitals,
retirement homes, hotels, and so on, from these credits. According to Fannie Mae,
there is an oversubscription for low-income housing tax credits each year, and they
are now allocated by lottery in some states because of the demand.

Homes for Rental Income

To qualify as an investment in the fullest sense, a house must be rented. Generally,
single-family house rentals generate only enough funds to cover the mortgage payments
and minimum maintenance costs. The owner of a detached house rarely secures cash

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 Unit 8: Investing in Residential Properties 145

flows that exceed breakeven requirements. Thus, any vacancy, even for a short time, seri-
ously erodes the profit potential of this type of rental-income property.

■■ FOR EXAMPLE  Consider an investment house valued at $150,000 purchased

with $30,000 cash and a loan for $120,000 payable at 6% interest. Assuming a rent of
$1,000 per month, this property will experience a 4% return on investment.

$12,000.00 Gross annual income

– 4,800.00 40% operating expenses ratio
7,200.00 Net operating income
– 7,200.00 Interest only @ 6%
(0) Cash flow
4,320.00 Depreciation ($120,000 × 0.036)
(4,320.00) Loss (tax shelter if qualified)
× 28% Tax bracket
$1,209.60 Tax savings (4% ROI)
An owner of a rental house must be personally responsible for the constant mainte-
nance of the property to ensure its continuous rental appeal. Maintenance of a single-unit
dwelling is costly, time-consuming, and inefficient in comparison with larger apartment
projects. The need for personal involvement of time and effort and the requirements of
maintaining a one-to-one relationship with tenants seriously inhibits the popularity and
profitability of this form of investment.
Some single-family-house investors have entered into partnerships with their tenants
on an equity sharing basis. The investor purchases the property and, instead of rent, the
tenant makes the loan payments and maintains the property. Then, at some specified time
in the future, they either refinance or sell the property and share in the profits, if any.
For those who are able to personally repair and rehabilitate older, worn-down proper-
ties, higher profits are possible. By purchasing dilapidated houses at bargain prices, these
investors can receive benefits in at least three ways:
1. An income stream that often shows a positive return on a small amount of invested
capital
2. An immediate growth in property value as a result of the repairs made; and as a result
of this added value
3. An expanded base for refinancing and continued investment pyramiding

Homes for Resale

Because of the increasing costs of constructing new homes, speculation in buying
and selling older houses is a popular form of real estate investment. The anticipation of
growth in value has attracted investors to buying homes, leasing them, then selling them
for profit. The rental income during the intervening years contributes to the carrying costs
of the investment.
Some investors pyramid their holdings by constantly buying and repairing older
homes for resale at higher prices. Profits from the sales are used to purchase more proper-
ties for rehabilitation.
Gentrification.  Many communities are expressing a growing interest in the renovation
of buildings in areas that are or were considered to be low income. This redevelopment

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 146 Essentials of Real Estate Investment Eleventh Edition

pushes up land values, rent, prices, and so on. That, of course, is good for property own-
ers, but not so good for tenants who generally need to move because of higher rents. This
results in gentrification, the upgrading of neighborhoods and the displacement of low-
income residents.

Homes for Rezoning

Generally, the most profitable detached-house investments include those located on
potentially rezonable lots. Depending on location and physical attributes, these houses
can often be renovated after rezoning and leased rather than sold. Frequently, these older
homes are particularly attractive to certain tenants who are able to capitalize on the archi-
tectural charm of such buildings to enhance their business activities. For example, law
offices, antique shops, and real estate offices enjoy a “home-office” environment when
located in older houses.

Conversion of Homes to Apartments

A unique investment opportunity is the conversion of large, older, but sturdily built
houses into several rental units. Many mansion-sized homes built on the periphery of
older, central, downtown areas and passed over by a city’s growth have fine conversion
possibilities. Often, the quality of construction of these houses is such that new partitions,
bathrooms, and kitchen facilities can be installed quickly and efficiently for a relatively
small cash outlay.
These apartments are usually in demand because of their proximity to downtown work
areas and their old-fashioned charm. The spacious rooms with high ceilings found in such
buildings appeal to many people, who will pay higher rents to enjoy this environment.
In the past, many of these grand old homes were purchased and razed by builders
of high-rise apartment and office buildings. Now, community planners are encouraging
conversion of the remaining properties into apartments or offices and requiring the reten-
tion of their historic architectural styles.

THE FAIR HOUSING ACT

The rules and regulations of the Civil Rights Act (Title VIII—Fair Housing, effective
December 31, 1968, as amended) are of significance to investors. The act and its amend-
ments are designed to eliminate discrimination in the sale or rental of housing based on
race, color, religion, sex, national origin, disability, or familial status. Investors who own
three or fewer single-family homes, and who do not use real estate licensees to assist in the
sale of the home(s), are exempt. In addition, owners of multifamily homes of two to four
units who live in one of the units and who do not use a real estate licensee to assist in the
rental of the units are also exempt.
These exemptions do not indicate that the government sanctions discrimination
under any circumstances. Investors are strongly advised to avoid any and all discrimina-
tory situations.
The original act was expanded in 1988 to include protection against discrimination
for persons with disabilities and families with children. The law extends fair housing pro-
tection to persons with physical or mental disabilities. However, it specifically excludes
persons who would pose a direct threat to the health and safety of others.

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 Unit 8: Investing in Residential Properties 147

The law stipulates that apartment buildings with four or more units must be acces-
sible to persons in wheelchairs. In buildings with no elevators, only the first-floor units are
covered by this provision. All doors and hallways in the building, as well as in individual
units, must be wide enough to allow passage by wheelchairs. Light switches, electrical out-
lets, and other controls also must be wheelchair accessible. Bathroom walls are required to
be reinforced to accommodate the installation of grab bars, and kitchens and bathrooms
must be designed to allow free mobility for persons with disabilities.
The law also covers families with children under the age of 18, including pregnant
women. All-adult communities are banned, except those that operate specifically for per-
sons who are at least 62 years of age. Housing in which at least 80% of the units are
occupied by at least one resident who is 55 years old is also exempt, if approved by HUD.
Although the Fair Housing Act is a federal law and is under the jurisdiction of
HUD, its implementation is generally left to the individual states, which have inaugu-
rated their own open-housing regulations. These state laws are usually broader in scope
than the federal law, and many include prohibitions against discrimination in financing
and appraising of real property as well as in leasing and selling. Any state fair housing law
must have at least the same seven protected classes as the federal law.
When a problem occurs under the open-housing laws, a complaint is filed with the
local commissioner, who investigates accordingly. The commissioner attempts to solve the
dilemma amicably and without litigation. If a suit is necessary, it is initiated by the com-
plainant in the appropriate state or federal court. In addition, the U.S. Attorney General’s
office may bring an action for injunctive relief in the federal court having jurisdiction over
the dispute.
A complainant can generally expect an answer to a locally filed action within 30 days.
If filed at the federal court level, an answer should be forthcoming within 100 days. Viola-
tors who refuse to obey the order of the court are held in contempt and fined or sent to
prison for up to six months. Persons found guilty of bringing false charges or complaints
with “willful intent” to falsify are subject to five years imprisonment or a $10,000 fine.
For more information on these laws, see Figure 8.1: Federal Fair Housing and Credit
Laws.

FIGURE 8.1  Federal Fair Housing and Credit Laws

Legislation Race Color Religion National Sex Age Marital Disability Familial Public Assistance
Origin Status Status Income
Civil Rights Act of 1866 • •
Fair Housing Act of • • • •
1968 (Title VIII)
Housing and • • • • • •
Community
Development Act of
1974
Fair Housing • •
Amendments Act of
1988
Equal Credit • • • • • • • •
Opportunity Act of
1974 (lending)

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 148 Essentials of Real Estate Investment Eleventh Edition

MULTIUNIT APARTMENT RENTALS

Rental apartments are a popular form of living unit in this country. Ranging in size
from a single small room above a garage to the numerous duplexes, triplexes, and giant
apartment structures found in all major communities, rental units vary widely in price,
design, amenities, and profitability.
After decades of fulfilling the American Dream of owning a home, the pendulum is
swinging back to favor apartment living. Renters have become older, more affluent, and
more educated. In recent years, as homeowners have experienced layoffs at work, houses
have been foreclosed upon in record numbers, and credit has been negatively affected,
more people are moving into rental properties. Because of the economic downturn, the
apartment market is growing and multihousing starts are up. National vacancy rates are
currently at 4.9% and forecasted to increase to 5.1% (though these rates vary by city).
Rents are projected to rise 3.9% in 2015, and rental prices are expected to outpace infla-
tion in 2016. According to the National Association of REALTORS®, low housing inven-
tory and the sizable demand for rentals will keep rents rising above inflation in coming
years.
New designs and locations in downtown areas are also spurring the increasing pop-
ularity of apartments, and the tax law allowing for exemptions from profits of up to
$250,000 per person from the sale of a home provides additional incentive to shift to
apartment living.

Management Responsibilities
More than any other type of real estate investment, apartments require the greatest
amount of management participation in terms of physical maintenance and continuing
tenant goodwill. The responsibilities increase with the number of apartments owned.
The National Multi Housing Council (NMHC) reports that the attraction and reten-
tion of high-caliber individuals as apartment managers ranks near the top of priorities for
investment apartment owners. About one-half of the more than 300,000 apartment prop-
erty managers are employees of real estate agency and management firms. Another 40%
are self-employed, and the remainder work for agencies of state and federal governments.
Apartment property managers fall into two general groups: on-site and off-site man-
agers. On-site managers are responsible for the day-to-day operations for a single proj-
ect. Their duties include maintenance, dealing with tenant requests and complaints, and
showing vacant apartments to prospective tenants. They keep records of income and
expenditures and submit regular reports to supervisors or owners.
Off-site managers exercise supervisory authority over on-site personnel at a number
of properties. They act as the liaison between the on-site manager and the property own-
ers. They market vacant space and establish rental rates.
Apartment management companies have created access to online credit scoring to
facilitate the leasing process. In addition, they have established webpages offering apart-
ments available for online viewing and leasing.
Leases.  The formal document that stipulates the length and the terms of a tenancy is
called a lease. A lease is a legally enforceable contractual agreement between a landlord
and a tenant. In exchange for a tenant’s promise to pay the rent on time and to maintain
the property in good condition, the landlord grants the tenant possession of the premises

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and guarantees the tenant’s rights to the peaceful use of the property for the duration of
the lease term (see Figure 8.2: Residential Lease).

FIGURE 8.2  Residential Lease

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FIGURE 8.2  Residential Lease (Continued)

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As important as the term of the tenancy may be, the investor’s prime concern is the
rent that the tenant is to pay for the use of the property. Rental payments by tenants are
the owner’s major source of income. Most leases require that rent be paid on some regular,
fixed-amount basis, usually monthly. Although most apartment leases are established for
one-year periods, some larger, more expensive complexes use leases of longer duration. In
these cases, rent might be payable on a graduated basis. For example, a three-year lease for
$21,600 could be paid at the rate of $500 per month for the first year, $600 per month
for the second year, and $700 per month for the third year. This technique enables a
tenant to offset the costs of moving and furnishings in the earlier period of the lease. It
also raises the rent gradually, allowing an easier absorption of higher charges in the later
periods.
A lease includes a promise to pay a certain sum of money as rent over a specified time
period. Probably more animosity is generated over broken leases than any other aspect
of the landlord-tenant relationship. Invariably, tenants lose their jobs, are transferred,
become ill, get divorced or married, or purchase a house, but the binding legal nature of
a lease inhibits and prohibits a tenant’s freedom to change housing to suit current needs.
A formal lease stipulates the monthly rental amounts and other terms in a written agree-
ment, whereas an informal, but still legally enforceable, monthly arrangement may be
made through an oral commitment between the parties.
The absence of a lease would disturb many tenants because under such an arrange-
ment, the landlord has the power to arbitrarily adjust the rents and conditions of occu-
pancy. Some tenants, however, are relieved at the lack of a lease and are willing to risk a
rent raise in exchange for the freedom of being able to move when desired. Most landlords
observe a no-rent-raise policy for a year as an operational strategy because they also run
the risk of a tenant’s moving to a competitor’s project. In the absence of a lease, tenants
should still be required to sign an agreement to observe the rules and regulations of their
occupancy.
Deposits.  Most states, under statutes governing landlord-tenant relationships, stipulate
that the landlord may collect a deposit under a lease, but that deposit must be maintained
in a separate account with any accruing interest belonging to the tenant. This creates a
bookkeeping chore.
To avoid this problem, many smaller residential project managers eliminate front-end
deposits and require the first and last months’ rents in advance. Larger projects collect
deposits and account for them as prescribed by law.
Evictions.  Although the laws governing evictions for nonpayment of rent vary through-
out the states, the following rules generally prevail:
●● When a tenant neglects or refuses to pay rent when due, or when a tenant violates any
provision of the lease, the landlord may, without formal demand, reenter and take
possession or commence an action for recovery of the leased premises.
●● The action shall be conducted as provided for actions for forcible entry or detainer
and shall be heard not fewer than 5 nor more than 30 days after its commencement.
●● If, after judgment for the plaintiff, the defendant tenant refuses or fails to pay the rent
owing and due, the landlord shall have a lien upon and may seize as much personal
property of the tenant located on the premises as is necessary to secure payment of
the rent.

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Provisions for amenities.  Depending on the size of the project, residential rental
properties often include some amenities besides the normal landscaping and architectural
style of the construction. In fact, the ability to enjoy a swimming pool, sauna, clubhouse,
tennis court, putting green, ski slope, marina, beach, or golf course is what many apart-
ment dwellers now seek for the amount of rent they pay. Whereas a tenant might not
be able to afford these amenities in a detached house, the availability of these facilities is
often a deciding factor when renting an apartment in a specific project.
Many apartment complexes are designed to attract persons with similar tastes, such
as retirement villages, ski resorts, golf and tennis groupings, and similar special-interest
rental developments.
The maintenance and management of these amenities generate problems and costs
for the project’s owners—costs usually passed along to the tenants in the form of higher
rents or use fees. The larger rental projects capitalize on their amenities by providing pro-
fessional recreational directors who oversee organized, planned functions within the proj-
ect. Ranging from dances to bingo games, these activities bring the tenants together and
encourage friendships, which, in turn, act to create that sought-after longevity of tenancy
so important for continued successful rental operations. Many of the more active apart-
ment complexes find that they have lists of people waiting to move in at the first opportu-
nity rather than the sporadically vacant apartments found in less well-organized projects.

Duplexes and Triplexes

Probably the most effective starter for a real estate investment portfolio is a duplex or
triplex apartment building. A beginning investor can occupy one unit while renting the
other(s). In this manner, the owner-landlord is on the premises to minimize maintenance
responsibilities. One example of investing in a triplex is outlined in Case Study 8.1.

Case Study 8.1

Triplex Profitability Analysis

This property consists of a brick building containing three two-bedroom, two-bath apart-
ments, each renting for $1,400 per month.They are unfurnished except for stove, refrigerator,
carpets, and drapes, and the tenants pay their own gas and electric bills. Operating expenses,
including an amount for vacancy, total 40% of the gross annual income. The property is avail-
able for $400,000 with $50,000 cash and a 15-year carryback at 8.64% interest-only payment.
The following is a return analysis:
$50,400 Gross annual income
– 20,160 Operating expenses (40%)
30,240 Net operating income
– 30,240 Debt service ($100,000 @ 8.64% interest only)
0 Cash flow
– 7,272 Depreciation ($200,000 × 3.636% annually)
(7,272) Loss
× 28% Tax bracket
2,036 Tax savings (rounded)
+ 20,000 Growth in value (5% annual average)
$22,036 Bottom-line return (44.07% on $50,000 investment, rounded)

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This analysis shows the effect of a breakeven cash flow. It is difficult to generate any strong
positive cash flows with smaller investments without making larger down payments or financ-
ing at lower than market interest rates. Note that eliminating an amount for growth, this
investment’s yield is only 4.07% ($2,036 ÷ $50,000 = 0.0407), not enough to attract an inves-
tor. Thus, the smaller property has to be purchased at a price low enough to allow the inclu-
sion of a growth factor.

Another advantage for the owners-tenants of a duplex or triplex is the development

of a tax shelter for the premises as investment property. This technique requires that
the owners “pay” a fair-market rent for their apartment as well as collect rents from the
other tenants. By including this rent in the reported annual income, the entire property
becomes eligible for allowable deductions as income property, including maintenance
costs, property taxes, insurance premiums, utilities, when applicable, and depreciation.
Thus, the owners may be able to shelter the entire income from the investment.

Multiunit Apartment Projects

The number of apartments in any one project might be 10, 50, 100, or even 1,000
units or more. Depending on the nature of the specific rental complex, there are vary-
ing degrees of management responsibility that reflect the size and scope of the project.
However, regardless of size, basic financial principles of rental property are essentially the
same, the only significant difference being the amount of money involved. One example
of investing in a large apartment complex is outlined in Case Study 8.2.

Case Study 8.2

100-Unit Apartment Complex Profitability Analysis

Now examine the economics of a 100-unit apartment complex. The apartment mix and
monthly rental schedule are as follows:

10 efficiency apartments @ $1,250 per month $12,500

20 one-bedroom apartments @ $1,350 per month 27,000
60 two-bedroom apartments @ $1,500 per month 90,000
10 three-bedroom apartments @ $1,650 per month 16,500
Total monthly rent: 146,000
Total annual rent: 1,752,000
Income from other sources (laundry, parking, etc.) 27,000
Gross annual income $1,779,000

Operating expenses, including a vacancy factor, are estimated to be 45% of the total gross
income. The property is evaluated at $9,000,000 with $2,000,000 allocated to the land and
$7,000,000 as the building’s basis for depreciation. An investor in the 35% tax bracket may
purchase this property with a $1,800,000 cash down payment to a new $7,200,000 first

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 154 Essentials of Real Estate Investment Eleventh Edition

mortgage payable at 8% interest-only, due in full in 15 years. Here is a first year’s profitability
analysis of this investment:

$1,779,000 Gross annual income

– 800,550 Operating expenses (45%)
978,450 Net operating income
– 576,000 Debt service ($7,200,000 @ 8%)
$ 402,450 Net cash flow
– 254,520 Depreciation ($7,000,000 @ 0.03636)
$147,930 Taxable income
$402,450 Net cash flow before taxes
– 51,776 Taxes (35% bracket)
$350,674 Net cash flow after taxes
÷ 1,800,000 Investment
19.48% Cash-on-cash ROI

Note the absence of any principal add-back in this analysis because of an interest-only mort-
gage. Note also the absence of a growth factor. Its inclusion would raise the bottom-line yield
substantially. However, unlike smaller properties, which generally follow the market values
closely, larger properties invariably lag behind. In this case, the value of $9,000,000 will prob-
ably remain constant for a while, depending on the local economic circumstances. In decid-
ing to purchase this property, an investor would concentrate on the almost 20% ROI as the
measure of profitability.

COOPERATIVES
A number of people wish to combine the economic benefits of home ownership with
the carefree attributes of apartment living. While home ownership provides an inflation-
ary hedge through value growth and equity buildup plus the tax shelters of property tax
and mortgage interest deductions, living in an apartment minimizes a tenant’s mainte-
nance responsibilities and usually provides a compatible community environment. In
addition, apartment living often provides tenants with a pool, sauna, marina, golf course,
and tennis courts, amenities most persons cannot afford on their own.
The cooperative apartment–ownership format provides an investor with an oppor-
tunity to marry the best of two housing concepts: ownership and tenancy. As with the
condominium, which will be examined later in this unit, the cooperative provides an
individual investor with the capability of being an owner and simultaneously enjoying
the tenancy of an apartment, maximizing both the economic and the social benefits that
accompany this arrangement.

History
A cooperative is a union of members formed for the achievement of a mutually sat-
isfactory goal. The benefits of goal attainment are shared by the members in direct pro-
portion to the labor and capital contributed to the cooperative enterprise. A real estate

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cooperative involves the joining together of persons for the purpose of owning real prop-
erty, usually an apartment building.
The concept of community housing is as old as humanity, dating back to the group
sharing of a tree or cave. Then, as now, the right to share in the living accommodations
was contingent on membership in the group. Ownership of the cave was a function of the
group’s ability to maintain control of the area—usually by force.
Today, property control is a function of our laws defining the rights of ownership.
Cooperative ownership as a legal means of holding title to property dates back to the
1880s in the United States, and even earlier in Europe. Until the end of World War II,
however, cooperative ventures in this country were somewhat limited. It wasn’t until the
postwar period, when mortgage financing and all types of housing were in short supply,
that cooperative corporations were organized on a large scale to combat high rents, espe-
cially in Chicago, Los Angeles, New York, and Philadelphia. The cooperative has been
eclipsed in popularity by the condominium.

Ownership Design
Cooperatives fall into two general categories—those that are publicly assisted and
those that are private. Publicly assisted cooperatives are designed to serve lower-income
groups through rent and mortgage interest subsidies and Federal Housing Administration
loans. FHA Section 213 provides up to 97% insured financing for eligible cooperative
enterprises. FHA Section 221(d)(2) provides up to 100% insured financing for up to 40
years at below-market interest rates to solve certain pressing inner-city housing short-
ages. Section 236 provides direct mortgage interest subsidies for low-income cooperative
developments.
Private cooperatives can be designed as either trusts or corporations. A trust coop-
erative places legal ownership of the property in the name of a trust company, which
then issues beneficial participation certificates to purchasers of units in the cooperative.
Ownership of this certificate includes the right to lease a unit subject to the cooperative’s
rules and regulations. Officers of the trust retain the responsibility for maintaining and
managing the cooperative.
Most cooperatives are organized as private corporations. This ownership form is
probably the most efficient in design because it provides for the election of directors
by the apartment owners–shareholders. These officers of the corporation then assume
the responsibilities for management. At the same time, the individual shareholders are
immune from direct personal liability for corporate obligations.
A corporate cooperative vests ownership of the property in the name of a corporation.
Stock in this corporation is issued and sold to apartment buyers in denominations pro-
portionate to the value of the apartments available for lease. Buyers select a specific apart-
ment, purchase a corresponding amount of stock in the owning corporation, and execute
a proprietary lease with what is now their own company. The lessees are then subject to
the rules and regulations established in the corporate charter and bylaws.
Under the terms of a proprietary lease, the specific unit is inseparable from the entire
ownership format. The amount of rent to be paid is a function of the proportionate
share of the apartment’s value, compared with the total value of the project. For example,
assume a 200-apartment high-rise cooperative with an overall value of $8 million. An
owner of a $40,000 apartment (stock is issued to the owner in this amount) has a 0.5%

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 156 Essentials of Real Estate Investment Eleventh Edition

obligation for operating costs ($40,000 ÷ $8,000,000 = 0.005). If costs equal $100,000
for the year, this apartment owner–tenant’s contribution for operating costs is $500, or
$41.66 per month ($100,000 × 0.005 = $500 ÷ 12 = $41.66).

Financing
Developers of cooperatives secure the land for the project by purchase or lease; con-
struct the apartment building, usually in the form of a high-rise or group of high-rise
structures; and offer the apartments for sale. The purchaser is actually sold stock in the
corporation that owns the structure in an amount commensurate with the value of the
apartment chosen.
The stock may be purchased for cash or on terms. If cash is paid, then the lease for
the subject apartment is developed at a rent reflecting the tenant’s proportionate obliga-
tion for operating costs, as described earlier. These costs include property taxes, insurance
premiums, and maintenance expenses. If the stock is purchased on terms, after an accept-
able down payment has been made, the buyer will execute an installment contract with
the corporation to include an appropriate amount for principal and interest in addition
to the proportionate operating charges.

Tax Benefits
Most privately developed cooperatives allow their shareholders to benefit from any
gain in the sale of their individual stock. However, government-sponsored projects limit
the amount of profit a shareholder may earn to the original purchase price of the stock
plus any principal paid on the mortgage and any capital improvements made to the indi-
vidual apartment. Under the provisions of Section 216 of the IRS Code, a cooperative
shareholder may deduct from taxable income the monies paid for proportionate shares
of the property taxes and interest paid on the corporation’s indebtedness. Furthermore,
if professionals or businesses use the cooperative property for the production of income,
they are also eligible for depreciation allowances.
To qualify for these deductions under Section 216, 80% of the cooperative’s income
must be derived from tenant-owner rentals. Hence, a project designed to allocate space
for rental income other than that from the tenant-owners’ units, such as street-level offices
or retail shops, must observe the 20% limitation on such income to preserve the indi-
vidual shareholder’s tax benefits.

Current Trends
Cooperatives as a form of apartment ownership currently appear to have the greatest
appeal to high-income individuals who wish to control their environments completely.
By forming a closed corporation and limiting the sale of its stock, a cooperative can
legally circumvent the open-housing laws. If a cooperative requires only cash purchases
to be made (thus eliminating any delinquent mortgage-payment problems) and strictly
enforces the buyback provisions in its bylaws, it can be designed to serve the interests of
people who desire a completely homogeneous and carefully controlled economic, as well
as social, environment.
All other forms of community housing must be offered for sale to the general pub-
lic. For this reason, most middle-income cooperatives have been converted to condo-
miniums to avoid the problems of delinquent rental payments and subsequent mortgage

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foreclosures. However, government-sponsored, low-income cooperatives are still being

promoted as a means of raising housing standards in the central areas of many large cities.

CONDOMINIUMS
The condominium, a natural alternative to the cooperative, is based on the indi-
vidual ownership of space in a multiunit building, be it apartment, store, office, or other
real property. Unlike the cooperative, the condominium-ownership design removes the
risk of reliance on others who might fail to make mortgage payments and consequently
jeopardize an entire project.

History
Although present to a small degree in early Rome, condominiums did not become
popular until medieval times when they effectively solved housing shortages in the walled
cities of Europe. The condominium concept, as developed in the middle-European coun-
tries, became called co-proprietary ownership and assumed varying degrees of importance
down through the centuries.
The idea was transported to South America by the immigrants of the early 1900s.
Years before the United States accepted this form of ownership, many other countries,
including Belgium, Brazil, Chile, Germany, Italy, and Mexico, had developed statutes
recognizing and defining the condominium horizontal regime as a legal proprietorship.
With passage of the 1961 National Housing Act, condominiums were legally recog-
nized in this country for the first time. Section 234 of this act provided FHA mortgage
insurance for apartments to be built in densely populated areas of Puerto Rico, which
was suffering from a severe housing shortage. High-rise structures were constructed and
individual mortgages arranged under FHA terms for persons who wished to purchase
their own apartments. The concept, however, was slow to be accepted by mainland devel-
opers. By 1968, only California, Florida, Michigan, and the District of Columbia had
constructed any significant number of condominiums.
During the early 1970s, “condomania” spread throughout the nation. A national
housing shortage coupled with an easy money market gave rise to an apartment-build-
ing boom that used the condominium format as a selling technique. In 1972, however,
adverse national publicity concerning the abuses perpetrated by some unscrupulous
developers slowed the condo boom considerably. There were reports of condominium
developers who retained the legal ownership of the land under their projects plus the ame-
nities constructed thereon, such as the swimming pool and clubhouse, and then charged
apartment owners extraordinary land rents and exorbitant amenity-use fees. These reports
quickly dampened the public’s enthusiasm for condominium ownership.
As a result of purported and proved abuses, new laws controlling condominium con-
struction and management have been adopted by most states. Currently, condominiums
have matured into an efficient and viable form of property ownership that offers investors
great flexibility in designing their realty holdings.

Ownership Design
Condominiums can be established for any type of real property, not just for apart-
ment buildings. Other applications of this ownership form will be examined in later

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units. The organizational design, however, is essentially the same for all condominium
developments.
Most states have enabling legislation that establishes the legal structure under which a
condominium can be developed. Among other stipulations, these statutes include provi-
sions for
●● recognition of divided ownerships transferable by existing title documents,
●● establishment of a binding declaration of bylaws among the participants that cannot
be voided or altered without mutual consent,
●● restrictions against further partitioning of the property described in the condomin-
ium regime, and
●● establishment of separate property tax assessments on each clearly defined unit.
The organization of a condominium requires that the developer first file a declaration
of condominium and a master deed with the appropriate local government registration
office. Then, each purchaser of a condominium unit secures an individual deed to an
apartment, which defines a fee simple ownership plus an undivided legal interest in all
common areas of the condominium structure.

Management
The bylaws of each condominium regime include a provision for the establishment
of an association of owners to supervise the management of the project. Included in
this management responsibility is care of the common areas as well as enforcement of
the project’s rules and regulations. Each condominium-unit owner receives a vote in the
association, and the group elects a board of directors to assume the responsibilities of
management.
In addition to supervising the personnel and services necessary for the maintenance of
the property, the board develops the association’s annual budget, including the amounts
required for property taxes, insurance premiums, and operating costs for the common
areas. The board submits this budget to the general membership for approval, and its
adoption forms the basis of a special assessment charged each condominium-unit owner.
This common-area assessment fee is based on the ratio of a particular unit’s purchase
price to the total original value of the project. Thus, the owner of a $40,000 apartment
in a $2 million project will have a constant assessment ratio factor of 2% ($40,000 ÷
$2,000,000 = 0.02), which will be applied to the annual operating expenses to determine
the proportionate share. A common-area operations budget of $30,000 would require a
contribution of $600, or $50 per month, from this owner ($30,000 × 0.02 = $600 ÷ 12
= $50).
In addition to collecting the monthly common-area operating fees from the associa-
tion’s members, most condominium managers impose an additional charge to accumulate
reserves in anticipation of major repairs and replacements. To assess the owners for their
proportionate contributions to this sinking fund, which is deposited separately into an
interest-earning savings account, the useful lives of the major components of the com-
mon areas are analyzed. The sinking fund charges applied in a high-rise project would
normally be greater than those for a low-rise apartment building because of additional
maintenance responsibilities, such as the roof and elevator(s), in the former structure. In
a low-rise, while individual owners might be responsible for repairs to the roof, there are
no elevators to maintain.

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Financing
In effect, a high-rise condominium is a vertical subdivision, with each floor represent-
ing a block and each apartment or office space a lot. Likewise, low-rise condominium
structures are horizontal subdivisions, with the improvements joined together by com-
mon walls, eliminating the side yards. Thus, a developer generally secures funds for a
condominium development from sources that normally provide monies for subdivision
site improvements and construction financing, such as commercial banks or mortgage
bankers. A condominium-apartment buyer generally secures a loan from a lender in the
home-mortgage field, similar to a buyer purchasing a single-family detached house.
A real estate lender views a high-rise condominium apartment as a “house in the air,”
or a cube of space circumscribed by walls. The individual apartments are collateral for
specific loans, and their values are determined much as are the values of individual houses.
In the event of a default, a lender can foreclose on the collateral and assume an ownership
role with all of the associated duties and obligations until the apartment can be resold.
Thus, all of the normal realty lending activities apply to the financing of condominium
property.
Condominiums are accepted by the FHA and VA for their insurance and guarantee
programs. Moreover, they are considered by these federal agencies to be important vehi-
cles for the provision of needed housing for low-income and middle-income individuals.

Tax Benefits
Because a condominium unit is considered to be a basic form of real estate, all of
the tax benefits accruing to property owners also apply to condo owners. Deductions for
property taxes and mortgage interest are available to the owner-occupant, while operat-
ing costs and depreciation allowances are deductible if the apartment is rented as income
property. If an owner wants to sell the unit, any profits secured from the sale do not have
to be shared with a corporation (as in cooperative ownership) and can be postponed
through the use of an installment sale or like-property exchange.

Current Trends
The condominium form of ownership is likely to continue in importance, retaining
its position in the housing market and as a viable ownership alternative for singles and
childless couples.
In addition to apartments, the condominium format can be applied to office and
commercial buildings and to industrial and factory-built home parks as well. Even single-
family, detached houses are being constructed around condominium-area amenities, such
as golf courses or marina facilities. In this type of condo development, the purchaser
receives a deed to the house and underlying lot plus an undivided interest in the ameni-
ties. A regular fee for the use of these facilities is assessed by the managing association and
charged to the subdivision homeowners, establishing a private club atmosphere.
Retirement and recreational developments have also used the condo format, many
very successfully. Retirement communities have burgeoned all over the country, primarily
in the warm-weather states (see Unit 12). These developments, which cater to the tastes
and physical abilities of the owners, are usually composed of a mixture of single-family
detached homes and condominium apartments. Other retirement villages consist entirely
of condominiums. The larger factory-built home projects, in which each person owns a

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 160 Essentials of Real Estate Investment Eleventh Edition

lot in common with the other lot owners, provide for shared ownership and use of the
common-area roads, pool, and clubhouse.
Recreational condominium projects also have become successful as members of our
society have become more affluent and acquired more leisure time. Ski areas, ocean and
lake resorts, and golf courses increasingly catch the eye of the astute investor-developer as
potential building sites.
Securities rule.  Careful attention should be paid to second-home investment con-
dominiums that are purchased with a money-back guarantee and lock-in management
agreement with the selling agency. The Securities and Exchange Commission (SEC) has
interpreted that these purchases are not considered real estate per se, but rather securities,
which their promoters and developers must register for SEC supervision. If this inter-
pretation prevails and the investments are not real estate, then the IRS may disallow any
realty tax benefits. Consequently, investors in this area of real estate would have to prove
that they were taking the risks normally associated with investment activity to be eligible
for income property allowances.
Time-sharing.  An innovative ownership format that is a spinoff of the recreational con-
dominium concept is the time-share. Here, a condominium unit can be designed for
multiownership, with each owner having a specific period of use. Consequently, in theory
at least, 26 persons could jointly own one condominium apartment and each use it for
two weeks of the year.
Expanding on this theme, the joint owner of a mountain condominium apartment
could trade the time allocation with the owner of a seaside condominium. Through the
services of an association of time-sharing owners, this approach has been further extended
to include foreign country condominium owners. A two-week stay in a Monaco condo-
minium is possible in exchange for the use of an Atlantic City apartment.

CONVERSIONS TO CONDOMINIUMS
One of the more creative real estate investment opportunities is the conversion of
rental properties into condominium ownerships. Depending on market conditions at the
time of conversion, as revealed by a feasibility study, an owner of an apartment, office, or
commercial building can file the appropriate documents to declare the existing property
a condominium and proceed to sell the individual apartments, office units, or stores. The
basic market of potential purchasers of the converted units is the tenants occupying the
building.
The most successful conversions are of properties that are successful rentals. People
want to be there and will buy. The least successful conversions are those of problem prop-
erties. A conversion will not attract buyers to an unattractive property.
Some investors are engaged solely with conversions as profit-making ventures and
travel the country purchasing property specifically to convert into condominiums. In
land use, the principle of agglomeration is reflected by combining small parcels to make
one large, more valuable property. These investors apply the agglomeration principle in
reverse—when converting to individual units, the sum of the parts exceeds the value of
the whole. Other investors use this technique as a means of securing a final gain for the
sale of their property when all the depreciation has been used up. Still others use conver-
sion as a means of selling their property to avoid rent ceilings placed by local govern-

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 Unit 8: Investing in Residential Properties 161

ment agencies. These ceilings quickly dry up rental cash flow because property taxes,
utility charges, and maintenance costs continue to rise unabated. In many cities, there
are restrictions on condominium conversions, such as lottery procedures and minimum
rental vacancy requirements. City planners sometimes desire to maintain the pool of
affordable rental housing by restricting conversions.
Case Study 8.3 provides an overview of converting a large apartment complex into
condominiums.

Case Study 8.3

Problem Analysis: 100-Unit Apartment Conversion

A conversion analysis measures a property’s value as an ongoing rental operation against the
potential total value to be derived from the sale of the individual units, be they apartments,
offices, stores, or other types of space.

Examine the economics of the conversion of a 100-unit apartment complex to a condomin-

ium-ownership format. The property includes 100 apartment units situated in 10 separate,
individual, wood-frame and stone-faced buildings, clustered around a swimming pool and club-
house. In addition to its garages and storage facilities, the property is surrounded by high
hedges and tall trees that effectively isolate it from the adjoining neighborhood. This feeling
of unity is enhanced by the rustic alpine decor complementing the rolling eight-acre terrain.
The project is 20 years old and fully depreciated by its owner. It includes one-bedroom, two-
bedroom, and three-bedroom apartments, all with fireplaces, kitchens with built-in appliances,
and individual central heating and cooling units.

The buildings include a total of 150,420 square feet—of which 40,420 square feet are the
hallways, laundry rooms, and storage spaces—leaving 110,000 square feet as the rentable area.
Market rents for this property are estimated to be an average of 35 cents per square foot per
month. Thus, the gross annual rent from the apartments is $462,000 (110,000 square feet ×
0.35 = $38,500 × 12 months = $462,000). Together with $8,000 as additional annual income
from laundry machines and separate garage rentals, the property generates $470,000 total
annual gross income. Assuming total operating expenses of $212,000, including vacancies, the
net operating income before debt service is $258,000 ($470,000 – $212,000 = $258,000).

In this example, the $258,000 net operating income indicates a market value of $2,580,000
for the property as a rental investment. This amount is derived from an application of the
income-approach appraisal technique, using a 10% capitalization rate. A capitalization rate may
be interpreted as that rate of return from a particular investment with which an investor is
satisfied. Thus, an investment of $2,580,000 will develop a return of $258,000 at a 10% rate
($2,580,000 × 0.10 = $258,000, or $258,000 ÷ 0.10 = $2,580,000).

This value can be compared with the total amount that could be secured from the sale of the
individual apartments as condominiums. There are various appraisal methods to estimate the
sales value of converted condominium apartments. One is the market approach, in which an
estimate of value is derived by comparing the subject property to similar properties recently
sold. Another appraisal method is the cost approach, which estimates the total costs for
rebuilding the property today and then deducts an amount for depreciation commensurate
with the subject property’s loss in value over time.The income approach provides an estimate
of a property’s value based on the capitalization of its net income stream, as applied above.

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 162 Essentials of Real Estate Investment Eleventh Edition

In appraising the value of the apartments as individual units, a combination of the market and
cost approaches develops a factor of $60 per square foot of living area as a proper com-
parison unit. This amount reflects the current depreciated value of all of the improvements,
including the value of the land. Thus, the total amount of money that can be secured from the
sale of the individual apartments is estimated to be $6,600,000 (110,000 square feet of living
area × $60 = $6,600,000).

Estimating a 40% sales cost factor, including required renovations as well as commissions, title
examination and insurance fees, escrow, legal, and mortgage-placement charges, the net pro-
ceeds from the sale would equal $3,960,000 ($6,600,000 × 0.40 = $2,640,000 and $6,600,000
– $2,640,000 = $3,960,000).

The difference in the value of the project as a rental operation versus its potential net sales
income is $1,380,000 ($3,960,000 – $2,580,000 = $1,380,000). Thus, the owner stands to
make a substantial profit on such a conversion.

Procedure
The conversion procedure involves filing the necessary legal documents to secure
approval from the appropriate local government agencies, as described earlier. Then a
marketing strategy is designed to reflect the current local demand for the type of space
being offered for sale. This plan includes a price schedule of the individual units as a func-
tion of their size and location within the complex. In addition, a program for financing
the individual sales with local lenders must be developed in advance.
Many conversions, especially of older apartment buildings, require extensive renova-
tion and modernization of improvements to comply with current building codes and to
provide for the government’s disability requirements. Structures with more than three
floors may require the installation of elevators, and others may need their stairwells
remodeled to meet current fire protection standards.
When extensive repairs must be made, care should be taken to minimize disturbance
of the present tenants to preserve rental cash flow during the conversion period. One of
the greatest risks of the conversion technique is the possible mass exodus of tenants and
the elimination of rental income before sales commence. A converter should be prepared
to meet this financial contingency with adequate capital reserves and a sound marketing
plan.
A natural, often readily available, market for the converter-investor is the tenant who
already occupies the property involved. An honest and forthright approach is required
when notifying tenants of the conversion decision. A tenant’s alternatives are relatively
simple—purchase the unit and retain possession or be prepared to move when the unit
is sold.
Often, the harshness of the buy-or-move alternative can be softened with a new
lease for six months or a year to enable the tenant to find other quarters. More effective
from the converter’s viewpoint, however, is to arrange the purchase terms specifically for
the tenant-occupant so that little cash is needed and the required mortgage payment
approximates the present rental amount. Thus, the tenant can become an owner with
little change in financial position. This approach can overcome some of the sales resistance
from tenant-occupants, but experience has shown that only 30%–50% of current tenants
choose to become owners.

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 Unit 8: Investing in Residential Properties 163

Midconversion Difficulties
Aside from the expected difficulties encountered with condominium organization
and renovation, some conversion projects undergo extraordinary problems during the
marketing period.
At some point in the sales program, a mixture of tenants, resident owners, and non-
resident owners may all share an interest in the same project. Problems may arise, such as
inconsistent payment of rent and association dues, ignored rules, and noninvolvement of
resident owners.
The converter must consider the solution to these problems at the outset, establish a
clear and concise set of rules and regulations, and devise a set of enforceable penalties to
back them up. As this is a complicated process, conversion programs should be closely
supervised by competent lawyers, accountants, and property managers.

SUMMARY
This unit examined the alternatives available for investments in residential properties,
including single-family detached homes, multiunit apartment projects, cooperatives, and
condominiums.
More investments are made in residential properties than in all other forms of real
estate combined. The most common ownership is the single-family detached home. An
owner-occupied home, however, does not fully fit the technical description of an invest-
ment because it does not generate income. Still, a homeowner does consider a house as an
investment and profits from it through property tax and mortgage interest deductions, as
well as through possible growth in value.
To qualify as an investment in the fullest sense, a house needs to be rented. House
rentals usually generate only enough income to cover the minimum maintenance expenses
plus mortgage payments. Detached houses situated in areas with rezoning potentials are
more profitable. Here, the rental income generated during the holding period prior to
rezoning acts to develop a return on an investor’s initial cash outlay, and the expected
increase in property value reflects potentially large profits.
For investment purposes, duplex, triplex, and larger multiunit apartment projects
provide investors with many tax-sheltered, profit-making opportunities. Because it
involves a large degree of personal commitment to management, residential rental-apart-
ment ownership requires more of an owner’s time and effort than do most other forms
of realty investment. Depending on the size of the project, these responsibilities can be
delegated to professional management firms.
Single apartments in a multiunit building may be owned by individuals who join
together in cooperatives or condominiums to enjoy the positive attributes of apartment
living while minimizing the responsibilities of home ownership. The benefits of apartment
living, with friends and activities close by, appeal to a large segment of our population.
A cooperative is based on a corporate format, in which individual shareholders exe-
cute proprietary leases for apartments suitable to their needs. The corporation owns the
property, but the shareholders can benefit from deductions for their proportionate pay-
ments for property taxes and interest.

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 164 Essentials of Real Estate Investment Eleventh Edition

In a condominium, a specific apartment is actually owned in fee simple by an indi-

vidual, who also acquires a joint ownership interest, together with the other apartment
owners, in the areas common to the overall project. Such common areas include the land,
parking areas, hallways, elevators, interior walls, and roof.
Condominium owners are responsible for the costs of maintaining their individual
apartments, including principal and interest, property taxes, and insurance premiums
involved in the apartments’ ownerships. Owners are also responsible for contributing to
the maintenance costs of the common areas on a proportionate basis relative to the value
of their apartments compared with the value of the overall project. Building and liability
insurance may be part of the condominium association fee.
In both forms of single-apartment ownership, the cooperative and the condominium,
an owner may occupy the apartment and enjoy the facilities provided or may sell or rent
the apartment as desired but must observe the rules, regulations, and bylaws of the spe-
cific project. In each case, the administration of the property is the responsibility of an
association whose membership comprises all of the apartment owners. The association
elects a board of directors to supervise the daily operations, most often through the ser-
vices of a full-time resident manager.
Another investment alternative is the conversion of improved income properties to
condominium ownerships. Applicable to apartments as well as to office buildings, shop-
ping centers, and other commercial uses, the condominium conversion technique enables
an owner to capitalize to the highest degree when selling the property. Rather than offer
the property for sale as an operating rental project, an owner can create a condominium
regime and offer each apartment, office, or store for sale to individual buyers. This strategy
often develops profits in excess of the value of the property as an operating rental project.
Because of the many complexities involved, including the financing arrangements
and usual renovations required by local building inspection agencies, professional advice
from lawyers, accountants, building contractors, and real estate brokers should be sought
by a converter before conversion plans are undertaken.

DISCUSSION TOPICS
1. Discuss the pros and cons of a lease versus a month-to-month tenancy from both the
tenant’s and the landlord’s points of view.
2. Investigate the requirements for rezoning a property in your community, including
the various government agencies and commissions involved in reviewing the request
and holding public hearings. Which agency finally grants the rezoning ordinance?

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 Unit 8: Investing in Residential Properties 165

UNIT EXAM 6. The conversion of a rental apartment project to a

condominium includes all of the following proce-
1. For a single-family housing unit to be considered
dures EXCEPT
a true real estate investment, the house must
a. evicting all the present tenants.
be bought for any of the following purposes
b. bringing the structure up to the current build-
EXCEPT
ing code.
a. resale.
c. filing legal documents for government agency
b. rent.
approval.
c. occupancy.
d. arranging financing for the apartments sold.
d. rezoning.
7. All of the following are exempt from the provi-
2. Investors generally consider a single-family home
sions of the Fair Housing Act EXCEPT
purchase to
a. private clubs renting properties to their
a. be a speculative and specialized activity.
members.
b. be a desirable investment alternative.
b. private owners of four or more houses.
c. require little expert knowledge.
c. closed cooperative corporations.
d. need little advance financial planning.
d. a home sold without a real estate broker.
3. To be a profitable investment, an apartment proj-
8. The Fair Housing Act extends its coverage to
ect must be all of the following EXCEPT
include all of the following EXCEPT
a. well located.
a. persons with mental disabilities.
b. well designed.
b. persons with physical disabilities.
c. clear of debt.
c. families with children under 18 years of age.
d. properly maintained.
d. elderly persons over 62 years of age.
4. A taxpayer in the 28% bracket is entitled to a
9. The formation of a condominium requires the
$1,000 tax credit. If the tax obligation is $7,800
filing of a declaration of intentions including
before the credit, how much will it be afterward?
provisions for all of the following EXCEPT
a. $6,240
a. recognition of divided ownerships.
b. $6,800
b. establishment of a binding set of bylaws.
c. $7,520
c. creation of a single master mortgage.
d. $8,800
d. restrictions against further partitioning.
5. An investment in an apartment building is con-
10. An apartment tenant with a lease that stipulates
sidered economically feasible if it
“the rent shall be $6,000 for the year payable at
a. breaks even.
$500 per month starting March 1” moves out on
b. returns a profit on the investment.
June 15 during the term of the lease. The land-
c. returns a profit and the investment.
lord is entitled to recover which of the following
d. can be converted to a condominium.
amounts?
a. $0
b. $250
c. $500
d. $4,000

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 Investing in Office
Buildings
Unit

9
LEARNING OBJECTIVES
After successfully completing this unit, you will be able to
●● explain the processes of office building management,
●● list the types of office investments, and
●● describe important provisions of the Americans with Disabilities Act (ADA).

Americans with Disabilities Act escalation clause office park

(ADA) homogeneous tenancy rental concessions
Building Owners and Managers Institute of Real Estate sublease
Association (BOMA) Management (IREM) tax clause
central business district (CBD) leasehold

INTRODUCTION
Our nation’s business activities are oriented to an office environment. Each profes-
sion, government agency, financial institution, corporation, or business needs an office to
house its service activities. The largest industrial firms require a main office in which to
centralize their management operations, in addition to branch offices located in each city
in which plants manufacture their products. The General Services Administration of the
U.S. federal government is the world’s largest lessee of office space. It is responsible for
providing the housing for government activities, which range from post office operations,
through the parks service, to the space program, in addition to the myriad of activities in
between.
After years of distress, the U.S. office market is rebounding. In 2015, office leasing
activity reached its highest level in two years at just above 64 million square feet, led by
Boston, Chicago, Los Angeles, and Washington, D.C., where demand has intensified as
science and technical industries expanded outside of supply-constrained Northern Cali-
fornia, Pacific Northwest, and New York. Demand is expected to accelerate in coming
years.

166

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 Unit 9: Investing in Office Buildings 167

In 2015, overall vacancy remains relatively high at 15% but is projected to continue
falling. Salt Lake City, Portland, San Francisco, and New York have maintained single-
digit vacancy rates as urban markets continue to dominate suburbs in terms of demand.
These same low vacancy rates, however, are forcing tenants to explore new, untapped
real estate markets. Tightening market fundamentals are also driving landlord confidence
across the majority of markets.
Downtown areas—also called the central business district (CBD) —include the
most significant concentrations of premier office space. The growing influence of “smart
buildings” that can accommodate modern technology and provide adequate heating, ven-
tilation, and air-conditioning systems means that existing buildings increasingly suffer
from functional obsolescence. This often justifies new construction in office markets that
seem to have adequate supplies of space. Data centers and network operational centers are
becoming more popular real estate investments.
The characteristics of a suitable location in the central city include adequate parking,
an aesthetically pleasing ambiance, and proximity to government entities, transportation,
lodging, restaurants, retail businesses, and other office buildings. In the suburbs, there
should be an absence of adverse influences or activities and access to good roads, trans-
portation, air service, parking, and other office buildings.
The factors considered to be essential in deciding on the location of a company’s
headquarters were derived from a survey of the top executives from 400 nationwide orga-
nizations. Listed in descending order of importance, those factors are
●● large functional space,
●● quality of community life,
●● room to expand,
●● efficient access to market(s),
●● low cost,
●● good business climate,
●● community image,
●● available qualified labor supply,
●● social climate, and
●● college and university availability.
This unit investigates the management requirements common to most office build-
ings, large or small, and examines the varied investment opportunities in this segment of
the real estate market.

OFFICE BUILDING MANAGEMENT

Whether investors in office space are large companies involved in high-rise projects
or private developers investing in low-rise or midrise buildings, they have similar manage-
ment responsibilities. A profitable venture requires a careful market study to determine
the demand for the subject space in terms of existing rentals and future needs. Rental

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 168 Essentials of Real Estate Investment Eleventh Edition

policies and procedures must be established that will initially attract new tenants and still
remain flexible enough to keep these tenants for long periods of time. Included in the
marketing of office space are viable rental schedules within the terms and conditions of
leases.

Market Analysis
Prior to any investment in office property, the availability and character of neigh-
boring competitive properties should be ascertained. The direction and degree of future
trends are more significant than the present status of the market. Primary consideration
should be given to the demand for space by new businesses in the area, the expansion rate
of existing tenants, and the number and types of tenants who desire to move from their
present locations.
To gain more definitive perspectives, the investor should study the market for office
space segmentally, according to age, condition, location, facilities, and amenities. An
overall market vacancy figure of 5% may actually include a more specific 10% vacancy
rate for new office space and a 2% rate for a city’s central business district. Market infor-
mation is available from local newspaper reports, the local chamber of commerce, private
research firms’ monthly reports, and the local units of the Building Owners and Man-
agers Association (BOMA) and the Institute of Real Estate Management (IREM).
BOMA’s website is www.boma.org, and IREM’s is www.irem.org.
The relocation of tenants from older structures to newer properties should be exam-
ined carefully to approximate the degree of movement from one to the other. An estimate
can then be made of the potential attractiveness of a new structure, and new uses for older
buildings may be discovered. For example, older space vacated by tenants moving to new
quarters is often occupied by businesses that have relatively little customer contact. For
these firms, a prestigious location is less important than convenience of layout and reason-
able rent. Once the demand pattern for an area is identified, a rent schedule for a specific
property within that market can be established.

Establishing a Rent Schedule

As with most rental properties, the charge for the use of space is probably the most
significant factor, not only in attracting tenants but also in establishing the profitability
of the investment. Depending on the economic stability of the area in question, the
condition of the market for the particular investment under consideration, the quality of
the building, and the services provided, a realistic rent schedule should be prepared and
administered forthrightly by the property owner or manager. Rental rates that are unre-
alistically high result in vacancies and serious cash-flow shortages, while rates that are too
low minimize the investment’s profit potential.
Generally, office rent schedules are established on a base rate plus extra charges for
special services. Primarily, a tenant is concerned with the interior space allocated for use,
although the building’s location, its condition, and the availability of amenities are also
considered when the rent is negotiated. As a result of the primary concern with space,
office rents are usually established as a certain dollar amount per square foot of usable
space. Thus, a base rate of $12 per square foot per year will result in a rent of $1,000 per
month for an office with 1,000 square feet of interior space (1,000 × $12 = $12,000 ÷ 12
= $1,000).

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 Unit 9: Investing in Office Buildings 169

Rent is affected by many elements, including the competitive market, the location of
the subject property, the quality of the building, the services provided by management,
and the inclusion of partitions, floor covering, air conditioners, utilities, parking facili-
ties, and similar extras. In addition, a rental rate is influenced by the location of the office
within the building itself—lobby and top-floor locations usually command the highest
rates.
Because the determination of rent is based on the space used by the tenant, the areas
used for an entry lobby, hallways, stairwells, elevator shafts, bathrooms, storage bins, and
the like are considered nonproductive in terms of generating cash flows. The charges for
their use are built into the base rate in the lease contract. As a result, an office building is
described as having a specific degree of efficiency. For example, if a certain building has
10% of its overall square feet included in these nonproductive areas, it is said to be 90%
efficient, whereas a building with 20% of its space used as hallways and so forth is con-
sidered to be 80% efficient.
Applying the efficiency factor that exists for a particular building allows an investor
to estimate the number of rentable square feet available and establishes a basis for mak-
ing an economic analysis of an investment’s potential profitability. For example, an 80%
efficient structure containing 50,000 total square feet has only 40,000 rentable square feet
to which the rental rate is applied to determine the possible gross annual income from
this investment.
It may appear as though a highly efficient building would generate a commensurately
high gross annual rent, but this is not always the case. For example, a building with 10%
of its total area devoted to nonproductive space may have narrow hallways and a small,
unimpressive lobby. Although the efficiency rate for this structure is higher than that of a
building with a larger lobby and wider hallways, the rental rate might be lower, reflecting
a less prestigious building. Thus, the achievable gross rents would actually be less than
those for a comparable structure with a lower efficiency factor.

Net Leases
Often rents are established on a net basis, a double-net basis, or even a triple-net
basis. A net lease would have the tenant pay a proportionate amount for property taxes,
insurance, and utilities in addition to the base rent. A double-net lease would include
the tenant also paying for maintenance costs. A triple-net lease would include the tenant
paying for all operating costs, and sometimes even the interest payments on the lessor’s
mortgage on the property, in addition to the base rent. These net leases are popular with
investors who want to establish a fixed, steady stream of income without having to handle
the problems associated with management and maintenance. The use of the terms net,
double-net, and triple-net are not used consistently in the industry. It is prudent to clarify
in any conversation or lease exactly what the parties mean when using these terms. Exactly
what expenses will the tenant be expected to absorb? Among the expenses often included
in a net lease are common area maintenance (CAM) charges. CAM charges often include
fees to cover maintenance costs on items shared by all the tenants, such as parking lots,
atriums, public restrooms, hallways, and the like.

Marketing Office Space

Marketing office space requires a systematic and continuing program to attract
prospective tenants and maintain their occupancy after they have moved in. Generally,

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 170 Essentials of Real Estate Investment Eleventh Edition

new tenants are interested in getting a rental bargain while at the same time acquiring
increased office and building efficiency, economy of operational expenses, and a dignified
and convenient location that complements the enterprise involved.
Managers often display great zeal and ingenuity in seeking new tenants. Care, how-
ever, must be taken to qualify new applicants regarding their financial ability, current
needs, and future growth potential.
One of the most common methods to attract tenants to an office project is hiring
a broker appropriate for the area. This broker may use signs placed on the property;
advertisements in local newspapers and regional editions of national magazines; and pro-
motional brochures distributed electronically or by direct mail to all businesses in the
geographic area. The use of social media has also expanded in this arena.
On-site leasing centers are often included in larger projects to centralize the activities
involved in renting available space and to house the management staff. The objective of an
on-site manager operating out of a leasing center is to present the building’s features with
sophisticated audio and visual productions and thereby create the appropriate environ-
ment for effective lease negotiations and closings.
Rental concessions.  In the quest for new tenants, landlords and their agents often
devise creative means of generating interest in their project. A popular technique is to
offer certain rental concessions to make leasing office space in a new building a presti-
gious move as well as a decided bargain.
Although it appears that simply decreasing the rent for the office space is the most
effective rental concession, in reality, the owner of an office building is often precluded
from doing so by the terms and conditions of a mortgage loan. Because a net market rent
is used to substantiate the granting of a mortgage loan in the first place, any reduction of
the scheduled rent would reduce the value of the entire project. As a result, landlords do
not reduce rent per se but offer other concessions, for example, a free rental period that
allows the tenant time to get settled and adjust to the new office. However, any conces-
sions that seriously erode the net rental income are often not tolerated by the lenders.
Additional concessions may be granted by a landlord in return for a lease commitment
from a new tenant. These could include the installation of partitions, carpets, drapes, and
fixtures, as well as the inclusion of utilities costs and janitorial services in the rent rate for
a certain period of time.
One of the more intriguing concessions employed by lessors of new multistoried
office buildings is the owner-developer’s assumption of the responsibility for a new ten-
ant’s remaining obligation on an old lease. Rental agents of new office space often use
the telephone listings of businesses in a given area to cold canvass and solicit new ten-
ants. In the presentation, the agent indicates that the management of the new building
will assume responsibility for the old lease. Thus, depending on the success of this form
of solicitation, a developer may become obligated to pay the rent on a number of newly
assigned leases.
The alternatives for managing surplus space until its lease expires include keeping it
empty or minimizing the carrying costs by subleasing it at any rent obtainable. Often, the
developer offers the landlord a buy-out settlement based on a cash payment in exchange
for the cancellation of the lease. In any event, the developer’s responsibilities are relatively
short-lived when compared to the long-term investment in the new office project.

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 Unit 9: Investing in Office Buildings 171

Lease Agreements
Generally, a standard lease agreement is used in renting office space. Depending on
individual circumstances, however, special clauses may be included to satisfy the specific
requirements of the parties involved. Leases will vary greatly across the country due to the
fact that landlord-tenant law is based upon state, not federal, law. All leases, including a
“standard” lease, should be carefully reviewed by each party’s legal counsel.
Tax clause.  As a result of constantly increasing property taxes in many areas of the
country, a tax clause is becoming a common requirement in office leases, including those
drawn for relatively short time periods. A tax clause stipulates that the tenant will pay any
increase in taxes over the base year in addition to the contract rent.
Escalation clause.  Paralleling the rising taxes across the country is the dramatic increase
in utility charges, often to the point of actually eliminating a landlord’s profits on the
investment. To offset this problem, most office leases are now designed to pass utility
costs on to the tenant. This can be accomplished by installing individual meters for each
office, an expensive and often impossible task. More likely, a lease will be arranged with
an escalation clause so the rent can be adjusted annually to reflect increasing expenses for
utility charges. Either the rent can be increased by some specific factor, say 5% per year,
or the tenant may be obligated to pay a proportion of the overall increased utility cost, in
addition to the base rent, much as is done under a tax clause.
Services included.  Office leases often provide for the tenant to receive certain special
services for which additional rent is paid. These services can include utilities, as men-
tioned above, as well as janitorial and maintenance care. In certain office arrangements,
the services of a central receptionist, access to photocopying facilities, and so forth, are
included in the lease agreement.
To accommodate continually emerging cyberspace technology, many landlords are
providing tenants with special electronic services and high-speed internet access.
Assignment and subletting.  No doubt, one of the more controversial clauses in an
office lease is the provision that the tenant be allowed to assign or sublet space in the
event of a change in circumstances. In effect, this is an escape clause for the old tenant
that obligates the landlord to accept the new tenant. In some cases, depending on the
market for office space in a particular area, a tenant may be able to sublease a unit for a
rent higher than that stipulated in the original lease and thus actually make a profit on the
landlord’s investment. Often, leases require that these tenants provide the landlord with
50%–100% of any excess rent the tenant may collect from the subtenant. To provide
protection against the assignment or subletting of space to a tenant not acceptable to the
landlord, an office lease often includes the provision that the landlord’s written permission
must first be secured, such permission not to be unreasonably withheld.
This is an example of the type of issue that should be reviewed in any lease. Some
states’ law presumes that a lease may be assigned or sublet at any time unless the lease says
otherwise. If so, then the lease may require that the landlord receive some, or even all, of
any additional rent collected from a subtenant. Other states, such as Texas, will only allow
a tenant to assign or sublease with the landlord’s written consent.

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 172 Essentials of Real Estate Investment Eleventh Edition

TYPES OF OFFICE INVESTMENTS

Office-building owners range from the individual owner-occupant to the large cor-
porate conglomerate. Most central-city, multistory office buildings are owned by large
institutional investors that have the financial capability to support the investment over the
initial years when cash returns are limited. The smaller office-building owner, unable to
compete with the corporate giants, has turned to the suburban market for profitable office
investments. These outlying developments range from converted old houses to modern
preplanned office parks.

Low-rise Office Buildings

Owning a small office building is similar to owning a small apartment building in
terms of constant tenant turnover and management responsibilities. Although office ten-
ants generally fulfill their lease commitments, small offices tend to be difficult to rent on
long-term leases.
A prime location is not an overriding factor for many tenants of low-rise office build-
ings. Consequently, profitable investments can be made in office units located on second-
ary streets, enabling an investor to offer somewhat lower rents. In fact, many large-parcel
developments are designed to attract high-rent tenants to the more prominent street-front
exposures, with smaller offices constructed toward the rear areas of the lot. Of course,
appropriate access and off-street parking facilities must be provided, not only to satisfy
zoning requirements but also to attract tenants.
Owners of low-rise office developments are usually able to pass the responsibility for
interior maintenance to their tenants while retaining the obligation for all major repairs
and exterior care. The degree of these responsibilities is a function of the size of the proj-
ect. For example, the tenant in a one-office home conversion normally accepts most of
the maintenance tasks; if the house contains four offices, the owner of the building usu-
ally maintains the exterior and provides office-cleaning services, whereas the tenants are
responsible for interior maintenance, repairs, and decorating.
Neighborhood offices.  The most popular forms of low-rise office investments are usu-
ally found in smaller projects designed to serve neighborhood needs. The conversion of
old homes into offices is a much-favored technique in this category. The charm of spa-
cious, high-ceilinged rooms, the generous use of fine woods, and the period-piece qual-
ity of decor appeals to many business and professional tenants. When these homes are
located in relatively accessible areas of a neighborhood, they attract lawyers, accountants,
smaller insurance companies, and real estate brokers. Frequently, the architectural beauty
of these converted offices adds a special uniqueness that holds tenants for comparatively
long time periods.
Other types of neighborhood offices include those situated above street-level stores
that front on main thoroughfares with a high volume of pedestrian traffic. These locations
appeal to dentists, optometrists, lawyers, and others who cater to an established clientele
but who do not require the more impressive and expensive premises of the retailer. A
modern variant of this type of office space is the small, mixed-use commercial center con-
structed around an inner courtyard containing some artistic focal point, such as a foun-
tain or sculpture. In this design, the retail shops occupy the ground-floor spaces, while the
offices are located at balcony level, with entrances facing the courtyard.

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 Unit 9: Investing in Office Buildings 173

Medical office buildings.  Among the more profitable low-rise office investments are
clinics housing a number of medical practitioners, such as doctors and dentists, who have
joined together to offer services from one centralized location. Depending on the size and
scope of the clinic, a pharmacy and a laboratory might also be included on the premises.
Although clinic designs vary, most include the doctors’ offices as complete, self-suf-
ficient units. Others are developed around the theme of a central reception and waiting
room. Here, participating doctors share the costs of a central filing and billing system, as
well as a pool of receptionists, nurses, medical technicians, and typists.
The additional plumbing, parking, and special electrical requirements involved in
clinic construction, including ceiling-to-floor partitions, greatly exceed the costs of other
forms of office construction. Therefore, the rents are higher and the leases longer than for
standard office space. As a result, many doctors have formed groups to develop clinics that
they themselves own, often as condominium units.
Homogeneous tenants.  Other nonmedical groups may also be joined together in
mutually beneficial relationships. For example, executive office suites could be offered to
insurance agents, real estate brokers, mortgage bankers, title insurance companies, law-
yers, and accountants who could form a homogeneous tenant grouping in the financial
center of a neighborhood office development. A beauty salon, barber shop, physical fit-
ness studio, and health food retailer would also make a complementary group.
A variation of this approach uses the same theme to attract a group of tenants offer-
ing the same service. Thus, a lawyer’s building or an insurance building can be developed,
where a person seeking these special services can choose from a number of practitioners,
all housed in the same structure.
These homogeneous tenancies lend themselves to central receptionists, common
electronic services, photocopying facilities, telephone answering services, and other shared
office amenities. Such systems are especially attractive to both newly licensed professionals
and thrifty old-timers. This central design enables a tenant to choose considerably smaller
office space than would be necessary if the centralized services were not provided. Conse-
quently, the rents can be commensurately less, although a contribution of a proportionate
sum of money for compensation of those who staff the central services would be stipu-
lated in the lease agreement.

Mixed-Use Buildings
Investors often design buildings that are established to attract a number of different
types of tenants. For example, consider the construction of a building that would pro-
vide underground parking, street level retail spaces, office accommodations on floors 2
through 10, and apartments above.

High-rise Office Buildings

In most metropolitan areas, the largest amount of office space is contained within sky-
scrapers constructed to house a single institutional tenant, a group of tenants, or both. The
financial ability to carry negative-cash-flow investments for a number of years has prob-
ably made high-rise offices the exclusive investment prerogative of major corporations.
Often, a large company erects an office tower, occupies some of the space for its own
operations, and leases to others the area it does not immediately require.

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 174 Essentials of Real Estate Investment Eleventh Edition

Usually, the management strategy for these large developments includes the oppor-
tunity for the major tenant to expand into the leased space as the need arises. Other large
corporations construct their own wholly occupied high-rise towers in strategic mid-city
locations to enjoy the advantages of centralized services. These companies often incor-
porate unique architectural designs to establish publicity value, such as the shape of the
Transamerica Pyramid in San Francisco.
Case Study 9.1 provides a five-year analysis for a high-rise office building.

Case Study 9.1

Five-Story Office Building

The property is located at the intersection of two heavily traveled major arteries. It is a new,
glass-walled, five-story office building containing 50,000 total square feet, 40,000 of which are
rentable space. The other 10,000 square feet include the entry lobby, hallways, elevator shafts,
bathrooms, storage space, and utility rooms. A paved parking area surrounds the building. The
rents vary from floor to floor but average $10 per square foot of rentable area per year. Oper-
ating expenses are 35% of the gross rents, including vacancy and reserves.The total cost of the
project is $2.5 million, and the investors can secure a first mortgage for $1.75 million (70%
of value) payable at 10% interest-only for 15 years. This requires a $750,000 cash investment.
Depreciation is established at an annual straight rate of 2.564% (39 years straight-line), which
is applied to a book basis beginning at $2 million. The land is booked at $500,000. All leases
are established for five years, at which time the property will be sold. The following tabulation
shows a profit analysis of this project, including its sale. All rents and operating expenses are
kept constant for the five-year analysis:

I. Annual Income
$400,000 Gross annual income
– 140,000 35% operating expense ratio
260,000 Net operating income
– 175,000 Debt service (10% interest-only on $1.75 million)
$85,000 Gross income before depreciation
– 51,280 Depreciation ($2 million @ 0.02564, 39 years straight-line)
$33,720 Taxable income
× 0.34 Tax bracket
$11,465 Income taxes
85,000 Gross income before depreciation
– 11,465 Income taxes
$73,535 Cash-on-cash ROI 9.8% on $750,000 investment

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 Unit 9: Investing in Office Buildings 175

II. Sale at End of Five Years

$3,000,000 Net sale price
– 2,243,600 Adjusted book basis ($2.5 million – $256,400)
756,400 Gross gain
× 0.15 Maximum capital gain tax
$113,460 Income taxes
642,940 Net profit
÷ 5 years Holding period
128,588 Annualized gain (rounded)
÷ 750,000 Investment
17.00% Annualized yield on gain
+ 9.80% Cash-on-cash annual ROI
26.80% Bottom-line annualized ROI

Note that this analysis does not consider the time value of money.

Office Parks
The congestion of downtown areas and the inconvenience this crowding creates in
terms of traffic and lack of adequate parking facilities often hamper efforts to provide
efficient services. Many inner-city companies, following current migrational trends, have
settled into buildings located in suburban office parks.
In addition to quick accessibility from suburban home to suburban office, many
office parks offer additional amenities to attract tenants. Some provide recreational, cul-
tural, or dining facilities within the complex, in addition to a preplanned and well-main-
tained ambience, to serve tenants and their clients. Full-range indoor gymnasiums, pools,
tennis courts, and health club facilities, as well as quality restaurants, are available in some
modern office-park projects.
Rental achievement requirements.  In the development of many new commercial
real estate projects, including high-rise office buildings and office parks, the financing
pattern requires that the investment’s breakeven point be met by advance lease commit-
ments from creditable tenants. Before issuing a construction loan, an interim financier
will insist on the developer securing an agreement from a permanent lender to issue a
long-term mortgage at the completion of construction, the proceeds of which will take
out the interim mortgagee.
Although many permanent loan financiers, such as insurance companies, will readily
issue such standby commitments for economically sound developments, they will only
fund their commitments when the buildings are completed according to the approved
plans and specifications. In addition, and as a condition of the loan under a rental achieve-
ment clause, these lenders require enough advance leases to be secured by the developer to
meet at least the investment’s fixed expenses of property taxes, insurance premiums, basic
maintenance costs, and mortgage payments.
Thus, an investor involved in the development of a new project must solicit leases
prior to the completion of construction. Whereas the developer of a shopping center may

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 176 Essentials of Real Estate Investment Eleventh Edition

need only advance commitments from a few basic major tenants, an office building devel-
oper usually needs to secure leases from numerous individual tenants to meet the lender’s
rent-up requirements. Most office building managers need to produce leases for approxi-
mately 80% of full occupancy to reach a breakeven point, a relatively arduous task.

Office Condominiums
The office condominium concept, long used by doctors and dentists in their clinics,
has won widespread interest around the country as other tenants seek to become own-
ers. This desire results from rising rental rates for all types of rental space. To guarantee a
controlled cost, many office tenants are becoming office owners.
Ownership of an office condominium is similar to ownership of a residential condo-
minium. A prescribed space is owned in fee simple, together with an undivided owner-
ship of the common areas. These common areas include the land under the building, the
parking area, the entry hall and other hallways, bathrooms, utility and storage rooms, and
the roof. The individual owners belong to an association that is responsible for mainte-
nance of the common areas plus enforcement of the adopted rules and regulations. Each
owner contributes a proportionate share of the common area costs as association fees,
which are adjusted by the board of directors to reflect annual fluctuations.
One of the advantages of condominium office ownership, in addition to controlled
occupancy costs, is the possibility of equity growth through mortgage principal paydown
plus increasing value. Although owners are allowed to deduct interest, property taxes,
association fees, maintenance, and depreciation, they forfeit rent as a deductible expense,
so these benefits are minimized somewhat. Still, an owner, unlike a tenant, can participate
in the building’s management policies.
Probably the most serious problem facing a condominium office owner is the limi-
tation on future expansion because it may be impossible to acquire adjoining, already-
owned offices. Under these circumstances, the only alternative may be to sell and move.

Conversion to Condominiums
An office building owner may find it expedient to convert the investment into a con-
dominium. By using the concepts of conversion discussed for the apartment project in the
previous unit, the tenants can be given the right to purchase their offices prior to the proj-
ect being offered for sale to the public. Case Study 9.2 is an example of such a conversion.

Case Study 9.2

24-Unit Condominium Office Complex

As part of a larger park development, the developers set aside three acres on which 24 con-
dominium office suites were constructed. These garden units are arranged around a central
courtyard, with each office having a private entrance. This arrangement has given the complex
an aspect of separation from the other buildings in the project.The units are of contemporary
design, one and two stories in height, and include modules of 1,200, 1,500, 2,400, and 4,800
square feet. Each is self-contained, with separate heating and cooling facilities, as well as indi-
vidual bathrooms and utility meters.

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 Unit 9: Investing in Office Buildings 177

The land under the condominium project is held under a 99-year lease rather than in fee
simple. This leasehold arrangement, a feature of the sales package, created an unusual mar-
keting problem for the developers. Although it allowed for a lower initial purchase price, it
also required overcoming predictable customer resistance to the nonownership ramifications
of the leasehold.

Each purchaser of a condominium office suite automatically becomes a member of the asso-
ciation organized to manage and maintain the common areas and supervise the condominium
bylaws.The member’s voting rights are based on the percentage of space purchased in relation
to the overall building area of the complex. The association establishes the fees to be paid by
its members for common area upkeep. These fees are shown in the following tabulation:

1,200 sq. ft. 1,500 sq. ft. 2,400 sq. ft. 4,800 sq. ft.
Janitorial services $45.60 $57.00 $91.20 $182.40
Insurance 7.20 9.00 14.40 28.80
Ground lease 129.60 162.00 259.20 518.40
Land taxes 26.40 33.00 52.80 105.60
Common area 16.80 21.00 33.60 67.20
services
Accounting fees 14.40 18.00 28.80 57.60
Total monthly $240.00 $300.00 $480.00 $960.00
payment

After the appropriate renovation, filing of condominium papers, arrangement

of financing, sales promotion, and closings, an office building can be subdivided into
individual, private office ownerships that include an undivided interest in the common
areas. These common areas are the roof, elevators, hallways, entry area, utility and storage
rooms, and the land under the project, including the parking areas. Similar to apartment
condominiums, the new owners would form their own association, responsible for the
upkeep and taxes on these common areas. As with apartment condominiums, an office
condominium owner is responsible for the principal, interest, property taxes, insurance,
and maintenance of the specific office space plus a proportionate share of the expenses for
the common areas.
This raises the problem of what would happen if some unit owners lost their proper-
ties through bankruptcy. The other unit owners would have to meet the property tax,
maintenance, and insurance premium liabilities. This could put all of them in jeopardy.
Careful attention must be paid to all contingencies and provisions made for a real estate
condo conversion.

THE AMERICANS WITH DISABILITIES ACT (ADA)

Much like the Fair Housing Act, investors must also be aware of the Americans with
Disabilities Act (ADA). The most pertinent provisions for investors are contained in
Title I, which deals with employment, and Title III, which contains requirements con-
cerning public accommodations. Modifications to a property that may be required under

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 178 Essentials of Real Estate Investment Eleventh Edition

this law are the responsibility of both the owner and the tenant. However, the cost of the
modifications may be paid as negotiated in the lease.
The following information was obtained from the Department of Justice’s website
www.ada.gov/cguide.htm.
The ADA prohibits discrimination on the basis of disability in employment, State
and local government, public accommodations, commercial facilities, transpor-
tation, and telecommunications. It also applies to the United States Congress.

To be protected by the ADA, one must have a disability or have a relationship or

association with an individual with a disability. An individual with a disability is
defined by the ADA as a person who has a physical or mental impairment that
substantially limits one or more major life activities, a person who has a history
or record of such impairment, or a person who is perceived by others as having
such impairment. The ADA does not specifically name all of the impairments
that are covered.

ADA Title I: Employment

Title I requires employers with 15 or more employees to provide qualified indi-

viduals with disabilities an equal opportunity to benefit from the full range of
employment-related opportunities available to others. For example, it prohibits
discrimination in recruitment, hiring, promotions, training, pay, social activities,
and other privileges of employment. It restricts questions that can be asked about
an applicant’s disability before a job offer is made, and it requires that employers
make reasonable accommodation to the known physical or mental limitations of
otherwise qualified individuals with disabilities, unless it results in undue hard-
ship. Religious entities with 15 or more employees are covered under title I.

Title I complaints must be filed with the U. S. Equal Employment Opportunity

Commission (EEOC) within 180 days of the date of discrimination, or 300 days
if the charge is filed with a designated State or local fair employment practice
agency. Individuals may file a lawsuit in Federal court only after they receive a
“right-to-sue” letter from the EEOC.

Charges of employment discrimination on the basis of disability may be filed at

any U.S. Equal Employment Opportunity Commission field office. Field offices
are located in 50 cities throughout the U.S. and are listed in most telephone
directories under “U.S. Government.” For the appropriate EEOC field office in
your geographic area, contact:

(800) 669-4000 (voice)

(800) 669-6820 (TTY)
www.eeoc.gov

Publications and information on EEOC-enforced laws may be obtained by

calling:

(800) 669-3362 (voice)

(800) 800-3302 (TTY)

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 Unit 9: Investing in Office Buildings 179

For information on how to accommodate a specific individual with a disability,

contact the Job Accommodation Network at:

(800) 526-7234 (voice)

(800) 781-9403 (TTY)
http://askjan.org

SUMMARY
This unit examined various aspects of office building ownership, including manage-
ment concerns common to such projects, regardless of size. A review of the various types
of offices available to an investor was included.
Typically, an office building investor will make careful market studies before becom-
ing involved in a specific project. Not only will the existing trends in supply and demand
for offices be examined but, more particularly, the segment of the office market that per-
tains to the building under consideration will be scrutinized. Primary consideration will
be given to the demand for space by new businesses in the area as well as to the expansion
and movement of existing tenants.
Probably the most significant factor in the success of an office building investment is
the establishment of a competitive but profitable rental schedule. Based on an annual rate
per square foot of usable space, a required lease payment is a function of many variables,
including competitive rents, the location and quality of the subject building, the services
provided by management, and the floor in the building where the space is located.
Often, landlords will offer concessions when soliciting new office tenants. Unable
under many circumstances to lower rents, a landlord may provide a free rental period to
offset some of the tenants’ move-in costs. Additional inducements offered to attract new
tenants include the installation of interior partitions, floor covering, heating and cooling
equipment, payment of utilities costs, and provision of janitorial services. Developers of
new high-rise office projects sometimes offer to assume the liability for the balance of new
tenants’ old leases to induce them to move into their new building.
Invariably, an office lease includes special clauses designed to solve specific problems.
Often, a tax clause is inserted that specifies the tenant’s responsibility to pay any increase
in taxes over the base year in addition to the stipulated rent. Some leases include an esca-
lation clause that allows the rent to be raised automatically to cover increased utility and
maintenance expenses. An office building owner may include a subletting privilege in the
lease but invariably reserves the right to approve the new tenant.
The widespread popularity of low-rise office buildings provides investors with innu-
merable opportunities to participate in this form of real estate ownership. Ranging from
the converted house to the modern office park, these offices can be leased to small and
large companies alike. Many small offices are found above stores along major arterial
streets as well as in spaces allocated for this use within the arcades of large shopping cen-
ters. The most popular forms of low-rise office investments are found in smaller projects
designed to serve neighborhood needs.
Some specialty small-office groupings are designed as clinics and house a number
of medical practitioners. These homogeneous tenants complement each other’s activities

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 180 Essentials of Real Estate Investment Eleventh Edition

through referrals and cooperation. Other homogeneous tenancies include the comple-
mentary services of professionals such as financiers, lawyers, and insurance agents.
Most high-rise office buildings are found in the central areas of cities, although some
communities allow skyscrapers in other sections as well. Sometimes, a high-rise structure
is designed around a single major tenant that actually owns the entire building. Other
high-rise office structures enjoy a mixed use, with some located in preplanned, suburban
office parks. The modern office park also includes such amenities as on-site parking and
recreational and dining facilities.
The Americans with Disabilities Act (ADA) has an impact on the rental industry, and
investors should be familiar with its provisions. A disability under this federal statute is
defined as “a physical or mental impairment that substantially limits one or more major
life activities.”

DISCUSSION TOPICS
1. Discover what concessions are being offered to prospective tenants from the manager
of a high-rise office building in your area.
2. Secure an inventory of the tenants in a nearby office park and analyze their mix on the
basis of the services they offer and percentage of the total space they occupy. If pos-
sible, also secure the schedule of rents paid and compare these charges with the rents
for similar office space available outside an office-park environment.

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 Unit 9: Investing in Office Buildings 181

UNIT EXAM 6. Under the Americans with Disabilities Act, dis-

ability is defined as
1. Our nation’s trend toward service-oriented busi-
a. any impairment of any kind.
ness activities is
b. a physical impairment that substantially limits
a. decreasing but requiring more office space.
one or more major life activities.
b. increasing but requiring less office space.
c. a physical impairment that substantially limits
c. decreasing and requiring less office space.
any life activities.
d. increasing and requiring more office space.
d. a physical or mental impairment that substan-
2. For most small, low-rise office-building tially limits one or more major life activities.
investments,
7. Which of the following definitions is TRUE ?
a. financing is usually difficult to secure.
a. Tax clause: the landlord pays any increase in
b. rents are generally higher than for larger
property taxes.
projects.
b. Acceleration clause: the tenant pays an
c. major arterial locations are not of prime
increase in rent to offset rising utility and
importance.
maintenance charges.
d. securing tenants is generally a difficult task.
c. Escalation clause: the balance of rent is due in
3. Small, low-rise office developments are generally full prior to the lease expiration.
designed d. Subleasing clause: the tenant has the right to
a. to serve the needs of the community. rent the office space to someone else.
b. to serve the needs of the neighborhood.
8. While studying the market for office space, to
c. as preplanned office parks.
establish the feasibility of a new project, the
d. as potentially high-rent operations.
analyst should segment the market by all of the
4. High-rise office developments are generally following attributes EXCEPT
designed for all of the following EXCEPT a. zoning.
a. to serve the community. b. location.
b. as institutional, owner-occupied buildings. c. age.
c. to serve the neighborhood. d. amenities.
d. as an office-park complex.
9. In terms of requirements for a company’s
5. Rental concessions usually include all of the fol- headquarters location, which of the following
lowing EXCEPT received top priority in a survey of nationwide
a. free rent for a specified time. organizations?
b. carpets, drapes, and partitioning. a. Low cost
c. lowering the rent. b. Qualified labor supply
d. purchase of a prospective tenant’s existing c. Large functional space
lease. d. Social climate
10. The establishment of a rental schedule for an
office building depends LEAST on which of the
following?
a. The economic stability of an area
b. The owner’s desired return on the investment
c. The physical condition of the building
d. The services provided

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 Investing in Commercial
Real Estate
10 Unit

LEARNING OBJECTIVES
After successfully completing this unit, you will be able to
●● describe the different types of commercial opportunities, including strip stores and shopping centers,
●● understand lease and tenant issues in strip stores and shopping centers, and
●● explain how the rise of e-commerce affects investing in commercial buildings.

anchor tenant neighborhood shopping center regional center

common-area fee off-street parking strip store
community shopping center option super-regional center
graduated lease percentage clause tenant mix
mall

INTRODUCTION
The commercial real estate market includes strip store buildings, neighborhood shop-
ping centers, community shopping centers, regional shopping centers, factory outlet
malls, and the e-commerce shopping alternatives.
As of 2015, the condition of the commercial real estate market has improved sub-
stantially in contrast with recent prior years. New supply is at a historic low, partially
because market rents have not generally justified new construction and because financ-
ing has remained relatively constrained. This leaves opportunities for upside potential
via increased occupancy and rents. Furthermore, the improved housing market should
lead to an improved retail environment. With home prices recovering and financial mar-
kets making strong gains, household wealth has risen to more than 5.5 times disposable
income, the 20-year average. Also, the annual expansion in retail sales, 6% per annum,
indicates that retail activity is on its way to achieving a rate consistent with job creation
and income growth. All of this points to further boosts to the continued strengthening of
the commercial real estate recovery.

182

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 Unit 10: Investing in Commercial Real Estate 183

STRIP STORE BUILDINGS

In most American cities and towns, small store buildings line both sides of the com-
munity’s busiest streets. These stores offer commodities and services of every nature and
description and serve the neighborhood, as well as the entire city, with their wares. Like
the smaller apartment and office buildings previously described, strip stores are found
everywhere.
Their general availability and rectangular design permit great flexibility for a variety
of tenant uses. The relatively simple installation of carpeting, draperies, and partitions can
convert a standard 20-foot by 60-foot module into an inviting office. The attachment of a
counter and the appropriate stoves, refrigerators, tables, and chairs would create a restau-
rant in this same space. Shelves and display counters might transform it into a dress shop,
pants store, or family shoe center, while chairs and booths could make it into a barber
shop or beauty salon. Strip stores may contain art galleries, flower stores, jewelry shops,
and boutiques—among other things—and offer continuing tenancies and unlimited con-
version possibilities.

Appeal to Small Investors

It usually costs very little more to purchase two-store or three-store buildings than it
does to buy a duplex, triplex, or small office structure. Primarily because of the longevity
of commercial tenants and fewer management responsibilities than residential rentals,
these opportunities are attractive to the small investor. Mortgage loans are relatively easy
to secure on this type of investment. A typical package of strip stores is a set of three
20-foot by 60-foot buildings constructed on a commercially zoned, neighborhood lot.
By designing the buildings so that the entry doors and bathrooms adjoin each other
in two of the three buildings and postponing the erection of store-separating partitions
until the areas are leased, a tenant needing 40 feet of space can be accommodated as well
as one requiring 20 feet or even 60 feet. In fact, by constructing the shell of a building
and attempting to rent it before completing the interior, a landlord may also attract ten-
ants who require special installations. A liquor store owner, who would need the special
plumbing and electrical installations associated with a walk-in cooler, and a barber, who
would require appropriate unique plumbing, are two such tenants.

Management Requirements
Most strip store leases are designed to run three to five years with options to renew
included to protect the tenant. Once a tenant has established a clientele in a neighbor-
hood, the lease is likely to be renewed indefinitely.
Short-term strip store leases usually designate fixed rental terms and include renewal
options providing for rent increases to offset rising operating expenses—utilities, property
taxes, insurance premiums, and maintenance costs. Although commercial tenants will
often accept the responsibility for minor interior maintenance, major repairs and exterior
upkeep usually remain the landlord’s domain. With this in mind, a financial analysis of a
strip store investment should include reserves for replacement of the roof, furnace, cool-
ing systems, and other major property components.
When a tenant requires an option to renew a lease, it should be clear to the landlord
that this entails giving up control of the property for both the lease period and the option
period. In addition, an option may or may not be exercised when it becomes due. A ten-

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 184 Essentials of Real Estate Investment Eleventh Edition

ant may ignore the option and move or decide to negotiate with the landlord for new
terms, depending on market conditions at renewal time. Consequently, the terms of any
renewal become a function of market conditions as they change from time to time.
Except for strip stores that have some unique quality of design or location, most rents
are established on a regular payment basis over the term of the lease. Some special cir-
cumstances require the inclusion of a percentage clause (for example, a gas station lease
might have a fixed rent plus a penny or two per gallon override). Some leases also contain
a property tax clause, which requires that the tenant pay any future taxes exceeding the
base amount in effect at the inception of the lease.
The owner of strip store buildings often finds that the success of the investment is
very much a function of the success of the tenants as entrepreneurs. If tenants cannot
show a profit in a particular location, no matter how low the rental charge is, they will
probably be unable to pay it. On the other hand, if the tenants are doing well, rent is the
least concern.
Thus, as a general rule, a landlord’s profits are very closely related to a tenant’s success.
In the case of a small store lease, the landlord-tenant relationship is one of interpersonal
dependency, not just a legal binder. It is in the best interests of a landlord to help a tenant
succeed, even to the point of decreasing rent during the startup period to enable the ten-
ant to become established. A graduated lease is extremely useful in this regard, starting
with a low rent in the initial period and gradually increasing to accommodate a successful
tenant’s ability to meet a higher payment schedule. If the tenant fails, even at the lower
rents, it is just as well because the sooner the unfortunate mismatch is recognized, the
sooner the landlord can lease the building again.
Case Study 10.1 explores an example of strip store development.

Case Study 10.1

Strip Store Development

This block-long property consists of 600 feet of frontage on a major thoroughfare and is 150
feet deep to a 20-foot alley. The investors rezoned the parcel to commercial—it had been
apartment zoning—by inviting adjoining neighbors to participate in its design. They quickly
eliminated any fast food, gas stations, or all-night markets to control noise and traffic. The
architecture was to conform to the neighborhood, and no unsightly signs or disturbing lights
were erected. The alley was paved, and a seven-foot wall was built on the house side of the
alley to help buffer noise. All stores were set back from the main street a distance of 40 feet
to allow for front parking.

The 43,200-square-foot building was designed to be built in nine stages of 60 by 80 feet each,
starting from one corner.The building code required a 30-foot setback at each corner to allow
for traffic visibility. The 60-foot modules were designed to be rented in multiples of 20 feet,

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with the tenants choosing the space they needed. Once the construction started, the buildings
filled quickly and took nine months to rent. The final tenant mix is as follows:
Shoe store 100 feet
Ice cream parlor 40 feet
Bicycle shop 80 feet
Lamp shop 40 feet
Candy store 60 feet
Barber shop 40 feet
Carpet shop 60 feet
Beauty shop 40 feet
Real estate office 40 feet
Insurance office 40 feet

NEIGHBORHOOD SHOPPING CENTERS

A neighborhood shopping center is designed to provide for the sale of necessary
goods (food, drugs, sundries) and personal services (laundry, dry cleaning, barbering, shoe
repairing) for the daily needs of the people in the immediate neighborhood. This type of
center is usually situated on a four-acre to 10-acre site and normally serves a trade-area
population of 5,000 to 40,000 persons within a six-minute driving distance, approxi-
mately 1.5 miles from the center.

Tenant Mix
The neighborhood center usually has as its major tenant a supermarket or national
drug-discount store, or both, which will occupy approximately 30% of its 30,000 to
100,000 square feet of gross leasable area. Other tenants may include a general mer-
chandise store; clothing, shoe, and furniture stores; financial offices; and other service
businesses.
The grouping is arranged on a readily accessible site and offers ease of shopping
through adequate off-street parking facilities and agreeable surroundings. Often, the
supermarket adjoins the drugstore, with common entry into both establishments. The
other stores are generally arranged in a straight line that doglegs toward the streets, with
parking spaces in front of the building. Thus, shoppers may drive directly to the store
of their choice, park briefly while completing their purchases, and pull away quickly
and efficiently. When compared with the inconvenience of the curbside parking required
around strip stores, neighborhood centers have made serious inroads into the strip store’s
ability to compete for the shopper’s dollar.
There is a trend developing in neighborhood shopping centers where the drugstore is
becoming a stand-alone building. Several of the newer shopping centers are moving away
from the attached-buildings format to one, two, or up to five stores in a perimeter with
parking available in front of each group.

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 186 Essentials of Real Estate Investment Eleventh Edition

Percentage Leases
Neighborhood centers are generally located at the intersection of major streets on
corners of land designated for this use when the raw acreage was originally subdivided.
Sometimes a neighborhood center is constructed off the corner, on a parcel of land situ-
ated in the middle of a block but facing a major thoroughfare. This off-corner location
acts to relieve the traffic congestion normally associated with a major intersection and
improves the accessibility to the parking area.
Wherever the center is located, its development creates a small monopoly for com-
mercial tenants wishing to capitalize on the consumer traffic that it generates by its very
existence. A landlord can secure a bonus from tenants who want to locate in the center.
This bonus is achieved in the form of a percentage lease in which a tenant agrees to pay
a fixed minimum rent plus or against a specified percentage of the gross business. The
minimum rent develops a basic return on the property owner’s investment, and the per-
centage override ensures the owner a share in the tenant’s success as a result of locating in
the center.
For example, a supermarket may execute a lease with a minimum rent imposed as a
function of the number of square feet occupied plus 1% of the gross sales above a desig-
nated amount. A dress shop may lease space on the basis of a minimum rent against 4%
of the gross, or a jeweler might agree to a 10% overage. Figure 10.1: Retail Premises Lease
shows a sample shopping center lease agreement.
Noncompete clauses are often used with retail centers. Landlords may promise not to
lease to any firm that competes with the tenant, and the tenant may promise not to open
another location within an agreed distance of the center so as not to draw away potential
business from the current location.

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FIGURE 10.1  Retail Premises Lease

lease Agreement for Shopping Center Property

Shopping Centers, Inc.

Retail Premises Lease
Between SHOPPING CENTERS, INC., LESSOR and ____________________________________________________

_______________________________________________________________________________________________
LESSEE
This LEASE is made and entered into this ___________ day of _______________________, 20 ______ by and
between
SHOPPING CENTERS, INC., a __________________________________ corporation, hereinafter called LESSOR,
and
______________________________________________________________________________________________

______________________________________________________________________________________________
hereinafter called LESSEE.
WITNESSETH: That for and in consideration of the rentals hereinafter provided, and the covenants and agreements
hereinafter contained, LESSOR leases unto LESSEE the following described premises, which premises LESSOR
warrants it has good right to lease, to wit:

referred to hereinafter as “Leased Premises.” A diagram of said premises, for purpose of reference and illustration
only, is attached hereto and made a part hereof as “Exhibit A.”
The Leased Premises are part of LESSOR’S property known as “BIG REGIONAL SHOPPING CENTER,” and in
which center other retail space is leased by LESSOR to other LESSEES. All areas in the Center other than retail
space, including but not limited to, walks, parking lots, open areas, public facilities, etc., are designated “common areas”
as used in this lease. All common areas are under the complete and exclusive control of LESSOR.
LESSOR and LESSEE further covenant and agree as follows:
1. TERM OF LEASE. This lease shall be for a term of ___________________________________________________

( _______ ) years, commencing upon the ______ day of ___________________, 20 ________, and ending _____ day
of ___________________, 20 ________.
2. RENTAL. LESSEE agrees to pay to LESSOR, its successors and assigns, as rental for said Leased Premises, the
following:
(a) Base Rent. LESSEE shall pay, as base rent, the sum of __________________________________________

DOLLARS ( $__________ ) annually, in twelve installments of ____________________________________________

DOLLARS ( $__________ ) on the first day of each month during the term of this lease.
LESSOR acknowledges the receipt of _______________________________ DOLLARS ($ ______ ) as
advance payment of the first and last months’ rent for the above term of this lease, and as earnest money assuring
LESSEE will enter into possession as agreed under the terms of this lease.

Source: Floyd M. Baird

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FIGURE 10.1  Retail Premises Lease (continued)

lease Agreement for Shopping Center Property (continued)

(b) Tax and Insurance Allocation, Ratio, and Adjustment. In addition to the base rent above provided, and as
additional rent, LESSEE shall pay its proportionate share of all taxes, general and special, assessed against every part
of the entire real property of which the Leased Premises are a part, and also its proportionate share of the cost of all
fire, windstorm and other hazard insurance carried upon the entire real property of which the Leased Premises are
a part. LESSEE’S proportionate share of taxes and insurance costs shall be in the ratio that the floor area leased to
LESSEE bears to the total floor area of the entire property of which the Leased Premises are a part, which ratio shall
be applied to the total taxes assessed and insurance costs to determine LESSEE’S proportionate share. LESSOR shall
estimate for the period from the effective date of this Lease to January 1st next following, the amount of LESSEE’S
proportionate share of taxes and insurance costs, as provided above, based upon taxes and insurance premiums paid
during the previous year. This proportionate share shall be the proportionate share of the LESSEE for the full year
multiplied by the ratio that the number of months of this Lease prior to January 1st next following the execution of
this lease, bears to twelve. LESSEE shall pay the amount so determined to LESSOR, in equal installments concurrent
with payment of the base rental, commencing with the first day of the first full month of the term of this Lease, and
ending with the rental payment due December 1st next following the effective date of this Lease. On or before
January 1st next following the effective date of this Lease, and on or before each succeeding January 1st thereafter,
LESSOR shall estimate LESSEE’S pro rata share of the taxes and insurance costs for the succeeding calendar year,
as provided above, and shall notify LESSEE of the amount of said estimate. LESSEE shall pay to LESSOR monthly
thereafter during the ensuing calendar year, concurrent with the payment of the base rental, 112 th of the amounts so
estimated.

LESSOR shall keep annual records of the amount of taxes assessed and insurance costs paid and shall compute
LESSEE’S pro rata share thereof. Within a reasonable time after January 1st of each year following the effective date
of this Lease, LESSOR shall notify LESSEE of said LESSEE’S proportionate share of the taxes and insurance costs. If
the monthly payments previously made by LESSEE are not sufficient to pay said LESSEE’S proportionate share of the
taxes and insurance, LESSEE shall pay to LESSOR, within thirty (30) days after receipt of notice of said deficiency, the
amount by which the actual costs of said LESSEE’S proportionate share of taxes and insurance exceed the estimated
amount paid by LESSEE. If the estimated amount paid by LESSEE exceeds the LESSEE’S share of the taxes assessed
and the cost of insurance, LESSOR shall credit said excess to LESSEE and shall reduce the estimated amount to
be paid by LESSEE for the ensuing year by that amount. LESSEE shall have the privilege of examining records and
computations upon which charges are made under these provisions.

(c) Percentage Rent. In addition to the payment of the Base Rent and all other rents and payments required
hereunder, LESSEE shall pay to LESSOR, annually, the amount, if any, by which _____________ percent ( ____ %) of
the gross sales of merchandise (as hereinafter defined) during each Lease Year exceeds the aggregate amount of base
rent paid by LESSEE to LESSOR attributable to said lease year, the method of computation and manner and time of
payment of said percentage rent being more fully set forth hereinafter.

(d) Statement of Revenue. LESSEE shall submit to LESSOR, at the close of each month or within 10 days
thereafter, a statement, signed by LESSEE and the manager of the store, showing the “gross sales of merchandise” for
each day of said month.

(e) Gross Sales of Merchandise Defined. The term “gross sales of merchandise,” as used in this Lease, is
hereby defined to mean and include all sales of merchandise of every kind and character, and to include all revenues
from all departments and services and sources made from the Leased Premises, for both cash and credit, including all
orders taken and merchandise sold from the Leased Premises and filled or delivered from or to any other store or
place, excluding taxes and refunds.

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FIGURE 10.1  Retail Premises Lease (continued)

lease Agreement for Shopping Center Property (continued)

(f) Computation and Payment of Percentage Rent. Concurrently with the furnishing of the monthly
statements of gross sales of merchandise as hereinafter provided, LESSEE shall pay to LESSOR, as an installment
payment to apply on the percentage rent due hereunder, any amount by which the percentage listed in (c) above
multiplied by the gross sales of merchandise as shown on the monthly statement exceeds one month’s Base Rent
at the then current rate. Said percentage rent shall be computed at the close of each month or within 10 days
thereafter, and shall be payable monthly as aforesaid. However, such percentage rent shall be annualized and subject
to adjustment at the end of each Lease year. Within 60 days after the close of each Lease Year hereunder, LESSEE
shall submit to LESSOR its statement showing the gross sales of merchandise for such Lease Year. Concurrently
therewith, LESSEE shall pay LESSOR the amount of the percentage listed in (c) above multiplied by the gross sales
of merchandise as shown upon the statement for the Lease Year less the aggregate monthly installment payments
of percentage rent as heretofore provided for which have been paid for the Lease Year. If the aggregate monthly
installment payments on percentage rent exceed the annual percentage rent due the excess shall be applied on future
annual percentage rents due hereunder and any unapplied balance shall be refunded at the end of the term of this
lease.

(g) Lease Year Defined. For all purposes under this lease, the term “Lease Year” shall mean the period from
the commencement date of the term of this lease to the anniversary date of the first day of the month in which the
commencement date of the term of this lease occurs and each 12 months period thereafter.

(h) Books and Records. LESSEE shall keep, in the Leased Premises, a permanent and accurate record in
accordance with generally accepted accounting principles, consistently applied, showing “gross sales of merchandise”
for each day during the term hereof, which record shall include all supporting and allied records, including but not
limited to cash register receipts and sales tax reports. All such records shall be open to LESSOR at all reasonable
times for the purpose of determining and verifying the percentage rent due. LESSEE shall retain and preserve all
sales slips, cash register receipts and all other records pertinent to “gross sales of merchandise” for at least one year
following the close of each Lease Year.

(i) Audit. LESSOR may at any reasonable time audit the records of LESSEE. If LESSOR audits the records
of LESSEE and such audit reveals a greater amount of “gross sales of merchandise” than LESSEE has reported to
LESSOR, LESSEE shall immediately pay the full and true amount of percentage rental due and shall pay all costs of the
audit after notice thereof. If “gross sales of merchandise,” as shown by the audit, do not exceed those reported by
LESSEE to LESSOR, the audit shall be at the expense of LESSOR.

3. CHANGE OF BASE RENT DUE TO COST OF LIVING (CPI). Base rent as provided herein shall be adjusted in
the same proportion as the fluctuation in the U.S. Department of Labor’s Consumer Price Index published by the
Bureau of Labor Statistics. For the purposes of this paragraph, the base month will be the month next preceding
the first full month of the term of this Lease and the monthly rental commencing with the 13th month of this Lease
will fluctuate in the same proportion that said Consumer Price Index is higher or lower than such base month
on a cumulative basis. Such proportion will be computed annually for the first month following the completion
of each twelve (12) months of the Lease, and the new rent derived from such computation shall be in effect for
the next twelve months. In no event however, will an adjustment be made which would reduce the Base Rental
rate to an amount less than the rate set forth in this Lease. The necessary calculation for the adjustment required
herein will be made as quickly as possible but in the event a rent paying date occurs before the adjustment can be
calculated an amount equal to the then current unadjusted Base Rental rate will be paid by LESSEE to LESSOR on
the rent payment date and as soon as the calculation of the adjustment has been made an additional payment will
be immediately paid by LESSEE to LESSOR or a reduction on the next due Base Rental payments will be made,
whichever is appropriate in order to cure any underpayment or overpayment of Base Rent.

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FIGURE 10.1  Retail Premises Lease (continued)

lease Agreement for Shopping Center Property (continued)

4. PARKING. LESSEE agrees to cause its employees to park only in such places as provided and designated by
LESSOR for employee parking. Upon written request from LESSOR, LESSEE will within five days furnish the state
automobile license numbers assigned the cars of all employees.

5. LIGHTING. LESSEE shall keep the display windows in the Leased Premises well lighted from dusk until 10:00
o’clock P.M. (local time) during each and every day of the term of this lease, and shall pay its portion of the cost of
electric current and maintenance resulting from exterior lighting of the building and parking lot, based upon the ratio
set out in 2(b) above.

6. MERCHANTS ASSOCIATION. Should there be an association of the merchants in the shopping center of which
the Leased Premises are a part, LESSEE shall belong to such association and pay reasonable dues assessed by a
majority of the members of the association. The obligation to pay such reasonable dues shall be an obligation under
this Lease.

7. MAINTENANCE.
(a) Exterior. LESSOR shall be responsible for the maintenance of the exterior of the outside walls and
Common Areas of the building, parking lot, roof, walkways, stairways, walks, drives, streets, alleys, yards, and other
areas common to the premises of which the Leased Premises are a part. The pro rata cost of such maintenance
shall, however, be paid monthly as billed, by the LESSEE to LESSOR in the ratio that the square footage of the Leased
Premises bears to the square footage occupied by all tenants of the premises of which the Leased Premises are a
part.

(b) Interior. LESSEE shall maintain and keep in good repair the interior of the Leased Premises and all
electrical and plumbing fixtures and equipment in the interior, including but not limited to, exposed installations on
floors, walls and ceilings, all installations of any kind made by LESSEE, all hardware, interior painting and decoration
of every kind, and all doors, windows, and screens. LESSEE shall replace all broken or damaged glass on the Leased
Premises at LESSEE’S sole cost. LESSEE will maintain and keep clear all floor drains and drain lines of all kinds in or
upon the Leased Premises to their juncture with public sewer main.

(c) Heating and Air Conditioning. Heating and air-conditioning equipment, and hot water heaters, where
present, shall be and remain the property of LESSOR. Where such equipment is installed by LESSEE, said equipment
shall remain upon the Leased Premises at the termination of this Lease, and become property of LESSOR. LESSOR
shall not be responsible for maintenance, repair, or replacement of any such equipment, or damage caused by or
because of such equipment. LESSEE shall hold LESSOR harmless from any damage caused by or because of such
equipment, and in the event damage to the Leased Premises or the premises of which the Leased Premises are a part
occurs by or because of such equipment, LESSEE shall immediately, and at LESSEE’S sole cost, repair and restore the
damaged premises to their original condition. In the event of LESSEE’S failure, for a period of five days, to begin such
restoration, LESSOR may make the necessary repair and restoration and LESSEE shall reimburse LESSOR the cost
thereof.

8. HOURS OF BUSINESS. LESSEE shall conduct its business in the Leased Premises during the regular and
customary hours of such type of business and on all business days, and will conduct said business in a lawful manner
and in good faith to the end that LESSOR may during the term of this lease receive the maximum amount of rental
income reasonably to be anticipated from the conduct of said business.

9. AWNINGS AND WINDOW COVERINGS. LESSEE shall not install awnings or other fixtures on the exterior of
the building without prior written consent of LESSOR. In the event the Leased Premises have any exposed windows
not used for merchandise display, LESSEE will install, at LESSEE’S cost, venetian blinds or other window coverings
specified by LESSOR. LESSEE shall keep and maintain all awnings, venetian blinds, and other window coverings in a
state of repair satisfactory to LESSOR.

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FIGURE 10.1  Retail Premises Lease (continued)

lease Agreement for Shopping Center Property (continued)

10. SIGNS. LESSEE is privileged to provide a store identification sign of its choice subject to consent and approval
of LESSOR as to the type, design, construction, material used, and method of mounting. Any sign shall be installed and
maintained by LESSEE so as to prevent all exterior water from entering the Leased Premises. LESSEE is responsible
for securing any necessary permits and the payment of any fees in connection with erection of said sign. Damage to
persons or property as a direct or indirect result of LESSEE’S sign is an exclusive risk of the LESSEE.

11. TRADE FIXTURES. LESSEE may install such trade fixtures as are reasonable and proper in carrying out the
business which LESSEE is authorized to conduct in the Leased Premises. If LESSEE is not in violation of any of the
terms or conditions of this Lease at the termination thereof, or any extension thereof, LESSEE shall remove all
trade fixtures, including signs, from the Leased Premises and restore said premises to their original condition, all at
LESSEE’S expense, except for any alterations, additions, or improvements as provided for in Paragraph 14 of this
lease. If LESSEE is in violation of any terms or conditions of this Lease, however, such trade fixtures shall remain on
the Leased Premises and shall be subject to the terms of the Landlord’s lien hereinafter contained.

12. ADDITIONAL BUILDING. LESSOR reserves the right at any time to build additional stories on the building
occupied by LESSEE and to any building adjoining the same, and reserves the right to close any skylights and windows
(except display windows) and to run necessary pipes, conduits, and ducts through the herein Leased Premises.
LESSOR further reserves the right to use and lease such additional space in such manner as LESSOR, at its sole
option, may choose.

13. NOT A PARTNERSHIP. Nothing contained herein shall be deemed or construed by the parties hereto, or by any
third party, as creating the relation of principal and agent or of partnership or of joint venture between the parties
hereto, it being understood and agreed that neither the method of computation of rent, nor any other provision
contained herein, nor any acts of the parties hereto, shall create any relationship between the parties hereto other
than the relationship of LESSOR and LESSEE.

Source: Floyd M. Baird

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Condominium Conversions
More than any other type of shopping center, neighborhood groupings lend them-
selves to conversion to condominiums. The sale of individual store buildings would prob-
ably produce more profit than selling the center as a whole to a single investor.
The beginning legal procedure is the same as that for an apartment or office conver-
sion. Then the tenants can be approached to purchase their own store buildings and
receive an undivided interest in the common area parking spaces as well.
Case Study 10.2 provides an overview for a neighborhood shopping center.

Case Study 10.2

Neighborhood Shopping Center
This 10-year-old center contains numerous shops, medical suites, and office spaces
arranged around a centrally landscaped mall. It is connected to the residential area it
serves by major arterial streets with traffic lights that control ingress and egress. The
tenant mix is intended to provide the surrounding residential neighborhood with basic
everyday needs. Its anchor tenants are a national chain food market and drugstore. The
complete tenant mix of the center is listed below.

Square Feet Square Feet

Food market 25,000 Interior decorator 2,500
Drugstore 13,000 Bank 2,500
Sporting goods 5,000 Sewing center 2,500
Motorcycle dealer 5,000 Savings association 1,500
Hardware store 5,000 Dry cleaner 1,500
Medical offices 4,500 Carpet store 1,500
Insurance broker 4,250 Real estate broker 1,500
Shoe store 3,600 Florist shop 1,200
Liquor store 3,600 Women’s wear shop 1,200
Restaurant 3,600 Gift shop 1,200
Men’s shop 3,000 Small shops (10) 6,850

COMMUNITY SHOPPING CENTERS

In addition to the convenience goods and personal services offered by the neighbor-
hood center, a community shopping center provides an even wider range of facilities for
the sale of large appliances, furniture, apparel, and related services.
Designed around one or more major department or variety stores as the anchor ten-
ants, also called magnet stores, plus a supermarket and other retail and service stores, a

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community shopping center has a gross leasable area ranging from 100,000 to 300,000
square feet, needs 10 to 30 acres or more, and serves a trade area population of 40,000 to
150,000 people located up to 3.5 miles from the center.

Tenant Mix
A community shopping center devotes approximately 20% of its space to a supermar-
ket, 30% to a major general merchandise tenant, 25% to other clothing and shoe retailers,
and the balance to other kinds of merchandisers and service businesses.
This type of center is midway between the neighborhood and the regional shopping
center and incorporates a little of both in its design. Some community shopping centers
include a major national department store plus a locally prominent department store,
positioning them at either end of a group of stores occupied by smaller tenants. The two
anchor tenants create foot traffic that is attracted into the connecting local tenant stores
by window displays, signs, and other promotional devices.
Community shopping centers are usually designed with the stores lining a central
mall area. In warm-weather states this mall is generally uncovered, but in most inclement-
weather areas the mall is either covered or enclosed completely and temperature con-
trolled for customer comfort. Whereas the neighborhood center’s format encourages a
quick shopping trip, the community shopping center’s design is such that the customer
is enticed into spending more time visiting from shop to shop and making purchases in
the process.
Because these centers are larger in size than neighborhood centers, many overlapping
types of businesses are represented. This situation offers a customer the opportunity to
compare prices and quality on similar articles in a number of competing stores. The intent
is to convince shoppers that the center can serve most of their needs—all they have to do
is seek out the appropriate vendor to achieve satisfaction.
Community shopping centers do not grant tenants the same exclusivity for their
lines as do neighborhood centers. Thus, there may be a number of men’s clothing estab-
lishments, dress shops, and shoe stores in one community shopping center. However, to
prevent unusual shifts in lines of merchandise, it is necessary to include in each lease the
general types of products or services the store will be allowed to carry. Each store is thus
limited in the type of business to be conducted, and the landlord can maintain an appro-
priate tenant mix.
In this regard, management is always concerned that tenants generate the type of traf-
fic flow that will provide all of the businesses in the center with customers on a continu-
ous basis. The owners of a successful center enjoy the opportunity of carefully choosing
tenants from a list of those waiting for openings to occur, thus ensuring the symbiosis that
a successful center requires.
On the other hand, the management of centers with high turnovers and a number
of vacancies are often reduced to accepting tenants who do not generate traffic just to fill
their spaces. These tenants include those that rent space for warehousing their merchan-
dise, those that need office space, recruiting centers, and other nonretail vendors.
A serious problem for investors in shopping centers occurs when retailers close their
shops at various centers, with some companies going bankrupt. Those that close because it
is less expensive to pay rent on the closed store than to continue to operate create a special
problem for the center’s management. When the leases contain a clause specifying that the

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tenant has to remain open and continue its business on 100% of its premises, the landlord
has the right to obtain specific performance of this provision. This covenant of continuous
operation is designed to create the ambiance of a successful center and to ensure that the
needs of the shoppers are met, regardless of retailer difficulties.

Management Requirements
The management of a community shopping center usually involves the services of
a professional who has had experience in dealing with national tenants as well as with
more prominent local retailers. Besides the normal leasing duties of the manager, daily
responsibilities include the supervision of maintenance personnel and security guards.
These duties require an on-premises supervisor, although many community as well as
neighborhood shopping centers are managed by companies with offices located away
from the centers. The efficiency of these centralized activities expands a management
company’s ability to handle a number of shopping centers, plus other income properties,
from a single main office.
Lease terms for major tenants usually range from 15 to 20 years, whereas local ten-
ants’ leases may range from only 5 to 10 years. Renewal options are often based on a right
of first refusal. The leases of untried tenants invariably include a landlord’s cancellation
clause that can be exercised if the gross volume of business does not meet expectations.
The percentage lease is the tool employed to establish the landlord-tenant relationship
in a community shopping center. Such a lease includes rent to be charged on the basis of
a minimum rate against a percentage of the monthly gross business but also includes an
arrangement for an annual adjustment. This adjustment acts to balance the peak-season
months against those months when gross volume is low. The center’s management must
have access to each tenant’s books to verify these figures, and provisions are made to hire
outside auditors for periodic reviews to offset any possible disputes in rent computations.
To pay for the costs of maintaining the parking area and joint walkways, community
shopping center tenants are usually charged a common-area fee in addition to their rent.
These fees are also used to offset the charges incurred for advertising, flyers, bulk mailings,
and parking area promotional activities. Common-area charges are usually based on the
ratio of the tenant’s floor area to the center’s total floor area. Sometimes they are imposed
as a flat charge.
Management often plays a more prominent role in the activities of community shop-
ping centers than it does in those of neighborhood centers. Special promotions are con-
tinually designed to attract shoppers to the center. These activities may directly involve
the tenants, as do sidewalk sales, or they might involve such outside attractions as carni-
vals or art fairs.
Community-shopping-center tenants often find it expedient to join together in an
association whose elected leaders represent them in disputes with the management. The
association often accepts responsibility for supervising activities designed to promote the
center.

REGIONAL AND SUPER-REGIONAL SHOPPING CENTERS

The largest of the shopping center designs is the regional center, providing general
merchandise, apparel, furniture, and home furnishings in full depth and variety. At least

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 Unit 10: Investing in Commercial Real Estate 195

one national, full-line department store is the major drawing power, with most regionals
having two, and some even three such tenants to establish the magnetic nodes for the
foot traffic between shops. Regionals range in scope from 300,000 to 1,000,000 square
feet of gross leasable area on at least 30 acres of ground and serve a trade area of 150,000
to 400,000 or more people. This trade area may extend upward of 15 miles, depending
on the accessibility of highways. Regionals are, in effect, a wide assortment of downtown
stores, all collected under one roof, with controlled free parking, offering the suburban
customer convenient, full-line shopping facilities.
Some regional shopping centers, called super-regional centers or megacenters, are
part of a larger, overall land plan that includes their being buffered by office towers and
apartment buildings that create a self-contained consumer market. However, there is a
limitation on the size of the center itself—a limitation imposed by a shopper’s ability to
walk a certain distance, especially with packages in hand. Consequently, regionals are rela-
tively compact in design and offer a basement and second floor as an alternative to lateral
expansion. This requires vertical transportation facilities, usually in the form of staircases
in the common areas. Elevators and escalators are often located within the stores them-
selves and act as subtle enticements to shoppers to do some impulse buying.

Tenant Mix
Unlike the other centers, the regional usually has no food market, although various
packaged grocery items are found in its many stores. Rather, 50% of the center is occu-
pied by general merchandise stores, 15% by clothing and shoe retailers, 10% by other
dry-goods shops, and 25% by service and related businesses. Many regionals include an
auditorium that is available for special community meetings as well as for promotional
efforts. Movie theaters are also available, as are numerous eating establishments designed
around a food court and entertainment facilities.

Building Design
To achieve the greatest interplay among the stores, a regional center is usually designed
around a mall area with the major national tenants located at either end. The inclusion of
a third major tenant requires a central location opening on the mall, while a fourth major
is positioned directly across and facing the central area.
When the key tenants have been assembled, the other tenants, large and small, are
strategically located where they will be most appealing to the pedestrian traffic flow in
the mall. Some types of businesses have special locational requirements. For example,
a drugstore and a dry cleaner need to be immediately accessible from the parking area.
Furniture stores require many square feet of display area, expensive if on the main floor.
Thus, a typical furniture store layout would include a main floor entry, an attractive dis-
play room in a basement, a second-floor area, or a dogleg wrapped around the rears of
adjacent smaller stores.
Specialty shops and those that feature high-quality, high-priced lines will normally be
grouped near the department store featuring this type of merchandise, while the popu-
larly priced stores are grouped in immediate proximity to their complementary depart-
ment store. Stores that specialize in convenience goods are located as close as possible to
the parking area. Supplementary stores, such as those that offer hardware, electrical repair,
and home furnishings, are usually located close together. Gasoline stations, repair shops,

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 196 Essentials of Real Estate Investment Eleventh Edition

auto supplies, garden nurseries, outdoor furniture, and other stores of this nature are usu-
ally located at the exterior of the center or even in separate buildings.
The International Council of Shopping Centers reports a trend in shopping center
development: clustering similar stores in one area of the center (the older tradition was
to place anchor tenants at the ends of the center and to locate noncompetitive stores
between them). For example, three shopping centers owned by General Growth Prop-
erties, Inc. have employed this trend. At the Park Place Mall in Tucson, Arizona, five
jewelry stores are grouped around a center court. At the Park Meadows Mall in Littleton,
Colorado, home furnishing stores are placed close together. At the Glendale Galleria in
Glendale, California, a cluster of stores catering to the teen market, called The Zone, was
created. This innovative approach is in response to shoppers not being willing to spend
time walking the mall looking for specific items.
Some regionals are designed around an open mall, but most have enclosed malls to
provide a comfortable shopping environment that is heated in the winter and cooled
in the summer. Sculptural displays or fountains usually highlight important mall areas,
while many benches for resting are conveniently located along the preplanned pedestrian
routes.

Management Requirements
Regional centers require at least one full-time manager to be on the premises and
available during shopping hours. Management is responsible for securing new tenants,
renewing existing leases, supervising daily operations, and dealing with shoppers’ com-
plaints. A full crew of maintenance engineers is available at all times, as is a corps of
security guards charged with maintaining decorum and handling emergency situations.
Because 60% of the shopping in this country occurs at night, lighting and security are
important management responsibilities.
All regional centers include an active merchants’ association to which, according to
their leases, all tenants must belong. Together with the center’s management, this asso-
ciation is responsible for the varied promotional activities so essential to this form of
shopping enterprise. Ranging from local artists’ displays to seasonal programs of enter-
tainment, regional promotional activities are a constant and demanding part of manage-
ment responsibility. There are companies that specialize in promoting and bringing events
to retail centers.
There are numerous shopping centers that combine many of the individual attributes
of the three major types described. They are called hybrid shopping centers and fall some-
where in between the neighborhood, community, and regional classifications.

Factory Outlet Malls

Once a major industry of 9,000 stores representing over 500 manufacturers, factory
outlet malls are currently a dying breed. Only a few enjoy continued good business while
the others appear to be suffering from the competition of the burgeoning e-commerce
market and the large, warehouse-type stores and clubs such as Walmart, Home Depot,
Sam’s Club, and Costco. In addition, it appears the merchandise in the factory outlet
malls is no longer the bargain it used to be and, in many instances, is higher in price than
similar merchandise in local stores.

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 Unit 10: Investing in Commercial Real Estate 197

E-COMMERCE COMPETITION
The recent recession and the wave of e-commerce in recent years have redefined the
retail market equation. The days of the suburban mall anchored by a mid-market depart-
ment store are fading, and investors should anticipate a tremendous revolution in retail
trends over the course of the next decade. Issues shaping retail trends include the consoli-
dation and emergence of super-chain stores, the rise of both budget and premium brands,
and a transformation of physical retail, driven by mobile technologies in our “always-
connected” world, a world that is transforming the retail experience for consumers.

Dying Malls
Analysts estimate that up to a third of this country’s existing 1,300 malls are obsolete
or nearly so. These malls are being hurt by faltering department stores, competition from
no-mall discounters such as Walmart, and growing e-commerce networks.
Lee Schalop, an analyst with the Bank of America, reports that 20% of these “D”
malls need to be refurbished, converted to other uses, or demolished entirely. A growing
trend has been to convert these malls to other uses such as government service centers,
office complexes, or entertainment parks (for example, Netpark in Tampa, Florida). Great
opportunities are available to investors that find new and innovative uses for these prop-
erties. Experts predict that what is likely to emerge over the next several years is a retail
landscape with somewhat fewer regional malls than exist today.

SUMMARY
In most American cities and towns, small store buildings line both sides of the com-
munity’s busiest streets. Housing all forms of retail businesses and services, the strip store
building offers a small real estate investor a viable alternative for investment dollars. The
flexibility of the store module allows a property owner to create new uses relatively inex-
pensively to meet the demands of an ever-changing market. Thus, a store that would
house a pizza vendor for one period may be easily converted into a real estate office for
the next.
Although strip stores generally have a higher tenant turnover than do larger shopping
centers, the tenancies of successful entrepreneurs may continue indefinitely. In addition,
commercial tenants usually accept the responsibility for maintaining the structure, which,
when coupled with long-term occupancy, appeals to a great many real estate investors.
Strip store rents are invariably based on a fixed amount for a set period of time, with
the inclusion of escalation clauses for longer leases. Percentage clauses are usually included
for those strip stores that occupy a unique or monopolistic site, such as a corner gas sta-
tion. In most strip store leases, the tenant is able to secure an option to renew, which tends
to place control in the tenant’s hands.
Neighborhood, community, and regional shopping centers appeal to investors with
financial capacities for larger projects. Neighborhood shopping centers are designed to
cater to the everyday needs of residents in the center’s immediate vicinity. With a food
market and a drugstore as basic tenants, the neighborhood center also provides shopping
facilities for other necessary goods and personal services.

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 198 Essentials of Real Estate Investment Eleventh Edition

The community center, on the other hand, expands the number of tenants to include
department and variety stores, as well as the convenience goods tenants found in the
neighborhood arrangement. This enlarged tenant mix allows the community center to
serve a market area of up to 150,000 people.
The regional center provides the greatest variety of comparison shopping by housing
a number of purveyors of the same type of product. Regionals are generally composed of
at least two nationally prominent department store tenants that anchor each end of a mall
area. With dozens of smaller tenants lining this mall, the shopper is able to choose goods
and services from competing shops.
In terms of management responsibilities and lease arrangements, the three types of
shopping centers have much in common. Most tenants are required to pay a basic mini-
mum rent plus or against a specified percentage of gross business. Thus, a landlord par-
ticipates in the success of the tenants and capitalizes on the monopolistic quality of the
center. In exchange, the management provides the maintenance and security required in
such large projects.
Most centers require that their tenants join an association that assumes the respon-
sibility for generating and supervising advertising and promotional activities designed to
attract shoppers. In addition, the associations’ directors usually represent the tenants in
their negotiations with management regarding store hours, participation in promotions,
and determination of assessments for common-area maintenance.
E-commerce is transforming the retail market equation and investors must anticipate
a major shift in retail trends over the course of the next decade.

DISCUSSION TOPICS
1. Investigate what rent-up requirements the permanent lenders in your area demand
before they will issue a standby loan commitment on a new community or regional
shopping center.
2. Choose a neighborhood shopping center in your area and compose a feasibility study
on its conversion to condominium ownership. Compare the value of the center as a
single investment entity to its total value as a condominium conversion.

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 Unit 10: Investing in Commercial Real Estate 199

UNIT EXAM 7. When a tenant does $5,000, $6,000, and $7,000

gross business in each of three successive months,
1. All of the following tenants generate traffic in a
which of the following relationships is FALSE ?
community shopping center EXCEPT
a. Monthly rents of $500, $600, and $700 = a
a. a supermarket.
$500 monthly minimum against 10% of the
b. a discount store.
gross
c. an auto repair shop.
b. Equal rentals of $500 per month for each of
d. a furniture warehouse.
the three months = $6,000 as fixed annual
2. Which of the following statements is FALSE ? rental
a. Strip stores provide neighborhood shopping c. Monthly rents of $500, $600, and $700 =
services. $6,000 per year as a graduated monthly rental
b. Neighborhood shopping centers provide their d. Monthly rents of $1,000, $1,100, and $1,200
customers with necessary goods and services. = a $500 monthly minimum plus 10% of the
c. Community shopping centers service a trade- gross
area population of over 400,000 persons.
8. What does Figure 10.2 represent?
d. Regional shopping centers are constructed on
parcels of land containing at least 30 acres. FIGURE 10.2  Retail Area
3. Most strip store leases are drawn for

Broadway
a. less than one year.
b. one to five years.
c. five to 10 years.
Main Street
d. longer than 10 years.
a. A neighborhood shopping center
4. Which of the following types of shopping centers b. A set of strip stores
does not usually include competitive stores selling c. A community shopping center
the same merchandise? d. A regional shopping center
a. Large and small shopping centers
b. Neighborhood centers 9. Which of the following is expected to transform
c. Community centers the retail market over the course of the next
d. Regional centers decade?
a. General mall
5. The small investor is attracted to strip store build- b. Strip store shops
ings for all of the following reasons EXCEPT c. Community centers
a. affordability. d. E-commerce
b. ease of financing.
c. off-street parking convenience. 10. The type of shopping center that includes office
d. convertibility to other uses. towers and apartment buildings in its design is a
a. regional center.
6. When a commercial tenant has the right to b. community center.
extend the lease at a price and terms established c. super-regional center.
at the time of the lease inception, the lease pro- d. strip store grouping.
vides for
a. an option to renew.
b. a right of first refusal.
c. a right of subordination.
d. a right of redemption.

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 Investing in Industrial
Properties
11 Unit

LEARNING OBJECTIVES
After successfully completing this unit, you will be able to
●● describe the current industrial real estate market,
●● list the characteristics of industrial real estate, and
●● describe the various types of industrial investments.

business park incubator industrial building net lease

Comprehensive Environmental industrial development bond potentially responsible party (PRP)
Response, Compensation, and industrial park railroad spur
Liability Act (CERCLA)
infant industry revenue bond
functional obsolescence
labor-intensive self-storage facility
general obligation bond
loft building warehouse building
incremental taxes

INTRODUCTION
The technical and legal expertise required to develop industrial property makes it
one of the more complicated types of real estate investments. The developer must not
only guarantee the industrialist labor pools, utilities, and transportation facilities but also
satisfy the rigorous regulations of government agencies concerned with zoning, licens-
ing, and environmental controls. It is no longer possible simply to convince a prospec-
tive industrialist to move to a new community; purchase a parcel of land near a freeway,
railroad, or airport; and quickly construct a building. Now the industrial developer must
be concerned with the adequacy of the available utilities and waste-disposal provisions,
as well as with the various impacts the project will have on the environment, both local
and regional.

200

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 Unit 11: Investing in Industrial Properties 201

THE INDUSTRIAL REAL ESTATE MARKET

The success of the e-commerce market is reshaping the industrial space market in
many parts of the country. Demand is rising for both new and converted buildings to
warehouse products being sold with the promise of 24-hour to 48-hour delivery. Properly
located properties in space near airports remain in high demand. For example, Trammel
Crow Company, in partnership with the AMB Property Corporation (a REIT), con-
structed an air cargo center at the Portland International Airport in Oregon that directly
accesses the landing strips. Called “high throughput” buildings, the air cargo is unloaded
at one end and immediately transported to waiting trucks at the other end. Another such
facility is located at the Dallas/Fort Worth International Airport.
Other technology firms throughout the country require customized industrial space
to satisfy their unique e-commerce needs. Consequently, commercial real estate investors
are increasingly factoring in the influence of technology, collaborating increasingly with
potential and existing tenants at the design stages to understand tenants’ technological
needs and to incorporate those needs as an integral part of a building’s design.

Land-Use Patterns
Most industrial developments have in common the basic locational dilemma of isola-
tion from the residential areas of a community. A concern for the health of citizens has
led community regulatory agencies to require that industrial activities that create noise,
smoke, and waste be isolated in designated areas, preferably as far away from homes as
possible. As a result, transportation facilities must be available to provide workers with
easy access and to allow for ease in receiving raw materials and shipping finished goods.
Isolation also creates the problem of securing the utility services needed for manufactur-
ing, including facilities for electricity, natural gas, water, and waste disposal.

Attracting New Industry

Despite the no-growth attitudes of political leaders in some cities throughout this
country, many others actively seek to attract industry. Because they recognize the numer-
ous economic benefits that stem from new employment opportunities, many expanding
communities offer special incentives to induce manufacturers and other employers to
relocate, sometimes called a “beggar-thy-neighbor” policy.
Subsidized plant locations.  One technique uses the community’s taxing power to
float industrial development bonds and then uses the proceeds to purchase land and
build the plants required by new firms moving to the community. The payments on these
bonds are made by the city from taxes collected for this purpose (general obligation
bonds) or from the rents collected from the industrial tenants (revenue bonds). In either
case, a community can adjust the charges to prospective employers and thereby provide
economic incentives for locating in that particular area.
Tax waivers.  In addition to low rents, city leaders may offer a new industry certain tax
waivers. Property taxes may be waived for specified periods of time if a company agrees to
purchase a plant instead of leasing it. Inventory taxes may be waived for the term of the
lease or longer, depending on circumstances. Local income taxes, as well as state income
taxes in certain cases, may be waived for prescribed time periods to allow an infant indus-
try an opportunity to mature.

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 202 Essentials of Real Estate Investment Eleventh Edition

Theoretically, these tax waivers—as well as the plant subsidies—will cost a commu-
nity little, if any, money because of the incremental taxes that will be generated. These
extra taxes will emanate from the incomes of the newly employed and the properties they
will require for housing and peripheral services.

Economic Feasibility
In addition to industrial developments sponsored directly by community leaders,
usually under the direction of an industrial development board, individuals and corpo-
rations also invest in industrial properties. The objective of an industrial developer is to
match a particular property with a specific firm. This process requires a detailed study of
local market conditions as well as the tenant’s needs.
Locational preferences.  When selecting plant sites, industrial firms will be looking to
minimize transportation costs in the acquisition of raw materials and the distribution of
finished goods. In addition, production costs will be analyzed in terms of wages, rents,
taxes, and other necessary expenses. In a highly competitive market, the site offering the
lowest costs will be chosen.
The special characteristics of a firm determine to a large extent where it will locate.
Companies that are market oriented and rely on a large consumer population will locate
close to these customers. A bottler of soft drinks is an example of this type of industry. A
firm that depends on heavy or bulky raw materials will elect to locate near these resources
to minimize transportation costs; for example, a steel mill should be located near supplies
of iron ore or coal deposits. A labor-oriented firm requires a location that will attract the
types of workers required for its activities. Thus, a research company would seek a site near
a university, but a manufacturing plant might prefer a location closer to a large market of
semiskilled laborers.
Local market conditions.  An industrial firm that anticipates a move into a new area
requires precise data concerning the economic base of the community and its demogra-
phy. Data describing the available labor force, its skills, educational levels, and turnover
ratios will be accumulated. In addition, an industrialist will require firsthand knowledge
of the political attitudes of the community leaders and the degree to which they will
cooperate in establishing a new plant. Sources of income and property taxes, tax rates,
assessment policies, municipal services, and zoning ordinances are all vital inclusions in
the evaluation of a community.
Much of this information can be obtained from public sources, such as the Census
Bureau, property-tax rolls, and local employment agencies. Other data can be gathered
from development groups, municipal agencies, utility companies, and research bureaus
maintained by universities and local banks.

CHARACTERISTICS OF INDUSTRIAL REAL ESTATE

The term industry includes all activities involved in the production, storage, and
distribution of tangible goods. Industrial property includes the plants, lofts, and ware-
houses located throughout this country, and the construction of these facilities requires
vast amounts of investment capital. Many manufacturers feel that their own funds are
more productive when used in the operation of their industry. Consequently, industrial
real estate is generally investor-owned, with the manufacturer assuming a tenant’s role.
Frequently, a sale-leaseback-buyback ownership agreement, described in Unit 6, is used.

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 Unit 11: Investing in Industrial Properties 203

Building Characteristics
Industrial buildings are classified as general purpose, special purpose, or single pur-
pose, depending on their adaptability.
●● General-purpose buildings have a wide range of alternative uses. These properties can
be adapted for light manufacturing or assembly plants or simply used as warehouses.
●● Special-purpose buildings have certain physical characteristics that limit the scope
of their use. For example, only a few industrial enterprises require heavily insulated
cold-storage facilities.
●● Single-purpose buildings are suitable for only one use, such as a steel mill. These
single-purpose properties are difficult, if not impossible, to convert to other uses.
Institutional buildings such as theaters, churches, and government structures should
not be considered special-purpose property because they are not used for industrial
purposes.
Because of the specific purpose of some buildings and the unusual size of others,
industrial property is considered a slow turnover commodity in the real estate market.
This poor liquidity increases an investor’s risk and requires that an industrial property
owner seek out an experienced and knowledgeable tenant. The value of this type of prop-
erty is closely intertwined with the profitability of the firm that occupies the premises. If
the tenant is unsuccessful, the building will be vacated and difficult to rent.
More so than in any other form of real estate investment, an industrial tenant’s instal-
lation of heavy equipment and machinery will ensure the longevity of the tenancy. In fact,
the cost of installing expensive and bulky equipment often forms the basis for the observ-
able inertia of large manufacturing firms that remain in one location for several genera-
tions. Although this longevity is favorable to an investor’s yield, functional obsolescence
can sometimes place the operating firm at an economic disadvantage in competing with
companies that have located in modern, more efficient plant facilities.
When industrial firms locate in outlying areas, they tend to prefer single-story build-
ings because of the efficiency of manufacturing operations made possible by this design.
A single-level plant lends itself to greater flexibility in the use of open areas and promotes
the efficient flow of goods through the building. The expediency of a horizontal floor
plan, which allows for greater ease in the handling of materials as well as for an assembly-
line arrangement for the use of machinery, gives the one-story industrial tenant a com-
petitive edge in the marketplace.

Land Characteristics
Industrial property development requires land that is properly zoned, includes a suffi-
cient amount of square footage for buildings and off-street parking, and has access to util-
ity facilities and major transportation arteries adequate to serve the prospective enterprise.
Utilities.  One of the important variables for an industrial developer to consider is the
availability of electricity and natural gas. In the future, perhaps only lands that are now
serviced or can be serviced with these utilities will receive permission to be improved for
industrial use. Where these utilities are available, their costs must be included in the fea-
sibility analysis of a major project. Utility charges are becoming an important part of an
operations statement because their increasing costs can seriously erode the profits from an
otherwise potentially successful investment.

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 204 Essentials of Real Estate Investment Eleventh Edition

Not only must basic utilities be available for an industrial development but waste-
disposal facilities must also be provided. The treatment of solid and liquid wastes is now
an essential concern of every industrial developer. Proof must exist, to the satisfaction
of all concerned parties, both public and private, that appropriate provisions are being
made for the disposal of wastes without disturbing the natural environment. The recent
emphasis on control of polluters has placed new industrial developments under the care-
ful scrutiny of zoners, planners, air and water quality-control agencies, and environmen-
talists of every order.
Compounding the problem of sewage disposal is the isolation required for activities
that create the greatest amount of waste. Whereas clean industry can locate in towns and
on existing sewer lines, heavy industry is relegated to more distant areas where no sewage
disposal facilities exist. Faced with this problem, industrial developers of outlying proper-
ties must often provide their own disposal systems, usually at high installation costs. Sep-
tic tanks and leaching fields are generally not adequate to service a manufacturing plant,
so a treatment pond must be constructed, along with sewer lines to transport the waste
over a substantial distance. Just imagine the clamor of property owners that adjoins such
a malodorous pond!
Railroad spurs.  Generally, industries produce products in large volume and require
facilities for the receipt of bulk raw materials as well as for the shipment of finished goods.
Other than companies dealing in relatively small, expensive items that justify the costs
of air freight, many manufacturing operations require a plant location adjoining a rail-
road spur. The railroad cars can then be available at dockside for efficient loading and
unloading.
Most railroad companies will cooperate in constructing a spur line to a new plant to
serve a potential shipper. Allocations for the costs of such installations are based on the
anticipated volume of business—that is, the higher the volume, the more likely the pos-
sibility that the railroad company will absorb the costs. Often, a developer will have to pay
for the installation of a spur line, but in the case of an industrial park, railroad service
may well provide the marketing attraction necessary for a successful sales effort.
Highway access.  In addition to railroads, many industries rely on trucks to transport
goods into and out of their plants. Every industrial plant design includes provisions for
loading docks and an adequate area for the turning radius of 18-wheelers to serve truck
traffic. Smaller companies, lacking access to an adjoining railroad spur, often deliver
their products by truck to a railroad siding, where the merchandise is transferred to a
railroad car for shipment to the customer. The reverse process is used when goods are
received. Thus, easy access to a major highway is also considered an essential factor in
most decisions concerning an industry’s location, with an ideal site being one that is situ-
ated between a railroad and a major highway. Highway access must also be considered for
employee commuters.
Harbor facilities.  Despite the efficiency of the railroad and trucking systems in pro-
viding shipping facilities for manufacturing activities in this country, most of our major
metropolitan cities have well-developed seaports. The only large metroplex in the nation
without a seaport is Dallas/Fort Worth. The good harbor facilities found at the various
river, gulf, Great Lake, and ocean port cities are a reflection of the vast amount of goods
being transferred by water in national and international trade.
Water routes are used primarily by shippers of heavy or bulky items from materials-
oriented industries. Internal waterways provide an inexpensive means for transporting

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 Unit 11: Investing in Industrial Properties 205

sand, gravel, coal, ore, and other cargo of this nature. Towed by tugs, fully laden barges
of these raw materials are delivered to their users up and down the navigable rivers of this
country.
Storage areas often are constructed at strategic points on the periphery of a commu-
nity where the materials can be dumped from barges and held in anticipation of shipment
inland by truck or rail.
Harbor facilities are receiving increased attention from the federal government. Many
harbors, like the one at Port Brownsville, Texas, have been deepened and enlarged to meet
growing needs. Communities along the northern and southern boundaries of the United
States have experienced increased activity in exports and imports to and from Canada
and Mexico as a result of the North American Free Trade Agreement (NAFTA), enacted
in 1994.

Labor Supply
A feasibility study of an industrial development should include a careful analysis
of both the quantity and the quality of the available labor supply. Whether an industry
requires the extensive use of machines or an intensive use of workers, an available pool of
potential employees, trained or trainable, is essential to its success.
In addition to the personnel needed for a labor-intensive industry, the strength of
their unions is also an important consideration in industrial location decisions. A brief
glance at the burgeoning industrial South and the relatively diminished industrial North
illustrates industrialists’ efforts to move away from powerful labor unions. Of course,
there is no way to escape the impact of unionization because workers tend to join together
for mutual benefits, and unions continue to emerge in each new geographic location.
An interesting pattern of commuting habits evolves when the labor supply is analyzed
in terms of white-collar and blue-collar workers. Many labor-intensive manufacturing
enterprises are restricted to the outlying areas of a community. This situation requires that
blue-collar workers travel from their homes, usually in the central city areas, out to the
plants. At the same time, central city areas have evolved into financial, government, and
office centers that require the services of white-collar workers, who must travel from their
suburban homes into the center of the city. This, of course, results in rush-hour traffic
jams.

Lease Characteristics
An industrial lease usually takes one of two forms—gross or net. Both forms contain
many of the provisions already discussed in the units on residential, office, and commer-
cial properties, including a description of the premises, lease term, rent, security deposit,
use of premises, and the legal responsibilities and remedies of the parties. However, the
conditions of an industrial lease involving taxes, insurance, maintenance responsibilities,
and other legal factors are highly individualized, and each lease must be negotiated spe-
cifically between the individual owners and tenants.
Mainly because of the high costs involved in establishing a manufacturing operation,
most industrial leases are designed to run for long periods of time. As a result, these long-
term leases are established on a fully net basis. Unlike a gross lease in which the landlord
pays the property taxes, insurance premiums, and maintenance costs, the fully net lease
requires that the tenant pay these expenses in addition to the basic rent. Thus, an owner
of an industrial property is guaranteed an agreed-on return on the investment over the
term of the lease period.

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 206 Essentials of Real Estate Investment Eleventh Edition

Of course, there are innumerable variations of the basic gross and net leases. For
example, a tenant may be required to pay only incremental property taxes and insurance
premiums, with the landlord obligated to pay the costs for these items that existed when
the lease originated. A tenant may be required to contribute a specified sum to offset any
increase in maintenance cost or be obligated to pay an escalating base rental amount as a
result of the fluctuations of the consumer price index—one measurement of inflation over
the lease period. Other variations can be designed to reflect the special relationships that
exist between specific parties to an industrial lease.
As in most decisions to invest in real estate, competent legal advice should be sought
in the preparation of the documents required in each transaction.

Environmental Concerns
Particularly important with industrial properties are the various environmental con-
cerns that may arise. Of special importance to investors is the Comprehensive Environ-
mental Response, Compensation, and Liability Act (CERCLA) of 1980. Under this
statute the cost of environmental cleanup may fall to any potentially responsible party
(PRP). PRPs include the property owner, previous owners, property managers, and any-
one who produced, transported, or installed the hazardous material, even if they were not
aware of the environmental problems.
An “ innocent landowner” defense does exist but only for an owner that used reason-
able diligence in discovering a problem before acquisition of the property and no prob-
lems were found. This reasonable diligence entails a Phase I Environmental Assessment,
and if this report shows no problems, then a purchaser may assert the innocent landowner
defense.
A Phase I assessment includes basic research to determine whether or not there may
be a problem. This entails a title search, interviews with persons familiar with the prop-
erty, and a review of any previous records on the uses of the property. Should a possible
problem be discovered (i.e., the property was once used by a dry cleaner or as a gas sta-
tion), then a Phase II assessment is performed.
A Phase II assessment is designed to confirm the presence and extent of an envi-
ronmental problem and may include soil, air, and water testing. Once the presence and
extent of the environmental problem is identified, then a Phase III Environmental Assess-
ment is completed.
The Phase III assessment is the final step before the actual cleanup begins. The Phase
III assessment details how the environmental cleanup is to be performed.
More information concerning environmental issues and regulations may be found
online at www.epa.gov.

TYPES OF INDUSTRIAL INVESTMENTS

Industrial activities range from upholstering living room chairs, to the manufacture
of air cargo planes, and include the entire spectrum in between. The upholsterer can work
in a room behind a retail furniture store; the plane manufacturer requires acres of space.
Thus, large or small, industrial activities are usually housed in some form of improved
real estate.

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 Unit 11: Investing in Industrial Properties 207

Industrial Parks
A popular form of industrial property development is the industrial park, which
offers many advantages to both industry and the community.
Industry benefits by having a choice of readily available sites, usually located on the
outskirts of the community, at relatively reasonable costs. Operating economies, such as
a common sewage facility, can be realized, and amenities can be offered that will give the
park a prestigious atmosphere. With properly designed subdivision restrictions, tenants
and owners alike may enjoy protective covenants that enable them to control their envi-
ronment and provide opportunities for them to interrelate.
An industrial park benefits a community because of its ability to attract new indus-
tries. As a result, the community can expand its economic and tax base, provide more
efficient use of municipal services, and exercise control over isolated industrial operations.
One form of industrial park is designed as a land-banking operation and is usually
developed either by a railroad on land earmarked for large shippers or by a community-
sponsored organization empowered to expand the industrial base. Raw acreage is subdi-
vided into lots, improved with street and utility installations, and offered for sale or lease.
Often, an active campaign is mounted to entice manufacturers to move into the area from
another community.
Another form of industrial park is developed by an individual owner-investor who
offers a complete package of land and building to a prospective buyer or tenant. The user
can specify the design of the construction, usually a form tailored to specific needs, and
the industrial park owner thus acts as a land banker, holding lots until they are needed.
In either case, an industrial park is a preplanned subdivision designed to satisfy the
needs of industrial users and to provide the lot sizes, utilities, road installations, and
restrictions essential for an efficient and prestigious operation.
One basic rule for all industrial park developments is to provide as much flexibility
as possible in the layout plan. This can be accomplished by effective block planning and
stage development. Block designs should include parcels of differing dimensions that can
be used separately or combined to satisfy special requirements. Stage development speci-
fications restrict activities to one area at a time, preclude checkerboarding of the entire
park by haphazard locational decisions, and allow for flexibility in future development.
Restrictive covenants prepared by the developer are established to ensure compat-
ibility among occupants and between the park and the community in which it is located.
Again, flexibility is required to avoid any unreasonable impositions that might be unac-
ceptable to potential occupants. Most restrictions prohibit any uses that might prove
offensive, such as those generating excessive odors, smoke, or noise. Some restrictions
establish minimum site sizes, site coverage, building setbacks, designated parking and
loading areas, outdoor storage limitations, landscaping responsibilities, construction
design, sign control, and other provisions peculiar to a specific park.
Besides planning homogeneous landscaping, the developer should also weigh the
value of providing restaurants and other amenities conducive to attracting tenants to
larger parks. Some industrial developments might include a clubhouse with sleeping facil-
ities, as well as showers, saunas, a swimming pool, a gymnasium, exercise equipment, and
meeting rooms.

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 208 Essentials of Real Estate Investment Eleventh Edition

Industrial park management, although demanding at the outset, does not require
a great deal of effort once the park is established. Tenants usually execute long-term net
leases or purchase their own properties. In the latter case, the owners usually form an
association similar to that of a condominium association to solve mutual problems. In
a tenancy situation, as discussed previously, the terms of the net industrial lease usually
require the tenants to assume responsibility for paying property taxes and insurance and
for maintaining their individual properties.
Industrial park properties have had a relatively flat level of inventory and rent growth
in the last several years.

Manufacturing Buildings
In addition to industrial parks, there are numerous free-standing industrial build-
ings housing all forms of manufacturing activity and located on individual plots of land
in various areas of a community. A typical investment for the small limited partnership
is an incubator industrial building of 5,000 to 25,000 square feet. Designed to house
new companies during their start-up periods, these buildings are located on numerous
available lots throughout a community. A variation on this theme is the business park,
increasingly popular in the Southwest. These parks are patterned after the industrial park
but include retail, office, manufacturing, and storage facilities in one cohesive unit.
Historically, most manufacturing operations were located in the central area of a
community, with housing developing along major streets in a radial pattern from these
job nuclei. Many of these older manufacturing establishments, called loft buildings, are
currently obsolete, made so by technological improvements and the need for greater oper-
ating efficiency. A tall building housing a single manufacturer and designed so that vari-
ous operations are carried out on different floors causes vertical transportation problems
that most manufacturers prefer to avoid. Currently, a one-story building that permits
horizontal traffic flow is preferred for most manufacturing operations.
The operational dictates of manufacturing therefore require that large industrial
plants move to the periphery of communities where ample land is available at reasonable
costs. This movement often results in the abandonment of many older buildings in cen-
tral city areas. Depending on their physical condition, some are converted to other uses
or destroyed in urban renewal projects.
Despite the general movement to the suburbs, some loft buildings continue to house
the activities of manufacturers for whom moving would be unprofitable or who can still
operate with relative efficiency in the old vertical manner. An example of this is the gar-
ment manufacturing industry, which continues its production in the old loft buildings of
New York City. For the most part, however, the loft is becoming obsolete, with virtually
no new construction in this style having taken place within the past two decades. The
vacant spaces in many loft buildings have been filled by tenants who require inexpensive
storage areas or unusually large office spaces at rents much lower than those available in
competing office buildings.

Warehouse Buildings
Throughout the country, there is a proliferation of warehouse buildings designed to
provide enclosed storage facilities for goods and merchandise of all types and descriptions.
Individuals and businesses alike use these warehouses to store goods for extended periods
of time, as well as to facilitate the transshipment of smaller lots of merchandise from a
larger initial bulk quantity.

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 Unit 11: Investing in Industrial Properties 209

In addition to privately owned industrial warehouse buildings, the large warehouses

of major furniture-moving companies, like Bekins and Mayflower, can be found in many
American communities. These storage facilities are offered for rent to the general public,
and customers may pick up and deliver their own goods as well as hire the transfer com-
pany for these services. The managers of these warehouses charge a fee for every entry to
either add or remove goods held in storage.
The wide-span, open-bay design of these warehouse buildings allows most items to
be placed into standard-sized containers, which are then efficiently stacked by forklift
trucks, with the high ceilings allowing maximum use of the interior warehouse space.
Thus, rents are based on the number of cubic feet occupied by the goods and are imposed
as a monthly charge.
Self-storage facilities.  A different system of short-term storage is the self-storage
facility, built as separate bins to be rented by individuals who retain complete control
during the term of tenancy. Thus, by affixing a lock to the storage bin door, a tenant may
add or remove belongings as often as desired without incurring extra charges. The rent for
these spaces is a fixed monthly rate, with the tenant responsible for pickup and delivery of
the stored goods. Management supervises the project during regular operating hours and
provides 24-hour security.
An estimated 2.3 billion square feet of self-storage facilities now exist in this country.
About 30% are located in three states: California, Texas, and Florida. Two types of per-
sons require self-storage: persons living in homes without adequate storage and persons
moving into or out of spaces who need temporary storage. The use of self-storage units
has become more popular as many people have lost their homes due to the bad economy
and need a place to hold their belongings while they temporarily rent or downsize as
they financially regroup. Fully 77% of demand for self-storage emanates from residential
property users. One out of 10 households currently rents a self-storage unit, up 65% over
the last 15 years. Another 18% of demand comes from commercial firms that save money
with self-storage rather than traditional warehousing. It is predicted that the demand for
self-storage is likely to grow as individuals accumulate more goods, including recreational
equipment and vehicles, and as population mobility increases.

Conversions of Lofts and Warehouses

Old lofts and warehouses are regaining popularity with real estate investors. From
abandoned lofts in downtown areas to older warehouses in the suburbs, innovative and
economically successful conversions to other profitable uses are taking place. Not only is
loft space being converted into low-cost offices, but downtown buildings are also being
transformed into interesting and desirable apartments. High ceilings and large rooms
become effective marketing attractions for rentals and have led to remarkable success for
this type of enterprise.
While upper floors are used for offices or apartments, the ground-floor space is usu-
ally converted into specialty restaurants and retail stores. Here, the unfinished look of
exposed bricks and pipes is blended into a counterculture decor that appeals to the cus-
tomer’s sense of adventure. Some cities have had entire areas redeveloped into new and
unusual uses that attract throngs of visitors. The Quay in Kansas City, Haymarket Square
in downtown Boston, Old Town in Omaha, and much of downtown Cleveland are just a
few of these rejuvenated areas. At the same time, individual large old warehouse buildings
are becoming community focal points after their conversion to other uses. Such remod-
eled structures may house spaghetti or steak houses, such as Denver’s Larimer Square Spa-

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 210 Essentials of Real Estate Investment Eleventh Edition

ghetti House or the Spaghetti Factory in downtown San Diego. An old chocolate factory
is the cornerstone of the famous Ghirardelli Square on the San Francisco Embarcadero,
which houses numerous small shops and boutiques catering to the tastes of thousands of
daily visitors. Another example of a successful conversion is the Trolley Square Shopping
Center in Salt Lake City, once the stables and trolley barn for the old street transporta-
tion company. Creative investment opportunities are available everywhere for the alert
developer.
Case Study 11.1 outlines the development of an industrial park.

Case Study 11.1

Industrial Park Development

A 40-acre parcel of land on the periphery of a community was purchased for use as an indus-
trial park. The ground is flat, has good drainage, faces a paved county highway that leads to
a freeway interchange within three miles, and has access to a nearby railroad trunk line. The
property is serviced by city water and sewage facilities, and natural gas and electric utilities
are available.

The development plans include subdivision of the land into 40 light industrial sites, each having
road and rail access, according to the illustration below:

115' ROAD
315'

1 2 3 4 5 6 7 8 9 10

RAILROAD
ROAD

ROAD

ROAD

RAILROAD

ROAD

In addition to providing for the organization of a property owners’ association, a set of restric-
tions and regulations has established setback requirements and controls on parking and prop-
erty uses. The intent of the protective covenants is to
●● ensure that the park will be maintained as an attractive setting with landscaping, open
areas, and well-developed structures;

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 Unit 11: Investing in Industrial Properties 211

●● protect the owners, lessees, and subtenants against improper and undesirable use of the
surrounding property;
●● protect against the property’s depreciation in value; and
●● prevent haphazard and unharmonious improvement in the park.

The protective covenants require that all plans and specifications for new structures and
other improvements be approved in writing by a committee of the owners’ association. In
addition, no building can be constructed closer than 30 feet to any lot line or road, and the
association may require a 10-foot easement on all sides of each lot for the purpose of plant-
ing and maintaining trees, shrubs, and bushes. Minimum standards must be observed regard-
ing fences, building elevations, compatibility of accessory buildings, shielding of roof-mounted
equipment, and signs. The owners are also required to contribute to a fund for the mainte-
nance of the roadways and landscaping. Finally, the restrictions provide for the developer to
repurchase any tract at the same price paid for the property if, after two years, the buyer has
not begun construction. This clause effectively prohibits parcels from being left idle or used
for speculative purposes.

Financial Analysis

The 40 acres were purchased for $20,000 per acre, and the developer spent an additional
$5,000 per acre for roads, railroad spurs, utility services, and landscaping. A market study
reveals that the 40 sites can probably be sold over a five-year period at an average price of
$54,000 per lot. Sales costs are projected to include 10% for commissions and $104,000 for
other costs, including interest, title searches, and service fees.The developer anticipates a 25%
average annual return on the total investment. The buyer made a $200,000 cash down pay-
ment and agreed to make $150,000 annual payments on the balance.

Analysis A: Annual Cash-on-Cash ROI

Item Year 1 Year 2 Year 3 Year 4 Year 5

Cash payment $200,000 $150,000 $150,000 $150,000 $150,000
Improvements 200,000
Negative 32,000
Total cash 400,000 582,000 732,000 882,000 1,032,000
Income 432,000 432,000 432,000 432,000 432,000
Expenses 64,000 64,000 64,000 64,000 64,000
Net income 368,000 368,000 368,000 368,000 368,000
Yields (32,000) 218,000 218,000 218,000 218,000
÷ Cash 400,000 582,000 732,000 882,000 1,032,000
C/C ROI (8%) 37.46% 29.78% 24.72% 21.12%

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 212 Essentials of Real Estate Investment Eleventh Edition

SUMMARY
This unit examined the unique qualities and characteristics of industrial property as
an alternate method of real estate investment. The technical and legal expertise required to
develop industrial property makes it one of the more complicated types of investment. In
addition to satisfying the plant design and locational requirements of a potential tenant,
the industrial property developer must also meet the increasingly stringent environmental
controls and other regulations of local government agencies.
Despite the number of communities committed to no-growth policies, many cit-
ies are still actively seeking to attract new industry to their environs. These expanding
communities establish industrial property development agencies empowered to offer new
employers subsidized plant locations and tax waivers to entice them to their cities.
Basically, the possibility of more economical operation is what attracts a firm to a
new site. Suburban and rural locations provide inexpensive land for one-story construc-
tion but also present problems in securing utility connections and waste-disposal services.
Adequate transportation facilities and the quantity and quality of the labor supply also
affect locational decisions. Finally, a knowledgeable potential tenant will analyze the com-
munity’s tax base, zoning ordinances, and political attitudes toward industry before mak-
ing a move.
Many industrial buildings are designed as general-purpose structures with a wide
range of alternative uses. These buildings provide an investor with flexibility for reuse if a
tenant leaves, thus reducing risk. Special-purpose or single-purpose industrial structures
designed for a specific firm require long-term leases from highly creditable tenants to
offset an investor’s risk. Generally, industrial real estate is considered nonliquid because of
the many unique physical requirements for development.
In addition to the zoning, utilities, and labor inputs essential to develop industrial
property, adequate transportation facilities must be readily accessible. Railroad spurs and
sidings, as well as major highways, are usually prerequisites for a successful industrial
investment. Often, a railroad company will pay for the installation of a spur track to a
new industrial tenant in anticipation of new shipping business. Just as often, an industrial
park developer will have to pay for construction of a spur track into the subdivision to
attract new tenants.
Most industrial leases are drawn for long time periods and are designed on the basis
of net rents. A net lease requires that a tenant pay property taxes, insurance, and mainte-
nance costs in addition to a base rent. Thus, because the cost of these items is absorbed by
the tenant over the term of the lease, the landlord’s yield is preserved. Often, an escalation
clause is included in a long-term net industrial lease to offset the effects of inflation.
Industrial investments include industrial parks, manufacturing buildings, warehouse
buildings, and the conversion of old lofts and warehouses into new and profitable uses.
Industrial parks are preplanned subdivisions that house all forms of commercial activities,
including manufacturing, storage, distribution, sales, service, and research and develop-
ment. One kind of park is designed only for the sale or lease of lots, whereas another may
include a lot and building in a package deal. In either case, the park generally is designed
around a set of restrictive covenants that specify the types of uses allowed as well as the
architecture of the buildings. Industrial park management is active at its inception and
usually becomes passive once the park is established.

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 Unit 11: Investing in Industrial Properties 213

Old loft buildings are generally obsolete but are still being used to house the activities
of businesses for whom moving would be unprofitable or for tenants who desire inexpen-
sive bulk storage or office space. Warehouse buildings are designed to provide enclosed
storage facilities for goods and merchandise for extended periods of time. Tenants pay for
the use of space in these buildings by the cubic foot and must also pay a fee each time the
goods are moved. Self-storage facilities, on the other hand, provide enclosed storage in
the form of individual bins that remain under the complete control of the tenant during
the term of occupancy.
Conversions of old lofts and warehouses into new uses, such as restaurants, offices,
apartments, and shopping centers are a promising source of real estate investment
opportunities.

DISCUSSION TOPICS
1. Determine what, if anything, is being done in your community to entice new indus-
try to locate there.
2. Research the economic results of the multiplier effect of a new industry coming to
your town. Estimate how it would affect your community if the new enterprise hires
500 people.

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 214 Essentials of Real Estate Investment Eleventh Edition

UNIT EXAM 6. From a community’s point of view, the benefits

of encouraging the development of an industrial
1. Modern industrial buildings are generally con-
park would include all of the following EXCEPT
structed as all of the following EXCEPT
a. economic-base expansion.
a. custom-designed, specialized facilities.
b. tax-base expansion.
b. multistory, high-rise structures.
c. limiting urban sprawl.
c. single-floor complexes in park-like
d. efficient use of municipal services.
environments.
d. plants adjoining a railroad line or highway, or 7. A “beggar-thy-neighbor” policy is exemplified by
both. a. an upstream community dumping raw sewage
into a river.
2. The demand for industrial space depends to a
b. one community’s air pollution standards
large degree on all of the following EXCEPT
being less stringent than its neighbors’.
a. the condition of the business cycle in the
c. two adjoining communities constructing a
overall national economy.
mutually beneficial urban renewal project.
b. the supply of available and proposed indus-
d. a community engaging in an active campaign
trial space.
to entice manufacturers from other communi-
c. the number of new housing starts.
ties to move into its area.
d. local and regional economic conditions.
8. Industrial park restrictive covenants would usu-
3. The popularity of industrial parks depends to a
ally include all of the following EXCEPT
large extent on all of the following EXCEPT
a. specified lot sizes.
a. the trend toward one-story buildings on large
b. prohibitions against incompatible lot uses.
sites.
c. building setback requirements.
b. downtown traffic congestion and parking
d. construction design controls.
limitations.
c. expansion and improvement of interstate 9. Revenue bonds issued to develop industrial prop-
highways. erties are repaid from
d. the economic difficulties of the nation’s a. taxes imposed on local property owners.
railroads. b. incremental taxes earned from increased
values.
4. An infant industry is one that
c. rents charged new industrial tenants.
a. is being approached to come to a community.
d. inventory taxes charged to new tenants.
b. has been in one location for many years.
c. is just beginning to be successful. 10. Functional obsolescence is most clearly defined as
d. has expanded to branches in other states. a. the cost of removing hazardous wastes.
b. the outmoded condition of a building.
5. From an industry’s point of view, the benefits of
c. the obsolete design of a building.
locating in an industrial park include all of the
d. equipment deterioration.
following EXCEPT
a. immediate site readiness.
b. symbiosis with other firms in the park.
c. operating economies.
d. unrestricted site uses.

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 Investing in Special
Real Estate
12 Unit

LEARNING OBJECTIVES
After successfully completing this unit, you will be able to
●● describe manufactured-home parks as an investment opportunity,
●● list other realty investment opportunities, such as hotels, amusement parks, and senior housing, and
●● list alternative investment opportunities, such as mineral rights and real estate mortgage investment conduits
(REMICs).

air rights Ginnie Mae repossession

congregate care center manufactured home retirement community
discount mineral rights royalty income
Fannie Mae property tax lien secondary market
franchise real estate mortgage investment strip
Freddie Mac conduit (REMIC) tranche

INTRODUCTION
In addition to the more traditional forms of real estate investment—land, houses,
apartments, offices, commercial properties, and industrial developments—there are
numerous opportunities to participate in profitable ventures in specialized real estate.
This category includes manufactured-home parks, motels, amusement parks, and golf
courses. Other alternate forms of real estate investment are franchises, mineral rights, air
rights, and real estate securities. This unit examines these and other diverse opportunities.

MANUFACTURED-HOME PARKS
An important category in real estate investment is the development of land for man-
ufactured-home parks, for both renting and selling space. Renting a space in a park is
similar to renting an apartment, whereas the purchase of a condominium manufactured-
home lot parallels the purchase of a residential lot in a subdivision.

215

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 216 Essentials of Real Estate Investment Eleventh Edition

The successful development of manufactured-home parks, both as rentals and as con-

dominiums, is attracting investors to this form of realty venture. Their growing interest is
based on three interrelated phenomena—a dramatic increase in the costs of constructing
more traditional housing, our population’s increasing longevity, and the effective vesting
of numerous pension and retirement programs. Manufactured homes appeal to people
who cannot afford the costs of more traditional housing, as well as to a large segment of
retired people attracted by the amenities that the various parks provide. In many cases,
the receipt of both pension and Social Security benefits allows retirees to move to warm-
weather states, where manufactured-home parks are found in abundance.
Manufactured homes, originally called mobile homes, were originally regarded as
minimal-quality housing. Since 1976, this type of housing has been regulated by the
Department of Housing and Urban Development under its Manufactured Home Con-
struction and Safety Standards. The standards are similar to those established for site-built
housing and, as a result, manufactured homes have not only become more durable and
safer, but their appearance has significantly improved. Modern manufactured housing
is often entirely compatible with site-built housing and may well be the most affordable
housing on the market today.
In some cases, the establishment of a manufactured-home park is an interim use
of land while the owner waits for development to move into the area. It may also be an
answer to a shortage of affordable homes, providing a viable alternative for low-income
and moderate-income occupants. The cost of housing in a manufactured-home park is fre-
quently 20 to 30% less than the cost of conventional housing elsewhere in a community.

Location and Design

The land for manufactured-home parks is invariably located in relatively isolated
areas of a community because this form of real estate development has not generally been
accepted by either land planners or owners of more traditional housing. In many com-
munities, these parks are considered to be undesirable developments, a stigma traceable to
the growth of a myriad of “trailer parks” after World War II. These trailer parks jammed
up to 20 units on one acre, and they became havens for transients. They developed into
slum-like environments detrimental to the values of surrounding properties. With the
advent of the modern, well-landscaped, preplanned manufactured-home park, featuring
only seven to 10 units per acre, this negativism is largely being overcome in a growing
number of communities.
Because many parks are located on outlying parcels of land, the initial outlay of funds
required for site acquisition may be relatively small. However, improving this property
with roads, utilities, concrete pads, and amenities is a costly investment, much of which
can be financed through local banks or savings institutions. The FHA also provides special
mortgage insurance for manufactured-home park financing. The design of a manufac-
tured-home park can follow a horizontal grid pattern, a herringbone layout, or a series of
concentric circles or half circles around a centrally located office or clubhouse, as shown
in Figure 12.1: Designs of Manufactured-Home Parks. The grid pattern places the units
in a horizontal position, with each pad parallel to all others. A more efficient design is the
placement of units at an angle to the street, herringbone style, which allows the homes to
be more easily maneuvered in and out of position.

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 Unit 12: Investing in Special Real Estate 217

FIGURE 12.1  Designs of Manufactured-Home Parks

Most new parks provide occupants with special amenities, including swimming
pools, clubhouses, tennis and shuffleboard courts, laundry rooms, and storage facilities.
Many modern parks also include a separate parking area for travel trailers and other rec-
reational vehicles.

Spaces for Rent

The rent for spaces in a manufactured-home park depends on the location of the
park, the size of the unit, and the amenities included in the project. Some parks require
leases for specific terms; others operate on a month-to-month basis. The tenant is usually
responsible for moving the unit into place and setting it up. Most quality parks insist that
a front patio and cabana be installed as a condition of the lease. These improvements are
required to create an atmosphere of unity and permanence in the park.
The financial success of a rental park is largely a function of the managerial skills of
the owner or manager. The availability of well-planned social activities and the constant
maintenance and cleanliness of a park often make the difference between whether it suf-
fers chronic vacancies or enjoys full occupancy. Some parks are so popular that they main-
tain a list of potential tenants waiting to move in as soon as a vacancy occurs.
The profitability of a rental park is based on the same variables that exist in other
improved-property investments. However, the deductions for depreciation are limited to
the improvements made to the land: utility installations, concrete pads, the clubhouse,
laundry rooms, and storage buildings. When compared with other improved income
property, this lack of depreciation shelter, plus the high degree of personal involvement
required in management, inhibits investment in this form of real estate. In effect, a
manufactured-home rental park is considered a business venture more than a real estate
investment.
When rental spaces are in short supply in a particular community, local manufac-
tured-home dealers sometimes develop new parks to provide unit spaces for customers.
Occasionally, dealers enter into joint ventures with landowners for such purposes.
Sometimes rental-park owners have the opportunity to acquire ownership of the
units from tenants who wish to dispose of their holdings or from executors of the estates
of deceased owners. These units can be rented by the park owner, and the income can be
sheltered by appropriate depreciation deductions.

Spaces for Sale

Another approach to manufactured-home park development is the sale of individual
lots. This is an increasingly popular application of the condominium concept, in which
a buyer secures a deed to a lot plus an undivided interest in the common areas. The lot is

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 218 Essentials of Real Estate Investment Eleventh Edition

described in legal terms and is an identifiable portion of land lying within the park area.
The common property includes the roadways, clubhouse, and amenities.
After acquiring a suitable site, a developer subdivides the land into a prescribed num-
ber of lots according to an officially approved plan. These lots, fully improved with con-
crete pads, sewer and water connections, and other utilities, are then sold to individual
owners. The development includes a set of bylaws that call for the establishment of an
association of lot owners to manage the common areas and to enforce the covenants,
conditions, and restrictions of the park.
Manufactured-home dealers engage in condominium park developments and
sell package deals that include both lot and unit for one price under a single financial
arrangement.

Manufactured-Home Sales
More than 30 million people live in manufactured housing in the United States.
Manufactured-homes sales account for approximately 11% of single-family home sales.
Fannie Mae now treats loans for manufactured homes in the same manner as site-built
homes. Mortgage loans on manufactured homes must meet criteria specific to the indus-
try, but obtaining loans to purchase modular and manufactured homes is no longer the
onerous exercise it once was. With average prices for new units at $68,300, these units are
an attractive alternative to site-built single-family homes.
New manufactured-home communities are designed to accommodate larger, con-
temporary units on no more than five sites per acre, together with various on-site ameni-
ties appealing to the local market.

DIVERSE REALTY INVESTMENTS

It is often difficult to distinguish between real estate as an investment and real estate
as a business. A clear delineation exists when one person owns the real estate and another
operates a business on the property. Here, the real estate is clearly its owner’s investment,
and the businessowner pays rent. However, there are diverse investments that involve real
estate as a part of the business itself—for example, hotels, motels, amusement parks, golf
courses, housing for the elderly, medical buildings, repossessions, and property tax liens.

Hotels and Motels

Commercial hotels.  Commercial hotels are designed to serve the individual business
traveler. They contain some meeting space and food services. They enjoy strong week-
day demand but suffer low weekend occupancies. Traditionally, commercial travelers are
the backbone of the lodging industry, paying full rates for their accommodations with
expense accounts, thus minimizing price resistance. The advent of new technologies such
as video communications and telecommuting may alter the need for business travel and
have an adverse effect on the commercial hotel business.
Convention hotels.  Convention hotels contain extensive meeting space that attracts
the meeting and group market segments. Most cater to both commercial and convention
guests. These properties require specialized management expertise. Convention hotels are
affected by general economic conditions and may be threatened to some degree by emerg-

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 Unit 12: Investing in Special Real Estate 219

ing video conferencing technology such as webinars. The high costs of developing new
convention hotels will limit new supply growth and protect existing properties.
Resort hotels.  Catering to vacationers, resort hotels provide good long-term invest-
ment opportunities, particularly in areas that are not too seasonal. People will continue to
take vacations regardless of new technologies, and business is good in resort hotels because
of increased leisure time and expanding two-income families.
All-suite hotels.  All-suite hotels offer guest rooms larger than those found in tradi-
tional hotels, as well as limited meeting and public space. This expanded space appeals to
business travelers and their families and has been effective in attracting travelers, filling
rooms during weekdays as well as usually slow weekends.
Extended-stay hotels.  Extended-stay hotels are lodging facilities with kitchens, liv-
ing areas, and bedrooms that resemble apartment buildings. They cater to travelers who
intend to stay in one area for a longer time—a week or more. Thus, these hotels do not
experience weekend occupancy declines. These properties often achieve occupancy lev-
els reaching 80% and enjoy special operating efficiencies brought about by lower guest
turnover.
Motels.  The motel industry emerged as a result of our mobile society’s demands for
convenient temporary housing along the nation’s major highways. Development of land
for motel construction is considered a real estate investment, and the operation of the
motel itself is a business venture. When the operator of a motel also owns the real estate,
the charges for mortgage interest, property taxes, insurance premiums, maintenance costs,
and depreciation become deductible expenses on the operating statements of the business,
and the income from the operations is considered active.
Hotel-condos.  Hotel-condo hybrids are upscale luxury hotels that sell some of the units
as condos. The owners enjoy the investment aspects of owning real estate coupled with the
amenities of a full-service hotel. Many luxury hotel chains such as Ritz-Carlton, Hilton,
and Four Seasons have embraced this concept. These properties are often a second home
for the owners, and the hotels will assist in leasing the units when the owner is absent.
Often the hotel and unit owner will split the rental income produced.

Amusement Parks
The amusement park as a real estate investment is enjoying continuing popularity
throughout the country. Based on the successes of Disneyland and Knott’s Berry Farm in
the Los Angeles area, theme amusement parks have emerged in all parts of the nation. Just
a few examples of these enterprises are Disney World, the three SeaWorlds, Silver Dollar
City, Worlds of Fun, Six Flags, and Cedar Point.
An amusement park development requires a high level of technical expertise, begin-
ning with the choice of its theme and continuing through design and the construction of
its various attractions. Many larger parks incorporate peripheral complementary real estate
developments into their overall designs. Often, hotels, motels, shopping centers, restau-
rants, and, occasionally, houses and apartments are made part of the park development.

Golf Courses
Although golf courses as business enterprises are sometimes located in isolated areas,
they are more often developed as an integral part of a centrally located municipal park

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 220 Essentials of Real Estate Investment Eleventh Edition

or new subdivision. There are a number of golf courses that are designed as private clubs,
with membership and greens fees along with concessions and pro-shop income providing
the cash flows necessary for financial success.
The construction of a golf course is a complicated, highly technical undertaking. The
success of such a project is largely a function of its location, site suitability, and challeng-
ing layout. Most large courses are designed by professional golfers, who act as consultants
to the developers.
The acreage needed for a golf course is determined to a great extent by what type
of course is planned. Normally, 120 to 180 acres of gently rolling land is considered
adequate for a regulation 18-hole course, while approximately 70 acres are needed for a
9-hole course. Par-three courses can be constructed on 30 to 45 acres, if the fairways are
designed in parallel.
The costs of constructing a golf course vary greatly, depending on the terrain and
natural setting. These costs include the price of the land; its preparation; the installation
of fairways, greens, and sprinkler systems; and the acquisition of necessary equipment.
Course maintenance costs have spiraled dramatically in the past years.

Senior Housing
Two types of senior housing are popular real estate investments: retirement commu-
nities and congregate care centers.
Retirement communities.  This special form of community is designed to cater to
the growing retirement market. The retirement community stresses lifestyle amenities,
recreation, shopping convenience, comfort, minimum maintenance, and a high degree
of security. Blended into a well-planned unity, retirement developments include single-
family dwellings, condominiums, garden apartments, town houses, shopping centers, and
recreation facilities. Some larger projects include golf courses, swimming pools, club-
houses, hobby shops, medical clinics, and convalescent centers.
Congregate care centers.  A special form of senior housing, the congregate care cen-
ter, including assisted living facilities and nursing homes, is emerging as an important real
estate investment alternative. Designed in the format of an apartment hotel or complex,
these developments provide housing, food, maintenance, and health care within one facil-
ity. At least 70% of all people over 65 will require long-term care during their lifetime and
more than 40% will need a nursing home facility.
According to the NIC Investment Guide, a report from the National Investment Cen-
ter for the Seniors Housing & Care Industry (NIC), demand for senior housing and care
is driven by a combination of age, frailty, wealth, income, and desire to live in a senior
housing community. The most prominent trend is the growing senior population result-
ing from the baby boom. As of 2010, 6% of the U.S. population were aged 75 years or
older. The level of seniors in this age group will continue to grow at a steady pace through
2020. An important factor contributing to demand for senior housing is increased life
expectancy. Recent emphasis on healthy living, combined with advances in medicine, has
led to seniors living longer, thus increasing the length of time they stay in a senior hous-
ing community.
These trends warrant the attention of real estate investors as they consider their invest-
ment options.

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 Unit 12: Investing in Special Real Estate 221

Medical Buildings
Specialization has long been the custom within the medical profession, but special-
ization of facilities for doctors’ offices has not kept pace with the need. Private investors
may participate in providing real estate facilities for medical practitioners under FHA
Title XI (mortgage insurance for constructing or rehabilitating group-medical-practice
buildings) and Title XV (mortgage insurance for new or rehabilitated hospitals owned by
nonprofit organizations). Doctors generally prefer locations close to major medical facili-
ties in buildings that can provide complementary, as well as peripheral, medical services.
Medical buildings are generally more expensive to build than conventional offices
because of parking, water, and electrical requirements. Successful medical developments
require special consideration of doctors’ unique needs. Proper planning includes con-
stant consultation with architects and the doctors themselves on how best to design the
complex. Large, multidoctor facilities produce maximum tenant interest and better use
of the land. The larger projects offer a greater potential patient-referral system, based on
a proper mix of tenants as well as on such auxiliary facilities as a pharmacy and a clinical
pathology lab.

Repossessions and Property Tax Liens

There are numerous opportunities for real estate investments through the acquisi-
tion of property from repossessions, which now occur more frequently as a result of
default on mortgage payments and less frequently from the nonpayment of property
taxes, income tax liens, and other obligations.
In seeking out leads to these opportunities, investors usually contact the various local
banks and savings associations as well as community lawyers. Perusal of the local newspa-
pers can also alert investors to foreclosures and tax delinquencies.
Careful consideration should be given to the legal ramifications of acquiring good
title to foreclosed properties. The services of a knowledgeable real estate attorney or title
company are strongly recommended.
There are thousands of owners who, for one reason or another, do not pay their prop-
erty taxes on time. After a year, these unpaid taxes become liens of the highest priority
against the property itself. These property tax liens come before any existing loans or
other liens, even IRS liens.
In most county jurisdictions, property tax liens are auctioned to investors who buy
them for the interest they earn. For example, in Pima County, Arizona, the tax liens incur
a penalty interest rate of 16% after one year’s delinquency. They are then auctioned to the
bidder who will bid the least amount of interest under 16%. Most bids are made at the
full 16%.
The property owner in Arizona has three years to redeem, after which the successful
bidder can perfect ownership in the property by filing a foreclosure. This rarely occurs
because most owners do not want to lose their property. Property tax liens may be handled
differently in other parts of the country and offer alternative investment opportunities.

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 222 Essentials of Real Estate Investment Eleventh Edition

ALTERNATE INVESTMENT OPPORTUNITIES

A number of investments that are not classified as real estate per se are definitely real
estate oriented. These alternate investment opportunities include franchises, mineral and
air rights, and dealing in real estate securities.

Franchises
Franchises have become such an integral part of our economy that it is difficult to
recall a time when this type of cooperative business arrangement did not exist.
Real estate investors often negotiate with franchise owners when arranging leases. A
franchise is created when a franchisor grants to a franchisee an exclusive right to engage
in the distribution of services or goods under a prescribed marketing plan or system. The
operation of the business then follows this plan, using the franchisor’s trademark and des-
ignated operating format to provide uniformity among all franchise members. Among the
many nationally known franchises are McDonald’s, Kentucky Fried Chicken, U-Haul,
Midas, and Orkin.
Although some franchise operators prefer to purchase land and develop their own
buildings, others prefer to be tenants. A lease for property designed to house a franchise
operation is usually a three-party agreement among the landlord, the franchisee, and the
franchisor. The building frequently reflects an easily recognized architectural design and
is built from plans provided by the franchisor. Many of these buildings are designed for
only a single purpose; therefore, to offset the risks involved, a developer usually requires
a lease that generates enough rental cash flow not only to yield a return on the invest-
ment but also to return the developer’s entire cash outlay during the initial lease period.
Any renewals can be negotiated at rents appropriate to the market, depending on specific
circumstances.

Mineral Rights
In this country, an owner of real property is legally entitled to control the miner-
als, natural gas, oil, and water that lie below the surface of the land. When minerals are
removed from the ground, they assume the quality of personal property and can be sold
separately from the real estate itself. Because minerals, natural gas, and oil have value,
whenever the existence of a substantial quantity of these commodities is discovered in a
specific location, a market for their exploitation is developed. Dealers in mineral rights
are very active in some areas of the country, such as Arizona, California, New Mexico,
Montana, Oklahoma, Texas, and Wyoming, where some land is purchased and sold pri-
marily on the basis of its mineral content.
Often, owners of mineral-bearing lands retain the rights to these minerals when they
dispose of the real estate. This allows them to sell or lease their mineral rights to others
engaged in the mining business. Generally, the retention, or reservation, of mineral rights
is accompanied by some specified surface access for their removal. In the absence of the
opportunity to enter the surface of a property for direct vertical excavation or drilling, the
owner or lessee of the mineral rights may be forced to arrange for vertical descent on an
adjoining property and then make a lateral underground approach to the minerals.
Owners of mineral rights receive income in one of three ways—by selling the rights,
by leasing the rights, or by selling the minerals themselves. Selling the rights yields a one-

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 Unit 12: Investing in Special Real Estate 223

time payment, whereas leasing the mineral rights provides royalty income, which may
continue for the term of the lease. For example, the owner of oil rights might receive a
royalty per barrel of oil extracted, and the owner of copper rights might receive a royalty
per pound of refined ore over the duration of the excavator’s lease.
Investors are attracted to mineral exploration for the tax shelter it offers. Operating
expenses, deductions for mining activities, as well as generous depletion allowances are
available under current income tax laws.

Air Rights
Although dealing in air rights has hitherto been unheard of in many parts of this
country, as the cost of urban land continues to rise, the air is becoming a new arena for
real estate investments. The sale or lease of air rights offers an investor a vastly expanded
opportunity for constructing high-rise buildings on strategically located sites in central
city areas.
The use of the airspace over a specific property often implies the presence of an exist-
ing building or other improvements, such as roadways or railroad tracks. Thus, any con-
tract involving the construction of a new building into the air will require an agreement
with the base-property owner concerning the surface area to which the edifice will be
affixed.
Some developments are anchored by huge columns that straddle the existing build-
ing and support a platform on which the new construction is erected. Other buildings
are constructed on a platform supported by a central core, much like a golf tee. This core
is constructed in the center of the existing building with access to the street through a
hallway. The core contains the utilities and elevators that serve the offices or apartments
built in the airspace above.
Other uses of airspace include the construction of buildings over roadways, in which
the streets actually become tunnels through these structures. Properties developed over
Riverside Drive in New York City illustrate this technique. The Merchandise Mart in
Chicago is an example of a building constructed over railroad tracks.
Airspace can sometimes be a vital part of a real estate investment that depends for
its success on an ongoing, uninterrupted view of a lake or ocean where the rents are a
function of this view. Owners of such properties might be well-advised to ensure this
view by either purchasing or leasing the airspace over adjoining properties that might be
used for other buildings. A case in point is the Lake Point Tower in Chicago, which was
constructed near, but not quite at, the very end of a strip of land extending into Lake
Michigan. Developers purchased the tip of the land and erected a high-rise building that
effectively blocked the view from the existing structure.

Water Rights
Water rights have become increasingly more important. Who owns the water and
who has the right to use it? These issues are controlled by state law and will vary greatly.
Real estate development has been halted in some areas due to lack of water. Developers
must include research of available water supplies into any feasibility studies. Some inves-
tors profit by buying and selling water rights. Property values, especially in some of the
western states, may be affected significantly by the water rights that are appurtenant to
the land. Private entities assemble water rights to sell to municipalities that are sometimes
miles away from the source of water.

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 224 Essentials of Real Estate Investment Eleventh Edition

Real Estate Securities

Although not technically real estate investors in the truest sense of the word, dealers
in real estate securities are actively participating in the market by providing the funds
necessary to complete most realty transactions. Lenders who originate most of the senior
mortgage loans often sell these securities in the secondary market through the services of
Fannie Mae, Ginnie Mae, and Freddie Mac.
Dealing in real estate securities offers an investor a viable alternative to the responsi-
bilities that accompany the more active management role associated with traditional real
estate investments. A lender assumes a passive role in the operations of a realty venture
but still participates as a sort of partner, collecting a portion of the profits in the form
of interest. Even more attractive to those who enter this field, the payments do not stop
until the loan is repaid, despite the fluctuations of the rental marketplace. Thus, a lender
can anticipate receiving a steady income stream in the future, an income that develops a
return on the investment commensurate with the risk involved. If the borrower does not
fulfill the contractual obligations, the property that is the collateral for the loan reverts to
the lender.
Junior securities.  In addition to the activities of the secondary mortgage market in
dealing with the purchase and sale of senior mortgages, there is a growing demand to use
money for trading in junior real estate securities. Because of the rising cost of land and
the expenses connected with its preparation, as well as increasing construction costs and
the climbing prices for used properties, a second or third mortgage or a land contract is
often the only way a property can be financed. Generally, the seller ends up carrying back
a junior loan to facilitate the sale of the property.
By its very nature, junior finance is a relatively high-risk investment. Junior means
second in priority behind an existing first mortgage lien; thus, there is a greater risk of loss
in the event of a default. In a foreclosure, the senior mortgagee is paid first, and then the
junior lienholders receive their payments from any excess funds secured at the property’s
auction.
However, junior financing instruments can be made more secure. Junior lenders
often insist on the inclusion of a “cross-defaulting” clause in their contracts, whereby the
borrower will default if he defaults on any other obligation. Wraparound contracts can be
established with payments routed through a collection agency or a trustee to ensure the
loan’s close supervision. Property subject to a contract for deed can be placed into a trust,
eliminating much of the inherent risks.
Generally, returns required for junior loans are secured by negotiated interest rates,
substantial placement fees, or discounting.
Discounting.  Discounting raises the yield of a receivable for its buyer without affect-
ing the terms of the loan contract. When a real estate loan is originated at a 9% nominal
(contracted) interest rate and is sold to a securities dealer for its face value, the purchaser
earns a true 9% return on the investment. If, however, the current market interest rate
is lower than 9%, the contract will be sold at a premium—an amount higher than its
face value—which has the effect of reducing the yield to more closely reflect the current
market conditions.

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 Unit 12: Investing in Special Real Estate 225

More commonly, however, a mortgage is sold at a discount —an amount less than its
face value—to raise the yield for its purchaser. The amount of the discount is a function
of the mortgage buyer’s yield requirements, the contract’s interest rate, and the term of
the loan.

■■ FOR EXAMPLE  Examine a mortgage for $10,000 with interest-only payments at

the rate of 9% per year, due in full in five years. A securities purchaser who requires a 12%
return on the investment will pay exactly $8,918.57 for this contract.

$900.00 Annual interest-only payment

× 3.604776 Factor for PWA @ 12%, 5 years
$3,244.30 Present worth of annuity
$10,000.00 Reversion at end of 5 years
× 0.567427 Factor for PW of $1 @ 12%, 5 years
5,674.27 Present worth
+ 3,244.30 Present worth of annuity
$8,918.57 Present worth of contract

Real Estate Mortgage Investment Conduits (REMICs)

Real estate mortgage investment conduits (REMICs) are an ownership entity that
can hold mortgages and issue multiple classes of ownership interests in the form of pass-
through certificates, bonds, or other securities. The overall goal of this entity is to simplify
the structure of the secondary mortgage market. Even more important, however, the
income from a REMIC is considered passive rather than portfolio. Thus, it may be used
to offset passive losses.
Under a REMIC, mortgages are pooled in various categories called tranches and
sold to investors requiring specific yields for specific risks. For example, one tranche may
include only fixed-rate loans; another, only variable-rate loans. Another may pool only
long-term loans; another, only short-term loans.
All of the tranches offer pass-through services, where interest-only, principal-only, or
a combination of both is passed through to the holder of the securities. Various arrange-
ments can be made with receipts as well. For example, payments can be passed through as
they are received or they can be paid on a guaranteed basis, whether the REMIC receives
them or not. The prices of the tranches are reflective of the risks and yields expected.
The most recent innovations in this program are interest-only (IO) and principal-only
(PO) strips. Strips can be either highly speculative or act as a hedging vehicle, depending
on when the loans in the pool are paid in full. IO strips decrease in value when interest
rates fall, and refinancing induces accelerated prepayments of existing loans. Thus, the
holders will receive less interest. However, PO strips will increase in value under these
same circumstances because their holders will receive principal payments at a faster rate.
In the event of rising interest rates, the reverse is true.

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 226 Essentials of Real Estate Investment Eleventh Edition

SUMMARY
This unit examined the opportunities for private investment in manufactured-home
parks and such diverse realty projects as hotels, motels, amusement parks, and golf courses,
as well as alternate ventures into franchises, mineral rights, air rights, and mortgage secu-
rities. All of these investments are somewhat removed from the more standard real estate
opportunities and, as a result, require special skills and knowledge to ensure success.
Manufactured homes appeal to a growing segment of the American population
because of increased costs of more standard housing, increased life expectancies, and the
effective vesting of many pension and retirement funds. Despite its increasing importance,
many community planners frown on this form of property development because of the
notion that a “trailer park” is detrimental to property values and places undue strain on
city services. Despite this handicap, most modern manufactured-home parks are designed
to provide a comfortable and secure residential environment, with some parks offering
relatively luxurious accommodations at reasonable rates. These parks include such ameni-
ties as swimming pools, clubhouses, meeting rooms, organized social activities, and other
provisions for tenant comfort and entertainment.
An alternate land-development program is to construct a modern manufactured-
home park and sell the spaces to individual owners in a condominium format. The own-
ers join in an association for their mutual benefit, much as they do in condominium
apartment developments.
Hotels, motels, theme amusement parks, and golf courses may be considered busi-
nesses as well as realty investments. As a result, the land involved is very much a part of
the business activity. Hotels and motels serve the traveler’s need for short-term housing
accommodations. The investment opportunities in this form of real estate run the entire
gamut from small mom-and-pop operations to luxurious resorts. Amusement parks are
specialized investments that require high levels of technical and managerial skill to ensure
success. These same requirements are essential to any golf course investment if it is to
succeed.
Anticipating an aging baby boom population, some investors are concentrating on
developing senior housing. Others seek the security of long-term medical tenancies while
others like to speculate in buying repossessions from institutional lenders.
Some real estate investors deal with franchises when leasing property for the opera-
tion of special businesses. Franchises are designed to direct the operation of a business so
that it follows a prescribed marketing plan under a recognized trade name and property
design.
Trading in mineral rights often results in substantial royalties on precious minerals,
natural gas, and oil removed from under the land. Some investors deal only in buying
and selling the rights to minerals and never actually become involved in the excavation or
drilling process themselves.
A market in air rights is emerging in this country as a result of the increasing costs of
urban land. As a result, the sale or lease of air rights offers an investor expanded oppor-
tunities to participate in this form of real estate. Dealers in air rights must make arrange-
ments to control a portion of the surface if they anticipate constructing a building.
Dealing in mortgage securities offers an investor a viable alternative to the responsi-
bilities that accompany the ownership of real estate. In effect, a mortgagee is, to a limited

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 Unit 12: Investing in Special Real Estate 227

extent, a partner with the owner of the property and collects a portion of the profits in the
form of interest on the loan, despite the fluctuations of the marketplace.
Real estate mortgages are created by lenders, both large and small, and the securities
they originate are often sold in the market. Senior loans are traded in the secondary mar-
ket through Fannie Mae, Ginnie Mae, and Freddie Mac. Junior loans are sold to securities
buyers, who normally require discounts to enhance their yields.

DISCUSSION TOPICS
1. Discuss with the planning and zoning officials in your area their attitudes toward the
desirability and location of constructing new manufactured-home rental and sales
parks. Did you discern any prejudice in their remarks and, if so, do you think the
prejudice is valid?
2. Examine the deed to your property (or any property). Are your mineral rights reserved
by the government or by a private individual?

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 228 Essentials of Real Estate Investment Eleventh Edition

UNIT EXAM Use Figure 12.2 to answer questions 6 and 7. Note that
answers are rounded.
1. When you own your own space in a manufac-
tured-home park, you are in FIGURE 12.2  Annual Compound Interest at 12%
a. a cooperative. Period PW $1 PWA $
b. a condominium.
1 0.8928 0.8928
c. a rental park.
d. an RV park. 2 0.7972 1.6900
3 0.7118 2.4018
2. Depreciation deductions in a manufactured-
4 0.6355 3.0373
home park that leases vacant spaces can be taken
on all of the following EXCEPT 5 0.5674 3.6048
a. concrete pads. 6. What will a 12% investor pay for a new, 8%,
b. tenants’ manufactured homes. four-year, $5,000 interest-only second mortgage?
c. the recreation center. a. $4,200
d. blacktop roads. b. $4,392
3. Which of the following relationships is FALSE ? c. $4,460
a. Convention hotels—large meeting rooms d. $5,000
b. Commercial hotels—strong weekend demand 7. What will a 12% investor pay for a two-year-
c. Resort hotels—vacationers old, 8%, five-year, $5,000 interest-only second
d. Extended-stay hotels—kitchen apartments mortgage?
4. Knott’s Berry Farm, Silver Dollar City, and Six a. $4,375
Flags refer to b. $4,400
a. new communities. c. $4,519
b. theme amusement parks. d. $5,000
c. recreational condominiums. 8. All of the following types of housing are designed
d. urban renewal projects. specifically for the elderly EXCEPT
5. The retention of mineral rights in a parcel of land a. a congregate care center.
is called b. an assisted living project.
a. an agglomeration. c. a life care center.
b. an amalgamation. d. a low-cost rental.
c. a reservation. 9. Investors in property tax liens mainly earn profits
d. a restriction. from the
a. interest charged on the liens.
b. rents from the properties.
c. sale of the properties after foreclosure.
d. sale of the liens at discounts.
10. Strips and tranches are part of which of the fol-
lowing alternative real estate investments?
a. Real estate securities
b. Mineral rights
c. REMICs
d. Repossessions

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 Glossary

active income  Income acquired in the pursuit of a assemblage  The process of combining two or more
taxpayer’s main occupation. parcels of real estate into one.
adjustable-rate mortgage (ARM)  A mortgage loan assumable  A loan that may be taken over (assumed)
that has an interest rate that is changed (adjusted) by a buyer when purchasing a parcel of real estate.
periodically based upon an index agreed to between a Often requires the lender to approve the new buyer.
borrower and a lender. before-tax cash flow  The money left after debt service
air rights  The right to use the open space above a has been subtracted from the net operating income
property. Generally the surface is used for another and before income tax is paid.
purpose. betterments  Improvements to property made by
alternative minimum tax (AMT)  Required if its tenants.
application to the taxpayer’s special preference items blue-sky law  Refers to the laws targeted to control
exceeds the regular tax amount. “puffing” by land promoters.
Americans with Disabilities Act (ADA)  Federal law boot  Money or property given to make up any differ-
that is designed to allow persons with disabilities rea- ence in value or equity between two properties in a
sonable access to public areas. 1031 exchange.
amortization  The systematic repayment of a loan by breakeven point  That point at which gross income
periodic installments of principal and interest over equals fixed costs plus variable costs.
the entire term of the loan agreement.
build to suit  A building to be constructed to serve the
anchor tenant  A major department store in a shop- special needs of a specific tenant.
ping center.
Building Owners and Managers Association
ancillary probate  Process of settling an estate when (BOMA)  An association of building owners and
property is located in a state other than the deceased’s managers founded in 1921 to address issues in the
main residence. building management industry.
annual percentage rate (APR)  The effective or actual bundle of rights  Describes the owner’s rights of con-
interest rate, which may be higher or lower than the trol over property.
nominal or contract interest rate because it includes
loan closing costs. business park  A preplanned conglomeration of
buildings in one area designed to house activities of a
annuity  A series of regular payments or receipts over business nature.
a period of years.

229

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 230 Essentials of Real Estate Investment Eleventh Edition

buyer’s market  When the supply of a commodity construction loan  An open-end mortgage loan, usu-
exceeds the demand. ally for a short term, obtained to finance the actual
capital gains income  The taxable profit derived from construction of buildings on a property.
the sale of a capital asset. contract for deed  A contract under which the pur-
capitalization rate  The rate of return, based on pur- chase price is paid in installments over a period of
chase price, that would attract capital. time during which the purchaser has possession of
the property but the seller retains title until the con-
caps  Limits to the increases in either the interest rate tract terms are completed; usually drawn between
or payment amount under an adjustable-rate mort- individuals. Also called a land contract, installment
gage. Often includes an annual limit and a lifetime contract, or agreement of sale.
limit.
conversion  (1) To change to another use, as chang-
ceiling  An absolute maximum rate of interest that ing rental apartments to condominiums or lofts to
may be charged under an adjustable-rate loan. apartments. (2) The appropriation of property that
central business district (CBD)  An agglomeration belongs to another.
of businesses and services in the center of a city; cooperative  A multiunit building whose title is held
“downtown.” by a trust or corporation for the benefit of persons
collapsible corporation  A corporation designed to living in the building. The residents are beneficial
exist only during the course of constructing a large owners of the trust or shareholders of the corpora-
project. After completion, it is dissolved. tion, each possessing a proprietary lease.
collateral  Property, real or personal, pledged as secu- cosign  Additional signatures in a real estate agreement
rity to back up a promise to repay a debt. providing extra guarantees.
common-area fee  In condominiums, the charge for curtesy rights  The rights of a widower in the estate of
taxes, insurance, maintenance, and so forth, appor- his deceased wife.
tioned to each owner and, in shopping centers, to cycle  Events that repeat themselves on a regular basis;
each tenant. may be a business cycle, an economic cycle, or a real
common areas  Those areas in a condominium that estate cycle.
are held as common elements. debt coverage ratio  The number of times the annual
community property  The assumed form of owner- net operating income will pay the annual debt service
ship for married persons in Texas. as required by the lender.
community shopping center  A type of center that is debt service  The principal and interest payment on
larger than a neighborhood center but smaller than a a loan.
regional center. deed of trust  A financing instrument in which the
compound interest  Interest paid on interest earned. borrower/trustor conveys title into the hands of a
Comprehensive Environmental Response, Compen- third-party trustee to be held for the beneficiary/
sation, and Liability Act (CERCLA)  A federal law lender. When the loan is repaid, title is reconveyed to
that defines liability for environmental cleanups. the trustor. If default occurs, the trustee exercises the
power of sale on behalf of the lender/beneficiary. Also
condominium  The fee simple ownership of an called a trust deed.
apartment or a unit; generally in a multiunit build-
ing; includes an undivided interest in the common deed restrictions  Private restrictions on land use
elements. placed on property through provisions in a deed.

congregate care center  A form of housing in which default  Nonperformance of a duty; failure to meet an
tenants have access to a communal dining room, obligation when due.
physical and social amenities, and, often, a health deferred exchange  A time-delayed trading of like
care center. properties.

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 Glossary
231

deficiency judgment  The difference in the amount eviction  The legal dispossession of an errant borrower
received at an auction of defaulted property between or tenant.
the amount owed and the amount received as an exchange  To trade like properties, thus avoiding
award to the lender. income tax liability under IRS 1031.
demand  The desire to acquire properties or services. exculpatory clause  (1) A clause sometimes inserted
depreciation  Appraisal: Loss of value due to physical in a mortgage note in which the lender waives the
deterioration, functional obsolescence, or economic right to a deficiency judgment. (2) As used in a lease,
obsolescence. Accounting: Allowable deduction for a clause that intends to relieve the landlord from
the recapture of the investment. liability for tenants’ personal injuries and property
discount  A payment of less than the face amount of a damage.
security as a consequence of the contract interest rate factoring  Receivables sold to generate cash flow.
being lower than the market rate. Fair Housing Act  A federal law that prohibits dis-
discount rate  The rate of interest charged by the Fed- crimination in the sale, rental, financing, or appraisal
eral Reserve to its member banks to borrow money. of most types of housing.
discounted cash flow  The present worth of a series of Fannie Mae  A privately owned corporation, origi-
receipts over time. nally created as a federal agency, that provides a major
discretionary funds  Money available for investment secondary mortgage market.
in excess of that needed for necessities. feasibility study  A market or financial analysis of a
discretionary trust  A trust that may be changed at proposed investment with emphasis on the attainable
the will of its owners. income, probable expenses, and most advantageous
use and design.
dower rights  The rights of a wife in the estate of her
deceased husband. fee simple ownership  A title that is unqualified; the
most complete form of ownership; conveys the high-
draws  A system of payments made by a lender to a est bundle of rights. Also called fee simple absolute
contractor as designated stages of a building’s con- title.
struction are completed.
fixed costs  Those costs of operating a property that
due diligence  An investigation to find all facts of do not change with the occupancy level; for example,
material interest to an investor. landscape maintenance.
due-on-sale clause  A clause in a mortgage or trust fixed expenses  Costs that are more or less permanent
deed that stipulates that a borrower cannot sell or and vary little from year to year—such as real estate
transfer the property without prior written consent taxes and insurance for fire, theft, and hazards—and
of the lender. Also called an alienation clause. often stay the same no matter what the occupancy
easy money  When interest rates are low and funds for level of the property may be.
loans are plentiful. fixity  Real estate that is permanently attached to the
effective gross income (EGI)  The total income from ground.
the property. foreclosure  Court action initiated by the mortgagee
Environmental Protection Agency (EPA)  A federal or a lienor for the purpose of having the debtor’s real
agency that sets standards, determines how much estate sold to pay the mortgage or other lien.
pollution is tolerable, establishes timetables to bring forgoing  The act of not doing something. Not accept-
polluters into line with its standards, and enforces ing a benefit now, often in the hope of greater ben-
environmental laws. efits later.
escalation clause  A clause in a loan instrument that franchise  By private contractual agreement, a busi-
provides for increases in payments or interest based ness that uses a designated trade name and operating
on predetermined schedules or on a specified eco- procedures.
nomic index, such as the cost-of-living index.

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 232 Essentials of Real Estate Investment Eleventh Edition

Freddie Mac  An organization that operates much like incremental taxes  Additional taxes generated as a
Fannie Mae to provide a secondary market for mort- result of new industry moving into an area.
gages issued by the members of the Federal Home incubator industrial building  A structure provided
Loan Bank system. by the community to encourage growth of a new
functional obsolescence  Defects in a building or company.
structure that detract from its value or marketability; index  A benchmark that is used to adjust the interest
usually the result of layout, design, or other features rate in an adjustable-rate loan; for example, the one-
that are less desirable than features designed for the year Treasury bill.
same functions in newer property.
industrial development bond  Securities issued to
general obligation bond  System of financing in pay for the development of a new industry, usually in
which the community is held responsible for making the form of general obligation bonds.
payments for capital improvements, usually included
in property taxes. industrial park  A controlled development designed
to accommodate specific types of industry.
general partnership  A type of partnership wherein all
the partners share in the operation, profit, and losses infant industry  Newly formed businesses.
both jointly and severally. inheritability  Under our allodial system, the ability
Ginnie Mae  A federal agency created in 1968 to take to leave property to heirs.
over special assistance and liquidation functions of installment factor  Gain divided by equity and
Fannie Mae. Ginnie Mae participates in the second- applied to annual portions of principal received as
ary market through its mortgage-backed securities payments on an installment contract to determine
pool. taxable amount.
graduated lease  A contract specifying rental increases Institute of Real Estate Management (IREM)  A pro-
in regular increments. fessional association of real property managers that
graduated payment loan  A loan for which payments awards the Certified Property Manager designation.
increase regularly over time. interest factor (IF)  The proportion that determines
grantor retained income trust (GRIT)  A trust the time value of money.
wherein the income from the trust goes to the grant- interim loan  A short-term loan made during con-
ors until death, at which time the income goes to the struction, to be replaced by a permanent loan upon
named beneficiaries. completion.
growth management  Policies that control growth of internal rate of return (IRR)  The rate at which the
a community. present worth of an annuity plus reversion exactly
highest and best use  That possible use of property equals the investment price.
that will produce its greatest net income and thereby investment trust  A trust designed to act as an invest-
develop its highest value. ment conduit for small investors that enables them to
hobby tax rules  Rules that limit allowable deduc- pool their resources.
tions on enterprises that do not clearly show a profit irrevocable trust  A permanent arrangement that can-
motive. not be changed until the goals of the trust have been
homogeneous tenancy  A business tenancy in which met.
similar or complementary goods or services are joint tenancy  Ownership of real estate by two or
offered. more parties; includes rights of survivorship where
horizontal regime  Condominium ownership of a the deceased’s interest passes automatically to the
unit above ground. surviving joint tenant(s).
hypothecation  The act of pledging real estate as secu- joint venture  The joining of two or more people in
rity without surrendering possession of the property. a specific business enterprise. A common joint ven-
ture is a type of equity participation arrangement in

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 Glossary
233

which a lender puts up funds, a developer contributes mall  The common walking areas of large shopping
expertise, and the two become partners in the project. centers.
junior loan  Any loan that is not in first lien position. manufactured home  Prefabricated homes built in a
labor-intensive  A business depending more on labor factory and transported to a lot for installation.
than on machines. market analysis  An analysis designed to uncover the
land banking  Purchasing and holding land for future conditions and trends of a marketplace.
development. market segmentation  Due to the fractured aspect of
lease  A written or oral contract between a landlord the real estate business, the market tends to be local
(the lessor) and a tenant (the lessee), transferring the in nature and its conditions may vary greatly from
right to exclusive possession and use of the landlord’s location to location.
real property to the lessee for a specified period of time market value  The highest price for which a property
and for a stated consideration (rent). Leases for more would sell, assuming a reasonable time for the sale
than one year must be in writing to be enforceable. and a knowledgeable buyer and seller acting without
leasehold  The tenant’s legal interest in a property. duress.
leveraging  Use of borrowed money to finance the mineral rights  Ownership rights to all minerals
purchase of an investment. located on or under land and to the profits realized
from the sale of these minerals.
lien  A legal claim that one party has against the prop-
erty of another as security for a debt. minimum housing standards  Minimum building
and housing codes adopted by many communities to
limited liability company (LLC)  Enjoys a corporate protect the health and safety of the public.
form and the tax advantages of a partnership without
the restrictions of an S corporation. mortgage  A document establishing real property as
security for the repayment of a debt.
limited partnership  A legal entity that includes a
general partner, who actively manages the invest- negative amortization  Less than interest-only loan
ment, and limited partners, whose only personal lia- payments, which cause the balance of a loan to
bility is their investments. Income taxes vest at each increase by the amount of the deficient interest.
individual partner level. neighborhood shopping center  The smallest planned
liquidity  Condition under which something can be center.
sold promptly at market value. net lease  A lease requiring the tenant to pay the costs
living trust  An arrangement whereby legal title to of operating the building, including maintenance,
property is transferred by the owner (trustor) to a taxes, insurance, and repairs, in addition to the rent.
third person (trustee) to be held and managed by the net operating income (NOI)  The income left after all
trustee for the trustor’s benefit and under the trustor’s the operating expenses have been paid.
control for a certain period of time until specific goals nominal interest rate  The rate of interest defined in
have been attained. Also called an inter vivos trust. the contract.
Established to facilitate the management of proper-
ties during the grantors’ lives. Usually resolves into a note  A signed instrument acknowledging a debt and
testamentary trust on their deaths. promising repayment.
location  Where the property is. An indispensable off-street parking  Parking spaces on private land, as
component for an evaluation analysis. in shopping centers.
loft building  A large, warehouse-type building usu- office park  A preplanned conglomeration of build-
ally located in a central city area. ings in one area designed to house activities of a busi-
ness nature.
longevity  The concept of real estate that recognizes
the long-term nature of most real estate investments. operating expenses  Periodic and necessary expenses
essential to the continuous operation and mainte-
nance of an income property.

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 234 Essentials of Real Estate Investment Eleventh Edition

opportunity cost  The amount of money that could real estate  A portion of the earth’s surface, extend-
be earned through alternative investments. ing downward to the center of the earth and upward
option  An agreement to keep open an offer to sell or into space, including all things permanently attached
purchase property for a prescribed period. thereto by nature or people, and all legal rights
therein.
partially amortized loan  A loan that has a series of
payments, part principal and part interest, that is not real estate investment trust (REIT)  An unincorpo-
sufficient to pay off the total loan at maturity. There rated trust set up to invest in real estate that must
is a remaining amount of principal (a balloon) that have at least 100 investors, with management, con-
must be paid at the end of the loan term. trol, and title to the property in the hands of trustees.
partnership  An association of two or more individu- real estate mortgage investment conduit (REMIC)  A
als who operate a business as co-owners. pool of mortgages in which investors may purchase
proportionate interests.
passive income  Income from real estate rentals; owner
does not take a role as manager. real estate mortgage trust (REMT)  A business trust,
similar to a REIT, that invests in mortgage securities
percentage clause  A clause in a contract that stipu- rather than in real estate.
lates that a tenant pays a fixed percent of the gross
income against a specified minimum rental. real property  The rights of real estate ownership;
often called the bundle of legal rights. See also real
permanence  An attribute of real estate that recognizes estate.
that real estate investment is long term, complex, and
often requires large sums of money. recognized gain  Profit from the sale of an investment
that is taxable in the current year.
personal property  Movable property that does not fit
the definition of realty. regional center  A large agglomeration of shops
and stores in one location. Includes more than one
plat  An official map of an area that is recorded in the department store.
public record.
regular corporation  A corporation that is not an S
plottage  The subsequent increase in value of a group corporation or LLC.
of adjacent properties when they are acquired by the
same owner and combined into one property. Regulation Z  The truth-in-lending portion of the
Consumer Credit Protection Act of 1968. It requires
portfolio income  Income from interest, dividends, complete disclosure of the total costs involved in
and royalties. most credit activities.
potentially responsible party (PRP)  An entity that, relative scarcity  A situation in which the consumer
under the Comprehensive Environmental Response, perceives a shortage and bids up the value of the com-
Compensation, and Liability Act (CERCLA), may be modity accordingly.
liable for the costs of an environmental cleanup.
release clause  A clause included in a blanket mort-
present worth  Discounting money to be received in gage that provides that on payment of a specific sum
the future to determine its value today. of money, the lien on a particular parcel or portion of
property  Anything capable of being owned. the collateral will be released.
property tax lien  A lien placed on real property until rental concessions  Perquisites offered to entice new
such time as the property tax bill is paid. tenants, such as free rent for a few months or build-
proprietary lease  In a corporation cooperative, the outs in the form of partitions or paint.
lease issued to an individual shareholder occupant. repossession  The act of placing property into the
pyramiding  A method of acquiring additional prop- hands of the holder of the security after foreclosure.
erties by refinancing equities. reserves  A portion of earnings set aside to cover pos-
railroad spur  A branch line constructed to an indus- sible future losses.
trial project for dockside loading and unloading.

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 Glossary
235

retirement community  A residential community severalty  Ownership of property vested in one person
designed to fit the needs and lifestyles of older alone.
persons. sheltering  Having income deemed as either nontax-
return on investment (ROI)  An annual percentage able, as in the deduction of expenses, or as tax deferred,
derived from dividing cash invested into net after-tax as in cost recovery (depreciation) deductions.
income. sinking fund  A savings account designed to accu-
revenue bond  Bonds to be repaid by the fees charged mulate funds in anticipation of meeting a balloon
for the use of the funded project. payment.
rezoning  The process of changing from one land use sole and separate ownership  Individual ownership
to another, usually more intensive. by a married person.
right of first refusal  The right of a person to have the split-fee financing  A financing arrangement wherein
first opportunity to either purchase or lease a specific the lender purchases land and leases it to a developer
parcel of real property. while at the same time financing the construction of
risk  The possibility of loss. the improvements.
royalty income  Profits secured from mineral rights, spot zoning  A single property with a permitted use
oil wells, and publications. See also portfolio income. not in conformity with the surrounding properties.
S corporation  A corporation with a maximum of 75 strip  Part of a REMIC’s assets; interest-only (IO) or
shareholders that is taxed like a partnership. principal-only (PO) portions of its inventory can be
sold separately.
sale-leaseback-buyback  A financing arrangement
under which an investor purchases real estate owned strip store  Store buildings found along a community’s
and used by a business corporation, then leases the arterial roads.
property back to the business; includes a buy-back subdivision restrictions  Restrictions, often created
option. by a city, that places minimum requirements in the
scheduled gross income (SGI)  The amount of rental development of any subdivision within the jurisdic-
income the property could produce with 100% occu- tion of that city.
pancy and with all tenants paying full rent. subject to  Becoming responsible, but not assuming
secondary market  A marketplace in which mortgages personal liability, for an existing loan.
and trust deeds are traded. See also Fannie Mae, Fred- sublease  The right of a primary tenant to rent a prop-
die Mac, and Ginnie Mae. erty to a subsequent tenant. Usually maintains the
securities  Something given, deposited, or pledged to continued liability of the primary tenant.
make secure the fulfillment of an obligation, usu- super-regional center  Regional shopping centers that
ally the repayment of a debt. Generically, mortgages, include apartment and office buildings.
trust deeds, and other financing instruments backed supply  Products and services available for
by collateral pledges are termed securities for invest- consumption.
ment purposes.
sweat equity  The amount of equity created in a prop-
self-storage facility  Neighborhood storage facilities erty by the work and improvements made by the
usually designed as individual cubicles; accessible direct labor of a person such as an owner.
daily.
syndicate  A group of two or more people united for
seller’s market  When demand exceeds supply. the purpose of owning an investment. A syndicate
senior loan  Any loan that has priority over another. may operate as a corporation, general partnership, or
setback requirement  Local zoning and building code limited partnership.
specifications stipulating the amount of open space tax clause  In a lease, a clause requiring the tenant to
to be preserved in the front, rear, and side yards. pay any increase in property taxes over the base year’s
amount.

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 236 Essentials of Real Estate Investment Eleventh Edition

tax credit  A credit applicable directly against taxes time value of money  The present worth of future
due; a 100% deduction. income.
tax shelter  A phrase often used to describe some of topography  The surface characteristics of land.
the tax advantages of real estate investment, such as tranche  Parts of a REMIC’s assets.
deductions for depreciation, interest, taxes, and so
forth. value in use  A specific use that defines a property’s
value.
taxable income  The net income, after allowable
deductions and adjustments, on which the tax rate variable costs  Operating expenses of a property that
is applied. will change with the occupancy level; for example,
management fees based on rent collected.
tenancy by the entirety  The joint ownership, recog-
nized in most states, of property acquired by hus- variable expenses  The expenses that vary according to
band and wife during marriage. On the death of one the occupancy level such as supplies, water, and any
spouse, the survivor automatically becomes the sole management fees that are tied to the amount of rent
owner of the property. collected.
tenancy in common  A form of inheritable co-own- variable interest rate  An approach to financing in
ership under which each owner holds an undivided which the lender is permitted to alter the interest
interest in real property. rate, with a certain period of advance notice, based
on a specific base index. Monthly loan payments
tenant mix  In a shopping center, the description of can then be increased or decreased or maturity can
occupants by the types of businesses in which they be extended, depending on how the base index
are engaged. fluctuates.
term loan  A loan to be paid in full at a specified time; warehouse building  Buildings used for storage.
not an amortizing loan.
wraparound loan  A new loan that encompasses any
testamentary trust  A trust that commences on the existing loan without disturbing the legal priority of
demise of the trustor. an underlying loan.
tight money  When interest rates are high and funds
for loans are scarce.
time-share  A real estate ownership form that permits
multiple purchasers to buy undivided interests in a
resort condominium with the right to use the facility
for a specified time period.

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 Answer Key

Answer Key for Unit Exam 1

1. c 
2. a 
3. c 
4. d 
5. d 
6. c 
7. d 
8. b 
9. b 
10. a 

Answer Key for Unit Exam 2

1. c 
2. d 
3. c 
4. b 
5. a 
6. c 
7. c 
8. d 
9. b 
10. c 

Answer Key for Unit Exam 3

1. c 

237

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 238 Essentials of Real Estate Investment Eleventh Edition

2. d 
3. b 
4. c 
5. d 
6. d 
7. b 220 – 20 = 200; 385 – 35 = 350 × 200 = 70,000 ÷ 3,500 = 20.
8. a 
9. c 
10. d 

Answer Key for Unit Exam 4

1. c 
2. d 
3. b 
4. b 
5. d 
6. b 
7. c 
8. c 
9. d 100,000 – 20,000 = 80,000 × 0.02564 = 2,051 × 10 = 20,510; 80,000 – 20,510 = 59,490 + 20,000 =
79,490.
10. b Gain ÷ equity = 40,000 ÷ 60,000 = 66⅔.

Answer Key for Unit Exam 5

1. b 50,000 – 15,000 = 35,000 – 25,000 = 10,000 ÷ 100,000 = 10%.
2. c 300,000 × 0.036 = 10,800.
3. c 
4. b 100,000 ÷ 17.001 = 5,882.
5. a 100,000 ÷ 133.3339 = 749.99.
6. c 100,000 ÷ 7.8431 = 12,750.
7. b 10,000 × 6.8109 = 68,109. 150,000 × 0.1827 = 27,405. 68,109 + 27,405 = 95,514.
8. b 5.6502 – 3.6048 = 2.0454 2nd 5-year IF. 6.8109 – 5.6502 = 1.1607 3rd 5-year IF. 5,000 × 3.6048 =
18,024. 10,000 × 2.0454 = 20,454. 15,000 × 1.1607 = 17,410. 87,500 × 0.1827 = 15,986 + 17,410 +
20,454 + 18,024 = 71,874.
9. b 
10. b 

Answer Key for Unit Exam 6

1. d 
2. b 

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 Answer Key 239

3. b 
4. d 
5. b 
6. c 
7. c 
8. d 
9. b 
10. c 50,000 × 0.02 = 1,000 + (10,000 × 0.10 = 1,000) = 2,000 ÷ 10,000 = 20%.

Answer Key for Unit Exam 7

1. c 6,000 × 10 = 60,000 – 30,000 = 30,000 ÷ 0.10 = 300,000.
2. a 
3. b 
4. a 
5. b 
6. d 
7. d 
8. c 
9. c 
10. d 

Answer Key for Unit Exam 8

1. c 
2. c 
3. c 
4. b 
5. c 
6. a 
7. b 
8. d 
9. c 
10. d July through February = 8 months total × $500 = $4,000.

Answer Key for Unit Exam 9

1. d 
2. c 
3. b 
4. c 
5. c 
6. d 

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 240 Essentials of Real Estate Investment Eleventh Edition

7. d 
8. a 
9. c 
10. b 

Answer Key for Unit Exam 10

1. d 
2. c 
3. b 
4. a 
5. c 
6. a 
7. c 
8. b 
9. d 
10. c 

Answer Key for Unit Exam 11

1. b 
2. c 
3. d 
4. c 
5. d 
6. c 
7. d 
8. a 
9. c 
10. c 

Answer Key for Unit Exam 12

1. b 
2. b 
3. b 
4. b 
5. c 
6. b 5,000 × 0.08 = 400 × 3.0373 = 1,214.92. 5,000 × 0.6355 = 3,177.50 + 1,214.92 = 4,392.42.
7. c 5,000 × 0.08 = 400 × 2.4018 = 960.72. 5,000 × 0.7118 = 3,559.00 + 960.72 = 4,519.72.
8. d 
9. a 
10. c 

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 Index

$25,000 exception 64 B Civil Rights Act of 1968 146 cooperative 154, 155
balance principle 9 collapsible corporation 26 categories 155
A before-tax cash flow 88 collateral 103 format 154
acreage 131 beneficiary 33 commercial banks 104 ownership 155
active income 63 betterments 10 commercial hotel 218 private 155
add-on interest 81 biweekly mortgage 116 commercial property 55 publicly assisted 155
adjustable-rate mortgage blue-sky laws 29 common area 158 corporation 25, 66
(ARM) 115 bond yields 12 community 21, 23, 52, 128, characteristics 25
adjusted basis 65 boot 72 192 income 66
adjusted gross income (AGI) borrower obligations 116 acceptance 128 ownership 25
64 breakeven point 90 profile 52 cosign 107
adjustments 65 Building Owners and Managers property 21, 23 creative financing arrangements
affordable housing 144 Association (BOMA) 168 shopping center 192 113
air rights 223 build to suit 130 compensation 57 credit loss 88
all-inclusive loan 111 bundle of rights 2, 19 component depreciation 68 credit union 107
allowed costs of sale 64 business park 208 compound interest 82, 84, 86 curtesy rights 24
all-suite hotel 219 buydown mortgage 116 definition 82 cycle 7, 8
alternative minimum tax buyer’s market 7 future worth 84
(AMT) 66 buy-out formula 28 present worth 86 D
American Recovery and Comprehensive Environmental debt coverage ratio 104
Reinvestment Act 4 C Response and Liability Act debt service 88
Americans with Disabilities Act call clause 113 (CERCLA) 57 deed in lieu of foreclosure 117
(ADA) 177 capital 10, 13 condominium 157, 160, 176, deed of trust 108
amortization 79 preservation 10 192 deed restrictions 50
amusement park 219 requirements 13 conversions 160, 176, 192 default 117, 118
anchor tenant 192 capital gains 64, 65 definition 157 definition 117
ancillary probate 19 calculation 65 ownership 157 notice of 118
annual percentage rate (APR) profits 64 conformity principle 9 deferred exchange 73
82 taxes 65 congregate care center 220 deficiency judgment 118
annuity 83 capitalization rate 89 construction loan 104 demand 5, 7
anonymous ownership 35 caps 115 continual life 25 components 5
anticipation principle 9 C corporation 25 contract for deed 109 function of 7
asbestos 58 ceiling 115 contribution principle 9 Department of Housing and
assemblage 131 central business district (CBD) conventional loan 110 Urban Development
assignment 171 167 convention hotel 218 (HUD) 136
assumable 114 centralized management 25 conversions 146 depreciation 67
change 10 definition 67
IRS tax schedule 67

241

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 242 Essentials of Real Estate Investment Eleventh Edition

discount 225 modification programs 5 highway access 204 definition 95

discounted cash flow 93 FHA-loan 157, 159 hobby tax rules 128 spreadsheet analysis 97
discount rate 85 condominiums 157, 159 Home Affordable Modification Internal Revenue Code 15, 71
discretionary funds 3 Fidelity Federal Savings and Program (HAMP) 5 Section 1031 71
discretionary trust 34 Loan v. de la Cuesta 114 Home Affordable Refinance sustainability 15
disintegration 10 finance 104, 107, 109, 111, Program (HARP) 5 Internal Revenue Service (IRS)
diverse realty investments 218 113, 114, 156, 159 home improvement loan 105 26, 33, 36, 63, 67, 128,
double net lease 169 alternative arrangements Homeowners Affordability and 156
double taxation 26, 66 111, 114 Stability Plan 4 cooperative provisions 156
dower rights 24 condominium 159 homogeneous tenancy 173 hobby tax rules 128
draws 105 cooperative 156 horizontal regime 157 income categories 63
due diligence 42 forms of 107 hotel 218 investment trust 36
due-on-sale 113 fund sources 104 hotel-condo 219 Letter Ruling 9226035 33
duplex 152 special provisions 113 Housing and Urban S corporation criteria 26
types of 109 Development Act 136 tax depreciation schedule
E financial analysis 78 hybrid trust 38 67
e-commerce 197 Financial Stability Improvement hypothecation 103 Interstate Land Sales Full
economic feasibility 202 Act 5 Disclosure Act 136
economic oversupply 53 fixed cost 90 I inter vivos trust 34
effective gross income (EGI) fixed expenses 88 improvement district bonds intestate 21
88 fixity 3 106 investment 10, 11, 13, 36, 222
environmental impact studies foreclosure 117 income 63 advantages 11
43, 55 Foreign Investment in Real income tax 13, 66 alternate opportunities
environmental issues 59 Property Tax Act 38 incremental taxes 202 222
Environmental Protection foreign investors 38 incubator industrial building disadvantages 13
Agency (EPA) 15, 43 forgoing 3 208 purpose of 10
duties 43 franchise 222 index 115 trust 36
guidelines 43 Freddie Mac 224 individual financing 107 involuntary conversion 70
sustainability 15 full partnership 27 individual ownership 19 irrevocable trust 34, 35
equilibrium 10 functional obsolescence 203 industrial development bonds
equitable redemption 118 201 J
equity 36, 105, 110 G industrial park 204, 207, 210 joint tenancy 19
investment 110 gains 69 industrial property 55, 201, Joint tenancy with rights of
loan 105 Garn–St. Germain Depository 202, 206 survivorship 21
trust 36 Institutions Act 114 characteristics of 202 joint venture 33, 112
escalating loan 115 general obligation bonds 201 feasibility studies 55 judicial foreclosure 118
escalation clause 171 general partnership 27 investment type 206 junior loan 111
estate tax 65, 74 general purpose building 203 real estate market 201 junior securities 224
eviction 151 gentrification 145 infant industry 201
exchange 71 gift tax 65, 74 inheritability 19 K
exculpatory clause 114 Ginnie Mae 224 innocent landowner defense Koch v. Commissioner of IRS
extended-stay hotel 219 golf course 219 43, 206 116
exterior attributes 57 graduated lease 94, 184 installment factor 71
graduated-payment loan 115 installment-sale deferment 70
L
F grantor retained income trust Institute of Real Estate
labor-intensive 205
factoring 134 (GRIT) 35 Management (IREM) 168
labor supply 205
factory outlet mall 196 group ownership 24 institutional lenders 104
land 127, 129, 132, 133, 134,
fair housing 147 growing equity mortgage integration 9
137, 203
Fair Housing Act 146, 147 (GEM) 116 interest 66, 78, 115
banking 137
Fannie Mae 224 growth management 128 expense 66
characteristics 203
farming losses 127 financial analysis provisions
evaluation 132
feasibility studies 42 H 78
future value of 129
Federal Deposit Insurance harbor facilities 204 rate 115
promotions 133, 134
Corporation (FDIC) 105 hazard insurance premium 117 interest factor (IF) 84
speculation 127
Federal Reserve System 105 hazardous waste 57 interim loan 104
landlord 14
fee simple ownership 19 highest and best use 9 interior attributes 57
land-use patterns 201
FHA loan 5 high-rise office buildings 173 internal rate of return (IRR)
lead-based paint 59
95, 97

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 Index
243

lease 130, 148, 171, 186, 205 medical office buildings 173 owner association 157 location 126
agreements 171 mineral rights 222 owner-occupied homes 143 managers 148
characteristics 205 minimum housing standards ownership, state-by-state 21 neglected maintenance
definition 148 51 117
resale versus 130 mixed-use buildings 173 P property tax 117, 221
shopping center property mold 58 partially amortized loan 115 delinquency 117
186 mortgage 79, 108, 114, 119 participation mortgage 116 lien 221
leasehold 177 amortization triangle 79 partnership 27 proprietary lease 155
lease-purchase option 116 assumption 114 passive income 63 pyramiding 69
leverage 12, 92, 103 constants 119 payment delinquency 117
lien 109 definition 108 pension funds 106 R
life insurance companies 105 factor 79 percentage clause 184 radon gas 59
like-kind property 72 mortgage bankers 106 percentage lease 186 railroad spur 204
limited liability company (LLC) mortgage brokers 106 permanence 3 real estate 2, 7, 63, 106, 224
33 motel 219 personal control 13 bonds 106
limited partnership 28 multiunit apartment rentals personal liability 25 cycle 7
liquidity 13 148, 153 personal property 2, 68 definition 2
living trust 34 definition 2 professional 63
loan-to-value ratio (LTV) 110 N guidelines 68 securities 224
location 126, 202 National Environmental Policy pierce the corporate veil 25 real estate investment trust
lock-in clause 113 Act 43 planned growth 51 (REIT) 37, 106
loft building 208 National Housing Act 157 planned unit development Real Estate Modernization
longevity 3 National Multi Housing (PUD) 51 Act 38
low-income housing 144 Council (NMHC) 148 plat 45 real estate mortgage investment
low-rise office buildings 172 negative amortization 115 definition 45 conduit (REMIC) 225
neighborhood 52, 53, 55, 172, plottage 131 real estate mortgage trust
M 185, 192 portfolio income 63 (REMT) 38, 106
magnet store 192 boundaries 52 positive leverage 92 Real Estate Settlement
mall 193, 197 definition 52 potential gross income 88 Procedures Act (RESPA)
management 14, 183, 194, economy 53 potentially responsible parties 117, 136
196, 208 facilities 55 (PRP) 43, 206 escrow payments 117
activity 14 offices 172 power-of-sale foreclosure 118 interstate land sales 136
community shopping shopping center 185, 192 prepayment clauses 113 realized gain 69
center 194 survey data 55 prepayment penalties 113 realized selling price 64
industrial park 208 net lease 169, 205 prepayment privileges 113 real property 2, 3, 19, 63
regional center 196 net operating income (NOI) present worth 85, 86, 93 categories 63
strip stores 183 88 analysis 93 characteristics 3
manufactured home 216, 218 net present value (NPV) 85 example 93 definition 2
manufactured-home park 216, nominal interest rate 82 of annuity 86 ownership 19
217 noncompete clause 186 of dollar 85 realty market 4
location 216 noninstitutional lenders 106 principal residence 70 recognition clause 134
spaces for rent 217 note 108 private loan company 107 recognized gain 69
spaces for sale 217 private mortgage insurance redemption period 118
manufacturing buildings 208 O (PMI) 110 refinance 69
market 4, 9, 202 occupancy rate 53 probate 19 pyramiding through 69
conditions 202 office building 167, 172, 174 profit 10 tax-free 69
segmentation 4 case study 174 profitability analysis 152, 153 regional center 194
value 9 management 167 multiunit apartment regular corporation 25
market analysis 43, 45, 52, types of 172 complex 153 Regulation Z 134
55, 168 office condominiums 176 triplex 152 related persons 73
community profile 52 office park 175 profitability measures 87 relative scarcity 5
data evaluation 55 off-street parking 185 promotional lots 133 release clause 134
environmental protection operating cost 11, 66 property 2, 56, 57, 117, 126, rent 88, 168
43 operating expense 58, 88 127, 148 loss 88
factors 52 definition 88 analysis 56 schedule 168
government regulations 45 property analysis 58 attributes 57 rental achievement
office building 168 operating statement 88 definition 2 requirements 175
maximum price 119 opportunity cost 85, 128 features 127 rental concessions 170
medical buildings 221 option 183 liens 117 rental homes 144

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 244 Essentials of Real Estate Investment Eleventh Edition

repossessions 221 simple interest 78 credit 144 V

resale 130, 131, 145 single-family detached homes relief 11 vacancy loss 88
acreage for 131 143 shelters 66 VA loan 5
homes for 145 single-lot investments 129 waiver 201 modification programs 5
lease versus 130 single-purpose building 203 taxable income 66 VA-loan 159
reserves 88 sinking fund 158 Tax Reform Act of 1986 68 condominium 159
residential lots 129 site 56 Technical and Miscellaneous value 8, 90
residential property 55 sole and separate ownership 23 Revenue Act (TAMRA) 35 formula 90
resort hotel 219 sole ownership 23 technical oversupply 53 theory 8
restrictions 50 special-purpose building 203 tenancy by the entirety 20 value in use 9
restrictive covenants 207 speculative lots 129 tenancy in common 20 variable cost 90
retirement community 220 split-fee financing 112 tenant mix 185, 193, 195 variable expenses 88
retirement funds 106 spot zoning 129 community shopping variable interest rate 115
return on investment (ROI) statutory redemption 118 centers 193 variable-payment schedules
87, 91, 92 stock yields 12 neighborhood shopping 115
analysis 91 strict foreclosure 118 center 185 voluntary conveyance 117
definition 87 strip 225 regional center 195
example 92 strip store 183, 184 term loan 115 W
revenue bonds 201 case study 184 testamentary trust 34 warehouse building 208
rezoning 129, 146 investor appeal 183 testate 21 water rights 223
right of first refusal 27 management 183 time-share 160 Whiteco Industries Inc. v.
risk 4, 14 Subchapter S Revision Act 26 time value of money 85 Commissioner of IRS 68
rollover loan 116 subdivision 45, 50, 137, 138 timing 127 wraparound loan 111
royalty income 223 land bankers 137 topography 127
mixed-use case study 138 toxic mold 58
Y
S plat approval 45 tranches 225
yield 12
sale-leaseback 112 regulations 45 transferable interests 26
sale-leaseback-buyback 112 restrictions 50 transfer clause 113
subject to 114 transportation facilities 54 Z
savings institutions 105
sublease 171 triple net lease 169 zero-percent financing (ZPF)
scheduled gross income (SGI)
substitution principle 9 triplex 152 116
88
subsurface attributes 56 trust 33, 36 zoning 46
S corporation 26
super-regional center 195 creation 33 classifications 46
Section 1031 71
supply 7 definition 33 ordinances 46
securities 160
Securities and Exchange surface attributes 56 offering 36
Commission (SEC) 160 survivorship 19 ownership 33
self-storage facility 209 sustainability 15 trustor/trustee 33
seller’s market 7 sweat equity 3 two-party exchange 72
senior housing 220 syndicate 28
senior loan 110 U
separate property 21 T undivided interest 20
services 171 tax 11, 66, 144, 156, 159, 171, Uniform Partnership Act 27,
setback requirement 49 201 29
severalty 24 clause 171 utilities 54, 203
sheltering 11 condominium 159
short sale 118 cooperative 156

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Notes
Notes