Chapter 17 (Real Estate Investment Analysis and Business Opportunity Brokerage) Flashcards
Need for Real Estate Investment Analysis
A knowledge of real estate investment analysis is important to a licensee in Florida because a real estate licensee is allowed to sell investment property. The public regards a real estate broker or sales associate as an expert in all types of properties. While the rewards of negotiating the purchase or sale of investment property are often greater than they are for other types of real estate, so are the liabilities for untrained or unknowledgeable people. Cases have gone to court because real estate licensees either gave bad advice or did not properly analyze an investment before recommending a course of action that could have been avoided by a knowledgeable professional.
Potential investors go to real estate professionals for help and guidance. Licensees must be qualified to provide the needed expertise when they accept the trust and confidence of a client. At the beginning of this book, the point was made that real estate licensees have one major commodity to offer the public—expertise. But part of being a professional also includes knowing when to consult a specialist (e.g., an attorney or an accountant) and when to have one’s seller or buyer consult a specialist. The purpose of this unit, therefore, is familiarization, a first step toward developing expertise in real estate investment matters.
Investment
An investment is the outlay of an investor’s money in anticipation of income or profit.
Investors use some of their own money called equity AND borrowed funds.
*Real estate investment analysis is the process of determining the extent to which real estate investments will achieve an investor’s objectives.
Experience indicates that investors are motivated by one or a combination of objectives:
(1) safety of principal
(2) protection against inflation
(3) liquidity
(4) increased income (current and/or future)
(5) tax advantages
Investors may choose to invest in real estate through a limited partnership.
Another alternative is to invest in real estate through a real estate investment trust (REIT).
A real estate investment trust (REIT) offers investors the opportunity to invest in income-producing real estate properties.
Individual REITs generally specialize in a particular type of property, such as multifamily communities, retail malls and shopping centers, office properties, and so forth.
They provide a means for individuals to pool resources for investment in a professionally managed portfolio of real property and/or mortgages secured by real property.
REITs are attractive because they offer diversification and liquidity, they are similar to mutual funds, and they offer the advantages of skilled centralized management and continuity of operation. REITs may be purchased through a stockbroker.
Types of Real Estate Investments
Investors interested in real estate can choose from several general types: residential, commercial, industrial, agricultural, and business opportunities.
- Investments in residential properties include single-family homes, condominiums, apartments, and other multifamily complexes.
Most experts agree that investing in an apartment project (or other income-producing property) is economically feasible when the projected future net income over a predetermined period will permit return of the investment (recover invested capital) and allow the investor an appropriate rate of return over the investment period.
- In assessing the desirability of an apartment complex, several criteria should be considered, including the following:
Location, effective gross income, operating expenses, and property taxes.
Existing properties should be inspected carefully, and repair and maintenance records should be studied to ensure that the property has been well maintained.
A lack of proper maintenance is called deferred maintenance.
- The commercial category includes retail and office properties.
Retail properties include downtown commercial properties, shopping centers, and regional malls.
A shopping center’s economic characteristics depend on the nature of existing leases and on operating expenses.
An investor should study all leases carefully to find out how much of the original term remains, whether investors participate in tenant income from sales, and whether the leases provide for appropriate costs to be shifted to tenants.
Long-term leases and a tendency on the part of tenants to renew their leases are among the main attractions of investing in office properties.
- Industrial uses of real estate in urban areas generally involve manufacturing, assembly, and/or distribution.
To be suitable for industrial use, a site should be located near transportation facilities such as railroad stations, expressways, and airports because of the need to receive and ship by rail, truck, and air.
- Agricultural properties are often purchased by farsighted investors-developers looking for large tracts of land that lie in the path of foreseeable urban growth.
However, the holding period to realize such development potential may be many years.
- One of the categories that Chapter 475, F.S., defines as real estate is “any interest in business enterprises or business opportunities.”
This category includes the sale or lease of a business and goodwill of an existing business, including business assets such as the stock of a corporation.
Advantages of Real Estate as an Investment
Real estate investments have the following advantages:
- Rate of return.
Historically, real estate has produced a high rate of return for the owner-investor, compared with other types of investments.
- Tax advantages.
Although the Tax Reform Act of 1986 eliminated or seriously reduced some of the tax advantages, real estate investments still receive some tax benefits.
- Hedge against inflation.
The Bureau of Labor Statistics publishes the Consumer Price Index (CPI).
The CPI measures the average change in prices over time for a fixed “market basket” of goods and services.
Each of the thousands of items in the market basket is assigned a weight, according to its current relative importance to a consumer’s budget.
Costs of housing, food, clothing, transportation, medical care, entertainment, and other goods and services are obtained to determine price movements.
The results then provide a reliable indicator of inflation.
Historically, real estate prices have increased (property appreciation) at a faster pace than inflation.
If a parcel of real property is acquired at market value or less, an owner will normally find that the sale price increases faster than other “market basket” prices.
This ability to maintain or increase purchasing power is one reason real estate is regarded as one of the best protections against inflation.
- Leverage.
Real estate is typically highly leveraged.
An investor can usually borrow 70% to 75% of the appraised value to finance a real estate investment.
The goal of leveraging is to increase one’s yield (return) on equity (investor’s own capital) by using borrowed funds.
- Equity buildup.
As a property appreciates in value and the mortgage debt is reduced, the investor’s equity grows.
Disadvantages of Investing in Real Estate
Following are some of the disadvantages of investing in real estate:
- Illiquidity.
Liquidity refers to the ability to sell an investment very quickly without loss of one’s capital.
Real estate is not considered a liquid investment.
Therefore, it is said to be illiquid.
Recall that two of the critical assumptions associated with the definition of market value were that:
(1) neither the buyer nor the seller is under any compulsion to buy or sell
AND
(2) the property is exposed on the market for a reasonable period of time.
2. Market is local in nature.
The real estate market is very local in nature.
An investor usually is interested in a particular property type and geographic area.
Other types of investments, such as stocks, are bought and sold in an international marketplace.
- Need for expert help.
Many expenses are associated with investing in real estate, including the need for property managers, financial consultants, and legal experts.
- Management.
Real estate is a labor-intensive investment.
Properties must be cared for, rents collected, and so forth.
- Risk.
An investor must weigh the chance of losing invested capital.
Tenant turnover, increasing property taxes, and increased costs associated with operations are a few examples of the types of risk to which a real estate investor is exposed.
Analyzing Investment Properties
A number of factors (influences or forces) affect supply and demand, and thus the value, of investment real estate.
Each of the various types of investment properties has a particular set of considerations that real estate licensees need to recognize.
These value-creating influences affect a property, depending on its relationship to the economy, location, physical characteristics, and legal characteristics.
Relationship to the Economy
One of the external forces affecting a property is the economy or, more appropriately, the economies.
Both the local and the national economies must be considered.
Local Economy
Local economic considerations include the existing stock of available units and new development of competing properties.
Supply and demand factors are important considerations.
An investor would be ill-advised to begin construction of a new apartment complex in a community already experiencing a surplus of new apartment units.
The productivity of the property would be impaired to the extent that the investor could not hope to achieve maximum return on the investment.
National Economy
The national debt, employment levels, interest rates, availability of credit, and construction costs are some of the factors that influence the national economy and also the real estate market.
Location
The importance of location is undisputed as it applies to real property.
No two parcels of real property are exactly alike because location alone creates a difference.
Each property is unique and in a fixed location.
Investor preferences for location vary.
The economic characteristic called situs (the preference by people for a certain location) indicates the influences on value created by location.
Because real property is fixed in its location, it is affected greatly by its immediate surroundings.
A change in land use of surrounding properties, for example, can have a positive or a negative impact on a particular property.
Destination Properties
Because the land is immobile, investors must find ways to direct an income stream to the property.
Destination properties include service industries that support the needs of a local community, such as local repair shops, barbershops, local real estate agencies, and financial institutions.
Origin Properties
Origin properties are just as immobile and fixed as destination properties, but often they are not as attractive or as well situated on access routes.
As a result, they must originate something (a product) to seek out an income stream.
Assembly plants, manufacturing facilities, and distribution centers represent origin properties.
These properties are regarded as export activities in any analysis of a community’s economic base.
Physical Characteristics
If one site and its building’s size, shape, and form were the same as all others, an investor could make investment decisions based on location alone.
Seldom, if ever, are two properties found with identical physical characteristics.
Site
In evaluating properties, investors are faced with the same problems as appraisers.
One of the more common ways of neutralizing variables of a site is through the use of units of comparison.
Usually, both appraisers and investors use square feet, front feet, or acres as units of comparison.
These methods of comparing sites are practical because they permit direct comparison of competing sites, regardless of differences in size or shape.
- For residential properties, the square-foot method is usually used.
- For commercial properties, either the front-foot or the square-foot unit of comparison may be used. For farms or large tracts of undeveloped land, the acre normally is used.
Other physical characteristics of a site that deserve an investor’s consideration are related to topography.
A site’s surface, subsoil structure, drainage, orientation and view, and exposure to or protection from possible noxious environmental influences are all elements for consideration in a thorough site analysis.
Building
Potential real estate investors will normally have at least one alternative to buying an existing property:
They could buy a vacant site and construct a new building. Even when this course of action is not a serious consideration, the cost of this alternative approach tends to set the maximum price they will pay for an existing property.
If the existing building has deficiencies, the value of these deficiencies subtracted from the cost of a new building indicates a reasonable market value for the building.
Notice the use of the term market value, rather than investment value. Investment value is not market value.
Investment value is the worth of a building or property to an individual investor based on that investor’s individual standards for achieving a goal.
It is not established by market activity; although, that may be a major influence.
The value of investment property should be based on the return and appreciation it will yield, not only on the cost to build.
The following are three considerations that influence a building’s investment value:
- Exterior considerations.
The first impression a building makes on both tenants and customers is its exterior and its environment. The visual image (curb appeal) is of great importance: building age and design, landscaping, walkways, and parking areas. Is it well maintained? What is lacking? What needs repairing? Is each repair major or minor? Is each deterioration curable (correction adds value) or incurable (correction costs more than the value added)?
- Interior considerations.
Investors need to make a deliberate and thorough inspection of the premises and make a record as the inspection progresses.
All of the following should be noted: the number and condition of each individual office or apartment (the size, layout, number of rooms and baths, and the views from each location); the overall physical quality of the building from the inside; the condition of the plumbing, hardware, carpeting, walls, appliances, and electrical fixtures; and the condition of halls, foyers, entrances, laundry rooms, storage rooms, and recreation facilities.
- Building operating expenses.
While the cost of property taxes and insurance are beyond the control of investors, these costs should be verified.
All other operating expenses should be examined carefully before investing. Have previous owners allocated annual amounts to a reserve for replacement of short-lived items (e.g., appliances, carpets, drapes)? Do recorded expenditures for repairs and maintenance reflect the approximate condition of the building? Will the investor be required to spend more in the future for maintenance and repairs?
*In many instances, the exterior and interior features of a building at first may satisfy a potential investor.
Analysis of operating expenses, however, may eliminate the property from further consideration because of unusual expenses attributable to building location, orientation, or design.
For example, there may be an abnormally high expenditure for electricity owing to faulty design or an exceptionally high expense for cooling and heating because of glass walls or inadequate insulation.
Legal Characteristics
Investors in real estate are investing in more than land, buildings, and equipment.
They are in-vesting in a bundle of legal rights and protected interests.
The value of their investment is influenced by the degree to which these rights and ownership interests are present.
Rights
Before investing, investors must determine what type of legal entity will be best to accomplish their investment objectives.
A variety of legal ownership forms are available, and each has its own legal and tax consequences.
The most commonly used forms of investment ownership are sole proprietorships, tenancies in common, joint tenancies, limited partnerships, corporations, business trusts, and REITs.
Whether a property is expected to show a tax loss or a profit frequently determines the type of ownership form to use.
The desirability of having the survivorship feature of joint tenancy sometimes determines whether to use tenancy in common.
Both a limited partnership and a corporation provide liability protection.
While the corporate form is more complex, the ability to raise capital by selling stock might influence investors to use the corporate form.
Each form of ownership offers advantages and disadvantages.
Investors should seek professional advice in determining the greatest net advantage.
Limitations
Many authorities believe that a type of risk termed legal risk is associated with real estate investments:
Risk is inherent in acquiring title to real property.
Warranty deeds and title insurance serve to minimize such risk but do not entirely eliminate it.
Additionally, litigation against real property owners because of alleged noncompliance with ordinances, tenant suits, or liability for accidents occurring on the property is a potential problem that is part of the legal risk.
An important consideration for all investors should be to determine whether the use of a site represents its highest and best use.
In most situations, the legal use of land is prescribed by zoning ordinances and represents the highest use of a site.
It is up to the potential investor to decide which of the alternative types of available improvements and uses might represent the best use, in accordance with the concept of highest and best use.
Fortunately, procedures have been developed by appraisers to assist in making such decisions.
Assessment of Risks
Risk is the chance of losing all or part of an investment. Some degree of risk is always associated with an investment.
Static risk is risk that can be transferred to an insurer such as the risk of vandalism, fire, and so forth.
Dynamic risk is risk that arises from the continual change in the business environment and, therefore, cannot be transferred to an insurer.
Risks Associated with General Business Conditions
- Business Risk.
Sometimes called operating business risk, this category of risk is associated with the degree of variance between budgeted (projected) income and expenses and actual income and expenses.
- Financial Risk.
Sometimes called operating financial risk, this category of risk is associated with the ability of a property to pay operating expenses with funds provided from operations, borrowing, and equity sources.
- Purchasing-Power Risk.
This category of risk is related to inflation.
In an inflationary period, the ability of a property to produce a good yield may be offset by a corresponding loss of purchasing power because of inflation.
After paying all expenses, a loss may result from what first appeared to be a profitable investment.
The reason is that if the rents are fixed by the lease, the gross income may not keep pace with inflation, while the operating expenses increase at the inflation rate.
- Interest-Rate Risk.
Remember the IRV formula in unit 15?
To find the value of a property using this formula, the net operating income (NOI) is divided by the rate of capitalization (required rate of return).
While debt service (financing cost) is not deducted from gross income to arrive at net income, an investor nevertheless has to pay that debt service, which effectively reduces the real yield.
Assume, for the moment, that the only change in a real estate investment is that the interest rate is raised by the lender.
The property remains unchanged, the owners remain the same, and management does not change.
However, with the increase in interest rates, the value of the property as an investment goes down. That is interest-rate risk at work.
Risks That Affect Return
Historically, businesses and individuals have put money in investments that offer the highest return commensurate with the liquidity and safety of the money.
- Liquidity Risk.
Real estate investments are particularly susceptible to liquidity risk (illiquidity).
Liquidity risk is the possible loss that may be incurred if the investment has to be converted quickly into cash.
There is no highly organized market for real estate investments, and their resale usually requires time and considerable expense.
- Safety Risk.
Safety risk is the possible loss of invested capital (return of investment) and/or expected earnings (return on investment).
Safety risk is composed of market risk (possible loss of invested capital) and risk of default (possible loss of earnings):
- Market risk is the type of risk associated with a decrease in the market value of an investment as a result of increased interest rates (the interest-rate risk at work).
Often, market risk is magnified by long periods of time. Leaving the money invested exposed to the cyclical gyrations of the money markets over extended periods increases the risk of loss. For example, savings associations can lose money by holding long-term investments in low-yielding mortgages.
- Risk of default is the risk that promised earnings will be lost by the investor because of the failure of the investment to earn as expected.
If everything were equal, an investor would prefer a liquid, short-term investment because less risk would be involved.
However, the possibility of a higher yield will induce some investors to commit funds to a less-liquid, long-term investment.
It is a basic economic premise that risk and the desired rate of return are directly related (e.g., high risk, high return).
Leverage
Leverage is the use of borrowed funds to finance the purchase of an asset.
Leverage is the use of other people’s money to make more money.
Most investors use leverage to increase their purchasing power.
For example, an investor purchases a property for $1 million and 10% down. The investor has increased purchasing power by using borrowed funds to purchase a property costing 10 times the cash investment.
An investor’s goal is not only to increase purchasing power but also to earn a higher return on equity.
The investor wants an investment property that can produce cash flow in excess of the cost of borrowing the funds.
- If the benefits from borrowing exceed the costs of borrowing, it is called positive leverage.
- If the borrowed funds cost more than they are producing, it is called negative leverage.
To understand the impact of leveraging, consider a property that costs $100,000 and produces net income of $10,000 per year.
If purchased for cash, the investor’s annual rate of return on the equity invested is 10% ($10,000 income ÷ $100,000 equity).
Assume instead that this investor leverages the purchase by borrowing $75,000 at 8% ($6,000 interest) annually and makes a down payment of $25,000.
The $10,000 income earned from the investment in the previous example is reduced by the cost of financing to $4,000.
The resulting return on equity invested is an attractive 16% ($4,000 income taking into account financing cost ÷ $25,000 equity = .16 or 16% rate of return on equity). This is positive leverage at work!
The higher the interest rate and the higher the loan-to-value ratio, the more cash flow from operations required to pay the principal and interest payments.
If cash flow is reduced by in-creasing vacancy rates or an overzealous earnings forecast, the risk is greater because the larger the loan amount, the greater the chances that the investor will either have to invest more out-of-pocket funds or default on the mortgage.
This increased risk is the price an investor pays for the higher potential benefits of leverage.
Business Brokerage
Business brokers and business entities engaged in the sale, purchase, or lease of businesses must qualify and hold a real estate licenses.
Business brokerages may be classified into business enterprise brokerages and business opportunity brokerages.
- Business enterprise brokers normally deal in corporate transactions involving the sale and purchase of businesses that provide goods and/or services.
Ordinarily, business enterprises are large transactions usually involving the purchase or exchange of corporate stock and the purchase of corporate assets (an asset is anything of value). - Business opportunity brokers typically deal in the sale and purchase of smaller businesses, such as sole proprietorships.
These businesses have limited amounts of fixed assets (e.g., real property, equipment).
Sometimes, the real estate owned by the business is the primary component of value.
Other times, the real estate involved is in the form of a lease.
Most business leases are assignable.
Whether an existing lease is assigned to the new business owner depends on the terms of the lease.
Business brokers must understand and be able to value a business opportunity, including tangible assets and intangible assets.
A tangible asset can be touched and has actual substance such as inventory.
Intangible assets are assets that cannot be touched and that do not have actual substance such as a business opportunity’s reputation.
Similarities to Real Estate Brokerage
The sale of real property or an assignment of a long-term lease is typically involved in business brokerage activities.
Business brokerage activities requires a real estate license under Chapter 475, Part I, F.S.
