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Week 5 Slides Rotman Fall 2021

The document discusses investment analysis and taxation of income properties. It covers topics such as motivations for real estate investing, investment strategies, market analysis, projecting cash flows, investment analysis methods like IRR and NPV, debt financing, taxation of operating income and property sales, and calculating after-tax cash flows and investment returns. The goal is to analyze real estate investments both before and after accounting for tax implications.

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jasonmao6969
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33 views

Week 5 Slides Rotman Fall 2021

The document discusses investment analysis and taxation of income properties. It covers topics such as motivations for real estate investing, investment strategies, market analysis, projecting cash flows, investment analysis methods like IRR and NPV, debt financing, taxation of operating income and property sales, and calculating after-tax cash flows and investment returns. The goal is to analyze real estate investments both before and after accounting for tax implications.

Uploaded by

jasonmao6969
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Real Estate Investment

& Finance
Joseph Shaw
Agenda – Week 5

 Review of Week 4 – Any Questions?


 Lecture – Chapter 11
Chapter 11
Investment Analysis and
Taxation of Income Properties

©2022 McGraw Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written
consent of McGraw Hill Education.
Motivations for Investing
 Rate of return – annual net income from operations
 Price appreciation – in anticipation of selling

properties after some holding period


 Diversification – most investors want to hold a variety

of investment types
 Tax benefits – historically, investors have paid little or

no taxes on returns from real estate investments for


many years
Real Estate Market Characteristics
 The Real Estate Cycle – the cyclical nature of the
real estate industry
General Investment Strategies
 Core – acquiring existing, seasoned, relatively low-risk
properties that are at least 80 percent leased to tenants with
low credit risk.
 Core “Plus” – combines core investment with a strategy to
make minor changes in the management of the property with a
releasing program.
 Value Added – used to focus on some aspect of properties that
are not being optimized
 Opportunistic Investing – involves acquiring properties from
investors in financial difficulty or properties needing
renovation, upgrading, or repositioning.
Specialized Investment Strategies
 Property Sector Investing

 Contrarian Investing

 Market Timing

 Growth Investing

 Value Investing

 Core Property Investing


Specialized Investment Strategies
 Size-Based Strategy

 Tenant-Based Strategy

 Arbitrage Investing

 Turnaround Investing

 Opportunistic Investing

 Blue Chip Investing

 Development
Market Analysis
 Demand for space – comes from potential tenants who desire to use the
space for their business
 Supply of Space – comes from investors who have purchased or developed
building and are willing to make that space available for rent
 Market Rents – rental rates and the growth in rents are highly correlated
with occupancy rates
 Forecasting Supply, Demand, Market Rents, and Occupancy –
◦ We can estimate demand based on expected employment growth for the
foreseeable future
◦ We can estimate supply as the expected amount of new space likely to be added
to the market
◦ We also consider any likely changes to the amount of space per employee
Making Investments: Projecting
Cash Flows
 Base Rent
 Market Rent
 Expense Stops – place an upper limit on the amount of
operating expenses that will have to be paid by the owner
 Net Operating Income – projected revenues less projected
operating expenses
 Expected Outlays for Replacements and Capital
Improvements – outlays of a recurring nature for the
replacement of items that wear out in the normal operating
cycle of a property
 Estimated Sale Price – an estimate of what the property might
sell for
Investment Analysis
 Internal Rate of Return (IRR)
◦ The discount rate forces the net present value to equal zero.
◦ If IRR > r; Accept Project
◦ If IRR < r; Reject Project
◦ Where r is a required return or hurdle rate
Investment Analysis
 Net Present Value (NPV)
◦ Discounted value of the future expected cash flows net of any
outlays
◦ The discount rate is the capital cost for the investor.
◦ If NPV>0, accept project
◦ If NPV<0, reject project
◦ NPV is the increase in wealth to the equity investor
Introduction to Debt Financing
 Measures of Investment Performance Using Ratios
◦ Equity Dividend Rate – calculated by dividing the BTCF in the
first year by the initial equity investment
◦ Debt Coverage Ratio – the ratio of NOI to the mortgage
payment
 Before-Tax Cash Flow from Sale
◦ Internal Rate of Return to Equity Investor
 Summary of Investment Analysis Calculations
Debt Financing
 Equity Dividend = NOI - ADS
◦ NOI = Net Operating Income
◦ ADS = Annual Debt Service; the annual payment on debt
 The equity dividend is also referred to as the before-
tax cash flow from operations (BTCF0).
Debt Financing
 Equity Dividend Rate =
Equity Dividend/Initial Equity Investment
 Also called the “cash on cash” rate

 Debt Coverage Ratio (DCR) = NOI/ADS


 The DCR is a vital ratio for lenders.
 What if the DCR<1?
Debt Financing
 Example 11-1:
◦ $1,000,000 Property;
◦ 95% allocated to building and 5% to land
◦ 70% LTV; 7% Interest Rate, 30 Years
◦ $700,000 debt; $300,000 equity
◦ Monthly Payment = $4657.11
◦ ADS = 12 x $4657.11 = $55,885
◦ NOI1 = $85,000
Before-Tax Cash Flow
 Equity Dividend = NOI-ADS
◦ $85,000 - $55,885 = $29,115
◦ This is also the BTCFo for this year.
 Equity Dividend Rate = EQDIV/Equity
◦ $29,115/$300,000 = 9.71%
 Debt Coverage Ratio =
◦ $85,000/$55,885 = 1.521
 These ratios all pertain to the first year of
operations
Before-Tax Cash Flow
 Example 11-1 continued….
 Before-Tax Cash Flow from the Property Sale

(BTCFs):
◦ BTCFs = Sales Price – Mortgage Balance
◦ In Example 11-1, if the property were sold in Year 4 for
$1,100,000 then
◦ BTCF = $1,100,000 - $668,322 = $421,678
 The mortgage loan balance ($668,322) is computed as previously.
See Chapter 4.
Taxation of Income-Producing Real
Estate
 Does not include real estate held as a personal
residence by individuals
◦ Personal residences cannot be depreciated for tax purposes
 We assume that the property is not held for resale to
others
◦ Individuals holding property for resale to others in the ordinary
course of business are referred to as dealers
◦ Real property held for resale by a dealer is not depreciable for
tax purposes
Taxable Income from Operation of
Real Estate
 Taxable income from operating income property ≠
BTCF because:
◦ Only the interest portion of a loan payment is deductible from
the NOI for tax purposes
◦ The tax code allows owners to deduct a depreciation allowance
from NOI
 Taxable Income = NOI – Interest – Depreciation
Allowance
Adjustments to Taxable Income
 Depreciation Allowances
◦ Depreciable Basis – generally equal to the cost of the
improvements where cost is generally defined to include the
acquisition price of the improvements plus any installation costs
associated with placing them into service
 Loan Points – must be deducted ratably over the term of
the loan
 Tax Liability and After-Tax Cash Flow – calculated by
multiplying the taxable income by the investor’s marginal
tax rate
◦ Marginal tax rate - the rate which the additional income from the
investment under consideration will be taxed
After-Tax Cash Flows
 Calculating the after-tax cash flow from operations
 Step 1: Compute taxable income

Net Operating Income


- Depreciation
- Interest
Taxable Income
After-Tax Cash Flows
 From Slide 11-10, Depreciation is based on a
building value of $950,000 over 27.5 years
◦ Depreciation = $950,000/27.5 = $34,545

◦ Interest = $48,775 using the “amort”


function on the financial calculator.
After Tax Cash Flows
 From Example 11-1, year 1 taxable income would
be:

NOI = $85,000
Depreciation - $34,545
Interest - $48,775
Taxable Income $ 1,680
After Tax Cash Flows
 Step 2: Compute Taxes
 Taxes (at 28%) = .28 x $1680 = $470
 Step 3: Compute after-tax cash flow from

operations for year 1


 ATCF = BTCF – Taxes
1 1

= $29,115 - $470
= $28,645
After Tax Cash Flows
 Taxes on the property sale
◦ Gain from property value increase
 Taxed at capital gains rate for the investor
◦ Gain from prior depreciation
 Taxed at 25%
After Tax Cash Flows
 From Example 11-1
 Before tax cash flow from the property sale = $421,678
 Step 1: Compute tax on property value increase:

$1,100,000 - $1,000,000 = $100,000


Taxed at 15% capital gains rate = $15,000
After Tax Cash Flows
 Step 2: Compute tax on prior depreciation:
4 Years at $34,545 = $138,180
Taxed at 25% = $34,545

 Step 3: Compute total taxes from sale:


$34,545 + $15,000 = $49,545
After Tax Cash Flows
 Step 4: Compute after-tax cash flow from the
property sale
 ATCF = BTCF – Taxes
s s

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


 Analysis
◦ Compute After-Tax Internal Rate of Return
◦ Compute After-Tax Net Present Value
Taxable Income from Disposal of
Depreciable Real Property
 Gross sales price - any cash or other property received
in payment for the property sold, pus any liabilities
against the property assumed by the buyer.
 Net sales proceeds – gross sales price minus selling
expenses
 Gain or loss – net sales proceeds minus adjusted basis
which is original basis plus the cost of any capital
improvements, alterations, or additions made during
the period of ownership, less accumulated depreciation
taken to date.
After-Tax Investment Analysis
 After-Tax Cash Flow from Operations – BTCF less
taxes
◦ Depreciation – lowers taxable income
 After-Tax Cash Flow from Sale
◦ Total capital gain results from
 price appreciation which has a maximum capital gain tax rate of
15%
 accumulated depreciation which has a maximum tax rate of 25%
 After-Tax IRR – based on the after-tax cash flow
 Effective Tax Rate – the difference between the before-
tax IRR and the after-tax IRR
A Note about Passive Losses
 Income and Loss Categories:
◦ Passive income or loss

◦ Active income or loss

◦ Portfolio income or loss

 Special Exceptions to PAL Rules – applies to


individual rental property owners
◦ Can offset active income with up to $25,000 of passive activity
losses from rental real estate activities

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