Transcript Investments in Real Assets

Prof. Hagen Sinodoru, MBA • Banking and Finance • www.sinodoru.com
St. Petersburg State University of Economics and Finance
Chapter 20
McGraw-Hill/Irwin
Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
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Understand the advantages and disadvantages of real assets
Explain the portfolio significance of the correlations between real
estate and other assets
Explain the characteristics of investing in real estate
Discuss the various forms of financing for real estate
investments
Explain the traditional appeal of precious metals as a form of
investments
Understand the factors that influence the value of collectibles
20-2
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Advantages and Disadvantages of Real Assets
Real Estate as an Investment
Real Estate Returns and Correlations
Valuation of Real Estate
Forms of Real Estate Ownership
Gold and Silver
Precious Gems
Other Collectibles
Appendix 20A: A Comprehensive Analysis for Real
Estate Investment Decisions
20-3
Real assets are tangible assets that may be:
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Seen
Felt
Held
Collected
Real assets during inflationary environments
have at times outperformed financial assets.
Examples:
• Real estate
• Gold and silver
• Diamonds
• Coins, stamps, and antiques
20-4
20-5
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An inflation hedge
Hedge against unknowns, fears
Effective vehicle for diversification
Improves portfolio risk-return alternatives
Low correlation with monetary assets
May provide psychic pleasure
20-6
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Lack of large, liquid, efficient markets
Larger commissions & spreads compared to
securities
No current income except from real estate
Storage and insurance costs
Unit costs may be high
Cyclical hysteria or overreactions periodically
occur (timing may be tricky)
20-7
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About half of U.S. households own real
estate as a home or investment
Brokerage and investment firms have
entered the market to:
◦ Buy
◦ Sell
◦ Finance
◦ Syndicate property
Real estate has increased to 10% of pension
fund portfolios today
20-8
Investments may include:
 Homes
 Duplexes
 Apartments
 Offices
 Industrial buildings
 Shopping centers
 Hotels and motels
 Undeveloped land
20-9
The Tax Reform Act of 1986
 Substantially increased wait time to take full
advantage of real estate tax deductions
 Severely restricted writing-off of paper real
estate losses by passive investors against other
forms of income
Made real estate
investment less attractive
20-10
Negative impact of tax reform on real
estate blamed for declining economic
conditions of late 1980s and early 1990s
1. Fewer new properties were developed
2. Gluts in office space/apartments shrank
3. Rents increased on existing properties
4. Eventual higher real estate evaluations
20-11
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Less supply plus higher demand equals
higher real estate values
Historically low interest rates also contributed
to an increase in demand
Bubble eventually burst in 2007
An 18 month recession followed
◦ Second worse since Great Depression
◦ 10% unemployment
20-12
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What are the long-term portfolio implications of
holding real estate?
◦ Real estate has a low correlation with stocks/bonds
◦ Low correlations could increase portfolio return and
reduce portfolio standard deviation
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Historically, only small cap stocks have out
performed real estate on a risk-adjusted basis
Real estate also provides steady cash flow
20-13
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The Cost Approach
Comparative Sales Value
The Income Approach
In most cases, a final value may
be determined from a combination
of the three approaches.
20-14
Cost to replace an asset at current prices
used as the value of real estate
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Easy for new property
Harder for older buildings
Poor location makes building worth less than its
replacement cost
Economic conditions influence value
20-15
Find value using comparable property
prices in the neighborhood
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True comparables may be difficult to find
Combine sale values of several comparable
properties to “average” out differences
20-16
The stream of net earnings generated by an
income-producing property capitalized as a
measure of that property’s worth
Annual net operating income
= Valuation
Capitalization rate (Cap rate)
20-17
Future realistic values of annual
rentals minus expenses such as
property taxes, insurance, …
Annual net operating income
Capitalization rate (Cap rate)
= Valuation
The rate of return required by
investors in similar-type
investments
20-18
Example:
Projected annual net operating income = $17,500
Market capitalization rate = 10%
Value based on this approach:
$17,500
= $175,000
0.10
20-19
Income approach helpful but overly simplistic:
 Annual NOI* changes over time
 Difficulty of choosing a capitalization rate
* NOI = Net operating income
20-20
Benefits of combining the 3 approaches:
 Can use insights provided by each
individual approach
 Can overcome some limitations involved
in using only single approach
20-21
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Fixed-Payment Mortgage
◦ Most frequently used
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Adjustable Rate Mortgage (ARM)
Graduated Payment Mortgage (GPM)
Shared Appreciation Mortgage (SAM)
Other Forms of Mortgages (equity
participation arrangement)
20-22
Ownership of real estate can take many forms:
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Individual or Regular Partnership
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Syndicate or Limited Partnership
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Real estate investment trust (REIT)
20-23
Individual ownership or regular partnership
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Simplest way from a legal viewpoint
Take advantage of personal knowledge of local markets and
changing conditions to enhance returns
Well-defined center of responsibility often leads to quick
corrective actions
Often lacks ability to pool adequate capital to engage in
large-scale investments
Often lacks expertise to develop wide range of investments
Unlimited liability for the investor
20-24
Syndicate or Limited Partnership
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General partner forms partnership
◦ Unlimited liability
◦ Responsible for managing property
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Limited partners purchase participation units
◦ Liability limited to initial investment
◦ No responsibilities – merely investors
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Front-end fees to General Partner
◦ 5-25%
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Blind pool or are specific projects identified?
Public offering
◦ Involves larger total amounts
◦ SEC registration
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Private offering
◦ Local in scope
◦ Maximum 35 investors
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Secondary (resale) markets exist but dealer spreads and commissions
high
20-25
Real Estate Investment Trust
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Similar to mutual funds or investment companies
Trade on organized exchanges or over-the-counter
Pool investor funds
No minimum investment other than cost of share
Most liquid type of real estate investment
Large secondary market
20-26
Real Estate Investment Trust (continued)
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To qualify, trust must receive 75% of income from real estate
◦ Rents
◦ Interest on mortgage loans
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Must distribute at least 95% of income as cash dividend
Equity Trusts
◦ Buy, operate, and sell real estate as investment
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Mortgage Trusts
◦ Make long-term loans to real estate investors
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Hybrid Trusts
◦ Engage in activities of both equity and mortgage trusts
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There are more than 400 REITS in existence
20-27
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Precious metals
◦ Most volatile of real asset investments
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Historically, gold and silver:
◦ Move up in value during troubled times
◦ Decline in value during stable & predictable
periods
20-28
Major factors that drive up gold prices are:
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Fear of war
Political instability
Inflation
Different forms of gold ownership:
 Gold Bullion
 Gold Coins
 Gold Stocks
 Gold Futures Contracts
 Gold ETF (GLD)
20-29
20-30
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Many of the same investment characteristics as
gold
◦ Hedge against inflation
◦ Potential safe haven investment during troubled
times
Silver’s
price per
ounce
1976
1980
2006
2010
$5
$50
$12
$29
20-31
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Used for:
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Different forms of silver ownership:
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Heavy industrial and commercial applications
Photography
Electronic
Electrical manufacturing
Electroplating
Silverware and jewelry
Silver
Silver
Silver
Silver
Bullion
Coins
Futures Contract
Mining Stocks
20-32
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Diamonds
Rubies
Sapphires
Emeralds
Gems appeal to investors because of their:
◦ Small size
◦ Easy concealment
◦ Great durability
20-33
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Market knowledge is most important
Must either be an expert or deal with “honest”
expert
Better to buy higher quality, smaller-carat
diamond than lesser quality, higher-carat
diamond
20-34
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Art
Antiques
Stamps
Chinese ceramics
Rare books
Psychic pleasure as well as opportunity for
profit
20-35
Appendix 20A
20-36
Any asset’s ultimate worth
is based on the present value
of its future cash flows
20-37
1. Determine purchase price, size of mortgage, annual mortgage
payment
2. Compute the net operating income for each year of the
anticipated holding period
3. Translate this to annual cash flow during the holding period
4. Project the selling price of the property after the holding period
5. Discount the annual cash flows and the anticipated selling price
after the holding period back to the present to determine the
present value of the future benefits
6. Compare the upfront cash commitment to the present value of
future benefits to determine if the property provides a positive net
present value
20-38
Assume:
 Six-unit apartment complex
 Purchased for $180,000
 Loan 80% of the value at 12% for 20 years
 The loan would be for $144,000 ($180,000 x 80%)
 Balance of $36,000 ($180,000 - $144,000) put up in cash
 From table below, annual mortgage payment for 20 years at
12% is $19,280
20-39
Assume buyer intends to hold property for 4 years and then
sell it. We can determine the value each year from the table
below:
20-40
Income from operations must be adjusted by
nonoperating factors such as:
 Interest expense
 Depreciation
 Taxable income/losses
 Related taxes or tax shield benefits
 Repayment of the mortgage
20-41
 Table 20A-3 Subtracts depreciation and interest expense
from net operating income to find taxable income or loss for
each year
20-42
 To the extent the investor is actively involved with the
property, the losses during the first two years can be used as
a tax shield (shelter) for other income as reflected in Table
20A-4
20-43
 Net Operating Income is combined with annual tax shield
benefits or taxes owed & the annual mortgage payments to
determine the total annual value of cash flow in Table 20A-5
20-44
 Property purchased for $180,000
 Appreciates 6% per year over 4 year period
 Sales value: $180,000 x 1.262* = $227,160
Net proceeds from selling the property after subtracting sales
commission & fees of 7% 
= $277,160 – (0.07 x $227,160) = $211,259
*Appendix A – Compound sum 4 periods at 6% the factor is 1.262
20-45
To the extent that the net proceeds exceed the book value of the property, a
capital gains tax has to be paid:
• Book value = Purchase price of
minus [4 years of depreciation: 4 x $5,096]
=
$180,000
$ 20,384
$159,616
=
$211,259
$159,616
$ 51,643
• Capital gain = Net proceeds of sale
minus book value
20-46
• Funds from sale = Net Proceeds
minus Capital gains tax [15% x $51,643]
$211,259
$ 7,746
= $203,513
• From the funds from the sale, the investor must pay off the mortgage balance
of $134,432 that exists after four years of repayments of principal:
Funds from sale
Payoff of mortgage
Net cash flow (from sale)
$203,513
- $134,432
= $ 69,081
20-47
If investor’s required rate of return on real
estate investments is 12%, the present value
of the future cash flows is $52,461.
20-48
The Net Present Value of the Investment:
$52,461 Present value of future cash flows
- $36,000 Upfront cash investment
= $16,461 Net present value
Investment earns more than the required return of 12% and is
attractive, earning about 22%.
Caveat: Real estate is illiquid investment and
almost the entire return here is based on the
assumption of a 6% yearly increase in value
20-49
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An essential consideration in a real estate
investment analysis is the cost of financing
Prior example:
◦ Loan of $144,000
◦ Over 20 years
◦ At 12% interest
◦ Payments $19,280
Table 20–1 page 542 shows the effects of
various interest rates on annual payments
20-50