Chapter 17 - Real Estate Investments and Business Opportunity Brokerage

The most important factor underlying every investment decision

Economic soundness

Factors to take into consideration when performing an investment analysis

• Land use controls
  (i.e. zoning, restrictions, permitting)
  

• Economic forces
  (i.e. population growth, foreign capital, taxation)

Potential benefits and rewards for real estate investors

Income, equity build-up, appreciation in value, tax benefits, positive leverage, and prestige

Possible disadvantages of real estate investment

Illiquidity, the local (immobile) nature of real estate, management expense, need for expert advice (brokers, accountants, etc.)

Types of investment property

Agricultural, business opportunities (buying/managing a business), commercial, industrial, office, or residential

An investment that allows groups of investors to pool their resources to invest in larger, professionally managed, income-producing property

Real estate investment trust (REIT); Investment trusts invest in office buildings, large apartment complexes, and retail centers)

Investment term that refers to the sale price less any costs of the sale

Amount realized, or net proceeds from sale; Costs of the sale include commissions, advertising, legal fees, seller-paid points and closing costs

Original value of an asset for tax purposes

Basis, or cost basis; Used to determine the gain or loss on the sale or exchange of property

Measurement of how much is invested in a property for tax purposes, including any capital improvements such as a new addition to the home, paving the driveway, replacing the roof, or new central air

Adjusted basis; 

By adding the cost of improvements to the basis, the gain is reduced, decreasing the capital gains tax owed

Increase/decrease in the value of an asset, such as personal or investment property, that gives it a higher/lower value than the cost of purchasing the asset

Capital gain/loss; A capital gain/loss is not realized until the property is sold

Movement of money into or out of a business or investment, measured over a period-of-time

Cash flow; May be positive (more coming in than going out) or negative (more going out than coming in)

Increase in the value of an investment over time

Appreciation; Appreciation can occur for many reasons, such as inflation, supply and demand, and capital improvements

Income tax deduction that allows a taxpayer to recover the cost of investment property over a number of years

Tax depreciation, also referred to as cost recovery

Difference between the current market value of a property and the amount the owner still owes on the mortgage

Equity; The initial down payment creates equity. Additional equity is created through principal reduction and appreciation

An asset’s ability to be quickly converted through an act of buying or selling without causing a significant movement in price and with minimum loss of value

Liquidity; Liquid assets can be sold quickly with minimal loss of value. Real estate is relatively illiquid since it cannot be transferred as easily as other assets

Legal method of minimizing or decreasing an investor’s taxable income, and therefore, their tax liability

Tax shelter; 

Depreciation can reduce taxable income and is a form of tax shelter

1. Dynamic risk

2. Static risk

Two types of risk involved in real estate investment

Risk that can be offset by insurance, such as fire, flood, or robbery

Static risk

The type of risk associated with changes in general market conditions

Dynamic risk

Types of dynamic risk associated with real estate investment

• Business risk

• Financial risk

• Inflationary (or purchase power) risk

• Interest rate risk

• Liquidity risk

• Market risk

The use of borrowed funds to purchase assets; Using other people’s money (OPM) to purchase investments

Leverage; 

The investor hopes to earn a higher rate of return as a result of borrowing rather than paying cash

The two types of leverage

Positive and negative

Positive leverage

If the investment returns more to the investor than the cost (interest rate) of the loan

Negative leverage

If the investment returns less to the investor than the cost (interest rate) of the loan

Three types of operating expenses used to estimate value with the direct capitalization technique

1. Fixed expenses (FE)

2. Variable expenses (VE)

3. Reserves for replacements

Operating expense that does not change with occupancy, such as property taxes and hazard insurance

Fixed expenses

Operating expense for funds that are set aside to replace short-lived items such as major appliances carpet, or roof

Reserves for replacements

Operating expense that changes with occupancy, such as property taxes and hazard insurance

Variable expenses

Items NOT included in operating expenses

Mortgage payments, tax depreciation, capital improvements, personal expenses unrelated to operation of the property, and income taxes

The first step in evaluating an investment property

Preparation of a reconstructed operating statement; Shows annual forecasts of income and expenses over a period of time

Formula used to determine the cash throw-off (CTO), also referred to as the before-tax cash flow (BTCF), for an investment property

Net operating income

– Annual debt service*

Cash Throw-off

*Annual debt service is also one year’s mortgage payments

Ratio that expresses the relationship between the expenses incurred in operating the property with the amount the investor actually receives

Operating expenses ÷ Effective gross income = Operating expense ratio

𝑂𝐸/𝐸𝐺𝐼=𝑂𝐸𝑅

Ratio that measures financial risk in an investment by comparing the loan amount to the price, or value, of the property; The percentage of the property value that is debt

Loan-to-value ratio =

Loan amount ÷ Property value

𝐿𝑇𝑉=𝐿𝑜𝑎𝑛 𝑎𝑚𝑜𝑢𝑛𝑡/𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑣𝑎𝑙𝑢𝑒

Formula used to calculate profit or loss on the amount originally invested

Profit or Loss % = Amount Made ÷ Original Amount Paid

Interest and principal factor used to calculate a level monthly payment necessary to pay off both principal and interest over the term of a loan

Loan constant;

Today, this method is usually replaced with calculators and computers to calculate payments and amortization schedules

Time period over which residential investment property owners may depreciate a portion of their investment under current tax law (Modified Accelerated Cost Recovery System - MACRS)

27.5 years on a straight-line basis

Time period over which non-residential investment property owners may depreciate a portion of their investment under current tax law (Modified Accelerated Cost Recovery System - MACRS)

39 years on straight-line basis

Formula for determining the original cost of an investment property (total acquisition cost)

Original purchase price + Closing costs (such as survey and appraisal costs)

Formula for determining the basis for depreciation of an investment property (the portion of the total cost, including closing costs, that applies to improvements)

Total acquisition cost x Percentage the building (improvement) represents of the total investment

Formula for determining the amount (adjusted basis) that a residential property investor may deduct each year for tax purposes on a straight-line basis

Basis for depreciation ÷ 27.5 (years for residential straight-line depreciation)

Formula for determining the amount (adjusted basis) that a non-residential property investor may deduct each year for tax purposes on a straight-line basis

Basis for depreciation ÷ 39 (years for non-residential straight-line depreciation)

Profit made when an income-producing property is sold

Capital gain;

The IRS provides capital gain tax rates based on taxpayer marital status and income

Three classifications of income under the Tax Reform Act of 1986

Active, passive, and portfolio income;

Losses cannot be offset against income from a different classification

Income that comes from salaries and wages

Active income

Income that comes from dividends

Portfolio income

Income that comes from investments in which the investor does not materially participate, such as rental income

Passive income

Method available to real estate investors to defer capital gain by exchanging properties with another real estate investor in a like-kind exchange

Tax-deferred exchange

Non-real-estate property (money) exchanged as part of a tax-deferred exchange

Boot;

Any boot is taxable to the recipient

A form of seller financing where capital gains tax is paid each year on the payments received, spreading the tax out over several years and reducing the tax due in any one tax year

Installment sale

Real estate service connected with the sale or lease of a business that may or may not include real estate

Business brokerage; Requires a real estate license and licensee must be able to analyze financial statements and understand operating income statements and balance sheets

The sale or lease of a business involving a transaction in excess of $200,000

Business enterprise;

Usually involving the transfer of stock or other securities when additional licensing is required

The sale or lease of a business involving with sales prices of $200,000 or less

Business opportunity; 

Many are sole proprietorships or partnerships that do not involve stock. Sale may include inventory and fixtures only with transfer of lease

The appraisal approach used to value a failing business that is not expected to continue to do business

Liquidation value approach;

Can also be used to establish the minimum value of a profitable business

The value of a failing business that remains after liquidating all the assets of the business and satisfying all the liabilities

Liquidation value

The intangible value of the name of a business in the marketplace

Goodwill

Assets that have physical existence such as buildings, personal property, furniture, and office equipment

Tangible assets

Assets that have no physical existence, but have monetary value, such as stock, trademarks, copyrights, noncompetition contracts, franchises, and goodwill

Intangible assets

The value sought in a business appraisal for all tangible and intangible assets

Going concern value

Uses for a business appraisal

To establish a purchase price or obtain a loan, or for insurance purposes; Also, for condemnation, buy-sell agreements, property or estate settlements, or employee stock option plans

Items of value that are owned by a business

Assets; Anything of value that can be converted into cash

Debts that are owed by a business, such as accounts and notes payable, and long- and short-term debt

Liabilities

Difference between assets and liabilities

Owner’s equity = Assets - Liabilities

Steps in the sale of a business

1. Acquire the listing

2. List the assets

3. Valuation

4. Deduct liabilities

5. Stock valuation

6. Legal compliance

7. Close the transaction