Chapter 17: Real Estate Investments & Business Opportunity Brokerage

Question 1

Investment Analysis

Answer 1

A thorough analysis is critical when evaluating the potential of a real estate investment. Investment analysis must take into consideration land use controls, such as zoning, deed restrictions, and permitting requirements that affect the value of a property. Investment analysis considers economic forces, such as population growth, investment of foreign capital, and the impact of taxation on real estate investments. The most important factor underlying every investment decision is economic soundness.

The process of investment analysis begins with the search for and location of potentially desirable real estate investments that are based upon the investor’s personal objectives. Real estate licensees should be capable of evaluating the advantages and disadvantages of a potential real estate investment compared to alternative investments.

Question 2

Advantages and Rewards

Answer 2

real estate investors can receive potentially significant rewards from real estate investments that include income generated by the property, a build-up of equity, appreciation in value, tax benefits, positive leverage, and prestige. Investment in real estate can also serve as a hedge against inflation when the property has level-payment mortgage where the payments remain the same, but the rental income increases with inflation.

Question 3

Disadvantages

Answer 3

disadvantages of investing in real estate include the illiquidity of property (it cannot be bought or sold as quickly as other assets), the local (immobile) nature of the real estate market compared to other types of investments that can be bought and sold in a variety of markets, the expense or overhead required to manage the property or hire a property manager, and the need for additional investment assistance from experts such as brokers, tax accountants, and other professionals.

Question 4

Types of Investment Properties

Answer 4

1. Agricultural
2. Business Opportunities
3. Commercial
4. Industrial
5. Office
6. Residential

Question 5

Agricultural

Answer 5

agricultural property investors have many different motivations for investing in agricultural land. Some investors wish to personally engage in agricultural endeavors, while others may own the land and lease it to others for agricultural activities. Investors may also purchase agricultural land in the path of growth, allowing for lower taxes through agricultural exemptions, before ultimately selling or developing the property.

Question 6

Business Opportunities

Answer 6

are typically smaller local businesses, such as barbershops, hair salons, print shops, corner stores, and boat rental businesses. Often an investor may be looking for a small business that he or she could own and manage, creating an income for him or herself. Business opportunities are normally values based upon applying a multiplier to the net income being produced by the business. Value may also be applied to intangible assets such as a business’s name or reputation in the community.

Question 7

Commercial

Answer 7

commercial investment properties include retail centers, such as regional shopping centers usually located near major transportation routes. Major retail centers attract anchor tenants that draw people to the center. Typically, these are the name-brand department stores in which people plan to shop. They are called generative functions, since they generate customer traffic to the center. Suscipient functions are businesses that attract passersby, such as card and gift shops, ice cream and novelty stores, and so on.

Question 8

Industrial

Answer 8

industrial investment properties involve manufacturing, assembly, and distribution. These properties are located most often near major transportation arteries. Weight-reducing operations, such as mining operations, prefer locations near the source of their raw materials. Weight-gaining operations, such as assembly plants, prefer locations close to their market areas in order to reduce transportation costs.

Question 9

Office

Answer 9

office investment properties are usually located in central business districts or professional office parks in suburban areas near their tenant base. Offices are usually good long-term investments since office tenants generally lease for extended periods.

Question 10

Residential

Answer 10

Residential investment property is available in a wide range of prices. Important factors to be considered when selecting residential properties are location, availability of transportation, schools, and shopping. Typical residential investments include condominiums, villas, single-family homes, and apartment complexes.

Question 11

Real Estate Investment Trusts (REITs)

Answer 11

A real estate investment trust (REIT) is a type of business trust that allows groups of investors to invest in income-producing property. A REIT provides a method for individuals to pool financial resources to invest in larger, professionally managed properties.

Investment trusts invest in office buildings, large apartment complexes, and retail centers.

Purchasing shares in a REIT is similar to purchasing shares in a mutual fund.

Question 12

Amount Realized

Answer 12

The amount realized, also referred to as net proceeds from sale, is expressed by the following formula:
Amount Realized = Sale Price – Costs of Sale

Sale price is the total amount the seller receives for the sale, including money, notes, mortgages, or other debts the buyer assumes as part of the sale. The costs of sale include brokerage commissions, relevant advertising, legal fees, seller-paid points, and other closing costs paid by the seller.

Question 13

Basis

Answer 13

Or cost basis, is the original value of an asset for tax purposes. When purchasing a home, the basis includes the purchase price and any associated acquisition costs.

Basis is used to determine the gain or loss on the sale, exchange, or other disposition of a property.

Question 14

Adjusted basis

Answer 14

Adjusted basis is a measurement of how much is invested in a property for tax purposes, including any IRS-allowed improvements, referred to as capital improvements. Examples of capital improvements include a new addition to the home, paving the driveway, replacing the roof, installing central air conditioning, and rewiring the home. By adding the cost of improvements to the basis, the amount of gain is reduced, thereby decreasing the amount of capital gains tax otherwise owed.

The adjusted basis may also include certain IRS-allowed reductions including such items as depreciation of investment property, casualty losses, and residential energy credits.

Question 15

The basic formula for adjusted basis is

Answer 15

Adjusted Basis = Cost Basis + Increases - Decreases

Question 16

Capital Gain/ Loss

Answer 16

A capital gain is an increase in the value of an asset, such as personal or investment property, that gives it a higher value than the cost of purchasing the asset. If a property sells for more than the purchase costs, there is a capital gain. A capital loss is incurred when there is a decrease in the value of an asset that gives it a lower value than the cost of purchasing the asset.

A capital gain or loss is not realized until the property is sold. A capital gain may be short term (one year or less) or long term (more than one year) and must be claimed on the investor’s tax return.

Question 17

The capital gain formula

Answer 17

Gain = Amount Realized – Adjusted Basis

Question 18

Cash Flow

Answer 18

Cash flow is the movement of money into or out of a business or investment, measured over a period-of-time. Generally speaking, cash flow is the money that remains after all the income, such as rents, are collected and all the day-to-day expenses associated with owning the property are paid.

Question 19

Cash Flow can be ongoing or

Answer 19

one-time. Ongoing cash flows are received by the investor throughout the investment holding period, as in rental income. One-time cash flows are sales proceeds received as a result of the sale of an investment property.

Question 20

Positive Cash Flow

Answer 20

occurs when there is more money coming in than going out, resulting in money remaining.

Question 21

Negative Cash Flow

Answer 21

occurs when there is more money going out than coming in, resulting in a deficiency that the investor or business owner must pay out of pocket.

Question 22

What type of cash flow do most investors and business owners desire?

Answer 22

a positive cash flow in order to achieve a profit and a high rate of return on their investment. However, there are tax benefits to negative cash flows.

Question 23

Appreciation

Answer 23

is an increase in the value of an investment over time. Investment property can appreciate in value for many reasons, such as inflation, supply and demand, and capital improvements. Most real estate investors purchase income property with the goal of realizing a positive cash flow and appreciation.

Question 24

Tax Depreciation

Answer 24

also referred to as cost recovery, is an income tax deduction that allows a taxpayer to recover the cost of investment property over a number of years.

Question 25

Tax Shelter

Answer 25

A tax shelter is a legal method of minimizing or decreasing an investor’s taxable income, and therefore, his or her tax liability. Depreciation of a real estate investment can reduce an investor’s taxable income and is, therefore, a form of tax shelter.

Question 26

Equity

Answer 26

Equity is the difference between the current market value of a property and the amount the owner still owes on the mortgage. The initial down payment creates equity. Additional equity is created through principal reduction and appreciation.

Question 27

Equity advantage for investor

Answer 27

One advantage of investing in real estate is the equity build-up that can occur on mortgaged rental property. An investor who collects rent from a tenant can use the rental income to pay expenses and reduce the principal amount of the loan, which can increase the equity in the property. Over time, the tenant essentially pays for the property to the benefit of the investor. Some investors consider equity build-up as a good use of cash flows when the interest rates on savings accounts and certificates of deposits are lower than the rate of return on the investment property.

Question 28

Liquidity

Answer 28

Liquidity refers to an asset’s ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value. Cash is the most liquid asset.

Question 29

Liquid Asset

Answer 29

A liquid asset can be sold rapidly with minimal loss of value. The essential characteristic of a liquid market is that there are ready and willing buyers and sellers at all times.

Question 30

Iliquid asset

Answer 30

An illiquid asset is one which is not readily saleable due to uncertainty about its value or lull in the market in which it is regularly traded. One disadvantage of investing in real property is that property is considered an illiquid asset, which cannot be transferred as easily as other assets, such as stocks or bonds.

Question 31

Risk

Answer 31

Risk is the possibility of losing all or part of the investment. Every investment involves a certain degree of risk. Investors attempt to evaluate and minimize risk. There are two primary types of risk: dynamic and static.

Question 32

Dynamic Risk

Answer 32

is risk associated with changes in general market conditions.

Question 33

Static Risk

Answer 33

is risk that can be offset with insurance, such as fire, flood, robbery, and so on.

Question 34

A feasibility study

Answer 34

A feasibility study is used as a basis for making a real estate investment decision. The feasibility study assesses financial, government, legal, social, physical, and locational factors that may influence the investor’s decisions, based on anticipated risk and potential reward.

Question 35

Types of dynamic risk

Answer 35

1. Business risk 2. Financial risk 3. Inflationary risk 4. Interest rate risk 5. Liquidity risk 6. Market risk

Question 36

Business risk

Answer 36

is the possibility that an investment will yield lower than anticipated profits, or that it will experience loss rather than a profit. Business risk is measured by comparing actual income and expenses to budgeted income and expenses. If expenses are higher than projected, and/or income is lower than projected, the investment could be in jeopardy.

Question 37

Financial risk

Answer 37

is associated with extremely high expenses and/or extremely low income. The investor may be faced with adding to the original investment to keep it in operation. In the alternative, the investor may have to borrow more money or sell other assets to raise capital to prevent losing the investment. If an investor is unable to make the required payments on their debt obligations, they risk defaulting on the loan.

Question 38

Inflationary risk

Answer 38

or purchasing-power risk, is the risk that future inflation will cause a decrease in purchasing power of the currency, resulting in a rise in the cost of goods and services. Inflation causes the investor’s expenses to increase. Potential buyers may also law the purchasing power to buy the property.

Question 39

Interest rate risk

Answer 39

is the effect of the economy on the investment. If the value of a dollar increases or decreases because of inflation or deflation, interest rates could increase or decrease, which may affect the value of the investment or reduce the likelihood of selling it.

Question 40

Liquidity risk

Answer 40

is the risk that an investment property cannot be bought or sold quickly enough to prevent or minimize loss.

Question 41

Market risk

Answer 41

is the possibility for an investor to experience losses due the effect of the national or local real estate market. There are many sources of market risk that can affect the real estate market, including recessions, unemployment rates, availability of financing, changes in the economy, and other local conditions affecting specific markets.

Question 42

Leverage

Answer 42

Leverage is the use of borrowed funds to purchase assets. Most investors make real estate investments with borrowed money. Positive leverage allows an investor to earn a higher rate of return on funds invested by borrowing than they could earn by paying cash for the investment. Financial leverage can be either positive or negative.

Question 43

Positive leverage

Answer 43

occurs if the investment returns more to the investor than the cost of borrowing the money necessary to purchase the investment.

Question 44

Negative leverage

Answer 44

occurs if the investment returns less to the investor than the cost of borrowing the money necessary to purchase the investment.

Question 45

Leverage for investor

Answer 45

In most instances, an investor will use leverage to purchase real estate because of the expectation of positive leverage. However, highly leveraged investments require cash flows from the property to make the mortgage payments; debt service that is too high may make that impossible.

Question 46

Reconstructed Operating Statement

Answer 46

Evaluating an investment property begins with the preparation of a reconstructed operating statement, showing annual forecasts of income and expenses over a period of time. Required rates of return based on forecasted income, expenses, risk, and length of the ownership period are applied to estimate the value of the property. The rate used to estimate value is dictated by the individual investor’s requirements, but tempered by a competitive market.

Question 47

An analysis of the past income and expenses

Answer 47

An analysis of the past income and expenses of an income-producing property can help to evaluate the future income of the property. However, it should be noted that new ownership and new management often result in a change in the operating characteristics of a property.

Question 48

Historical information is obtained from

Answer 48

Historical information is obtained from current owners to serve as a basis for making projections, but cannot always be relied upon. Consequently, figures obtained from the current owner must be evaluated based on the individual investor’s requirements and allowances made for any changes that are anticipated in income and expenses.

Question 49

Analysis must be based on

Answer 49

As a result, the analysis must be based on revised historical operating data. In this case, the reconstructed operating statement includes items not included by the current owner and deletes items that are not expected to recur. Other figures may be increased or decreased based on the investor’s operating philosophy and management.

Question 50

Calculating the Net Result of Investment

Answer 50

The forecast of income and expenses is performed in the same manner as with income approach “stack formula”. However, investment analysis goes beyond the calculation of the net operating income and considers the effect of financing and taxation on the investment.

Question 51

Net Result of Investment formula

Answer 51

PGI = Potential Gross income -V&C = Vacancy and Collection losses +OI = Other Income (other than rent) EGI = Effective Gross Income -OE = Operating Expenses (FE + VE + Reserve) NOI =Net Operating Income -ADS = Annual Debt Service (one year’s mortgage payments) CTO = Cash Throw-Off (BTCF, Before-Tax Cash Flow)

Question 52

Operating Expenses (OE)

Answer 52

Operating expenses include fixed expenses, variable expenses, and a reserve for replacements.

Question 53

Fixed Expenses (FE)

Answer 53

includes costs that do not change with the level of occupancy, such as real estate taxes and hazard insurance.

Question 54

Variable Expenses (VE)

Answer 54

changes with the level of occupancy and include costs, such as management fees, maintenance, utilities, yard care, janitorial, etc.

Question 55

Reserve for Replacements (R)

Answer 55

is a noncash expense. This money is for future use to replace worn-out components, called short-lived items, such as carpeting, appliances, central heat and air systems, roof coverings, and so on.

Question 56

What is not considered an operating expense

Answer 56

Mortgage payments, called debt service, are not considered an operating expense. Real estate does not borrow money, people do. This type and amount of financing is dictated by the needs of the investor, not the property. It would be inappropriate to charge the property for something unrelated to its operation.

Question 57

Before- and After- tax Cash Flow

Answer 57

After the net operating income is estimated, debt service is subtracted to obtain the cash throw-off (CTO). This is also called the before-tax cash flow (BTCF). Investors will be concerned with an additional computation to determine the after-tax cash flow (ATCF), which is beyond the scope of the pre-license course. NOI = Net Operating Income -ADS = Annual Debt Service CTO = Cash Throw-off (BTCF)

Question 58

Applying Ratios for Analysis

Answer 58

The objective of real estate investment analysis is to assist an investor in choosing the best property available among available alternatives and to base a price decision on the analysis performed. Applying ratios to the forecasted income and expenses can facilitate analysis. Ratios commonly used in the evaluation of income properties include the operating expense ratio and the loan-to-value ratio.

Question 59

Operating Expense Ratio

Answer 59

expresses the relationship between the expenses incurred in operating the property (the operating expenses) with the amount the investor actually receives (the effective gross income). This relationship is expressed as a percentage or ratio. The formula is as follows: Operating Expense Ratio = Operating Expenses (OE) ÷ Effective Gross Income (EGI)

Question 60

Loan-to-Value Ratio (LTV)

Answer 60

measures financial risk in an investment by comparing the mortgage loan amount to the price, or value, of the property. This ratio indicates the percentage of the property value that is represented by debt. A higher LTV ratio increases the risk of the borrower’s default. The formula is as follows: Loan-to-value (LTV) ratio = Loan amount ÷ Property value

Question 61

Calculating Profit on Investment

Answer 61

Profits from investments are calculated on the amount that is originally invested, not on the amount received when the investment is sold or liquidated. The following formula is used to determine the profit based on the original investment amount paid: Profit % = Amount Made ÷ Original Amount Paid The amount made is the amount left over after subtracting the amount paid from the amount received from the liquidation or sale.

Question 62

Calculating Rate of Return (ROR)

Answer 62

The money made in an investment is referred to as the return. The investment amount made with the original purchase is referred to as the capital, or capital investment. The return from an investment is calculated based upon the capital investment. Investors want to achieve a high rate of return. The IRV formula discussed in Chapter 16 to derive capitalization rates can also be used to calculate the rate of return (ROR). Dividing the net operating income (NOI) by the investment value will provide the investor with the ROR. Rate of return (ROR) = Net operating income (NOI) ÷ Investment value

Question 63

Equity Dividend Ratio

Answer 63

If the investor wishes to determine the rate that is being received based upon the actual equity invested (vs. the rate on the overall investment), then an equity dividend ratio would be used. The formula for equity dividend ratio (EDR) is: Equity dividend ratio (EDR = Cash throw off (CTO) ÷ Original equity The equity dividend ratio provides the investor with a more accurate picture as to the return on the money actually invested.

Question 64

Applying a Loan Constant

Answer 64

A loan constant is an interest and principal factor used to calculate a level monthly payment necessary to pay off both principal and interest over the term of the loan. Today, financial calculators and computers are typically used to calculate payments and amortization schedules. In the past, booklets were published where the interest rate and term of the loan were matched to arrive at a constant. The constant was then applied to the original loan amount to determine the monthly payment.

Question 65

The Impact of Federal Taxation

Answer 65

Real estate investment strategies and long-term planning of investment portfolios are impacted by federal taxation. Since taxation is an important consideration in all real estate transactions, real estate licensees must be knowledgeable concerning tax matters. However, they must also exercise extreme caution to avoid giving advice regarding tax matters. Investors should be advised to seek the advice of qualified experts in the field of taxation. The Tax Reform Act of 1986, the Tax Act of 1993, the Taxpayer Relief Act of 1997, and revisions to the tax code made in 2003 have made significant changes in tax treatment associated with real estate.

Question 66

Deduction of Depreciation

Answer 66

One benefit that is not available to homeowners but is available to investors and the owners of businesses is the ability to deduct a portion of the money that they have invested in their property each year from their gross income. This deduction is referred to as cost recovery, or tax depreciation.

Question 67

Modified Accelerated Cost Recovery System (MACRS)

Answer 67

MACRS was adopted in 1986, thereby replacing the Accelerated Cost Recovery System that was implemented in 1980. Cost recovery, in the language of the tax code, refers to tax depreciation. The MACRS stipulates the time periods over which investment real estate can be depreciated for tax purposes. The time period begins when the property is placed in service, which, essentially, means the time in which title is taken.

Question 68

Residential: Depreciate over 27.5 years

Answer 68

Tax law currently allows the owners of residential and low-income investment properties to depreciate a portion of their investment over 27.5 years on a straight-line basis. The residential category includes single-family rentals, all apartment rentals, and mobile homes.

Question 69

Nonresidential: Depreciate over 39 years

Answer 69

The owners of nonresidential investment properties may depreciate a portion of their investment over 39 years, also on a straight-line basis. Hotels and motels are classified as nonresidential. To calculate the amount of the allowable deduction, the total cost of acquisition, including the total cost of the property plus closing costs, is allocated on a percentage basis to the land and improvements. The basis for depreciation is that portion of the total cost, including closing costs, which applies to the improvements. Land cannot be depreciated. This amount is evenly divided by the number of years allowed, either 27.5 or 39, depending on the type of property. That is what is meant by straight-line; the same dollar amount is deducted each year. This percentage can be calculated by having an appraisal made or using the percentages of land and improvements utilized by the property appraiser’s office. The basis is reduced each year by the amount allowed until the total depreciable basis equals zero or the property is sold.

Question 70

Capital Gains Tax

Answer 70

Capital gain is profit made when an income property is sold. If tax depreciation has been deducted during the ownership period, the proceeds of a sale will be taxed at two different rates. The capital gains tax rate is for capital assets held over 12 months. A portion of depreciation claimed during the ownership must be recaptured at the time of sale, and is taxed at a depreciation recapture rate of 25%. Profit made on the sale of property owned for a period of 12 months or less is taxed at the investor’s ordinary tax rate.

Question 71

Income Classification

Answer 71

Under the Tax Reform Act of 1986, income must be separated into three categories: - Active Income: from salaries and wages - Passive Income: from rental activity and any investments in which the investor does not materially participate. - Portfolio Income: from dividends The significance of the separation of income into separate categories is that a loss cannot be offset against income from another classification; it can be offset only by income in the same classification. This is in order to eliminate many forms of tax shelters, and to expose more income to federal income tax. Losses that cannot be offset by gains in any given year must be carried forward to subsequent years; they may not be deducted against income from other sources such as salary, interest, dividends, or other active business income. If a property is sold at a gain, any losses from previous years may be used to offset losses carried forward.

Question 72

Income Classification: Limited exception

Answer 72

A limited exception is when a small investor has an opportunity to retain a tax shelter advantage. An investor with an adjusted gross income of $100,000 or less may offset up to $25,000 of passive losses against active portfolio income as long as, management decisions are made by the taxpayer, the taxpayer owns at least 10% of the investment, and the adjusted gross income of the taxpayer is below $100,000. This benefit is phased out on a percentage basis when the investor’s income rises above $100,000, and is eliminated when the investor’s income is above $150,000. This limited exception exists even if a rental agent or property management firm handles the property. Management decisions include approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions.

Question 73

Income Classification: the exception for real estate licensees

Answer 73

is found in the Tax Law of 1993 that provides additional relief for real estate licensees who spend a minimum of 750 hours per year in the real estate business and incur passive loss from rental activities. Licensees who own investment real estate should contact their tax accountants for clarification of this provision.

Question 74

What are the two methods an investor can use when a property is sold to reduce or defer the amount of tax due on the transaction?

Answer 74

1. Tax-deferred Exchange | 2. Installment Sale

Question 75

Tax-deferred Exchange

Answer 75

allows any capital gain realized from the sale of investment property to be transferred into another property by exchanging properties with another investor. An investment real estate that is exchanged for other investment real estate is called a like-kind exchange. The problem with this type of transaction is that most properties do not have the same value. Therefore, in order to conclude the exchange, investors often include cash, or other forms of unlike property, to equalize the transaction. Unlike property received in a tax-deferred exchange is called boot and is taxable to the recipient. To the extent that the equities are equal, the capital gain is deferred, or postponed, until the property is sold. Note that this does not eliminate the tax; it is allowed to be recognized in a later tax year. This can be an advantage in tax planning, particularly when an investor expects to be in a lower income tax bracket in future years.

Question 76

Installment Sale

Answer 76

is a form of seller financing. No down payment is required to qualify as an installment sale. It qualifies as long as at least one payment is received in a tax year subsequent to the year of sale. Under installment sale treatment, only the percentage of gain received in any given year is taxable. Therefore, the gain can be spread over several years, thereby reducing the amount of tax due in any tax year.

Question 77

Investment Interest Limitations

Answer 77

Deduction of investment interest is limited to the amount of net investment income within the tax year. The investment interest limitation applies to all interest paid for tax years beginning after December 31, 1986, regardless of when the debt was incurred. - Investment Interest: is all interest charged on debt that is not incurred in connection with the taxpayer’s primary trade or business. - Investment Income: Is gross income from interest, dividends, rents, royalties, and income not derived from a trade or business. - Net Investment Income: is the excess of investment income over investment expense.

Question 78

At-Risk Rules

Answer 78

A taxpayer may deduct losses from an activity only to the extent of the amount of investments capital that is at risk. Retained provisions if the Tax Reform Act of 1986 include credits for a taxpayer who restore a historical building. The Act also provides credits for qualified low-income housing projects.

Question 79

Sale or Lease of a Business

Answer 79

A business brokerage offers real estate services that are connected with the sale or lease of businesses. The sale of a business may or may not include the sale of real property.

Question 80

Regulated by F.S. 475 as a Real Estate Transaction

Answer 80

The sale or lease of a business is a real estate transaction. Persons and firms that offer brokerage services connected with the sale or lease of a business are regulated by F.S. 475, and must hold a real estate license. Regulation of business brokerage became effective in 1982. The legislature believed a real estate license should be required in the brokerage of a business since the transaction almost always involves either the sale of real estate or negotiation of a lease.

Question 81

Dealing in Securities Requires a Separate License

Answer 81

The sale of a business may involve the transfer of ownership of shares of stock, limited partnership interests, or other forms of securities. Persons who deal in securities are required to have a separate license. Real estate licensees must be certain that securities laws are not violated when listing or selling a business.

Question 82

Business Broker May Need a Securities License

Answer 82

A real estate licensee may also need to hold a securities license if the transaction includes the transfer of corporate stock or limited partnership interests. Legal counsel is strongly advised before proceeding with the sale of a business.

Question 83

Business Brokerage: Expertise Required

Answer 83

Business brokerage consists primarily of analyzing financial statements. Those engaged in this aspect of real estate are required to have knowledge concerning business formations, and be able to read and understand operating statements and financial balance sheets. An income statement is a history of income and expenses over a stated period, such as a month or a year. A balance sheet reflects the financial condition of a business as of a particular time. Generally, business brokers work in conjunction with certified public accountants and attorneys, requiring an understanding of corporate finance and knowledge regarding the classes and characteristics of corporate stock, securities analysis and valuation, capital management, and budgeting. A business broker must have knowledge regarding business accounting, including classes of assets and liabilities, income statement analysis, balance sheet analysis, cash-flow analysis, asset depreciation methods, and taxation.

Question 84

Business Enterprise

Answer 84

involves transactions that are in excess of $200,000. The brokerage of larger businesses usually involves the transfer of stock shares or other types of security. The transaction may or may not involve the sale of real estate. If not, negotiation of a lease may be required. Markets for business enterprises are typically wider in geographic scope than markets for individual parcels of real estate.

Question 85

Business Opportunity

Answer 85

involves smaller businesses with sales prices of $200,000 or less. These businesses typically have a limited amount of assets. The ownership of such businesses may also involve securities, but many are sole proprietorships or partnerships that do not. The sale of many of these businesses involves only the sale of inventory and fixtures, and an assignment of a lease.

Question 86

Assets

Answer 86

are items of value that are owned by a business. Assets include accounts and promissory notes receivable, cash, inventory, production machinery, real estate, personal property, patents, trademarks, and goodwill (the value of the name of the business in the marketplace).

Question 87

Liabilities

Answer 87

are debts that are owed by a business. Liabilities include accounts and notes payable, and long and short-term debt. Short-term liabilities are debts that must be recognized within one year or less. Long-term liabilities are debts that will not come due for more than a year, such as mortgage balances.

Question 88

Owner's Equity

Answer 88

is the difference between assets and liabilities.

Question 89

Basic Accounting Formula

Answer 89

Assets – Liabilities = Owner equity

Question 90

Capital

Answer 90

is the total amount that is invested. Capital includes the funds that were used to start the enterprise, money that is invested during operation, and retained capital.

Question 91

Tangible Assets

Answer 91

are assets that have physical existence such as buildings, furniture, office equipment, and so on.

Question 92

Intangible Assets

Answer 92

have no physical existence, but have monetary value. Intangible assets include stock shares, trademarks, copyrights, research and development expenses, noncompetition contracts, franchises, and goodwill.

Question 93

Reasons for a Business Appraisal

Answer 93

Business owners or potential purchasers may request an appraisal in order to establish a sales or purchase price, obtain a loan, or for insurance purposes. Other reasons include condemnation, buy-sell agreements, property settlements, estate settlements, or to be used in connection with employee stock option plans.

Question 94

Liquidation Value Approach

Answer 94

The comparable sales approach, cost-depreciation approach, and income approach can all be used to appraise a business. A fourth method, the liquidation value approach, may also be used. This approach is unique to the valuation of a business. Liquidation value is the value that remains after liquidating all the assets of the business and satisfying all the liabilities. This approach is used to value a failing business that is not expected to continue to do business. It can also be used to establish the minimum value of a profitable business.

Question 95

Going Concern Value

Answer 95

The appraisal of a profitable business presents a unique challenge. The value of the business is not just the value of any real estate owned, but rather, a composite of the values of the real estate, personal property, and intangible assets, such as licenses, franchises, noncompetition contracts, and so on. When the value of all assets is combined, it creates what is known as going concern value.

Question 96

Uniform Commercial Code (UCC)

Answer 96

The UCC is a body of standardized rules that regulate commercial transactions throughout the nation by focusing on the sale and financing of personal property. Florida has adopted a version of the UCC as law. When personal property is sold in a commercial transaction, a Bill of Sale is used to identify the property conveyed. This document is similar to a deed. If financing is involved, a standard Security Agreement is used to identify the property that is security for the debt. The Security Agreement is similar to a mortgage and is usually recorded to protect the lender’s interest in the property. An attorney muse be retained to prepare documents used in compliance with the UCC; real estate licensees may not prepare these on behalf of customers or principals.

Question 97

Steps in the Sale of a Business

Answer 97

1. Acquire the listing 2. List the assets 3. Valuation 4. Deduct liabilities 5. Valuation of stock 6. Legal compliance 7. Close the transaction

Question 98

Acquire the Listing

Answer 98

The listing process is virtually the same as listing other property for sale.

Question 99

List the assets

Answer 99

A detailed list of all tangible and intangible assets is required.

Question 100

Valuation

Answer 100

Estimate the value of the business by using the appropriate appraisal methods.

Question 101

Deduct liabilities

Answer 101

The value established in Step 3 must be reduced by the amount of liabilities, long- and short-term. This includes the value of any preferred, outstanding stock.

Question 102

Valuation of stock

Answer 102

If a corporation is being sold by transferring shares of stock, the share value must be determined. Divide the net value of the business by the number of shares to determine the per-share value.

Question 103

Legal compliance

Answer 103

Review the transaction carefully before proceeding in order to be certain that all laws have been complied with. This includes real estate, securities, mortgage brokerage licensing laws, and UCC requirements.

Question 104

Close the transaction

Answer 104

Locate a buyer who is interested in the business and conclude the sale.