Lesson 1 Flashcards
Payback period
The length of time required for the stream of cash flows produced by the investment to equal the original cash outlay. When deciding between investment options, and all other investment decision-making criteria being equal, the investment with the shortest payback period is considered the better investment.
Characteristics of real estate assets (ILIT)
Immobility, longevity, indivisibility, tax benefits. These characteristics differentiate real estate assets from many other investments and can impact the level, timing, or riskiness of the future benefits of a real estate asset compared to other investments.
Economic life
The period over which improvements to real property contribute to property value. The economic life of a real estate asset can be, and generally is, shorter than its physical life.
Holding period
The time from purchase to the subsequent sale of an asset. Apartment and commercial properties have an average holding period of approximately 5 years.
Characteristics of real estate markets (LHDG)
Localization, high information and transaction costs, discontinuous price information, government intervention
Characteristics of competitive market
1) Many buyers and many sellers in the market 2) Goods offered by the various sellers are largely the same
Characteristics of efficient market
1) Real estate investors act quickly on any information they receive 2) Prices adjust rapidly on receipt of the information
Advantages of real estate investments (HFTI)
High returns, financial leverage, tax sheltering, inflation hedge
When can higher returns exist in a market?
Higher than normal returns can only exist in a market if either the investments have greater risk or the market is non-competitive or non-efficient. In a competitive market, an investor can earn higher returns only by choosing riskier investments.
Financial leverage
The use of fixed-cost debt in an investment to increase the return to the equity investor. They key element in financial leverage is having debt financing where costs are a set percentage of the loan amount and the lender does not otherwise participate in the benefit flows of the investment.
Tax shelter
An investment that reduces or defers an investor’s income tax liability. Tax shelter benefits in a real estate investment can result from the investor being able to deduct from taxable income certain expenses that do not represent a cash outlay in the investment.
Inflation hedge
An investment that offers an investor protection against the loss of purchasing power resulting from the rising prices of goods and services to the degree that the investor’s equity increases in value at a rate equal to or greater than inflation. Key characteristics of real estate that enable it to be a potential inflation hedge are supply inelasticity and responsiveness of rents to inflation.
Disadvantages of real estate investments (FIIM)
Financial risk, interest rate risk, illiquidity, management
Financial risk
The risk to an investor created by financial leverage. The higher the LTV ratio of the financing of an investment (assuming non-participatory debt), the great the variation of equity flows and returns from a change in NOI (or property appreciation) and the higher the level of financial risk
Interest rate risk
The investment risk resulting from volatile interest rates. Interest rate volatility increases the risk in real estate investment by causing the cost of mortgage debt at renewal to be highly uncertain. The higher the degree of financial leverage, the greater the decline in rates of return from an increase in interest rates.
Illiquidity: a) definition, b) 2 factors upon which liquidity in property markets is dependent
Inability of an asset to be readily converted into cash. The liquidity of property markets is dependent upon the number of participants in these markets and whether barriers to market entry exist in the form of capital constraints
Management
Directing or conducting business affairs, including maintenance, repair, determination and receipt of revenues and payment of expenses, and leasing of real property
Steps in the investment analysis process (ICPAM)
- Identify investor’s decision framework
- Collect market information
- Perform financial analysis
- Apply selection criteria
- Make investment decisions
Selection criteria categories
- Basic or first year measures
- Discounted cash flow techniques
- Portfolio analysis
Basic or first year measures
Limit the analysis to only the benefits and costs in the first year of the holding period
Discounted cash flow techniques: a) vs first year measures, b) underlying concept
Go beyond the basic or first year measures by bringing into the analysis the projected net benefit flows after the first year of the investment. The concept underlying these techniques is that the value of a real estate investment is equal to the present value of future cash flows.
Decision criteria (DCF techniques)
NPV ≥ 0
IRR ≥ investor’s target rate
Payback period ≤ investor’s target time frame
Where a feasibility study may be useful
- Developing a site
- Site search
- Investment consultant
8 steps in the valuation process
- Identification of the problem 2. Scope of work determination 3. Data collection and property description 4. Data analysis 5. Site value opinion 6. Application of the approaches to value 7. Reconciliations of value indications and final opinions of value 8. Report of defined value
Mortgage constant
Annual debt service / loan amount
Determinants of asset value
Level, timing, and riskiness of future benefits
Real estate market imperfections
a) Barriers to entry: high information costs due to localized nature of real estate sub-markets, possible capital constraints created by the indivisibility of real estate assets
b) Information inefficiencies: localized sub-markets, varying levels of access to and cost of information between investors
Advantages to real estate investment market of financial leverage
Reduces market inefficiency by lowering capital constraints and reducing effect of asset indivisibility as one of the barriers to entry, increasing participation in real estate investment markets
