1. real estate

Real Estate Space and Asset
Markets
Module 1:
Real Estate Investment Analysis
Two Types of Real Estate
Markets
A market is a mechanism for the
voluntary exchange of goods and
services among owners.
There are two types of real estate
markets for our consideration in this
course. They are:
Real Estate Space Market
Real Estate Asset Market
2
Real Estate Space Market
The term “space market” is the market
for the usage of real property.
In this market, tenants exchange rent
with landlords for the right to use land
and built space.
This market is often called “the rental
market.”
3
Real Estate Asset Market
The term “asset market” refers to the
mechanism for the voluntary exchange
of ownership of real property.
In this market, buyers exchange money
with sellers for ownership rights to land
and built space (real estate).
This market is often called “the
property market.”
4
Let’s first consider several
characteristics of “space
markets.” After that, we will
look at the characteristics of
“asset markets.”
5
Characteristics of the Space
Market: Demand and Supply
Demand side of this type of market
includes individuals, households, or
firms who want to use space for
consumption or production purposes.
Supply side of this type of market
includes real estate owners who “rent”
(used as a verb here) space to tenants.
6
Characteristics of the Space
Market: Rent
 “Rent” as noun refers to the price of the
right to use space for a period of time.
May be measured in $ per square foot per
year (office space), $ per month per unit
(apartments) or various other methods.
Determined by the interaction of supply and
demand forces.
7
Characteristics of the Space
Market: Equilibrium
When the quantity of space demanded
equals the quantity supplied, the
market is in equilibrium.
The observed rent at equilibrium is
called market rent.
8
Characteristics of the Space
Market: Market Rent Changes
The principle of supply and demand
states that equilibrium price in a market
is directly related to changes in demand
and inversely related to changes in
supply.
Market rent, therefore, is directly
related to changes in demand and
inversely related to changes in supply.
9
Characteristics of the Space
Market: Segmentation
The real estate space market is highly
segmented, meaning that it tends to be local
in nature and specialized by property usage.
Within each segment, or submarket, the
same good may have a different equilibrium
price.
Market rent for office space may differ
significantly between Seattle and Miami.
Market rent for retail space and warehouse
space in the same city may different
dramatically.
10
Why is the Real Estate Space
Market Segmented?
On the demand side:
Users require specific types of space
Users require specific locations
On the supply side:
Buildings are built for specific uses
Buildings are fixed in location
Thus, we often talk of “geographic” or
“property usage” submarkets.
11
Characteristics of the Space
Market: Demand Curve
The typical space market (or
submarket) has a “downward sloping”
demand curve.
$25
REAL RENT
$20
Real Estate Demand Curve
$15
$10
$5
3.5
4
4.5
5
5.5
QUANTITY OF SPACE (Mil. SF)
6
6.5
12
Characteristics of the Space
Market: “Kinked” Supply
The typical space market (or
submarket) has a “kinked” supply
curve.
$25
REAL ESTATE SUPPLY CURVE
REAL RENT
$20
KINK
$15
EXISTING
QUANTITY
$10
$5
3.5
4
4.5
5
5.5
QUANTITY OF SPACE (Mil SF)
6
6.5
13
Characteristics of the Space
Market: Why these shapes?
The shape of the demand curve makes sense
when we consider that users will prefer more
space when prices are low than they will
when prices are high.
The shape of the supply curve (kinked)
makes sense when we consider that the
amount of built space is fixed in the short run
because it takes a long time to add new
space and because existing space lasts a long
time.
14
Characteristics of the Space
Market: Where is the Kink?
The kink occurs at the price equal to the
marginal cost of adding new space to the
submarket.
From basic economics, we know that the
supply function for a competitively produced
product equals the marginal cost function.
The marginal cost of built space includes site
acquisition costs, construction costs, and the
developer’s necessary profits.
15
Characteristics of the Space
Market: Impact of the Kink
Placing the supply and demand curves on the
same graph, we can see the impact of the
kink on equilibrium prices in a submarket.
REAL RENT
$25
D2
$20
D1
16
LRMC
D0
$15
13
$10
S1
$5
3.5
4
4.5
5
5.5
QUANTITY OF SPACE (Mil
As demand increases from
D0 to D1, equilibrium price
increases from about $13 to
about $16. If demand
continues to increase to D2,
the price remains at $16 as
new space is brought online
by suppliers (S2).
S2
6
6.5
16
Some Important Observations
 In submarkets with rising long-run marginal costs
(rising land prices make the next building more
expensive than the prior one), the supply curve is
increasing beyond the existing supply quantity.
 In submarkets with falling long-run marginal costs
(the next building is cheaper to construct than the
prior one), the supply curve is decreasing beyond the
existing supply quantity.
 In most U.S. space submarkets, the supply curve is
flat beyond the existing supply quantity because the
next building probably costs the same as the
previous one (in real terms).
17
Example of Space Market
Dynamics: Cincinnati, Ohio
In the mid 1980’s, the market rent for office space was $16 per square foot per
year with about 5 million square feet of space.
 In the late 1980’s, developers increased supply by 1 million square feet in
anticipation of increased demand. (S1 to S2)
 The demand increase did not materialize and rent fell to about $13.
 In the recession of the early 1990’s, demand fell from D1 to D0 and rents fell
further to about $10.

REAL RENT
$25
$20
D1
16
LRMC
D0
$15
13
$10
S1
$5
3.5
4
4.5
5
5.5
QUANTITY OF SPACE (Mil
S2
6
6.5
18
Characteristics of the Asset
Market:
 “Asset market” refers to the market for the
ownership of real estate assets (land and the
buildings on it) rather than the use of space in real
estate assets.
 Buyers in this market purchase real estate in
expectation of receiving future cash flows (rent paid
by tenants).
 These buyers could buy other kinds of assets (stocks,
bonds, etc.) that would also produce future earnings.
 In this sense, the real estate asset market is really a
part of the larger capital market.
19
Overview of Capital Markets
Capital markets can be divided into four
categories
Public equity markets
Private equity markets
Public debt markets
Private equity markets
Where do real estate assets fit?
In all four categories, in some fashion!
20
Types of Capital Asset Markets
and Investment Products
Public
Markets
Private
Markets
Equity Assets
Stocks
REITS
Mutual Funds
Real Property
Private firms
Oil and gas
partnerships
Debt Assets
Bonds
MBS
Money Instruments
Bank loans
Whole mortgages
Venture debt
21
Characteristics of Capital
Markets
 Public markets are more liquid than private markets
and thus are more informationally efficient.
 Private markets are usually for transactions involving
“whole” assets rather than shares of assets (like
stocks) as we typically see in public markets.
 Debt assets give their owners the rights to future
cash flows to be paid by borrowers on loans.
 Equity assets give their owners the rights to the
residual cash flows generated by an underlying asset
after other claim holders (including debtors) have
been paid.
22
Pricing Real Estate Assets
Commercial property prices are typically
quoted in terms of “Cap Rates” (short
for “capitalization rates”)
Also known as overall rate (OAR)
Defined as:
current annual net income
Cap Rate 
property price
23
Characteristics of Cap Rates
 Cap Rate can be thought of as:
 Current yield on the investment
 Inverse of a “price/earnings” ratio
 Three major determinants of the cap rate are:
 Opportunity Cost of Capital - from the capital market.
Considers how much investors could earn on other types of
capital assets. Higher OCC implies higher cap rate.
 Growth Expectations – from the space market. Considers
how much investors think net cash flows will increase in the
future. Higher growth implies lower cap rate.
 Risk – from both the space and capital markets. Considers
how risky a property is relative to other properties and other
asset types. Higher risk implies higher cap rate.
24
Is the Asset Market Segmented?
No (not very)
 “Physical Capital” = Real physical assets that produce real goods or services
over an extended period of time.
 “Financial Capital” = Money.
 Physical capital is specific and relatively immobile.
 Financial capital is fungible (homogeneous) and very mobile.
 In the real estate asset market, financial capital is used to purchase physical
capital assets.
 The real estate space market deals with physical capital.
 The real estate asset market deals with financial capital.
 Financial capital can quickly and easily flow from a Manhattan office building to
a Chicago office building or a Dallas apartment building. Returns are returns are
returns, because $$$ are $$$ are $$$, whether those $$$ come from New York
office rents, Chicago office rents, or Dallas apartment rents. Therefore:
 THE REAL ESTATE ASSET MARKET IS NOT SEGMENTED LIKE THE
SPACE MARKET
25
The Real Estate Asset Market is Actually Quite
“Integrated”
 By this, we mean that asset prices are quite similar across different
asset types, as shown in the graph of cap rates.
Cap Rates (OARs) for Commercial Property
As of 3rd Quarter, 1994
0.12
11.20%
11.27%
10.57%
9.79%
0.1
9.60%
9.73%
9.44%
9.35%
Cap Rate (Income / Asset Value)
8.73%
0.08
8.90%
8.88%
7.73%
0.06
0.04
0.02
0
Malls
Office(CBD)
Office(LA)
Office(DC)
Warehouse
Hotels(Lux)
Property Type/Location
26
What is the overall magnitude of real estate in
the capital market?
Real Estate Assets account for:
50%
15%
85%
15%
of
of
of
of
all
all
all
all
Private Debt
Public Debt
Private Equity
Public Equity
27
Another view of real estate in
the capital market
Real estate accounts for about 40% of total
investable capital in the U.S., distributed as:
3% private commercial mortgages
1% CMBS
4% RMBS
5% private residential mortgages
12% residential property equity
7% commercial property equity
3% agricultural/timberland
1% REITs
28
The Real Estate System
Module 3:
Real Estate Investment Analysis
What Links the Asset and
Space Markets?
The real asset and space markets discussed
in the previous module are linked together by
the development industry.
The manner in which the development
industry accomplishes this complex task is the
focus of this module.
The development industry, the real estate
asset market, and the real estate space
market together form the real estate system.
30
Property Development
Industry
Property development is a creative,
entrepreneurial process characterized by…
 Vision
 Greed
 Cooperation
 Risk
(Some of the most entertaining features of
American capitalism.)
31
Development is highly cyclical.
Buildings are “long-lived” assets, it is
only the demand for new built space
that supports the development industry.
Because this demand is sensitive to
general economic changes, the
development industry is subject to
“boom-bust” cycles.
32
Where does Development fit
in the Real Estate System?
 The development industry is the converter of financial capital
into physical capital.
Financial
Resources
Development
Industry
New
Built
Space
Physical
Resources
33
An Overview of the Real
Estate System

In addition to converting financial capital into physical capital, the development industry
serves as a feedback loop from the asset market to the space market, adding to the supply
side of the space market.
SPACE MARKET
SUPPLY
(Landlords)
ADDS
NEW
DEMAND
(Tenants)
LOCAL
&
NATIONAL
ECONOMY
RENTS
&
OCCUPANCY
FORECAST
FUTURE
DEVELOPMENT
INDUSTRY
ASSET MARKET
IF
YES
IS
DEVELPT
PROFITABLE
?
CONSTR
COST
INCLU
LAND
SUPPLY
(Owners
Selling)
CASH
FLOW
PROPERTY
MARKET
VALUE
MKT
REQ’D
CAP
RATE
CAPI
TAL
MKTS
DEMAND
(Investors
Buying)
34
The 4-Quadrant Model
To explain the long-run equilibrium
simultaneously between and within the asset
and space markets requires a more detailed
model than the simple supply/demand model.
We will consider the DisPasquale-Wheaton
“4-Quadrant Model” that depicts four distinct
relationships simultaneously.
The model is really nothing more than 4
simple graphs shown with a dashed rectangle
linking them together.
35
A Personal Note:
 My eyes glazed over and I started sweating profusely the first
time I looked at this model and heard one of its authors discuss
it at an academic conference, but it’s really not so bad when
you understand its component parts.
 Once I took it apart and put it back together, I discovered it is a
pretty clever way to describe about how things “work” in real
estate markets.
 Our text book authors do a great job of explaining the model,
but it may take several “readings” before you fully grasp it.
36
The 4-Q’s in the 4-Quadrant Model
The four main issues addressed by the model
are:
How are rents determined in the space market?
(NE quadrant)
How are properties valued in the asset market?
(NW quadrant)
What determines the amount of new construction?
(SW quadrant)
How is new construction related to the existing
stock of space? (SE quadrant)
37
The 4-Quadrant Model
Asset Market:
Valuation
Rent $
D
Space Market:
Rent Determination
D
R*
P*
Q*
Price $
Asset Market:
Construction
Stock SF
C*
Space Market:
Stock Determination
Construction SF
38
Northeast Quadrant: Rent
Determination
Horizontal axis is the physical stock of space
in the market in square feet.
Vertical axis is the rent for space in $ per
square foot per year.
Demand for space is shown as the downward
sloping line, just as in the familiar
supply/demand model.
Existing space is shown as Q*
Equilibrium rent is shown as R*
39
Northwest Quadrant:
Valuation
Horizontal axis is price per square foot of
space in the asset market.
Vertical axis is the rent per square foot of
space.
The line represents the cap rate, which we
know expresses the price of real estate as a
yield measure.
The equilibrium price is shown as P*
 Note the we are assuming that prices increase as we move left
along the horizontal axis in this quadrant.
40
Southwest Quadrant:
Construction
Horizontal axis is price per square foot of
space.
Vertical axis is the amount or rate of
construction activity.
The line represents the relationship between
property values (prices) and construction
activity.
The equilibrium amount of construction
activity is shown as C*
 Note that we are assuming that price increases as we move left
on the horizontal axis and that construction increases as we
move down the vertical axis.
41
Southeast Quadrant: Stock
Adjustment
Horizontal axis is the physical stock of space
in the market in square feet.
Vertical axis is the amount or rate of
construction activity.
The line relates the average rate of
construction per year to the total stock of
space that can be maintained in the market.
The equilibrium level of supply of built space
is shown as Q*
42
What’s the Big Deal about the
4Q Model?
 The 4-Quadrant model helps explain Boom and Bust
Cycles in Real Estate Markets.
 Boom means that space markets see an extended
rise in occupancy and rents.
 Bust means that space markets see an extended
period of falling occupancy and rents.
 Similarly, property prices (in the asset market) tend
to exhibit periods of rising and falling prices
corresponding to ups and downs in the space market.
43
Demand increases can trigger
a boom-bust cycle
Let’s use the model to see how an
increase in demand can lead to a boombust cycle.
To do so, we first must understand how
the model responds to two types of
demand changes
Demand changes in the space market
Demand changes in the asset market
44
Demand Increase in Space
Market
Let the line DD shift to DD1 resulting in a
new equilibrium quantity, Q**
The initial reaction is a dramatic price
increase (boom).
To maintain a steady state (long run
equilibrium), price and other equilibrium
points must change as shown by the new,
larger dashed rectangle on the next slide.
45
The 4-Quadrant Model with a
Space Side Demand Increase
Rent $
Asset Market:
D1
D
Valuation
Space Market:
Rent Determination
R**
D
P**
D1
Q**
Price $
Stock SF
Asset Market:
Construction
C**
Space Market:
Stock Determination
Construction SF
46
So, what does the model say?
Initially, a demand increase in the space
market would result in a price increase in the
asset market, then fall back a bit (bust) as
the market returns to its long-run steady
state due to new construction.
A demand increase in the space market in the
long run results in
a rent increase
a price increase in the property market
an increase construction
an increase equilibrium stock of space
47
Demand Increase in the Asset
Market
Continuing along our path to explaining
booms and bust, now we will consider what
the model tells us about an increase in
demand in the asset or property market.
Such an increase is equivalent to an increase
in the price investors are willing to pay for
real estate per dollar of rental income, or,
equivalently, a decrease in the cap rate.
This situation is shown graphically on the
next slide.
48
The 4-Quadrant Model with an
Asset Side Demand Increase
Asset Market:
Rent $
Valuation
D
11%
Space Market:
Rent Determination
8%
D
R**
Q**
Price $
P**
Stock SF
Asset Market:
Construction
C**
Space Market:
Stock Determination
Construction SF
49
Now what does the model
say?
Initially, prices would rise dramatically
(boom), but then fall back a bit (bust) as the
market returns to its long-run steady state
due to new construction.
An increase in demand in the asset market
(lower cap rate) in the long run leads to
An increase in prices
An increase in construction
An increase in equilibrium stock of space
A decrease in equilibrium rent
50
Back to the Boom-Bust Idea…
 We just saw how usage demand growth and investor
demand growth can individually cause an
“overshooting” of real estate asset pricing.
 When both types of demand increases happen
simultaneously, the overshooting may be even more
dramatic: prices rise significantly, then fall back even
deeper, thus exacerbating the boom-bust cycle.
 If market participants had perfect foresight about
how much prices/rents should initially move, the
overshooting would not happen and the cycle would
be avoided.
51
Real Estate Investment
Analysis
Module 4: Real Estate Market
Analysis
Real Estate Market Analysis:
Why do it?
 The term “real estate market analysis” refers to use of a practical
collection of analytical tools and procedures that relate the
fundamental principles of real estate market dynamics to the specific
decision at hand.
 Where to locate a branch office?
 What size or type of building to develop on a specific site?
 What type of tenants to look for in marketing a particular building?
 What the rent and expiration term should be on a given lease?
 When to begin construction on a development project?
 How many units to build this year?
 Which cities and property types to invest in so as to allocate capital
where rents are more likely to grow?
 Where to locate new retail outlets and/or which stores should be
closed?
53
Broadly Speaking…
Real estate market analysis usually requires
quantitative or qualitative understanding (&
prediction) of both the demand side and
supply side of the space usage market
relevant to some real estate decision.
The focus might be microlevel, such as a
feasibility analysis for a specific site or property
Or, the focus might be more general, such as a
general characterization of the supply/demand
conditions in a particular space submarket.
54
Variables of Interest in Market
Analysis
To evaluate a real estate space submarket,
analysts tend to focus on a few primary
indicators that characterize both the supply
and demand sides of the submarket and the
balance (equilibrium) between them.
Vacancy rate
Market Rent
Quantity of new construction starts
Quantity of new construction completions
Absorption of new space
55
Vacancy Rate
By definition, the vacancy rate refers to the
percentage of the stock of space in the
market that is not currently occupied.
Vacancy Rate = Vacant Space/Total Space
The vacancy rate reflects the balance between
supply and demand.
In most markets, it is normal for some vacancy to
exist (the natural vacancy rate) even when supply
and demand are in balance.
When actual vacancy rises above the natural vacancy
rate, rents tend to fall.
When actual vacancy falls below the natural vacancy
rate, rents tend to increase.
56
Market Rent
By definition, market rent is the level of rents
being charged on typical new leases currently
being signed in the market.
asking rents may differ from effective rents
Market rent is another indicator of the balance
between supply and demand in a market.
Can be tricky to measure because
it is private information and
lease terms may differ dramatically from tenant to tenant
57
Constructions Starts and
Completions
 Construction is an important “supply side”
indicator.
“Starts” indicate the amount of space currently in
the “pipeline” and likely to be added to the supply
in the near future
“Completes” indicate the amount of space just
arriving in the market.
Of course, we need to consider the net addition to
supply (after taking demolition and renovations
into account).
58
Absorption of New Space
By definition, absorption refers to the
amount of additional space that
becomes occupied during a year.
Absorption is a “demand side” indicator.
Gross absorption – total amount of space
leased, regardless of where tenants come
from
Net absorption – net change in the amount
of space occupied in a market.
59
The Concept of “Months
Supply”
 The variables we just reviewed are commonly used indicators of
supply/demand conditions in space submarkets.
 The concept of “months supply” combines several of these
variables to help us understand a market even better.
 By definition, months supply is the sum of current vacant space
in the market and new construction started but not completed,
divided by 1/12th of the annual net absorption in the market.
Vacancy  Construction
Months Supply 
Net Absorption / 12

This measure tells how long it will take (in months) for all of the vacant space in the market
to be absorbed, driving the vacancy rate to zero.
 Analysts compare the months supply to the length of time it takes to complete new
construction to see if the market can support a new project. If the months supply is
much greater than the average construction period, the market is “oversupplied.”
Otherwise, it might be time to start a new project in this market.
60
Some Tips for Market Analysis
 Define the market carefully along geographic and usage dimensions,
recognizing that most metropolitan areas form markets that can be
usefully divided into smaller submarkets. The next slide describes how
the Atlanta office market can be “divided.”
 Carefully consider the time period to be covered in the analysis
 5 – 10 years into the future is desirable
 3 years is more feasible in most cases
 Recognize the differences between and the benefits of a simple trend
extrapolation and a structural analysis
 Trend extrapolation predicts the future purely based on historical
trends and patterns
 Structural analysis attempts to predict the future by identifying and
quantifying the underlying determinants of market trends.
61
Atlanta
62
Performing a Market Analysis
 In both types of analysis (extrapolation and structural) the steps
are:




First, inventory the existing supply and evaluate the pipeline.
Second, relate the demand sources to the space usage demand.
Third, forecast future demand for and supply of space
Compare the forecasted demand for space with the forecasted
supply of space to see if the market will be “over” or “under”
supplied in the future.
 In tight markets (under supplied, landlord market), we expect to
see higher rents and lower vacancy rates.
 In loose markets (over supplied, tenant market), we expect to
see lower rents and higher vacancy rates.
63
A Simple, But Sophisticated Model of
Real Estate Space Market Dynamics
 Section 6.2 of the Geltner-Miller text presents a formal “stockflow” model for forecasting equilibrium changes in a real estate
space market.
 The model is really just six linked equations that reflect the
relationships among supply, demand, construction, rent, and
vacancy over time.
 The model allows simulation and forecast of rents, vacancy,
construction, and absorption in a market each year.
 We won’t concern ourselves too much with the mathematical
details of the model, but it is helpful to see how changes in the
inputs to the model alter the forecasts of the future.
 Putting the equations into Excel gives us an opportunity to “play
around” with the inputs and see what happens to the forecasts.
This will be part of the homework assignment.
64
Real Estate as an Investment
Module 5: Real Estate Investment
Analysis
How this Module is Organized
We first consider the investment
industry in the U.S. as a whole.
The term industry is defined as purposeful
work and diligence.
The investment industry is a major
business sector in the U.S.
Second, we will consider the role of real
estate as an asset class in the
investment industry.
66
The Investment Industry
 Investors are the “players” in the investment industry. They buy and
sell capital assets, thus they make up both the supply and demand side
of capital markets.
 The term investment is defined as the act of putting money aside that
would otherwise be used for current consumption.
 Different investor types may have different reasons for investing the
way they do and in the assets they choose, but they all share one
common thought: to forego consumption now in the expectation of
being able to consume more later as a result (wealth maximization.)
 Differences between investors is labeled as investor heterogeneity. This
is the primary reason so many different types of investment
opportunities exist in the capital market.
 The ultimate objective of wealth maximization can be divided into two
different objectives:
 Growth (or savings) objective
 Income (or current cash flow) objective
67
Growth vs. Income as
Investor Objectives
 An investor focused on growth probably has a relatively long
time horizon with no immediate or likely immediate need to use
the money being invested.
 An investor focused on income probably has a shorter
investment horizon and an ongoing need to use money
generated by the investment.
 Of course, some investors may decide to place part of their
wealth portfolio in investments intended to satisfy both of these
objectives, thus implying there is a continuum between these
two extreme objectives. (Note that our textbook is somewhat
ambiguous on this point, claiming that the two objectives are
mutually exclusive, yet acknowledging that some investors
pursue both objectives at the same time with parts of their
portfolios.)
68
Investor Constraints
 All investors, regardless of their focus on growth, income, or some
combination, face one or more of the following constraints:
 Risk – possibility that future investment performance may vary
over time in an unpredictable way
 Liquidity – the ability to sell and buy investment assets quickly at
full value without affecting the price of the assets
 Time Horizon – the future time over which the investor’s objectives,
constraints, and concerns are relevant.
 Investor Expertise and Management Burden – how much ability
and desire the investor has to manage the investment process and
the investment assets
 Size – how “big” the investor is in terms of the amount of capital
 Capital constraint- whether the investor can obtain access to
additional capital easily if good investment opportunities are
available
69
General Structure of Investment
Products and Vehicles
 The term underlying assets refers to directly productive physical
capital, such as an office building or an industrial or service
corporation.
 Investment products or vehicles are based on these underlying assets
and represent claims on the cash flows generated by the underlying
assets.
 In the case of a corporation that generates cash flow through the
production and sale of goods and services, investors may hold claims
to the cash flow in the form of common stock, corporate bonds,
options on the stock, or ownership in mutual funds that own these
claims.
 In real estate, the investment products are slightly different. The
“bricks and mortar” generate cash flow, and investors may hold claims
to the cash flow in the form of mortgages, mortgage securities, direct
equity ownership, shares of REITs, partnership interests, and CREFS.
70
Real Estate as an Asset Class
Where does real estate fit into the investment
industry?
Real estate as an asset class appeals to certain
investors depending on their unique investment
objectives and constraints.
Capital assets can be divided into 4 broad classes:
Cash
Stocks
Bonds
Real estate
71
Historical Performance of
Major Asset Classes 1969-98
Value of $1 with Reinvestment
$45
Stocks $39.14
Real Est 14.91
LT Bond 14.32
TBills
6.67
CPI
4.34
$40
$35
$30
$25
$20
$15
$10
$5
$0
69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98
CPI
TBill
SP500
LGBond
RE
72
More Recent Performance of Major
Asset Classes (1983-98)
Exhibit 7-7b: Value of $1 with Reinvestment, 1983-98
$14
Stocks $11.83
Bonds
6.05
Real Est 2.97
Tbills
2.36
CPI
1.62
$12
$10
$8
$6
$4
$2
$0
83
84
85
CPI
86
87
88
TBill
89
90
91
SP500
92
93
94
LGBond
95
96
97
98
RE
73
What About Risk in These
Asset Classes?
 If we measure risk as the volatility (standard deviation) in historic,
annual returns for the four major asset classes, we would expect the
asset with the highest average yield to have the highest risk. This slide
and the next one supports this idea.
Exh.7-9a: Avg.Ann.Total Return (70-98)
16%
14%
12%
10%
8%
6%
4%
2%
0%
T Bills
G Bonds
Income
Real Estate
Growth
Stocks
74
Comparing “Risk” for the 4 Major Asset Classes
Exh.7-9b: Annual Volatility (70-98)
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
T Bills
G Bonds
Real Estate
Stocks
75
The “Roller Coaster Ride” in Commercial
Property Prices: 1970-98
Price Level Index U.S. Institutional Real Estate
2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
Overbuilding
S&L Dereg
Boom, Tax incentives
ERISA: MPT
=>P.F. demand
REITs
inflation fears
REIT bust,
Recession
Tax reform
Disinflation
S&L Crisis: FIRREA
Recession
Securitizatn:
- REITs
- CMBS
69 71
73 75 77
79 81
83 85
87 89
91 93
95 97
99
76
Measuring Investment
Performance
Module 7: Real Estate Investment
Analysis
The Concept of “Returns”
 Investors use the concept of returns to “quantify” or
measure investment performance .
 “Returns” refers to:
Profits, measured as a percentage of the
investment amount
What you’ve got minus what you had to begin
with as a proportion of what you had to begin
with
 Quantitative return measures are necessary to:
Measure past performance (ex post or historical
returns)
Express expectations about future performance
(ex ante or expected returns)
78
Two Major Types of Return
Measures
There are two major types of
mathematical return definitions:
Period-by-period returns
Simple holding period return (HPR)
Multiperiod returns
Internal rate of return (IRR)
79
Holding Period Returns (HPR)
 Also known as “periodic returns,” holding period returns (HPR)
measure what the investment grows to within each single
period of time.
 HPR assume all cash flows (or valuations) occur only at the
beginning and end of the period of time with no intermediate
cash flows.
 Returns are measured separately over each of a sequence of
regular and consecutive (relatively short) periods of time such
as daily, monthly, quarterly, or annual return series.
 HPR can be averaged across time to determine the “timeweighted” multiperiod return.
80
Two Ways to “Average”
 There are two different ways to calculate the “Average” of a data series and
each has its advantages and disadvantages, depending on the situation at hand.
 Arithmetic average = sum of the observations divided by the number of
observations
 Geometric average = nth root of the product of “1 plus each observation,”
minus 1
 [(1+data1)x(1+data2)x…x(1+dataj)]^(1/j) –1
 Arithmetic mean is always greater than the geometric mean, especially if the
data are more volatile.
 Arithmetic mean is a better estimate of central tendency than the geometric
mean.
 The income and appreciation components of the arithmetic mean sum to the
arithmetic mean total return.
 The geometric mean is a better indicator of the average growth rate over a time
period because it recognizes compounding, if any.
 The geometric mean is not affected by volatility in the data.
 The income and appreciation components of the geometric mean do not sum to
the geometric mean total return.
81
IRR as a Multiperiod Return
Measure
 How can we measure returns when the cash flows of
an investment occur at more than two points in time?
 The internal rate of return (IRR) is the most common
multiperiod return measure.
 We usually quote the IRR as a per annum (per year)
rate.
 The IRR is a dollar-weighted return because it
reflects the effect of having different amounts of
money invested at different periods of time during
the lifetime of an investment.
82
Advantages and Disadvantages of Periodic and
Multiperiod Return Measures

ADVANTAGES OF PERIOD-BY-PERIOD (TIME-WEIGHTED) RETURNS:
 ALLOW YOU TO TRACK PERFORMANCE OVER TIME, SEEING WHEN INVESTMENT IS DOING
WELL AND WHEN POORLY.
 ALLOW YOU TO QUANTIFY RISK (VOLATILITY) AND CORRELATION (CO-MOVEMENT) WITH
OTHER INVESTMENTS AND OTHER PHENOMENA.
 ARE FAIRER FOR JUDGING INVESTMENT PERFORMANCE WHEN THE INVESTMENT
MANAGER DOES NOT HAVE CONTROL OVER THE TIMING OF CASH FLOW INTO OR OUT OF
THE INVESTMENT FUND (E.G., A PENSION FUND).

ADVANTAGES OF MULTI-PERIOD RETURNS:
 DO NOT REQUIRE KNOWLEDGE OF MARKET VALUES OF THE INVESTMENT ASSET AT
INTERMEDIATE POINTS IN TIME (MAY BE DIFFICULT TO KNOW FOR REAL ESTATE).
 GIVES A FAIRER (MORE COMPLETE) MEASURE OF INVESTMENT PERFORMANCE WHEN
THE INVESTMENT MANAGER HAS CONTROL OVER THE TIMING AND AMOUNTS OF CASH
FLOW INTO AND OUT OF THE INVESTMENT VEHICLE (E.G., PERHAPS SOME "SEPARATE
ACCOUNTS" WHERE MGR HAS CONTROL OVER CAPITAL FLOW TIMING, OR A STAGED
DEVELOPMENT PROJECT).

NOTE: BOTH HPR AND IRR ARE WIDELY USED IN REAL ESTATE INVESTMENT
ANALYSIS
83
Periodic Returns in Detail
 We can define the most common HPR (total
return represented as “r”) as follows:
rt = ( CFt + Vt-Vt-1 ) / Vt-1 or as
rt = (( CFt + Vt ) / Vt-1 ) - 1
 where:
CFt= Cash Flow (net) in period "t";
Vt=Asset Value ("ex dividend") at end of period "t".
84
Breaking Down the HPR
 The HPR from the previous slide can be broken down
into two component parts:
"INCOME RETURN" ("y", AKA "CURRENT
YIELD", OR JUST "YIELD“
 yt = CFt / Vt-1
"APPRECIATION RETURN" ("g", AKA "CAPITAL
GAIN", OR "CAPITAL RETURN", OR
"GROWTH"):
 gt = ( Vt-Vt-1 ) / Vt-1 = Vt / Vt-1 - 1
NOTE: rt = yt + gt
85
Example of HPR Breakdown
 Suppose we have a property that is valued at
$100,000 at the end of 2000. If the property
generates net rent during 2001 of $10,000 and is
worth $101,000 at the end of 2001, what is the r, g
and y for 2001?

y2001 = 10,000/100,000 = 10%

g2001 = (101,000-100,000)/100,000 = 1%
r2001 = 10% + 1% = 11%
86
MultiPeriod Returns in Detail
 When we wish to quantify the return of an investment earned over a
multiperiod span of time we have two options:
 Time-weighted average return (arithmetic or geometric average)
 Dollar-weighted average return (such as the Internal Rate of
Return defined in the previous module)
 Time-weighted returns ignore the amount of money invested in
the investment during the individual time periods and any cash
flows that occur within the individual time periods.
 Dollar-weighted returns take these issues into consideration.
 The type of measure we should used varies with the type of
situation we are trying to evaluate. We will see a common
“hybrid” of these two types when we review the NCREIF
Property Index later in this presentation.
87
Measuring Risk in Returns
 Intuitively, risk in investment analysis refers to the
possibility of not making the expected return.
 We can measure risk by the standard deviation of the
future return possibilities. We call this measure
“volatility.”
 The larger the standard deviation, the greater the
volatility or risk.
88
Comparing Risk for 3
Investments
 The figure below shows the probability distributions of the
expected returns for three different investments. The greater
the standard deviation, the “wider” the distribution, thus the
greater the risk. Note that the expected return for each is 10%.
100%
Probability
A
75%
50%
B
25%
C
0%
-10%
Figure 1
-5%
0%
5%
10%
15%
20%
25%
30%
Returns
89
The Risk-Return Tradeoff
 Generally speaking, investors don’t like risk. So, the capital markets
must compensate them by providing higher expected returns on more
risky assets, as shown in the graph below.
 It may be helpful for you to think of expected return for an investment
opportunity as the sum of the risk-free rate and a “risk premium.” The
risk premium increases for riskier investments.
Expected
Return
rf
Risk
90
One last item … the NCREIF
Index
 The most widely referenced measure of returns to commercial
real estate investment is the NCREIF Property Index (NPI).
 NPI is published quarterly by the National Council of Real Estate
Investment Fiduciaries and is based on regular appraisals of a
large sample (2500+) properties worth about $70 billion located
all across the U.S.
 The NPI is broken down by property type and geographic
region: office, retail, industrial, apartment; East, Midwest,
South, and West.
 The NPI is a uniquely defined time-weighted return measure
that accounts for the fact that the index is published quarterly,
but real estate investments generate cash flows on a monthly
basis.
91
NPI formula
 The formula for the NCREIF Property Index is:
rNPI 
End Val  Beg Val  ( PS  CI )  NOI
Beg Val  (1 / 2( PS  CI )  (1 / 3) NOI
 This measure assumes that one third of each quarter’s Net
Operating Income (NOI) is received at the end of each month
within the quarter and that any capital improvement
expenditures (CI) or partial sales (PS) occur at the midpoint of
the quarter.
 NCREIF also breaks down the NPI into income and appreciation
components defined as:
g NPI 
End Val  Beg Val  ( PS  CI )
Beg Val  (1 / 2)( PS  CI )  (1 / 3) NOI
y NPI 
NOI
Beg Val  (1 / 2)( PS  CI )  (1 / 3) NOI
92
Discounted Cash Flow and
NPV
Module 8: Real Estate Investment
Analysis
Reviewing the Relationship
between Returns and Values
 In the previous module, we spent considerable time discussing
the concept of returns and how important they are to real
estate investors.
 In order to actually earn returns, of course, investors must
purchase investments.
 Our task in this chapter is to consider how investors determine
how much they will are willing to pay for an investment that is
expected to generate cash flows.
 Expected return serves as the link between cash flows and
values.
 The tool we will use for evaluating values of specific investment
opportunities in light of expected returns is called Discounted
Cash Flow Valuation (DCF).
94
The Discounted Cash Flow
Valuation Procedure
The discounted cash flow valuation
(DCF) procedure consists of three
steps:
Forecast the expected future cash flows
Ascertain the required total return
Discount the cash flows to present value at
the require rate of return.
95
Demonstrating DCF
 Mathematically, the DCF procedure can be written as follows,
where V = value of the investment today.
V
E0 [CF1 ]
E0 [CF2 ]
E0 [CFT 1 ]
E0 [CFT ]





1  E0 [r ] 1  E0 [r ]2
1  E0 [r ]T 1 1  E0 [r ]T
 where:
 CFt = Net cash flow generated by the property in period “t”;
 V = Property value at the end of period “t”;
 E0[r] = Expected average multi-period return (per period) as
of time “zero” (the present), also known as the “going-in
IRR”;
 T = The terminal period in the expected investment holding
period, such that CFT would include the re-sale value of the
property at that time, in addition to normal operating cash
flow.
96
DCF Example
 Imagine a single-tenant office building with a six-year lease that
includes a rent “step-up” in the 4th year that will generate the following
net cash flows to the property owner.
 Years 1, 2 and 3: $1,000,000 per year
 Years 4, 5 and 6: $1,500,000 per year
 In addition, the property is expected to be sold for 10 times is thencurrent rent at the end of the 6th year.
 Suppose that 10% is appropriate expected average total return (goingin IRR) that would entice you to purchase this building in light of its
risk relative to other competing investment opportunities and their
expected returns.
 The value of this building is calculated as follows:
13,757,000 =
1,000,000 1,000,000 1,000,000 1,500,000 1,500,000 16 ,500,000
+
+
+
+
+
(1.10 )
(1.10 )2
(1.10 )3
(1.10 )4
(1.10 )5
(1.10 )6
97
Choosing the Right Discount
Rate in DCF
 In DCF calculations, larger discount rates result in smaller
present values.
 Relatively small errors in the discount rate (measured in basis
points) can cause dramatic errors in value calculations
(measured in dollars).
 Keep in mind that different cash flows in the DCF model may
pose different risk levels (forecasting rent with existing leases is
“easier” than trying to forecast rent from potential leases with
unknown tenants), thus requiring different discount rates or a
“blended” rate that takes into account the variation in risk.
 Using a blended rate (which is what we normally do) is not such
a bad shortcut if that’s the way market participants really
approach the valuation process, even if it is not technically
correct.
98
Two Common DCF “Shortcuts”
 While DCF analysis is considered to be the theoretically correct
approach to valuation, there may be times when other
approaches are acceptable.
 Two shortcut approaches commonly used in real estate are:
 Direct Capitalization Technique
V=I/R, where V is value, I is net income, and R is the
overall capitalization rate discussed in Chapter 1 of the
textbook (a yield measure, not a total return measure).
 Gross Income Multiplier Technique
V=GIxGIM, where V is value, GI is gross income, and
GIM is the gross income multiplier prevailing in the
market.
 Shortcuts can be useful in practice, but we should realize that
they may omit important information that could be relevant to
the valuation decision.
99
Watch out for the garbage truck!
No matter how sophisticated the DCF
approach looks and no matter if the
math “adds up,” the valuation can be
no better than the quality of the inputs:
cash flow forecast and discount rate
assumptions.
In other words:
Garbage in, Garbage Out
100
Making the Investment
Decision with NPV
 We discussed the concept of Net Present Value and how it could be
used as a decision tool in the module addressing “Present Value
Mathematics” or “Time Value of Money.”
 The NPV Rule says that an investor will choose to accept those
investment opportunities that are expected to generate a present value
of cash inflows equal to or greater than the present value of cash
outflows, with present values reflecting the investor’s require rate of
return.
 When faced with mutually exclusive investment choices, we should
choose the one with the largest positive NPV.
 The NPV Rule is consistent with the overall objective of all investors:
Wealth Maximization
 Due to competition, we would expect all investment opportunities to
reflect a zero NPV on a market value basis. Of course, we all hope to
find deals in which the rest of the market is “mispricing” the
opportunity, allowing us to identify projects that offer positive NPV on
an investment value basis make abnormal returns on.
101
What about the IRR as a
Decision Tool?
 Recall that we defined Internal Rate of Return (IRR) as the
discount rate which sets the NPV of an investment opportunity
equal to zero.
 If the calculated IRR of an investment opportunity is greater
than or equal to the required rate of return, then the investor
should accept the opportunity.
 The trouble with using IRR as a decision rule is that it does not
help us distinguish between mutually exclusive projects because
it ignores their scale (amount of dollars involved). Furthermore,
there are some situations when IRR cannot be calculated and
still other situations when there can be multiple IRRs.
 Thus, using the IRR as the “hurdle rate” for making investment
decision can lead to choices that do not “maximize wealth.”
102
Projecting Operating and
Reversion Cash Flows
Module 9: Real Estate Investment
Analysis
Property Level vs. Investor
Level Cash Flows
 Now that we understand the theoretical approach to
making real estate investment decisions using DCF
and NPV, our attention in this module focuses on
how to project or forecast the cash flows.
 Cash flow consists of two major components in most
real estate investments:
Cash flow from operations
 Cash flow from sale of the asset at the end of
holding period
 We will focus on “property level” before tax cash
flows for now, but later we will consider “investor
level” cash flows that reflect taxes and financing.
104
Property Before Tax Cash
Flow












Operating (all years):
Potential Gross Income = (Rent*SF)
- Vacancy Allowance = -(vac.rate)*(PGI)
+ Other Income = (e.g., parking, laundry)
- Operating Expenses
Net Operating Income
- Capital Improvement Expenditures
Property Before-tax Cash Flow
=
=
=
=
=
=
=
PGI
- v
+OI
- OE
NOI
- CI
PBTCF
Reversion (last year & yrs of partial sales only):
Property Value at time of sale
- Selling Expenses = -(e.g., broker)
Property Before-tax Cash Flow
=
=
=
V
- SE
PBTCF
 Most analysts use/recommend a 10 year projection period.
105
Some Issues in PBTCF
 How do we forecast vacancy (v)?
 Vac = (vac months)/(vac months + rented months) in typical
cycle;
 Look at typical vac rate in rental mkt, or history in subject
bldg.
 How do we forecast resale value (“reversion”, V at end)?
 Divide Yr.11 NOI by “going-out” (terminal) cap rate.
 What should be the typical relationship between the going-in
cap rate and the going-out cap rate?. . .
 Usually going-out  going-in (older bldgs have less growth & more
risk), esp. if little capital imprvmt expdtrs have been projected
106
Some More Issues in PBTCF
 Operating Expenses include:
 Fixed:
 Property Taxes
 Property Insurance
 Security
 Management
 Variable:
 Maintenance & Repairs
 Utilities (not paid by tenants)
 NOTE: OE do not include: income taxes or depreciation expense, but
must include mgt expense even if self-managed.
 Why? . . . Opportunity cost, “apples-to-apples” comparison with
alternative investments that you don’t have to manage yourself.
107
Yet more issues…..
 Capital Expenditures include:
 Leasing costs:
 Tenant build-outs or improvement expenditures (“TIs”)
 Leasing commissions to brokers
 Property Improvements:
 Major repairs
 Replacement of major equipment
 Major remodeling of building, ground & fixtures
 Expansion of rentable area
108
Discount Rates
The discount rate used to convert cash flows
into present values is:
is a multiperiod, dollar weighted average total
return expected by the investor in the form of a
“going-in” IRR
composed of the riskfree rate plus a risk premium
that accounts for risk in the cash flow projection
equal to the return investors could typically earn
on average in other investments of similar risk to
the subject property
derived from the capital markets.
109
A few thoughts on risk and
discount rates for DCF…
Risk is in the object not in the beholder.
Property "X" has the same risk for Investor "A" as
for Investor "B".
Therefore, oppurtunity cost of capital is same for
“A” & “B” for purposes of evaluating NPV of
investment in “X” (same discount rate). Unless,
say, “A” has some unique ability to alter the risk of
X’s future CFs. (This is rare: be skeptical of such
claims!)
110
How do we determine the
discount rate to use in DCF?
Usually a single ("blended") multi-year rate is
OK for valuation and investment analysis
("going-in IRR").
One source of info is direct surveys of market
participants (see www.korpacz.com)
Another source is historical evidence such as NPI.
Survey data tends to average about  200 bps >
Historical data.
111
Typical Going-In IRRs
For high quality ("class A", "institutional
quality") income property:
10% - 12%, stated
 8% - 10%, realistic
Lower quality or more risky income property
(e.g., hotels, class B commercial,
turnarounds, "mom & pops"):
12% - 15%
Raw land (speculation):
15% - 30%
112
How can we “back out” implied discount
rates from observed “cap rates?”
 Recall that we defined the cap rate as
 NOI / V  CF / V = y.
 Therefore, from market transaction data...
 Observe prices (V)
 Observe NOI of sold properties
 Observe "cap rates" = NOI / V.
 Compute: r = y + g  cap rate + g.
 So, we can get an idea what the market's expected total
return (discount rate) is for different types of properties by
observing the cap rates at which they are sold and then
making reasonable assumptions about growth expectations
(g).
113
More Microlevel Valuation
Ideas
Module 10: Real Estate
Investment Analysis
What makes real estate different from
traditional corporate investment decisions?
 The investment decision tools considered thus far in this course are
really the same tools that any investor should use to analyze any type
of investment opportunity (real estate or any other type).
 In corporate finance courses, the tools we have been using (DCF, NPV,
IRR) are called “capital budgeting tools.”
 Three characteristics of real estate that differ from traditional corporate
investment decisions include:
 A well-functioning market exists for real estate assets (unlike
assembly lines or microchip fabrication machines)
 The market, though well-functioning, is not as “informationally
efficient” as the market for publicly traded securities such as stocks
and bonds.
 In addition to the private real estate asset market, a parallel, public
real estate market exists (REITs) that implies that there may be
arbitrage opportunities for real estate assets.
115
Investment Vs. Market Value
 Market value is the expected price at which an asset can be sold in the
current market
 If we actually sold an asset, the observed price has an equal
probability of being above or below the “expected price.”
 Appraisers sometimes say that market value is the value of a
property to the “typical buyer” in the market.
 In this sense, market value can be regarded as “opportunity value,”
or, “the most probable price.”
 Investment value is the value of an asset to a particular owner,
reflecting that owner’s unique situation.
 In most corporate capital budgeting decisions, there is no wellfunctioning market for the underlying physical assets, so NPV decisions
are based on investment value.
 In real estate, the existence of the real estate asset market means that
both investment value and market value can be (and should be)
evaluated when making investment choices.
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Investment Value
 Investment value is measured by
considering:
 The cash flows expected to result under the particular owner’s
management and operation of the asset, as well as the owner’s
income tax situation.
 The cash flows on the right-hand side of the DCF formula may
differ from one investor to another!
 The discount rate that accounts for the risk inherent in the cash
flow forecast and the time value of money.
 Usually, the discount rate used in the DCF formula should be
the same for a particular property no matter who the investor
is, since all investors are competing in the same capital market.
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Using IV and MV to define NPV
 The NPV rule, in general, says we should accept only those
projects with “non-negative” NPV and, if faced with a mutually
exclusive choice, we should choose the project with the greatest
NPV.
 For a buyer, NPV is equal to “IV – MV”
 Buy it if it is worth more to you than it is to the typical
buyer!
 For a seller, NPV is equal to “MV – IV”
 Sell if if it is worth more to the “typical buyer” than it is to
you!
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Can Positive NPV Projects
Really Exist?
 In a perfectly competitive market with no information
asymmetries or other imperfections, competition would force
IV=MV for all investors for all assets, and everyone’s NPV would
be zero for all transactions.
 If IVbuyer = IVseller = MV, then NPV = zero for both buyer and
seller.
 This is what finance professors are talking about when they
lecture on “efficient market theory.”
 Don’t forget that “zero NPV” deals are still good!
 But, the real estate market is not so perfect and it is possible for
real estate deals to result in positive NPV for either the buyer,
the seller, or both simultaneously!
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How can we get positive NPV?
 We have already established that most investors face the same
discount rate (the opportunity cost of capital), so the only way NPV can
be positive for the buyer, the seller, or both in the same deal is if the
cash flows are different depending on who owns the property.
 Thus, the characteristics of the owner can affect NPV if the
characteristics affect the cash flow projection.
 Characteristics that might affect cash flow include:
Owner’s income tax status
Owner’s long-term use plan for the property
Owner’s management ability (economies of scale, specialized skills, etc.)
Transaction costs may vary across owners
Information asymmetries may result in different cash flow projections
across owners.
 Negotiating skills differ across owners.
 Time constraints and horizons may differ across owners.





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Arbitrage opportunities between the public and
private real estate asset markets.
 When the same asset is traded in two different markets at two
different prices, an opportunity exists to “buy low” in one market and
“sell high” in the other, or arbitrage.
 Researchers (Downs, Geltner, Giliberto & Mengden, Gyourko & Keim,
Graff & Young, Ling & Naranjo, Liu, etc.) have examined whether it is
possible to “arbitrage” between the private real estate asset market
(direct ownership of buildings) and the public real estate asset market
(REITs and other publicly traded assets.)
 The idea is that sometimes these two markets may not identically
“price” real estate cash flows, so investors who can spot the
opportunities may have a chance to arbitrage.
 The results of this research are mixed, and it is not clear that the
profits from arbitrage would be large enough to cover transaction costs
in the long run.
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Capital Structure
Module 11: Real Estate
Investment Analysis
Introduction to Capital
Structure Theory
 The term capital structure refers to the relative
proportion of equity (investor funds) and debt (lender
funds) in a real estate investment.
 Many assets in the real estate asset market are
funded with a combination of debt and equity.
 Real estate assets are well-suited as collateral for debt, so
lenders are accustomed to making real estate loans.
 Investors like the way debt allows them to magnify or
“lever” the amount of physical capital they control. (They
can buy more real estate with the same amount of investor
funds if they combine these funds with lender funds!)
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Mechanics of Leverage
 The physical principle of leverage says that the weight that can be
lifted using a lever and a fulcrum is equal to the weight on one end of
the lever times the ratio of the lengths of the two sides of the lever.
 The term “leverage ratio” refers to the ratio of the lengths of the two
sides of a physical lever
 In investment theory, the term leverage ratio is:
 LR = V/E = (L+E)/E
 V = value, E = equity, L = loan amount
A Physical Lever...
500 lbs
2 feet
5 feet
200 lbs
LIFTS
"Leverage Ratio" = 500/200 = 2.5
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Effects of Financial Leverage
 When an investor combines equity funds with
borrowed funds to leverage an investment, the
leverage increases the:
Expected return to the equity investor
Risk of the investment to the equity investor
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Example of the effect on expected
return
 Consider a property that can be purchased for
$100,000 today that will increase in value by 2%
during the next year and will generate $8,000 during
the year in cash flow for a total return of 10%.
 If an investor buys this building with $100,000 of
equity funds, the return on his equity investment will
be 10%
10,000/100000 = .10
 If an investor buys this building with $40,000 in
equity and $60,000 in debt at 8% interest (interest
only loan), the return on his equity investment is
13%
(10,000-4,800)/40000 = .13
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Example of the effect on risk
 Using debt funds increases the range, or volatility, of possible
outcomes, which we know as “risk.”
 Suppose the property in our example has
 a 50% chance of being worth $112,000 at the end of the
year and generating $9000 in cash flow and
 a 50% chance of being worth $92,000 and generating
$7,000
 Our expectation (mean) is that the property will be worth
$102,000 and generate $8,000 in income.
 Without leverage, the range of returns to the investor is 22%
(either 21% or –1%).
 With leverage (and the required interest payment0, the range of
returns to the investor is 55% (either 40.5% or –14.5%)
 Thus, leverage increases risk in direct proportion to the leverage
ratio (2.5 in this example)
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A Useful Formula: WACC
 To quantify the combined effects of leverage on risk and return, we
can use the following formula called the weighted average cost of
capital or WACC.
 rP=(LTV)rD + (1-LtV)rE
 Where rP is the free and clear return on the property rd is the return on
the debt (interest rate) rE is the return on the equity, and LTV is the
loan-to-value ratio (not leverage ratio!)
 The WACC can be used to estimate the required return for equity
investors in the real estate asset market.
 Suppose we know that current mortgage rates are 8% with 85%
LTV and the expected total return on properties is 10%.
Rearranging the above formula, we can solve to find equity return
(rE) of 16%.
 rE=(rD-LTVrD)/(1-LtV)
 16%=[10%-(.75)8%]/(1-.75)
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Leverage is a Two-Edged
Sword: It cuts both ways!
 In the previous example, leverage increased the expected
return to our equity investor from 10% to 13%. In some
situations, leverage can actually decrease the expected return
on equity.
 If rP > rD, leverage increases the expected equity return.
 If rP < rD, leverage decreases the expected equity return.
 If rP = rD, leverage has no impact on the expected equity
return.
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Income Tax Considerations
Module 12: Real Estate
Investment Analysis
Uncle Sam Wants Yours!
 So far in this course we have ignored the impact of income
taxes on the investment decision.
 For pension funds, life insurance companies and other similar
entities for whom investment returns are not subject to
taxation, ignoring taxes is perfectly legitimate.
 For the rest of us, income taxes are an important consideration
that can dramatically affect the investment decision.
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PBTCF vs Equity ATCF
 The property level before tax cash flow used in the DCF model
thus far in this course is often significantly different from the
property owner’s “equity after tax cash flows” due to accrual
based IRS rules relating to:
 Depreciation – a non-cash expense that reflects the accrual
of losses in property value over time
 Capital expenses – a cash item, but IRS requires
depreciation over the life of the improvement
 Debt amortization – mortgage payments include principal
and interest, but only the interest portion is an expense,
since principal reduction just moves money from one pocket
to the other.
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Defining EATCF
 We can define Equity After Tax Cash Flow (EATCF)
from operations as:
PGI
-V
=EGI
-OE
=NOI
-CI
=PBTCF
-DS (debt service)
-Income tax
=EATCF
Note that taxes are determined by:
NOI
- Interest
- Depreciation deduction
= Taxable income
x Investor’s income tax rate
= Income tax
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Defining After Tax Reversion Cash
Flow (ATRCF)
 Recall that our DCF formula requires that we consider the cash flow on
reversion at the end of the holding period. For taxable investors,
reversion may result in tax consequence.
 We can define the After Tax Reversion Cash Flow as:
Gross sale proceeds
Note that taxes due on sale are calculated as:
- selling expenses
= Net sale proceeds
NSP
- Loan payoff
- Adjusted Basis
- Taxes due on sale
=Taxable gain on sale
= ATRCF
x Capital gain tax rate
= taxes due on sale
Note: adjusted basis (net book value) is
simply original basis + capital improvement
expenditures – accumulated depreciation.
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Other Tax Concepts: Original
Tax Basis
 Original (initial) Tax Basis - the costs of acquiring property
by purchase, including everything of value given in exchange
(excluding items deductible as current operating expenses)
 cash
 debt
 legal work
 title insurance
 other fees or charges
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Other Tax Concepts:
Allocating the Tax Basis
 Allocating the Tax Basis - the initial basis is allocated
between the costs of land and the costs of improvements in a
manner which reflects their respective market values
 The portion attributable to improvements is often called the
Depreciable Basis
 Three methods for allocating the tax basis:
specify the price of each component in the purchase
contract
use the ratio of land value to building value as employed
by the tax assessor
have an appraiser estimate the relative values of land
and buildings
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Other Tax Concepts:
Adjusting the Basis
 Adjusting the Basis - three main topics to consider:
 Cost Recovery Allowance (depreciation)
 Capital Improvements
 Partial Sale
137
Cost Recovery Allowance
(depreciation)
 Cost Recovery Allowance (depreciation)
 our federal government taxes income, not wealth (supposedly)
 to allow investors to recover their investment capital (wealth) without
paying taxes on it (again), the IRS permits taxpayers to deduct from
otherwise taxable income an allowance for recovery of invested capital
 applies to virtually all investment in assets held for business or income
purposes, including property improvements, but excluding land
 depreciable life is the phrase commonly used to refer to the period
over which costs for such assets may be recovered
 residential income property: 27.5 years (80%+ of gross rents from
residential tenants)
 non-residential income property: 39 years
 land improvements (walks, roads, sewers, gutters, fences): 15 years
 personal property such as appliances, automobiles: 5 years
 personal property such as officer furniture, fixtures, equipment: 7 years
138
Computing the Depreciation
Deduction
 The annual Cost Recovery Allowance (depreciation deduction) is
prorated by months for property owned for less than a full calendar
year
 mid-month convention - during the month a property is placed into
service, and the month when a property is removed from service, the tax
payer may claim only half of the monthly allowance.
Example: consider a taxpayer who acquires a residential income property
on March 2, 2001, and operates it until she sells it on November 29,
2003. The depreciable basis is $240,000. The annual depreciation or
recovery allowance is: 240,000/27.5 = $8,727. The first and last years
of ownership, however, require use of the mid-month convention.





2001:
2002:
2003:
Total
Note:
9.5 x (8,727/12) =
full year
10.5 x (8,727/12) =
$6,909
$8,727
$7,636
$23,272
A “half-year convention” applies to personal property
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How do Capital Improvement
Expenditures affect taxable income?
 Capital Improvements
 when an investor expends additional funds to improve a property, the IRS
may classify those expenditures as capital improvements rather than
operating expenses
 expenditures that add to the value or extend the life span of the
improvements are capital improvements
 expenditures that only maintain the properties operating condition are
current operating expenses
 whereas operating expenses are deductible in the year they are incurred,
capital improvements must be deducted via cost recovery allowances
 of course, investors would generally prefer to classify all expenditures as
operating expenses to reduce their taxable income in the year the expenses
are incurred
 Partial Sale
 when a portion of a property is sold, the tax basis must be reduced by the
portion of the total basis attributable to the part sold
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What discount rate should we
use for After-Tax DCF?
 Now that we can project cash flows on an after-tax
basis, we can apply the DCF formula to make
investment decisions using the NPV rule.
 Of course, we have to use the appropriate discount
rate to use the DCF correctly.
 When the property we are considering “trades” in a
reasonably competitive market, the appropriate
discount rate is the opportunity cost of capital.
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