i
Wayne E. Etter
Professor
Department of Finance
and
Real Estate Center
Texas A&M University
College Station, Texas
ii
Dr. R. Malcolm Richards, Director
Advisory Committee: Don Ellis, Del Rio, chairman; Conrad Bering, Jr.,
Houston, vice chairman; Michael M. Beal, College Station; Patsy Bohannan,
The Woodlands; Dr. Donald S. Longworth, Lubbock; Andrea Lopes Moore,
Houston; John P. Schneider, Jr., Austin; Richard S. Seline, Alexandria, VA;
Jack Tumlinson, Cameron; and Pete Cantu, San Antonio, ex-officio
representing the Texas Real Estate Commission.
© 1995, Real Estate Center. All rights reserved.
Publication 1055
ISBN 1-56248-008-1
iii
Contents
Preface vii
1 Introduction to Real Estate
Investment Analysis
Investment by Design 1
2 Real Estate Investors in Today’s
Economic Environment
Why Investors Invest 7
U. K. Investors Seek Diversity 11
3 Real Estate Risks
Complexities of Real Estate Investment 17
4 Real Estate Economics
Price Elasticity of Demand 23
Scarcity Benefits Investors 28
Using Economic Rent Theory 33
External Obsolescence 38
iv
5 Real Estate Market Research
Case Study: Wilma and the FTZ 44
Analyzing Housing Markets for the Elderly 49
6 Financial Feasibility Analysis
Profitable Apartment Construction 55
7 Assembling the Data
Conducting a Multi-Year Analysis 60
8 Evaluating the Data
How Present Value Works 72
Using Present Value Analysis 78
Calculating Mortgage Loans 84
Estimating Value 89
Direct Capitalization or Discounted
Cash Flow Analysis? 95
9 Analyzing Risk and the Use
of Debt
Debt Financing: Rewards and Risks 100
Appraising in Difficult Markets 105
Towards Evaluating Commercial Properties 110
v
10 Asset Management
Asset Management Essentials 114
San Felipe Court: A Successful Renovation 118
A Matter of Assumptions 123
Buy or Lease? The Commercial Property
Decision 127
Distressed Property Decisions 132
The Disinvestment Decision 138
About the Authors 145
vi
Preface
This volume is a collection of short articles that, with one
exception, were previously published by the Real Estate Center.
Most of them were written for publication in the “Instructor’s
Notebook” series in Tierra Grande; several were co-authored with
colleagues at the Real Estate Center or with other real estate profes-
sionals. Although initially they were not planned for publication in a
single volume, they gradually accumulated until their compilation as
a real estate investment analysis primer seems reasonable.
The articles are organized as they would be for an actual
class. Introductory articles provide an overview of real estate invest-
ment and development. Only after developing an awareness of the
unique nature of real estate are technical topics introduced. Even
with these topics, however, the goal is to explain the basic analytical
tools instead of offering “cook book solutions.” With a thorough
understanding of these tools, a broad variety of real estate problems
can be addressed.
“Investment by Design” sets forth the basic steps for real
estate investment analysis: determine market support, test financial
feasibility, determine the adequacy of the return to equity and
compare property’s value to its cost. These four points are the
cornerstones of the real estate development and investment courses
offered at Texas A&M University.
“Why Investors Invest” and “U.K. Investors Seek Diversity”
both reach the same general conclusion: real estate investors want
quality properties that will provide income and appreciation over the
anticipated holding period. To help understand the real estate risks
these investors face, the major risks of income-producing real estate
and the particular characteristics that accentuate its riskiness are
examined in “Complexities of Real Estate Investment.”
The application of economic analysis to real estate markets
is explored in “Price Elasticity of Demand,” “Scarcity Benefits
vi i
Investors,” “Using Economic Rent Theory” and “External Obsoles-
cence.” Knowledge of these basic economic concepts can turn a
series of real estate market observations into a solid understanding of
their significance with the further potential of predicting where the
market will go next.
“Wilma and the FTZ” and “Analyzing Housing Markets for
the Elderly” lay out the process of real estate market research.
Although each article deals with a specific real estate product, both
demonstrate that the principles of real estate market research can be
applied broadly.
“Profitable Apartment Construction” provides a definition
and an illustration of financial feasibility analysis. Determining if a
proposed development (or redevelopment) can generate sufficient
rental income to cover operating expenses, support sufficient debt to
finance the property and provide a satisfactory cash return to the
owner is, perhaps, the most basic format for real estate financial
analysis.
“Conducting a Multi-Year Analysis” sets out the basic process
for estimating cash flow from operations and resales. Although not
previously published by the Real Estate Center in this format, this
volume could not be considered a real estate investment primer
without its inclusion.
Present value techniques for evaluating the assembled data
are examined in “How Present Value Works,” “Using Present Value
Analysis” and “Calculating Mortgage Loans.” Then, building on the
basic internal rate of return and net present value calculations, the
concepts of direct capitalization and investment value are examined
in “Estimating Value” and “Direct Capitalization or Discounted Cash
Flow Analysis.”
The advantages and risks of using debt to finance income-
producing real estate are examined in “Debt Financing: Rewards and
Risks” and “Appraising in Difficult Markets.” Because debt intro-
duces financial risk (see “Complexities of Real Estate Investment”), a
property’s total risk can become excessive when too much debt is
used. “Towards Evaluating Commercial Properties” presents an
approach for controlling a property’s total risk.
Asset management has emerged as an important area of real
estate investment. “Asset Management Essentials” and “San Felipe
Court: A Successful Renovation” outline and illustrate the use of
decision-making techniques for choosing a strategy to maximize the
value of an income-producing property. “A Matter of Assumptions”
vi i i
examines the importance of the assumptions made by asset manag-
ers when estimating a building’s value on a tenant-by-tenant basis
while “Leasing versus Buying” illustrates the decision-making
process a commercial or industrial space user would apply in making
that decision. “Distressed Property Decisions” explores an important
area of asset management, while procedures for deciding to sell or
hold a property are outlined in “The Disinvestment Decision.”
Together, the articles provide basic information about a
variety of real estate development and investment topics. Conse-
quently, whether information is sought about a particular technique,
such as income capitalization, or about the broad process of investing
in income-producing real estate, this volume should be useful.
Because the articles were published over a period of several
years, the particular market conditions analyzed or described at the
time of their original publication may have changed. The principles
illustrated, however, remain useful.
I wish to thank the co-authors for their contributions. They
supplied ideas, data and text and also suggested analytical ap-
proaches, reviewed drafts and provided many helpful suggestions.
Also, I wish to thank the Real Estate Center staff for their
help in preparing these articles for publication, especially Dr. Shirley E.
Bovey for her careful and thoughtful editing. Without their efforts,
this volume could not have been published.
Wayne E. Etter
January 1995
I NTRODUCTI ON TO REAL ESTATE I NVESTMENT ANALYSI S
1
Investment
by Design
Evaluating the potential of a proposed real estate investment
requires a carefully designed, analytical plan. By logically arranging a
series of questions, a plan can be developed that minimizes the
chance of overlooking an important fact about the property.
Questions are answered through a careful evaluation of the
specific data assembled for the analysis. When there is a lack of
data, no further consideration should be given to the proposed real
estate investment until the data are available; the temptation to
ignore the question must be resisted. Of course, prior to beginning
the analysis, the investor must establish criteria for evaluation
whether or not an answer to a question is satisfactory. Although
there can be any number of questions, they can be considered under
four broad categories.
Determine Market Support
The presence of sufficient market support is determined by
analyzing the supply and demand for space within a defined market
area. Factors that define market areas vary according to property
type; a retail space market is defined differently than an office space
October 1988
Wayne E. Etter
Introduction to Real
Estate Investment
Analysis
1
I NVESTMENT BY DESI GN
2
market. In no case are market areas defined simply by drawing
circles having radii of one or two miles. Within a defined market
area, the supply and demand for space for particular market
segments is then identified.
What types of space are available in the market? How much
space of each type is available in the market? What types of space
users are in the market now? What types of space are in demand?
What changes in the demand for space are foreseen? What is the
underlying cause of the expected change in future demand? Is an
expected increase in the demand for space related to the expansion of
businesses within the market area that will require additional office
space? Or, is an expected increase in the demand for retail shopping
space related to an increased residential population in the market?
When will there be a need for additional space?
By answering these questions, the investor can determine if
there is an unmet need for space in the market area. If so, the
research should conclude with an estimate of the number of square
feet of space required and the price users are willing to pay for it.
Marketing research usually is thought of in connection with
new developments. Developers, lenders and investors want to know
if there will be sufficient demand for the to-be-built space. But
marketing research can play an equally important role when an
investor is considering changing a property’s existing use or when an
investor is considering investing in a property when the use will
remain the same.
How does “choosing a good location” differ from marketing
research? Good locations are important and are based on the needs
of particular activities. For instance, certain commercial activities
require minimum lot sizes along a major arterial street with particu-
lar kinds of ingress and egress. Additional requirements may include
easy access to wholesalers, shippers, customers or market centers.
Locating such a site does not automatically make it suitable for the
activity, however. There must be adequate demand for the space; a
good location cannot assure demand.
What are the benefits of good marketing research? Obvi-
ously, identification of an unmet need increases the probability of
success. The late Professor James A. Graaskamp suggested the
identification of an unmet need provides a competitive edge for the
investor that can result in a fully leased property–perhaps at a
premium rent. This competitive edge provides the best defense
against future properties entering the market–satisfied tenants are
less likely to move to a competing property. Because a property’s
I NTRODUCTI ON TO REAL ESTATE I NVESTMENT ANALYSI S
3
value is a function of its ability to generate rent, an increased rent
results in an increased value. Ultimately, the investor will enjoy a
greater rate of return from the identification of an unmet need.
In addition, marketing research can protect against the
consequences of the competitive price cutting that takes place in
overbuilt markets. Although reducing the rental rate in an overbuilt
market may cause some additional space to be leased, the lower rate
also may result in less total rent being collected. For example,
decreasing the rental rate for retail space will bring some additional
space users into the market, but it is unlikely to result in substantial
numbers of entrepreneurs deciding to enter the retail business or
encourage existing retailers to expand. These decisions will depend
on factors other than the price of retail space.
Furthermore, because all other owners will likely decrease
their rental rates as well, the rental income of all owners will decline
if the average market rental rate declines sufficiently. Thus, price
cutting by the owners of vacant retail space in such a market will
neither significantly increase the demand for space nor provide the
investor with a superior competitive position. Good marketing
research can help an investor avoid overbuilt markets. If there are no
strong indications that the investment under consideration will fill
an unmet need, it should not be given further consideration.
Test Financial Feasibility
The investor, having established that a particular property
will fill an unmet need, next tests the project’s financial feasibility.
If the property can generate adequate net operating income to
support sufficient debt to finance the property and provide a
satisfactory cash return to the developer-investor, the project is
financially feasible. This is a test of the property’s ability to gener-
ate adequate cash in the short run. Making this determination
requires answers to questions such as: How much will the project
cost? How much rent will the project produce? What are the
expected operating expenses? How much net operating income will
the project generate? Given current market conditions and lending
requirements, how large a loan will the net operating income sup-
port? And, given the estimated cost of the project and the desired
equity contribution of the developer-investor, can the project be
financed? A project’s financial feasibility is best explained as a
balance among the:
• property’s expected cost,
• property’s expected operating performance,
I NVESTMENT BY DESI GN
4
• lender’s requirements and mortgage market conditions and
• investor’s required before-tax, cash-on-cash return.
If there is a proper balance among these factors, the property
should generate enough rent to pay all the operating expenses, to
repay the debt used to finance the property and meet the investor’s
expected cash return. Properties that do not meet this test have little
promise even when there is a demand for the space. And, when
properties promise little in the short run, it is risky to assume that
they will improve in the long run. If, however, an investor deter-
mines there is both a demand for the space and the property is
financially feasible, the analysis moves to long-term considerations.
Is After-Tax Return to Equity Sufficient?
The expected after-tax rate of return from a real estate
investment is determined by the expected benefits of the invest-
ment–after-tax cash flow and appreciation–and the cash required to
purchase the property. The expected rate of return can then be
compared with the minimum return the investor requires to
undertake the investment. The investor’s required return is estab-
lished by examining the returns available from other investments
having a similar level of risk.
A proper calculation of the rate of return involves the use of
present value techniques so that the rate will reflect both the amount
and timing of the cash inflows and outflows. This rate is known as
the internal rate of return.
Why must the project’s after-tax internal rate of return be
considered even if the project is financially feasible? The investor’s
required return, as used in the determination of financial feasibility,
is based on a single year’s before-tax income–it is a short-term
measure and does not encompass the period during which the
investment is expected to be held. As a consequence, the investor
must consider the effect of taxes, financing and future events on the
property; this is the essential contribution made by the after-tax
internal rate of return calculation.
Real estate is particularly affected by future events because of
its characteristics: large economic size, physical immobility and long
economic life. In short, a property investment involves a relatively
sizable dollar investment that cannot be moved and that must
generate income during a long period. Thus, successful real estate
investing involves making decisions about the future level of rents,
operating expenses, appreciation rates and tax laws. These, in turn,
I NTRODUCTI ON TO REAL ESTATE I NVESTMENT ANALYSI S
5
depend on the rate and direction of urban growth, price inflation,
international events, political events and so forth.
As the information is gathered, the investor necessarily will
be addressing questions about risk. Risk exists in all projects, but
some are more risky than others. The degree of risk depends on the
difference between expected and actual outcomes. If the expected
outcome is guaranteed, then the risk is negligible; if there is substan-
tial uncertainty about the expected outcome, then the risk is great.
For a single project, the best way to reduce risk is to improve the
analysis of the variables that produce the project’s expected rate of
return. In this way, the spread between expected and actual out-
comes can be minimized.
As the scope of discounted cash flow analysis is examined,
one of its prime benefits becomes clear. In gathering the data
required to make the analysis, much will be learned about the
investment under consideration. Estimating the rate of return may
be secondary to the knowledge gained from gathering the informa-
tion. Nevertheless, the prospective investment must promise a
satisfactory rate of return or its consideration should be abandoned.
Compare Value to Cost
The investment value of any asset is equal to the present
value of its future cash flows, discounted at the appropriate rate. A
property’s investment value is not the same as fair market value or
loanable value. It is the value that an investor determines after
establishing a set of investment requirements and expectations about
the property; this value is compared to a property’s offering price or
cost to see if it exceeds the cost of the property.
The investor anticipates cash benefits in the form of after-tax
cash flow and appreciation. The lender generally receives a mortgage
payment in an amount agreed upon in advance but also may expect a
share of other benefits such as rents, cash flow or appreciation. It
usually is assumed that the amount loaned is equal to the present
value of the lender’s expected benefits discounted at the lender’s
required rate of return (generally the face interest rate of the loan). A
property’s investment value is equal to the present value of all the
cash benefits expected by the equity investor, discounted at the
investor’s required rate of return, plus the amount of the
mortgage.
The property’s investment value is based on all the projec-
tions, assumptions and so forth that have been made by the equity
investor and the lender. In addition, the required rate of return and
I NVESTMENT BY DESI GN
6
the specific tax rates are taken into account. Thus, the investment
value is for a particular property and for a particular set of circum-
stances. Because it is not an estimate of fair market value, there is
no reason to expect that the property can be purchased for the
estimated investment value. Rather, this is the value of the property
under a particular set of circumstances, and if unreasonable assump-
tions, projections and so forth are made, the investment value
calculated for a particular investor may be different from the
property’s market price.
However, the terms of purchase, financing or a particular
investor’s tax situation can increase the property’s investment value.
This may explain why one investor may be willing to pay more for
a property than another: the assumptions used and the terms
available produce a higher estimate of investment value. Never-
theless, if the property’s investment value does not equal or exceed
its cost, the property should not be purchased.
Conclusion
As the investor progresses through the analysis, the
property’s suitability as an investment will be established. If the
answer to any one of the questions is negative, the analysis should be
abandoned. There is no logical reason to proceed to any of the
remaining questions. Furthermore, positive answers to one or more
of the questions should not induce the investor to disregard a nega-
tive answer to the next question. By adhering to a carefully designed
analytical plan, an investor can maximize the probability of choosing
real estate investments that will prove successful in the long run.
REAL ESTATE I NVESTORS I N TODAY ’S ECONOMI C ENVI RONMENT
7
Why Investors
Invest
Assembling real property investment portfolios and develop-
ing property requires money. Do investors supply funds for real
estate investment and development because they like real estate? Or
do they supply their money in exchange for an expected return
appropriate for the level of risk? Or are they initially more concerned
with the expected return than with risk?
As they did in the early 1980s, today’s individual investors
supply considerable money for real estate. Studying investors’ appar-
ent motivations during these two periods provides insight into a
future capital-raising approach for the real estate industry.
Then: Tax Benefits Reign
Several key factors produced the surge of investor interest in
income-producing real estate during the 1980s.
First, the Economic Recovery Tax Act of 1981 was a principal
stimulant of this escalation as individual investors sought to take
advantage of the expanded real estate tax benefits. Second, inflation-
ary economic conditions also caused many investors to anticipate
rapid appreciation of their real estate investment.
Summer 1994
Wayne E. Etter
Real Estate Investors
in Today’s Economic
Environment
2
I NVESTMENT BY DESI GN
8
Third, many investments depended heavily on money
borrowed from deregulated, federally insured financial institutions to
magnify the benefits of tax shelter and expected appreciation for the
individual investor. Investors could deduct interest and depreciation
expense on the entire property and enjoy all the benefits of the
property’s appreciation even though their equity investment might
be quite small.
Because of the emphasis on tax benefits, which appeared to
be automatic, and similar expectations about property appreciation,
individual investors and syndicators sometimes analyzed the actual
property only superficially. Risk was of little obvious concern; data on
the supply and demand for space, rents, vacancy rates, operating
expenses and the actual rates of property appreciation for surround-
ing property often were ignored.
The circumstances of the early 1980s that fueled individual
real estate investment expansion changed significantly by late 1986.
Because of the extensive unneeded development that took place in
some areas during the early 1980s, the prospect for property appre-
ciation and sufficient cash flow to service debt was reduced. In
addition, the 1986 Tax Reform Act significantly affected the status of
real estate as a tax-sheltered investment; the tax benefits enjoyed in
the past by real estate investors were no longer available. Conse-
quently, commercial real estate values declined, and lenders were
forced to foreclose on many properties.
These points are well known to anyone familiar with the
history of commercial and multifamily real estate during the 1980s.
Two points should be emphasized, however. First, investors expected
high yields; syndications projecting internal rates of return in excess
of 20 percent were common. Second, many investors seemed oblivi-
ous to the proposition that real estate is risky. As a consequence, the
large expected returns caused money to pour into real estate, but
when the commercial real estate market collapsed, many investors
were disillusioned.
Now: Attractive Cash Yields
According to the National Association of Real Estate Invest-
ment Trusts, the total value of real estate investment trust (REIT)
shares offered during 1993 was about $12.8 billion. The graph shows
annual equity offerings were less than $2 billion in nine of the
preceding 11 years.
Why are REITs suddenly so popular? Because they invest in
real estate? Not really. They are popular with investors because their
REAL ESTATE I NVESTORS I N TODAY ’S ECONOMI C ENVI RONMENT
9
current cash yield is attractive. In some cases, falling interest rates
have made REIT shares attractive relative to certificates of deposit.
Rather than replace maturing higher yield CDs with lower yield
CDs, some investors buy REIT shares.
REITs are similar to stock mutual funds; individual investors
purchase shares that represent an undivided interest in the properties
owned by the REIT. REITs do not pay corporate taxes if they pass
through 95 percent of their portfolio income to their shareholders.
REIT shares are traded on the stock exchange; thus, they are a highly
liquid, particularly when compared to the real estate limited partner-
ship interests owned by many investors in the 1980s.
During the past few months, a number of institutions have
sold foreclosed properties from their portfolios at reported prices of as
much as 50 percent less than their original valuation. Many of these
distressed properties were purchased by REITs. When investors buy
the REIT shares, money is provided to pay for the purchased proper-
ties plus the organizers’ and underwriters’ fees and profit.
Developers that need cash to pay debts on already developed
properties are taking advantage of the demand for REIT shares by
organizing REITs. REITs are popular with developers because they
provide capital for development when few sources are available. The
REIT sells shares to investors and buys the developers’ properties.
I NVESTMENT BY DESI GN
10
Wall Street firms like REITs because they provide activity for
underwriting departments and merchandise to sell. And the demand
for REIT shares is credited with firming or increasing prices in the
commercial property market.
What about the risk of owning REIT shares? As with the real
estate investors of the 1980s, it is not clear that today’s REIT inves-
tors are thinking about risk.
Notably, some high-quality REITs are offered. Today, most
REITs are issuing stock to finance the purchase of completed proper-
ties. This is in sharp contrast to their activities in the early 1970s
when they used short-term funds to make high interest rate develop-
ment and construction loans.
Nevertheless, a portfolio of distressed properties does not
automatically become a portfolio of sound properties, even if they are
purchased by an REIT for 50 percent of their original value. The
quality of each property in the portfolio depends on the usual set of
local market factors. If the portfolio’s income does not materialize,
the value of the REIT’s shares will decrease.
Lessons Learned
Three lessons can be gleaned from this historical compari-
son. First, these two groups of investors sought real estate invest-
ments for yield. Real estate is just another investment.
Second, the two investors’ groups had different expectations.
The first group consisted of high-income investors who sought high
yields through tax benefits and appreciation. Some of today’s inves-
tors want only to do better than the current yield on certificates of
deposit; interest-rate-sensitive investors could sell their shares if CD
yields increase. Although packaged quite differently, real estate
investments can fulfill different expectations.
Third, the first group left the real estate market after their
losses. Initially, they paid little attention to risk, and they paid a
price for their inattention. The second group likely will leave too if
their expectations are not realized. What will happen to the value of
REIT shares remains to be seen, but if significant numbers of REIT
portfolios are too risky or if interest rates increase sufficiently,
investors are likely to lose again.
The large expected returns of the 1980s were achieved by
introducing significant business and financial risk, whereas most
REITs today are making nonleveraged property purchases at prices
below replacement cost. Thus, they avoid some of the problems that
the limited partnerships of the 1980s had–too much debt combined
REAL ESTATE I NVESTORS I N TODAY ’S ECONOMI C ENVI RONMENT
11
with inflated purchase prices necessary to magnify the value of tax
shelter benefits. However, foreclosed properties may suffer from
inadequate demand in their specific markets even though no debt
financing is involved and even though they were purchased at low
prices.
Defining the Opportunity
The two periods offer the real estate industry an opportunity
to study investors’ motives and develop an appropriate product to
take advantage of these motives. Investors will supply equity funds to
the real estate industry in return for a satisfactory expected yield
with little apparent concern for risk. However, they exit the market
when their expectations are not realized.
If the real estate industry develops a nonspeculative product
with limited risk and a satisfactory return, the industry might be
rewarded with a steady source of equity funding. As the current
demand for REIT shares by ordinary investors illustrates, the product
need not provide unusually high expected returns. This is important
because historically real estate returns have not been unusually high.
The challenge to those who seek capital in the real estate
industry is not to develop a complex financial product; rather, it is to
limit the issuance of securities to those backed by quality properties.
Such a practice will produce a high quality security that will find a
ready market. Because these securities will have a reasonable risk,
their yield can be competitive with that of other securities of similar
risk. To achieve this, however, will require that real industry partici-
pants develop a discipline rarely seen during the last decade.
Although many Americans believe the purchase of U.S. real
estate by foreign investors is not desirable, others disagree. In par-
ticular, many Texas real estate brokers are interested in foreign real
estate investors because they anticipate sizable purchases in the
Texas market.
This article examines a major group of United Kingdom
(U.K.) property market investors and their present motivation to
U. K. Investors Seek
Diversity
April 1991
Wayne E. Etter
Andrew E. Baum
I NVESTMENT BY DESI GN
12
invest in the U.S. real estate market. According to the Survey of
Current Business, U.K. investors have the largest foreign direct
investment in U.S. real property. These investors are dominated by
two types of institutional investors: pension funds and insurance
companies.
U.K. pension funds and insurance companies purchase
existing properties and finance the development of new properties
that are added to their portfolios upon completion. They also may
form partnerships to fund pooled property vehicles managed by
merchant banks or life insurance companies. Each property in a
pension fund portfolio is owned for the fund’s sole benefit and is
purchased for the particular fund in an all-equity transaction.
Properties owned by life insurance companies may be general
company investments or held for the benefit of a particular pension
fund managed by the insurance company or as one of several invest-
ments included in a unit scheme. From time to time, the pension
funds and life insurance companies sell properties to adjust their
portfolios; trading activity increased greatly during the 1980s.
As of December 1988, about 8.5 percent of U.K. pension
funds’ net assets were invested in property. Although the proportion
of assets invested in property is about the same as it was in Decem-
ber 1985, property investment increased about £5 billion during the
three-year period. About 15.3 percent of U.K. insurance companies’
net assets were invested in property as of December 1988, an in-
crease of almost 1 percent since December 1985. In absolute terms,
insurance companies held about £14.6 billion more property invest-
ments at the end of 1988 than at the end of 1985.
Why Do They Invest in Real Estate? Although there are
many reasons why U.K. pension funds and insurance companies
hold real estate, the following three are important. First, real estate is
expected to produce a reasonable return for a reasonably low risk.
Furthermore, real estate returns are believed to have little or no
correlation with returns from their other principal investments
(common stocks, bonds and mortgages for the most part). Thus, the
effects on portfolio yields and values caused by adverse common
stock, credit market conditions or both will not be accentuated by
simultaneously adverse changes in the real estate market.
Second, real estate is held by pension funds and insurance
companies because their competitors hold real estate. In one survey,
pension fund managers indicated their most important comparative
performance standard is the performance of other property funds.
REAL ESTATE I NVESTORS I N TODAY ’S ECONOMI C ENVI RONMENT
13
Therefore, they imitate their competitors’ investment strategies,
attempting to do at least as well. Third, real estate is considered a
hedge against inflation. Because payments to beneficiaries often are
linked to the inflation rates, pension funds and insurance companies
invest in real estate expecting to offset inflationary effects.
Why Do They Invest Abroad? Many U.K. investors seek
geographic portfolio diversification of both their security and property
portfolios. Because the U.K. property market is small relative to the
funds available for investment, opportunities to use funds in the U.K.
market are limited. Therefore, these investors must diversify through
foreign real estate markets. Foreign markets also may offer high returns
and low correlation with U.K. real estate. Keen competition for suitable
investment properties in the U.K. property market drives down U.K.
property yields. Many U.K. investors are seeking larger investment
returns than they believe are available in the U.K. market.
What Are Their Investment Requirements? When investing
abroad, U.K. investors seek top quality buildings with strong market
positions. These properties have little business risk and are expected
to produce regular income and to increase in value over time.
Returns from foreign properties must compare favorably with
property returns currently available in the United Kingdom.
Generally, property portfolios are expected to have a higher
total yield than equity, bond and mortgage portfolios. To be consid-
ered for acquisition, properties should have an expected internal rate
of return (also known in the United Kingdom as the total return) of
15 to 20 percent. Presently, the expected return on U.K. equities is
about the same as for property, while the return on government
bonds and mortgages is about 12 percent and 14 percent, respec-
tively. Currently, the U.K. overall capitalization rate (known there as
the initial yield) is about 6 percent for retail properties, 7 percent for
office properties and 10 percent for industrial properties.
Short-term vs. Long-term Performance. A recent study of
U.K. property pension fund investors indicates that real estate is
generally considered a long-term investment by them, but the
comments of some interviewed managers indicate that in recent
years there is more pressure for short-term investment performance.
Short-term is defined by a majority of these managers as one year or
less; likewise, a majority consider the long-term to be five to ten
years or more. The most important investment objective for the
majority of the interviewed managers short-term and long-term is to
provide good performance.
I NVESTMENT BY DESI GN
14
Measuring Current Performance. In the United Kingdom, a
property’s current performance usually is measured by its annual
total return:
(1) Total return = Income return + Capital return
The components of total return are defined as follows:
(2) Income return =
Annual income
Current value
The tenant ordinarily bears all operating expenses of the
property; the owner generally considers the rental income as the
property’s annual income. Thus, the income return is the same as
the overall capitalization rate used by U.S. real estate investors. This
return is equivalent to a current after-tax return for a U.K. pension
fund–they are tax exempt and typically make 100 percent equity
purchases. Although life insurance companies also make 100 percent
equity purchases, they are only partially tax exempt.
(3) Capital return =
Current value - Previous period value
Previous period value
The capital return is simply the percentage change in a
property’s current value from its previous period value. This measure
of the return is dependent on periodic appraisals of the property and is
subject to error.
While U.K. institutional investors are concerned with a
proposed investment’s expected internal rate of return over the
anticipated holding period, expectations about both current income
and appreciation must regularly be achieved. Only properties offering
this potential are of interest to these investors.
Where Are Their Investment Opportunities? U.K. pension
funds and insurance companies invest in real properties, both in the
United Kingdom and overseas. Americans are aware of the activities
of foreign real estate investors in the United States and might
assume the U.S. property market dominates the attention of foreign
investors. In addition to providing opportunities for geographic
diversification and reasonable returns, the United States possesses
political and economic stability–on a relative scale, the United States
continues to be a haven for those concerned with investment safety.
Currently, however, real estate investment opportunities in
Western and Eastern Europe are emerging that will compete with
U.S. properties for the attention of U.K. (and other foreign) investors.
Why is this?
REAL ESTATE I NVESTORS I N TODAY ’S ECONOMI C ENVI RONMENT
15
First, the dramatic changes in Eastern Europe are encourag-
ing many investors to supply funds needed by these emerging market
economies for real estate development.
However, current developments in Western Europe are even
more significant. The 12 European countries (including the United
Kingdom) of the European Union (E.U.) became a single market on
December 31, 1992; soon three additional European countries will
join the E.U. Their land area is about one fourth that of the United
States, but their 1986 population was about one-third greater.
Although such comparisons are difficult, the 12 E.U. countries’ 1987
gross national product nearly equalled that of the United States.
Becoming a single market means there is free movement of
goods, labor, services and capital among E.U. countries. Furthermore,
there will be a “harmonization” of laws, indirect taxation, agricul-
tural policies and so forth. Eventually, they hope to achieve monetary
union; if they do, it will be possible for E.U. investors and businesses
to shift funds among E.U. countries without foreign exchange risk.
Thus, the E.U. is about to emerge as an important market area–one
that is much stronger economically than were the 12 independent
countries with trade barriers, conflicting laws and tax policies and 12
monetary systems.
These changes are expected to produce increased economic
activity with significant real estate investment opportunities. This
accounts for the present intensity of interest in European real estate by
many institutional property market investors.
What about Texas Real Estate? Texas properties will be
competing with many other markets now for U.S. and foreign
investors. Attracting U.K. investors is particularly worthwhile
because they usually make 100 percent equity purchases; mortgage
financing (that is difficult to arrange in Texas) is not required to
facilitate U.K. purchases.
Texas properties are low-cost by international standards and
institutional investors such as pension funds still desire broad
geographic diversification. To interest U.K. investors, however, Texas
brokers must offer sound properties in areas with high demand and
supply constraints. Interested Texas real estate brokers must realize
that U.K. investors want only properties that will produce regular
current income and appreciation during the anticipated holding
period.
Texas real estate brokers with properties to present to U.K.
investors may wish to contact one of the following firms.
I NVESTMENT BY DESI GN
16
Baring, Houston & Saunders Healey & Baker
Property Consultants 29 St. George Street
104-106 Leadenhall Street Hanover Square
London EC3A 4AA London WIA 3BG
Debenham Tewson Hillier Parker
& Chinnocks 77 Grosvenor Street
3 - 5 Swallow Place London W1A 2BT
London W1A 4NA
Jones Lang Wootton
Richard Ellis Chartered Surveyors
Berkeley Square House 22 Hanover Square
London W1X 6AN London W1A 2BN
Edward Erdman Knight Frank & Rutley
6 Grosvenor Street 20 Hanover Square
London W1X 0AD London W1R 0AH
Fletcher King Savills
Stratton House 20 Grosvenor Hill
Stratton Street London W1X 0HQ
London W1X 5AE
REAL ESTATE RI SK S 17
Complexities of Real
Estate Investment
Real estate investments generate cash flows from three
principal sources: operations, appreciation and equity build-up.
• Cash flow from operations represents the cash benefit the
property provides after operating expenses, debt service and
income tax are paid from the rental income. These benefits are
expected throughout the investment’s economic life.
• Appreciation represents an important source of real estate
returns. Over time, well-located and well-maintained properties
are expected to generate increased income that will be reflected
in higher property value.
• Equity build-up results from the periodic reduction in the
mortgage. These benefits can be obtained only if the property is
refinanced, or it is sold at a sufficiently high price.
As investors estimate the present value of these future cash
benefits, they are necessarily concerned with risk exposure because
the value of any asset is equal to the present value of its future cash
flows. If an investor is certain the actual cash flows will be the same
in amount and timing as those expected when the investment is
July 1991
Wayne E. Etter
Real Estate
Risks
3
I NVESTMENT BY DESI GN
18
made, the investor will not consider it risky. If, however, the prob-
ability of variation between expected and actual cash flows is high,
the investment will be considered risky. Because investors expect a
higher return from undertaking a risky investment, they apply higher
discount rates when they estimate the present value of an invest-
ment. The result? A stream of risky cash flows is worth less than a
stream of more certain cash flows.
Real Estate Investment Characteristics
The risks of an income property’s future cash flows cannot
be evaluated without understanding how they are related to real
estate characteristics. Although real estate investments have many
characteristics, three are particularly important.
First, real estate investments are physically immobile–they
cannot be moved. Second, they have a long economic life–they must
produce cash returns over a long period if their cost is to be recov-
ered. Economic life is the time required for the property’s cost to be
recovered from operations; it differs from the investor’s expected
holding period. Even when an investor anticipates a five- or ten-year
holding period, the future buyer of the property anticipates a satisfac-
tory cash flow during a future holding period and so on.
Third, they have a large economic size–a single property
requires a large dollar investment compared to the minimum pur-
chase of common stock, for instance. Although it is difficult to relate
these three characteristics to each of the seven risks, the characteris-
tics accentuate real estate’s risk exposure.
Relationship of Characteristics to Risks
Business Risk. Real estate’s physical immobility and long
economic life are strongly associated with business risk–the risk of
failing to generate sufficient income. This failure can result from
attracting too few tenants, lower than anticipated rental rates caused
by high vacancies in competing properties, declining business condi-
tions in the market area and so on.
Consider the plight of a shopping center owner when demo-
graphic changes adversely affect the center’s market area. The
center’s tenants can follow their customers to other neighborhoods
and markets, but the shopping center cannot be moved. Its owner
must suffer the consequences of reduced cash flow from operations
and lowered expectations of cash flow from appreciation and equity
build-up. And because the shopping center has a long economic life,
it must sustain its operational cash flow for a long period.
REAL ESTATE RI SK S 19
A property may appear to be ideally located when it is
constructed; the adverse demographic changes may take place some
years after its construction. Because of the property’s long economic
life, the center’s cost may not be recovered even after generating
sufficient cash flow for several years.
Management Risk. Real estate’s physical immobility and
long economic life also are strongly associated with management
risk–the risk of failing to respond properly to changing business
conditions to maintain the efficiency and profitability of the property.
Because real estate cannot be moved and must sustain its cash flow
during its economic life, the probability of changing business condi-
tions is high during the property’s economic life.
Considering the shopping center example, one might ask
what a good manager could have done to predict the demographic
changes and react to minimize their impact on the property’s cash
flow. Some investment managers may perceive such changes in
business conditions and act rapidly to forestall their effect, while
others may take no action or act improperly.
Financial Risk. Because real estate investments traditionally
are financed with debt, financial risk is significant; furthermore, real
estate’s physical immobility, long economic life and large economic
size accentuate the financial risk. Because the debt is unlikely to be
repaid in a short time, the property must generate adequate cash
flow throughout its long economic life.
As with business risk, many changes can occur during this
time that adversely affect the property’s income stream. Because the
property cannot be moved, the probability of changes adversely
affecting the owner’s ability to meet the mortgage payment is
increased. Real estate’s large economic size often requires invest-
ments to be financed with high loan-to-value ratio turns into an
equal disadvantage when the property’s income declines.
Financial leverage is truly a “two-edged sword.” This is a
particularly significant risk when the terms of financing are arranged
during periods of high interest rates.
Political Risk. Because real estate is located permanently
within a particular political jurisdiction, it is subject to the
community’s attitude toward property. Accordingly, it is subject to
zoning, land-use regulations and building codes imposed by that
jurisdiction. Because of its long economic life, such regulation might
become more severe during the economic life. But increased regula-
tion can prevent competition, thus enhancing the value of existing
I NVESTMENT BY DESI GN
20
properties. Finally, large projects may be reviewed more strenuously
by regulators at all levels.
Of course, the long economic life also subjects the investor to
tax law changes. For instance, the 1986 Tax Reform Act altered real
estate’s status as a tax sheltered investment. Prior to the act, many
investors expected tax benefits to be a significant portion of total
cash flow; when this portion of the investment’s cash benefits was
eliminated, the value of their investment declined. The act also
increased the capital gains tax liability generated by the sale of real
estate. Many investors anticipated a lower rate of capital gains
taxation when they invested. Thus, they not only must anticipate a
larger tax on the sale, they also may expect a future buyer to offer
less for the property because for that buyer the expected flow of cash
benefits has been reduced.
Inflation Risk. Because real estate investments have a long
economic life, investors must correctly anticipate the inflation rate
for the long term. When future cash flows are reinvested, they will
buy less than expected if the inflation rate is greater than expected;
furthermore, future cash flows may be less than expected as a result
of inflation–operating expenses may exceed expectations, for
example.
Although inflationary gains should not be confused with
appreciation, real estate values generally have performed well during
periods of moderate inflation. However, higher than expected
inflation rates may induce others to purchase and develop real estate
to hedge against inflation. If, as a result, the supply of rentable space
exceeds the demand for rentable space, rental rates and property
values will fall. Finally, inaccurate inflation forecasts result in
choosing inaccurate discount rates that can have an important effect
on the present value of future benefits.
Liquidity Risk. Real estate’s physical immobility and large
economic size make it particularly subject to liquidity risk. Its
physical immobility makes it unique–a severe hindrance to selling it
quickly without loss. The liquidity of real estate investments also is
hampered because of their large economic size–the buyer of the
property must invest more cash than required for many other
investments.
Interest Rate Risk. Real estate investment’s long economic
life and large economic size increase the exposure to interest rate
risk. Because many investors value properties by capitalizing their
net operating income, i.e., net rental income less the property’s
REAL ESTATE RI SK S 21
operating expenses, the capitalization rate is an important determi-
nant of value. Although there are two basic approaches to developing
this rate, both approaches produce a result that is highly correlated
with interest rates.
Some investors use discounted cash flow analysis to value
properties, but their discount rates also are related positively to
interest rates. Because of real estate’s long economic life, fluctua-
tions in market interest rates during that period are virtually certain.
As interest rates rise, property values will fall and vice versa.
An investor wanting to sell a property may find that a prospective
buyer reduces the offering price because of rising interest rates. The
large economic size requires many real estate investments to be
financed largely with debt, thereby making such investments even
more interest sensitive. Although fixed-income securities are the
usual example for this type of risk, income properties clearly are not
immune.
The lesson for today’s real estate investor is clear. As recent
events have shown, real estate is not a riskless investment. Failure
to recognize the threat of the combined effect of business risk and
financial risk seems particularly important.
Many speculative properties were financed with high debt-to-
equity ratios–sometimes in excess of 90 percent. The mortgage
payments on such properties were large because of the high debt-to-
equity ratio and interest rate levels; in many cases, the investor
needed a 95 percent occupancy rate to generate sufficient net operat-
ing income to service the debt. When the supply of space exceeded
demand, rent concessions were made in an attempt to fill the proper-
ties with tenants. Although rent concessions may have attracted
tenants in some cases, they were little help to the market as a whole.
The other risks of real estate were present, too. Many
properties were developed by inexperienced developers and purchased
as investments by inexperienced investors. Thus, the management
expertise needed to avert disaster was not available. Too, many
investors were affected by the tax law changes–the result of their
exposure to political risk. Lost tax shelter benefits and the increased
capital gains tax rate hit the investor hard–not only were the
investor’s expectations of cash flow and appreciation benefits re-
duced, buyers also had reduced expectations and offered less for the
property as a result.
Many investors expected the inflation rates of the 1970s and
early 1980s to continue and, therefore, they believed the price of real
I NVESTMENT BY DESI GN
22
properties would continue to increase. Many of these investments
were dependent on price appreciation to provide a satisfactory return
to the investor, but the inflation rate decline signaled an end to the
expected rate of property appreciation. Because of the excess supply
in some markets, rental rates and property values have decreased.
In such markets, real estate’s liquidity risk also is signifi-
cant–investment properties are not easy to sell today. Perhaps
interest rate risk has had the least effect on investors in the recent
past. Although capitalization rates and discount rates have risen,
this probably reflects an adjustment for risk rather than changes in
the interest rate.
Many investors have suffered because of their exposure to
these risks. Furthermore, investors have suffered because they do
not understand the relationship between real estate characteristics
and the risks of ownership. Thus, a substantial number of properties
and their owners fell victim to these risks and to the fundamental
characteristics of real estate during the recent economic slump.
Real Estate Investment Risks
Real estate investments are subject to a number of risks, but
they are usually considered under the following headings:
Type Risk
Business The property will fail to generate sufficient
income.
Management The property’s managers will fail to respond
properly to changes in the business environ-
ment and, therefore, fail to earn a satisfactory
return.
Financial The property will have inadequate income to
meet debt service requirements.
Political A government action adversely affects the
property or the investor.
Inflation Cash benefits received in the future will have
less purchasing power than an equal cash
benefit received today.
Liquidity A property cannot be sold quickly without loss
or large selling expense.
Interest The property’s value will decrease because of
increased interest rates.
REAL ESTATE ECONOMI CS
23
Price Elasticity
of Demand
Real estate prices and rents are established in the market
through the interaction of supply and demand. Although most real
estate brokers and investors acknowledge the importance of supply
and demand, some have not considered the efficacy of this knowl-
edge in analyzing real estate markets.
The determination of the market price of an acre of land is
illustrated in Figure 1. The supply curve illustrates that the eco-
nomic supply of a particular type of real estate is relatively fixed in
the short run; the demand curve shows the price elasticity of
demand for a particular type of real estate product. Discussions of
this concept often involve consumer products such as butter and
wheat; in this article the usefulness of the concept to real estate
brokers and investors is explained and illustrated.
What Is Price Elasticity of Demand?
Price elasticity of demand is the percentage change in the
quantity demanded that results from a percentage change in price
and is useful in analyzing markets. If prices are increased (decreased)
October 1991
Wayne E. Etter
Ivan W. Schmedemann
Real Estate
Economics
4
I NVESTMENT BY DESI GN
24
and quantity demanded decreases (increases) proportionally more
than the price change, then demand is price elastic. Accordingly, as
shown in Figure 2, the demand curve slopes down and to the right at
an angle of more than 45 degrees. If the change in quantity demanded
is less than proportional to the change in price, the demand is price
inelastic, and the demand curve slopes down and to the right at an
angle of less than 45 degrees.
What are the requirements for a product to be price elastic–
that is, the change in quantity demanded is more than proportional
to the change in price? A product’s price elasticity of demand is
relatively elastic if it has one or more of these characteristics:
• Close substitutes. If a product has many close substitutes,
buyers turn to substitute products when prices increase; they
purchase fewer substitutes when prices decrease.
• Important percentage of buyers’ budgets. When a product is
an important fraction of buyers’ budgets, buyers tend to reduce
expenditures for a product as its price increases; if the product
is not an important fraction of buyers’ budgets, price increases
are tolerated.
• Many uses. Purchases of products with many uses decline in
response to price increases; substitute products are purchased to
Figure 1
REAL ESTATE ECONOMI CS
25
replace lower priority uses. Purchases of these products increase
in response to price decreases as purchases for inferior uses are
increased.
Figure 2
Analyzing Land Investments
The concept of price elasticity of demand may be used to
analyze land investments. Assume an investor is considering pur-
chasing and developing a 200-acre wooded, rolling tract in a rural
cattle-producing area. The intention is to maximize the tracts resale
value.
The tract could be cleared and planted with grass–making it
ideal for cattle. Or, the woods could be retained, gullies converted to
lakes rather than reshaped and grassed, existing wildlife habitat
enhanced rather than destroyed and other amenities added–making
it ideal for recreation. Assuming equivalent development costs, the
investor’s dilemma is to choose the development plan that will
maximize the property’s resale price.
How can the concept of price elasticity be applied here? The
investor should select the development plan that produces the
product with the greatest price inelasticity. Why? Because the price
of such a product may be increased with the least negative effect on
the quantity demanded. And which product will have the greatest
price inelasticity? To answer this question, land is examined in terms
of the requirements for price elasticity.
I NVESTMENT BY DESI GN
26
Do land parcels have close substitutes? Although each land
parcel is unique, many land parcels are close substitutes for other
land parcels. This is particularly true of agricultural land, but it also
is true of much urban land. This characteristic makes the demand
for land price elastic.
Does the purchase of land represent a large percentage of a
buyer’s budget? Most land purchases involve large dollar amounts;
as a result, land purchases are an important part of the purchaser’s
budget. Small tracts generally command a higher per acre price
because more buyers can afford small tracts. This makes the demand
for small tracts somewhat more inelastic than for larger parcels with
similar characteristics.
Do land parcels have many uses? Most land parcels have
alternative uses. As the price of land increases, inferior uses will be
given up; as the price of land decreases, it will return to inferior uses.
This characteristic makes the demand for land with many uses price
elastic.
There is little the investor can do to make a land purchase
an unimportant part of the future buyer’s budget or eliminate land’s
multiple use potential. But the investor can select the development
plan that results in the product with the fewest substitutes.
One of the investor’s tasks in making this choice is to
analyze the local land market to determine the availability of close
substitutes for each type of development. Of course, each parcel of
land is unique, but there may be close substitutes in the vicinity.
If the investor clears the land and plants grass in an area
where cattle raising is common, there will be other similar properties
nearby; the potential for raising the price of the property is limited by
the availability and price of close substitutes. Further, cattle prices
and production costs will affect the market price of such land.
Because the site is in a cattle-raising area, recreational
development of the property could result in a property with few close
substitutes in that area; if so, the price elasticity of demand will be
relatively inelastic for recreational use of the land. Given some level
of demand for this type of property in the area, the property may
command a greater resale price when developed for recreational
purposes than when developed as a cattle ranch. Careful market
research should clarify this dilemma.
Analyzing Changes in Apartment Rental Rates
Price elasticity of demand may be used to predict the out-
come of price changes in the real estate market. For example, assume
REAL ESTATE ECONOMI CS
27
an urban apartment market with 95 percent occupancy. Further,
assume a particular quality or type of apartment unit. What happens
if apartment owners increase rents (within limits) in response to
increased demand? Apartments also can be examined in terms of the
requirements for price elasticity.
Do apartments have close substitutes? In one sense, all
types of housing are substitutes for other types–all are shelter. But are
most tenants able to move from apartments to single-family houses
if apartment rents increase? Many will be unable or unwilling to
purchase a single-family home. (Of course, some single-family homes
are rented and may compete with apartments.) If other types of
housing are not affordable or not desired, they are not close substi-
tutes for apartments. Thus, apartment rents can be increased with-
out a loss in revenue because few substitutes are available. There-
fore, the demand for apartments under these conditions is price
inelastic.
Do apartment rents represent an important part of a
buyer’s budget? Yes, apartment renters are price conscious. This
factor seems to make apartments less price inelastic. Prospective
tenants may decrease their consumption of apartment space if rents
are increased, although existing tenants are not likely to do so.
Furthermore, apartments are lumpy goods; it is impossible to make
small adjustments to the quantity consumed.
Do apartments have many uses? No, their use is normally
limited to residential use. Therefore, other uses of the space will not
be given up as rents are increased. On this point, the demand for
apartments does not seem to be price elastic.
Because of the first and third reasons, the demand for
apartments is considered to be relatively price inelastic within a
limited price range. What does this suggest about raising apartment
rents to increase income? Because market rents are established by
supply and demand, an individual apartment owner cannot raise the
rent for a standard apartment. But when market demand increases
relative to supply, rental rates can be increased because the demand
for apartments is price inelastic. There are few feasible substitutes
within an area available to apartment dwellers, and it is difficult for
them to economize on their space consumption even though their
rent is increased.
Furthermore, because apartments do not have other uses,
tenants using the space for inferior purposes will not give up units as
rent increases. Thus, with sufficient demand, an increase in the
I NVESTMENT BY DESI GN
28
rental rate normally results in a less-than-proportional decrease in
the quantity of space demanded.
Real Estate Market Research
Real estate market research should be used to avoid markets
in which an investor must engage in competitive price cutting to sell
or lease real estate. For example, assume investors overestimate the
demand for apartment space and, therefore, increase the supply of
apartment space beyond the amount required to satisfy the demand.
Furthermore, what if apartment owners respond to their mistake by
a competitive reduction of rental rates to attract tenants? Decreasing
the rental rate will bring some tenants into the market, but it is
unlikely to result in substantial numbers of persons in a given local
market deciding to rent apartments or persons in other areas decid-
ing to move to the market to take advantage of the reduced rental
rates. These decisions depend on factors other than the rental rate.
The best way to avoid this situation is to invest in apartments with
few close substitutes and an effective demand.
Thus, to take advantage of the concept of price elasticity of
demand, real estate brokers and investors should locate space or
product shortage through market research. In such a market, a
sustainable competitive edge can be achieved by supplying a differen-
tiated real estate product for which there is a demand; tenants or
buyers pay a full price for the product.
The combination of a general oversupply of investment real
estate in many areas of the United States and the 1986 Tax Reform
Act has changed the thrust of real estate investment analysis. Prior
to the 1986 Tax Reform Act, appreciation was assumed to be an
automatic by-product of real estate and tax benefits flowed from
owning it. Users’ demand for space was ignored. Investors’ interests
appeared to be well served by a steady supply of newly developed
properties.
Scarcity Benefits
Investors
October 1991
Wayne E. Etter
Ivan W. Schmedemann
REAL ESTATE ECONOMI CS
29
Today, however, successful real estate investors must locate
properties that are in short supply relative to user demand. Scarcity
offers three primary benefits to income property investors. Scarcity
• enables investors to increase rents in response to increased
demand,
• enables investors to avoid decreasing rents as a response to
competition from similar properties and
• increases a property’s market value.
Increasing Rent
The concept of price elasticity of demand was considered in
the previous section. Its principal lesson is that income properties
have a relatively price inelastic demand because such space has few
substitutes and few alternative uses. This means that if there is not
an excess supply of a specific type of space relative to effective
demand, investors can (within a limited range) raise rents in re-
sponse to increased demand. This is because space consumers
cannot shift to substitutes in the short run or discontinue inferior
uses of the space when rental rates are increased.
Examination of this economic concept suggests that real
estate investors should seek differentiated real estate investments
for which there is an effective demand. Such properties are rela-
tively scarce and their users tolerate price increases if demand is
sufficient. Alternatively, investors should avoid markets with an
abundant supply of an undifferentiated, homogeneous product.
Avoiding Price Competition
A second benefit of owning a property in short supply is
avoiding the need for competitive pricing. For instance, assume the
supply of retail space is increased (from S1 to S2) without a corre-
sponding shift in the demand for retail space (see Figure 1). Decreas-
ing the price per square foot may bring some retail space users into
the market, but it is unlikely to result in substantial numbers of
entrepreneurs entering retailing or to encourage existing retailers to
expand. These decisions depend on factors other than the price of
retail space.
The financial consequences of cutting price to attract retail
tenants are illustrated by the supply and demand functions in Figure
1. At a price of $1.20 per square foot per month, 20,000 square feet
of space are leased, and the rental income is $24,000 per month. At a
price of $1.05 per month, 22,000 square feet of space are leased, and
the rental income is $23,100 per month.
I NVESTMENT BY DESI GN
30
Similarly, cutting the office space or apartment rental rate
when supply exceeds demand is unlikely to increase the short-run
demand for space. How many businesses will lease additional office
space because rental rates decrease if they do not need the additional
space? How many apartment dwellers lease additional space because
rental rates decrease if they do not need the additional space? In each
case, changes other than the price are required to increase the
quantity of space demanded for offices and apartments.
These considerations suggest a diminishing marginal utility
for space–each square foot of additional space has less value to the
user than did the preceding square foot. Because businesses and
consumers have limited budgets, they normally will not lease space
they cannot use, no matter how much the rental rate declines.
Although some owners will decrease rental rates as a competitive
tool to attract tenants, in time, no one will be better off. When other
owners cut the rental rate first, however, it will be necessary to meet
the competition. But this necessity can be avoided by investing in
differentiated (unique) properties.
A property in short supply relative to demand commands a
greater rent than those readily available. The greater rent per square
foot results in more net operating income per square foot that is
normally capitalized into increased value per square foot. For
Figure 1
REAL ESTATE ECONOMI CS
31
example, assume two properties cost the same per square foot, but
one’s locational advantage allows its owner to charge a greater rent.
The effect on value is illustrated in Figure 2.
Locating Unmet Needs
Because of these benefits, real estate investors should
conduct market research to identify market segments where space
is and will continue to be in short supply relative to effective
demand. By identifying markets with unmet needs and supplying
those needs, real estate investors can achieve a sustainable competi-
tive edge and reap the benefits of scarcity.
Many real estate investors disregard the benefits of market
research. Some investors even view careful market research as an
unnecessary impediment to the development and investment
process. However, market research aids in reducing risk in the
investment and development process.
Although scarcity may be defined as an absolute space
shortage of one of the specific property types (for example, multifam-
ily residential, office, industrial or retail space), there may be product
gaps within any broadly defined property type. Because individual
properties within each property type can be differentiated by factors
such as quality, design, amenities, site layout and location, an unmet
need may exist within one of the subgroups.
Within the multifamily residential category, for example,
properties are located in small communities, medium-size cities and
large cities. Each of these multifamily subgroups can have market
subsets such as housing for low-income families, young
professionals, retired persons and college students. Furthermore,
Figure 2
Property
1 2
Rent per sq. ft. $0.50 $0.55
Operating expense per sq. ft. 0.15 0.15
Net operating income per sq. ft. 0.35 0.40
Capitalization rate 0.10 0.10
Capitalized value per sq. ft. $3.50 $4.00
I NVESTMENT BY DESI GN
32
design, quality and site layout can distinguish a project from its
competition. Finally, locational advantages that link the site and
residents’ jobs, schools and retail centers can minimize the cost of
travel (in money, time and stress) and provide a comparative
advantage for the investor.
Superior location alone can differentiate a property; however,
its competitive edge can be sustained only if it is properly developed
and managed. Thus, a skillful combination of location and manage-
ment can be used to maintain the property’s competitive position.
By systematically analyzing the supply and demand for space
within these subgroups, the investor can locate investment opportu-
nities. Thus, real estate market research is an important means of
locating properties that provide the benefits of scarcity. Such research
involves more than choosing among the various property types.
Lending Standards, Government Control
During the early 1980s, eager lenders financed the steady
supply of income properties to investors. Now lenders have adopted
more stringent real estate loan standards. This situation differs
considerably from the early 1980s when many properties were
financed even though demand appeared to be insufficient to justify
the property.
Only properties with a strong market position can obtain
financing. If the investor with an outstanding investment opportu-
nity receives financing or presently owns a quality property, then the
investor can be less concerned about competition from future devel-
opment. Unless sufficient demand supports the new property, it will
not receive financing. If new market entrants are limited to preleased
properties, the potential for competitive price competition is reduced.
Investors with solid properties were made worse off in the
past when weak projects were financed because their completion
often resulted in competitive properties. Thus, the lack of current
debt availability contributes to scarcity by limiting the development
of competitive buildings and creates investor interest in renovating
existing properties with good locations.
Investors also may focus on areas governed by strict planning
and development controls. Local regulation of real estate
development is a special means of achieving a sustainable monopoly
position. Such control is limited in the United States, but other
countries, such as the United Kingdom, regulate development
extensively.
REAL ESTATE ECONOMI CS
33
Many investors have viewed planning and development
controls as obstacles to the free flow of desirable investment proper-
ties to the market. Of course, it can be argued that developers’
interests are harmed by excessive regulation–developers generally
focus on supplying space in response to demand. Furthermore, space
consumers’ interests also may be harmed by excessive regulation–
they may pay premium rents because of scarcity. On the other hand,
the cost of excess development is significant to investors, developers,
financial institutions and taxpayers.
Although some might oppose such regulation, investors
must consider the benefits of scarcity–in such an environment, their
property becomes more valuable. Thus, their interests are served by
regulation that restricts the supply of competitive properties. Accord-
ingly, careful investors seek out markets with supply constraints.
Real estate investors must bear in mind the benefits of
properties that are in short supply relative to tenant demand. The
potential for loss is reduced while the potential for gain is enhanced.
Accordingly, they should conduct market research to select suitable
properties for investment. Rigorous lending standards and the
regulation of real estate development also reduce the risk to current
property market investors.
Using Economic
Rent Theory
January 1991
Wayne E. Etter
Ivan W. Schmedemann
Analyzing real estate markets is an important task for real
estate brokers and investors. Using appropriate economic theory
yields a greater likelihood of correct and consistent results. Why?
Because theories are predictive devices. In other words, economic
theories help to make estimates about future events. If theories
cannot do this, they still may be interesting, but they have little
practical value.
Economic rent theory is useful for real estate market analy-
sis. Although this may seem a rather obscure (or even impractical)
topic to many (and some may never have heard of it), it can provide
useful insights when one must form an opinion about the future
course of a real estate market. This discussion illustrates how to use
economic rent theory for analyzing the Texas apartment market.
I NVESTMENT BY DESI GN
34
Reviewing a number of apartment appraisals in several Texas
cities results in two major observations about the state’s apartment
market.
• The final estimate of value often is less than the cost of con-
structing a new apartment building.
• The overall capitalization rates (net operating income/reported
sales price) vary among the cities and markets.
For a real estate broker or an investor, a proper interpretation
of these observations is important. As is well known, the early 1980s
featured substantial overbuilding as anticipated tax benefits and
appreciation appeared sufficient to provide satisfactory returns
without any consideration of fundamental property economics. The
question, “Are there sufficient tenants willing to pay sufficient rent to
produce a positive cash flow?”, often went unasked and unanswered.
The 1986 Tax Reform Act erased tax benefits and the
oversupply of property stopped the expectation of immediate
property appreciation. Today, income and long-term growth are
valued, but the supply of and demand for apartment space has
resulted in low rents and much slower growth expectations.
Therefore, estimated market values often are less than the cost of
constructing new apartments. Accordingly, there is little new
apartment construction in most Texas cities.
Turning to the second observation, one assumes areas with
lower overall capitalization rates are markets in which apartment
buyers are willing to pay a higher price for the income stream than in
areas with higher overall capitalization rates. These buyers appar-
ently believe the demand for apartment space, rents and, in time,
apartment values will increase. Because buyers do not have equiva-
lent expectations about other areas, they will pay less for the income
streams there.
The real estate broker or investor interested in analyzing
these observations and making predictions about a local apartment
market can use economic analysis.
Market rents are set by supply and demand. In the short
run, the supply of apartment space is fixed–additional apartment
space may require a year to 18 months to be planned, built and
offered to the market. Likewise, an oversupply of apartment space
will not evaporate quickly.
The demand for apartment space results from a number of
factors, but changes in population, employment, single-family
housing costs and interest rates are important influences.
REAL ESTATE ECONOMI CS
35
Figure 1A illustrates how supply and demand interact to
establish the local market’s apartment rental rate. Where demand
D
1
, for example, equals supply, the market rental rate is P
1
with
tenants using Q
1
units of apartment space.
Also in Figure 1A, the effect of an increase in demand is
shown–the demand curve shifts to the right. Up to a point, the
demand can be met by absorbtion of available space as shown by the
demand curve shift from D
1
to D
2
. Rental rates have risen to P
2
with
tenants using Q
2
units of space. If the demand curve shifts far
enough to the right beyond D
3
, the rental rate rises, but in the short
run, there is no additional space to lease. Therefore, the supply curve
becomes vertical. Tenants are competing with one another for a
limited supply of space.
Real estate brokers or investors who foresee, within a reason-
able time, the shift in the demand curve from D
1
to D
2
or beyond
might recommend or consider the purchase of the property even if
the present overall capitalization rate is low. They might do so even
if the property does not currently produce a positive before-tax cash
flow. With rising rents and satisfactory management, the property
should begin to produce a positive before-tax cash flow. Furthermore,
because the present low capitalization rate is an indicator of expected
higher future rents, the capitalization rate will rise when the higher
rental rates are achieved, provided that continuing rental rate in-
creases are not expected. If continuing rental rate increases are
expected, however, the capitalization rate could remain low. This
would result in the increased income stream being capitalized into a
higher property value.
Figure 1
I NVESTMENT BY DESI GN
36
The apartment market can be analyzed further using eco-
nomic rent theory. Economic rent theory is based on the principle
that an owner of existing apartment space will continue supplying
space if the marginal revenue (the revenue from supplying an addi-
tional apartment unit exceeds the marginal cost (the cost of supply-
ing one more apartment unit). Thus, the supplier will stop supplying
when the revenue from renting the apartment equals the cost of
supplying the apartment. At that point, supplying an additional unit
will make the owner worse off as marginal revenue (which equals
average revenue per unit) equals marginal cost. This means the cost
of achieving 100 percent occupancy through additional advertising,
management expenses, reduced rent or all three may exceed the
benefit of the additional rental income received. Thus, for a particular
property, the optimum occupancy level may be less than 100 percent.
As illustrated in Figure 1A, the rental rate is dependent on
the supply and demand for apartment space. For any level of occu-
pancy, total revenue is equal to the quantity of apartment units
leased multiplied by the unit rental rate (see Figures 1B, 1C, 1D).
Total cost includes all the factors of production–land, labor,
capital and management. Normally, as the number of units rented by
a single owner increases, the average unit cost first decreases because
the fixed costs are spread over larger quantities of output. Likewise,
the marginal cost declines. At some point, however, the marginal
cost begins to rise because of inefficiencies that result in increased
costs. This, in turn, causes the average unit cost of supplying an
apartment unit to increase. At any level of output, total cost equals
the quantity of apartment units leased multiplied by the average unit
cost (see Figure 1B, 1C, 1D).
When demand is large relative to supply, the owner is able to
charge a high rental rate. It may be that at this rental rate, total
revenue exceeds total cost–when this is the case, the amount of
revenue in excess of total cost is known as economic rent (or net
return). Because total costs include all production factors (including
management compensation), markets in which economic rent is
being produced will attract competitors seeking abnormal profits.
When competitors enter the market and demand is unchanged, the
market rental rate will decline, and the abnormal profits or economic
rent will disappear.
To illustrate, Figure 1 depicts the property at each of the
three stages of demand. At demand D
1
, price P
1
is established and
quantity Q
1
units of space are leased. At this price, total revenue
REAL ESTATE ECONOMI CS
37
(P
1
x Q
1
) is less than total cost (C
1
x Q
1
) and a loss (negative eco-
nomic rent) results.
Over time, demand improves to D
2
and the price increases to
P
2
. The apartment owner supplies space equal to quantity Q
2
. At this
price, total revenue (P
2
x Q
2
) is equal to total cost (C
2
X Q
2
). There is
no economic rent, but all costs of production are covered at this
price. Rental concessions have vanished.
When the demand curve shifts to D
3
, however, the price
increases to P
3
, and the quantity of space supplied increases to Q
3
. At
this rental rate, total revenue (P
3
x Q
3
) is greater than total cost (C
3
x
Q
3
); economic rent exists. This means the rewards of owning apart-
ments are such that others could be attracted to supply space with
the expectation of earning above-average profits.
Assuming an owner’s property is well managed and main-
tained, how should the owner view the prospect of competition from
new construction? Today, many Texas apartment owners face this
situation.
Economic rent theory can assist in analyzing this aspect of
the Texas apartment market because it is based on the sound
business principle that total costs must be covered before additional
resources will be brought into production–in this case apartment
space. Total costs include the cost of land, labor, capital and
management. If expected apartment rents are sufficient to cover
these costs and more, then new apartments will be built. Translated
into investment terms, the expected rate of return is greater than
the required return.
For this analysis, it is important to remember that today
many apartment properties with 90 percent or greater occupancy
rates at market rents have market values that are less than their
replacement costs. It is, therefore, possible that an existing property
purchased at a depressed price can produce economic rent (returns in
excess of the cost of land, labor, capital and management). A new
property, however, could not produce economic rent at current
market rents.
Consider, for example, Figure 2. It begins at the last stage of
Figure 1. The existing property produces economic rent as previously
demonstrated, but, because of the cost of new construction, the new
property has higher costs at all levels of output and, therefore,
produces negative economic rent at current market rents. Of course,
some rental premium may be possible because the property is new,
but rents higher than the current market are required if the property
I NVESTMENT BY DESI GN
38
Figure 2
External
Obsolescence
The discussion of economic rent theoryillustrates how an
existing property purchased at a depressed price can produce an
adequate return at current market rents, but a new property can not.
As illustrated in the figure, the higher costs of new construc-
tion cannot be covered by current market rents, and a loss results.
But, until market rents increase, current owners are protected from
the competition of new properties. In general, when this condition
exists, appraisers conclude that a property has sustained external
obsolescence. Although real estate appraisers spend a good deal of
effort trying to measure external obsolescence precisely, many
investors may not understand the importance of external obsoles-
cence when making the investment decision.
External obsolescence, sometimes called economic or envi-
ronmental obsolescence, is “the diminished utility of a structure
because of negative influences from outside the site.” Normally,
October 1992
Wayne E. Etter
Ivan W. Schmedemann
is to produce an economic rent. If the required increase is large, the
owner of an existing property is protected (at least temporarily) from
the competition of new properties.
REAL ESTATE ECONOMI CS
39
external obsolescence is found when an existing property becomes
subject to negative influences: e.g., a declining neighborhood causes
an otherwise well-constructed and well-maintained building to
command less rent than comparable buildings receive in other
neighborhoods. Its reduced ability to generate adequate rent is
attributed to external obsolescence.
Estimating External Obsolescence
Real estate appraisers normally use three approaches to
estimate value: the cost approach, the sales comparison approach
and the income capitalization approach. When the independent use
of each approach produces three approximately equal value
estimates, the logic of market participants is confirmed.
By comparing the actual sale prices for comparable properties
and the cost of a new property, the belief that buyers will pay no
more for an existing property than the cost of constructing a compa-
rable property is asserted. Likewise, by comparing a property’s
capitalized income value with the prices buyers are paying for
comparable properties and the cost of constructing a comparable
property, the belief that the price buyers pay for a property is a
function of its ability to produce income is asserted. Sometimes,
however, the cost approach value estimate is considerably more than
the value estimate of the other two approaches. When this occurs,
the appraiser must discover if the cause of the difference is external
obsolescence.
When expected rents decline and buyers pay less for proper-
ties because of the reduced income stream, the income capitalization
approach and the sales comparison approach produce smaller market
value estimates. Although land costs may decline, the other costs of
constructing a new property probably will not decline. Therefore,
external obsolescence is estimated and deducted from the subject
property’s depreciated replacement or reproduction cost so that in
the final value indication, the cost approach estimate will be closer to
those from the other two approaches.
Of course, estimating external obsolescence requires an
appropriate methodology. If external obsolescence is improperly esti-
mated, the cost approach cannot be used to confirm the other value
estimates that take into account the market effects of the reduced rent.
Estimating the amount of external obsolescence is normally
done by capitalizing the rent loss caused by the negative economic
influence. The rent loss is estimated by comparing the subject’s rent
with that of comparable properties in other neighborhoods. External
I NVESTMENT BY DESI GN
40
obsolescence is also estimated by examining the difference in sales
prices of comparable properties within and outside the affected
neighborhood.
With either approach, the calculated amount is allocated
between land and improvements. Only the amount allocated to
improvements is deducted from the depreciated reproduction or
replacement cost of the improvements because the current market
value of land is used in the cost approach. Any decline in land value
resulting from negative influences from outside the site will be
reflected in the land’s current market value estimate.
At present, however, numerous properties have market
values that are less than their depreciated replacement or
reproduction cost plus land. This condition generally is attributable
to an oversupply of the property type within these markets and/or a
decline in general economic conditions rather than to the more
limited causes of a declining neighborhood in the midst of other
economically healthy neighborhoods. These properties’ inability to
generate sufficient rent to justify their construction also may be
attributed to external obsolescence, but how is external obsolescence
to be estimated using the usual methods if the entire city has
suffered an economic decline and few properties are left unaffected?
What will serve as the standard for comparison?
A suggested approach for estimating external obsolescence
under such circumstances is to estimate the rental rate necessary to
Period of Protection
from the Competition of New Construction
REAL ESTATE ECONOMI CS
41
support new construction and the time period that will elapse before
actual market rents increase sufficiently to support new construction.
The difference between the two rental rates is rent loss; the present
value of the rent loss is used as the basis for estimating the
property’s external obsolescence.
Another suggested approach is to compare the property’s cost
with its investment value. The property’s investment value is
estimated using assumptions about expected rental rates, operating
expenses, financing, required return and so forth.
Both suggested approaches are dependent on assumptions
about the future. If the amount of external obsolescence is based on
estimates of the future, it is difficult to evaluate the estimate’s
quality. If the appraiser’s estimate of future rental rates and other
important data is incorrect, the estimate of economic obsolescence is
useless or misleading.
What might serve as a useful measure of economic obsoles-
cence under such circumstances? If there are sufficient sales of
comparable properties, another approach is to calculate the cost to
replace or reproduce each of the comparable sales. The difference
between their market price and their cost may be attributed to
external obsolescence. If this calculation is made for several proper-
ties, a percentage reduction could be developed from sales data and
applied to the subject property.
Why Is External Obsolescence
Important to Investors?
When there is external obsolescence, the cost of constructing
a comparable new property (including land cost) will exceed its
market value and little, if any, new construction is expected to take
place. Thus, the concept of external obsolescence is important to
investors who are considering purchasing an existing property; the
property’s estimated economic obsolescence can serve as an indicator
of the likelihood of competition from new buildings. In particular, a
relatively large amount of economic obsolescence suggests higher
market rents will be necessary before new construction is feasible.
For example, an investor may be considering the purchase of
a 20,000 square-foot building with an estimated market value of
$300,000. The estimated cost (including land) of constructing a
comparable property is $600,000. If the property has no physical
deterioration or functional obsolescence, the $300,000 difference
between the property’s market value and the cost to construct a
comparable property is attributable to external obsolescence.
I NVESTMENT BY DESI GN
42
If the property’s current rental rate is $3.42 per square foot
per year (28.5 cents per square foot per month) and the buyer of the
property receives the financing assumed in Table 1, a cash-on-cash
return of approximately 12 percent will be received.
The calculation of the rental rate necessary to support new
construction is presented in Table 2. The difference between the
current market rental rate (28.5 cents per square foot) and the rental
rate required to support new construction (39 cents per square foot)
is the investor’s margin of safety.
Of course, the investor must estimate the time required for
market rental rates to increase to the necessary level to make new
construction feasible. The time required will depend on the supply
and demand for space within the market area and the expected rate
of increase in land and construction costs.
If the particular market has significant vacancies, rental rates
will climb slowly unless a sharp upsurge in demand is expected. On
the other hand, if the vacant space is not really suitable for satisfying
future demand, rental rates may quickly increase sufficiently to
support new construction even though some properties remain
vacant. Nevertheless, investors who carefully pick among existing
properties can gain some protection from the competition of new
properties.
Table 1. Expected Cash-on-Cash Return
from Existing Property
Expected purchase price $300,000
Estimated loan amount (10.5%, 25 years) 210,000
Required equity investment $ 90,000
Estimated potential gross income $ 68,400
Estimated vacancy and collection loss (20%) 13,680
Estimated effective gross income $ 54,720
Estimated operating expenses 20,000
Net operating income $ 34,720
Annual debt service 24,030
Before-tax cash flow $ 10,690
Cash-on-cash return =
Before-tax cash flow
Equity investment
11.9% =
10,690
90,000
REAL ESTATE ECONOMI CS
43
Table 2. Estimating the Required Rental Rate
to Support New Construction
Estimated cost of land and improvements $600,000
Estimated loan amount 420,000
Estimated equity required $180,000
Required rental rate:
Annual debt service (10.5%, 25 years) 48,060
Required cash-on-cash return (12%) 21,600
Required net operating income 69,660
Estimated operating expenses 20,000
Estimated required effective gross income 89,660
Estimated vacancy rate (5%) 4,719
Estimated potential gross income 94,379
Estimated monthly per square-foot rental rate $ 0.39
I NVESTMENT BY DESI GN
44
Case Study: Wilma
and the FTZ
The oversupply of developed commercial real estate in
most Texas markets means little new commercial development
activity in these markets in the near term. Those who hope to
continue some level of development or redevelopment activity would
do well to reflect on an important point made by the late Professor
James A. Graaskamp of the University of Wisconsin at Madison. He
says that developers cannot be successful if they supply a product
that is already in the market. Instead, they must seek an unmet
need; in supplying that unmet need, they must achieve a sustainable
competitive edge that will allow them to reap the benefits of their
monopoly position. These benefits were analyzed in “Scarcity Ben-
efits Investors.”
Identifying an unmet need and designing a strategy to
achieve a sustainable, competitive edge are not easy tasks. This
section provides a case analysis of one real estate developer’s pursuit
of these goals.
July 1992
Wayne E. Etter
John Y. Massey
Real Estate Market
Research
5
REAL ESTATE MARK ET RESEARCH
45
Wilma Southwest, Inc.
Wilma Southwest, Inc., of Houston is a subsidiary of Wilma
International, a development firm headquartered in the Netherlands.
Wilma undertakes property development projects on its own and
with joint-venture partners. Because Wilma and its investors are
conservative and because of the well-known difficulties of developing
in the Houston market, speculative development is avoided.
In the early 1980s, Wilma owned 457 acres near Houston’s
Intercontinental Airport with good access to the city’s freeway
system and to rail transportation; Wilma executives wanted to
develop the site to its maximum value. This property was marketed
as Central Green Business Park.
Wilma’s land could have been developed for a variety of
users, but lenders and investors required developments to demon-
strate financial feasibility. This meant that before construction
began, Wilma needed to locate tenants willing to lease the completed
space at rental rates sufficient to service the debt and provide an
adequate return to Wilma’s investors.
With other completed space in the market area remaining
unleased, Wilma’s site had to fill special needs if it were to be
developed. Although near the airport, it was not the only site there.
Likewise, it was not the only site with access to Houston’s freeway
system and to rail transportation. Thus, Wilma needed to devise a
development strategy taking advantage of these attributes and
permitting the site to fulfill an unmet need that competitive sites
could not supply.
Finding the Unmet Need
Market segmentation means dividing a market into distinct
subsets of customers. Many manufacturing and service firms use
this approach to aid in product development and marketing; it also
can be applied to real estate markets. In the case of real estate, the
market is divided into tenant subsets with the goal of locating one or
more subsets with unmet needs. Thus, it is a conceptual approach to
isolating an unmet need.
The distinction between market segmentation and product
differentiation is important. For real estate markets, product differen-
tiation means supplying several product styles in hopes that various
users will find at least one of the styles attractive or acceptable, e.g.,
office spaces varying in size and quality.
The distinction between market segmentation and market
area also must be borne in mind. A market area has boundaries; it is
I NVESTMENT BY DESI GN
46
a defined geographical area. Distinct subsets of customers may exist
within the defined geographical area. Thus, medical doctors desiring
office space are a distinct subset of customers; they may desire to
lease office space in particular market areas.
Development Strategy
Because Wilma Southwest was a subsidiary of a Dutch
parent firm, developing sites for firms involved in international trade
was not unknown to them. And because Houston is an important
foreign trade hub with both an international airport and a major
seaport, many importing and exporting firms are located in Houston.
Therefore, Wilma began to seek a way to attract these firms to
Central Green Business Park.
To assist in attracting these firms, Wilma Southwest sought
a foreign trade zone (FTZ) designation from the Foreign Trade Zones
Board (a U.S. government agency) in mid-1985. When a site is
established as an FTZ, it is deemed to be outside the United States
for duty and revenue purposes, even though it is physically located
within the country’s borders. This attracts firms engaged in import-
ing and exporting for the following reasons.
• Normally, duty payments are made when imported goods arrive
in the United States. If the goods are imported and warehoused
in an FTZ, however, duty payments are delayed until the goods
are shipped to a U.S. customer. Delaying the payment provides
a time value of money benefit for the importer-exporter located
in the FTZ.
• The duty payments made when goods are imported into the
United States can be avoided by the importer-exporter located
in an FTZ if goods are exported after storage, sorting, testing or
repackaging. A business location outside the FTZ does not
provide this advantage.
• Often the duty on parts is charged at a higher rate than the
duty on the finished products. Because duty is not paid when
parts are imported into the FTZ, finished products can be
assembled within the FTZ and then sold to U.S. customers.
Duty on the finished products will be charged at the lower rate.
Assembling products outside the FTZ will not provide this
advantage.
• Sometimes part of imported material becomes scrap during the
assembly or manufacturing process. Because duty is not paid
when parts are imported into the FTZ and assembled into
finished products, duty on the scrap will be avoided when the
REAL ESTATE MARK ET RESEARCH
47
products are sold to U.S. customers. In addition, duty on the
finished products may be charged at the lower rate. Assembling
products outside the FTZ will not provide this advantage.
• Imported goods and goods stored for export are federally exempt
from the annual personal property tax levied by local
governments.
For these reasons, locating in an FTZ could prove attractive
to an import-export firm, even though competing space located
outside an FTZ might be otherwise competitive in design, price or
location. In fact, an import-export firm considering leasing space
within an FTZ could estimate the added value of the location. If, for
example, the duty saved is $50,000, a tenant occupying 36,000
square feet saves $1.39 per square foot per year (a little less than 12
cents per square foot per month). Increased volume over time could
further raise the location’s value.
The FTZ also would provide Wilma with a sustainable
competitive edge. Although other FTZs could be approved in the
area, authorities would prefer the current one to be fully developed
before approving others. And the application process for a new FTZ
takes 12 months to two years. This gave Wilma adequate time to
find sufficient tenants to test the quality of the idea.
Success of the Strategy
In late 1987, Wilma obtained an FTZ designation for ap-
proximately 13 acres of their total 457 acres at Central Green
Business Park. After this designation, progress was slow. Eventually,
Phase I–a 100,000 square-foot multi-tenant office-warehouse com-
plex–was completed in January 1986 and totally leased. The complex
was sold to an investor group in 1989.
Construction of Phase II, a second office-warehouse complex,
was initiated in August 1990, the only project of this type con-
structed in the north Houston market during 1990. By year’s end, 90
percent of this 104,000-square-foot facility was preleased at rates
that supported the cost of the new construction. Phase II was com-
pleted in January 1991 and fully leased by January 1992.
As the business benefits of the FTZ became known, the
increased interest by potential tenants caused Wilma to consider
expanding their FTZ. An application to increase the FTZ from 13
acres to approximately 43 acres was submitted in November 1990.
The request was granted in April 1991. A second increase, requested
in June 1991 to expand the FTZ from 43 acres to 156 acres, was
approved in December 1991.
I NVESTMENT BY DESI GN
48
Not all Phase I and II tenants were engaged in international
commerce; about 43 percent of the Phase II tenants chose the project
because it was located in the FTZ. Obviously, Central Green Busi-
ness Park had a broad appeal. Among the tenants attracted to
Wilma’s Phase I and II developments in Central Green Business Park
because of the FTZ were:
• two distributors of imported industrial valves;
• seven freight forwarding firms (assist other businesses in their
export activities);
• three customshouse brokerage firms (assist other businesses in
their import activities);
• several firms that crate exports for shipment;
• a specialist in handling dangerous goods; and
• an international parcel-package-letter express delivery service.
Wilma Southwest, Inc., recognized firms in the import-
export business as a particular market segment. The increasing
importance of foreign trade to the U.S. and Texas economies and the
potential effects of the North American Free Trade Agreement on
Texas-Mexican commerce suggest an increasing need for space in
FTZs.
Because FTZs provide specific financial advantages to firms
engaged in international commerce, there may be other development
opportunities in the market. Knowledgeable real estate brokers may
wish to discuss the advantages of FTZs with their clients when
appropriate.
What Is the Lesson?
Real estate development can succeed in difficult markets.
The key is to locate tenants who need something not currently
available in the market and deliver that product to them. In addition,
the developer must secure the strongest monopoly position possible by
being the first to recognize an opportunity so that the competitive edge
can be maintained.
REAL ESTATE MARK ET RESEARCH
49
The U.S. population over 65 years old was estimated to be
30.9 million (12.5 percent of the total) in 1989. It is expected to
grow to more than 59.7 million (20 percent of the total) by 2025.
Most of the growth, however, is projected to occur after 2010. The
elderly often are seen as a promising market for new housing, but
the identification of promising elderly housing markets is difficult.
The elderly populations have a number of demographic,
health and socioeconomic characteristics that must be considered to
properly assess these markets. Some of the more important show the
elderly population:
• will increase rapidly by 2025, with most growth occurring after
2010;
• comprises 40 to 50 percent of the elderly in the age groups over
75 in which health problems substantially limit independent
living (this suggests that those 65-74, rather than older seg-
ments of the elderly, are the prime target group for independent
forms of living);
• has a much higher proportion of women than the population as
a whole, and these women are increasingly likely to live alone
even at older ages;
• is much less likely to move than the nonelderly and generally
wish to remain close to children who provide social and physi-
cal support;
• is a much higher proportion of the racial majority than of the
minority population and will be slower to reflect the racial-
ethnic changes occurring in the population as a whole;
• is likely to prefer housing options that allow independent living
at moderate costs; and
• has limited resources or they are in homes that may be difficult
to sell or which they may be hesitant to sell.
These factors suggest that those most likely to purchase
elderly housing services will be among geographic populations with
Analyzing Housing
Markets
for the Elderly
April 1991
Wayne E. Etter
Steve H. Murdock
I NVESTMENT BY DESI GN
50
growing concentrations in the youngest elderly age groups. These
factors further suggest that such services may require the develop-
ment of products intended to meet the needs of elderly women who
are likely to live alone. Furthermore, the population using elderly
housing and other real estate services is likely to be those elderly
living near to the site where the services will be provided; the elderly
are unlikely to migrate unless the destination is an area with unique
natural beauty or other special features.
Because of the diverse characteristics of the elderly popula-
tion and localized differences, there is little doubt that detailed
market research is essential prior to initiating a project intended
for an elderly market. To successfully market housing to the elderly
requires the identification of a particular market segment with unmet
demand within a particular market area that can be supplied profitably.
Elderly Housing Categories
Real estate market research is the analysis of supply and
demand for a particular type of property within a particular market
area. Housing especially designed for the elderly is typically separated
into three categories. This means that a particular type of housing
must be the focus of the analysis. A description of the three catego-
ries follows.
• Independent Living Facilities are characterized by communi-
ties for persons over a certain minimum age (about 50). These
living facilities do not provide health care facilities, and resi-
dents are expected to care for themselves.
• Congregate Care Facilities include persons who cannot func-
tion independently; thus, they are usually older (typically 75 to
85) than those in independent living facilities. Although such
facilities usually do not provide health care services, they do
provide meals, maid service and various daily activities for the
residents.
• Assisted Living Facilities provide assistance to residents in
most areas of daily life, including personal (bathing and dress-
ing) and medical care. Residents are usually older (85 years and
older) than residents in the other two types of facilities.
Defining Market Area
Because the desire to remain within a community is an
important consideration to the elderly, the market area for a particu-
lar project is small. Generally, therefore, only areas within the
REAL ESTATE MARK ET RESEARCH
51
immediate community or metropolitan area should be included as a
part of a housing development’s market.
Areas without significant numbers of elderly are poor choices
for developing such housing unless the available amenities have an
exceptional appeal.
Analyzing Supply by Product
An inventory of specially constructed housing for the elderly
must be developed and should include certain information about
each housing development within the defined market area. First, the
market orientation of each development must be defined. Determine
if existing developments provide independent living, congregate care
or assisted living facilities. Next, collect information that differenti-
ates projects within each of the three market orientations. For each
development, determine the:
• product features,
• tenant amenities,
• availability of medical services,
• group activities and
• quality of management.
Finally, data that provide market information about each develop-
ment is needed. This information includes:
• date sales or leasing began (or will begin),
• amount of space leased,
• amount of vacant space available for lease,
• amount of space per month leased during the past 12 months and
• current sales prices or rental rate and terms.
Although such data provide information about supply, they
also are indicators of demand. When data are collected in sufficient
detail, it may be possible to identify particular product types with
high occupancy rates, those that have experienced large amounts of
absorbed space in the past year or both. Although more research is
required, these product types may represent areas of potential
opportunity for the developer.
Analyzing Demand
Because of the demographic conclusions, a key question for
the developer considering entering this market in a particular area is:
“What is the effective demand for a particular type of housing
especially designed for the elderly?” Effective demand is demand
backed by the ability to purchase. Answering this question requires
market research. Although a number of elderly might like to move to
I NVESTMENT BY DESI GN
52
specially designed housing (or even need to), how many of them can
afford it?
Because of the importance of age and the type of housing
selected, the elderly within a particular market area must be
analyzed by age groups. For example, before building a particular
number of independent living units, the developer’s research must
focus on potential space users 65 to 74 years old–the population
group most likely to select such housing.
If the developer’s project is to be successful, not only must
there be a sufficient number of elderly within the proper age group,
there also must be a sufficient number within the group with the
income to afford the offered housing. Therefore, the demand must be
estimated by income levels as well as by age.
Finally, there must be a sufficient number of the proper age
who have sufficient income to afford the housing and who desire to
move to a particular type of housing for the elderly. When the
number of persons who both can afford and desire a particular type of
housing currently unavailable within their market area is deter-
mined, the developer will know the extent of the unmet need within
the market area. The number of elderly falling into this category may
be much smaller than anticipated. Thus, this information is neces-
sary to avoid making an incorrect decision and potential financial
disaster.
Secondary Sources of Information
In most forms of marketing analysis, U.S. Census and other
secondary data play a key role. Such data are likely to be particularly
useful because of the 1990 Census. It is important to know the types
and sources of available data.
A useful Census data source for isolating possible market
areas for the development of housing for the elderly is the Public-Use
Microdata Sampling Units (PUMS). This data series divides Texas
into a number of sampling areas. For each area, substantial data are
available. For example, assume a developer is interested in supplying
high quality retirement housing to married couples 65 to 74 years
old. Because these retirement units are high quality, the developer
estimates annual household income must be $40,000 or more.
The PUMS data illustrate how they can be used to assist in
the analysis. Comparing the data for the two areas reveals the first
area to have much more potential than the second. Area A has a
large number of married householders in the relevant age group, a
REAL ESTATE MARK ET RESEARCH
53
large number of householders who rent (and are more likely to move
than those who own) and a substantial number with household
incomes of $40,000 or more.
PUMS Data for Area A, 1980 1980 1980 1980 1980
Age
65-69 70-74
Number of households 19,520 18,100
Number of married households 9,300 7,880
Number of rental housing 6,080 5,480
Number having income over $40,000 1,900 1,300
Area B has less than 10 percent of the number of total house-
holds and married households in the relevant age groups. In addi-
tion, the number of households in rental housing and the number
having incomes more than $40,000 is small. Clearly, further analysis
of Area A is warranted.
PUMS Data for Area B, 1980
Age
65-69 70-74
Number of households 1,680 980
Number of married households 880 540
Number of rental housing 220 220
Number having income over $40,000 120 0
Primary Data for Marketing Analyses
When a promising market area is identified, primary data
are collected to estimate the proportion of the potential market that
would actually move into the proposed development. Primary data
obtained by personal interviews, telephone interviews, mail surveys
and other means are used to make this estimate.
Although questionnaire and personal interview design are
best left to those familiar with doing marketing research, the devel-
oper must review the questions to be asked to ensure that the market
research will provide the desired information. If the developer is
I NVESTMENT BY DESI GN
54
intent on developing a particular type of housing for the elderly, then
the market research must be addressed to an identified age group and
household type–not the elderly population in general. On the other
hand, a developer may be willing to supply any identified, unmet
need. In this case, the market research is stratified by age group so
that data about each age group are obtained, and the potential of
various types of housing can be evaluated.
The developer needs information about the range of respon-
dents’ income to determine the development quality desired and that
can be sustained in a specific market area. The questions also must
establish the respondents’ interest in leaving their present housing if
housing with the desired features becomes available at an appropri-
ate price.
With this information, the number of households that can be
expected to move to the project within a reasonable time can be
estimated. This is an estimate of the unmet need of a particular
market segment in a specific market area. From this estimate, the
project’s definition will evolve in the following terms:
· orientation,
· size,
· quality and features and
· selling price and rental rates.
Project definition is a function of the number of elderly in
the proper age group with the means to afford the housing and the
desire to move to it. The project must appeal to the correct age
group, have the number of units required by the market and have
features the segment wants.
Despite expected growth of the elderly population, developers
of housing for the elderly should proceed cautiously. The principal
growth of the elderly population is expected after 2010. Moreover,
the diverse characteristics of the present elderly population and their
general desire to remain within a familiar community may limit the
effective demand for a particular type of elderly housing product in
the target market area. Although market research can assist in
identifying promising market areas, it cannot eliminate the risk of
developing housing for the elderly.
FI NANCI AL FEASI BI L I TY ANALYSI S
55
Profitable Apartment
Construction
A previous section examined the importance of external
obsolescence for real estate investors. When there is widespread
external obsolescence in a market, current property owners are
protected from the competition of new properties until market rents
increase. This is a case analysis of the Bryan-College Station student
housing market. It illustrates how current property owners are
protected from the potential competition of new apartments in the
market area.
Student Housing Market
At present, the Bryan-College Station student rental housing
market occupancy rates are near 100 percent from September
through May; summer occupancy rates and rental rates are rising.
Students (and parents) often complain that rents are too high and
that apartments are too hard to locate at the beginning of the fall
semester. But several weeks after the fall semester begins, everyone
seems to be settled.
For the past several years, Texas A&M University has
implemented an enrollment management plan to limit the student
January 1993
Wayne E. Etter
Financial Feasibility
Analysis
6
I NVESTMENT BY DESI GN
56
population on its main campus to 41,000. Previous efforts to control
enrollment through raising admission standards did not affect total
enrollment. At present, however, financial limitations related to the
state’s budget problems are likely to force Texas A&M to control
enrollment. On the other hand, Texas A&M’s enrollment is not
likely to decline; more than 14,000 freshman applications were
received for the fall 1992 semester, and only 6,100 were accepted.
Thus, future demand for student housing appears steady.
Despite the expected level of student demand for housing,
rising rental rates and the near-zero vacancy rate, little private sector
housing has been added since 1984. Students wonder why additional
rental units are not being constructed by the private sector.
The answer to private sector involvement requires an exami-
nation of the financial feasibility of constructing new apartments.
The key to this analysis is the level of costs and rents, assuming that
demand for the space exists. First, however, the role of the current
low expectations of property appreciation and the current absence of
any real estate tax shelter benefits in the lack of apartment develop-
ment since 1984 is examined.
Appreciation and Tax Shelter Benefits
A decade ago, most real estate investors expected their
properties to appreciate rapidly. Perhaps these expectations were
unwarranted, but it was not unusual for investors to use estimated
annual property appreciation rates of 12 percent or more. The 1981
Economic Recovery Act created a huge demand by investors for
residential and commercial real estate because paper losses generated
by rapid depreciation could be used to offset investors’ other taxable
income. Often the combination of expected appreciation and tax
shelter benefits could offset the fact that a property’s rent was
insufficient to cover operating expenses and debt service. The inves-
tor still believed that a satisfactory return would be had when the
property was sold after a five-to-seven-year holding period.
With the passage of the 1986 Tax Reform Act, tax shelter
benefits were eliminated, and, therefore, the after-tax cash benefits of
owning real estate were sharply reduced. The reduction in cash
benefits from the tax law changes was accentuated by the onset of
recession in Texas. A fall in the market value of many multifamily
residential properties followed. Many properties went into default as
investors considered it unwise to continue making mortgage
payments on loans that exceeded the property’s market value.
FI NANCI AL FEASI BI L I TY ANALYSI S
57
Purchasers of these defaulted properties bought them for less than
their replacement cost and were able to obtain a positive cash flow
from the property despite the low market rents then prevailing.
Construction Costs
Today, investors have only modest expectations of property
appreciation and tax shelter benefits are not available. As a result, a
multifamily property investor must anticipate that rents will cover
all operating costs and debt service as well as provide a 10 to 11
percent current cash return on the equity invested. Under these
circumstances, the following question arises: Are rental rates suffi-
cient to justify new apartment construction? A large gap between the
current and the required rental rate means it will be some time
before new construction will occur.
If a proposed apartment complex can generate adequate
rental income to cover operating expenses, support sufficient debt to
finance the property and provide a satisfactory cash return to the
owner, it is financially feasible to develop the property. The first step
in making this determination is to estimate the property’s cost.
Current market information suggests that two-bedroom,
two-bathroom apartments and three-bedroom, two-bathroom
apartments have the highest demand in the Bryan-College Station
student housing market. Students have a high preference for these
apartments because they can share the kitchen and living area while
having their own bedroom, thereby reducing the per student cost
while maximizing their privacy. Thus, for the purposes of this
analysis, the cost of constructing a 925-square-foot two-bedroom,
two-bathroom apartment and an 1,100-square-foot three-bedroom,
two-bathroom apartment was estimated.
To estimate land costs, construction of 20 units per acre is
assumed, although the maximum apartment density in the city of
College Station is 24 units per acre. Apartment developers prefer to
purchase land that costs no more than $1.75 to $2 per square foot or
about $75,000 to $85,000 an acre. A price of $80,000 per acre is
used in the analysis; therefore, the unit land cost is $4,000.
Because no apartment construction has occurred in the
Bryan-College Station market area for several years, the base
construction cost is taken from the Marshall Valuation Service and
adjusted for time and the local economy. The cost of built-ins,
parking lot, recreation facilities and landscaping is based on
Marshall Valuation Service and local estimates. A 12 percent
I NVESTMENT BY DESI GN
58
entrepreneurial profit is considered reasonable. As reported in Table 1,
the apartment units’ respective estimated costs are $48,051 and
$54,110.
Required Rental Rates
To estimate the rent required to support the construction of
these apartments, the following operating and financing assumptions
were used.
• Amount of financing: 80 percent of total cost
• Terms of financing: 10 percent, 30 years
• Required cash-on-cash return: 11 percent
• Vacancy and bad debt loss: 5 percent
• Operating expense ratio: 30 percent
The monthly unit rent and rent per square foot required to
support the apartment construction are presented in Table 2. These
required rental rates are higher than the spring 1992 average high
rental rates reported by Branson Research Associates for Bryan-
College Station student housing market.
The difference between the nine-month lease rate and the
one-year lease rate is important. Although the market is moving in
the direction of one-year leases, the average high rental rates for
spring 1992 are an unknown mixture of lease arrangements. To
compete for tenants, the owners of a new apartment complex will
not be able to demand that tenants sign one-year leases, but charging
the required nine-month rental rate would put them at a serious
competitive disadvantage relative to owners of existing apartments.
Table 1. Estimated Apartment Construction Costs
Two-bedroom Three-bedroom
two-bath two-bath
Construction cost (sq. ft.) $35.63 $34.88
Unit size 925 1,100
Unit construction cost $32,958 $38,368
Built-ins 1,200 1,200
Other unit costs
Landscaping and pool 1,765 1,765
Parking 2,280 2,280
Office and laundry 700 700
Land 4,000 4,000
Entrepreneurial profit 5,148 5,797
Total estimated cost $48,051 $54,110
FI NANCI AL FEASI BI L I TY ANALYSI S
59
Thus, market rental rates must increase by a considerable amount to
encourage new construction. And, the cost of new construction is
likely to continue rising.
But such an increase is not likely in the short-run because
market rents are established by supply and demand; an individual
apartment owner cannot raise the rent for a typical apartment to the
level required to support new construction. However, owners of
properly maintained, well-located properties purchased for prices
based on past or current market rents will be able to gradually
increase their rental rates while maintaining their occupancy. Rental
rates can be increased gradually because few alternatives exist in the
local student housing market, and students will find it difficult to
economize on their space needs, i.e., the demand for apartments is
price inelastic.
On the other hand, an increase large enough to justify new
construction is unlikely because current apartment owners do not
need such rates for profitable operation. If demand remains steady,
current property owners will be protected from the competition of
new properties for several years.
Table 2. Estimated Rental Rate Required
to Support Construction
Two-bedroom Three-bedroom
two-bath two-bath
Construction cost $48,051 $54,110
Mortgage loan (80% of cost) 38,441 43,288
Equity investment $9,610 $10,822
Required before-tax cash flow
for 11% return on equity 1,057 1.190
Mortgage payment (10%, 30 years) 4,078 4,592
Required net operating income $5,135 $5,782
Operating expenses 2,370 2,669
Required effective gross income $7,505 $8,451
Vacancy and collection loss 395 445
Required gross possible income $7,900 $8,896
Estimated required monthly rent per unit
One-year lease $658 $741
Nine-month lease 878 988
*Average high market rent (an unknown
mixture of lease terms)
Spring 1992 $509 $715
*Source: Branson Research Associates, Bryan, Texas
I NVESTMENT BY DESI GN
60
Conducting a Multi-Year
Analysis
The expected rate of return from a real estate investment is
determined by the expected benefits of the investment–cash flow and
appreciation–and the cash required to purchase the property. Although
there are a number of popular nondiscounted measures of the rate of
return, a proper calculation uses present value techniques so that the
rate will reflect the timing of the cash inflows and outflows.
Equally important, however, is the need for good data. Ex-
pected rate of return means nothing if the projected costs and benefits
used in the calculation are incorrect.
Real estate is particularly affected by future events because of
three important characteristics: physical immobility, long economic
life and large economic size. In short, a property investment involves
a relatively large dollar investment that cannot be moved and that
must generate income for a long period. Thus, successful real estate
investing involves decisions about the future level of rents, operating
expenses, appreciation rates and tax laws. These, in turn, depend on
the rate and direction of urban growth, price inflation, international
events, political events and so forth.
As the information is gathered, the investor necessarily will
be addressing questions about risk. Risk exists in all projects, but
January 1995
Wayne E. Etter
Assembling the Data 7
ASSEMBL I NG THE DATA
61
some are more risky than others. The degree of risk depends on the
difference between expected and actual outcomes. If the expected
outcome is guaranteed, then the risk is negligible; if the expected
outcome is uncertain, then the risk is large. For a single project, the
best way to reduce risk is to improve the analysis of the variables that
produce the project’s expected rate of return. In this way, the spread
between expected and actual outcomes can be minimized.
As the scope of the analysis is examined, one of its prime
benefits becomes clear: in gathering the data required to make the
analysis, much will be learned about the investment under consider-
ation. Estimating the rate of return may be secondary to the knowl-
edge gained from gathering the information. Nevertheless, the pro-
spective investment must promise a satisfactory rate of return or be
abandoned.
Most real estate investment decisions and market valuations
are made using either net operating income or before-tax cash flow
from operations and resale. For some individual real estate invest-
ment decisions, however, estimating after-tax cash flow from opera-
tions and resales is desirable. The calculations are illustrated in the
appendix.
Analyzing income-producing real estate requires all expected
cash flows to be specified. These flows can be categorized as those
associated with the project’s
• origination,
• operation and
• termination.
Project Origination
To estimate the cash investment required for an existing
property, the amount of mortgage financing is netted against total
purchase price. To estimate the cash investment required for a
to-be-developed property, the amount of mortgage financing is netted
against estimated total project cost.
Assume these basic facts of a project origination:
Cost of land $130,680
Cost of building 612,080
Total cost $742,760
Mortgage (12%, 25 years) -557,070
Initial equity $185,690
I NVESTMENT BY DESI GN
62
Project Operation
Before-tax cash flow from operations for each year is esti-
mated from the project’s expected rent, vacancy rate, operating ex-
penses and mortgage payment.
Estimating net operating income
With the cost estimated, additional market information is
needed to prepare pro forma or projected operating statements.
Specifically, estimates of rental rates, vacancy rates and operating
expenses are needed for the property. These data can be obtained from
the feasibility analysis if one is available.
Square feet of net leasable space 20,000
Rent per square foot per year (0.55 x 12) $6.60
Potential gross income $132,000
Miscellaneous income 0
Less vacancy
and collection loss (5%) -6,600
Effective gross income $125,400
Less operating expense -36,000
Net operating income $89,400
Before-tax cash flow from operations
Before-tax cash flow from operations is estimated by subtract-
ing the expected mortgage loan payment from net operating income
(NOI). For example:
Net operating income $89,400
Mortgage payment -71,026
Before-tax cash flow $18,374
Calculating the amount of the mortgage loan payment re-
quires the loan amount and the mortgage constant. For the example
property, the annual payment is calculated as follows:
Loan amount x mortgage constant = annual payment
$557,070 x .1275 = $71,026
Preparing multi-year projections
In addition, the following data will be needed to complete the
specification of before-tax cash flow from operations for the holding
period:
• estimated holding period,
ASSEMBL I NG THE DATA
63
• estimated rental growth rate,
• estimated operating expense growth rate,
• estimated vacancy rates and
• annual mortgage payment for remaining years of estimated hold-
ing period.
Using an estimated holding period of five years, an estimated
rental growth rate and operating expense growth rate of 3 percent,
NOI and before-tax cash flow from operations can be estimated for the
example property. These estimates are presented in Table 1.
Table 1. Before-Tax Cash Flow to Equity from Operations
Y YY YYear 1 ear 1 ear 1 ear 1 ear 1 Y YY YYear 2 ear 2 ear 2 ear 2 ear 2 Y Y Y Y Year 3 ear 3 ear 3 ear 3 ear 3 Y Y Y Y Year 4 ear 4 ear 4 ear 4 ear 4 Y Y Y Y Year 5 ear 5 ear 5 ear 5 ear 5
Gross possible income $132,000 $135,960 $140,039 $144,240 $148,567
Less vacancy and
collection loss -6,600 -6,798 -7,002 -7,212 -7,428
Effective gross income $125,400 $129,162 $133,037 $137,028 $141,139
Less operating expense -36,000 -37,080 -38,192 -39,338 -40,518
Net operating income $89,400 $92,082 $94,844 $97,690 $100,620
Less mortgage payment -71,026 -71,026 -71,026 -71,026 -71,026
Before-tax cash flow
from operations $18,374 $21,056 $23,818 $26,663 $29,594
Project Termination
The net resale price and the before-tax cash flow from the
resale are estimated from the expected resale price, expected selling
expenses and the unpaid mortgage balance.
Estimating the expected resale price
The project’s expected resale price is of particular concern
because significant appreciation is often required to produce a satisfac-
tory rate of return. By carefully examining the project’s current value
and its expected resale price, the investor can estimate the apprecia-
tion potential of the property and the contribution of this component
to the project’s rate of return.
Evaluating the property’s current value. There is a relation-
ship between a property’s NOI and its value. When the following
calculation is made using the subject property’s data, the result is
known as the overall capitalization rate.
NOI
Value
I NVESTMENT BY DESI GN
64
Using the property’s total cost or purchase price and its
estimated NOI for the first “normal” year–the year in which expected
occupancy will be obtained–the overall capitalization rate can be
calculated. By comparing the property’s overall capitalization rate
with the market capitalization rate for similar properties, the
reasonableness of the price that the investor is paying for the property
can be evaluated. For instance, if the property under consideration is
offered for sale at an overall capitalization rate of 8.5 percent but
similar properties are selling for 10 percent market capitalization rates,
the investor should seek the reason(s) for the price difference. If the
original purchase price is too great, the investor must expect a smaller
increase in the project’s value because a future buyer cannot be
expected to pay too much for the property.
Estimating the expected resale price. The expected resale
price at the end of the holding period is estimated by using the
expected market capitalization rate to capitalize the NOI projected for
the year following the sale. The NOI for the year following the sale is
used because the buyer at the end of year five will purchase the
property’s future NOI rather than its past NOI. For example, to
estimate the resale price at the end of a five-year holding period:
NOI (year 6)
Expected resale price = —————————————
Market capitalization rate
$103,639
$1,036,391 = ————
.10
The expected resale price should appear reasonable when
compared to expected changes in the NOI and the market. For
example, if no rent increase is projected, this approach will make it
difficult to justify an increase in the property’s value over time. Of
course, annually increasing rents are a common assumption. Further-
more, a property that has operated successfully for several years may be
considered less risky than a newer property. In this case, a lower
capitalization rate may be used to estimate the resale price than was
used in evaluating the purchase price.
A second approach to evaluating the expected resale price is to
calculate the annual compound rate of growth necessary for the
property to appreciate to the expected resale price. Does this rate of
growth seem reasonable when compared to recent growth rates of
similar properties in the area? And, is it reasonable to assume that
ASSEMBL I NG THE DATA
65
this rate of appreciation will continue in the market? Local real estate
brokers are a good source for obtaining this information.
Net resale price and before-tax
cash flow from resale
With the expected resale price estimated, expected selling
expenses are deducted to arrive at the net resale price. When the
unpaid mortgage balance is deducted from the net resale price, the
result is called before-tax cash flow from resale. For example:
Expected resale price $1,036,391
Less selling expenses -41,456
Net resale price $ 994,935
Less unpaid mortgage balance -530,528
Before-tax cash flow from resale $ 464,408
The procedure for calculating the unpaid mortgage balance is
presented in “Calculating Mortgage Loans.”
Summary
The final result of the preceding calculations is the summary
of all before-tax cash flows to equity–both from operations and the
expected proceeds from the resale of the property. A summary of
these projected cash flows for the example property is presented in
Table 2.
Table 2. Before-Tax Cash Flow to Equity
Y YY YYear 1 ear 1 ear 1 ear 1 ear 1 Y YY YYear 2 ear 2 ear 2 ear 2 ear 2 Y YY YYear 3 ear 3 ear 3 ear 3 ear 3 Y YY YYear 4 ear 4 ear 4 ear 4 ear 4 Y YY YYear 5 ear 5 ear 5 ear 5 ear 5
Before-tax cash flow
from operations $18,374 $21,056 $23,818 $26,663 $ 29,594
Before-tax cash flow
from resale 464,408
Before-tax cash flow
to equity $18,374 $21,056 $23,818 $26,663 $494,002
Appendix
After-tax cash flow from operations
After-tax cash flow from operations is estimated by subtracting
estimated income tax liability from before-tax cash flow from opera-
tions. The project’s taxable income must be estimated first. Taxable
income is calculated as:
I NVESTMENT BY DESI GN
66
Potential gross income $132,000
Miscellaneous income 0
Less allowance for vacancy
and collection loss (5%) -6,600
Effective gross income $125,400
Less operating expenses -36,000
Net operating income $ 89,400
Less: Depreciation -21,331
Interest -66,848
Amortized financing costs -0
Taxable income $ 1,221
Thus, it is necessary to calculate the annual depreciation and
the annual amortized financing costs and to separate the mortgage
payment into its principal and interest components.
Depreciation. The modified accelerated cost recovery system
(MACRS) is used to depreciate income-producing real estate placed in
service after 1986. This depreciation system is not related to the
property’s physical depreciation or useful life. Furthermore, current
law permits the depreciation of income-producing real estate even
when it appreciates.
Current tax law requires income-producing real estate to be
depreciated according to the tables shown in Table 3. Note that Table
3.A is to be used for the depreciation of residential property; Table 3.B
is for the depreciation of nonresidential property. Assuming a residen-
tial property is placed in service in January, the first year’s depreciation
is calculated as follows:
Depreciable value x recovery percentage = depreciation
$612,080 x .03485 = $21,331
Interest. For the example property, the first year’s interest
payment is calculated:
Loan amount x interest rate = interest payment
$557,070 x .12 = $66,848
Permanent Financing Costs. Permanent financing costs are
amortized for the term of the mortgage loan using the straight-line
method. Had the mortgage lender charged a 2 percent fee for the
example loan, an additional cost of $11,141 would be incurred.
Amortizing this amount for the 25-year life of the mortgage results in
an annual amortization of $445.
ASSEMBL I NG THE DATA
67
Table 3. Depreciation Rates
Table 3.A
Residential Rental Property (27.5- year)
Use the column for the month of taxable year placed in service
Year 1 2 3 4 5 6 7 8 9 10 11 12
1 3.485% 3.182% 2.879% 2.576%2.273% 1.970% 1.667% 1.364% 1.061% 0.758% 0.455% 0.152%
2-9 3.636% 3.636% 3.636% 3.636%3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636%
Table 3.B
Nonresidential Real Property (39-year)
Use the column for the month of taxable year placed in service
Year 1 2 3 4 5 6 7 8 9 10 11 12
1 2.461% 2.247% 2.033% 1.819% 1.605% 1.391% 1.177% 0.963% 0.749% 0.535% 0.321% 0.107%
2-39 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564%
Note: Note: Note: Note: Note: Depreciation rates may change as new tax laws go into effect. These
tables are current as of J anuary 1995. Future users may wish to contact the IRS
or a tax consultant to verify depreciation rates in effect at that time.
A complete residential rental property depreciation table may be found in
Depreciation, Department of the Treasury, Internal Revenue Service, Publica-
tion 534 (Rev. Dec. 1987), pp. 30-31.
Source: Source: Source: Source: Source: 1994 Instructions for Form 4562, Department of the Treasury,
Internal Revenue Service, p. 7.
I NVESTMENT BY DESI GN
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Income Tax Liability. The estimated income tax payment is
calculated by applying the appropriate income tax rate to the estimated
taxable income. For the purposes of illustration, the marginal tax rate
of 28 percent is assumed. Thus:
Net operating income $89,400
Less: Depreciation -21,331
Interest -66,848
Amortized financing costs -0
Taxable income $ 1,221
Tax rate .28
Income tax $ 342
If taxable income is negative, the loss is carried forward.
Losses carried forward accumulate until they are offset by positive
taxable income or the property is sold.
1
For example:
Taxable Loss carried Net carried Net taxable
Year income forward forward income Tax due
1 $(43,920) $43,920 $43,920 $ 0 $ 0
2 (22,685) 22,685 66,605 0 0
3 4,678 0 61,926 0 0
4 34,348 0 27,578 0 0
5 66,519 0 0 38,940 10,903
It is possible that no income tax will be paid while the
property is held; the accumulated losses are used to offset the capital
gain when the property is sold.
There are two exceptions to the foregoing for some investors.
First, rental real estate annual operating losses of as much as
$25,000 can be used to offset active trade or business income and
portfolio income for investors with adjusted gross incomes of as
much as $100,000. The offset is reduced 50 cents for each $1 more
than $100,000 of adjusted gross income; thus, for investors with
adjusted gross incomes of $150,000 or more, there is no allowable
offset. Investors who use this exception must be actively engaged in
the management of the rental real estate; they may not be limited
partners and must own at least a 10 percent interest in the rental real
estate.
Second, investors may deduct unlimited real estate losses if
(a) more than half of all personal services they perform during the
year are for real property trades or (real estate related) businesses in
which they materially participate and (b) they perform more than
750 hours of service per year in those real estate activities. Material
ASSEMBL I NG THE DATA
69
participation requirements are met if the investor is involved in real
estate operations on a regular, continuous and substantial basis. This
provision may be especially useful for real estate professionals.
2
After-tax cash flow from operations. The final step required
to estimate after-tax cash flow from operations is to subtract the
estimated income tax payment from estimated before-tax cash flow
from operations. Thus:
Before-tax cash flow from operations $18,374
Less income tax liability -342
After-tax cash flow from operations $18,032
Using the data from Table 1, after-tax cash flow from opera-
tions can be estimated for the example property. These estimates are
presented in Table 4.
Table 4. After-Tax Cash Flow to Equity from Operations
Year 1 Year 2 Year 3 Year 4 Year 5
Net operating income $89,400 $92,082 $94,844 $97,690 $100,620
Depreciation 21,331 22,255 22,255 22,255 22,255
Interest 66,848 66,347 65,786 65,157 64,452
Taxable Income $ 1,221 $ 3,480 $ 6,804 $10,278 $ 13,913
Before-tax cash flow
from operations $18,374 $21,056 $23,818 $26,663 $ 29,594
Income tax liability 342 974 1,905 2,878 3,896
After-tax cash flow
from operations $18,032 $20,081 $21,913 $23,786 $ 25,698
After-tax cash flow from resale. The after-tax cash flow from
resale is determined by subtracting any capital gains tax from the
before-tax cash flow from resale. Thus:
Expected resale price $1,036,391
Less selling expenses -41,456
Net resale price $ 994,935
Less unpaid mortgage balance -530,528
Before-tax cash flow from resale $ 464,408
Less capital gains tax -101,508
After-tax cash flow from resale $ 362,900
I NVESTMENT BY DESI GN
70
Determining the capital gain tax. The capital gain tax is
calculated as follows:
Step 1
Cost of land $130,680
Cost of improvements 612,080
Total cost $742,760
Less accumulated depreciation -110,352
Adjusted basis $632,408
Step 2
Resale price $1,036,391
Less selling expense -41,456
Net resale price $ 994,935
Less adjusted basis -632,408
Capital gain $ 362,527
Step 3
Capital gain $ 362,527
Less accumulated loss carry forward -0
Net taxable gain $ 362,527
Tax rate x .28
Capital gain tax $ 101,508
For the purposes of illustration, the maximum capital gain tax
rate of 28 percent is assumed.
Summary
The final result of the preceding calculations is the summary
of all after-tax cash flows to equity–both from operations and the
expected proceeds from the resale of the property. A summary of these
estimated cash flows for the example property is presented in Table 5.
Table 5. After-Tax Cash Flow to Equity
Y YY YYear 1 ear 1 ear 1 ear 1 ear 1 Y YY YYear 2 ear 2 ear 2 ear 2 ear 2 Y Y Y Y Year 3 ear 3 ear 3 ear 3 ear 3 Y YY YYear 4 ear 4 ear 4 ear 4 ear 4 Y YY YYear 5 ear 5 ear 5 ear 5 ear 5
After-tax cash flow
from operations $18,032 $20,081 $21,913 $23,786 $ 25,698
After-tax cash flow
from resale 362,900
After-tax cash flow
to equity $18,032 $20,081 $21,913 $23,786 $388,598
ASSEMBL I NG THE DATA
71
Notes
1
Income is segregated into active trade or business income,
passive investment income and portfolio income. All real estate
income from operations or gains is classified as passive investment
income. If the property produces an operating tax loss after the
deduction of interest and depreciation, the loss can be used only to
offset positive income from other passive investments. If the real
estate investor has no other passive investments that produce positive
income, the loss can be carried forward and used to offset positive
passive income in the future, or it can be written off when the
property is sold. Thus, the project may not produce any taxable
income for a number of years but neither will it produce tax shelter.
Unless an investor has properties that are producing taxable income,
investing in a property that produces losses will have little attraction.
Prior to the 1986 Tax Reform Act, the opposite was true.
2
Jerrold J. Stern, “Passive Loss Rules Eased for Real Estate
Professionals,” Tierra Grande (Spring 1994), pp. 17-18.
I NVESTMENT BY DESI GN
72
How Present Value
Works
Present value analysis is one of the fundamental tools of
financial analysis. Although making a proper and thorough financial
analysis involves present value analysis, it is not the most important
step in financial analysis.
Present value is simply a way of dealing with expected cash
outlays and benefits to be paid out and received over time. When the
analyst is satisfied with the quality of the financial data, present
value analysis is used to calculate a proposed investment’s expected
net present value or internal rate of return so that each project under
consideration can be measured against the investor’s required return.
Present value analysis also is used by real estate appraisers.
Today, many people are proficient at using financial calcula-
tors and personal computer software programs for making present
value calculations. However, many people also have difficulty with
present value calculations when they confront a problem not covered
by the examples in the calculator manual–knowing a series of
keystrokes or how to input data does not demonstrate a knowledge of
present value.
January 1990
Wayne E. Etter
Evaluating
the Data
8
EVALUATI NG THE DATA
73
Present value analysis is based on the idea that more is better
than less and that sooner is better than later; both the magnitude
and the timing of the cash flows are considered. Having more ben-
efits from the investment sooner means that they can be reinvested
sooner; given that the reinvestment takes place at a positive rate of
interest, present value analysis allows a present sum of money to be
compared with a larger sum to be received in the future.
Present value analysis helps to decide if the future benefits
are sufficient, given their cost. Although present value analysis is a
fundamental tool of all investment decision making, it is particularly
important in real estate investment analysis because income-produc-
ing properties usually have rather long recovery periods.
Real estate investments, like all other investments, involve
the expenditure of funds to obtain the right to receive a set of uncer-
tain, future cash flows. Thus, there are three essential elements to
the investment: a cash outlay, expected cash flows (or benefits), and
an interval between the time of making the investment and receiving
its benefits.
Because present value analysis is an important communica-
tion system, the following conventions are used when analyzing
income-producing properties. First, it is usually assumed that cash
outlays are made at the beginning of the period of analysis, some-
times called time zero. Second, it is usually assumed that positive or
negative cash flows occur at the end of the period. Third, the period
is usually one year.
Problems involving leases, compound interest or compound
growth rates may be calculated for periods other than a year. When
lease agreements are being analyzed, the payments may be paid at
the beginning of the period, and the length of the period must be
specified (month, quarter, year). Compound interest and compound
growth rate problems require the specification of the time of pay-
ment and the length of the period.
Present value analysis is based on the concept of compound
interest–how much must be invested today at a given rate to accu-
mulate to $1 over a specified number of years (or other period)?
Thus, the amount that must be invested now is dependent on the
rate of compound interest and the length of time the investment is
left to accumulate. The compound sum of $1 table, for example,
includes the following information:
I NVESTMENT BY DESI GN
74
Number of years
(periods) 10%
1 1.100
2 1.210
3 1.331
These entries are calculated with the formula (1 + i)
n
with i
being the interest rate and n being the number of years (periods). For
example, (1 + 0.10)
3
= 1.331. The entry “1.331” shows that if $1 is
invested now and left to compound at the rate of 10 percent for three
years, the investment’s accumulated value will be $1.331:
$1.00 Initial investment
+ .10 Interest for year 1
$1.10 Balance at the end of year 1
+ .11 Interest for year 2
$1.21 Balance at the end of year 2
+ .121 Interest for year 3
$1.331 Final value
How does a present value table differ from a compound
interest table? The present value of $1 table, for example, includes
the following information:
Number of years
(periods) 10%
1 0.909
2 0.826
3 0.751
These entries are calculated with the formula 1 / (1 + i)
n
with i being the interest rate and n being the number of years (peri-
ods). For example, 1 / (1 + 0.10)
3
= 0.751. The entry “0.751” says
that if 75.1 cents are invested now and left to compound at the rate of
10 percent for three years, the investment’s terminal value will be $1:
$0.7510 Initial investment
+ .0751 Interest for year 1
$0.8261 Balance at the end of year 1
+ .08261 Interest for year 2
$0.90871 Balance at the end of year 2
+ .090871 Interest for year 3
$0.999571 (= $1) Final value
EVALUATI NG THE DATA
75
Thus, the difference between the compound interest table
and the present value table is that the compound interest table is
used to calculate the amount $1 will become if invested for a certain
number of periods at a particular interest rate. The present value
table is used to calculate the number of cents that must be invested for
a certain number of periods at a particular interest rate to become $1.
Compound interest tables and present value tables are
available widely. They are found in many real estate textbooks and
are published in special books of financial tables.
Suppose an investor wishes to value a series of annual cash
benefits. Present value analysis is applied to this problem by multi-
plying the expected benefits by the proper present value factor. If the
expected cash benefits are $1,000 at the end of years 1, 2 and 3, and
the required return is 10 percent, the problem is solved as follows.
Annual 10% Present
Cash Value Present
Year Benefit Factor Value
1 $1,000 x .909 = $909
2 1,000 x .826 = 826
3 1,000 x .751 = 751
Present value of benefits $2,486
The calculated present value of the three annual cash ben-
efits is $2,486. What does this mean? It means that if the investor is
satisfied that a 10 percent return is appropriate for this investment,
then a maximum price of $2,486 can be paid for the right to these
future cash flows. The present value of each year’s cash benefit, if
left to compound at 10 percent for the respective number of years,
will have a terminal value of $1,000 as previously demonstrated.
If the investor believes that a 15 percent return is more
appropriate, the maximum price that can be paid for the benefits is
$2,284:
Annual 15% Present
Cash Value Present
Year Benefit Factor Value
1 $1,000 x .870 = $870
2 1,000 x .756 = 756
3 1,000 x .658 = 658
Present value of benefits $2,284
I NVESTMENT BY DESI GN
76
Why does the lower rate generate a higher present value?
This result is logical if the annual $1,000 payments are considered
the fixed benefits of the investment. Less will be paid for the benefits
if they are to provide a 15 percent return on investment instead of a
10 percent return. Thus, for investments with a fixed income
stream, their rate of return and value vary inversely. As required
return rises, investment value declines.
Although some believe that inflation is the reason that future
dollars are brought to their present value, present value analysis has
nothing directly to do with inflation. Future dollars are worth less
because they are not available now; if they were, they could be
reinvested. Future dollars also may be worth less because of their
expected lower buying power but, in that case, a higher reinvestment
rate will equalize the expected rate of inflation. This process is
identical to that of investors demanding higher interest rates during
periods when higher rates of inflation are expected.
An annuity is a finite stream of equal periodic cash benefits.
When calculating the present value or the rate of return of an annu-
ity, the present value of $1 received annually for N years table may
be used to reduce the computations required. For example, the
present value of a three-year annual annuity of $1,000 per year is
calculated as follows:
$1,000 annual payment
x 2.283 factor for three years, 15 percent
$2,283 present value of the annuity
Such benefit streams are encountered in real estate analysis
when lease payments, mortgages and other financial instruments are
being analyzed, but they are encountered rarely otherwise.
The analysis of income-producing properties usually involves
cash flows that vary from year to year and may be negative in some
years. These cash flow patterns can be handled as easily as equal
annual payments using present value analysis.
Annual 10% Present
Cash Value Present
Year Benefit Factor Value
1 $2,400 x .909 = $2,182
2 2,000 x .826 = 1,652
3 -1,000 x .751 = -751
4 400 x .683 = 273
5 -1,000 x .621 = -621
Present value of benefits $2,735
EVALUATI NG THE DATA
77
In an earlier example, the present value of receiving $1,000
annually for three years was determined to be $2,486 at a 10 percent
discount rate. What is the effect of speeding up the rate of the cash
benefits while holding the total constant? For example, what is the
present value of the stream if $2,000 is received the first year and
$500 in years two and three?
Annual 10% Present
Cash Value Present
Year Benefit Factor Value
0 $2,000 x .909 = $1,818
1 500 x .826 = 413
2 500 x .751 = 375
Present value of benefits $2,606
The result is an increase in the present value of the income
stream; the stream is more valuable because the extra $1,000 is
received sooner and can be invested for two years. This will more
than offset the effect of the smaller cash benefits in years two and
three.
Just as present value results in an investment having a
higher value if cash flows are received sooner, present value results in
higher values when cash outlays are delayed. Thus, investment
analysis must take the timing of cash outlays into account. For
instance, a total cash outlay of $1 million, when spread over three
years, has the following present value:
Annual 10% Present
Cash Value Present
Year Benefit Factor Value
0 $200,000 x 1.000 = $200,000
1 400,000 x .909 = 363,600
2 400,000 x .826 = 330,400
Present value of benefits $894,000
With a basic understanding of how present value works, the
technique can be applied to investment decision making. Using
present value to calculate an investment’s internal rate of return and
net present value will be considered next.
I NVESTMENT BY DESI GN
78
The basic idea of present value reveals the attributes that
cause present value analysis to be used for analyzing investments.
• All cash flows during the life of the investment are considered.
This includes the investment outlay, both positive and negative
operating cash flows and appreciation.
• The timing of all cash flows is considered. Present value analy-
sis makes those projects with delayed investment outlays or
those producing cash flows sooner more attractive than those
projects with immediate investment outlays or those producing
delayed cash flows.
• Present value analysis considers an investor’s desire to reinvest
the cash benefits derived from the investment.
Present value analysis is used to determine a project’s
acceptance or rejection by calculating a proposed investment’s net
present value and internal rate of return. This discussion focuses on
the investor’s required rate of return and these two present value
techniques.
An investor uses different required rates of return for differ-
ent investments because the risk of all investments is not the same;
normally, as the level of risk increases, the required rate of return is
increased. Although risk considerations are beyond the scope of this
article, it is necessary to understand only that an investor establishes
a required rate of return for all investments being considered. The
level of risk inherent in each investment is reflected in the required
rate of return.
Net Present Value. Using the investor’s required return to
calculate the present value of the future benefits and subtracting the
investment’s cost from the present value of the future benefits gives
the investment’s net present value. For example, an investor with a
required rate of return of 15 percent is considering an investment
that costs $2,284 and promises $1,000 annual cash benefits for three
years. What is the net present value?
Using Present Value
Analysis
April 1990
Wayne E. Etter
EVALUATI NG THE DATA
79
Annual 15% Present
Cash Value Present
Year Benefit Factor Value
1 $1,000 x .870 = $ 870
2 1,000 x .756 = 756
3 1,000 x .658 = 658
Present value of benefits $2,284
Cash outlay 2,284
Net present value $ 0
If the net present value is zero (the present value of the
future benefits is equal to their cost), the investment’s return will be
equal to the investor’s required rate of return. A better understanding
of how a net present value of zero provides the required rate of return
can be had by considering the following example:
Investment Outstanding
Year Cash Flow 15% Return Recovery Investment
0 -$2,284 $2,284.00
1 1,000 $342.60 $657.40 1,626.60
2 1,000 243.99 756.01 870.59
3 1,000 130.59 869.41 $ 1.18
As shown, the first year’s cash flow of $1,000 provides the
investor with a 15 percent return on the $2,284 invested for the first
year and reduces the amount of unrecovered investment by $657.40.
By the end of the third year, the amount invested has been recov-
ered–the small remainder results from rounding–and the investor has
earned 15 percent each year on the amount of the unrecovered
investment. Thus, the rate of return accounts for both the return on
and the return of the investment.
The present value of an income stream discounted at the
required rate of return is the price that must be paid for the future
benefits if the required rate of return is to be earned. When the
present value of the benefits exceed their cost, the net present value
is positive, and the investor receives a return in excess of the re-
quired return. If the net present value is negative, the investment’s
return will be less than the investors required return. For any given
set of cash benefits and cash outlay, an increase in the required rate
I NVESTMENT BY DESI GN
80
of return decreases the investment’s net present value. If the required
return becomes too great, the net present value becomes negative.
When two or more projects are being compared, they can be
ranked according to their net present value. All other things being
equal, the project with the largest net present value will be selected
because it will maximize the investor’s wealth.
Internal Rate of Return. An investment’s expected rate of
return can be compared directly with the investor’s required return.
In the discussion of net present value, it was observed that there is a
particular rate of discount that will make the net present value equal
to zero. This rate is known as the internal rate of return. To find this
rate, trial discount rates are chosen until the rate that results in a net
present value of zero is found. As Figure 1 shows, a positive net
present value of $37 is obtained with a discount rate of 14 percent.
Because a net present value of zero is desired, a higher rate, say 16
percent, is tried. This rate yields a negative $38 net present value.
Finally, a discount rate of 15 percent is used and a net present value
of zero results.
Financial calculators and electronic spreadsheet programs
make this calculation in a similar fashion–electronic spreadsheet
programs, for instance, require a “guess” rate to begin the calculation
of the internal rate of return.
As with the net present value method, the internal rate of
return is used to compare alternatives. When two or more projects
are being compared, the projects can be ranked according to their
internal rate of return; each also is compared with the investor’s
required rate of return. This comparison is shown in Figure 2.
EVALUATI NG THE DATA
81
Projects A and B have internal rates of return in excess of the
investor’s required rate of return and are acceptable; projects C and
D have internal rates of return less than the investor’s required rate
of return and are not acceptable. If only one project can be funded,
the project with the largest internal rate of return ordinarily will be
selected because choosing it will maximize the investor’s wealth
(assuming that all alternatives are equal in risk).
To use present value analysis, one must have a clear under-
standing of net present value and the internal rate of return methods.
Many investors calculate both the net present value and the internal
rate of return for each investment. Others prefer to use only the
internal rate of return because they understand the general concept
of rate of return. Therefore, they rely on it to determine if an
investment’s return is adequate relative to the required rate of return
and for ranking alternative investments.
Is the use of the internal rate of return instead of net present
value in real estate investment analysis a problem? Ordinarily, this is
not a problem because both usually result in the same ranking of
alternative investments. However, this question arises because it is
possible for an investor choosing between two mutually exclusive
alternatives (choosing between financing proposals, for example) to
discover that one alternative generates the largest net present value
and the other generates the largest internal rate of return. Although
the circumstances that result in such conflicts are not common in
the analysis of income properties, exploring this question provides
additional insight into these two approaches to measuring an
investment’s expected return.
I NVESTMENT BY DESI GN
82
Although investors have many goals, their ultimate invest-
ment goal is assumed to be wealth maximization. Using this as a
guide, the example of an investment costing $2,284 and providing
$1,000 annual cash benefits for three years will be re-examined. It
was shown that this investment provides the investor with a 15
percent internal rate of return.
Annual 15% Present
Cash Value Present
Year Benefit Factor Value
1 $1,000 x .870 = $ 870
2 1,000 x .756 = 756
3 1,000 x .658 = 658
Present value of benefits $2,284
Cash outlay 2,284
Net present value $ 0
Internal rate of return 15%
However, if $2,284 is invested in an alternative investment
at a 15 percent compound rate for three years, it will become $3,474.
Why would an investor not prefer this investment to one that
produces three annual cash flows of $1,000? Because a basic assump-
tion of present value analysis is that cash flows are reinvested. If each
of the $1,000 cash flows is reinvested at 15 percent when it is
received, the future value of these cash flows is $3,474:
Accumulation Cash Flow
from Previous Reinvested at Interest
Year Year End of Year at 15% Total
1 $ 0 $1,000 $1,000
2 1,000 1,000 $150 2,150
3 2,150 1,000 324 3,474
Thus, because of the reinvestment of the cash flows at 15
percent, both investments will accumulate to the same future value.
If the reinvestment of the annual $1,000 cash flows is not possible or
if reinvestment will take place at a rate less than 15 percent, the
alternative investment providing $3,474 in three years would be
preferred. Accordingly, it can be seen that when an internal rate of
EVALUATI NG THE DATA
83
return is being calculated, it is assumed that the cash flows will be
reinvested at the internal rate of return. But when a large internal
rate of return is calculated, it may not be possible to find other
investments with equally large expected returns in which to reinvest
the cash flows.
On the other hand, in the calculation of the net present
value, the required rate of return is the reinvestment rate. The
required rate of return should reflect realizable returns in the market
for a given level of risk; furthermore, it is assumed that an investor
will not invest at a rate less than the required rate of return; if this
happens, the required rate of return has been improperly established.
The net present value method is used to choose between
alternatives when there is a ranking conflict between the net present
value and the internal rate of return. Why? With the net present
value method, reinvestment of the cash flows takes place at the
investor’s required rate of return, but with the internal rate of
return method, reinvestment of the cash flows must take place at
the internal rate of return. The internal rate of return can vary
from project to project; this, in turn, results in a varying reinvest-
ment rate assumption from project to project. However, the reinvest-
ment rate assumption is constant from project to project when the
net present value method is used. Furthermore, when the cash flows
are reinvested at the required rate of return, the project with the
largest net present value will maximize the investor’s wealth.
Calculating the net present value also is superior to calculat-
ing the internal rate of return if the annual cash flows change from
positive to negative to positive during the holding period. Under
these circumstances, calculating the internal rate of return can result
in multiple internal rates of return. No such possibility exists when
calculating net present value.
Once the proper interpretation of the net present value
method is firmly grasped, another advantage appears–it is easier to
calculate than the internal rate of return. Only a present value table
and a simple calculator are required whereas a financial calculator or a
computer is necessary to quickly calculate the internal rate of return for
a real estate investment having uneven cash flows over a long holding
period.
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84
Calculating Mortgage
Loans
April 1992
Wayne E. Etter
Mortgage loan calculations are based on present value
concepts. Although they usually are made with a calculator or a
computer, learning how present value basics can be used to calculate
the payment provides the understanding needed to solve practical
mortgage calculation problems.
Present Value Basics
A borrower obtains a $100,000, 10 percent, 25-year loan.
Repayment of this loan requires 25 annual payments of $11,017.
Because the annual payments are equal, they are an annuity, and its
present value can be calculated. Using a discount rate of 10 percent
(and ignoring rounding error), the present value of the annuity is
equal to the amount of the loan.
Annual payment x Annuity factor = Present value
(10%, 25 years) of payments
$11,017 x 9.077 = $100,000
The annuity factor can be calculated by solving for the
present value of a $1-per-year payment, discounted at 10 percent for
25 years or obtained from a present value table.
These terms can be rearranged to calculate the loan
payment:
Loan amount x
1
= Annual payment
Annuity factor
$100,000 x
1
= $11,017
9.077
Usually, however, the appropriate mortgage constant is used
to calculate the payment. Mortgage constant tables are found in
many real estate textbooks and are published in special books of
financial tables. The mortgage constant can be calculated by solving
for the payment of a $1 loan using the appropriate interest rate and
repayment term.
EVALUATI NG THE DATA
85
Loan amount x Mortgage constant = Annual payment
(10%, 25 years)
$100,000 x .11017 = $11,017
Examination of these two methods indicates that the annuity
factor and the mortgage constant are reciprocals:
1
= Mortgage constant
Annuity factor
When monthly mortgage payments are required, monthly
mortgage constants rather than annual mortgage constants are used.
Although most mortgage loans are repaid monthly, annual mortgage
loan payments normally are used for illustration.
If the borrower actually receives $100,000 from the lender
and then pays the $11,017 annually to the lender, the lender earns
and the borrower pays a true rate of 10 percent on the loan. In fact,
10 percent is the internal rate of return because 10 percent is the rate
of discount that makes the present value of the loan payments equal
to the loan amount. If less than $100,000 is received by the borrower
but payments of $11,017 are still made, then the true rate is greater
than 10 percent. This situation occurs when points or other financ-
ing costs are paid by the borrower to the lender.
Figure 1. Illustration of a Declining-Balance
Mortgage Loan
Loan amount: $100,000
Interest rate: 11%
Term: 10 years
Mortgage constant: 0.1698014
Payment: $16,980.14
Year Payment Interest Principal Balance
1 $16,980.14 $11,000.00 $5,980.14 $94,019.86
2 16,980.14 10,342.18 6,637.96 87,381.90
3 16,980.14 9,612.01 7,368.13 80,013.77
4 16,980.14 8,801.52 8,178.62 71,835.15
5 16,980.14 7,901.87 9,078.27 62,756.88
6 16,980.14 6,903.26 10,076.88 52,679.99
7 16,980.14 5,794.80 11,185.34 41,494.65
8 16,980.14 4,564.41 12,415.73 29,078.92
9 16,980.14 3,198.68 13,781.46 15,297.46
10 16,980.14 1,682.72 15,297.42 0.05
I NVESTMENT BY DESI GN
86
The calculated mortgage payment is sufficient to repay the
principal amount borrowed during the term of the loan. In addition,
the lender receives and the borrower pays the stated rate of interest
on the outstanding balance of the loan. Figure 1 illustrates how the
principal is repaid during the term of the loan. Note that a small
balance remains after the last payment. This will almost always be
true because all payments are rounded to the nearest cent.
Sometimes there is a need to estimate a mortgage’s unpaid
balance as of a certain date. For example, assume a $50,000 loan was
made for 25 years at an 8 percent rate. The appropriate mortgage
constant is 0.0937 and the annual payment is $4,685.
Loan amount x Mortgage constant = Annual payment
$50,000 x .0937 = $4,685
What is the unpaid balance of the loan after seven payments
have been made? Consider that the loan is still an annuity but has
only 18 remaining annual payments. To find the unpaid balance, the
present value of the annuity is calculated using the annuity factor for
8 percent and 18 years.
Annual payment x Annuity factor = Unpaid balance
$4,685 x 9.372 = $43,907.82
What if the owner desires to sell the mortgage after receiving
the seventh payment? Assume the current mortgage rate for this
type of loan is 12 percent. Again, the mortgage is an annuity with 18
remaining payments of $4,685. To determine the current market
price of the mortgage, the payments are discounted using the annuity
factor for 12 percent and 18 years.
Annual payment x Annuity factor = Market value
$4,685 x 7.250 = $33,966.25
The decreased value of the mortgage results from the fact
that the fixed payments must provide a higher rate of return to the
owner of the mortgage than is provided in the mortgage, i.e., 12
percent versus 8 percent. Note that the rate of return and value vary
inversely for a security that provides a fixed income stream.
Mortgage Constant
From the perspective just presented, mortgage constants are
simply numbers from a table used to calculate mortgage loan
EVALUATI NG THE DATA
87
payments. Although this is true, mortgage constants also indicate the
cash cost of borrowing money in much the same way as the interest
rate for other types of loans. For example, on a $100,000, 12 percent,
interest-only loan, the borrower expects to pay $12,000 annual
interest.
Annual interest
= Interest rate
Loan amount
$12,000
= 12 percent
$100,000
Because the mortgage loan payment includes principal and
interest, the annual payment must be larger than the amount
sufficient to pay the annual interest. If a 12 percent, $100,000
mortgage loan is to be repaid in 25 years, the annual payment is
$12,750.
Mortgage constant x Loan amount = Loan payment
.1275 x $100,000 = $12,750
Rearranging terms:
Loan payment (principal + interest)
= Mortgage constant
Loan amount
$12,750
= .1275 percent
$100,000
Thus, the mortgage constant, like the interest rate, expresses
the cash cost of borrowing money. Because of this, the mortgage
constant is often quoted as an indicator of borrowing costs in a
manner similar to the interest rate. When this is done, the mortgage
constant is expressed in percentage terms, not as a decimal fraction–
12.75 percent, not 0.1275.
The mortgage constant at a particular interest rate always
exceeds that interest rate because it includes the amount neces-
sary to repay the loan over the life of the loan and pay the interest
on the loan. Therefore, extending the maturity of the loan reduces
the payment because the principal repayment is spread over more
years. Thus, the mortgage constant is a function of the interest rate
and the maturity. A review of a mortgage constant table reveals that
as the loan maturity is increased, the mortgage constant decreases
from one plus the interest rate to a value almost equal to the interest
rate (the interest rate is the mathematical limit of the function).
I NVESTMENT BY DESI GN
88
Figure 2. Reduction in Annual Payments Required
to Amortize a $1,000 Loan
at Selected Rates and Maturities
Interest Annual payment Decrease from
Rate (%) 15 years 20 years 15-year payment (%)
6 $102.96 $ 87.19 15.32
8 116.83 101.85 12.82
10 131.47 117.46 10.66
12 146.83 133.88 8.82
Interest Annual payment Decrease from
Rate (%) 20 years 25 years 20-year payment (%)
6 $ 87.19 $ 78.23 10.27
8 101.85 93.68 8.02
10 117.46 110.17 6.21
12 133.88 127.50 4.76
Interest Annual payment Decrease from
Rate (%) 25 years 30 years 25-year payment (%)
6 $ 78.23 $ 72.65 7.13
8 93.68 88.83 5.18
10 110.17 106.08 3.71
12 127.50 124.14 2.63
For example, mortgage payments were calculated at four
different interest rates and for increasing maturities. These compari-
sons are presented in Figure 2. The mortgage constant and, therefore,
the annual cost of borrowing decreases as the maturity of the loan
increases. Note, however, that the percentage decrease is largest
when the loan term is increased from 15 to 20 years and the
decrease is least when the loan term is increased from 25 to 30
years. Further note that at higher interest rates there is less to be
gained in the way of mortgage payment reduction from extending the
loan’s maturity than there is at lower interest rates.
The ready availability of calculators and computers allows
most mortgage loan calculations to be made quickly and easily.
Sometimes, however, solving a problem requires more than knowl-
edge of the proper calculator keystrokes. In such cases, basic present
value concepts such as annuities and mortgage constants can be used
to assist in problem solving. Knowledge of these concepts provides
greater understanding of the usefulness of the result.
EVALUATI NG THE DATA
89
Now that the basics of present value have been presented,
the use of present value techniques to estimate the value of income-
producing real estate will be examined. Although some investment
considerations are introduced, the main focus of this series continues
to be explaining the mechanics of present value techniques.
As demonstrated in this section, the present value of all the
expected cash benefits, discounted at the appropriate discount rate is
the maximum price that can be paid for the expected cash benefits if
the required return is to be obtained. This maximum price may be
called the property’s investment value. Investors should seek
properties with investment values in excess of their cost.
The real estate investor anticipates cash benefits in the form
of after-tax cash flow from operations and resale. When debt is used,
the mortgage lender generally receives periodic mortgage payments of
a predetermined amount but also may expect a share of other
benefits such as rents, cash flow or appreciation. Thus, an income
producing property’s investment value is equal to the present
value of all cash benefits expected by the equity investor, discounted
at the investor’s required rate of return, plus the cash benefits
expected by the lender, discounted at the lender’s required rate of
return.
Estimating a property’s investment value is important. The
present value approach reflects all variables that contribute to a
property’s investment value and that an investor considers in mak-
ing the investment decision. If the property’s investment value does
not equal or exceed its purchase price or cost to develop, the property
should not be considered further.
The property’s cash benefits are based on projections and
assumptions about expected rental rates, vacancy rates and operating
expenses, financing terms and loan amount, tax rates and the
projected holding period made by the equity investor and the lender.
Because these projections and assumptions result in estimating the
after-tax cash flow from operations and resale (the equity investor’s
benefits) and the property’s estimated debt service (the lender’s
July 1990
Wayne E. Etter
Estimating Value
I NVESTMENT BY DESI GN
90
benefits), the property’s investment value is affected by any changes
in any of these variables.
In Figure 1, for example, estimates of after-tax cash flows
from operations and resale are presented. Except for the vacancy rate
assumption, both estimates of cash benefits are calculated using
identical inputs. The 10 percent vacancy rate assumption, versus the
5 percent vacancy assumption, resulted in reduced after-tax cash
flows from operations each year; furthermore, because the greater
vacancy reduced the property’s expected net operating income, the
property’s estimated resale price and after-tax cash flow from resale
was less at the end of the holding period. This vacancy assumption
results in a reduced investment value and demonstrates the
sensitivity of the calculation to changes in the assumptions.
As noted previously, the required rate of return is used in
calculating investment value. Because capital is usually contributed
by equity investors and lenders, each can have a different required
rate of return.
The required return on equity is the minimum after-tax rate
of return that an investor must earn on the equity-financed portion
of the investment. It is used to calculate the present value of the
estimated after-tax cash flow from operations and resale that accrues
to the equity investor. If the investor pays more for the expected
benefits than their present value, the investor’s wealth will decline
because the investor will have paid more for the expected income
stream than it is perceived to be worth.
Figure 1
5% Vacancy 10% Vacancy
Year ATCF/OP PV at 15% ATCF/OP PV at 15%
1 $ 7,695 $ 6,691 $ 5,286 $ 4,597
2 8,574 6,443 6,366 4,814
3 9,374 6,164 7,315 4,810
4 10,191 5,827 7,831 4,477
5 11,026 5,482 8,595 4,273
Total $ 30,647 $ 22,971
ATCF/SALE
5 $161,453 $ 80,271 $137,414 $ 68,319
PV of Equity 110,918 91,290
PV of Debt 240,898 240,898
Investment value $351,816 $332,188
EVALUATI NG THE DATA
91
The lending rate is the lender’s required rate of return, but it
is not necessary to discount the lender’s expected benefits to find the
present value of the lender’s portion: the loan amount is equal to the
present value of the lender’s expected benefits (mortgage receipts,
plus expected participation, if any) discounted at the lender’s re-
quired rate of return (the lending rate). Thus, as shown in Figure 1,
investment value may be calculated by adding the loan amount to
the present value of the equity benefits.
The property’s perceived risk, the terms of purchase, its
financing or a particular investor’s tax situation can affect the
property’s investment value for a particular investor. Thus, one
investor is willing to pay more for a particular property than another
investor. For example, the effect of using a 25 percent required rate of
return instead of 15 percent in calculating investment value is shown
in Figure 2. The difference in the two investment values results
entirely from the difference in the investor’s required rate of return,
which reflects a difference in the investor’s perception of the the
property’s risk. The degree of risk depends on the difference between
expected and actual outcomes. If the expected outcome is guaran-
teed, then the risk is negligible; if there is great uncertainty about the
expected outcome, then the risk is significant. The usual assumption
is that riskier investment streams are discounted at higher rates.
The effect of debt financing on a property’s investment value
also can be analyzed. For example, the effect of increasing the
amount of debt from 75 percent of cost to 90 percent of cost when
Figure 2
Year ATCF/OP PV at 15% PV at 25%
1 $ 7,695 $ 6,691 $ 6,156
2 8,574 6,443 5,487
3 9,374 6,164 4,799
4 10,191 5,827 4,174
5 11,026 5,482 3,613
Total $ 30,647 $ 24,229
ATCF/SALE
5 $161,453 80,271 52,905
PV of Equity $110,918 $ 77,134
PV of Debt 240,898 240,898
Investment value $351,816 $318,032
I NVESTMENT BY DESI GN
92
there is positive financial leverage is presented in Figure 3. If no other
assumptions are changed, this change increases the property’s
investment value. Such a result is entirely in accord with what is
observed in the real world: when lenders finance more generously,
investors are willing to pay higher prices for property. Although
investors may not make such calculations, they do understand the
benefits of using more debt. Of course, they may not always consider
the consequences of additional risk accompanying the additional
debt.
Thus, the investment value is for a particular property and
for a particular set of circumstances. Because it is not an estimate of
market value, the investor cannot necessarily expect to purchase or
sell the property for the estimated investment value; rather, this is
the value of the property using a particular set of assumptions; if
unreasonable assumptions are made, the investment value calculated
for a particular investor may vary from the property’s market price.
Obviously, these factors also affect the property’s expected
internal rate of return and net present value of equity as well. How-
ever, the present value approach to estimating investment value is
important because it is possible to determine the effect of particular
assumptions on the property’s investment value, and, therefore, it is
possible to explain why particular investors are willing to pay a price
for a property while other investors believe the property is overpriced:
the assumptions used and the terms available produce a higher
estimate of investment value. Negotiations between buyers and
Figure 3
75% Debt 90% Debt
Year ATCF/OP PV at 15% ATCF/OP PV at 15%
1 $ 7,695 $ 6,691 $ 2,143 $ 1,863
2 8,574 6,443 3,313 2,505
3 9,374 6,164 4,518 2,971
4 10,191 5,837 5,759 3,293
5 11,026 5,482 7,038 3,499
Total $ 30,647 $ 14,131
ATCF/SALE
5 $161,453 80,271 116,903 58,121
PV of Equity $110,918 $ 72,252
PV of Debt 240,898 289,877
Investment value $351,816 $362,129
EVALUATI NG THE DATA
93
sellers revolve about terms and price; therefore, the calculated
investment value may be compared to a property’s cost or offering
price.
Income capitalization often is used to estimate a property’s
current or future market value. Typically for this purpose, a
property’s net operating income (NOI) for an appropriate year is
divided by the overall capitalization rate derived from the market.
Assume, for example, that a property’s estimated NOI is $10,000
and an overall capitalization rate of 10 percent is used.
Net operating income
Estimated market value =
Overall capitalization rate
$10,000
$100,000 =
.10
Income capitalization and ordinary present value calcula-
tions can be combined to estimate market value. For example,
assume a property’s NOI is expected to increase from $5,000 to
$10,000 per year over a five-year period and then stabilize at
$10,000 per year. Capitalizing the first year’s NOI produces a value
of $50,000, which undervalues the property; capitalizing the stabi-
lized NOI produces a value of $100,000, which overvalues the
property. But by adding the present value of the NOI for years one
through five to the present value of the property’s capitalized value at
the end of year five, a better estimate of the property’s market value
is obtained. These calculations are presented in Figure 4.
Figure 4
Capitalized Present Value
Year NOI Value at 10%
1 $ 5,000 $4,545.45
2 6,000 4,958.68
3 7,000 5,259.20
4 8,000 5,464.11
5 10,000 6,209.21
10,000 = $100,000 62,092.13
.10 $88,528.79
I NVESTMENT BY DESI GN
94
However, what if the demand for space is currently depressed
and the property’s expected increase in NOI is based on an expected
increase in demand for space? Although the analyst may be
convinced that the demand will recover by the fifth year, the analyst
is concerned that the projected demand levels in the early years will
not be achieved. It may be prudent, therefore, to reflect this
perceived risk by adopting the unusual approach of discounting the
NOI in the early years at a higher rate than the later years when the
NOI is approaching the stabilized level (see Figure 5). A comparison
of Figures 4 and 5 indicates that the riskier income stream has the
lower value.
Figure 5
Capitalized Discount Present Value
Year NOI Value Rate (%) at 10%
1 $ 5,000 12.0 $ 4,464.29
2 6,000 11.5 4,826.16
3 7,000 11.0 5,118.34
4 8,000 10.5 5,365.88
5 10,000 10.0 6,209.21
10,000 = $100,000 10.0 62,092.13
.10 $88,076.01
Appraisal reports sometimes contain calculations similar to
those in Figure 4 and 5. These should be examined closely; in
particular, the discount rate selected should be carefully explained
and justified. In some cases, the discount rate is related to returns
available from securities such as U.S. government bonds or
certificates of deposit rather than the property market. However,
when the same income stream is being valued, the discount rate
and the capitalization rate ought to be derived from the same
source.
Because of recent developments in financial calculators and
personal computer software, it is possible to solve quickly a number
of real estate present value problems. Even with such assistance,
however, it is necessary to know how present value works. Providing
this knowledge is the purpose of the last three sections.
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95
Many commercial property market brokers, lenders and
owners use real estate appraisals having an income approach value
estimate derived from direct capitalization and discounted cash flow
(DCF) analyses. The differences between these methods and their
appropriate use are the focus of this section.
To estimate value with direct capitalization, a property’s
stabilized net operating income (NOI) is divided by the market
capitalization rate (Figure 1). Estimating value with DCF analysis
requires estimates of each year’s NOI along with the property’s
expected reversion value at the end of the analysis period. Usually
the analyst uses income capitalization to estimate the reversion.
These expected cash benefits are then discounted at the appropriate
rate to obtain the market value estimate, also shown in Figure 1.
Estimating Net Operating Income
Although these calculations are simple and straightforward,
they depend on the appraiser’s assumptions or estimates. When
using direct capitalization, the property’s stabilized NOI must be
estimated. This estimate is developed from market data (rental
rates, vacancy and collection loss rates and operating expense data)
for comparable properties in the market area; it represents the
appraiser’s opinion of how the property ought to perform.
Because the appraiser’s opinion is based on observed market
data, it’s difficult to quibble with his or her NOI estimate. When a
market is “normal,” the notion of stabilized NOI is particularly
useful.
But two areas are of special concern. First, what if the
property has significant vacancy at the time of the appraisal? Obvi-
ously, no one develops a property with the expectation of significant,
permanent vacancy. So, the appraiser may use a market vacancy rate
(or the anticipated vacancy rate when the property is fully leased)
Direct Capitalization
or Discounted Cash
Flow Analysis?
Fall 1994
Wayne E. Etter
I NVESTMENT BY DESI GN
96
Figure 1. Estimating Value with Direct Capitalization
and DCF Analysis
NOI $10,000
Value = ————————— = ––—— = $100,000
Capitalization rate .10
Year NOI Reversion Total
1 $10,000 $10,000
2 10,000 10,000
3 10,000 10,000
4 10,000 10,000
5 10,000 $100,000 $110,000
Present value at 10% = $100,000
rather than the property’s actual vacancy rate. This results in a
larger NOI for the subject property and may overstate the property’s
value. Second, if the property’s future NOI is expected to increase
because of greater demand for space that leads to higher rental rates,
direct capitalization of a single year’s NOI may understate the
property’s value.
Because DCF analysis permits annual adjustments in rental
rates, vacancy and collection loss rates and operating expenses, DCF
analysis can be used to reflect a buyer’s expectations of increasing
NOI over time. When a property is expected to become fully leased
during the next three to five years, for example, the current vacancy
rate can be reduced until the desired occupancy is reached.
This specification of expected changes results in realistic
NOI estimates throughout the period–a result far superior to capital-
izing a single year’s NOI. On the other hand, just assuming that the
vacancy rate will be reduced during the three-year period may lead to
overestimating NOI.
DCF analysis is ideally suited for situations such as this.
However, DCF analysis does not add much useful information when
the subject property is fully leased and no changes in occupancy or
the external environment are anticipated that will affect NOI. As
shown in Figure 1, the present value of a series of equal annual cash
flows is equivalent to the capitalized value.
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97
It is not an error to use DCF analysis to value a property
when no significant change in NOI is expected. However, appraisal
report users should understand that this technique’s results are no
better than those produced by a correct application of direct capitali-
zation. Of course, if both techniques, properly used, achieve similar
values, the estimated value has greater credibility.
Selecting Capitalization and Discount Rates
Theoretically, concerns about capitalizing a single year’s NOI
are eliminated by the appraiser’s skill in deriving the market capitali-
zation rate from comparable sales. If the market capitalization rate is
derived from sales of properties with vacancy rates comparable to the
subject and with comparable buyer expectations about becoming
fully leased (or for increased NOI), the subject property’s value could
be estimated with an unadjusted NOI and the market capitalization
rate.
Buyers who expect their properties’ occupancy levels to
improve pay prices that reflect this expectation. Likewise, buyers
who expect the future NOI of their properties to increase pay prices
reflecting that expectation. In both cases, expectations are reflected
by observed capitalization rates.
The appraiser’s problem arises when appropriate
comparables cannot be located. In this case, the appraiser must
develop the capitalization rate and estimate the NOI from the best
available comparables to produce a market value estimate that
reflects these expectations.
For DCF analysis, an appropriate discount rate is used to
convert the NOI estimates to a value estimate. When DCF analysis
is used to estimate a property’s market value, the discount rate
ought to be extracted from the market using the data of comparable
properties. Thus, the need for appropriate comparables is the same
for DCF analysis and for direct capitalization. (When DCF analysis
is used for investment analysis, the investor’s required rate of return
ought to be used to discount the expected cash flow.)
Deriving a discount rate from the market is more difficult
than estimating the market capitalization rate. For each comparable
property used in the derivation, the buyer’s expectations about future
NOI and reversion would have to be determined. This would allow
calculation of the discount rate that equates these expectations to the
purchase price. (Estimating the market capitalization rate requires
only each comparable property’s NOI and the reported sales price.)
I NVESTMENT BY DESI GN
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After obtaining the discount rate for each comparable prop-
erty, the analyst would select the appropriate discount rate for the
subject property. The process is the same as choosing the appropriate
capitalization rate from comparable sales.
While this procedure is possible, it would be difficult in
practice. Therefore, the discount rate often is estimated by adding a
risk premium and a liquidity premium to a relatively risk-free rate of
return, such as the U.S. Treasury bill rate or to the yield of some
other security. This built-up rate is used to discount the expected
cash flows. Although a theoretically correct approach, its use re-
quires a serious attempt to ascertain the risk and return differences
between the subject property and the security.
Investor surveys offer another approach for selecting an
appropriate discount rate. Such surveys report investors’ expecta-
tions for several different property types. The obvious problem with
their use is that they report general expectations rather than the
expectations for a specific property in a specific market.
Sometimes several different discount rates are tried; the rate
that results in a market value estimate approximately the same as
that obtained with direct capitalization is selected. Then, the
reasonableness of this rate of return is verified by comparing it to
investor returns in other markets.
Figure 2. A Comparison of Direct Capitalization
and DCF Analysis with Income Growth
Year NOI Reversion Total
1 $10,000 $10,000
2 10,500 10,500
3 11,000 11,000
4 11,500 11,500
5 12,000 $125,000 $137,000
Present value at 14.6% = $100,000
NOI $10,000
Value = ————————— = ——— = $100,000
Capitalization rate .10
EVALUATI NG THE DATA
99
Normally, the discount rate is greater than the capitalization
rate. Why? As reported in Figure 1, if no change in cash flows is
anticipated, the discount rate is equal to the capitalization rate.
However, as Figure 2 shows, an increasing income stream requires
that the discount rate be greater than the capitalization rate if the
two separately determined values are to be equal. (They must be
equal because the property can not have two values.) Therefore,
because forecasts of increasing income are common, the discount
rate used is normally greater than the discount rate. In fact, in a
perfect world, the discount rate is equal to the capitalization rate plus
the weighted average of the net operating income and the property
value annual growth rates.
Choice Difficult, Necessary
Direct capitalization and DCF analysis are each appropriate
in certain circumstances. In particular, direct capitalization is well
suited for properties expected to have stable NOI; DCF analysis is
well suited for properties expected to have fluctuating NOI. Selecting
the appropriate capitalization rate and discount rate may sometimes
be difficult for both techniques.
A prime benefit of DCF analysis is that in gathering the data
required to estimate NOI for the analysis period, a good deal is
learned about the subject property’s prospects. A DCF analysis
requires careful consideration of expected supply and demand for a
particular type of space and operating expenses. Properly done, such
an analysis can provide much information not apparent through
direct capitalization.
Often, however, the primary use of DCF analysis is the
confirmation of the direct capitalization market value estimate.
Despite the fact that for some properties the NOI estimates used in
DCF analysis may be more accurate, independent confirmation of
the direct capitalization market value estimate requires an appropri-
ate discount rate. Merely using a discount rate that seems reason-
able to get a value estimate with DCF analysis approximately equal
to the value estimate obtained with direct capitalization is not a
confirmation.
I NVESTMENT BY DESI GN
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Debt Financing:
Rewards and Risks
Using debt to finance income-producing real estate is an
accepted practice. Although the rewards of debt financing can be
significant, so are the risks. Unfortunately, many investors anticipate
only the rewards of debt financing and give little attention to risks.
Obviously, when debt financing is arranged, both the lender
and the investor anticipate that income will be adequate to service
the debt; in fact, the usual assumption is that a property’s net
operating income will increase during the
holding period. With fixed debt service,
this assumption results in an improving
margin of safety during the holding
period (Figure 1).
Nevertheless, the use of debt
gives rise to financial risk–the risk that
there will be inadequate income to meet
debt service requirements. Although
there may be a trend toward the use of
less debt in some real estate syndications,
the possible benefit of using less debt is
October 1989
Wayne E. Etter
Analyzing Risk
and the Use of Debt
9
ANALYZI NG RI SK AND THE USE OF DEBT
101
not well understood. In today’s market, however, consideration
should be given to revising the accepted practice of using as much
debt as can be obtained to finance real estate. This could create a
new investment product with reduced risk that appeals to investors
wary of traditionally financed real estate.
Why Use Debt?
The expected after-tax rate of return from a real estate
investment is determined by the expected benefits of the invest-
ment–after-tax cash flow and appreciation–and the cash required to
purchase the property. Investors determine a proposed real estate
investment’s expected rate of return and compare the result with the
minimum return required to undertake the investment. A further
test is a comparison of the property’s estimated investment value
with its cost. A property’s investment value is equal to the present
value of all the cash benefits expected by the equity investor, dis-
counted at the investor’s required rate of return, plus the amount of
the mortgage.
Real estate investors wish to use debt if its use will increase
the after-tax return on equity (ATRE) and the property’s investment
value. Using debt this way is known as financial leverage. For in-
stance, the ATRE and the investment value were calculated for a
typically structured income property using varying amounts of debt
with the following results:
Amount of debt (%) ATRE (%) Investment value ($)
None 13.26 301,198
50 17.23 334,943
75 23.84 351,815
90 37.27 361,329
When the amount of debt is held constant at 75 percent and
the interest rate is varied, the following results are obtained:
Interest rate (%) ATRE (%) Investment value ($)
10 27.04 362,974
12 23.84 351,815
14 20.42 340,106
16 16.77 327,506
18 13.26 314,829
20 9.90 302,103
I NVESTMENT BY DESI GN
102
Analyzing these results reveals that the ATRE and the
investment value of the property increase as a larger proportion of
the property is financed with debt having a constant cost. Also the
ATRE and the investment value decrease as the interest rate is
increased when the proportion of financing is held constant. Eventu-
ally, the ATRE and the investment value, when financed with high-
cost debt, are less than the property’s ATRE and the investment
value without debt. Thus, the beneficial effects of debt financing are
limited–expensive debt is worse than no debt.
Other factors also affect whether or not the use of debt is
favorable. If the expected benefits (after-tax cash flow and apprecia-
tion) increase for reasons such as increased rent levels, reduced
vacancy rates or operating expenses, increased rate of appreciation or
reduced tax rates, the expected ATRE and the investment value will
increase at any given debt level or interest rate. Therefore, increased
investor expectations justify the use of higher cost debt. During
periods of rapid property appreciation, high interest rates will not
deter investors from using debt financing to buy properties.
An investor is indifferent between two investment opportuni-
ties having the same expected rate of return only if they have the
same risk. Thus, the returns of various investments often are com-
pared by evaluating both their risk and their expected return. The
usual assumption is that riskier investments have increased returns
(Figure 2). Such investments also can have increased losses; the
line represents expected returns.
Risk exists in all projects, but some are more risky than
others. The degree of risk depends on the difference between ex-
pected and actual outcomes. If the expected outcome is guaranteed,
then the risk is negligible; if there is great uncertainty about the
expected outcome, then the risk is significant.
As earlier stated, financial risk is
present when debt is used. Because the
investor and the lender believe that the
debt can be managed when the property is
financed, the principal source of financial
risk is unanticipated variation in the
property’s income stream over time.
There is a particularly important connec-
tion between business risk (the risk of
failing to generate sufficient income),
management risk (the risk of failing to
respond properly to changes in the
ANALYZI NG RI SK AND THE USE OF DEBT
103
business environment and, therefore, failing to earn a satisfactory
return) and financial risk (the risk of having inadequate income to
meet debt service requirements).
If a project is believed to have little business and manage-
ment risk, then a high proportion of potential gross income could be
committed to the payment of operating expenses and debt service. If
the opposite is true, a much lower proportion of potential gross
income should be committed to the payment of operating expenses
and debt service. A project’s operating expenses are somewhat fixed
in the short-run and vary directly with potential gross income over
time; the operating expense ratio should be constant over time.
Limiting the total funds available for the payment of operating
expenses and debt service has a direct impact on the amount of
funds available for debt service and, therefore, the amount of debt,
called allowable debt.
Projects believed to have little business and management risk
(i.e., there is little expected variation in the income stream) could
have higher levels of debt without creating excessive financial risk.
On the other hand, projects believed to have significant exposure to
business and management risk should have much less debt so that
excessive financial risk is not created. For example, assume two
properties are identical except for risk:
Low-risk High-risk
property property
Potential gross income $100,000 $100,000
Percentage allowed for operating
expenses and debt service .90 .60
Funds available for operating
expenses and debt service $90,000 $60,000
Operating expenses 30,000 30,000
Available for debt service $60,000 $30,000
Divide by mortgage constant .1275 .1275
Allowable debt $470,588 $235,294
At any given mortgage constant, $60,000 will service twice
as much debt as $30,000. This approach allows the risky building
much less debt financing and achieves a result similar to what is
observed in other types of enterprises. Risky businesses must borrow
less than safer ventures.
I NVESTMENT BY DESI GN
104
What Are the Benefits of This Approach?
The foregoing approach to risk results in some properties
being financed with much less debt than is considered normal. But,
for either building, the use of more debt to increase the expected
ATRE or investment value increases the likelihood of default.
Suppose, therefore, that a property is financed with more
than the amount of allowable debt to raise its expected ATRE and
investment value. This will cause total risk to exceed an acceptable
level given the investors’ required return. Under such a circum-
stance, investors should increase their required rate of return. The
additional return expected from the additional debt is not without
additional risk–greater risk must be matched by a greater required
return–and, therefore, the calculated increase in the ATRE is not an
additional benefit received without cost. Likewise, when estimating a
property’s investment value, investors must apply a higher discount
rate to the expected benefit stream. As a result, the beneficial effect
of using more debt may be offset by the effect of the higher discount
rate with the possible result of a decrease in the property’s invest-
ment value.
On the other hand, it is possible to use even less debt or no
debt to further reduce the exposure to financial risk and, thereby,
reduce total risk. Using less debt (or no debt) should increase the
investment quality of a property; such a course of action should
result in investors reducing their required rate of return for the
property and applying a lower discount rate when calculating invest-
ment value. As a result, the reduced benefits from using less debt
may be offset by the willingness of investors to accept a lower ATRE
and by the effect of the lower discount rate with the possible result of
an increase in the property’s investment value.
Assume, for instance, that a commercial property is leased to
quality tenants; the lease has several years to run and there is reason
to believe the current tenants will wish to renew their lease. The
property may be classified as a low-risk property because there is a
reasonable probability that the difference between the property’s
expected income stream and actual income stream will be small. If
the property is conservatively financed (perhaps even 100 percent
equity), it will be even more attractive to conservative investors.
Under such circumstances, the property’s income stream will be
highly predictable; investors will pay a premium price for such a
property.
ANALYZI NG RI SK AND THE USE OF DEBT
105
Next consider a property characterized by more business and
financial risk–fewer quality tenants with less assurance of lease
renewal when the current leases expire. There is a greater probability
that there will be a difference between the expected income stream
and the actual income stream. Financing such a property with, say,
75 percent debt may result in the property’s total risk being exces-
sive. But, if this property is financed with less than 75 percent debt
(again, perhaps even 100 percent equity), investors may view the
property as an attractive investment. Properly estimated, the
property’s investment value may be higher with less or no debt.
Thus, the question is: Can an investor’s lower required rate
of return or discount rate offset the beneficial effects of financial
leverage on a property’s expected rate of return and investment
value? If so, income-producing real estate could be transferred from
the high-risk investment category when it is financed with a large
proportion of debt to a much lower risk category. Only by relating
investors’ required returns with risk and by calculating the invest-
ment value of a property using various assumptions can this ques-
tion be answered. If the answer is positive, more investors might be
attracted to real estate because income-producing real estate can
become a much less risky investment.
The real estate appraisal process depends on sales of compa-
rable properties and other market data. Although adjustments can be
made when the sold properties are not perfectly comparable to the
subject property, some sales are required. However, there have been
few recent property sales in some markets, and bid and ask price
may differ considerably.
Today, therefore, real estate appraisers often work in markets
where sales of comparable properties are infrequent or nonexistent.
To value properties in such a difficult market, they must use tech-
niques to compensate for the lacking market data.
This article examines the effect of few comparable sales on
one aspect of the appraisal process.
Appraising in
Difficult Markets
January 1992
Wayne E. Etter
I NVESTMENT BY DESI GN
106
Approaches to Real Estate Appraisal
There are three commonly accepted approaches to estimat-
ing value: the sales comparison approach, the cost approach and the
income approach. Each is dependent on accurate market data. But in
a market characterized by few sales and little development activity,
certain data are difficult to obtain.
• Sales comparison approach. The estimate of market value is
based on recent sales of comparable properties. A lack of recent
comparable sales reduces this approach’s contribution to the
final estimate of value.
• Cost approach. The estimate of market value is based on the
cost of developing a similar property. When market values are
less than the cost of developing a new property, little, if any,
development takes place and the cost approach’s contribution to
the final estimate of value is limited.
• Income approach. The estimate of market value is based on
the relationship between the income and value of similar
properties. A lack of recent sales of comparable properties
makes it difficult to estimate the relationship between income
and value. When sufficient recent sales are not available,
appraisers sometimes use other methods, such as the band of
investment approach, to estimate the relationship.
Because the sales comparison approach obviously cannot be
used when there are few, if any, recent sales of comparable properties
and because the cost approach explains little when the cost of
development exceeds the market value, appraisers rely on the income
approach in such markets.
Income Capitalization Approach
To estimate a property’s market value by the income capitali-
zation approach, the property’s stabilized net operating income
(NOI) is divided by the appropriate overall capitalization rate (OAR).
NOI is a proxy for the investor’s expected benefits–the after-
tax cash flow from operations and resale (NOI ignores debt and tax
implications). NOI is estimated by using market rents and vacancy
rates, typical operating expenses and so forth. The OAR is estimated
from comparable properties–comparable properties’ NOI is divided
by their reported sales price and the OAR is obtained. Thus, the
resulting value is estimated from market data; if the data are gath-
ered from actual comparables, the resulting value estimate is reliable.
The price paid by an investor for the expected benefits
reflects the investor’s required return. The OAR is not a real rate of
ANALYZI NG RI SK AND THE USE OF DEBT
107
return; rather, it reflects the relationship between a proxy for the
expected benefits and the price paid for those benefits. As the per-
ceived risk of receiving the benefits is reduced, the investor will pay a
greater price for the benefits (and vice versa).
Appraisers also use the band of investment approach to
estimate the OAR. This approach recognizes that income-producing
real estate typically is financed with a mixture of debt and equity and
that each financing source must receive a satisfactory return. If there
are no recent comparable sales, the OAR cannot be derived from
market data, but the band of investment approach can be used to
estimate the OAR if financing is available on the assumed terms.
When using the band of investment approach, the OAR is
estimated by taking a weighted average of the lender’s required
return (the mortgage constant) and the investor’s required equity
capitalization rate (before-tax cash flow divided by the initial equity
investment).
In theory, the OAR estimated by the band of investment
approach is equal to the OAR estimated from comparable sales
because both approaches should yield the same value. Thus:
NOI
=
NOI
= Value
OAR
1
OAR
2
OAR
1
= market data approach
OAR
2
= band of investment approach
The method used to estimate the OAR does not matter if
the assumed financing terms are available. But, what if the OAR is
estimated by the band of investment approach and the assumed
financing terms are not actually available in the market? This is an
important question. Although many income properties cannot be
financed today, many appraisers continue to assume the availabil-
ity of typical financing when they estimate the value of such
properties. To answer this question, the role of financial leverage
must be considered.
The purpose of financial leverage is to enhance the investor’s
after-tax return on equity. If there is less debt (or no debt), the after-
tax return on equity is reduced, holding all other variables constant.
Of course, using less debt reduces the project’s financial risk and an
investor might reduce the required rate of return because of the
project’s reduced financial risk. (For a more complete discussion of
financial leverage, see “Debt Financing: Rewards and Risks.”)
I NVESTMENT BY DESI GN
108
However, using less debt than has been typical (especially if
the typical debt is nonrecourse debt), may be viewed as an increased
risk by the investor who must now contribute a larger percentage of
equity than before. The investor may require a larger return on
equity, even though the project’s financial risk is reduced. At the very
least, the advantage of financial leverage is lost and the investor may
offer less for the property to earn the same after-tax return when the
property is acquired with reduced debt or no debt.
Consider, for example, an income property producing a
$39,000 NOI. Assuming that it can be financed with 75 percent debt
having a 12.75 percent mortgage constant and that the equity
investor’s required capitalization rate is 10.3 percent, the estimated
OAR is 12.1 percent and the property’s estimated value is $322,314.
Proportion x Cost
Debt .75 .1275 = .096
Equity .25 .1030 = .026
OAR .121*
NOI $39,000
Value = = $322,314
OAR .121
(* difference due to rounding)
Further assume that an investor uses a discounted cash flow
model with specific assumptions about rent, vacancy rates, operating
expenses, holding period, resale price and so forth to calculate the
expected after-tax internal rate of return on equity (ATIRRE). If the
investor uses these assumptions along with a $322,314 purchase
price and the foregoing financing terms, the expected ATIRRE is
approximately 24 percent. If the investor discovers that lenders will
lend only 60 percent of the purchase price, what is the OAR and the
property’s estimated value? If the debt and equity proportions are
changed, the following result is obtained.
Proportion x Cost
Debt .60 .1275 = .077
Equity .40 .1030 = .041
OAR .118
NOI $39,000
Value = = = $329,950
OAR .118
ANALYZI NG RI SK AND THE USE OF DEBT
109
This, however, is an error. The property’s value actually will
decrease (rather than increase from $322,314 to $329,950) be-
cause of the reduced financing. Why? If the investor requires an
ATIRRE of approximately 24 percent to undertake the investment,
the purchase price must decrease, holding constant all factors except
financing. Using the same assumptions as before, an ATIRRE of
about 24 percent results when the investor pays $289,000 and
obtains a loan equal to 60 percent of the purchase price using a
mortgage constant of 0.1275. Thus, the property’s capitalization rate
is 13.5 percent instead of 11.8 percent; this implies a required equity
capitalization rate of 14.5 percent.
NOI $39,000
= OAR = = .135
Value 289,000
Proportion x Cost
Debt .60 .1275 = .077
Equity .40 .1450 = .058
OAR .135
What if financing is unavailable? If the investor’s required
ATIRRE remains the same, the price must decrease to approximately
$208,600. Holding all other factors constant, the property’s capitali-
zation rate and equity capitalization rate increase to 18.7 percent.
NOI $39,000
= OAR = = .187
Value 208,600
Proportion x Cost
Debt n.a. nil = nil
Equity 1.00 .1870 = .187
OAR .187
Relationship to Current Market
How do these calculations relate to the current market?
They help to explain the gap between the sellers’ expected price and
the price buyers are willing to pay. Potential buyers are noting both
the reduced expectations about rental income and the lack of
typical financing. In the absence of market transactions, many
appraisal reports rely on the band of investment approach (or one of
the similar approaches) to derive an OAR. However, to assume
financing terms that are not available overstates the property’s
estimated market value, even though the property’s NOI may be
appropriately stabilized.
I NVESTMENT BY DESI GN
110
Towards Evaluating
Commercial
Properties
Many lenders no longer actively pursue commercial real
estate loans. Because of the widespread delinquencies of commercial
real estate loans made in the 1980s, lenders apparently believe other
sectors offer fewer problems, more opportunities or both. Addition-
ally, bank risk-based capital regulations and proposed insurance
company regulations require significantly more capital for commer-
cial real estate loans than for some other types of loans and assets.
The amount of capital required is based on the risk class of
the particular loan or asset. For example, investments in U.S.
government securities are considered risk-less; commercial real
estate loans are in the most risky category. A bank with assets
concentrated in commercial real estate loans (or other assets
considered equally risky) needs more capital than if it invests in less
risky assets or loans. Because capital has a cost, many commercial
banks find that investing in U.S. government securities is more
profitable than extending commercial real estate loans. With similar
rules set to take effect in the life insurance industry, that industry’s
role as a supplier of commercial real estate loans may diminish.
Among lenders who consider making new commercial real
estate loans, many are unwilling to make them on a nonrecourse
basis; they require personal guarantees in addition to liens on the
property. While other sources of commercial real estate financing,
such as real estate investment trusts, are increasingly important, the
issue of evaluating project risk appears to be central to the current
problems of financing commercial real estate.
Almost everyone who considers the problem of analyzing
commercial real estate suggests increasing the discount rate as a
means of compensating for risk. Increasing the discount rate reduces
the present value of the estimated cash flows and, therefore, the
property’s value because it is risky. Although this approach is correct,
this section focuses on controlling risk rather than adjusting for
Spring 1994
Wayne E. Etter
ANALYZI NG RI SK AND THE USE OF DEBT
111
risk. Paying a smaller price for risky real estate does not eliminate
the risk–the buyer just loses less.
Although several risks affect real estate value, three risks–
financial, business and management–are discussed here. Financial
risk (the possibility of inadequate income to service debt) is present
when debt is used. The investor and the lender must be convinced
that the debt can be managed if the pro forma projections made
when the property is financed are achieved. The principal reasons
why the debt service requirements may not be met are business risk
(the property may fail to generate sufficient income) and manage-
ment risk (the property’s managers may fail to respond properly to
changes in the business environment and, therefore, fail to earn a
satisfactory return).
A property’s income stream is the principal determinant of
its value and the source of the loan’s repayment unless the loan is
otherwise secured. Thus, if the property’s income stream varies over
time, there is great potential for default if the loan amount is deter-
mined, for example, by assuming a 95 percent occupancy rate and
lending 75 percent of a property’s capitalized value.
If the degree of business and management risk is assessed
and variation in the property’s income stream over time is highly
probable, less debt should be used.
Rating properties according to the expected stability of the
income stream permits lenders to loan an appropriate amount for
specific properties so total risk is not excessive. Although this would
be a new approach to financing real estate, it is similar to the ap-
proach used in home mortgage lending.
A prospective homebuyer cannot get a large loan just because
an expensive home is being purchased. This is true even though the
loan amount normally is limited to a percentage of the home’s value;
this allows the lender to foreclose on the asset in the event of a
default and sell it for an amount equal to or greater than the unpaid
loan balance. However, foreclosure and sale are the lender’s last
resort; lenders prefer to have the loan repaid as agreed.
To help ensure this result, lenders qualify the prospective
borrower’s ability to repay the loan by considering the applicant’s
current income and financial situation, credit history and employ-
ment record. If the applicant has an erratic income or employment
history or if an excessive proportion of the applicant’s current
monthly income is required to service the requested loan, the lender
refuses to grant the loan. Evaluating the stability of a commercial
I NVESTMENT BY DESI GN
112
property’s expected income stream is an entirely analogous analytical
problem.
As in home mortgage lending, the beginning point in
assessing the riskiness of a commercial property’s income stream is
developing a list of factors contributing to income stream fluctations.
The factors must be developed separately for each property type
(multifamily residential, office, retail, industrial). Furthermore, the
major property types must be subdivided into groups of properties of
varying size. Other property categories are possible. The important
point is to compare only like properties within the relevant market
area.
What factors are included? The following suggestions are a
starter list; they are not all-inclusive.
• Economic differences among market areas are important.
• Supply and demand conditions in the property’s market area
must be evaluated. Determine if an unmet need can be satis-
fied. How much vacant space exists currently in the market?
How likely is new space to enter the market? What is the
attitude of local planning authorities toward new space?
• The competitive position of the property must be assessed.
Evaluate the property’s site, age, size, construction quality and
design relative to similar properties.
• The property’s performance must be assessed. Analyze
occupancy, tenants’ credit quality, type of lease, average lease
rates and length of lease. When appropriate, tenant mix must be
evaluated.
• Additional factors must be considered for to-be-developed
properties. These include the developer’s reputation and
experience and the amount of pre-leasing. However, to-be-
developed properties should be scrutinized more than seasoned
properties because they have no market or operating history.
Many properties developed in the 1980s never achieved their
pro forma projections; perhaps to-be-developed properties
should be financed with more equity than seasoned properties
until their pro forma projections are achieved.
Identifying these factors is an ideal project for organizations
of real estate professionals. Once general agreement is reached about
which factors should be included and their relative importance, a
rating scale could be constructed.
Rating a property forces the analyst to consider carefully each
property characteristic in relation to other comparable properties in
ANALYZI NG RI SK AND THE USE OF DEBT
113
the market area. For example, “Retail Center A” with several “mom
and pop” tenants on month-to-month leases has a much less predict-
able income stream than “Retail Center B” with national credit
tenants on income long-term leases. Thus, Retail Center A receives a
lower score because it has more business and management risk. For
the more subjective factors, scaling may be difficult.
A property’s total score varies inversely with business and
management risk; a low score indicates more business and manage-
ment risk. When this is the case, the amount of debt financing should
be limited because the addition of financial risk creates excessive total
risk. For example, assume two properties are identical except for risk:
High-risk Low-risk
property property
Potential gross income $100,000 $100,000
Percentage allowed for oper-
ating expenses and debt
service x .60 x .90
Funds available for operating
expenses and debt service $60,000 $90,000
Operating expenses - 30,000 - 30,000
Available for debt service $30,000 $60,000
Divide by mortgage constant .1275 .1275
Allowable debt $235,294 $470,588
At any given mortgage constant, $60,000 will service twice
as much debt as $30,000. This approach allows the risky building
much less debt financing and achieves a result similar to what is
observed in other enterprises. Risky businesses qualify for less debt
than safer ventures.
Should an acceptable means of rating projects be developed,
the regulators might reduce the amount of capital required when
lenders grant an appropriate amount of credit to finance commercial
real estate. And even when debt financing is not used, an analysis of
a property’s business and management risk is useful. A proper
assessment of such risk assists in the assembly of all-equity portfo-
lios with a given risk level.
Finally, a project risk rating scale recognized by the market
would increase real estate’s liquidity. Illiquidity is a major real estate
risk; if illiquidity can be reduced, there is a positive impact on real
estate values.
I NVESTMENT BY DESI GN 114
10 Asset Management
Asset Management
Essentials
For the past several years, asset management has been much
discussed in real estate circles. Generally, this term describes a
decision-making technique for choosing a strategy to maximize the
value of an income-producing property.
This process is applied to a broad range of problems such as
analyzing the impact on value of a proposed property refurbishment
or considering the impact on value of gaining or losing a specific
tenant. Often competing strategies are under consideration, but the
one that maximizes the property’s value should be chosen.
Maximizing value is the goal of financial managers in many
industries outside real estate. For example, when financial managers
make plant expansion or product-line decisions, they often use
discounted cash flow analysis–a technique that helps select the
course of action giving the maximum present value.
Discounted cash flow analysis techniques have been adopted
by asset managers in the real estate industry for two basic reasons.
First, these techniques are made easy by powerful financial calcula-
tors and personal computers. Second, and much more important,
April 1993
Wayne E. Etter
ASSET MANAGEMENT 115
until recently, real property values appeared to increase without
management; the goal was to finance and build. Management of the
completed asset did not appear necessary.
Eventually, the degree of overbuilding and its effects became
obvious. Today, properties require management because an annual
increase in value can no longer be taken for granted. With excess
leasable space, competing successfully for tenants has become an
important goal of asset managers attempting to maintain or increase
property values. With this competition, the asset manager must
make a number of decisions that could affect the property’s value.
For example, how will refurbishing a property affect the occupancy
rate? Or, how will increasing or decreasing the rental rate affect
occupancy? These actions affect the income stream and, in turn, the
value of the property.
Analyzing the impact on value of such changes requires
accurate estimates of their impact on the future income stream.
When the effects are properly specified, discounted cash flow analysis
can be used to calculate whether the estimated change in the income
stream will have a positive or a negative effect on the property’s
value. Thus, there are two stages in the asset management process:
developing an asset management plan to generate the data necessary
for the analysis and analyzing the plan’s impact on the property’s value.
Developing the Asset Management Plan
Developing the asset management plan is the most impor-
tant part of the analysis because it is the basis for selecting the best
strategy. The plan enables the asset manager to quantify the differ-
ences between competing proposals and/or the status quo. The plan
must be developed in detail for each alternative strategy under
consideration and should include the following points.
First, the asset manager must have a comprehensive market
study for the property. The market study should provide information
about the types of space available in the market, the amount of space
available, the type of space being demanded, the changes expected in
the supply and demand for space and any currently unmet market
needs. Finally, the market study should provide an estimate of the
price prospective tenants (or buyers) are willing to pay for the space.
Second, a pro forma operating budget must be developed for
each alternative strategy being considered. The market study
provides information about the number of square feet to be leased
and the likely rental rate. Other data to be forecast for the holding
period include the expected operating expenses and the marketing
I NVESTMENT BY DESI GN 116
expense; the budget must emphasize both the need to provide
tenants with adequate services and cost control. Each budget will
become the basis for estimating that strategy’s effect on the property’s
present value and on its future selling price.
Third, any physical problems that need to be corrected before
the property can be leased (or sold) must be addressed. Likewise, are
there opportunities to upgrade the property through renovation or
refurbishment? The cost of both the necessary and optional changes
should be estimated carefully.
Fourth, a marketing plan must be developed. Without a plan
for action, nothing is likely to happen. The marketing plan should
cover the property’s image, strategies for positioning the property in
the market, pricing, marketing methods and materials and perfor-
mance standards. The marketing plan will have a cost; this cost
must be included in the pro forma operating budget.
Analyzing Each Strategy
The value of any asset, including income-producing real
estate, is equal to the present value of all the expected cash benefits,
discounted at the appropriate rate. Because present value mechanics
have been discussed previously, this discussion focuses on using
discounted cash flow analysis in asset management decisions. Using
discounted cash flow analysis to estimate a particular strategy’s
impact on value requires a clear understanding of what is to be
discounted and how to compare competing strategies.
Three different cash benefit streams can be discounted: net
operating income, before-tax cash flow and after-tax cash flow. The
calculation of these three measures is shown in the table.
Calculating the Cash Benefit Stream
Estimated potential gross income $210,000
Less estimated vacancy and collection allowance -21,000
Estimated effective gross income $189,000
Less estimated operating expenses -63,000
Estimated net operating income $126,000
Less estimated mortgage payment -99,180
Estimated before-tax cash flow $ 26,820
Less estimated income tax liability -1,447
Estimated after-tax cash flow $ 25,373
ASSET MANAGEMENT 117
When the net operating income is used to estimate the value
resulting from a particular strategy, no consideration is being given to
financing or taxes. Thus, the before-tax cash flow or after-tax cash
flow should be used when the asset manager’s decision involves
choosing among financing alternatives or analyzing tax impacts.
Because mutually exclusive strategies to maximize the
property’s value are being considered, the strategy producing the
largest net present value is chosen. Net present value is equal to the
present value of the expected income stream plus the present value
of the property’s estimated value at the end of the analysis period
minus the strategy’s cost. This result is compared with the net
present value of the property if no change is made.
When before-tax cash flow or after-tax cash flow from
operations and resale is chosen as the benefit stream to discount,
only the value of the equity interest is estimated; to estimate the
property’s value, therefore, the mortgage financing amount must be
added to the present value of the equity. To compare competing
strategies, each strategy’s cost must be subtracted from the
property’s estimated value. As before, the final value is compared
with the property’s value if no change is made.
The appropriate discount rate must be applied to the benefit
stream selected. In general, the following relationships should be
used as a guide in choosing the appropriate discount rate.
Cash benefit stream Appropriate discount rate
Net operating income Capitalization rate
Before-tax cash flow Before-tax, cash-on-cash return
After-tax cash flow After-tax return on equity
Sometimes the discount rate is estimated by examining
returns available from securities such as U.S. government bonds,
certificates of deposit or corporate bonds. Although such compari-
sons are interesting from a risk-return standpoint, the appropriate
discount rate should be obtained from the property market.
Once the detailed elements of the plan are developed, dis-
counted cash flow analysis may be used to choose the optimal
strategy. Today, however, discounted cash flow analysis is not as well
regarded as it once was.
For example, Cushman and Wakefield reports that “many
investors seem to have lost faith in cash flow forecasts and report
placing more emphasis on direct capitalization of current (as opposed
to forecasted) net operating income.” However, the poor investment
decisions of the past decade based on discounted cash flow analysis
I NVESTMENT BY DESI GN 118
Renovating an income-producing property is an ideal applica-
tion of asset management techniques. The first step in using
these techniques is the development of an asset management plan.
The plan should include a market study, a careful determina-
tion of the plan’s cost and an analysis of the renovation’s impact on
the income stream and the property’s value. Then, using the data
developed in the asset management plan, the decision maker must
determine if the renovation is justified by the increase in the
property’s value. This article demonstrates the application of asset
management techniques to the proposed renovation of St. Regis
Place, a Houston mixed-use complex.
The property, located in the Galleria-River Oaks area is a
242,909-square-foot, 325-unit apartment complex. In addition, a
54,975-square-foot office-retail development is on the site. The
complex was constructed in 1954 and needed substantial repair
when renovation was proposed in 1990.
The April 1990 monthly operating statement was typical of
the property’s performance prior to renovation.
Rental income
Apartments $108,982
Office-retail 26,182
Total $135,164
Operating expenses 76,222
Net operating income $ 58,942
Annualized net operating income $707,304
San Felipe Court:
A Successful
Renovation
Fall 1993
Wayne E. Etter
E.J. Cummins, Jr.
techniques resulted from flawed assumptions, such as unrealistic
occupancy and rental rates, rather than from the techniques them-
selves. The importance of making proper forecasts will be considered
in “A Matter of Assumptions.”
ASSET MANAGEMENT 119
Based on the actual rent collections and assuming 95 percent
of the total space was occupied, the average monthly rental rate for
the unrenovated apartments was 47.2 cents per square foot. The
average monthly rental rate for the unrenovated office-retail space
rate was 50.1 cents per square foot. Capitalizing the annualized net
operating income at 10 percent yields an estimated April 1990
market value of $7,073,040.
Asset Management Plan
The existing office-rental space tenants agreed to remain and
pay an increased rental rate after the renovation. However, a com-
prehensive study of the local apartment market was made to deter-
mine if sufficient tenant demand would exist for the renovated
apartments. The apartment market area contains multiple employ-
ment centers within five to ten minutes driving time of the site,
many retail attractions, hotels and several high-income residential
neighborhoods. The location of the complex relative to employment
was an important reason for tenants choosing to live there.
Within the market area there had been limited construction
of new apartments, some renovation of existing apartments and
some existing apartments being operated without renovation. Occu-
pancy rates generally in excess of 95 percent were found for each
category, indicating a strong demand for each.
However, monthly rental rates showed marked differences.
Depending on the size and type of unit, monthly rents in five newly
constructed apartment developments ranged from 85 cents to $1 per
square foot whereas monthly rents in five renovated apartment
developments ranged from 75 cents to 90 cents per square foot.
Monthly rental rates for apartments in five unrenovated develop-
ments ranged from 50 cents to 75 cents per square foot per month.
Thus, within one market area, demand came from three
distinct market segments or tenant types. Because of this, the
required rental rates for a renovated project seemed achievable in the
market area; current tenants would be replaced by other tenants
willing to pay higher rents.
To attain these higher rental rates, the property had to be re-
positioned in the market. This was to be accomplished in part by
renaming the complex–San Felipe Court–and renovating inside and
out. External renovation included:
• construction of a new facade;
• re-roofing, pool repair and parking improvements; and
• new security gate and landscaping.
I NVESTMENT BY DESI GN 120
Internal renovation included:
• new floor coverings;
• new appliances;
• new ceiling fans, light fixtures and mini-blinds;
• painting; and
• refinishing cabinets and counters.
The estimated cost of these renovations was $1.75 million.
In addition, the office space renovation was estimated to cost
$250,000 for a total of approximately $2 million. Thus, the
essential questions to be answered by the analysis are, first, whether
or not the renovation will increase the property’s value by more than
the renovation’s cost and, second, whether or not the expected
return on the incremental investment is sufficient.
To answer the first question, a pro forma December 1993
operating statement was prepared. By then, the renovation’s effect
on the property’s income stream was expected to be complete. A
68.6 cents estimated average monthly rental rate was used to figure
the rent collections for the renovated apartments, and a 68.8 cents
average monthly rental rate was applied to the renovated office-retail
space. These rental rates seemed achievable given the market study
findings. A 5 percent vacancy rate was assumed. The pro forma
statement was as follows:
Rental income
Apartments $ 166,636
Office-retail 37,823
Total $ 204,459
Less 5% vacancy 10,223
Effective gross income $ 194,236
Operating expenses 110,434
Net operating income $ 83,802
Annualized net operating income $1,005,624
Capitalizing the annualized net operating income at 10
percent yielded an estimated value of slightly more than $10 mil-
lion–a value increase of about $3 million between April 1990 and
December 1993.
Thus, a $2 million renovation was expected to increase
value by $3 million. Had the value increase been less than the
estimated renovation costs, the analysis would have ended at that
point.
ASSET MANAGEMENT 121
Of course, the sufficiency of the expected return on incre-
mental investment was another important consideration before
proceeding with the renovation. Estimating the return allowed the
expected return to be compared with those of other investment
opportunities. In this case, the incremental $2 million investment
was planned to take place during a 24-month period with the bulk of
renovation to be completed within 12 months. The $3 million
increase in value was assumed to be realized at the end of 42 months
to permit the calculation of the internal rate of return. In addition,
the change (positive or negative) in monthly net operating income
during the 42 months was treated as a positive or negative benefit, as
appropriate. The expected return on the incremental investment
was approximately 25.8 percent.
With San Felipe Court’s location and the market area de-
mand for space, the expected 25.8 percent return was considered
attractive given the low risk. The asset management plan was
adopted, financing was obtained and the renovation began. What
were the results?
Renovation Results
The renovations began in April 1990 and were largely
completed by September 1991, somewhat ahead of schedule.
Renovation costs totaled $1,821,463. The accompanying
graphs show an overview of the results achieved by the renovation
decision.
Figure 1: San Felipe Court Rent Collections
April 1990 to April 1993
I NVESTMENT BY DESI GN 122
Monthly rental collections through April 1993 are shown in
Figure 1. The increase in rental collections during the period demon-
strates that the asset management plan succeeded. The planned
increase in rental rates for the renovated property was achieved
because San Felipe Court’s location made it a desirable place to live,
and the renovation made tenants willing to pay higher rent to live
there.
In Figure 2, a three-month moving average of the property’s
estimated monthly change in value is compared to the cumulative
amount of renovation expenditure. The property’s monthly value
was estimated by capitalizing the annualized net operating income.
Then, the monthly change in value was estimated by subtracting
each month’s value from the estimated April 1990 value.
The property’s estimated value declined when the renovation
began as those units vacated for renovation did not generate rent. As
the renovation proceeded, however, rental collections and the
property’s estimated value began to increase. The goal of a $3
Figure 2. Estimated Value Change Compared
to Cumulative Renovation Expenditures
ASSET MANAGEMENT 123
A Matter
of Assumptions
Asset management generally describes the use of decision-
making techniques to choose a strategy for maximizing the value of
an income-producing property. (See previous article on page 114 for
overview.) Often, discounted cash flow (DCF) analysis is used to
help select the course of action that maximizes value. However, no
technique can yield a good decision if inappropriate assumptions are
used in the analysis. The importance of assumptions is the focus
here.
Today’s asset managers commonly use computerized DCF
analysis programs that calculate a property’s net operating income
(NOI) and the expense of maintaining the NOI; before-tax cash flow
and after-tax cash flow are not considered. These programs focus on
present and future leases on a tenant-by-tenant basis to estimate a
property’s value and require specific assumptions about the property
on a tenant-by-tenant basis. In addition to selecting a time period for
analysis, discount rate and a terminal capitalization rate, the
required assumptions for each present lease include:
1. current rental rate and rental growth rate,
2. estimated vacancy and collection loss,
3. current operating expense and operating expense growth rate
and
4. proportion of operating expense passed through to the tenant
according to the terms of the lease.
million value increase was reached in December 1992–one year
earlier than planned. Although the renovation and repositioning of
San Felipe Court was a success, a renovation can accomplish only
limited goals.
In general, overspending will not make an old property
competitive with new properties; after renovation, the property will
still be an old property. On the other hand, if renovation spending is
insufficient, the property’s planned repositioning will not be
achieved; repositioning the property requires more than performing
needed maintenance. Thus, the extent of the renovation must be
based on a carefully developed plan for the property.
Summer 1993
Wayne E. Etter
I NVESTMENT BY DESI GN 124
For a present tenant’s lease that expires prior to the end of
the analysis period or for a space that is currently vacant, additional
required assumptions include:
• items one to four if the current tenant is expected to renew the
lease,
• leasing commissions to secure the current tenant’s lease
renewal,
• time required to locate a new tenant if the current tenant does
not renew the lease or the space is currently vacant,
• alteration costs required to attract a new tenant,
• leasing commissions to secure the new tenant and
• items one to four for the new tenant.
With these data as inputs, the DCF program is used to
estimate the entire property’s annual NOI for the analysis period
and its reversion value at the end of the analysis period. The DCF
program is then used to calculate the present value of these future cash
benefits, i.e., the estimated property value.
The necessary assumptions appear rather straightforward
and well within the experience of most asset managers. Many users
might not question the effect of an individual assumption on the
final value estimate. However, they are important. To illustrate
their significance, the following example demonstrates the effect of
different assumptions on the present value of a single rental unit’s
NOI.
The Riverside Center is a multi-tenant retail building with
nine leasable units totaling 46,344 square feet. Unit 2 contains
5,221 square feet and is currently leased at a monthly rental rate of
45 cents per square foot; the lease has three remaining years. The
building manager estimates an annual 2 percent vacancy and collec-
tion loss.
Operating expenses are estimated to increase at an annual
rate of 5 percent; all operating expenses are passed through to the
tenant. A 2 percent commission will be paid for lease renewal; a 4
percent commission will be paid for a replacement tenant. All
renewals are based on three-year leases.
Typically, an asset manager might assume that the current
tenant in Unit 2 will renew the lease at a market rent, say 52 cents
per square foot per month, when the lease expires. Using these
assumptions to prepare a five-year analysis, the asset manager
produces the NOI forecast reported in Table 1. With a discount rate
of 12 percent, the estimated present value of Unit 2’s NOI is
$103,526.
ASSET MANAGEMENT 125
Table 1: NOI Forecast for Unit 2
Year 1 Year 2 Year 3 Year 4 Year 5
Gross Rental Income $28,193 $28,193 $28,193 $32,579 $32,579
Expected Expense Recapture 7,022 7,373 7,742 8,129 8,536
Gross Potential Income 35,216 35,567 35,935 40,708 41,115
Less: Vacancy and Collection Loss 564 564 564 652 652
Expected Effective Gross Income 34,652 35,003 35,372 40,057 40,463
Less: Turnover Rent Loss 0 0 0 0 0
Expected Expense Recapture Loss 0 0 0 0 0
Operating Expenses 7,022 7,373 7,742 8,129 8,536
Net Operating Income 27,630 27,630 27,630 31,927 31,927
Other Expenditures
Alterations 0 0 0 0 0
Commissions 0 0 0 1,955 0
Cash Flow After Other Expenditures 27,630 27,630 27,630 29,973 31,927
Present Value of Net Operating Income 104,768
Less Present Value of Other Expenditures 1,242
Total Present Value $103,526
Although any number of assumptions can be made about
Unit 2’s future, two are chosen to illustrate their effect on the
present value of Unit 2’s NOI. First, what if Unit 2 is vacated at the
end of year three and no replacement tenant is located? This would
not be an unusual assumption for a small retail property. Were this
to occur, not only would the unit not produce income in years four
and five, Unit 2’s pro rata share of operating expenses but also would
be borne by the owner during years four and five. Thus, NOI is
negative in years four and five. As reported in Table 2, the present
value of the NOI is $56,352–a significant reduction from the first
estimate of $103,526.
Second, what if Unit 2 is vacated by the current tenant at the
end of year three, but a replacement tenant is located? Again, this is
not an unusual assumption, but it does require the asset manager to
estimate the time needed to locate the new tenant.
With this assumption, the amount of rent and expense
recapture lost while the property is vacant can be estimated. Also,
the asset manager must estimate the per square foot cost of making
any property alterations necessary to meet the needs of the new
tenant.
Assuming three months are required to locate a new tenant
and make the necessary alterations at a cost of $3.47 per square foot,
the present value of the NOI is $84,303. These are critical assump-
tions. For example, if six months are required to locate another
I NVESTMENT BY DESI GN 126
tenant, and the alteration costs are $4 per square foot, the present
value of the NOI declines to $76,076. As shown in Table 2, both
present values sharply differ from that reported in Table 1.
Selecting the course of action that will maximize a property’s
value is another important use of such DCF programs. For example,
an asset manager may be negotiating a lease renewal with Unit 2’s
current tenant. If the lease is renewed at 52 cents per square foot per
month, and no alterations are required, the estimated present value
of the NOI is $103,526 as reported in Table 1. Suppose, however,
that the current tenant is negotiating for a lower rental rate.
If the current tenant does not renew the lease, a number of
results are possible. But, if the asset manager assumes that a re-
placement tenant can be found in three months if alteration costs of
$3.47 per square foot are incurred to satisfy the replacement tenant’s
requirements, the present value of Unit 2’s NOI will decline to
$84,303 as previously reported.
Table 2: A Comparison of Alternative Assumptions
Assumption Present value of NOI
1. Unit 2’s lease renewed by current tenant $103,526
2. Unit 2 vacated at the end of year 3 56,352
3. Unit 2 occupied by replacement tenant (1) 84,303
Unit 2 occupied by replacement tenant (2) 76,076
Using a DCF model, the asset manager can determine that
even if the current tenant’s monthly rental rate is reduced to 25
cents, it is sufficient to produce a present value equal to that of
seeking a new tenant if alterations are required. If the current tenant
agrees to a rate greater than 25 cents per square foot per month, and
no alterations are required, the property’s value will be greater than
if a new tenant is secured at 52 cents per square foot per month.
Rather ordinary assumptions have a significantly different
impact on the property’s value. In the example, a difference of about
$47,000 in the property’s value results from altering one assumption
about one rental unit.
Three observations seem warranted. First, each of the
example assumptions is ordinary; the user of a report based on the
DCF program might not question an asset manager who made any
one of them or appreciate the impact on value of such ordinary
ASSET MANAGEMENT 127
assumptions. Second, while it may be reasonable to assume a certain
future event, forecasting the details of that event may be difficult if
not impossible. For example, estimating the time required to re-lease
a unit and the per square foot costs of the alterations required to re-
lease it more than three years in the future is not likely to be accu-
rate. Third, when a DCF program is being used to estimate the
value of a larger property and these assumption are made for a large
number of tenants, the impact of the assumptions on the property’s
value may be significant.
Clearly, such DCF programs have the potential to produce
more accurate property value estimates. For an asset manager to
achieve that potential, however, requires considerable experience and
sophistication in making the required assumptions.
Buy or Lease?
The Commercial
Property Decision
January 1995
Wayne E. Etter
Fred F. Caldwell
The decision to buy or lease the space needed for conducting
the firm’s business activities is important. Although space costs are
significant business expenses, the buy or lease decision is more than
a financial decision. This article focuses on the analytical framework
for making this decision.
Although there are many variations, the buy or lease decision
typically arises in the following circumstances:
1. A business requires new or additional space. Its needs
can be satisfied by leasing space or by constructing or buying a single-
tenant or a multi-tenant building.
2. A business is currently leasing satisfactory space in a
single-tenant or a multi-tenant building and has the opportunity to
purchase the building.
The decision is a three-part process: the market analysis, the
financial analysis and other considerations.
Market Analysis
Real estate market research considers those factors that affect
the supply and demand for a particular type of space within the
I NVESTMENT BY DESI GN 128
specific market area. Conducting this research is a vital step in
deciding to buy or to lease because the property must be a good real
estate investment if it is purchased. Market information is crucial to
negotiating a competitive lease if the property is not purchased.
If rental rates are expected to rise (or fall) during the analysis
period, property values should rise (or fall) as well. When it is
concluded that rental rates and property values will increase, buying
the property is supported and vice versa. Because these conclusions
are so important for the financial analysis, the data used to reach
them must be carefully developed through market analysis.
For a basic outline of the real estate market research process,
see “Development by Design.”
Financial Analysis
In making the buy or lease decision, the financial analysis is
used to identify the financial advantage of one alternative over the
other. The principal focus of the analysis is to choose the alternative
that will provide the needed space at the least net cost. To determine
this, the present value of the after-tax cost and benefits of owning the
property is compared with the after-tax cost of leasing the space. All
other things being equal, the course of action with the least net cost
is chosen. Because lease payments, operating expenses, depreciation
and interest are deductible expenses, the analysis is usually made on
an after-tax basis.
When the choice is between buying or constructing a multi-
tenant building and leasing space, the consequences of becoming a
landlord are added to the analysis. By investing sufficient equity to
purchase or construct a multi-tenant building, the owner acquires
the present value of the after-tax income stream from the building’s
other tenants and the present value of the building’s after-tax cash
flow from resale and avoids the present value of the after-tax cost of
leasing space.
The firm’s required rate of return (or its cost of capital) is
used as the discount rate to calculate the present value of the cost to
lease and the cost to own. Because different firms have different
required rates of return (or cost of capital), they might use the same
assumptions about the costs and benefits of buying or leasing but
reach different conclusions about the best course of action.
The basic elements of a buy or lease analysis are illustrated
in the table. Assume the owner of an unincorporated business with
a 31 percent marginal tax rate can either purchase a building or lease
it for five years. If it is purchased for $100,000 plus $3,000 closing
ASSET MANAGEMENT 129
costs, the initial cash investment will be $28,000. The balance can
be financed with a $75,000, 9.5 percent, 20-year mortgage. The
building’s depreciable value is $83,000. The first year’s operating
expenses of $3,500 are estimated to increase 3 percent annually.
Because annual operating expenses, depreciation and interest are tax-
deductible, the actual annual cash outflow associated with purchas-
ing the building is the sum of the operating expenses and the mort-
gage payment less the tax shield provided by the deductible expenses.
To make an appropriate comparison with a five-year lease, it is
necessary to assume the property will be sold at the end of the fifth
year and to estimate the after-tax cash flow from resale. The
property’s estimated resale price at the end of the fifth year is
$116,000; the estimated after-tax cash flow from resale is $33,454.
If the building is leased for five years, the first year’s lease
payment will be $10,000. The following year’s lease payments are
scheduled to increase 3 percent annually. Annual lease payments
will be due in advance. The tenant will pay all operating expenses;
annual operating expenses are estimated to be the same as if the
building is purchased. Because the lease payments and the operating
expenses are tax deductible, the after-tax cost of leasing is the sum of
the lease payment and operating expenses less the tax shield pro-
vided by the deductible expenses.
Using a cost of capital of 10 percent, estimating the after-tax
cost of buying the property and leasing the property is illustrated in
the table. These calculations indicate a financial advantage for
buying the property; however, this advantage is dependent upon the
assumptions made about the resale of the property at the end of the
fifth year. Without the resale benefits, the total cost of leasing the
property is less than buying the property. Therefore, the assumption
of a 3 percent annual increase in the property’s value is critical. This
indicates the dependence of the financial analysis on the market
analysis.
The use of a resale assumption does not imply that the
property must be sold; rather, it is used to estimate the net equity in
the property so that buying can be compared with leasing over the
life of the lease.
Other Considerations
Because most leasing literature concerns leasing business
equipment, such as a truck, the buy or lease decision usually is
treated purely as a financial decision. Whether leased or purchased,
there is no difference in the truck’s ability to do the job. Thus, the
I NVESTMENT BY DESI GN 130
decision of whether to buy or lease a truck is about determining the
most financially advantageous way to gain the use of the truck for
the analysis period.
The decision of whether to buy or lease real estate is much
more than a financial decision, although the financial analysis is
important. The following points must be considered:
1. Business enterprises need space to conduct their business
activities, but in most cases, real estate is not their principal busi-
ness. If the firm leases needed space, it can adjust the amount of
leased space as market requirements change. If the firm owns real
estate, adapting quickly to changes in the market may be more
difficult because of the time required to plan and construct a property
or to buy a property when more space is needed or to sell the prop-
erty when less space is needed. A retailer, for example, may prefer to
lease space so that store locations can be changed in response to
market shifts.
On the other hand, an owner may enjoy greater flexibility in
using the property than a tenant. As space needs change, an owner
can make choices that support these needs.
2. If a multi-tenant building is constructed or purchased, the
business also becomes a landlord. Aside from the other conse-
quences of owning real estate, how will being a landlord fit in with
other business activities?
3. An existing building can be inspected to determine its
quality and its suitability for the business enterprise before it is
leased or purchased. In certain markets, an existing building’s
market value may be less than its replacement cost; if the space is
suitable for the business, it can be obtained at an attractive price.
How does buying an existing property differ from constructing the
property? A newly constructed property should have no functional
(or other) obsolescence and should be designed especially for the
user’s needs; however, when completed the new building may be
unsatisfactory and may have cost more than planned or both.
4. Balance sheet issues may be important to a company
making the buy or lease decision. For example, future borrowing
restrictions resulting from real estate debt may be a concern; if so,
leasing to keep real estate off the balance sheet may be an attractive
option.
Conclusion
The buy or lease decision melds the market and financial
analyses with other business considerations. This might result in a
ASSET MANAGEMENT 131
decision to lease even though purchasing the property appears to be
financially advantageous. The possibility of such an outcome
emphasizes the difference between purchasing real estate and other
business assets.
Buy or Lease Analysis
A. Buy A. Buy A. Buy A. Buy A. Buy
Y YY YYear 0 ear 0 ear 0 ear 0 ear 0 Y YY YYear 1 ear 1 ear 1 ear 1 ear 1 Y YY YYear 2 ear 2 ear 2 ear 2 ear 2 Y YY YYear 3 ear 3 ear 3 ear 3 ear 3 Y YY YYear 4 Y ear 4 Y ear 4 Y ear 4 Y ear 4 Year 5 ear 5 ear 5 ear 5 ear 5
Equity investment $28,000
Operating expense $ 3,500 $ 3,605 $ 3,713 $ 3,825 $ 3,939
Depreciation 2,043 2,128 2,128 2,128 2,128
I nterest 7,125 6,993 6,849 6,691 6,519
Total expense $12,668 $12,726 $12,690 $12,644 $12,586
Tax rate 0.31 0.31 0.31 0.31 0.31
Tax shield $ 3,927 $ 3,945 $ 3,934 $ 3,920 $ 3,902
Operating expense 3,500 3,605 3,713 3,825 3,939
I nterest 7,125 6,993 6,849 6,691 6,519
Principal 1,386 1,518 1,662 1,820 1,992
Tax shield (3,927) (3,945) (3,934) (3,920) (3,902)
Annual after-tax cost of
buying $ 8,084 $ 8,171 $ 8,290 $ 8,416 $ 8,548
After-tax cash flow resale $33,454
B. Lease B. Lease B. Lease B. Lease B. Lease
Y YY YYear 0 ear 0 ear 0 ear 0 ear 0 Y YY YYear 1 ear 1 ear 1 ear 1 ear 1 Y YY YYear 2 ear 2 ear 2 ear 2 ear 2 Y YY YYear 3 ear 3 ear 3 ear 3 ear 3 Y YY YYear 4 Y ear 4 Y ear 4 Y ear 4 Y ear 4 Year 5 ear 5 ear 5 ear 5 ear 5
Lease payment $10,000 $10,300 $10,609 $10,927 $11,255
Operating expense 3,500 3,605 3,713 3,825 3,939
Total expense $10,000 $13,800 $14,214 $14,640 $15,080 $3,939
Tax rate 0.31 0.31 0.31 0.31 0.31 0.31
Tax shield $ 3,100 $ 4,278 $ 4,406 $ 4,538 $ 4,675 $1,221
Lease payment 10,000 10,300 10,609 10,927 11,255
Operating expense 3,500 3,605 3,713 3,825 3,939
Less tax shield (3,100) (4,278) (4,406) (4,538) (4,675) (1,221)
Annual after-tax
cost of leasing $ 6,900 $ 9,522 $ 9,808 $10,102 $10,405 $2,718
I NVESTMENT BY DESI GN 132
C. Summary of the Analysis C. Summary of the Analysis C. Summary of the Analysis C. Summary of the Analysis C. Summary of the Analysis
Buying Buying Buying Buying Buying Leasing Leasing Leasing Leasing Leasing
Initial outlay $28,000 $ -0-
Present value of annual cost $31,387 $40,046
Total cost $59,387 $40,046
Present value of after-tax cash flow
from resale (20,772) -0-
Net cost $38,614 $40,046
Distressed Property
Decisions
April 1990
Wayne E. Etter
Scott Shaffer
Today, there are numerous distressed Texas properties. Many,
unable to generate sufficient net operating income (NOI) to service
debt, have been foreclosed and are in the hands of the original lender.
Further, the deterioration of the Texas commercial real estate market
resulted in the downfall of several of the state’s major commercial
banks and savings and loan associations (S&Ls).
In many cases, the problems of distressed properties can no
longer be solved by the particular financial institution that made the
loan. Instead, solving these problems is the responsibility of public
and private successor institutions. In addition to managing acquired
property, public agencies must wrestle with the larger issue of
disposing of entire institutions. While real estate literature has little
to offer with regard to the latter, much is known about the process of
analyzing distressed property.
Whether the final decision about these properties is made by
a private institution (commercial bank or S&L) or a public institu-
tion (the Federal Deposit Insurance Corporation or the Resolution
Trust Corporation), ideally, the decision will be made best if a proper
analytical approach is used to evaluate and manage these properties.
Losses suffered from nonfull repayment represent a signifi-
cant federal insurance problem that ultimately becomes a taxpayer
problem, but it is not related to the current market value of specific
ASSET MANAGEMENT 133
properties. Failure to grasp this distinction results in an overstate-
ment of the current real estate overhang and postpones the recovery
of Texas real estate markets. While national attention is focused on
the disposition of distressed real estate, similar energy has yet to be
spent on analyzing the institutional failures that contributed to the
crises. Analysis of such institutional problems is outside the focus of
this article.
Cost Considerations
The lender originally extends a loan with the expectation
that the borrower will repay it with interest. (Throughout the re-
mainder of this article, lender shall be used to denote the party to
whom the task of managing distressed real estate has fallen.) How-
ever, the analysis of a problem property requires recognizing that the
question has become one of selecting the course of action providing
the maximum recovery. In some cases, this solution will recover less
than the amount owed. Thus, the concept of sunk cost is an impor-
tant consideration for the lender in dealing with a problem property;
the amount owed is not unimportant, but it is not relevant for
making decisions. No future course of action can affect the amount
previously loaned; such actions can affect only the amount of recov-
ery. If a course of action is the best available solution, it must not be
rejected because it will not result in full repayment of the loan.
Opportunity cost also is important when considering holding
a nonperforming property or working with the borrower rather than
selling the property at its current value. If the property is sold, the
proceeds of the sale can be invested or loaned elsewhere to earn
profits for the lender. Thus, opportunity cost is the profit foregone
from other possible courses of action. Although the ultimate payoff
may be higher if the property is held, the opportunity cost of holding
the property must be considered. Finally, the out-of-pocket costs of
holding a nonperforming property or working with the borrower
must be considered. Utilities, insurance, property taxes, mainte-
nance, attorney fees, security and other costs of property manage-
ment must be considered.
Proceeding with the analysis first requires identification of
the problem. Is the principal reason for the property’s difficulty the
market (a lack of demand for space), physical or management? In
many cases, some element of each is involved; generally, however,
the most significant problem will be an apparent lack of demand for
the space. If the property is complete, but empty, there likely are
market problems. If the property is incomplete, it may be because
I NVESTMENT BY DESI GN 134
there would be insufficient tenants to successfully operate the
property.
Physical problems with ingress, egress, signage, visibility,
quality of construction and so forth inhibit leasing the property or
achieving the expected rental rate. The cost of correcting these
problems needs to be weighed against the probability that their
solution results in the property being leased. In some cases, the
property may be incomplete, and a decision must be made about
completing the property. Again, it is necessary to consider whether
the property can be leased when it is completed. The cost of elimi-
nating any environmental hazards also must be taken into account.
Management problems may exist as well. Developers with-
out adequate management skills may not be aware of possible
solutions or the need to test their feasibility. When this is the case,
lenders need to supply the expertise.
Solutions and Options
With the property’s primary problems identified, there are
four broad solutions available to the lender. The analytical problem is
not only to judge which of the proposed solutions is best but also to
decide whether or not the best solution makes the lender better off.
The first option is to sell the property “as is” for its cur-
rent market value. The property’s value may equal only the land
value because the improvement is deemed useless. Presumably this
results in a loss to the lender, but this may be the best course of
action if the project has little future. By disposing of the property, the
out-of-pocket holding costs and the opportunity costs of keeping it
will be avoided.
The second option is to hold the property or work with the
borrower to avoid default until market conditions improve. How-
ever, this option results in both out-of-pocket holding costs and
opportunity costs to the lender.
The third option is to advance the funds necessary to
improve the project, and then sell it. This may involve completing
or rehabilitating the property, initiating a new marketing program or
restructuring financial arrangements. This requires deciding whether
advancing the additional funds will make the project financially
feasible and whether the project’s value will increase by more than
the newly invested funds. As well as the added investment, this
option involves both out-of-pocket holding costs and opportunity
costs.
ASSET MANAGEMENT 135
The fourth option is the same as the third except that,
after advancing the funds necessary to improve the project, it is
operated rather than sold. This option involves the same consider-
ations as option three in determining if the additional funds will
make the project economically feasible and if the project’s value will
increase by more than the amount of the added funds advanced.
In considering the third and fourth options, lenders must
make economic judgments about the merits of acquiring a property
and investing adequate funds to cause it to perform at the highest
level possible in the current market. Over time the lender expects to
be rewarded by an enhanced market value for the property. Lenders
must be convinced that the property is a good investment at the price
paid for it: the sum of the property’s current market value plus
rehabilitation cost.
Economic Feasibility
Next, the economic feasibility of each proposed solution
must be established. An income property is economically feasible if
there is an adequate demand for the space and if it can generate
adequate NOI to support sufficient debt to finance the property
and provide a satisfactory cash return to its owner. Thus, ascer-
taining a proposed solution’s economic feasibility requires both
market research and financial feasibility analysis.
Market research is, of course, usually considered in connec-
tion with new developments. Developers, lenders and investors want
to know if there will be sufficient demand for the to-be-built space
for it to be taken up when the project is put on the market. But
market research also can play an equally important role for problem
properties.
In the case of many distressed properties, no market research
was carried out prior to the property’s development. Making the
decisions that were described previously requires considerable
dependence on a market study and, therefore, the first step with
almost all problem properties is to undertake a market study. For
such properties, the market research report should provide informa-
tion beyond that ordinarily found in a report prepared for new
developments.
Market research analyzes the supply and demand for space
within a given market and should provide answers to questions such
as:
• What types of space are available in the market?
• How much space of each type is available?
I NVESTMENT BY DESI GN 136
• What types of space users are in the market now?
• What types of space are being demanded?
• What changes in the demand for space are foreseen?
• What is the underlying cause of the expected change in future
demand?
• Is an expected increase in the demand for space because of the
expansion of businesses within the market area?
• Is an expected increase in the demand for retail shopping space
related to an increased residential population in the market?
• When will there be a need for additional space?
• Are there any current unmet needs for space?
If there is no unmet demand for space in the market area
that the property can supply now or later, the property should be sold
for its current value. If there is an unmet need for space that the
property can reasonably be expected to supply, the research should
provide an estimate of the number of square feet of space required,
the price that space users are willing to pay and an estimate of the
time required to lease.
The market study might show that the property is unsuited
for its intended use. If this conclusion is reached, the costs and
benefits of retro-fitting for conversion to another use must be
evaluated.
The report also should address the property’s physical
problems, if any. Are there physical shortcomings to correct before
the property can be leased at the anticipated rental rate?
Finally, the report should address the implementation of a
marketing plan for the property. Merely identifying an unmet need is
insufficient; the market must be aware of the available space.
Although the market study is an important test for possible
solutions, the analyst also must test the proposed solution’s financial
feasibility before implementing it. Given the current market value of
the property and the proposed solution’s cost, it is financially feasible
if the property can generate adequate net operating income to sup-
port sufficient debt to finance the property and provide a satisfactory
cash return to a potential buyer. The determination of financial
feasibility is dependent on the following information.
• Given a solution’s implementation, how much rent will the
project produce; what are the expected operating expenses; and
how much NOI will the project generate?
• Given current market conditions and lending requirements,
how large a loan will the NOI support?
ASSET MANAGEMENT 137
• Given the probable equity contribution of a potential buyer, can
the property be financed?
But even if a solution is found to be financially feasible, it
must be evaluated further by comparing the property’s expected
increase in value as a result of the proposed solution with the cost of
the proposed solution–is the increase in value greater than the cost of
improvements? If not, the property should be sold immediately for
its current market value. Making this decision is dependent on the
following information:
• What is the estimated maximum price a potential buyer will
pay for the property?
• Given the current market capitalization rate, what is the
estimated capitalized income value of the property?
• What is the estimated market value of the property now?
• What is the estimated cost of the solution?
• Will there be any special out-of-pocket holding costs?
Financially feasible solutions that require holding the prop-
erty until a higher market value is achieved must be tested with
discounted cash flow analysis. To pursue the final stage of the
analysis, it is necessary to estimate the following.
• How long must the property be held for the proposed plan to
work?
• What cash benefits will be received during the holding period?
• What is the estimated maximum price a potential buyer can
pay at the end of the holding period?
• What is estimated capitalized income value of the property at
the end of the holding period?
• What rate of discount should be applied to the expected cash
benefits during the holding period and the expected resale
proceeds? What is the opportunity cost of not selling the
property for its current value?
The solution chosen should be both economically feasible
and provide the greatest present value differential over immediately
selling the property for its current value plus the cost of the solution.
If none of the proposed solutions provides a positive present value
differential, it should be sold as is.
I NVESTMENT BY DESI GN 138
The Disinvestment
Decision
October 1990
Wayne E. Etter
Real estate investment is studied diligently, but
disinvestment (the decision to sell or hold a property) rarely is
considered. Unfortunately, lack of knowledge about disinvestment
can diminish an investor’s return because sometimes portfolio
performance is improved by selling a property and buying another
property or other asset with a higher expected return. This section
focuses on the fundamentals of making the decision to sell or hold
a property.
Fundamentals of Disinvestment
Although a holding period must be selected when estimating
a property’s net present value (NPV) or after-tax internal rate of
return on equity (ATIRRE), the decision to sell does not depend on
the expiration of the assumed holding period nor take place at some
predetermined time. An investor dare not make an investment
anticipating a seven-year holding period, for instance, and give the
property no further consideration for seven years. Instead, the
process of deciding whether to sell or hold the property should be
continual. Effectively, this process results in regular review of
current investments with the whole range of analysis techniques:
market research, financial feasibility study and discounted cash flow
diagnosis. Each of these techniques is used to make the disin-
vestment decision in the same way as in the investment decision.
The decision to sell or hold the property is made by compar-
ing the NPV or ATIRRE of
• selling the property and reinvesting the resale proceeds in a
property (or alternative investment) with equivalent risk to that
of
• continuing the investment in the property.
All other things being equal, the course of action with the
largest NPV or ATIRRE should be selected.
To compare, new investment opportunities are identified and
their expected cost and cash benefits estimated to determine their
expected NPV and ATIRRE. Then, these values are compared with
ASSET MANAGEMENT 139
the NPV and ATIRRE of the current property if it is kept by the
investor. Calculating these values involves estimating the property’s
current market value and its resale proceeds to estimate the current
equity investment in the property. In addition, after-tax cash flows from
operations during the anticipated holding period and from resale at the
end of the holding period are estimated.
An Example Calculation
This discussion focuses on the use of discounted cash flow
analysis in making the disinvestment decision (the fundamentals of
market research and financial feasibility analysis have been pre-
sented elsewhere).
An example property, purchased by an investor five years
ago, illustrates the analysis. The initial equity investment and the
estimated (pro forma) after-tax cash flows from operations and resale
at the time the property was purchased are presented in Figure 1.
Now, suppose the five-year period has elapsed. Although there is an
opportunity to sell this property for $450,000, the owner is consider-
ing keeping it because prospects seem promising. If the property is
retained for another five years, what is the estimated NPV and
ATIRRE?
Answering this question first requires identifying the current
equity investment. This is the amount that the investor can reinvest
elsewhere if the property is sold and is, therefore, the amount
committed to this property if it is kept. Put another way, this is the
opportunity cost of continuing the investment. Thus, when
estimating the rate of return and NPV of keeping the property, the
estimated after-tax cash flow from resale should be used as the
cost of the investment rather than the amount of the initial equity
investment.
Figure 1
(Based on Original Pro Forma
Rather than Actual Cash Flows)
Equity After-tax After-tax
Year Investment Cash Flow Resale Proceeds
0 $80,299
1 $7,695
2 8,574
3 9,374
4 10,191
5 $11,026 $161,453
Internal rate of return: 23.84%
Required rate of return: 15%
Net present value: $30,618
I NVESTMENT BY DESI GN 140
Although the original equity investment was $80,299 (see
Figure 1), the investor now has estimated recoverable equity of
$159,989 if the property is sold for $450,000 (see Figure 2); this is
the opportunity cost of holding the property. The increase from
$80,299 results from appreciation and repaying the loan.
Figure 2
(Based on Today’s Market Analysis)
Expected sales price $450,000
Less: Selling expenses 18,000
= Net sales price 432,000
Less: Unpaid mortgage balance 229,420
= Before-tax cash flow $202,580
Less: Capital gains tax 42,591
After-tax cash flow from resale $159,989
If the example property is held for another five years, the
estimated after-tax cash flow from operations and resale reported in
Figure 3 are expected. For this example, these cash flow projections
were estimated by continuing the original assumptions made for
growth rates and other variables.
Figure 3
(Based on Holding Property an Additional Five Years)
Equity After-tax After-tax
Year Investment Cash Flow Resale Proceeds
5 (end of year) $159,989
6 $11,879
7 12,749
8 13,635
9 14,537
10 $15,453 $219,791
Internal rate of return: 14.0%
Required rate of return: 15%
Net present value: -$5,785
The investor’s required return is 15 percent and continuing
to hold the property results in a negative NPV of -$5,785 and an
ATIRRE of 14 percent, which is less than the required rate of return
(Figure 3). Based on these calculations, the property should be sold
because it does not meet the investor’s requirements.
ASSET MANAGEMENT 141
Of course, even if the property’s NPV is positive and its
ATIRRE in excess of 15 percent, it should be sold if another invest-
ment opportunity offers a higher return with equivalent perceived
risk. Practically speaking, however, such a sale will not occur
unless the improvement in return is worthwhile.
Why would a property that had a positive NPV and an
acceptable ATIRRE at the time of acquisition be unacceptable now?
And, in particular, why is this true when the estimated after-tax cash
flows from operations and its market value are expected to increase
at the same annual rate during the next five years as the previous
five years? The answer is that the equity in the property has
increased relatively more than the expected benefits, causing the
NPV and ATIRRE to decline to unacceptable levels.
What about the property’s cash-on-cash return? The after-
tax, cash-on-cash return calculated with the initial equity investment
is reported in Figure 4. Because after-tax cash flow from operations
increases annually and the initial equity is held constant, there is the
appearance of increased cash-on-cash return. However, using the
opportunity cost of continuing the investment rather than the initial
equity as the denominator for years six through ten provides addi-
tional evidence of the investment’s decreased current return (Figure
4, column 2).
Figure 4
After-tax After-tax
Cash-on-Cash Return Cash-on-Cash Return
Year on Initial Equity (%) on Fifth Year Equity (%)
1 9.58
2 10.68
3 11.67
4 12.69
5 13.73
6 14.79 7.42
7 15.88 7.97
8 16.98 8.52
9 18.10 9.09
10 19.24 9.66
Another explanation of the property’s reduced return is that
by holding it the investor is not taking as much advantage of finan-
cial leverage as when the property was purchased. Financial leverage
is the use of debt to increase the investor’s ATIRRE; when debt is
used effectively, the return to equity increases as the proportion of
cost financed by debt increases. The original loan-to-value ratio was
I NVESTMENT BY DESI GN 142
75 percent; the current loan-to-value ratio is 51 percent (Figure 5).
The loan balance has decreased, the property’s value has increased
and the benefits of financial leverage have decreased.
Presumably, the property is appreciating because net operat-
ing income is increasing; this may result in an increasing debt-
coverage ratio and a decreasing break-even occupancy ratio for the
property (Figure 6). By selling the property and reinvesting the after-
tax resale proceeds, the investor can recapture the benefits of finan-
cial leverage in another property rather than provide the lender with
greater security.
Figure 5
Loan amount
= Loan-to-value ratio
Property value
$240,888
= 75% (year property purchased)
$321,197
$229,420
= 51% (current year)
$450,000
Finally, either a larger property or more than one property
might be purchased with the after-tax cash flow from resale. If a
property is appreciating and the debt is being reduced, then the
opportunity cost of continuing with the property increases with time.
Unless the expected benefits increase even faster than equity, at
some point the sale of the property will be attractive because the
equity freed from the property can be used to acquire properties with
greater returns than the property being held.
Figure 6
Debt Break-even
Year Coverage Occupancy
1 1.27 0.81
2 1.31 0.80
3 1.35 0.78
4 1.39 0.77
5 1.43 0.75
6 1.47 0.74
7 1.52 0.73
8 1.56 0.72
9 1.61 0.70
10 1.66 0.69
ASSET MANAGEMENT 143
Refinancing the Property
The foregoing example assumes the investor is willing and
able to sell the property if the NPV or ATIRRE of another option is
greater. Presumably, the investor can locate other investment oppor-
tunities that do meet the minimum requirements. In the real world,
however, this may not always be the case. For example, an investor
may be in a comfortable position with a property–it has a high
occupancy rate, a positive after-tax cash flow and is appreciating
nicely. Selling it to achieve a larger expected NPV in another property
may be viewed as risky and unappealing. Or, selling the current
property at a favorable price may be difficult because of market
inefficiencies; the characteristics of investment real estate preclude
its being bought and sold like securities.
An alternative to selling is to refinance the property. This
allows the investor to hold a known property while reducing the
equity investment and increasing the benefits of financial leverage.
For example, the owner of the example property could increase the
amount of debt to $283,500 and maintain a 1.25 debt coverage ratio;
this would reduce the equity investment (or opportunity cost) of
holding the investment to $107,373–a reduction of $52,616. If the
investment is continued for another five years, the estimated after-
tax cash flow from operation and sale also must be adjusted; the
larger loan amount results in larger interest payments and a larger
remaining mortgage balance at the end of the tenth year. These
changes are summarized in Figure 7.
Figure 7
Equity After-tax After-tax
Year Investment Cash Flow Resale Proceeds
5 (end of year) $107,373
6 $ 8,265
7 9,450
8 10,096
9 11,042
10 $12,009 $158,991
Internal rate of return: 16.2%
Required rate of return: 15%
Net present value: $4,928
The refinancing has a favorable effect on the property’s rate
of return. The estimated NPV is positive, and the ATIRRE is 16.2
percent. Because the investor’s required return is 15 percent, keeping
I NVESTMENT BY DESI GN 144
the property is now an acceptable option. In addition, the investor
has $52,616 to invest elsewhere, but an expected return of at least
15 percent must be obtained. However, the property should be sold
rather than refinanced if another investment opportunity offers a
higher return with equivalent risk.
145
I NDEX
About
the Authors
Wayne E. Etter is professor of finance with the Real Estate
Center and the Department of Finance at Texas A&M University.
He teaches in the Land Economics and Real Estate (LERE) program
in the College of Business and Graduate School of Business at Texas
A&M. After an early career in banking, he began his academic
profession at Ohio University. He came to Texas A&M in 1969.
Etter holds a Ph. D. in finance from The University of Texas
at Austin. He is the author of numerous articles and writes exten-
sively for the Center.
Andrew E. Baum holds the chair in land management at the
University of Reading, Reading, United Kingdom.
Fred F. Caldwell is president of CNI Commercial Real Estate
and Patrick Thomas Properties. He holds a Texas real estate broker’s
license.
E. J. Cummins, Jr. is the manager of the San Felipe joint
venture and holds a Texas real estate broker’s license.
Ivan W. Schmedemann has been head of the LERE program
since it began in 1972. He holds a Ph. D. in agricultural economics
from Texas A&M and is a professor in that department. His profes-
sional interests include appraisal and rural land economics. He
serves on the board of directors of the Natural Resources Foundation
of Texas.
Scott Shaffer is senior associate of CDS Research.
John Y. Massey is president of BYL International, Inc., a
consulting firm in international trade. He holds a Texas real estate
sales license and is a licensed U.S. Customshouse Broker.
Steve H. Murdock is director of the Texas State Data Center
and head of the Department of Rural Sociology, Texas Agricultural
Experiment Station, The Texas A&M University System.
doc_292218345.pdf
Wayne E. Etter
Professor
Department of Finance
and
Real Estate Center
Texas A&M University
College Station, Texas
ii
Dr. R. Malcolm Richards, Director
Advisory Committee: Don Ellis, Del Rio, chairman; Conrad Bering, Jr.,
Houston, vice chairman; Michael M. Beal, College Station; Patsy Bohannan,
The Woodlands; Dr. Donald S. Longworth, Lubbock; Andrea Lopes Moore,
Houston; John P. Schneider, Jr., Austin; Richard S. Seline, Alexandria, VA;
Jack Tumlinson, Cameron; and Pete Cantu, San Antonio, ex-officio
representing the Texas Real Estate Commission.
© 1995, Real Estate Center. All rights reserved.
Publication 1055
ISBN 1-56248-008-1
iii
Contents
Preface vii
1 Introduction to Real Estate
Investment Analysis
Investment by Design 1
2 Real Estate Investors in Today’s
Economic Environment
Why Investors Invest 7
U. K. Investors Seek Diversity 11
3 Real Estate Risks
Complexities of Real Estate Investment 17
4 Real Estate Economics
Price Elasticity of Demand 23
Scarcity Benefits Investors 28
Using Economic Rent Theory 33
External Obsolescence 38
iv
5 Real Estate Market Research
Case Study: Wilma and the FTZ 44
Analyzing Housing Markets for the Elderly 49
6 Financial Feasibility Analysis
Profitable Apartment Construction 55
7 Assembling the Data
Conducting a Multi-Year Analysis 60
8 Evaluating the Data
How Present Value Works 72
Using Present Value Analysis 78
Calculating Mortgage Loans 84
Estimating Value 89
Direct Capitalization or Discounted
Cash Flow Analysis? 95
9 Analyzing Risk and the Use
of Debt
Debt Financing: Rewards and Risks 100
Appraising in Difficult Markets 105
Towards Evaluating Commercial Properties 110
v
10 Asset Management
Asset Management Essentials 114
San Felipe Court: A Successful Renovation 118
A Matter of Assumptions 123
Buy or Lease? The Commercial Property
Decision 127
Distressed Property Decisions 132
The Disinvestment Decision 138
About the Authors 145
vi
Preface
This volume is a collection of short articles that, with one
exception, were previously published by the Real Estate Center.
Most of them were written for publication in the “Instructor’s
Notebook” series in Tierra Grande; several were co-authored with
colleagues at the Real Estate Center or with other real estate profes-
sionals. Although initially they were not planned for publication in a
single volume, they gradually accumulated until their compilation as
a real estate investment analysis primer seems reasonable.
The articles are organized as they would be for an actual
class. Introductory articles provide an overview of real estate invest-
ment and development. Only after developing an awareness of the
unique nature of real estate are technical topics introduced. Even
with these topics, however, the goal is to explain the basic analytical
tools instead of offering “cook book solutions.” With a thorough
understanding of these tools, a broad variety of real estate problems
can be addressed.
“Investment by Design” sets forth the basic steps for real
estate investment analysis: determine market support, test financial
feasibility, determine the adequacy of the return to equity and
compare property’s value to its cost. These four points are the
cornerstones of the real estate development and investment courses
offered at Texas A&M University.
“Why Investors Invest” and “U.K. Investors Seek Diversity”
both reach the same general conclusion: real estate investors want
quality properties that will provide income and appreciation over the
anticipated holding period. To help understand the real estate risks
these investors face, the major risks of income-producing real estate
and the particular characteristics that accentuate its riskiness are
examined in “Complexities of Real Estate Investment.”
The application of economic analysis to real estate markets
is explored in “Price Elasticity of Demand,” “Scarcity Benefits
vi i
Investors,” “Using Economic Rent Theory” and “External Obsoles-
cence.” Knowledge of these basic economic concepts can turn a
series of real estate market observations into a solid understanding of
their significance with the further potential of predicting where the
market will go next.
“Wilma and the FTZ” and “Analyzing Housing Markets for
the Elderly” lay out the process of real estate market research.
Although each article deals with a specific real estate product, both
demonstrate that the principles of real estate market research can be
applied broadly.
“Profitable Apartment Construction” provides a definition
and an illustration of financial feasibility analysis. Determining if a
proposed development (or redevelopment) can generate sufficient
rental income to cover operating expenses, support sufficient debt to
finance the property and provide a satisfactory cash return to the
owner is, perhaps, the most basic format for real estate financial
analysis.
“Conducting a Multi-Year Analysis” sets out the basic process
for estimating cash flow from operations and resales. Although not
previously published by the Real Estate Center in this format, this
volume could not be considered a real estate investment primer
without its inclusion.
Present value techniques for evaluating the assembled data
are examined in “How Present Value Works,” “Using Present Value
Analysis” and “Calculating Mortgage Loans.” Then, building on the
basic internal rate of return and net present value calculations, the
concepts of direct capitalization and investment value are examined
in “Estimating Value” and “Direct Capitalization or Discounted Cash
Flow Analysis.”
The advantages and risks of using debt to finance income-
producing real estate are examined in “Debt Financing: Rewards and
Risks” and “Appraising in Difficult Markets.” Because debt intro-
duces financial risk (see “Complexities of Real Estate Investment”), a
property’s total risk can become excessive when too much debt is
used. “Towards Evaluating Commercial Properties” presents an
approach for controlling a property’s total risk.
Asset management has emerged as an important area of real
estate investment. “Asset Management Essentials” and “San Felipe
Court: A Successful Renovation” outline and illustrate the use of
decision-making techniques for choosing a strategy to maximize the
value of an income-producing property. “A Matter of Assumptions”
vi i i
examines the importance of the assumptions made by asset manag-
ers when estimating a building’s value on a tenant-by-tenant basis
while “Leasing versus Buying” illustrates the decision-making
process a commercial or industrial space user would apply in making
that decision. “Distressed Property Decisions” explores an important
area of asset management, while procedures for deciding to sell or
hold a property are outlined in “The Disinvestment Decision.”
Together, the articles provide basic information about a
variety of real estate development and investment topics. Conse-
quently, whether information is sought about a particular technique,
such as income capitalization, or about the broad process of investing
in income-producing real estate, this volume should be useful.
Because the articles were published over a period of several
years, the particular market conditions analyzed or described at the
time of their original publication may have changed. The principles
illustrated, however, remain useful.
I wish to thank the co-authors for their contributions. They
supplied ideas, data and text and also suggested analytical ap-
proaches, reviewed drafts and provided many helpful suggestions.
Also, I wish to thank the Real Estate Center staff for their
help in preparing these articles for publication, especially Dr. Shirley E.
Bovey for her careful and thoughtful editing. Without their efforts,
this volume could not have been published.
Wayne E. Etter
January 1995
I NTRODUCTI ON TO REAL ESTATE I NVESTMENT ANALYSI S
1
Investment
by Design
Evaluating the potential of a proposed real estate investment
requires a carefully designed, analytical plan. By logically arranging a
series of questions, a plan can be developed that minimizes the
chance of overlooking an important fact about the property.
Questions are answered through a careful evaluation of the
specific data assembled for the analysis. When there is a lack of
data, no further consideration should be given to the proposed real
estate investment until the data are available; the temptation to
ignore the question must be resisted. Of course, prior to beginning
the analysis, the investor must establish criteria for evaluation
whether or not an answer to a question is satisfactory. Although
there can be any number of questions, they can be considered under
four broad categories.
Determine Market Support
The presence of sufficient market support is determined by
analyzing the supply and demand for space within a defined market
area. Factors that define market areas vary according to property
type; a retail space market is defined differently than an office space
October 1988
Wayne E. Etter
Introduction to Real
Estate Investment
Analysis
1
I NVESTMENT BY DESI GN
2
market. In no case are market areas defined simply by drawing
circles having radii of one or two miles. Within a defined market
area, the supply and demand for space for particular market
segments is then identified.
What types of space are available in the market? How much
space of each type is available in the market? What types of space
users are in the market now? What types of space are in demand?
What changes in the demand for space are foreseen? What is the
underlying cause of the expected change in future demand? Is an
expected increase in the demand for space related to the expansion of
businesses within the market area that will require additional office
space? Or, is an expected increase in the demand for retail shopping
space related to an increased residential population in the market?
When will there be a need for additional space?
By answering these questions, the investor can determine if
there is an unmet need for space in the market area. If so, the
research should conclude with an estimate of the number of square
feet of space required and the price users are willing to pay for it.
Marketing research usually is thought of in connection with
new developments. Developers, lenders and investors want to know
if there will be sufficient demand for the to-be-built space. But
marketing research can play an equally important role when an
investor is considering changing a property’s existing use or when an
investor is considering investing in a property when the use will
remain the same.
How does “choosing a good location” differ from marketing
research? Good locations are important and are based on the needs
of particular activities. For instance, certain commercial activities
require minimum lot sizes along a major arterial street with particu-
lar kinds of ingress and egress. Additional requirements may include
easy access to wholesalers, shippers, customers or market centers.
Locating such a site does not automatically make it suitable for the
activity, however. There must be adequate demand for the space; a
good location cannot assure demand.
What are the benefits of good marketing research? Obvi-
ously, identification of an unmet need increases the probability of
success. The late Professor James A. Graaskamp suggested the
identification of an unmet need provides a competitive edge for the
investor that can result in a fully leased property–perhaps at a
premium rent. This competitive edge provides the best defense
against future properties entering the market–satisfied tenants are
less likely to move to a competing property. Because a property’s
I NTRODUCTI ON TO REAL ESTATE I NVESTMENT ANALYSI S
3
value is a function of its ability to generate rent, an increased rent
results in an increased value. Ultimately, the investor will enjoy a
greater rate of return from the identification of an unmet need.
In addition, marketing research can protect against the
consequences of the competitive price cutting that takes place in
overbuilt markets. Although reducing the rental rate in an overbuilt
market may cause some additional space to be leased, the lower rate
also may result in less total rent being collected. For example,
decreasing the rental rate for retail space will bring some additional
space users into the market, but it is unlikely to result in substantial
numbers of entrepreneurs deciding to enter the retail business or
encourage existing retailers to expand. These decisions will depend
on factors other than the price of retail space.
Furthermore, because all other owners will likely decrease
their rental rates as well, the rental income of all owners will decline
if the average market rental rate declines sufficiently. Thus, price
cutting by the owners of vacant retail space in such a market will
neither significantly increase the demand for space nor provide the
investor with a superior competitive position. Good marketing
research can help an investor avoid overbuilt markets. If there are no
strong indications that the investment under consideration will fill
an unmet need, it should not be given further consideration.
Test Financial Feasibility
The investor, having established that a particular property
will fill an unmet need, next tests the project’s financial feasibility.
If the property can generate adequate net operating income to
support sufficient debt to finance the property and provide a
satisfactory cash return to the developer-investor, the project is
financially feasible. This is a test of the property’s ability to gener-
ate adequate cash in the short run. Making this determination
requires answers to questions such as: How much will the project
cost? How much rent will the project produce? What are the
expected operating expenses? How much net operating income will
the project generate? Given current market conditions and lending
requirements, how large a loan will the net operating income sup-
port? And, given the estimated cost of the project and the desired
equity contribution of the developer-investor, can the project be
financed? A project’s financial feasibility is best explained as a
balance among the:
• property’s expected cost,
• property’s expected operating performance,
I NVESTMENT BY DESI GN
4
• lender’s requirements and mortgage market conditions and
• investor’s required before-tax, cash-on-cash return.
If there is a proper balance among these factors, the property
should generate enough rent to pay all the operating expenses, to
repay the debt used to finance the property and meet the investor’s
expected cash return. Properties that do not meet this test have little
promise even when there is a demand for the space. And, when
properties promise little in the short run, it is risky to assume that
they will improve in the long run. If, however, an investor deter-
mines there is both a demand for the space and the property is
financially feasible, the analysis moves to long-term considerations.
Is After-Tax Return to Equity Sufficient?
The expected after-tax rate of return from a real estate
investment is determined by the expected benefits of the invest-
ment–after-tax cash flow and appreciation–and the cash required to
purchase the property. The expected rate of return can then be
compared with the minimum return the investor requires to
undertake the investment. The investor’s required return is estab-
lished by examining the returns available from other investments
having a similar level of risk.
A proper calculation of the rate of return involves the use of
present value techniques so that the rate will reflect both the amount
and timing of the cash inflows and outflows. This rate is known as
the internal rate of return.
Why must the project’s after-tax internal rate of return be
considered even if the project is financially feasible? The investor’s
required return, as used in the determination of financial feasibility,
is based on a single year’s before-tax income–it is a short-term
measure and does not encompass the period during which the
investment is expected to be held. As a consequence, the investor
must consider the effect of taxes, financing and future events on the
property; this is the essential contribution made by the after-tax
internal rate of return calculation.
Real estate is particularly affected by future events because of
its characteristics: large economic size, physical immobility and long
economic life. In short, a property investment involves a relatively
sizable dollar investment that cannot be moved and that must
generate income during a long period. Thus, successful real estate
investing involves making decisions about the future level of rents,
operating expenses, appreciation rates and tax laws. These, in turn,
I NTRODUCTI ON TO REAL ESTATE I NVESTMENT ANALYSI S
5
depend on the rate and direction of urban growth, price inflation,
international events, political events and so forth.
As the information is gathered, the investor necessarily will
be addressing questions about risk. Risk exists in all projects, but
some are more risky than others. The degree of risk depends on the
difference between expected and actual outcomes. If the expected
outcome is guaranteed, then the risk is negligible; if there is substan-
tial uncertainty about the expected outcome, then the risk is great.
For a single project, the best way to reduce risk is to improve the
analysis of the variables that produce the project’s expected rate of
return. In this way, the spread between expected and actual out-
comes can be minimized.
As the scope of discounted cash flow analysis is examined,
one of its prime benefits becomes clear. In gathering the data
required to make the analysis, much will be learned about the
investment under consideration. Estimating the rate of return may
be secondary to the knowledge gained from gathering the informa-
tion. Nevertheless, the prospective investment must promise a
satisfactory rate of return or its consideration should be abandoned.
Compare Value to Cost
The investment value of any asset is equal to the present
value of its future cash flows, discounted at the appropriate rate. A
property’s investment value is not the same as fair market value or
loanable value. It is the value that an investor determines after
establishing a set of investment requirements and expectations about
the property; this value is compared to a property’s offering price or
cost to see if it exceeds the cost of the property.
The investor anticipates cash benefits in the form of after-tax
cash flow and appreciation. The lender generally receives a mortgage
payment in an amount agreed upon in advance but also may expect a
share of other benefits such as rents, cash flow or appreciation. It
usually is assumed that the amount loaned is equal to the present
value of the lender’s expected benefits discounted at the lender’s
required rate of return (generally the face interest rate of the loan). A
property’s investment value is equal to the present value of all the
cash benefits expected by the equity investor, discounted at the
investor’s required rate of return, plus the amount of the
mortgage.
The property’s investment value is based on all the projec-
tions, assumptions and so forth that have been made by the equity
investor and the lender. In addition, the required rate of return and
I NVESTMENT BY DESI GN
6
the specific tax rates are taken into account. Thus, the investment
value is for a particular property and for a particular set of circum-
stances. Because it is not an estimate of fair market value, there is
no reason to expect that the property can be purchased for the
estimated investment value. Rather, this is the value of the property
under a particular set of circumstances, and if unreasonable assump-
tions, projections and so forth are made, the investment value
calculated for a particular investor may be different from the
property’s market price.
However, the terms of purchase, financing or a particular
investor’s tax situation can increase the property’s investment value.
This may explain why one investor may be willing to pay more for
a property than another: the assumptions used and the terms
available produce a higher estimate of investment value. Never-
theless, if the property’s investment value does not equal or exceed
its cost, the property should not be purchased.
Conclusion
As the investor progresses through the analysis, the
property’s suitability as an investment will be established. If the
answer to any one of the questions is negative, the analysis should be
abandoned. There is no logical reason to proceed to any of the
remaining questions. Furthermore, positive answers to one or more
of the questions should not induce the investor to disregard a nega-
tive answer to the next question. By adhering to a carefully designed
analytical plan, an investor can maximize the probability of choosing
real estate investments that will prove successful in the long run.
REAL ESTATE I NVESTORS I N TODAY ’S ECONOMI C ENVI RONMENT
7
Why Investors
Invest
Assembling real property investment portfolios and develop-
ing property requires money. Do investors supply funds for real
estate investment and development because they like real estate? Or
do they supply their money in exchange for an expected return
appropriate for the level of risk? Or are they initially more concerned
with the expected return than with risk?
As they did in the early 1980s, today’s individual investors
supply considerable money for real estate. Studying investors’ appar-
ent motivations during these two periods provides insight into a
future capital-raising approach for the real estate industry.
Then: Tax Benefits Reign
Several key factors produced the surge of investor interest in
income-producing real estate during the 1980s.
First, the Economic Recovery Tax Act of 1981 was a principal
stimulant of this escalation as individual investors sought to take
advantage of the expanded real estate tax benefits. Second, inflation-
ary economic conditions also caused many investors to anticipate
rapid appreciation of their real estate investment.
Summer 1994
Wayne E. Etter
Real Estate Investors
in Today’s Economic
Environment
2
I NVESTMENT BY DESI GN
8
Third, many investments depended heavily on money
borrowed from deregulated, federally insured financial institutions to
magnify the benefits of tax shelter and expected appreciation for the
individual investor. Investors could deduct interest and depreciation
expense on the entire property and enjoy all the benefits of the
property’s appreciation even though their equity investment might
be quite small.
Because of the emphasis on tax benefits, which appeared to
be automatic, and similar expectations about property appreciation,
individual investors and syndicators sometimes analyzed the actual
property only superficially. Risk was of little obvious concern; data on
the supply and demand for space, rents, vacancy rates, operating
expenses and the actual rates of property appreciation for surround-
ing property often were ignored.
The circumstances of the early 1980s that fueled individual
real estate investment expansion changed significantly by late 1986.
Because of the extensive unneeded development that took place in
some areas during the early 1980s, the prospect for property appre-
ciation and sufficient cash flow to service debt was reduced. In
addition, the 1986 Tax Reform Act significantly affected the status of
real estate as a tax-sheltered investment; the tax benefits enjoyed in
the past by real estate investors were no longer available. Conse-
quently, commercial real estate values declined, and lenders were
forced to foreclose on many properties.
These points are well known to anyone familiar with the
history of commercial and multifamily real estate during the 1980s.
Two points should be emphasized, however. First, investors expected
high yields; syndications projecting internal rates of return in excess
of 20 percent were common. Second, many investors seemed oblivi-
ous to the proposition that real estate is risky. As a consequence, the
large expected returns caused money to pour into real estate, but
when the commercial real estate market collapsed, many investors
were disillusioned.
Now: Attractive Cash Yields
According to the National Association of Real Estate Invest-
ment Trusts, the total value of real estate investment trust (REIT)
shares offered during 1993 was about $12.8 billion. The graph shows
annual equity offerings were less than $2 billion in nine of the
preceding 11 years.
Why are REITs suddenly so popular? Because they invest in
real estate? Not really. They are popular with investors because their
REAL ESTATE I NVESTORS I N TODAY ’S ECONOMI C ENVI RONMENT
9
current cash yield is attractive. In some cases, falling interest rates
have made REIT shares attractive relative to certificates of deposit.
Rather than replace maturing higher yield CDs with lower yield
CDs, some investors buy REIT shares.
REITs are similar to stock mutual funds; individual investors
purchase shares that represent an undivided interest in the properties
owned by the REIT. REITs do not pay corporate taxes if they pass
through 95 percent of their portfolio income to their shareholders.
REIT shares are traded on the stock exchange; thus, they are a highly
liquid, particularly when compared to the real estate limited partner-
ship interests owned by many investors in the 1980s.
During the past few months, a number of institutions have
sold foreclosed properties from their portfolios at reported prices of as
much as 50 percent less than their original valuation. Many of these
distressed properties were purchased by REITs. When investors buy
the REIT shares, money is provided to pay for the purchased proper-
ties plus the organizers’ and underwriters’ fees and profit.
Developers that need cash to pay debts on already developed
properties are taking advantage of the demand for REIT shares by
organizing REITs. REITs are popular with developers because they
provide capital for development when few sources are available. The
REIT sells shares to investors and buys the developers’ properties.
I NVESTMENT BY DESI GN
10
Wall Street firms like REITs because they provide activity for
underwriting departments and merchandise to sell. And the demand
for REIT shares is credited with firming or increasing prices in the
commercial property market.
What about the risk of owning REIT shares? As with the real
estate investors of the 1980s, it is not clear that today’s REIT inves-
tors are thinking about risk.
Notably, some high-quality REITs are offered. Today, most
REITs are issuing stock to finance the purchase of completed proper-
ties. This is in sharp contrast to their activities in the early 1970s
when they used short-term funds to make high interest rate develop-
ment and construction loans.
Nevertheless, a portfolio of distressed properties does not
automatically become a portfolio of sound properties, even if they are
purchased by an REIT for 50 percent of their original value. The
quality of each property in the portfolio depends on the usual set of
local market factors. If the portfolio’s income does not materialize,
the value of the REIT’s shares will decrease.
Lessons Learned
Three lessons can be gleaned from this historical compari-
son. First, these two groups of investors sought real estate invest-
ments for yield. Real estate is just another investment.
Second, the two investors’ groups had different expectations.
The first group consisted of high-income investors who sought high
yields through tax benefits and appreciation. Some of today’s inves-
tors want only to do better than the current yield on certificates of
deposit; interest-rate-sensitive investors could sell their shares if CD
yields increase. Although packaged quite differently, real estate
investments can fulfill different expectations.
Third, the first group left the real estate market after their
losses. Initially, they paid little attention to risk, and they paid a
price for their inattention. The second group likely will leave too if
their expectations are not realized. What will happen to the value of
REIT shares remains to be seen, but if significant numbers of REIT
portfolios are too risky or if interest rates increase sufficiently,
investors are likely to lose again.
The large expected returns of the 1980s were achieved by
introducing significant business and financial risk, whereas most
REITs today are making nonleveraged property purchases at prices
below replacement cost. Thus, they avoid some of the problems that
the limited partnerships of the 1980s had–too much debt combined
REAL ESTATE I NVESTORS I N TODAY ’S ECONOMI C ENVI RONMENT
11
with inflated purchase prices necessary to magnify the value of tax
shelter benefits. However, foreclosed properties may suffer from
inadequate demand in their specific markets even though no debt
financing is involved and even though they were purchased at low
prices.
Defining the Opportunity
The two periods offer the real estate industry an opportunity
to study investors’ motives and develop an appropriate product to
take advantage of these motives. Investors will supply equity funds to
the real estate industry in return for a satisfactory expected yield
with little apparent concern for risk. However, they exit the market
when their expectations are not realized.
If the real estate industry develops a nonspeculative product
with limited risk and a satisfactory return, the industry might be
rewarded with a steady source of equity funding. As the current
demand for REIT shares by ordinary investors illustrates, the product
need not provide unusually high expected returns. This is important
because historically real estate returns have not been unusually high.
The challenge to those who seek capital in the real estate
industry is not to develop a complex financial product; rather, it is to
limit the issuance of securities to those backed by quality properties.
Such a practice will produce a high quality security that will find a
ready market. Because these securities will have a reasonable risk,
their yield can be competitive with that of other securities of similar
risk. To achieve this, however, will require that real industry partici-
pants develop a discipline rarely seen during the last decade.
Although many Americans believe the purchase of U.S. real
estate by foreign investors is not desirable, others disagree. In par-
ticular, many Texas real estate brokers are interested in foreign real
estate investors because they anticipate sizable purchases in the
Texas market.
This article examines a major group of United Kingdom
(U.K.) property market investors and their present motivation to
U. K. Investors Seek
Diversity
April 1991
Wayne E. Etter
Andrew E. Baum
I NVESTMENT BY DESI GN
12
invest in the U.S. real estate market. According to the Survey of
Current Business, U.K. investors have the largest foreign direct
investment in U.S. real property. These investors are dominated by
two types of institutional investors: pension funds and insurance
companies.
U.K. pension funds and insurance companies purchase
existing properties and finance the development of new properties
that are added to their portfolios upon completion. They also may
form partnerships to fund pooled property vehicles managed by
merchant banks or life insurance companies. Each property in a
pension fund portfolio is owned for the fund’s sole benefit and is
purchased for the particular fund in an all-equity transaction.
Properties owned by life insurance companies may be general
company investments or held for the benefit of a particular pension
fund managed by the insurance company or as one of several invest-
ments included in a unit scheme. From time to time, the pension
funds and life insurance companies sell properties to adjust their
portfolios; trading activity increased greatly during the 1980s.
As of December 1988, about 8.5 percent of U.K. pension
funds’ net assets were invested in property. Although the proportion
of assets invested in property is about the same as it was in Decem-
ber 1985, property investment increased about £5 billion during the
three-year period. About 15.3 percent of U.K. insurance companies’
net assets were invested in property as of December 1988, an in-
crease of almost 1 percent since December 1985. In absolute terms,
insurance companies held about £14.6 billion more property invest-
ments at the end of 1988 than at the end of 1985.
Why Do They Invest in Real Estate? Although there are
many reasons why U.K. pension funds and insurance companies
hold real estate, the following three are important. First, real estate is
expected to produce a reasonable return for a reasonably low risk.
Furthermore, real estate returns are believed to have little or no
correlation with returns from their other principal investments
(common stocks, bonds and mortgages for the most part). Thus, the
effects on portfolio yields and values caused by adverse common
stock, credit market conditions or both will not be accentuated by
simultaneously adverse changes in the real estate market.
Second, real estate is held by pension funds and insurance
companies because their competitors hold real estate. In one survey,
pension fund managers indicated their most important comparative
performance standard is the performance of other property funds.
REAL ESTATE I NVESTORS I N TODAY ’S ECONOMI C ENVI RONMENT
13
Therefore, they imitate their competitors’ investment strategies,
attempting to do at least as well. Third, real estate is considered a
hedge against inflation. Because payments to beneficiaries often are
linked to the inflation rates, pension funds and insurance companies
invest in real estate expecting to offset inflationary effects.
Why Do They Invest Abroad? Many U.K. investors seek
geographic portfolio diversification of both their security and property
portfolios. Because the U.K. property market is small relative to the
funds available for investment, opportunities to use funds in the U.K.
market are limited. Therefore, these investors must diversify through
foreign real estate markets. Foreign markets also may offer high returns
and low correlation with U.K. real estate. Keen competition for suitable
investment properties in the U.K. property market drives down U.K.
property yields. Many U.K. investors are seeking larger investment
returns than they believe are available in the U.K. market.
What Are Their Investment Requirements? When investing
abroad, U.K. investors seek top quality buildings with strong market
positions. These properties have little business risk and are expected
to produce regular income and to increase in value over time.
Returns from foreign properties must compare favorably with
property returns currently available in the United Kingdom.
Generally, property portfolios are expected to have a higher
total yield than equity, bond and mortgage portfolios. To be consid-
ered for acquisition, properties should have an expected internal rate
of return (also known in the United Kingdom as the total return) of
15 to 20 percent. Presently, the expected return on U.K. equities is
about the same as for property, while the return on government
bonds and mortgages is about 12 percent and 14 percent, respec-
tively. Currently, the U.K. overall capitalization rate (known there as
the initial yield) is about 6 percent for retail properties, 7 percent for
office properties and 10 percent for industrial properties.
Short-term vs. Long-term Performance. A recent study of
U.K. property pension fund investors indicates that real estate is
generally considered a long-term investment by them, but the
comments of some interviewed managers indicate that in recent
years there is more pressure for short-term investment performance.
Short-term is defined by a majority of these managers as one year or
less; likewise, a majority consider the long-term to be five to ten
years or more. The most important investment objective for the
majority of the interviewed managers short-term and long-term is to
provide good performance.
I NVESTMENT BY DESI GN
14
Measuring Current Performance. In the United Kingdom, a
property’s current performance usually is measured by its annual
total return:
(1) Total return = Income return + Capital return
The components of total return are defined as follows:
(2) Income return =
Annual income
Current value
The tenant ordinarily bears all operating expenses of the
property; the owner generally considers the rental income as the
property’s annual income. Thus, the income return is the same as
the overall capitalization rate used by U.S. real estate investors. This
return is equivalent to a current after-tax return for a U.K. pension
fund–they are tax exempt and typically make 100 percent equity
purchases. Although life insurance companies also make 100 percent
equity purchases, they are only partially tax exempt.
(3) Capital return =
Current value - Previous period value
Previous period value
The capital return is simply the percentage change in a
property’s current value from its previous period value. This measure
of the return is dependent on periodic appraisals of the property and is
subject to error.
While U.K. institutional investors are concerned with a
proposed investment’s expected internal rate of return over the
anticipated holding period, expectations about both current income
and appreciation must regularly be achieved. Only properties offering
this potential are of interest to these investors.
Where Are Their Investment Opportunities? U.K. pension
funds and insurance companies invest in real properties, both in the
United Kingdom and overseas. Americans are aware of the activities
of foreign real estate investors in the United States and might
assume the U.S. property market dominates the attention of foreign
investors. In addition to providing opportunities for geographic
diversification and reasonable returns, the United States possesses
political and economic stability–on a relative scale, the United States
continues to be a haven for those concerned with investment safety.
Currently, however, real estate investment opportunities in
Western and Eastern Europe are emerging that will compete with
U.S. properties for the attention of U.K. (and other foreign) investors.
Why is this?
REAL ESTATE I NVESTORS I N TODAY ’S ECONOMI C ENVI RONMENT
15
First, the dramatic changes in Eastern Europe are encourag-
ing many investors to supply funds needed by these emerging market
economies for real estate development.
However, current developments in Western Europe are even
more significant. The 12 European countries (including the United
Kingdom) of the European Union (E.U.) became a single market on
December 31, 1992; soon three additional European countries will
join the E.U. Their land area is about one fourth that of the United
States, but their 1986 population was about one-third greater.
Although such comparisons are difficult, the 12 E.U. countries’ 1987
gross national product nearly equalled that of the United States.
Becoming a single market means there is free movement of
goods, labor, services and capital among E.U. countries. Furthermore,
there will be a “harmonization” of laws, indirect taxation, agricul-
tural policies and so forth. Eventually, they hope to achieve monetary
union; if they do, it will be possible for E.U. investors and businesses
to shift funds among E.U. countries without foreign exchange risk.
Thus, the E.U. is about to emerge as an important market area–one
that is much stronger economically than were the 12 independent
countries with trade barriers, conflicting laws and tax policies and 12
monetary systems.
These changes are expected to produce increased economic
activity with significant real estate investment opportunities. This
accounts for the present intensity of interest in European real estate by
many institutional property market investors.
What about Texas Real Estate? Texas properties will be
competing with many other markets now for U.S. and foreign
investors. Attracting U.K. investors is particularly worthwhile
because they usually make 100 percent equity purchases; mortgage
financing (that is difficult to arrange in Texas) is not required to
facilitate U.K. purchases.
Texas properties are low-cost by international standards and
institutional investors such as pension funds still desire broad
geographic diversification. To interest U.K. investors, however, Texas
brokers must offer sound properties in areas with high demand and
supply constraints. Interested Texas real estate brokers must realize
that U.K. investors want only properties that will produce regular
current income and appreciation during the anticipated holding
period.
Texas real estate brokers with properties to present to U.K.
investors may wish to contact one of the following firms.
I NVESTMENT BY DESI GN
16
Baring, Houston & Saunders Healey & Baker
Property Consultants 29 St. George Street
104-106 Leadenhall Street Hanover Square
London EC3A 4AA London WIA 3BG
Debenham Tewson Hillier Parker
& Chinnocks 77 Grosvenor Street
3 - 5 Swallow Place London W1A 2BT
London W1A 4NA
Jones Lang Wootton
Richard Ellis Chartered Surveyors
Berkeley Square House 22 Hanover Square
London W1X 6AN London W1A 2BN
Edward Erdman Knight Frank & Rutley
6 Grosvenor Street 20 Hanover Square
London W1X 0AD London W1R 0AH
Fletcher King Savills
Stratton House 20 Grosvenor Hill
Stratton Street London W1X 0HQ
London W1X 5AE
REAL ESTATE RI SK S 17
Complexities of Real
Estate Investment
Real estate investments generate cash flows from three
principal sources: operations, appreciation and equity build-up.
• Cash flow from operations represents the cash benefit the
property provides after operating expenses, debt service and
income tax are paid from the rental income. These benefits are
expected throughout the investment’s economic life.
• Appreciation represents an important source of real estate
returns. Over time, well-located and well-maintained properties
are expected to generate increased income that will be reflected
in higher property value.
• Equity build-up results from the periodic reduction in the
mortgage. These benefits can be obtained only if the property is
refinanced, or it is sold at a sufficiently high price.
As investors estimate the present value of these future cash
benefits, they are necessarily concerned with risk exposure because
the value of any asset is equal to the present value of its future cash
flows. If an investor is certain the actual cash flows will be the same
in amount and timing as those expected when the investment is
July 1991
Wayne E. Etter
Real Estate
Risks
3
I NVESTMENT BY DESI GN
18
made, the investor will not consider it risky. If, however, the prob-
ability of variation between expected and actual cash flows is high,
the investment will be considered risky. Because investors expect a
higher return from undertaking a risky investment, they apply higher
discount rates when they estimate the present value of an invest-
ment. The result? A stream of risky cash flows is worth less than a
stream of more certain cash flows.
Real Estate Investment Characteristics
The risks of an income property’s future cash flows cannot
be evaluated without understanding how they are related to real
estate characteristics. Although real estate investments have many
characteristics, three are particularly important.
First, real estate investments are physically immobile–they
cannot be moved. Second, they have a long economic life–they must
produce cash returns over a long period if their cost is to be recov-
ered. Economic life is the time required for the property’s cost to be
recovered from operations; it differs from the investor’s expected
holding period. Even when an investor anticipates a five- or ten-year
holding period, the future buyer of the property anticipates a satisfac-
tory cash flow during a future holding period and so on.
Third, they have a large economic size–a single property
requires a large dollar investment compared to the minimum pur-
chase of common stock, for instance. Although it is difficult to relate
these three characteristics to each of the seven risks, the characteris-
tics accentuate real estate’s risk exposure.
Relationship of Characteristics to Risks
Business Risk. Real estate’s physical immobility and long
economic life are strongly associated with business risk–the risk of
failing to generate sufficient income. This failure can result from
attracting too few tenants, lower than anticipated rental rates caused
by high vacancies in competing properties, declining business condi-
tions in the market area and so on.
Consider the plight of a shopping center owner when demo-
graphic changes adversely affect the center’s market area. The
center’s tenants can follow their customers to other neighborhoods
and markets, but the shopping center cannot be moved. Its owner
must suffer the consequences of reduced cash flow from operations
and lowered expectations of cash flow from appreciation and equity
build-up. And because the shopping center has a long economic life,
it must sustain its operational cash flow for a long period.
REAL ESTATE RI SK S 19
A property may appear to be ideally located when it is
constructed; the adverse demographic changes may take place some
years after its construction. Because of the property’s long economic
life, the center’s cost may not be recovered even after generating
sufficient cash flow for several years.
Management Risk. Real estate’s physical immobility and
long economic life also are strongly associated with management
risk–the risk of failing to respond properly to changing business
conditions to maintain the efficiency and profitability of the property.
Because real estate cannot be moved and must sustain its cash flow
during its economic life, the probability of changing business condi-
tions is high during the property’s economic life.
Considering the shopping center example, one might ask
what a good manager could have done to predict the demographic
changes and react to minimize their impact on the property’s cash
flow. Some investment managers may perceive such changes in
business conditions and act rapidly to forestall their effect, while
others may take no action or act improperly.
Financial Risk. Because real estate investments traditionally
are financed with debt, financial risk is significant; furthermore, real
estate’s physical immobility, long economic life and large economic
size accentuate the financial risk. Because the debt is unlikely to be
repaid in a short time, the property must generate adequate cash
flow throughout its long economic life.
As with business risk, many changes can occur during this
time that adversely affect the property’s income stream. Because the
property cannot be moved, the probability of changes adversely
affecting the owner’s ability to meet the mortgage payment is
increased. Real estate’s large economic size often requires invest-
ments to be financed with high loan-to-value ratio turns into an
equal disadvantage when the property’s income declines.
Financial leverage is truly a “two-edged sword.” This is a
particularly significant risk when the terms of financing are arranged
during periods of high interest rates.
Political Risk. Because real estate is located permanently
within a particular political jurisdiction, it is subject to the
community’s attitude toward property. Accordingly, it is subject to
zoning, land-use regulations and building codes imposed by that
jurisdiction. Because of its long economic life, such regulation might
become more severe during the economic life. But increased regula-
tion can prevent competition, thus enhancing the value of existing
I NVESTMENT BY DESI GN
20
properties. Finally, large projects may be reviewed more strenuously
by regulators at all levels.
Of course, the long economic life also subjects the investor to
tax law changes. For instance, the 1986 Tax Reform Act altered real
estate’s status as a tax sheltered investment. Prior to the act, many
investors expected tax benefits to be a significant portion of total
cash flow; when this portion of the investment’s cash benefits was
eliminated, the value of their investment declined. The act also
increased the capital gains tax liability generated by the sale of real
estate. Many investors anticipated a lower rate of capital gains
taxation when they invested. Thus, they not only must anticipate a
larger tax on the sale, they also may expect a future buyer to offer
less for the property because for that buyer the expected flow of cash
benefits has been reduced.
Inflation Risk. Because real estate investments have a long
economic life, investors must correctly anticipate the inflation rate
for the long term. When future cash flows are reinvested, they will
buy less than expected if the inflation rate is greater than expected;
furthermore, future cash flows may be less than expected as a result
of inflation–operating expenses may exceed expectations, for
example.
Although inflationary gains should not be confused with
appreciation, real estate values generally have performed well during
periods of moderate inflation. However, higher than expected
inflation rates may induce others to purchase and develop real estate
to hedge against inflation. If, as a result, the supply of rentable space
exceeds the demand for rentable space, rental rates and property
values will fall. Finally, inaccurate inflation forecasts result in
choosing inaccurate discount rates that can have an important effect
on the present value of future benefits.
Liquidity Risk. Real estate’s physical immobility and large
economic size make it particularly subject to liquidity risk. Its
physical immobility makes it unique–a severe hindrance to selling it
quickly without loss. The liquidity of real estate investments also is
hampered because of their large economic size–the buyer of the
property must invest more cash than required for many other
investments.
Interest Rate Risk. Real estate investment’s long economic
life and large economic size increase the exposure to interest rate
risk. Because many investors value properties by capitalizing their
net operating income, i.e., net rental income less the property’s
REAL ESTATE RI SK S 21
operating expenses, the capitalization rate is an important determi-
nant of value. Although there are two basic approaches to developing
this rate, both approaches produce a result that is highly correlated
with interest rates.
Some investors use discounted cash flow analysis to value
properties, but their discount rates also are related positively to
interest rates. Because of real estate’s long economic life, fluctua-
tions in market interest rates during that period are virtually certain.
As interest rates rise, property values will fall and vice versa.
An investor wanting to sell a property may find that a prospective
buyer reduces the offering price because of rising interest rates. The
large economic size requires many real estate investments to be
financed largely with debt, thereby making such investments even
more interest sensitive. Although fixed-income securities are the
usual example for this type of risk, income properties clearly are not
immune.
The lesson for today’s real estate investor is clear. As recent
events have shown, real estate is not a riskless investment. Failure
to recognize the threat of the combined effect of business risk and
financial risk seems particularly important.
Many speculative properties were financed with high debt-to-
equity ratios–sometimes in excess of 90 percent. The mortgage
payments on such properties were large because of the high debt-to-
equity ratio and interest rate levels; in many cases, the investor
needed a 95 percent occupancy rate to generate sufficient net operat-
ing income to service the debt. When the supply of space exceeded
demand, rent concessions were made in an attempt to fill the proper-
ties with tenants. Although rent concessions may have attracted
tenants in some cases, they were little help to the market as a whole.
The other risks of real estate were present, too. Many
properties were developed by inexperienced developers and purchased
as investments by inexperienced investors. Thus, the management
expertise needed to avert disaster was not available. Too, many
investors were affected by the tax law changes–the result of their
exposure to political risk. Lost tax shelter benefits and the increased
capital gains tax rate hit the investor hard–not only were the
investor’s expectations of cash flow and appreciation benefits re-
duced, buyers also had reduced expectations and offered less for the
property as a result.
Many investors expected the inflation rates of the 1970s and
early 1980s to continue and, therefore, they believed the price of real
I NVESTMENT BY DESI GN
22
properties would continue to increase. Many of these investments
were dependent on price appreciation to provide a satisfactory return
to the investor, but the inflation rate decline signaled an end to the
expected rate of property appreciation. Because of the excess supply
in some markets, rental rates and property values have decreased.
In such markets, real estate’s liquidity risk also is signifi-
cant–investment properties are not easy to sell today. Perhaps
interest rate risk has had the least effect on investors in the recent
past. Although capitalization rates and discount rates have risen,
this probably reflects an adjustment for risk rather than changes in
the interest rate.
Many investors have suffered because of their exposure to
these risks. Furthermore, investors have suffered because they do
not understand the relationship between real estate characteristics
and the risks of ownership. Thus, a substantial number of properties
and their owners fell victim to these risks and to the fundamental
characteristics of real estate during the recent economic slump.
Real Estate Investment Risks
Real estate investments are subject to a number of risks, but
they are usually considered under the following headings:
Type Risk
Business The property will fail to generate sufficient
income.
Management The property’s managers will fail to respond
properly to changes in the business environ-
ment and, therefore, fail to earn a satisfactory
return.
Financial The property will have inadequate income to
meet debt service requirements.
Political A government action adversely affects the
property or the investor.
Inflation Cash benefits received in the future will have
less purchasing power than an equal cash
benefit received today.
Liquidity A property cannot be sold quickly without loss
or large selling expense.
Interest The property’s value will decrease because of
increased interest rates.
REAL ESTATE ECONOMI CS
23
Price Elasticity
of Demand
Real estate prices and rents are established in the market
through the interaction of supply and demand. Although most real
estate brokers and investors acknowledge the importance of supply
and demand, some have not considered the efficacy of this knowl-
edge in analyzing real estate markets.
The determination of the market price of an acre of land is
illustrated in Figure 1. The supply curve illustrates that the eco-
nomic supply of a particular type of real estate is relatively fixed in
the short run; the demand curve shows the price elasticity of
demand for a particular type of real estate product. Discussions of
this concept often involve consumer products such as butter and
wheat; in this article the usefulness of the concept to real estate
brokers and investors is explained and illustrated.
What Is Price Elasticity of Demand?
Price elasticity of demand is the percentage change in the
quantity demanded that results from a percentage change in price
and is useful in analyzing markets. If prices are increased (decreased)
October 1991
Wayne E. Etter
Ivan W. Schmedemann
Real Estate
Economics
4
I NVESTMENT BY DESI GN
24
and quantity demanded decreases (increases) proportionally more
than the price change, then demand is price elastic. Accordingly, as
shown in Figure 2, the demand curve slopes down and to the right at
an angle of more than 45 degrees. If the change in quantity demanded
is less than proportional to the change in price, the demand is price
inelastic, and the demand curve slopes down and to the right at an
angle of less than 45 degrees.
What are the requirements for a product to be price elastic–
that is, the change in quantity demanded is more than proportional
to the change in price? A product’s price elasticity of demand is
relatively elastic if it has one or more of these characteristics:
• Close substitutes. If a product has many close substitutes,
buyers turn to substitute products when prices increase; they
purchase fewer substitutes when prices decrease.
• Important percentage of buyers’ budgets. When a product is
an important fraction of buyers’ budgets, buyers tend to reduce
expenditures for a product as its price increases; if the product
is not an important fraction of buyers’ budgets, price increases
are tolerated.
• Many uses. Purchases of products with many uses decline in
response to price increases; substitute products are purchased to
Figure 1
REAL ESTATE ECONOMI CS
25
replace lower priority uses. Purchases of these products increase
in response to price decreases as purchases for inferior uses are
increased.
Figure 2
Analyzing Land Investments
The concept of price elasticity of demand may be used to
analyze land investments. Assume an investor is considering pur-
chasing and developing a 200-acre wooded, rolling tract in a rural
cattle-producing area. The intention is to maximize the tracts resale
value.
The tract could be cleared and planted with grass–making it
ideal for cattle. Or, the woods could be retained, gullies converted to
lakes rather than reshaped and grassed, existing wildlife habitat
enhanced rather than destroyed and other amenities added–making
it ideal for recreation. Assuming equivalent development costs, the
investor’s dilemma is to choose the development plan that will
maximize the property’s resale price.
How can the concept of price elasticity be applied here? The
investor should select the development plan that produces the
product with the greatest price inelasticity. Why? Because the price
of such a product may be increased with the least negative effect on
the quantity demanded. And which product will have the greatest
price inelasticity? To answer this question, land is examined in terms
of the requirements for price elasticity.
I NVESTMENT BY DESI GN
26
Do land parcels have close substitutes? Although each land
parcel is unique, many land parcels are close substitutes for other
land parcels. This is particularly true of agricultural land, but it also
is true of much urban land. This characteristic makes the demand
for land price elastic.
Does the purchase of land represent a large percentage of a
buyer’s budget? Most land purchases involve large dollar amounts;
as a result, land purchases are an important part of the purchaser’s
budget. Small tracts generally command a higher per acre price
because more buyers can afford small tracts. This makes the demand
for small tracts somewhat more inelastic than for larger parcels with
similar characteristics.
Do land parcels have many uses? Most land parcels have
alternative uses. As the price of land increases, inferior uses will be
given up; as the price of land decreases, it will return to inferior uses.
This characteristic makes the demand for land with many uses price
elastic.
There is little the investor can do to make a land purchase
an unimportant part of the future buyer’s budget or eliminate land’s
multiple use potential. But the investor can select the development
plan that results in the product with the fewest substitutes.
One of the investor’s tasks in making this choice is to
analyze the local land market to determine the availability of close
substitutes for each type of development. Of course, each parcel of
land is unique, but there may be close substitutes in the vicinity.
If the investor clears the land and plants grass in an area
where cattle raising is common, there will be other similar properties
nearby; the potential for raising the price of the property is limited by
the availability and price of close substitutes. Further, cattle prices
and production costs will affect the market price of such land.
Because the site is in a cattle-raising area, recreational
development of the property could result in a property with few close
substitutes in that area; if so, the price elasticity of demand will be
relatively inelastic for recreational use of the land. Given some level
of demand for this type of property in the area, the property may
command a greater resale price when developed for recreational
purposes than when developed as a cattle ranch. Careful market
research should clarify this dilemma.
Analyzing Changes in Apartment Rental Rates
Price elasticity of demand may be used to predict the out-
come of price changes in the real estate market. For example, assume
REAL ESTATE ECONOMI CS
27
an urban apartment market with 95 percent occupancy. Further,
assume a particular quality or type of apartment unit. What happens
if apartment owners increase rents (within limits) in response to
increased demand? Apartments also can be examined in terms of the
requirements for price elasticity.
Do apartments have close substitutes? In one sense, all
types of housing are substitutes for other types–all are shelter. But are
most tenants able to move from apartments to single-family houses
if apartment rents increase? Many will be unable or unwilling to
purchase a single-family home. (Of course, some single-family homes
are rented and may compete with apartments.) If other types of
housing are not affordable or not desired, they are not close substi-
tutes for apartments. Thus, apartment rents can be increased with-
out a loss in revenue because few substitutes are available. There-
fore, the demand for apartments under these conditions is price
inelastic.
Do apartment rents represent an important part of a
buyer’s budget? Yes, apartment renters are price conscious. This
factor seems to make apartments less price inelastic. Prospective
tenants may decrease their consumption of apartment space if rents
are increased, although existing tenants are not likely to do so.
Furthermore, apartments are lumpy goods; it is impossible to make
small adjustments to the quantity consumed.
Do apartments have many uses? No, their use is normally
limited to residential use. Therefore, other uses of the space will not
be given up as rents are increased. On this point, the demand for
apartments does not seem to be price elastic.
Because of the first and third reasons, the demand for
apartments is considered to be relatively price inelastic within a
limited price range. What does this suggest about raising apartment
rents to increase income? Because market rents are established by
supply and demand, an individual apartment owner cannot raise the
rent for a standard apartment. But when market demand increases
relative to supply, rental rates can be increased because the demand
for apartments is price inelastic. There are few feasible substitutes
within an area available to apartment dwellers, and it is difficult for
them to economize on their space consumption even though their
rent is increased.
Furthermore, because apartments do not have other uses,
tenants using the space for inferior purposes will not give up units as
rent increases. Thus, with sufficient demand, an increase in the
I NVESTMENT BY DESI GN
28
rental rate normally results in a less-than-proportional decrease in
the quantity of space demanded.
Real Estate Market Research
Real estate market research should be used to avoid markets
in which an investor must engage in competitive price cutting to sell
or lease real estate. For example, assume investors overestimate the
demand for apartment space and, therefore, increase the supply of
apartment space beyond the amount required to satisfy the demand.
Furthermore, what if apartment owners respond to their mistake by
a competitive reduction of rental rates to attract tenants? Decreasing
the rental rate will bring some tenants into the market, but it is
unlikely to result in substantial numbers of persons in a given local
market deciding to rent apartments or persons in other areas decid-
ing to move to the market to take advantage of the reduced rental
rates. These decisions depend on factors other than the rental rate.
The best way to avoid this situation is to invest in apartments with
few close substitutes and an effective demand.
Thus, to take advantage of the concept of price elasticity of
demand, real estate brokers and investors should locate space or
product shortage through market research. In such a market, a
sustainable competitive edge can be achieved by supplying a differen-
tiated real estate product for which there is a demand; tenants or
buyers pay a full price for the product.
The combination of a general oversupply of investment real
estate in many areas of the United States and the 1986 Tax Reform
Act has changed the thrust of real estate investment analysis. Prior
to the 1986 Tax Reform Act, appreciation was assumed to be an
automatic by-product of real estate and tax benefits flowed from
owning it. Users’ demand for space was ignored. Investors’ interests
appeared to be well served by a steady supply of newly developed
properties.
Scarcity Benefits
Investors
October 1991
Wayne E. Etter
Ivan W. Schmedemann
REAL ESTATE ECONOMI CS
29
Today, however, successful real estate investors must locate
properties that are in short supply relative to user demand. Scarcity
offers three primary benefits to income property investors. Scarcity
• enables investors to increase rents in response to increased
demand,
• enables investors to avoid decreasing rents as a response to
competition from similar properties and
• increases a property’s market value.
Increasing Rent
The concept of price elasticity of demand was considered in
the previous section. Its principal lesson is that income properties
have a relatively price inelastic demand because such space has few
substitutes and few alternative uses. This means that if there is not
an excess supply of a specific type of space relative to effective
demand, investors can (within a limited range) raise rents in re-
sponse to increased demand. This is because space consumers
cannot shift to substitutes in the short run or discontinue inferior
uses of the space when rental rates are increased.
Examination of this economic concept suggests that real
estate investors should seek differentiated real estate investments
for which there is an effective demand. Such properties are rela-
tively scarce and their users tolerate price increases if demand is
sufficient. Alternatively, investors should avoid markets with an
abundant supply of an undifferentiated, homogeneous product.
Avoiding Price Competition
A second benefit of owning a property in short supply is
avoiding the need for competitive pricing. For instance, assume the
supply of retail space is increased (from S1 to S2) without a corre-
sponding shift in the demand for retail space (see Figure 1). Decreas-
ing the price per square foot may bring some retail space users into
the market, but it is unlikely to result in substantial numbers of
entrepreneurs entering retailing or to encourage existing retailers to
expand. These decisions depend on factors other than the price of
retail space.
The financial consequences of cutting price to attract retail
tenants are illustrated by the supply and demand functions in Figure
1. At a price of $1.20 per square foot per month, 20,000 square feet
of space are leased, and the rental income is $24,000 per month. At a
price of $1.05 per month, 22,000 square feet of space are leased, and
the rental income is $23,100 per month.
I NVESTMENT BY DESI GN
30
Similarly, cutting the office space or apartment rental rate
when supply exceeds demand is unlikely to increase the short-run
demand for space. How many businesses will lease additional office
space because rental rates decrease if they do not need the additional
space? How many apartment dwellers lease additional space because
rental rates decrease if they do not need the additional space? In each
case, changes other than the price are required to increase the
quantity of space demanded for offices and apartments.
These considerations suggest a diminishing marginal utility
for space–each square foot of additional space has less value to the
user than did the preceding square foot. Because businesses and
consumers have limited budgets, they normally will not lease space
they cannot use, no matter how much the rental rate declines.
Although some owners will decrease rental rates as a competitive
tool to attract tenants, in time, no one will be better off. When other
owners cut the rental rate first, however, it will be necessary to meet
the competition. But this necessity can be avoided by investing in
differentiated (unique) properties.
A property in short supply relative to demand commands a
greater rent than those readily available. The greater rent per square
foot results in more net operating income per square foot that is
normally capitalized into increased value per square foot. For
Figure 1
REAL ESTATE ECONOMI CS
31
example, assume two properties cost the same per square foot, but
one’s locational advantage allows its owner to charge a greater rent.
The effect on value is illustrated in Figure 2.
Locating Unmet Needs
Because of these benefits, real estate investors should
conduct market research to identify market segments where space
is and will continue to be in short supply relative to effective
demand. By identifying markets with unmet needs and supplying
those needs, real estate investors can achieve a sustainable competi-
tive edge and reap the benefits of scarcity.
Many real estate investors disregard the benefits of market
research. Some investors even view careful market research as an
unnecessary impediment to the development and investment
process. However, market research aids in reducing risk in the
investment and development process.
Although scarcity may be defined as an absolute space
shortage of one of the specific property types (for example, multifam-
ily residential, office, industrial or retail space), there may be product
gaps within any broadly defined property type. Because individual
properties within each property type can be differentiated by factors
such as quality, design, amenities, site layout and location, an unmet
need may exist within one of the subgroups.
Within the multifamily residential category, for example,
properties are located in small communities, medium-size cities and
large cities. Each of these multifamily subgroups can have market
subsets such as housing for low-income families, young
professionals, retired persons and college students. Furthermore,
Figure 2
Property
1 2
Rent per sq. ft. $0.50 $0.55
Operating expense per sq. ft. 0.15 0.15
Net operating income per sq. ft. 0.35 0.40
Capitalization rate 0.10 0.10
Capitalized value per sq. ft. $3.50 $4.00
I NVESTMENT BY DESI GN
32
design, quality and site layout can distinguish a project from its
competition. Finally, locational advantages that link the site and
residents’ jobs, schools and retail centers can minimize the cost of
travel (in money, time and stress) and provide a comparative
advantage for the investor.
Superior location alone can differentiate a property; however,
its competitive edge can be sustained only if it is properly developed
and managed. Thus, a skillful combination of location and manage-
ment can be used to maintain the property’s competitive position.
By systematically analyzing the supply and demand for space
within these subgroups, the investor can locate investment opportu-
nities. Thus, real estate market research is an important means of
locating properties that provide the benefits of scarcity. Such research
involves more than choosing among the various property types.
Lending Standards, Government Control
During the early 1980s, eager lenders financed the steady
supply of income properties to investors. Now lenders have adopted
more stringent real estate loan standards. This situation differs
considerably from the early 1980s when many properties were
financed even though demand appeared to be insufficient to justify
the property.
Only properties with a strong market position can obtain
financing. If the investor with an outstanding investment opportu-
nity receives financing or presently owns a quality property, then the
investor can be less concerned about competition from future devel-
opment. Unless sufficient demand supports the new property, it will
not receive financing. If new market entrants are limited to preleased
properties, the potential for competitive price competition is reduced.
Investors with solid properties were made worse off in the
past when weak projects were financed because their completion
often resulted in competitive properties. Thus, the lack of current
debt availability contributes to scarcity by limiting the development
of competitive buildings and creates investor interest in renovating
existing properties with good locations.
Investors also may focus on areas governed by strict planning
and development controls. Local regulation of real estate
development is a special means of achieving a sustainable monopoly
position. Such control is limited in the United States, but other
countries, such as the United Kingdom, regulate development
extensively.
REAL ESTATE ECONOMI CS
33
Many investors have viewed planning and development
controls as obstacles to the free flow of desirable investment proper-
ties to the market. Of course, it can be argued that developers’
interests are harmed by excessive regulation–developers generally
focus on supplying space in response to demand. Furthermore, space
consumers’ interests also may be harmed by excessive regulation–
they may pay premium rents because of scarcity. On the other hand,
the cost of excess development is significant to investors, developers,
financial institutions and taxpayers.
Although some might oppose such regulation, investors
must consider the benefits of scarcity–in such an environment, their
property becomes more valuable. Thus, their interests are served by
regulation that restricts the supply of competitive properties. Accord-
ingly, careful investors seek out markets with supply constraints.
Real estate investors must bear in mind the benefits of
properties that are in short supply relative to tenant demand. The
potential for loss is reduced while the potential for gain is enhanced.
Accordingly, they should conduct market research to select suitable
properties for investment. Rigorous lending standards and the
regulation of real estate development also reduce the risk to current
property market investors.
Using Economic
Rent Theory
January 1991
Wayne E. Etter
Ivan W. Schmedemann
Analyzing real estate markets is an important task for real
estate brokers and investors. Using appropriate economic theory
yields a greater likelihood of correct and consistent results. Why?
Because theories are predictive devices. In other words, economic
theories help to make estimates about future events. If theories
cannot do this, they still may be interesting, but they have little
practical value.
Economic rent theory is useful for real estate market analy-
sis. Although this may seem a rather obscure (or even impractical)
topic to many (and some may never have heard of it), it can provide
useful insights when one must form an opinion about the future
course of a real estate market. This discussion illustrates how to use
economic rent theory for analyzing the Texas apartment market.
I NVESTMENT BY DESI GN
34
Reviewing a number of apartment appraisals in several Texas
cities results in two major observations about the state’s apartment
market.
• The final estimate of value often is less than the cost of con-
structing a new apartment building.
• The overall capitalization rates (net operating income/reported
sales price) vary among the cities and markets.
For a real estate broker or an investor, a proper interpretation
of these observations is important. As is well known, the early 1980s
featured substantial overbuilding as anticipated tax benefits and
appreciation appeared sufficient to provide satisfactory returns
without any consideration of fundamental property economics. The
question, “Are there sufficient tenants willing to pay sufficient rent to
produce a positive cash flow?”, often went unasked and unanswered.
The 1986 Tax Reform Act erased tax benefits and the
oversupply of property stopped the expectation of immediate
property appreciation. Today, income and long-term growth are
valued, but the supply of and demand for apartment space has
resulted in low rents and much slower growth expectations.
Therefore, estimated market values often are less than the cost of
constructing new apartments. Accordingly, there is little new
apartment construction in most Texas cities.
Turning to the second observation, one assumes areas with
lower overall capitalization rates are markets in which apartment
buyers are willing to pay a higher price for the income stream than in
areas with higher overall capitalization rates. These buyers appar-
ently believe the demand for apartment space, rents and, in time,
apartment values will increase. Because buyers do not have equiva-
lent expectations about other areas, they will pay less for the income
streams there.
The real estate broker or investor interested in analyzing
these observations and making predictions about a local apartment
market can use economic analysis.
Market rents are set by supply and demand. In the short
run, the supply of apartment space is fixed–additional apartment
space may require a year to 18 months to be planned, built and
offered to the market. Likewise, an oversupply of apartment space
will not evaporate quickly.
The demand for apartment space results from a number of
factors, but changes in population, employment, single-family
housing costs and interest rates are important influences.
REAL ESTATE ECONOMI CS
35
Figure 1A illustrates how supply and demand interact to
establish the local market’s apartment rental rate. Where demand
D
1
, for example, equals supply, the market rental rate is P
1
with
tenants using Q
1
units of apartment space.
Also in Figure 1A, the effect of an increase in demand is
shown–the demand curve shifts to the right. Up to a point, the
demand can be met by absorbtion of available space as shown by the
demand curve shift from D
1
to D
2
. Rental rates have risen to P
2
with
tenants using Q
2
units of space. If the demand curve shifts far
enough to the right beyond D
3
, the rental rate rises, but in the short
run, there is no additional space to lease. Therefore, the supply curve
becomes vertical. Tenants are competing with one another for a
limited supply of space.
Real estate brokers or investors who foresee, within a reason-
able time, the shift in the demand curve from D
1
to D
2
or beyond
might recommend or consider the purchase of the property even if
the present overall capitalization rate is low. They might do so even
if the property does not currently produce a positive before-tax cash
flow. With rising rents and satisfactory management, the property
should begin to produce a positive before-tax cash flow. Furthermore,
because the present low capitalization rate is an indicator of expected
higher future rents, the capitalization rate will rise when the higher
rental rates are achieved, provided that continuing rental rate in-
creases are not expected. If continuing rental rate increases are
expected, however, the capitalization rate could remain low. This
would result in the increased income stream being capitalized into a
higher property value.
Figure 1
I NVESTMENT BY DESI GN
36
The apartment market can be analyzed further using eco-
nomic rent theory. Economic rent theory is based on the principle
that an owner of existing apartment space will continue supplying
space if the marginal revenue (the revenue from supplying an addi-
tional apartment unit exceeds the marginal cost (the cost of supply-
ing one more apartment unit). Thus, the supplier will stop supplying
when the revenue from renting the apartment equals the cost of
supplying the apartment. At that point, supplying an additional unit
will make the owner worse off as marginal revenue (which equals
average revenue per unit) equals marginal cost. This means the cost
of achieving 100 percent occupancy through additional advertising,
management expenses, reduced rent or all three may exceed the
benefit of the additional rental income received. Thus, for a particular
property, the optimum occupancy level may be less than 100 percent.
As illustrated in Figure 1A, the rental rate is dependent on
the supply and demand for apartment space. For any level of occu-
pancy, total revenue is equal to the quantity of apartment units
leased multiplied by the unit rental rate (see Figures 1B, 1C, 1D).
Total cost includes all the factors of production–land, labor,
capital and management. Normally, as the number of units rented by
a single owner increases, the average unit cost first decreases because
the fixed costs are spread over larger quantities of output. Likewise,
the marginal cost declines. At some point, however, the marginal
cost begins to rise because of inefficiencies that result in increased
costs. This, in turn, causes the average unit cost of supplying an
apartment unit to increase. At any level of output, total cost equals
the quantity of apartment units leased multiplied by the average unit
cost (see Figure 1B, 1C, 1D).
When demand is large relative to supply, the owner is able to
charge a high rental rate. It may be that at this rental rate, total
revenue exceeds total cost–when this is the case, the amount of
revenue in excess of total cost is known as economic rent (or net
return). Because total costs include all production factors (including
management compensation), markets in which economic rent is
being produced will attract competitors seeking abnormal profits.
When competitors enter the market and demand is unchanged, the
market rental rate will decline, and the abnormal profits or economic
rent will disappear.
To illustrate, Figure 1 depicts the property at each of the
three stages of demand. At demand D
1
, price P
1
is established and
quantity Q
1
units of space are leased. At this price, total revenue
REAL ESTATE ECONOMI CS
37
(P
1
x Q
1
) is less than total cost (C
1
x Q
1
) and a loss (negative eco-
nomic rent) results.
Over time, demand improves to D
2
and the price increases to
P
2
. The apartment owner supplies space equal to quantity Q
2
. At this
price, total revenue (P
2
x Q
2
) is equal to total cost (C
2
X Q
2
). There is
no economic rent, but all costs of production are covered at this
price. Rental concessions have vanished.
When the demand curve shifts to D
3
, however, the price
increases to P
3
, and the quantity of space supplied increases to Q
3
. At
this rental rate, total revenue (P
3
x Q
3
) is greater than total cost (C
3
x
Q
3
); economic rent exists. This means the rewards of owning apart-
ments are such that others could be attracted to supply space with
the expectation of earning above-average profits.
Assuming an owner’s property is well managed and main-
tained, how should the owner view the prospect of competition from
new construction? Today, many Texas apartment owners face this
situation.
Economic rent theory can assist in analyzing this aspect of
the Texas apartment market because it is based on the sound
business principle that total costs must be covered before additional
resources will be brought into production–in this case apartment
space. Total costs include the cost of land, labor, capital and
management. If expected apartment rents are sufficient to cover
these costs and more, then new apartments will be built. Translated
into investment terms, the expected rate of return is greater than
the required return.
For this analysis, it is important to remember that today
many apartment properties with 90 percent or greater occupancy
rates at market rents have market values that are less than their
replacement costs. It is, therefore, possible that an existing property
purchased at a depressed price can produce economic rent (returns in
excess of the cost of land, labor, capital and management). A new
property, however, could not produce economic rent at current
market rents.
Consider, for example, Figure 2. It begins at the last stage of
Figure 1. The existing property produces economic rent as previously
demonstrated, but, because of the cost of new construction, the new
property has higher costs at all levels of output and, therefore,
produces negative economic rent at current market rents. Of course,
some rental premium may be possible because the property is new,
but rents higher than the current market are required if the property
I NVESTMENT BY DESI GN
38
Figure 2
External
Obsolescence
The discussion of economic rent theoryillustrates how an
existing property purchased at a depressed price can produce an
adequate return at current market rents, but a new property can not.
As illustrated in the figure, the higher costs of new construc-
tion cannot be covered by current market rents, and a loss results.
But, until market rents increase, current owners are protected from
the competition of new properties. In general, when this condition
exists, appraisers conclude that a property has sustained external
obsolescence. Although real estate appraisers spend a good deal of
effort trying to measure external obsolescence precisely, many
investors may not understand the importance of external obsoles-
cence when making the investment decision.
External obsolescence, sometimes called economic or envi-
ronmental obsolescence, is “the diminished utility of a structure
because of negative influences from outside the site.” Normally,
October 1992
Wayne E. Etter
Ivan W. Schmedemann
is to produce an economic rent. If the required increase is large, the
owner of an existing property is protected (at least temporarily) from
the competition of new properties.
REAL ESTATE ECONOMI CS
39
external obsolescence is found when an existing property becomes
subject to negative influences: e.g., a declining neighborhood causes
an otherwise well-constructed and well-maintained building to
command less rent than comparable buildings receive in other
neighborhoods. Its reduced ability to generate adequate rent is
attributed to external obsolescence.
Estimating External Obsolescence
Real estate appraisers normally use three approaches to
estimate value: the cost approach, the sales comparison approach
and the income capitalization approach. When the independent use
of each approach produces three approximately equal value
estimates, the logic of market participants is confirmed.
By comparing the actual sale prices for comparable properties
and the cost of a new property, the belief that buyers will pay no
more for an existing property than the cost of constructing a compa-
rable property is asserted. Likewise, by comparing a property’s
capitalized income value with the prices buyers are paying for
comparable properties and the cost of constructing a comparable
property, the belief that the price buyers pay for a property is a
function of its ability to produce income is asserted. Sometimes,
however, the cost approach value estimate is considerably more than
the value estimate of the other two approaches. When this occurs,
the appraiser must discover if the cause of the difference is external
obsolescence.
When expected rents decline and buyers pay less for proper-
ties because of the reduced income stream, the income capitalization
approach and the sales comparison approach produce smaller market
value estimates. Although land costs may decline, the other costs of
constructing a new property probably will not decline. Therefore,
external obsolescence is estimated and deducted from the subject
property’s depreciated replacement or reproduction cost so that in
the final value indication, the cost approach estimate will be closer to
those from the other two approaches.
Of course, estimating external obsolescence requires an
appropriate methodology. If external obsolescence is improperly esti-
mated, the cost approach cannot be used to confirm the other value
estimates that take into account the market effects of the reduced rent.
Estimating the amount of external obsolescence is normally
done by capitalizing the rent loss caused by the negative economic
influence. The rent loss is estimated by comparing the subject’s rent
with that of comparable properties in other neighborhoods. External
I NVESTMENT BY DESI GN
40
obsolescence is also estimated by examining the difference in sales
prices of comparable properties within and outside the affected
neighborhood.
With either approach, the calculated amount is allocated
between land and improvements. Only the amount allocated to
improvements is deducted from the depreciated reproduction or
replacement cost of the improvements because the current market
value of land is used in the cost approach. Any decline in land value
resulting from negative influences from outside the site will be
reflected in the land’s current market value estimate.
At present, however, numerous properties have market
values that are less than their depreciated replacement or
reproduction cost plus land. This condition generally is attributable
to an oversupply of the property type within these markets and/or a
decline in general economic conditions rather than to the more
limited causes of a declining neighborhood in the midst of other
economically healthy neighborhoods. These properties’ inability to
generate sufficient rent to justify their construction also may be
attributed to external obsolescence, but how is external obsolescence
to be estimated using the usual methods if the entire city has
suffered an economic decline and few properties are left unaffected?
What will serve as the standard for comparison?
A suggested approach for estimating external obsolescence
under such circumstances is to estimate the rental rate necessary to
Period of Protection
from the Competition of New Construction
REAL ESTATE ECONOMI CS
41
support new construction and the time period that will elapse before
actual market rents increase sufficiently to support new construction.
The difference between the two rental rates is rent loss; the present
value of the rent loss is used as the basis for estimating the
property’s external obsolescence.
Another suggested approach is to compare the property’s cost
with its investment value. The property’s investment value is
estimated using assumptions about expected rental rates, operating
expenses, financing, required return and so forth.
Both suggested approaches are dependent on assumptions
about the future. If the amount of external obsolescence is based on
estimates of the future, it is difficult to evaluate the estimate’s
quality. If the appraiser’s estimate of future rental rates and other
important data is incorrect, the estimate of economic obsolescence is
useless or misleading.
What might serve as a useful measure of economic obsoles-
cence under such circumstances? If there are sufficient sales of
comparable properties, another approach is to calculate the cost to
replace or reproduce each of the comparable sales. The difference
between their market price and their cost may be attributed to
external obsolescence. If this calculation is made for several proper-
ties, a percentage reduction could be developed from sales data and
applied to the subject property.
Why Is External Obsolescence
Important to Investors?
When there is external obsolescence, the cost of constructing
a comparable new property (including land cost) will exceed its
market value and little, if any, new construction is expected to take
place. Thus, the concept of external obsolescence is important to
investors who are considering purchasing an existing property; the
property’s estimated economic obsolescence can serve as an indicator
of the likelihood of competition from new buildings. In particular, a
relatively large amount of economic obsolescence suggests higher
market rents will be necessary before new construction is feasible.
For example, an investor may be considering the purchase of
a 20,000 square-foot building with an estimated market value of
$300,000. The estimated cost (including land) of constructing a
comparable property is $600,000. If the property has no physical
deterioration or functional obsolescence, the $300,000 difference
between the property’s market value and the cost to construct a
comparable property is attributable to external obsolescence.
I NVESTMENT BY DESI GN
42
If the property’s current rental rate is $3.42 per square foot
per year (28.5 cents per square foot per month) and the buyer of the
property receives the financing assumed in Table 1, a cash-on-cash
return of approximately 12 percent will be received.
The calculation of the rental rate necessary to support new
construction is presented in Table 2. The difference between the
current market rental rate (28.5 cents per square foot) and the rental
rate required to support new construction (39 cents per square foot)
is the investor’s margin of safety.
Of course, the investor must estimate the time required for
market rental rates to increase to the necessary level to make new
construction feasible. The time required will depend on the supply
and demand for space within the market area and the expected rate
of increase in land and construction costs.
If the particular market has significant vacancies, rental rates
will climb slowly unless a sharp upsurge in demand is expected. On
the other hand, if the vacant space is not really suitable for satisfying
future demand, rental rates may quickly increase sufficiently to
support new construction even though some properties remain
vacant. Nevertheless, investors who carefully pick among existing
properties can gain some protection from the competition of new
properties.
Table 1. Expected Cash-on-Cash Return
from Existing Property
Expected purchase price $300,000
Estimated loan amount (10.5%, 25 years) 210,000
Required equity investment $ 90,000
Estimated potential gross income $ 68,400
Estimated vacancy and collection loss (20%) 13,680
Estimated effective gross income $ 54,720
Estimated operating expenses 20,000
Net operating income $ 34,720
Annual debt service 24,030
Before-tax cash flow $ 10,690
Cash-on-cash return =
Before-tax cash flow
Equity investment
11.9% =
10,690
90,000
REAL ESTATE ECONOMI CS
43
Table 2. Estimating the Required Rental Rate
to Support New Construction
Estimated cost of land and improvements $600,000
Estimated loan amount 420,000
Estimated equity required $180,000
Required rental rate:
Annual debt service (10.5%, 25 years) 48,060
Required cash-on-cash return (12%) 21,600
Required net operating income 69,660
Estimated operating expenses 20,000
Estimated required effective gross income 89,660
Estimated vacancy rate (5%) 4,719
Estimated potential gross income 94,379
Estimated monthly per square-foot rental rate $ 0.39
I NVESTMENT BY DESI GN
44
Case Study: Wilma
and the FTZ
The oversupply of developed commercial real estate in
most Texas markets means little new commercial development
activity in these markets in the near term. Those who hope to
continue some level of development or redevelopment activity would
do well to reflect on an important point made by the late Professor
James A. Graaskamp of the University of Wisconsin at Madison. He
says that developers cannot be successful if they supply a product
that is already in the market. Instead, they must seek an unmet
need; in supplying that unmet need, they must achieve a sustainable
competitive edge that will allow them to reap the benefits of their
monopoly position. These benefits were analyzed in “Scarcity Ben-
efits Investors.”
Identifying an unmet need and designing a strategy to
achieve a sustainable, competitive edge are not easy tasks. This
section provides a case analysis of one real estate developer’s pursuit
of these goals.
July 1992
Wayne E. Etter
John Y. Massey
Real Estate Market
Research
5
REAL ESTATE MARK ET RESEARCH
45
Wilma Southwest, Inc.
Wilma Southwest, Inc., of Houston is a subsidiary of Wilma
International, a development firm headquartered in the Netherlands.
Wilma undertakes property development projects on its own and
with joint-venture partners. Because Wilma and its investors are
conservative and because of the well-known difficulties of developing
in the Houston market, speculative development is avoided.
In the early 1980s, Wilma owned 457 acres near Houston’s
Intercontinental Airport with good access to the city’s freeway
system and to rail transportation; Wilma executives wanted to
develop the site to its maximum value. This property was marketed
as Central Green Business Park.
Wilma’s land could have been developed for a variety of
users, but lenders and investors required developments to demon-
strate financial feasibility. This meant that before construction
began, Wilma needed to locate tenants willing to lease the completed
space at rental rates sufficient to service the debt and provide an
adequate return to Wilma’s investors.
With other completed space in the market area remaining
unleased, Wilma’s site had to fill special needs if it were to be
developed. Although near the airport, it was not the only site there.
Likewise, it was not the only site with access to Houston’s freeway
system and to rail transportation. Thus, Wilma needed to devise a
development strategy taking advantage of these attributes and
permitting the site to fulfill an unmet need that competitive sites
could not supply.
Finding the Unmet Need
Market segmentation means dividing a market into distinct
subsets of customers. Many manufacturing and service firms use
this approach to aid in product development and marketing; it also
can be applied to real estate markets. In the case of real estate, the
market is divided into tenant subsets with the goal of locating one or
more subsets with unmet needs. Thus, it is a conceptual approach to
isolating an unmet need.
The distinction between market segmentation and product
differentiation is important. For real estate markets, product differen-
tiation means supplying several product styles in hopes that various
users will find at least one of the styles attractive or acceptable, e.g.,
office spaces varying in size and quality.
The distinction between market segmentation and market
area also must be borne in mind. A market area has boundaries; it is
I NVESTMENT BY DESI GN
46
a defined geographical area. Distinct subsets of customers may exist
within the defined geographical area. Thus, medical doctors desiring
office space are a distinct subset of customers; they may desire to
lease office space in particular market areas.
Development Strategy
Because Wilma Southwest was a subsidiary of a Dutch
parent firm, developing sites for firms involved in international trade
was not unknown to them. And because Houston is an important
foreign trade hub with both an international airport and a major
seaport, many importing and exporting firms are located in Houston.
Therefore, Wilma began to seek a way to attract these firms to
Central Green Business Park.
To assist in attracting these firms, Wilma Southwest sought
a foreign trade zone (FTZ) designation from the Foreign Trade Zones
Board (a U.S. government agency) in mid-1985. When a site is
established as an FTZ, it is deemed to be outside the United States
for duty and revenue purposes, even though it is physically located
within the country’s borders. This attracts firms engaged in import-
ing and exporting for the following reasons.
• Normally, duty payments are made when imported goods arrive
in the United States. If the goods are imported and warehoused
in an FTZ, however, duty payments are delayed until the goods
are shipped to a U.S. customer. Delaying the payment provides
a time value of money benefit for the importer-exporter located
in the FTZ.
• The duty payments made when goods are imported into the
United States can be avoided by the importer-exporter located
in an FTZ if goods are exported after storage, sorting, testing or
repackaging. A business location outside the FTZ does not
provide this advantage.
• Often the duty on parts is charged at a higher rate than the
duty on the finished products. Because duty is not paid when
parts are imported into the FTZ, finished products can be
assembled within the FTZ and then sold to U.S. customers.
Duty on the finished products will be charged at the lower rate.
Assembling products outside the FTZ will not provide this
advantage.
• Sometimes part of imported material becomes scrap during the
assembly or manufacturing process. Because duty is not paid
when parts are imported into the FTZ and assembled into
finished products, duty on the scrap will be avoided when the
REAL ESTATE MARK ET RESEARCH
47
products are sold to U.S. customers. In addition, duty on the
finished products may be charged at the lower rate. Assembling
products outside the FTZ will not provide this advantage.
• Imported goods and goods stored for export are federally exempt
from the annual personal property tax levied by local
governments.
For these reasons, locating in an FTZ could prove attractive
to an import-export firm, even though competing space located
outside an FTZ might be otherwise competitive in design, price or
location. In fact, an import-export firm considering leasing space
within an FTZ could estimate the added value of the location. If, for
example, the duty saved is $50,000, a tenant occupying 36,000
square feet saves $1.39 per square foot per year (a little less than 12
cents per square foot per month). Increased volume over time could
further raise the location’s value.
The FTZ also would provide Wilma with a sustainable
competitive edge. Although other FTZs could be approved in the
area, authorities would prefer the current one to be fully developed
before approving others. And the application process for a new FTZ
takes 12 months to two years. This gave Wilma adequate time to
find sufficient tenants to test the quality of the idea.
Success of the Strategy
In late 1987, Wilma obtained an FTZ designation for ap-
proximately 13 acres of their total 457 acres at Central Green
Business Park. After this designation, progress was slow. Eventually,
Phase I–a 100,000 square-foot multi-tenant office-warehouse com-
plex–was completed in January 1986 and totally leased. The complex
was sold to an investor group in 1989.
Construction of Phase II, a second office-warehouse complex,
was initiated in August 1990, the only project of this type con-
structed in the north Houston market during 1990. By year’s end, 90
percent of this 104,000-square-foot facility was preleased at rates
that supported the cost of the new construction. Phase II was com-
pleted in January 1991 and fully leased by January 1992.
As the business benefits of the FTZ became known, the
increased interest by potential tenants caused Wilma to consider
expanding their FTZ. An application to increase the FTZ from 13
acres to approximately 43 acres was submitted in November 1990.
The request was granted in April 1991. A second increase, requested
in June 1991 to expand the FTZ from 43 acres to 156 acres, was
approved in December 1991.
I NVESTMENT BY DESI GN
48
Not all Phase I and II tenants were engaged in international
commerce; about 43 percent of the Phase II tenants chose the project
because it was located in the FTZ. Obviously, Central Green Busi-
ness Park had a broad appeal. Among the tenants attracted to
Wilma’s Phase I and II developments in Central Green Business Park
because of the FTZ were:
• two distributors of imported industrial valves;
• seven freight forwarding firms (assist other businesses in their
export activities);
• three customshouse brokerage firms (assist other businesses in
their import activities);
• several firms that crate exports for shipment;
• a specialist in handling dangerous goods; and
• an international parcel-package-letter express delivery service.
Wilma Southwest, Inc., recognized firms in the import-
export business as a particular market segment. The increasing
importance of foreign trade to the U.S. and Texas economies and the
potential effects of the North American Free Trade Agreement on
Texas-Mexican commerce suggest an increasing need for space in
FTZs.
Because FTZs provide specific financial advantages to firms
engaged in international commerce, there may be other development
opportunities in the market. Knowledgeable real estate brokers may
wish to discuss the advantages of FTZs with their clients when
appropriate.
What Is the Lesson?
Real estate development can succeed in difficult markets.
The key is to locate tenants who need something not currently
available in the market and deliver that product to them. In addition,
the developer must secure the strongest monopoly position possible by
being the first to recognize an opportunity so that the competitive edge
can be maintained.
REAL ESTATE MARK ET RESEARCH
49
The U.S. population over 65 years old was estimated to be
30.9 million (12.5 percent of the total) in 1989. It is expected to
grow to more than 59.7 million (20 percent of the total) by 2025.
Most of the growth, however, is projected to occur after 2010. The
elderly often are seen as a promising market for new housing, but
the identification of promising elderly housing markets is difficult.
The elderly populations have a number of demographic,
health and socioeconomic characteristics that must be considered to
properly assess these markets. Some of the more important show the
elderly population:
• will increase rapidly by 2025, with most growth occurring after
2010;
• comprises 40 to 50 percent of the elderly in the age groups over
75 in which health problems substantially limit independent
living (this suggests that those 65-74, rather than older seg-
ments of the elderly, are the prime target group for independent
forms of living);
• has a much higher proportion of women than the population as
a whole, and these women are increasingly likely to live alone
even at older ages;
• is much less likely to move than the nonelderly and generally
wish to remain close to children who provide social and physi-
cal support;
• is a much higher proportion of the racial majority than of the
minority population and will be slower to reflect the racial-
ethnic changes occurring in the population as a whole;
• is likely to prefer housing options that allow independent living
at moderate costs; and
• has limited resources or they are in homes that may be difficult
to sell or which they may be hesitant to sell.
These factors suggest that those most likely to purchase
elderly housing services will be among geographic populations with
Analyzing Housing
Markets
for the Elderly
April 1991
Wayne E. Etter
Steve H. Murdock
I NVESTMENT BY DESI GN
50
growing concentrations in the youngest elderly age groups. These
factors further suggest that such services may require the develop-
ment of products intended to meet the needs of elderly women who
are likely to live alone. Furthermore, the population using elderly
housing and other real estate services is likely to be those elderly
living near to the site where the services will be provided; the elderly
are unlikely to migrate unless the destination is an area with unique
natural beauty or other special features.
Because of the diverse characteristics of the elderly popula-
tion and localized differences, there is little doubt that detailed
market research is essential prior to initiating a project intended
for an elderly market. To successfully market housing to the elderly
requires the identification of a particular market segment with unmet
demand within a particular market area that can be supplied profitably.
Elderly Housing Categories
Real estate market research is the analysis of supply and
demand for a particular type of property within a particular market
area. Housing especially designed for the elderly is typically separated
into three categories. This means that a particular type of housing
must be the focus of the analysis. A description of the three catego-
ries follows.
• Independent Living Facilities are characterized by communi-
ties for persons over a certain minimum age (about 50). These
living facilities do not provide health care facilities, and resi-
dents are expected to care for themselves.
• Congregate Care Facilities include persons who cannot func-
tion independently; thus, they are usually older (typically 75 to
85) than those in independent living facilities. Although such
facilities usually do not provide health care services, they do
provide meals, maid service and various daily activities for the
residents.
• Assisted Living Facilities provide assistance to residents in
most areas of daily life, including personal (bathing and dress-
ing) and medical care. Residents are usually older (85 years and
older) than residents in the other two types of facilities.
Defining Market Area
Because the desire to remain within a community is an
important consideration to the elderly, the market area for a particu-
lar project is small. Generally, therefore, only areas within the
REAL ESTATE MARK ET RESEARCH
51
immediate community or metropolitan area should be included as a
part of a housing development’s market.
Areas without significant numbers of elderly are poor choices
for developing such housing unless the available amenities have an
exceptional appeal.
Analyzing Supply by Product
An inventory of specially constructed housing for the elderly
must be developed and should include certain information about
each housing development within the defined market area. First, the
market orientation of each development must be defined. Determine
if existing developments provide independent living, congregate care
or assisted living facilities. Next, collect information that differenti-
ates projects within each of the three market orientations. For each
development, determine the:
• product features,
• tenant amenities,
• availability of medical services,
• group activities and
• quality of management.
Finally, data that provide market information about each develop-
ment is needed. This information includes:
• date sales or leasing began (or will begin),
• amount of space leased,
• amount of vacant space available for lease,
• amount of space per month leased during the past 12 months and
• current sales prices or rental rate and terms.
Although such data provide information about supply, they
also are indicators of demand. When data are collected in sufficient
detail, it may be possible to identify particular product types with
high occupancy rates, those that have experienced large amounts of
absorbed space in the past year or both. Although more research is
required, these product types may represent areas of potential
opportunity for the developer.
Analyzing Demand
Because of the demographic conclusions, a key question for
the developer considering entering this market in a particular area is:
“What is the effective demand for a particular type of housing
especially designed for the elderly?” Effective demand is demand
backed by the ability to purchase. Answering this question requires
market research. Although a number of elderly might like to move to
I NVESTMENT BY DESI GN
52
specially designed housing (or even need to), how many of them can
afford it?
Because of the importance of age and the type of housing
selected, the elderly within a particular market area must be
analyzed by age groups. For example, before building a particular
number of independent living units, the developer’s research must
focus on potential space users 65 to 74 years old–the population
group most likely to select such housing.
If the developer’s project is to be successful, not only must
there be a sufficient number of elderly within the proper age group,
there also must be a sufficient number within the group with the
income to afford the offered housing. Therefore, the demand must be
estimated by income levels as well as by age.
Finally, there must be a sufficient number of the proper age
who have sufficient income to afford the housing and who desire to
move to a particular type of housing for the elderly. When the
number of persons who both can afford and desire a particular type of
housing currently unavailable within their market area is deter-
mined, the developer will know the extent of the unmet need within
the market area. The number of elderly falling into this category may
be much smaller than anticipated. Thus, this information is neces-
sary to avoid making an incorrect decision and potential financial
disaster.
Secondary Sources of Information
In most forms of marketing analysis, U.S. Census and other
secondary data play a key role. Such data are likely to be particularly
useful because of the 1990 Census. It is important to know the types
and sources of available data.
A useful Census data source for isolating possible market
areas for the development of housing for the elderly is the Public-Use
Microdata Sampling Units (PUMS). This data series divides Texas
into a number of sampling areas. For each area, substantial data are
available. For example, assume a developer is interested in supplying
high quality retirement housing to married couples 65 to 74 years
old. Because these retirement units are high quality, the developer
estimates annual household income must be $40,000 or more.
The PUMS data illustrate how they can be used to assist in
the analysis. Comparing the data for the two areas reveals the first
area to have much more potential than the second. Area A has a
large number of married householders in the relevant age group, a
REAL ESTATE MARK ET RESEARCH
53
large number of householders who rent (and are more likely to move
than those who own) and a substantial number with household
incomes of $40,000 or more.
PUMS Data for Area A, 1980 1980 1980 1980 1980
Age
65-69 70-74
Number of households 19,520 18,100
Number of married households 9,300 7,880
Number of rental housing 6,080 5,480
Number having income over $40,000 1,900 1,300
Area B has less than 10 percent of the number of total house-
holds and married households in the relevant age groups. In addi-
tion, the number of households in rental housing and the number
having incomes more than $40,000 is small. Clearly, further analysis
of Area A is warranted.
PUMS Data for Area B, 1980
Age
65-69 70-74
Number of households 1,680 980
Number of married households 880 540
Number of rental housing 220 220
Number having income over $40,000 120 0
Primary Data for Marketing Analyses
When a promising market area is identified, primary data
are collected to estimate the proportion of the potential market that
would actually move into the proposed development. Primary data
obtained by personal interviews, telephone interviews, mail surveys
and other means are used to make this estimate.
Although questionnaire and personal interview design are
best left to those familiar with doing marketing research, the devel-
oper must review the questions to be asked to ensure that the market
research will provide the desired information. If the developer is
I NVESTMENT BY DESI GN
54
intent on developing a particular type of housing for the elderly, then
the market research must be addressed to an identified age group and
household type–not the elderly population in general. On the other
hand, a developer may be willing to supply any identified, unmet
need. In this case, the market research is stratified by age group so
that data about each age group are obtained, and the potential of
various types of housing can be evaluated.
The developer needs information about the range of respon-
dents’ income to determine the development quality desired and that
can be sustained in a specific market area. The questions also must
establish the respondents’ interest in leaving their present housing if
housing with the desired features becomes available at an appropri-
ate price.
With this information, the number of households that can be
expected to move to the project within a reasonable time can be
estimated. This is an estimate of the unmet need of a particular
market segment in a specific market area. From this estimate, the
project’s definition will evolve in the following terms:
· orientation,
· size,
· quality and features and
· selling price and rental rates.
Project definition is a function of the number of elderly in
the proper age group with the means to afford the housing and the
desire to move to it. The project must appeal to the correct age
group, have the number of units required by the market and have
features the segment wants.
Despite expected growth of the elderly population, developers
of housing for the elderly should proceed cautiously. The principal
growth of the elderly population is expected after 2010. Moreover,
the diverse characteristics of the present elderly population and their
general desire to remain within a familiar community may limit the
effective demand for a particular type of elderly housing product in
the target market area. Although market research can assist in
identifying promising market areas, it cannot eliminate the risk of
developing housing for the elderly.
FI NANCI AL FEASI BI L I TY ANALYSI S
55
Profitable Apartment
Construction
A previous section examined the importance of external
obsolescence for real estate investors. When there is widespread
external obsolescence in a market, current property owners are
protected from the competition of new properties until market rents
increase. This is a case analysis of the Bryan-College Station student
housing market. It illustrates how current property owners are
protected from the potential competition of new apartments in the
market area.
Student Housing Market
At present, the Bryan-College Station student rental housing
market occupancy rates are near 100 percent from September
through May; summer occupancy rates and rental rates are rising.
Students (and parents) often complain that rents are too high and
that apartments are too hard to locate at the beginning of the fall
semester. But several weeks after the fall semester begins, everyone
seems to be settled.
For the past several years, Texas A&M University has
implemented an enrollment management plan to limit the student
January 1993
Wayne E. Etter
Financial Feasibility
Analysis
6
I NVESTMENT BY DESI GN
56
population on its main campus to 41,000. Previous efforts to control
enrollment through raising admission standards did not affect total
enrollment. At present, however, financial limitations related to the
state’s budget problems are likely to force Texas A&M to control
enrollment. On the other hand, Texas A&M’s enrollment is not
likely to decline; more than 14,000 freshman applications were
received for the fall 1992 semester, and only 6,100 were accepted.
Thus, future demand for student housing appears steady.
Despite the expected level of student demand for housing,
rising rental rates and the near-zero vacancy rate, little private sector
housing has been added since 1984. Students wonder why additional
rental units are not being constructed by the private sector.
The answer to private sector involvement requires an exami-
nation of the financial feasibility of constructing new apartments.
The key to this analysis is the level of costs and rents, assuming that
demand for the space exists. First, however, the role of the current
low expectations of property appreciation and the current absence of
any real estate tax shelter benefits in the lack of apartment develop-
ment since 1984 is examined.
Appreciation and Tax Shelter Benefits
A decade ago, most real estate investors expected their
properties to appreciate rapidly. Perhaps these expectations were
unwarranted, but it was not unusual for investors to use estimated
annual property appreciation rates of 12 percent or more. The 1981
Economic Recovery Act created a huge demand by investors for
residential and commercial real estate because paper losses generated
by rapid depreciation could be used to offset investors’ other taxable
income. Often the combination of expected appreciation and tax
shelter benefits could offset the fact that a property’s rent was
insufficient to cover operating expenses and debt service. The inves-
tor still believed that a satisfactory return would be had when the
property was sold after a five-to-seven-year holding period.
With the passage of the 1986 Tax Reform Act, tax shelter
benefits were eliminated, and, therefore, the after-tax cash benefits of
owning real estate were sharply reduced. The reduction in cash
benefits from the tax law changes was accentuated by the onset of
recession in Texas. A fall in the market value of many multifamily
residential properties followed. Many properties went into default as
investors considered it unwise to continue making mortgage
payments on loans that exceeded the property’s market value.
FI NANCI AL FEASI BI L I TY ANALYSI S
57
Purchasers of these defaulted properties bought them for less than
their replacement cost and were able to obtain a positive cash flow
from the property despite the low market rents then prevailing.
Construction Costs
Today, investors have only modest expectations of property
appreciation and tax shelter benefits are not available. As a result, a
multifamily property investor must anticipate that rents will cover
all operating costs and debt service as well as provide a 10 to 11
percent current cash return on the equity invested. Under these
circumstances, the following question arises: Are rental rates suffi-
cient to justify new apartment construction? A large gap between the
current and the required rental rate means it will be some time
before new construction will occur.
If a proposed apartment complex can generate adequate
rental income to cover operating expenses, support sufficient debt to
finance the property and provide a satisfactory cash return to the
owner, it is financially feasible to develop the property. The first step
in making this determination is to estimate the property’s cost.
Current market information suggests that two-bedroom,
two-bathroom apartments and three-bedroom, two-bathroom
apartments have the highest demand in the Bryan-College Station
student housing market. Students have a high preference for these
apartments because they can share the kitchen and living area while
having their own bedroom, thereby reducing the per student cost
while maximizing their privacy. Thus, for the purposes of this
analysis, the cost of constructing a 925-square-foot two-bedroom,
two-bathroom apartment and an 1,100-square-foot three-bedroom,
two-bathroom apartment was estimated.
To estimate land costs, construction of 20 units per acre is
assumed, although the maximum apartment density in the city of
College Station is 24 units per acre. Apartment developers prefer to
purchase land that costs no more than $1.75 to $2 per square foot or
about $75,000 to $85,000 an acre. A price of $80,000 per acre is
used in the analysis; therefore, the unit land cost is $4,000.
Because no apartment construction has occurred in the
Bryan-College Station market area for several years, the base
construction cost is taken from the Marshall Valuation Service and
adjusted for time and the local economy. The cost of built-ins,
parking lot, recreation facilities and landscaping is based on
Marshall Valuation Service and local estimates. A 12 percent
I NVESTMENT BY DESI GN
58
entrepreneurial profit is considered reasonable. As reported in Table 1,
the apartment units’ respective estimated costs are $48,051 and
$54,110.
Required Rental Rates
To estimate the rent required to support the construction of
these apartments, the following operating and financing assumptions
were used.
• Amount of financing: 80 percent of total cost
• Terms of financing: 10 percent, 30 years
• Required cash-on-cash return: 11 percent
• Vacancy and bad debt loss: 5 percent
• Operating expense ratio: 30 percent
The monthly unit rent and rent per square foot required to
support the apartment construction are presented in Table 2. These
required rental rates are higher than the spring 1992 average high
rental rates reported by Branson Research Associates for Bryan-
College Station student housing market.
The difference between the nine-month lease rate and the
one-year lease rate is important. Although the market is moving in
the direction of one-year leases, the average high rental rates for
spring 1992 are an unknown mixture of lease arrangements. To
compete for tenants, the owners of a new apartment complex will
not be able to demand that tenants sign one-year leases, but charging
the required nine-month rental rate would put them at a serious
competitive disadvantage relative to owners of existing apartments.
Table 1. Estimated Apartment Construction Costs
Two-bedroom Three-bedroom
two-bath two-bath
Construction cost (sq. ft.) $35.63 $34.88
Unit size 925 1,100
Unit construction cost $32,958 $38,368
Built-ins 1,200 1,200
Other unit costs
Landscaping and pool 1,765 1,765
Parking 2,280 2,280
Office and laundry 700 700
Land 4,000 4,000
Entrepreneurial profit 5,148 5,797
Total estimated cost $48,051 $54,110
FI NANCI AL FEASI BI L I TY ANALYSI S
59
Thus, market rental rates must increase by a considerable amount to
encourage new construction. And, the cost of new construction is
likely to continue rising.
But such an increase is not likely in the short-run because
market rents are established by supply and demand; an individual
apartment owner cannot raise the rent for a typical apartment to the
level required to support new construction. However, owners of
properly maintained, well-located properties purchased for prices
based on past or current market rents will be able to gradually
increase their rental rates while maintaining their occupancy. Rental
rates can be increased gradually because few alternatives exist in the
local student housing market, and students will find it difficult to
economize on their space needs, i.e., the demand for apartments is
price inelastic.
On the other hand, an increase large enough to justify new
construction is unlikely because current apartment owners do not
need such rates for profitable operation. If demand remains steady,
current property owners will be protected from the competition of
new properties for several years.
Table 2. Estimated Rental Rate Required
to Support Construction
Two-bedroom Three-bedroom
two-bath two-bath
Construction cost $48,051 $54,110
Mortgage loan (80% of cost) 38,441 43,288
Equity investment $9,610 $10,822
Required before-tax cash flow
for 11% return on equity 1,057 1.190
Mortgage payment (10%, 30 years) 4,078 4,592
Required net operating income $5,135 $5,782
Operating expenses 2,370 2,669
Required effective gross income $7,505 $8,451
Vacancy and collection loss 395 445
Required gross possible income $7,900 $8,896
Estimated required monthly rent per unit
One-year lease $658 $741
Nine-month lease 878 988
*Average high market rent (an unknown
mixture of lease terms)
Spring 1992 $509 $715
*Source: Branson Research Associates, Bryan, Texas
I NVESTMENT BY DESI GN
60
Conducting a Multi-Year
Analysis
The expected rate of return from a real estate investment is
determined by the expected benefits of the investment–cash flow and
appreciation–and the cash required to purchase the property. Although
there are a number of popular nondiscounted measures of the rate of
return, a proper calculation uses present value techniques so that the
rate will reflect the timing of the cash inflows and outflows.
Equally important, however, is the need for good data. Ex-
pected rate of return means nothing if the projected costs and benefits
used in the calculation are incorrect.
Real estate is particularly affected by future events because of
three important characteristics: physical immobility, long economic
life and large economic size. In short, a property investment involves
a relatively large dollar investment that cannot be moved and that
must generate income for a long period. Thus, successful real estate
investing involves decisions about the future level of rents, operating
expenses, appreciation rates and tax laws. These, in turn, depend on
the rate and direction of urban growth, price inflation, international
events, political events and so forth.
As the information is gathered, the investor necessarily will
be addressing questions about risk. Risk exists in all projects, but
January 1995
Wayne E. Etter
Assembling the Data 7
ASSEMBL I NG THE DATA
61
some are more risky than others. The degree of risk depends on the
difference between expected and actual outcomes. If the expected
outcome is guaranteed, then the risk is negligible; if the expected
outcome is uncertain, then the risk is large. For a single project, the
best way to reduce risk is to improve the analysis of the variables that
produce the project’s expected rate of return. In this way, the spread
between expected and actual outcomes can be minimized.
As the scope of the analysis is examined, one of its prime
benefits becomes clear: in gathering the data required to make the
analysis, much will be learned about the investment under consider-
ation. Estimating the rate of return may be secondary to the knowl-
edge gained from gathering the information. Nevertheless, the pro-
spective investment must promise a satisfactory rate of return or be
abandoned.
Most real estate investment decisions and market valuations
are made using either net operating income or before-tax cash flow
from operations and resale. For some individual real estate invest-
ment decisions, however, estimating after-tax cash flow from opera-
tions and resales is desirable. The calculations are illustrated in the
appendix.
Analyzing income-producing real estate requires all expected
cash flows to be specified. These flows can be categorized as those
associated with the project’s
• origination,
• operation and
• termination.
Project Origination
To estimate the cash investment required for an existing
property, the amount of mortgage financing is netted against total
purchase price. To estimate the cash investment required for a
to-be-developed property, the amount of mortgage financing is netted
against estimated total project cost.
Assume these basic facts of a project origination:
Cost of land $130,680
Cost of building 612,080
Total cost $742,760
Mortgage (12%, 25 years) -557,070
Initial equity $185,690
I NVESTMENT BY DESI GN
62
Project Operation
Before-tax cash flow from operations for each year is esti-
mated from the project’s expected rent, vacancy rate, operating ex-
penses and mortgage payment.
Estimating net operating income
With the cost estimated, additional market information is
needed to prepare pro forma or projected operating statements.
Specifically, estimates of rental rates, vacancy rates and operating
expenses are needed for the property. These data can be obtained from
the feasibility analysis if one is available.
Square feet of net leasable space 20,000
Rent per square foot per year (0.55 x 12) $6.60
Potential gross income $132,000
Miscellaneous income 0
Less vacancy
and collection loss (5%) -6,600
Effective gross income $125,400
Less operating expense -36,000
Net operating income $89,400
Before-tax cash flow from operations
Before-tax cash flow from operations is estimated by subtract-
ing the expected mortgage loan payment from net operating income
(NOI). For example:
Net operating income $89,400
Mortgage payment -71,026
Before-tax cash flow $18,374
Calculating the amount of the mortgage loan payment re-
quires the loan amount and the mortgage constant. For the example
property, the annual payment is calculated as follows:
Loan amount x mortgage constant = annual payment
$557,070 x .1275 = $71,026
Preparing multi-year projections
In addition, the following data will be needed to complete the
specification of before-tax cash flow from operations for the holding
period:
• estimated holding period,
ASSEMBL I NG THE DATA
63
• estimated rental growth rate,
• estimated operating expense growth rate,
• estimated vacancy rates and
• annual mortgage payment for remaining years of estimated hold-
ing period.
Using an estimated holding period of five years, an estimated
rental growth rate and operating expense growth rate of 3 percent,
NOI and before-tax cash flow from operations can be estimated for the
example property. These estimates are presented in Table 1.
Table 1. Before-Tax Cash Flow to Equity from Operations
Y YY YYear 1 ear 1 ear 1 ear 1 ear 1 Y YY YYear 2 ear 2 ear 2 ear 2 ear 2 Y Y Y Y Year 3 ear 3 ear 3 ear 3 ear 3 Y Y Y Y Year 4 ear 4 ear 4 ear 4 ear 4 Y Y Y Y Year 5 ear 5 ear 5 ear 5 ear 5
Gross possible income $132,000 $135,960 $140,039 $144,240 $148,567
Less vacancy and
collection loss -6,600 -6,798 -7,002 -7,212 -7,428
Effective gross income $125,400 $129,162 $133,037 $137,028 $141,139
Less operating expense -36,000 -37,080 -38,192 -39,338 -40,518
Net operating income $89,400 $92,082 $94,844 $97,690 $100,620
Less mortgage payment -71,026 -71,026 -71,026 -71,026 -71,026
Before-tax cash flow
from operations $18,374 $21,056 $23,818 $26,663 $29,594
Project Termination
The net resale price and the before-tax cash flow from the
resale are estimated from the expected resale price, expected selling
expenses and the unpaid mortgage balance.
Estimating the expected resale price
The project’s expected resale price is of particular concern
because significant appreciation is often required to produce a satisfac-
tory rate of return. By carefully examining the project’s current value
and its expected resale price, the investor can estimate the apprecia-
tion potential of the property and the contribution of this component
to the project’s rate of return.
Evaluating the property’s current value. There is a relation-
ship between a property’s NOI and its value. When the following
calculation is made using the subject property’s data, the result is
known as the overall capitalization rate.
NOI
Value
I NVESTMENT BY DESI GN
64
Using the property’s total cost or purchase price and its
estimated NOI for the first “normal” year–the year in which expected
occupancy will be obtained–the overall capitalization rate can be
calculated. By comparing the property’s overall capitalization rate
with the market capitalization rate for similar properties, the
reasonableness of the price that the investor is paying for the property
can be evaluated. For instance, if the property under consideration is
offered for sale at an overall capitalization rate of 8.5 percent but
similar properties are selling for 10 percent market capitalization rates,
the investor should seek the reason(s) for the price difference. If the
original purchase price is too great, the investor must expect a smaller
increase in the project’s value because a future buyer cannot be
expected to pay too much for the property.
Estimating the expected resale price. The expected resale
price at the end of the holding period is estimated by using the
expected market capitalization rate to capitalize the NOI projected for
the year following the sale. The NOI for the year following the sale is
used because the buyer at the end of year five will purchase the
property’s future NOI rather than its past NOI. For example, to
estimate the resale price at the end of a five-year holding period:
NOI (year 6)
Expected resale price = —————————————
Market capitalization rate
$103,639
$1,036,391 = ————
.10
The expected resale price should appear reasonable when
compared to expected changes in the NOI and the market. For
example, if no rent increase is projected, this approach will make it
difficult to justify an increase in the property’s value over time. Of
course, annually increasing rents are a common assumption. Further-
more, a property that has operated successfully for several years may be
considered less risky than a newer property. In this case, a lower
capitalization rate may be used to estimate the resale price than was
used in evaluating the purchase price.
A second approach to evaluating the expected resale price is to
calculate the annual compound rate of growth necessary for the
property to appreciate to the expected resale price. Does this rate of
growth seem reasonable when compared to recent growth rates of
similar properties in the area? And, is it reasonable to assume that
ASSEMBL I NG THE DATA
65
this rate of appreciation will continue in the market? Local real estate
brokers are a good source for obtaining this information.
Net resale price and before-tax
cash flow from resale
With the expected resale price estimated, expected selling
expenses are deducted to arrive at the net resale price. When the
unpaid mortgage balance is deducted from the net resale price, the
result is called before-tax cash flow from resale. For example:
Expected resale price $1,036,391
Less selling expenses -41,456
Net resale price $ 994,935
Less unpaid mortgage balance -530,528
Before-tax cash flow from resale $ 464,408
The procedure for calculating the unpaid mortgage balance is
presented in “Calculating Mortgage Loans.”
Summary
The final result of the preceding calculations is the summary
of all before-tax cash flows to equity–both from operations and the
expected proceeds from the resale of the property. A summary of
these projected cash flows for the example property is presented in
Table 2.
Table 2. Before-Tax Cash Flow to Equity
Y YY YYear 1 ear 1 ear 1 ear 1 ear 1 Y YY YYear 2 ear 2 ear 2 ear 2 ear 2 Y YY YYear 3 ear 3 ear 3 ear 3 ear 3 Y YY YYear 4 ear 4 ear 4 ear 4 ear 4 Y YY YYear 5 ear 5 ear 5 ear 5 ear 5
Before-tax cash flow
from operations $18,374 $21,056 $23,818 $26,663 $ 29,594
Before-tax cash flow
from resale 464,408
Before-tax cash flow
to equity $18,374 $21,056 $23,818 $26,663 $494,002
Appendix
After-tax cash flow from operations
After-tax cash flow from operations is estimated by subtracting
estimated income tax liability from before-tax cash flow from opera-
tions. The project’s taxable income must be estimated first. Taxable
income is calculated as:
I NVESTMENT BY DESI GN
66
Potential gross income $132,000
Miscellaneous income 0
Less allowance for vacancy
and collection loss (5%) -6,600
Effective gross income $125,400
Less operating expenses -36,000
Net operating income $ 89,400
Less: Depreciation -21,331
Interest -66,848
Amortized financing costs -0
Taxable income $ 1,221
Thus, it is necessary to calculate the annual depreciation and
the annual amortized financing costs and to separate the mortgage
payment into its principal and interest components.
Depreciation. The modified accelerated cost recovery system
(MACRS) is used to depreciate income-producing real estate placed in
service after 1986. This depreciation system is not related to the
property’s physical depreciation or useful life. Furthermore, current
law permits the depreciation of income-producing real estate even
when it appreciates.
Current tax law requires income-producing real estate to be
depreciated according to the tables shown in Table 3. Note that Table
3.A is to be used for the depreciation of residential property; Table 3.B
is for the depreciation of nonresidential property. Assuming a residen-
tial property is placed in service in January, the first year’s depreciation
is calculated as follows:
Depreciable value x recovery percentage = depreciation
$612,080 x .03485 = $21,331
Interest. For the example property, the first year’s interest
payment is calculated:
Loan amount x interest rate = interest payment
$557,070 x .12 = $66,848
Permanent Financing Costs. Permanent financing costs are
amortized for the term of the mortgage loan using the straight-line
method. Had the mortgage lender charged a 2 percent fee for the
example loan, an additional cost of $11,141 would be incurred.
Amortizing this amount for the 25-year life of the mortgage results in
an annual amortization of $445.
ASSEMBL I NG THE DATA
67
Table 3. Depreciation Rates
Table 3.A
Residential Rental Property (27.5- year)
Use the column for the month of taxable year placed in service
Year 1 2 3 4 5 6 7 8 9 10 11 12
1 3.485% 3.182% 2.879% 2.576%2.273% 1.970% 1.667% 1.364% 1.061% 0.758% 0.455% 0.152%
2-9 3.636% 3.636% 3.636% 3.636%3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636% 3.636%
Table 3.B
Nonresidential Real Property (39-year)
Use the column for the month of taxable year placed in service
Year 1 2 3 4 5 6 7 8 9 10 11 12
1 2.461% 2.247% 2.033% 1.819% 1.605% 1.391% 1.177% 0.963% 0.749% 0.535% 0.321% 0.107%
2-39 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564% 2.564%
Note: Note: Note: Note: Note: Depreciation rates may change as new tax laws go into effect. These
tables are current as of J anuary 1995. Future users may wish to contact the IRS
or a tax consultant to verify depreciation rates in effect at that time.
A complete residential rental property depreciation table may be found in
Depreciation, Department of the Treasury, Internal Revenue Service, Publica-
tion 534 (Rev. Dec. 1987), pp. 30-31.
Source: Source: Source: Source: Source: 1994 Instructions for Form 4562, Department of the Treasury,
Internal Revenue Service, p. 7.
I NVESTMENT BY DESI GN
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Income Tax Liability. The estimated income tax payment is
calculated by applying the appropriate income tax rate to the estimated
taxable income. For the purposes of illustration, the marginal tax rate
of 28 percent is assumed. Thus:
Net operating income $89,400
Less: Depreciation -21,331
Interest -66,848
Amortized financing costs -0
Taxable income $ 1,221
Tax rate .28
Income tax $ 342
If taxable income is negative, the loss is carried forward.
Losses carried forward accumulate until they are offset by positive
taxable income or the property is sold.
1
For example:
Taxable Loss carried Net carried Net taxable
Year income forward forward income Tax due
1 $(43,920) $43,920 $43,920 $ 0 $ 0
2 (22,685) 22,685 66,605 0 0
3 4,678 0 61,926 0 0
4 34,348 0 27,578 0 0
5 66,519 0 0 38,940 10,903
It is possible that no income tax will be paid while the
property is held; the accumulated losses are used to offset the capital
gain when the property is sold.
There are two exceptions to the foregoing for some investors.
First, rental real estate annual operating losses of as much as
$25,000 can be used to offset active trade or business income and
portfolio income for investors with adjusted gross incomes of as
much as $100,000. The offset is reduced 50 cents for each $1 more
than $100,000 of adjusted gross income; thus, for investors with
adjusted gross incomes of $150,000 or more, there is no allowable
offset. Investors who use this exception must be actively engaged in
the management of the rental real estate; they may not be limited
partners and must own at least a 10 percent interest in the rental real
estate.
Second, investors may deduct unlimited real estate losses if
(a) more than half of all personal services they perform during the
year are for real property trades or (real estate related) businesses in
which they materially participate and (b) they perform more than
750 hours of service per year in those real estate activities. Material
ASSEMBL I NG THE DATA
69
participation requirements are met if the investor is involved in real
estate operations on a regular, continuous and substantial basis. This
provision may be especially useful for real estate professionals.
2
After-tax cash flow from operations. The final step required
to estimate after-tax cash flow from operations is to subtract the
estimated income tax payment from estimated before-tax cash flow
from operations. Thus:
Before-tax cash flow from operations $18,374
Less income tax liability -342
After-tax cash flow from operations $18,032
Using the data from Table 1, after-tax cash flow from opera-
tions can be estimated for the example property. These estimates are
presented in Table 4.
Table 4. After-Tax Cash Flow to Equity from Operations
Year 1 Year 2 Year 3 Year 4 Year 5
Net operating income $89,400 $92,082 $94,844 $97,690 $100,620
Depreciation 21,331 22,255 22,255 22,255 22,255
Interest 66,848 66,347 65,786 65,157 64,452
Taxable Income $ 1,221 $ 3,480 $ 6,804 $10,278 $ 13,913
Before-tax cash flow
from operations $18,374 $21,056 $23,818 $26,663 $ 29,594
Income tax liability 342 974 1,905 2,878 3,896
After-tax cash flow
from operations $18,032 $20,081 $21,913 $23,786 $ 25,698
After-tax cash flow from resale. The after-tax cash flow from
resale is determined by subtracting any capital gains tax from the
before-tax cash flow from resale. Thus:
Expected resale price $1,036,391
Less selling expenses -41,456
Net resale price $ 994,935
Less unpaid mortgage balance -530,528
Before-tax cash flow from resale $ 464,408
Less capital gains tax -101,508
After-tax cash flow from resale $ 362,900
I NVESTMENT BY DESI GN
70
Determining the capital gain tax. The capital gain tax is
calculated as follows:
Step 1
Cost of land $130,680
Cost of improvements 612,080
Total cost $742,760
Less accumulated depreciation -110,352
Adjusted basis $632,408
Step 2
Resale price $1,036,391
Less selling expense -41,456
Net resale price $ 994,935
Less adjusted basis -632,408
Capital gain $ 362,527
Step 3
Capital gain $ 362,527
Less accumulated loss carry forward -0
Net taxable gain $ 362,527
Tax rate x .28
Capital gain tax $ 101,508
For the purposes of illustration, the maximum capital gain tax
rate of 28 percent is assumed.
Summary
The final result of the preceding calculations is the summary
of all after-tax cash flows to equity–both from operations and the
expected proceeds from the resale of the property. A summary of these
estimated cash flows for the example property is presented in Table 5.
Table 5. After-Tax Cash Flow to Equity
Y YY YYear 1 ear 1 ear 1 ear 1 ear 1 Y YY YYear 2 ear 2 ear 2 ear 2 ear 2 Y Y Y Y Year 3 ear 3 ear 3 ear 3 ear 3 Y YY YYear 4 ear 4 ear 4 ear 4 ear 4 Y YY YYear 5 ear 5 ear 5 ear 5 ear 5
After-tax cash flow
from operations $18,032 $20,081 $21,913 $23,786 $ 25,698
After-tax cash flow
from resale 362,900
After-tax cash flow
to equity $18,032 $20,081 $21,913 $23,786 $388,598
ASSEMBL I NG THE DATA
71
Notes
1
Income is segregated into active trade or business income,
passive investment income and portfolio income. All real estate
income from operations or gains is classified as passive investment
income. If the property produces an operating tax loss after the
deduction of interest and depreciation, the loss can be used only to
offset positive income from other passive investments. If the real
estate investor has no other passive investments that produce positive
income, the loss can be carried forward and used to offset positive
passive income in the future, or it can be written off when the
property is sold. Thus, the project may not produce any taxable
income for a number of years but neither will it produce tax shelter.
Unless an investor has properties that are producing taxable income,
investing in a property that produces losses will have little attraction.
Prior to the 1986 Tax Reform Act, the opposite was true.
2
Jerrold J. Stern, “Passive Loss Rules Eased for Real Estate
Professionals,” Tierra Grande (Spring 1994), pp. 17-18.
I NVESTMENT BY DESI GN
72
How Present Value
Works
Present value analysis is one of the fundamental tools of
financial analysis. Although making a proper and thorough financial
analysis involves present value analysis, it is not the most important
step in financial analysis.
Present value is simply a way of dealing with expected cash
outlays and benefits to be paid out and received over time. When the
analyst is satisfied with the quality of the financial data, present
value analysis is used to calculate a proposed investment’s expected
net present value or internal rate of return so that each project under
consideration can be measured against the investor’s required return.
Present value analysis also is used by real estate appraisers.
Today, many people are proficient at using financial calcula-
tors and personal computer software programs for making present
value calculations. However, many people also have difficulty with
present value calculations when they confront a problem not covered
by the examples in the calculator manual–knowing a series of
keystrokes or how to input data does not demonstrate a knowledge of
present value.
January 1990
Wayne E. Etter
Evaluating
the Data
8
EVALUATI NG THE DATA
73
Present value analysis is based on the idea that more is better
than less and that sooner is better than later; both the magnitude
and the timing of the cash flows are considered. Having more ben-
efits from the investment sooner means that they can be reinvested
sooner; given that the reinvestment takes place at a positive rate of
interest, present value analysis allows a present sum of money to be
compared with a larger sum to be received in the future.
Present value analysis helps to decide if the future benefits
are sufficient, given their cost. Although present value analysis is a
fundamental tool of all investment decision making, it is particularly
important in real estate investment analysis because income-produc-
ing properties usually have rather long recovery periods.
Real estate investments, like all other investments, involve
the expenditure of funds to obtain the right to receive a set of uncer-
tain, future cash flows. Thus, there are three essential elements to
the investment: a cash outlay, expected cash flows (or benefits), and
an interval between the time of making the investment and receiving
its benefits.
Because present value analysis is an important communica-
tion system, the following conventions are used when analyzing
income-producing properties. First, it is usually assumed that cash
outlays are made at the beginning of the period of analysis, some-
times called time zero. Second, it is usually assumed that positive or
negative cash flows occur at the end of the period. Third, the period
is usually one year.
Problems involving leases, compound interest or compound
growth rates may be calculated for periods other than a year. When
lease agreements are being analyzed, the payments may be paid at
the beginning of the period, and the length of the period must be
specified (month, quarter, year). Compound interest and compound
growth rate problems require the specification of the time of pay-
ment and the length of the period.
Present value analysis is based on the concept of compound
interest–how much must be invested today at a given rate to accu-
mulate to $1 over a specified number of years (or other period)?
Thus, the amount that must be invested now is dependent on the
rate of compound interest and the length of time the investment is
left to accumulate. The compound sum of $1 table, for example,
includes the following information:
I NVESTMENT BY DESI GN
74
Number of years
(periods) 10%
1 1.100
2 1.210
3 1.331
These entries are calculated with the formula (1 + i)
n
with i
being the interest rate and n being the number of years (periods). For
example, (1 + 0.10)
3
= 1.331. The entry “1.331” shows that if $1 is
invested now and left to compound at the rate of 10 percent for three
years, the investment’s accumulated value will be $1.331:
$1.00 Initial investment
+ .10 Interest for year 1
$1.10 Balance at the end of year 1
+ .11 Interest for year 2
$1.21 Balance at the end of year 2
+ .121 Interest for year 3
$1.331 Final value
How does a present value table differ from a compound
interest table? The present value of $1 table, for example, includes
the following information:
Number of years
(periods) 10%
1 0.909
2 0.826
3 0.751
These entries are calculated with the formula 1 / (1 + i)
n
with i being the interest rate and n being the number of years (peri-
ods). For example, 1 / (1 + 0.10)
3
= 0.751. The entry “0.751” says
that if 75.1 cents are invested now and left to compound at the rate of
10 percent for three years, the investment’s terminal value will be $1:
$0.7510 Initial investment
+ .0751 Interest for year 1
$0.8261 Balance at the end of year 1
+ .08261 Interest for year 2
$0.90871 Balance at the end of year 2
+ .090871 Interest for year 3
$0.999571 (= $1) Final value
EVALUATI NG THE DATA
75
Thus, the difference between the compound interest table
and the present value table is that the compound interest table is
used to calculate the amount $1 will become if invested for a certain
number of periods at a particular interest rate. The present value
table is used to calculate the number of cents that must be invested for
a certain number of periods at a particular interest rate to become $1.
Compound interest tables and present value tables are
available widely. They are found in many real estate textbooks and
are published in special books of financial tables.
Suppose an investor wishes to value a series of annual cash
benefits. Present value analysis is applied to this problem by multi-
plying the expected benefits by the proper present value factor. If the
expected cash benefits are $1,000 at the end of years 1, 2 and 3, and
the required return is 10 percent, the problem is solved as follows.
Annual 10% Present
Cash Value Present
Year Benefit Factor Value
1 $1,000 x .909 = $909
2 1,000 x .826 = 826
3 1,000 x .751 = 751
Present value of benefits $2,486
The calculated present value of the three annual cash ben-
efits is $2,486. What does this mean? It means that if the investor is
satisfied that a 10 percent return is appropriate for this investment,
then a maximum price of $2,486 can be paid for the right to these
future cash flows. The present value of each year’s cash benefit, if
left to compound at 10 percent for the respective number of years,
will have a terminal value of $1,000 as previously demonstrated.
If the investor believes that a 15 percent return is more
appropriate, the maximum price that can be paid for the benefits is
$2,284:
Annual 15% Present
Cash Value Present
Year Benefit Factor Value
1 $1,000 x .870 = $870
2 1,000 x .756 = 756
3 1,000 x .658 = 658
Present value of benefits $2,284
I NVESTMENT BY DESI GN
76
Why does the lower rate generate a higher present value?
This result is logical if the annual $1,000 payments are considered
the fixed benefits of the investment. Less will be paid for the benefits
if they are to provide a 15 percent return on investment instead of a
10 percent return. Thus, for investments with a fixed income
stream, their rate of return and value vary inversely. As required
return rises, investment value declines.
Although some believe that inflation is the reason that future
dollars are brought to their present value, present value analysis has
nothing directly to do with inflation. Future dollars are worth less
because they are not available now; if they were, they could be
reinvested. Future dollars also may be worth less because of their
expected lower buying power but, in that case, a higher reinvestment
rate will equalize the expected rate of inflation. This process is
identical to that of investors demanding higher interest rates during
periods when higher rates of inflation are expected.
An annuity is a finite stream of equal periodic cash benefits.
When calculating the present value or the rate of return of an annu-
ity, the present value of $1 received annually for N years table may
be used to reduce the computations required. For example, the
present value of a three-year annual annuity of $1,000 per year is
calculated as follows:
$1,000 annual payment
x 2.283 factor for three years, 15 percent
$2,283 present value of the annuity
Such benefit streams are encountered in real estate analysis
when lease payments, mortgages and other financial instruments are
being analyzed, but they are encountered rarely otherwise.
The analysis of income-producing properties usually involves
cash flows that vary from year to year and may be negative in some
years. These cash flow patterns can be handled as easily as equal
annual payments using present value analysis.
Annual 10% Present
Cash Value Present
Year Benefit Factor Value
1 $2,400 x .909 = $2,182
2 2,000 x .826 = 1,652
3 -1,000 x .751 = -751
4 400 x .683 = 273
5 -1,000 x .621 = -621
Present value of benefits $2,735
EVALUATI NG THE DATA
77
In an earlier example, the present value of receiving $1,000
annually for three years was determined to be $2,486 at a 10 percent
discount rate. What is the effect of speeding up the rate of the cash
benefits while holding the total constant? For example, what is the
present value of the stream if $2,000 is received the first year and
$500 in years two and three?
Annual 10% Present
Cash Value Present
Year Benefit Factor Value
0 $2,000 x .909 = $1,818
1 500 x .826 = 413
2 500 x .751 = 375
Present value of benefits $2,606
The result is an increase in the present value of the income
stream; the stream is more valuable because the extra $1,000 is
received sooner and can be invested for two years. This will more
than offset the effect of the smaller cash benefits in years two and
three.
Just as present value results in an investment having a
higher value if cash flows are received sooner, present value results in
higher values when cash outlays are delayed. Thus, investment
analysis must take the timing of cash outlays into account. For
instance, a total cash outlay of $1 million, when spread over three
years, has the following present value:
Annual 10% Present
Cash Value Present
Year Benefit Factor Value
0 $200,000 x 1.000 = $200,000
1 400,000 x .909 = 363,600
2 400,000 x .826 = 330,400
Present value of benefits $894,000
With a basic understanding of how present value works, the
technique can be applied to investment decision making. Using
present value to calculate an investment’s internal rate of return and
net present value will be considered next.
I NVESTMENT BY DESI GN
78
The basic idea of present value reveals the attributes that
cause present value analysis to be used for analyzing investments.
• All cash flows during the life of the investment are considered.
This includes the investment outlay, both positive and negative
operating cash flows and appreciation.
• The timing of all cash flows is considered. Present value analy-
sis makes those projects with delayed investment outlays or
those producing cash flows sooner more attractive than those
projects with immediate investment outlays or those producing
delayed cash flows.
• Present value analysis considers an investor’s desire to reinvest
the cash benefits derived from the investment.
Present value analysis is used to determine a project’s
acceptance or rejection by calculating a proposed investment’s net
present value and internal rate of return. This discussion focuses on
the investor’s required rate of return and these two present value
techniques.
An investor uses different required rates of return for differ-
ent investments because the risk of all investments is not the same;
normally, as the level of risk increases, the required rate of return is
increased. Although risk considerations are beyond the scope of this
article, it is necessary to understand only that an investor establishes
a required rate of return for all investments being considered. The
level of risk inherent in each investment is reflected in the required
rate of return.
Net Present Value. Using the investor’s required return to
calculate the present value of the future benefits and subtracting the
investment’s cost from the present value of the future benefits gives
the investment’s net present value. For example, an investor with a
required rate of return of 15 percent is considering an investment
that costs $2,284 and promises $1,000 annual cash benefits for three
years. What is the net present value?
Using Present Value
Analysis
April 1990
Wayne E. Etter
EVALUATI NG THE DATA
79
Annual 15% Present
Cash Value Present
Year Benefit Factor Value
1 $1,000 x .870 = $ 870
2 1,000 x .756 = 756
3 1,000 x .658 = 658
Present value of benefits $2,284
Cash outlay 2,284
Net present value $ 0
If the net present value is zero (the present value of the
future benefits is equal to their cost), the investment’s return will be
equal to the investor’s required rate of return. A better understanding
of how a net present value of zero provides the required rate of return
can be had by considering the following example:
Investment Outstanding
Year Cash Flow 15% Return Recovery Investment
0 -$2,284 $2,284.00
1 1,000 $342.60 $657.40 1,626.60
2 1,000 243.99 756.01 870.59
3 1,000 130.59 869.41 $ 1.18
As shown, the first year’s cash flow of $1,000 provides the
investor with a 15 percent return on the $2,284 invested for the first
year and reduces the amount of unrecovered investment by $657.40.
By the end of the third year, the amount invested has been recov-
ered–the small remainder results from rounding–and the investor has
earned 15 percent each year on the amount of the unrecovered
investment. Thus, the rate of return accounts for both the return on
and the return of the investment.
The present value of an income stream discounted at the
required rate of return is the price that must be paid for the future
benefits if the required rate of return is to be earned. When the
present value of the benefits exceed their cost, the net present value
is positive, and the investor receives a return in excess of the re-
quired return. If the net present value is negative, the investment’s
return will be less than the investors required return. For any given
set of cash benefits and cash outlay, an increase in the required rate
I NVESTMENT BY DESI GN
80
of return decreases the investment’s net present value. If the required
return becomes too great, the net present value becomes negative.
When two or more projects are being compared, they can be
ranked according to their net present value. All other things being
equal, the project with the largest net present value will be selected
because it will maximize the investor’s wealth.
Internal Rate of Return. An investment’s expected rate of
return can be compared directly with the investor’s required return.
In the discussion of net present value, it was observed that there is a
particular rate of discount that will make the net present value equal
to zero. This rate is known as the internal rate of return. To find this
rate, trial discount rates are chosen until the rate that results in a net
present value of zero is found. As Figure 1 shows, a positive net
present value of $37 is obtained with a discount rate of 14 percent.
Because a net present value of zero is desired, a higher rate, say 16
percent, is tried. This rate yields a negative $38 net present value.
Finally, a discount rate of 15 percent is used and a net present value
of zero results.
Financial calculators and electronic spreadsheet programs
make this calculation in a similar fashion–electronic spreadsheet
programs, for instance, require a “guess” rate to begin the calculation
of the internal rate of return.
As with the net present value method, the internal rate of
return is used to compare alternatives. When two or more projects
are being compared, the projects can be ranked according to their
internal rate of return; each also is compared with the investor’s
required rate of return. This comparison is shown in Figure 2.
EVALUATI NG THE DATA
81
Projects A and B have internal rates of return in excess of the
investor’s required rate of return and are acceptable; projects C and
D have internal rates of return less than the investor’s required rate
of return and are not acceptable. If only one project can be funded,
the project with the largest internal rate of return ordinarily will be
selected because choosing it will maximize the investor’s wealth
(assuming that all alternatives are equal in risk).
To use present value analysis, one must have a clear under-
standing of net present value and the internal rate of return methods.
Many investors calculate both the net present value and the internal
rate of return for each investment. Others prefer to use only the
internal rate of return because they understand the general concept
of rate of return. Therefore, they rely on it to determine if an
investment’s return is adequate relative to the required rate of return
and for ranking alternative investments.
Is the use of the internal rate of return instead of net present
value in real estate investment analysis a problem? Ordinarily, this is
not a problem because both usually result in the same ranking of
alternative investments. However, this question arises because it is
possible for an investor choosing between two mutually exclusive
alternatives (choosing between financing proposals, for example) to
discover that one alternative generates the largest net present value
and the other generates the largest internal rate of return. Although
the circumstances that result in such conflicts are not common in
the analysis of income properties, exploring this question provides
additional insight into these two approaches to measuring an
investment’s expected return.
I NVESTMENT BY DESI GN
82
Although investors have many goals, their ultimate invest-
ment goal is assumed to be wealth maximization. Using this as a
guide, the example of an investment costing $2,284 and providing
$1,000 annual cash benefits for three years will be re-examined. It
was shown that this investment provides the investor with a 15
percent internal rate of return.
Annual 15% Present
Cash Value Present
Year Benefit Factor Value
1 $1,000 x .870 = $ 870
2 1,000 x .756 = 756
3 1,000 x .658 = 658
Present value of benefits $2,284
Cash outlay 2,284
Net present value $ 0
Internal rate of return 15%
However, if $2,284 is invested in an alternative investment
at a 15 percent compound rate for three years, it will become $3,474.
Why would an investor not prefer this investment to one that
produces three annual cash flows of $1,000? Because a basic assump-
tion of present value analysis is that cash flows are reinvested. If each
of the $1,000 cash flows is reinvested at 15 percent when it is
received, the future value of these cash flows is $3,474:
Accumulation Cash Flow
from Previous Reinvested at Interest
Year Year End of Year at 15% Total
1 $ 0 $1,000 $1,000
2 1,000 1,000 $150 2,150
3 2,150 1,000 324 3,474
Thus, because of the reinvestment of the cash flows at 15
percent, both investments will accumulate to the same future value.
If the reinvestment of the annual $1,000 cash flows is not possible or
if reinvestment will take place at a rate less than 15 percent, the
alternative investment providing $3,474 in three years would be
preferred. Accordingly, it can be seen that when an internal rate of
EVALUATI NG THE DATA
83
return is being calculated, it is assumed that the cash flows will be
reinvested at the internal rate of return. But when a large internal
rate of return is calculated, it may not be possible to find other
investments with equally large expected returns in which to reinvest
the cash flows.
On the other hand, in the calculation of the net present
value, the required rate of return is the reinvestment rate. The
required rate of return should reflect realizable returns in the market
for a given level of risk; furthermore, it is assumed that an investor
will not invest at a rate less than the required rate of return; if this
happens, the required rate of return has been improperly established.
The net present value method is used to choose between
alternatives when there is a ranking conflict between the net present
value and the internal rate of return. Why? With the net present
value method, reinvestment of the cash flows takes place at the
investor’s required rate of return, but with the internal rate of
return method, reinvestment of the cash flows must take place at
the internal rate of return. The internal rate of return can vary
from project to project; this, in turn, results in a varying reinvest-
ment rate assumption from project to project. However, the reinvest-
ment rate assumption is constant from project to project when the
net present value method is used. Furthermore, when the cash flows
are reinvested at the required rate of return, the project with the
largest net present value will maximize the investor’s wealth.
Calculating the net present value also is superior to calculat-
ing the internal rate of return if the annual cash flows change from
positive to negative to positive during the holding period. Under
these circumstances, calculating the internal rate of return can result
in multiple internal rates of return. No such possibility exists when
calculating net present value.
Once the proper interpretation of the net present value
method is firmly grasped, another advantage appears–it is easier to
calculate than the internal rate of return. Only a present value table
and a simple calculator are required whereas a financial calculator or a
computer is necessary to quickly calculate the internal rate of return for
a real estate investment having uneven cash flows over a long holding
period.
I NVESTMENT BY DESI GN
84
Calculating Mortgage
Loans
April 1992
Wayne E. Etter
Mortgage loan calculations are based on present value
concepts. Although they usually are made with a calculator or a
computer, learning how present value basics can be used to calculate
the payment provides the understanding needed to solve practical
mortgage calculation problems.
Present Value Basics
A borrower obtains a $100,000, 10 percent, 25-year loan.
Repayment of this loan requires 25 annual payments of $11,017.
Because the annual payments are equal, they are an annuity, and its
present value can be calculated. Using a discount rate of 10 percent
(and ignoring rounding error), the present value of the annuity is
equal to the amount of the loan.
Annual payment x Annuity factor = Present value
(10%, 25 years) of payments
$11,017 x 9.077 = $100,000
The annuity factor can be calculated by solving for the
present value of a $1-per-year payment, discounted at 10 percent for
25 years or obtained from a present value table.
These terms can be rearranged to calculate the loan
payment:
Loan amount x
1
= Annual payment
Annuity factor
$100,000 x
1
= $11,017
9.077
Usually, however, the appropriate mortgage constant is used
to calculate the payment. Mortgage constant tables are found in
many real estate textbooks and are published in special books of
financial tables. The mortgage constant can be calculated by solving
for the payment of a $1 loan using the appropriate interest rate and
repayment term.
EVALUATI NG THE DATA
85
Loan amount x Mortgage constant = Annual payment
(10%, 25 years)
$100,000 x .11017 = $11,017
Examination of these two methods indicates that the annuity
factor and the mortgage constant are reciprocals:
1
= Mortgage constant
Annuity factor
When monthly mortgage payments are required, monthly
mortgage constants rather than annual mortgage constants are used.
Although most mortgage loans are repaid monthly, annual mortgage
loan payments normally are used for illustration.
If the borrower actually receives $100,000 from the lender
and then pays the $11,017 annually to the lender, the lender earns
and the borrower pays a true rate of 10 percent on the loan. In fact,
10 percent is the internal rate of return because 10 percent is the rate
of discount that makes the present value of the loan payments equal
to the loan amount. If less than $100,000 is received by the borrower
but payments of $11,017 are still made, then the true rate is greater
than 10 percent. This situation occurs when points or other financ-
ing costs are paid by the borrower to the lender.
Figure 1. Illustration of a Declining-Balance
Mortgage Loan
Loan amount: $100,000
Interest rate: 11%
Term: 10 years
Mortgage constant: 0.1698014
Payment: $16,980.14
Year Payment Interest Principal Balance
1 $16,980.14 $11,000.00 $5,980.14 $94,019.86
2 16,980.14 10,342.18 6,637.96 87,381.90
3 16,980.14 9,612.01 7,368.13 80,013.77
4 16,980.14 8,801.52 8,178.62 71,835.15
5 16,980.14 7,901.87 9,078.27 62,756.88
6 16,980.14 6,903.26 10,076.88 52,679.99
7 16,980.14 5,794.80 11,185.34 41,494.65
8 16,980.14 4,564.41 12,415.73 29,078.92
9 16,980.14 3,198.68 13,781.46 15,297.46
10 16,980.14 1,682.72 15,297.42 0.05
I NVESTMENT BY DESI GN
86
The calculated mortgage payment is sufficient to repay the
principal amount borrowed during the term of the loan. In addition,
the lender receives and the borrower pays the stated rate of interest
on the outstanding balance of the loan. Figure 1 illustrates how the
principal is repaid during the term of the loan. Note that a small
balance remains after the last payment. This will almost always be
true because all payments are rounded to the nearest cent.
Sometimes there is a need to estimate a mortgage’s unpaid
balance as of a certain date. For example, assume a $50,000 loan was
made for 25 years at an 8 percent rate. The appropriate mortgage
constant is 0.0937 and the annual payment is $4,685.
Loan amount x Mortgage constant = Annual payment
$50,000 x .0937 = $4,685
What is the unpaid balance of the loan after seven payments
have been made? Consider that the loan is still an annuity but has
only 18 remaining annual payments. To find the unpaid balance, the
present value of the annuity is calculated using the annuity factor for
8 percent and 18 years.
Annual payment x Annuity factor = Unpaid balance
$4,685 x 9.372 = $43,907.82
What if the owner desires to sell the mortgage after receiving
the seventh payment? Assume the current mortgage rate for this
type of loan is 12 percent. Again, the mortgage is an annuity with 18
remaining payments of $4,685. To determine the current market
price of the mortgage, the payments are discounted using the annuity
factor for 12 percent and 18 years.
Annual payment x Annuity factor = Market value
$4,685 x 7.250 = $33,966.25
The decreased value of the mortgage results from the fact
that the fixed payments must provide a higher rate of return to the
owner of the mortgage than is provided in the mortgage, i.e., 12
percent versus 8 percent. Note that the rate of return and value vary
inversely for a security that provides a fixed income stream.
Mortgage Constant
From the perspective just presented, mortgage constants are
simply numbers from a table used to calculate mortgage loan
EVALUATI NG THE DATA
87
payments. Although this is true, mortgage constants also indicate the
cash cost of borrowing money in much the same way as the interest
rate for other types of loans. For example, on a $100,000, 12 percent,
interest-only loan, the borrower expects to pay $12,000 annual
interest.
Annual interest
= Interest rate
Loan amount
$12,000
= 12 percent
$100,000
Because the mortgage loan payment includes principal and
interest, the annual payment must be larger than the amount
sufficient to pay the annual interest. If a 12 percent, $100,000
mortgage loan is to be repaid in 25 years, the annual payment is
$12,750.
Mortgage constant x Loan amount = Loan payment
.1275 x $100,000 = $12,750
Rearranging terms:
Loan payment (principal + interest)
= Mortgage constant
Loan amount
$12,750
= .1275 percent
$100,000
Thus, the mortgage constant, like the interest rate, expresses
the cash cost of borrowing money. Because of this, the mortgage
constant is often quoted as an indicator of borrowing costs in a
manner similar to the interest rate. When this is done, the mortgage
constant is expressed in percentage terms, not as a decimal fraction–
12.75 percent, not 0.1275.
The mortgage constant at a particular interest rate always
exceeds that interest rate because it includes the amount neces-
sary to repay the loan over the life of the loan and pay the interest
on the loan. Therefore, extending the maturity of the loan reduces
the payment because the principal repayment is spread over more
years. Thus, the mortgage constant is a function of the interest rate
and the maturity. A review of a mortgage constant table reveals that
as the loan maturity is increased, the mortgage constant decreases
from one plus the interest rate to a value almost equal to the interest
rate (the interest rate is the mathematical limit of the function).
I NVESTMENT BY DESI GN
88
Figure 2. Reduction in Annual Payments Required
to Amortize a $1,000 Loan
at Selected Rates and Maturities
Interest Annual payment Decrease from
Rate (%) 15 years 20 years 15-year payment (%)
6 $102.96 $ 87.19 15.32
8 116.83 101.85 12.82
10 131.47 117.46 10.66
12 146.83 133.88 8.82
Interest Annual payment Decrease from
Rate (%) 20 years 25 years 20-year payment (%)
6 $ 87.19 $ 78.23 10.27
8 101.85 93.68 8.02
10 117.46 110.17 6.21
12 133.88 127.50 4.76
Interest Annual payment Decrease from
Rate (%) 25 years 30 years 25-year payment (%)
6 $ 78.23 $ 72.65 7.13
8 93.68 88.83 5.18
10 110.17 106.08 3.71
12 127.50 124.14 2.63
For example, mortgage payments were calculated at four
different interest rates and for increasing maturities. These compari-
sons are presented in Figure 2. The mortgage constant and, therefore,
the annual cost of borrowing decreases as the maturity of the loan
increases. Note, however, that the percentage decrease is largest
when the loan term is increased from 15 to 20 years and the
decrease is least when the loan term is increased from 25 to 30
years. Further note that at higher interest rates there is less to be
gained in the way of mortgage payment reduction from extending the
loan’s maturity than there is at lower interest rates.
The ready availability of calculators and computers allows
most mortgage loan calculations to be made quickly and easily.
Sometimes, however, solving a problem requires more than knowl-
edge of the proper calculator keystrokes. In such cases, basic present
value concepts such as annuities and mortgage constants can be used
to assist in problem solving. Knowledge of these concepts provides
greater understanding of the usefulness of the result.
EVALUATI NG THE DATA
89
Now that the basics of present value have been presented,
the use of present value techniques to estimate the value of income-
producing real estate will be examined. Although some investment
considerations are introduced, the main focus of this series continues
to be explaining the mechanics of present value techniques.
As demonstrated in this section, the present value of all the
expected cash benefits, discounted at the appropriate discount rate is
the maximum price that can be paid for the expected cash benefits if
the required return is to be obtained. This maximum price may be
called the property’s investment value. Investors should seek
properties with investment values in excess of their cost.
The real estate investor anticipates cash benefits in the form
of after-tax cash flow from operations and resale. When debt is used,
the mortgage lender generally receives periodic mortgage payments of
a predetermined amount but also may expect a share of other
benefits such as rents, cash flow or appreciation. Thus, an income
producing property’s investment value is equal to the present
value of all cash benefits expected by the equity investor, discounted
at the investor’s required rate of return, plus the cash benefits
expected by the lender, discounted at the lender’s required rate of
return.
Estimating a property’s investment value is important. The
present value approach reflects all variables that contribute to a
property’s investment value and that an investor considers in mak-
ing the investment decision. If the property’s investment value does
not equal or exceed its purchase price or cost to develop, the property
should not be considered further.
The property’s cash benefits are based on projections and
assumptions about expected rental rates, vacancy rates and operating
expenses, financing terms and loan amount, tax rates and the
projected holding period made by the equity investor and the lender.
Because these projections and assumptions result in estimating the
after-tax cash flow from operations and resale (the equity investor’s
benefits) and the property’s estimated debt service (the lender’s
July 1990
Wayne E. Etter
Estimating Value
I NVESTMENT BY DESI GN
90
benefits), the property’s investment value is affected by any changes
in any of these variables.
In Figure 1, for example, estimates of after-tax cash flows
from operations and resale are presented. Except for the vacancy rate
assumption, both estimates of cash benefits are calculated using
identical inputs. The 10 percent vacancy rate assumption, versus the
5 percent vacancy assumption, resulted in reduced after-tax cash
flows from operations each year; furthermore, because the greater
vacancy reduced the property’s expected net operating income, the
property’s estimated resale price and after-tax cash flow from resale
was less at the end of the holding period. This vacancy assumption
results in a reduced investment value and demonstrates the
sensitivity of the calculation to changes in the assumptions.
As noted previously, the required rate of return is used in
calculating investment value. Because capital is usually contributed
by equity investors and lenders, each can have a different required
rate of return.
The required return on equity is the minimum after-tax rate
of return that an investor must earn on the equity-financed portion
of the investment. It is used to calculate the present value of the
estimated after-tax cash flow from operations and resale that accrues
to the equity investor. If the investor pays more for the expected
benefits than their present value, the investor’s wealth will decline
because the investor will have paid more for the expected income
stream than it is perceived to be worth.
Figure 1
5% Vacancy 10% Vacancy
Year ATCF/OP PV at 15% ATCF/OP PV at 15%
1 $ 7,695 $ 6,691 $ 5,286 $ 4,597
2 8,574 6,443 6,366 4,814
3 9,374 6,164 7,315 4,810
4 10,191 5,827 7,831 4,477
5 11,026 5,482 8,595 4,273
Total $ 30,647 $ 22,971
ATCF/SALE
5 $161,453 $ 80,271 $137,414 $ 68,319
PV of Equity 110,918 91,290
PV of Debt 240,898 240,898
Investment value $351,816 $332,188
EVALUATI NG THE DATA
91
The lending rate is the lender’s required rate of return, but it
is not necessary to discount the lender’s expected benefits to find the
present value of the lender’s portion: the loan amount is equal to the
present value of the lender’s expected benefits (mortgage receipts,
plus expected participation, if any) discounted at the lender’s re-
quired rate of return (the lending rate). Thus, as shown in Figure 1,
investment value may be calculated by adding the loan amount to
the present value of the equity benefits.
The property’s perceived risk, the terms of purchase, its
financing or a particular investor’s tax situation can affect the
property’s investment value for a particular investor. Thus, one
investor is willing to pay more for a particular property than another
investor. For example, the effect of using a 25 percent required rate of
return instead of 15 percent in calculating investment value is shown
in Figure 2. The difference in the two investment values results
entirely from the difference in the investor’s required rate of return,
which reflects a difference in the investor’s perception of the the
property’s risk. The degree of risk depends on the difference between
expected and actual outcomes. If the expected outcome is guaran-
teed, then the risk is negligible; if there is great uncertainty about the
expected outcome, then the risk is significant. The usual assumption
is that riskier investment streams are discounted at higher rates.
The effect of debt financing on a property’s investment value
also can be analyzed. For example, the effect of increasing the
amount of debt from 75 percent of cost to 90 percent of cost when
Figure 2
Year ATCF/OP PV at 15% PV at 25%
1 $ 7,695 $ 6,691 $ 6,156
2 8,574 6,443 5,487
3 9,374 6,164 4,799
4 10,191 5,827 4,174
5 11,026 5,482 3,613
Total $ 30,647 $ 24,229
ATCF/SALE
5 $161,453 80,271 52,905
PV of Equity $110,918 $ 77,134
PV of Debt 240,898 240,898
Investment value $351,816 $318,032
I NVESTMENT BY DESI GN
92
there is positive financial leverage is presented in Figure 3. If no other
assumptions are changed, this change increases the property’s
investment value. Such a result is entirely in accord with what is
observed in the real world: when lenders finance more generously,
investors are willing to pay higher prices for property. Although
investors may not make such calculations, they do understand the
benefits of using more debt. Of course, they may not always consider
the consequences of additional risk accompanying the additional
debt.
Thus, the investment value is for a particular property and
for a particular set of circumstances. Because it is not an estimate of
market value, the investor cannot necessarily expect to purchase or
sell the property for the estimated investment value; rather, this is
the value of the property using a particular set of assumptions; if
unreasonable assumptions are made, the investment value calculated
for a particular investor may vary from the property’s market price.
Obviously, these factors also affect the property’s expected
internal rate of return and net present value of equity as well. How-
ever, the present value approach to estimating investment value is
important because it is possible to determine the effect of particular
assumptions on the property’s investment value, and, therefore, it is
possible to explain why particular investors are willing to pay a price
for a property while other investors believe the property is overpriced:
the assumptions used and the terms available produce a higher
estimate of investment value. Negotiations between buyers and
Figure 3
75% Debt 90% Debt
Year ATCF/OP PV at 15% ATCF/OP PV at 15%
1 $ 7,695 $ 6,691 $ 2,143 $ 1,863
2 8,574 6,443 3,313 2,505
3 9,374 6,164 4,518 2,971
4 10,191 5,837 5,759 3,293
5 11,026 5,482 7,038 3,499
Total $ 30,647 $ 14,131
ATCF/SALE
5 $161,453 80,271 116,903 58,121
PV of Equity $110,918 $ 72,252
PV of Debt 240,898 289,877
Investment value $351,816 $362,129
EVALUATI NG THE DATA
93
sellers revolve about terms and price; therefore, the calculated
investment value may be compared to a property’s cost or offering
price.
Income capitalization often is used to estimate a property’s
current or future market value. Typically for this purpose, a
property’s net operating income (NOI) for an appropriate year is
divided by the overall capitalization rate derived from the market.
Assume, for example, that a property’s estimated NOI is $10,000
and an overall capitalization rate of 10 percent is used.
Net operating income
Estimated market value =
Overall capitalization rate
$10,000
$100,000 =
.10
Income capitalization and ordinary present value calcula-
tions can be combined to estimate market value. For example,
assume a property’s NOI is expected to increase from $5,000 to
$10,000 per year over a five-year period and then stabilize at
$10,000 per year. Capitalizing the first year’s NOI produces a value
of $50,000, which undervalues the property; capitalizing the stabi-
lized NOI produces a value of $100,000, which overvalues the
property. But by adding the present value of the NOI for years one
through five to the present value of the property’s capitalized value at
the end of year five, a better estimate of the property’s market value
is obtained. These calculations are presented in Figure 4.
Figure 4
Capitalized Present Value
Year NOI Value at 10%
1 $ 5,000 $4,545.45
2 6,000 4,958.68
3 7,000 5,259.20
4 8,000 5,464.11
5 10,000 6,209.21
10,000 = $100,000 62,092.13
.10 $88,528.79
I NVESTMENT BY DESI GN
94
However, what if the demand for space is currently depressed
and the property’s expected increase in NOI is based on an expected
increase in demand for space? Although the analyst may be
convinced that the demand will recover by the fifth year, the analyst
is concerned that the projected demand levels in the early years will
not be achieved. It may be prudent, therefore, to reflect this
perceived risk by adopting the unusual approach of discounting the
NOI in the early years at a higher rate than the later years when the
NOI is approaching the stabilized level (see Figure 5). A comparison
of Figures 4 and 5 indicates that the riskier income stream has the
lower value.
Figure 5
Capitalized Discount Present Value
Year NOI Value Rate (%) at 10%
1 $ 5,000 12.0 $ 4,464.29
2 6,000 11.5 4,826.16
3 7,000 11.0 5,118.34
4 8,000 10.5 5,365.88
5 10,000 10.0 6,209.21
10,000 = $100,000 10.0 62,092.13
.10 $88,076.01
Appraisal reports sometimes contain calculations similar to
those in Figure 4 and 5. These should be examined closely; in
particular, the discount rate selected should be carefully explained
and justified. In some cases, the discount rate is related to returns
available from securities such as U.S. government bonds or
certificates of deposit rather than the property market. However,
when the same income stream is being valued, the discount rate
and the capitalization rate ought to be derived from the same
source.
Because of recent developments in financial calculators and
personal computer software, it is possible to solve quickly a number
of real estate present value problems. Even with such assistance,
however, it is necessary to know how present value works. Providing
this knowledge is the purpose of the last three sections.
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95
Many commercial property market brokers, lenders and
owners use real estate appraisals having an income approach value
estimate derived from direct capitalization and discounted cash flow
(DCF) analyses. The differences between these methods and their
appropriate use are the focus of this section.
To estimate value with direct capitalization, a property’s
stabilized net operating income (NOI) is divided by the market
capitalization rate (Figure 1). Estimating value with DCF analysis
requires estimates of each year’s NOI along with the property’s
expected reversion value at the end of the analysis period. Usually
the analyst uses income capitalization to estimate the reversion.
These expected cash benefits are then discounted at the appropriate
rate to obtain the market value estimate, also shown in Figure 1.
Estimating Net Operating Income
Although these calculations are simple and straightforward,
they depend on the appraiser’s assumptions or estimates. When
using direct capitalization, the property’s stabilized NOI must be
estimated. This estimate is developed from market data (rental
rates, vacancy and collection loss rates and operating expense data)
for comparable properties in the market area; it represents the
appraiser’s opinion of how the property ought to perform.
Because the appraiser’s opinion is based on observed market
data, it’s difficult to quibble with his or her NOI estimate. When a
market is “normal,” the notion of stabilized NOI is particularly
useful.
But two areas are of special concern. First, what if the
property has significant vacancy at the time of the appraisal? Obvi-
ously, no one develops a property with the expectation of significant,
permanent vacancy. So, the appraiser may use a market vacancy rate
(or the anticipated vacancy rate when the property is fully leased)
Direct Capitalization
or Discounted Cash
Flow Analysis?
Fall 1994
Wayne E. Etter
I NVESTMENT BY DESI GN
96
Figure 1. Estimating Value with Direct Capitalization
and DCF Analysis
NOI $10,000
Value = ————————— = ––—— = $100,000
Capitalization rate .10
Year NOI Reversion Total
1 $10,000 $10,000
2 10,000 10,000
3 10,000 10,000
4 10,000 10,000
5 10,000 $100,000 $110,000
Present value at 10% = $100,000
rather than the property’s actual vacancy rate. This results in a
larger NOI for the subject property and may overstate the property’s
value. Second, if the property’s future NOI is expected to increase
because of greater demand for space that leads to higher rental rates,
direct capitalization of a single year’s NOI may understate the
property’s value.
Because DCF analysis permits annual adjustments in rental
rates, vacancy and collection loss rates and operating expenses, DCF
analysis can be used to reflect a buyer’s expectations of increasing
NOI over time. When a property is expected to become fully leased
during the next three to five years, for example, the current vacancy
rate can be reduced until the desired occupancy is reached.
This specification of expected changes results in realistic
NOI estimates throughout the period–a result far superior to capital-
izing a single year’s NOI. On the other hand, just assuming that the
vacancy rate will be reduced during the three-year period may lead to
overestimating NOI.
DCF analysis is ideally suited for situations such as this.
However, DCF analysis does not add much useful information when
the subject property is fully leased and no changes in occupancy or
the external environment are anticipated that will affect NOI. As
shown in Figure 1, the present value of a series of equal annual cash
flows is equivalent to the capitalized value.
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97
It is not an error to use DCF analysis to value a property
when no significant change in NOI is expected. However, appraisal
report users should understand that this technique’s results are no
better than those produced by a correct application of direct capitali-
zation. Of course, if both techniques, properly used, achieve similar
values, the estimated value has greater credibility.
Selecting Capitalization and Discount Rates
Theoretically, concerns about capitalizing a single year’s NOI
are eliminated by the appraiser’s skill in deriving the market capitali-
zation rate from comparable sales. If the market capitalization rate is
derived from sales of properties with vacancy rates comparable to the
subject and with comparable buyer expectations about becoming
fully leased (or for increased NOI), the subject property’s value could
be estimated with an unadjusted NOI and the market capitalization
rate.
Buyers who expect their properties’ occupancy levels to
improve pay prices that reflect this expectation. Likewise, buyers
who expect the future NOI of their properties to increase pay prices
reflecting that expectation. In both cases, expectations are reflected
by observed capitalization rates.
The appraiser’s problem arises when appropriate
comparables cannot be located. In this case, the appraiser must
develop the capitalization rate and estimate the NOI from the best
available comparables to produce a market value estimate that
reflects these expectations.
For DCF analysis, an appropriate discount rate is used to
convert the NOI estimates to a value estimate. When DCF analysis
is used to estimate a property’s market value, the discount rate
ought to be extracted from the market using the data of comparable
properties. Thus, the need for appropriate comparables is the same
for DCF analysis and for direct capitalization. (When DCF analysis
is used for investment analysis, the investor’s required rate of return
ought to be used to discount the expected cash flow.)
Deriving a discount rate from the market is more difficult
than estimating the market capitalization rate. For each comparable
property used in the derivation, the buyer’s expectations about future
NOI and reversion would have to be determined. This would allow
calculation of the discount rate that equates these expectations to the
purchase price. (Estimating the market capitalization rate requires
only each comparable property’s NOI and the reported sales price.)
I NVESTMENT BY DESI GN
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After obtaining the discount rate for each comparable prop-
erty, the analyst would select the appropriate discount rate for the
subject property. The process is the same as choosing the appropriate
capitalization rate from comparable sales.
While this procedure is possible, it would be difficult in
practice. Therefore, the discount rate often is estimated by adding a
risk premium and a liquidity premium to a relatively risk-free rate of
return, such as the U.S. Treasury bill rate or to the yield of some
other security. This built-up rate is used to discount the expected
cash flows. Although a theoretically correct approach, its use re-
quires a serious attempt to ascertain the risk and return differences
between the subject property and the security.
Investor surveys offer another approach for selecting an
appropriate discount rate. Such surveys report investors’ expecta-
tions for several different property types. The obvious problem with
their use is that they report general expectations rather than the
expectations for a specific property in a specific market.
Sometimes several different discount rates are tried; the rate
that results in a market value estimate approximately the same as
that obtained with direct capitalization is selected. Then, the
reasonableness of this rate of return is verified by comparing it to
investor returns in other markets.
Figure 2. A Comparison of Direct Capitalization
and DCF Analysis with Income Growth
Year NOI Reversion Total
1 $10,000 $10,000
2 10,500 10,500
3 11,000 11,000
4 11,500 11,500
5 12,000 $125,000 $137,000
Present value at 14.6% = $100,000
NOI $10,000
Value = ————————— = ——— = $100,000
Capitalization rate .10
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99
Normally, the discount rate is greater than the capitalization
rate. Why? As reported in Figure 1, if no change in cash flows is
anticipated, the discount rate is equal to the capitalization rate.
However, as Figure 2 shows, an increasing income stream requires
that the discount rate be greater than the capitalization rate if the
two separately determined values are to be equal. (They must be
equal because the property can not have two values.) Therefore,
because forecasts of increasing income are common, the discount
rate used is normally greater than the discount rate. In fact, in a
perfect world, the discount rate is equal to the capitalization rate plus
the weighted average of the net operating income and the property
value annual growth rates.
Choice Difficult, Necessary
Direct capitalization and DCF analysis are each appropriate
in certain circumstances. In particular, direct capitalization is well
suited for properties expected to have stable NOI; DCF analysis is
well suited for properties expected to have fluctuating NOI. Selecting
the appropriate capitalization rate and discount rate may sometimes
be difficult for both techniques.
A prime benefit of DCF analysis is that in gathering the data
required to estimate NOI for the analysis period, a good deal is
learned about the subject property’s prospects. A DCF analysis
requires careful consideration of expected supply and demand for a
particular type of space and operating expenses. Properly done, such
an analysis can provide much information not apparent through
direct capitalization.
Often, however, the primary use of DCF analysis is the
confirmation of the direct capitalization market value estimate.
Despite the fact that for some properties the NOI estimates used in
DCF analysis may be more accurate, independent confirmation of
the direct capitalization market value estimate requires an appropri-
ate discount rate. Merely using a discount rate that seems reason-
able to get a value estimate with DCF analysis approximately equal
to the value estimate obtained with direct capitalization is not a
confirmation.
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Debt Financing:
Rewards and Risks
Using debt to finance income-producing real estate is an
accepted practice. Although the rewards of debt financing can be
significant, so are the risks. Unfortunately, many investors anticipate
only the rewards of debt financing and give little attention to risks.
Obviously, when debt financing is arranged, both the lender
and the investor anticipate that income will be adequate to service
the debt; in fact, the usual assumption is that a property’s net
operating income will increase during the
holding period. With fixed debt service,
this assumption results in an improving
margin of safety during the holding
period (Figure 1).
Nevertheless, the use of debt
gives rise to financial risk–the risk that
there will be inadequate income to meet
debt service requirements. Although
there may be a trend toward the use of
less debt in some real estate syndications,
the possible benefit of using less debt is
October 1989
Wayne E. Etter
Analyzing Risk
and the Use of Debt
9
ANALYZI NG RI SK AND THE USE OF DEBT
101
not well understood. In today’s market, however, consideration
should be given to revising the accepted practice of using as much
debt as can be obtained to finance real estate. This could create a
new investment product with reduced risk that appeals to investors
wary of traditionally financed real estate.
Why Use Debt?
The expected after-tax rate of return from a real estate
investment is determined by the expected benefits of the invest-
ment–after-tax cash flow and appreciation–and the cash required to
purchase the property. Investors determine a proposed real estate
investment’s expected rate of return and compare the result with the
minimum return required to undertake the investment. A further
test is a comparison of the property’s estimated investment value
with its cost. A property’s investment value is equal to the present
value of all the cash benefits expected by the equity investor, dis-
counted at the investor’s required rate of return, plus the amount of
the mortgage.
Real estate investors wish to use debt if its use will increase
the after-tax return on equity (ATRE) and the property’s investment
value. Using debt this way is known as financial leverage. For in-
stance, the ATRE and the investment value were calculated for a
typically structured income property using varying amounts of debt
with the following results:
Amount of debt (%) ATRE (%) Investment value ($)
None 13.26 301,198
50 17.23 334,943
75 23.84 351,815
90 37.27 361,329
When the amount of debt is held constant at 75 percent and
the interest rate is varied, the following results are obtained:
Interest rate (%) ATRE (%) Investment value ($)
10 27.04 362,974
12 23.84 351,815
14 20.42 340,106
16 16.77 327,506
18 13.26 314,829
20 9.90 302,103
I NVESTMENT BY DESI GN
102
Analyzing these results reveals that the ATRE and the
investment value of the property increase as a larger proportion of
the property is financed with debt having a constant cost. Also the
ATRE and the investment value decrease as the interest rate is
increased when the proportion of financing is held constant. Eventu-
ally, the ATRE and the investment value, when financed with high-
cost debt, are less than the property’s ATRE and the investment
value without debt. Thus, the beneficial effects of debt financing are
limited–expensive debt is worse than no debt.
Other factors also affect whether or not the use of debt is
favorable. If the expected benefits (after-tax cash flow and apprecia-
tion) increase for reasons such as increased rent levels, reduced
vacancy rates or operating expenses, increased rate of appreciation or
reduced tax rates, the expected ATRE and the investment value will
increase at any given debt level or interest rate. Therefore, increased
investor expectations justify the use of higher cost debt. During
periods of rapid property appreciation, high interest rates will not
deter investors from using debt financing to buy properties.
An investor is indifferent between two investment opportuni-
ties having the same expected rate of return only if they have the
same risk. Thus, the returns of various investments often are com-
pared by evaluating both their risk and their expected return. The
usual assumption is that riskier investments have increased returns
(Figure 2). Such investments also can have increased losses; the
line represents expected returns.
Risk exists in all projects, but some are more risky than
others. The degree of risk depends on the difference between ex-
pected and actual outcomes. If the expected outcome is guaranteed,
then the risk is negligible; if there is great uncertainty about the
expected outcome, then the risk is significant.
As earlier stated, financial risk is
present when debt is used. Because the
investor and the lender believe that the
debt can be managed when the property is
financed, the principal source of financial
risk is unanticipated variation in the
property’s income stream over time.
There is a particularly important connec-
tion between business risk (the risk of
failing to generate sufficient income),
management risk (the risk of failing to
respond properly to changes in the
ANALYZI NG RI SK AND THE USE OF DEBT
103
business environment and, therefore, failing to earn a satisfactory
return) and financial risk (the risk of having inadequate income to
meet debt service requirements).
If a project is believed to have little business and manage-
ment risk, then a high proportion of potential gross income could be
committed to the payment of operating expenses and debt service. If
the opposite is true, a much lower proportion of potential gross
income should be committed to the payment of operating expenses
and debt service. A project’s operating expenses are somewhat fixed
in the short-run and vary directly with potential gross income over
time; the operating expense ratio should be constant over time.
Limiting the total funds available for the payment of operating
expenses and debt service has a direct impact on the amount of
funds available for debt service and, therefore, the amount of debt,
called allowable debt.
Projects believed to have little business and management risk
(i.e., there is little expected variation in the income stream) could
have higher levels of debt without creating excessive financial risk.
On the other hand, projects believed to have significant exposure to
business and management risk should have much less debt so that
excessive financial risk is not created. For example, assume two
properties are identical except for risk:
Low-risk High-risk
property property
Potential gross income $100,000 $100,000
Percentage allowed for operating
expenses and debt service .90 .60
Funds available for operating
expenses and debt service $90,000 $60,000
Operating expenses 30,000 30,000
Available for debt service $60,000 $30,000
Divide by mortgage constant .1275 .1275
Allowable debt $470,588 $235,294
At any given mortgage constant, $60,000 will service twice
as much debt as $30,000. This approach allows the risky building
much less debt financing and achieves a result similar to what is
observed in other types of enterprises. Risky businesses must borrow
less than safer ventures.
I NVESTMENT BY DESI GN
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What Are the Benefits of This Approach?
The foregoing approach to risk results in some properties
being financed with much less debt than is considered normal. But,
for either building, the use of more debt to increase the expected
ATRE or investment value increases the likelihood of default.
Suppose, therefore, that a property is financed with more
than the amount of allowable debt to raise its expected ATRE and
investment value. This will cause total risk to exceed an acceptable
level given the investors’ required return. Under such a circum-
stance, investors should increase their required rate of return. The
additional return expected from the additional debt is not without
additional risk–greater risk must be matched by a greater required
return–and, therefore, the calculated increase in the ATRE is not an
additional benefit received without cost. Likewise, when estimating a
property’s investment value, investors must apply a higher discount
rate to the expected benefit stream. As a result, the beneficial effect
of using more debt may be offset by the effect of the higher discount
rate with the possible result of a decrease in the property’s invest-
ment value.
On the other hand, it is possible to use even less debt or no
debt to further reduce the exposure to financial risk and, thereby,
reduce total risk. Using less debt (or no debt) should increase the
investment quality of a property; such a course of action should
result in investors reducing their required rate of return for the
property and applying a lower discount rate when calculating invest-
ment value. As a result, the reduced benefits from using less debt
may be offset by the willingness of investors to accept a lower ATRE
and by the effect of the lower discount rate with the possible result of
an increase in the property’s investment value.
Assume, for instance, that a commercial property is leased to
quality tenants; the lease has several years to run and there is reason
to believe the current tenants will wish to renew their lease. The
property may be classified as a low-risk property because there is a
reasonable probability that the difference between the property’s
expected income stream and actual income stream will be small. If
the property is conservatively financed (perhaps even 100 percent
equity), it will be even more attractive to conservative investors.
Under such circumstances, the property’s income stream will be
highly predictable; investors will pay a premium price for such a
property.
ANALYZI NG RI SK AND THE USE OF DEBT
105
Next consider a property characterized by more business and
financial risk–fewer quality tenants with less assurance of lease
renewal when the current leases expire. There is a greater probability
that there will be a difference between the expected income stream
and the actual income stream. Financing such a property with, say,
75 percent debt may result in the property’s total risk being exces-
sive. But, if this property is financed with less than 75 percent debt
(again, perhaps even 100 percent equity), investors may view the
property as an attractive investment. Properly estimated, the
property’s investment value may be higher with less or no debt.
Thus, the question is: Can an investor’s lower required rate
of return or discount rate offset the beneficial effects of financial
leverage on a property’s expected rate of return and investment
value? If so, income-producing real estate could be transferred from
the high-risk investment category when it is financed with a large
proportion of debt to a much lower risk category. Only by relating
investors’ required returns with risk and by calculating the invest-
ment value of a property using various assumptions can this ques-
tion be answered. If the answer is positive, more investors might be
attracted to real estate because income-producing real estate can
become a much less risky investment.
The real estate appraisal process depends on sales of compa-
rable properties and other market data. Although adjustments can be
made when the sold properties are not perfectly comparable to the
subject property, some sales are required. However, there have been
few recent property sales in some markets, and bid and ask price
may differ considerably.
Today, therefore, real estate appraisers often work in markets
where sales of comparable properties are infrequent or nonexistent.
To value properties in such a difficult market, they must use tech-
niques to compensate for the lacking market data.
This article examines the effect of few comparable sales on
one aspect of the appraisal process.
Appraising in
Difficult Markets
January 1992
Wayne E. Etter
I NVESTMENT BY DESI GN
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Approaches to Real Estate Appraisal
There are three commonly accepted approaches to estimat-
ing value: the sales comparison approach, the cost approach and the
income approach. Each is dependent on accurate market data. But in
a market characterized by few sales and little development activity,
certain data are difficult to obtain.
• Sales comparison approach. The estimate of market value is
based on recent sales of comparable properties. A lack of recent
comparable sales reduces this approach’s contribution to the
final estimate of value.
• Cost approach. The estimate of market value is based on the
cost of developing a similar property. When market values are
less than the cost of developing a new property, little, if any,
development takes place and the cost approach’s contribution to
the final estimate of value is limited.
• Income approach. The estimate of market value is based on
the relationship between the income and value of similar
properties. A lack of recent sales of comparable properties
makes it difficult to estimate the relationship between income
and value. When sufficient recent sales are not available,
appraisers sometimes use other methods, such as the band of
investment approach, to estimate the relationship.
Because the sales comparison approach obviously cannot be
used when there are few, if any, recent sales of comparable properties
and because the cost approach explains little when the cost of
development exceeds the market value, appraisers rely on the income
approach in such markets.
Income Capitalization Approach
To estimate a property’s market value by the income capitali-
zation approach, the property’s stabilized net operating income
(NOI) is divided by the appropriate overall capitalization rate (OAR).
NOI is a proxy for the investor’s expected benefits–the after-
tax cash flow from operations and resale (NOI ignores debt and tax
implications). NOI is estimated by using market rents and vacancy
rates, typical operating expenses and so forth. The OAR is estimated
from comparable properties–comparable properties’ NOI is divided
by their reported sales price and the OAR is obtained. Thus, the
resulting value is estimated from market data; if the data are gath-
ered from actual comparables, the resulting value estimate is reliable.
The price paid by an investor for the expected benefits
reflects the investor’s required return. The OAR is not a real rate of
ANALYZI NG RI SK AND THE USE OF DEBT
107
return; rather, it reflects the relationship between a proxy for the
expected benefits and the price paid for those benefits. As the per-
ceived risk of receiving the benefits is reduced, the investor will pay a
greater price for the benefits (and vice versa).
Appraisers also use the band of investment approach to
estimate the OAR. This approach recognizes that income-producing
real estate typically is financed with a mixture of debt and equity and
that each financing source must receive a satisfactory return. If there
are no recent comparable sales, the OAR cannot be derived from
market data, but the band of investment approach can be used to
estimate the OAR if financing is available on the assumed terms.
When using the band of investment approach, the OAR is
estimated by taking a weighted average of the lender’s required
return (the mortgage constant) and the investor’s required equity
capitalization rate (before-tax cash flow divided by the initial equity
investment).
In theory, the OAR estimated by the band of investment
approach is equal to the OAR estimated from comparable sales
because both approaches should yield the same value. Thus:
NOI
=
NOI
= Value
OAR
1
OAR
2
OAR
1
= market data approach
OAR
2
= band of investment approach
The method used to estimate the OAR does not matter if
the assumed financing terms are available. But, what if the OAR is
estimated by the band of investment approach and the assumed
financing terms are not actually available in the market? This is an
important question. Although many income properties cannot be
financed today, many appraisers continue to assume the availabil-
ity of typical financing when they estimate the value of such
properties. To answer this question, the role of financial leverage
must be considered.
The purpose of financial leverage is to enhance the investor’s
after-tax return on equity. If there is less debt (or no debt), the after-
tax return on equity is reduced, holding all other variables constant.
Of course, using less debt reduces the project’s financial risk and an
investor might reduce the required rate of return because of the
project’s reduced financial risk. (For a more complete discussion of
financial leverage, see “Debt Financing: Rewards and Risks.”)
I NVESTMENT BY DESI GN
108
However, using less debt than has been typical (especially if
the typical debt is nonrecourse debt), may be viewed as an increased
risk by the investor who must now contribute a larger percentage of
equity than before. The investor may require a larger return on
equity, even though the project’s financial risk is reduced. At the very
least, the advantage of financial leverage is lost and the investor may
offer less for the property to earn the same after-tax return when the
property is acquired with reduced debt or no debt.
Consider, for example, an income property producing a
$39,000 NOI. Assuming that it can be financed with 75 percent debt
having a 12.75 percent mortgage constant and that the equity
investor’s required capitalization rate is 10.3 percent, the estimated
OAR is 12.1 percent and the property’s estimated value is $322,314.
Proportion x Cost
Debt .75 .1275 = .096
Equity .25 .1030 = .026
OAR .121*
NOI $39,000
Value = = $322,314
OAR .121
(* difference due to rounding)
Further assume that an investor uses a discounted cash flow
model with specific assumptions about rent, vacancy rates, operating
expenses, holding period, resale price and so forth to calculate the
expected after-tax internal rate of return on equity (ATIRRE). If the
investor uses these assumptions along with a $322,314 purchase
price and the foregoing financing terms, the expected ATIRRE is
approximately 24 percent. If the investor discovers that lenders will
lend only 60 percent of the purchase price, what is the OAR and the
property’s estimated value? If the debt and equity proportions are
changed, the following result is obtained.
Proportion x Cost
Debt .60 .1275 = .077
Equity .40 .1030 = .041
OAR .118
NOI $39,000
Value = = = $329,950
OAR .118
ANALYZI NG RI SK AND THE USE OF DEBT
109
This, however, is an error. The property’s value actually will
decrease (rather than increase from $322,314 to $329,950) be-
cause of the reduced financing. Why? If the investor requires an
ATIRRE of approximately 24 percent to undertake the investment,
the purchase price must decrease, holding constant all factors except
financing. Using the same assumptions as before, an ATIRRE of
about 24 percent results when the investor pays $289,000 and
obtains a loan equal to 60 percent of the purchase price using a
mortgage constant of 0.1275. Thus, the property’s capitalization rate
is 13.5 percent instead of 11.8 percent; this implies a required equity
capitalization rate of 14.5 percent.
NOI $39,000
= OAR = = .135
Value 289,000
Proportion x Cost
Debt .60 .1275 = .077
Equity .40 .1450 = .058
OAR .135
What if financing is unavailable? If the investor’s required
ATIRRE remains the same, the price must decrease to approximately
$208,600. Holding all other factors constant, the property’s capitali-
zation rate and equity capitalization rate increase to 18.7 percent.
NOI $39,000
= OAR = = .187
Value 208,600
Proportion x Cost
Debt n.a. nil = nil
Equity 1.00 .1870 = .187
OAR .187
Relationship to Current Market
How do these calculations relate to the current market?
They help to explain the gap between the sellers’ expected price and
the price buyers are willing to pay. Potential buyers are noting both
the reduced expectations about rental income and the lack of
typical financing. In the absence of market transactions, many
appraisal reports rely on the band of investment approach (or one of
the similar approaches) to derive an OAR. However, to assume
financing terms that are not available overstates the property’s
estimated market value, even though the property’s NOI may be
appropriately stabilized.
I NVESTMENT BY DESI GN
110
Towards Evaluating
Commercial
Properties
Many lenders no longer actively pursue commercial real
estate loans. Because of the widespread delinquencies of commercial
real estate loans made in the 1980s, lenders apparently believe other
sectors offer fewer problems, more opportunities or both. Addition-
ally, bank risk-based capital regulations and proposed insurance
company regulations require significantly more capital for commer-
cial real estate loans than for some other types of loans and assets.
The amount of capital required is based on the risk class of
the particular loan or asset. For example, investments in U.S.
government securities are considered risk-less; commercial real
estate loans are in the most risky category. A bank with assets
concentrated in commercial real estate loans (or other assets
considered equally risky) needs more capital than if it invests in less
risky assets or loans. Because capital has a cost, many commercial
banks find that investing in U.S. government securities is more
profitable than extending commercial real estate loans. With similar
rules set to take effect in the life insurance industry, that industry’s
role as a supplier of commercial real estate loans may diminish.
Among lenders who consider making new commercial real
estate loans, many are unwilling to make them on a nonrecourse
basis; they require personal guarantees in addition to liens on the
property. While other sources of commercial real estate financing,
such as real estate investment trusts, are increasingly important, the
issue of evaluating project risk appears to be central to the current
problems of financing commercial real estate.
Almost everyone who considers the problem of analyzing
commercial real estate suggests increasing the discount rate as a
means of compensating for risk. Increasing the discount rate reduces
the present value of the estimated cash flows and, therefore, the
property’s value because it is risky. Although this approach is correct,
this section focuses on controlling risk rather than adjusting for
Spring 1994
Wayne E. Etter
ANALYZI NG RI SK AND THE USE OF DEBT
111
risk. Paying a smaller price for risky real estate does not eliminate
the risk–the buyer just loses less.
Although several risks affect real estate value, three risks–
financial, business and management–are discussed here. Financial
risk (the possibility of inadequate income to service debt) is present
when debt is used. The investor and the lender must be convinced
that the debt can be managed if the pro forma projections made
when the property is financed are achieved. The principal reasons
why the debt service requirements may not be met are business risk
(the property may fail to generate sufficient income) and manage-
ment risk (the property’s managers may fail to respond properly to
changes in the business environment and, therefore, fail to earn a
satisfactory return).
A property’s income stream is the principal determinant of
its value and the source of the loan’s repayment unless the loan is
otherwise secured. Thus, if the property’s income stream varies over
time, there is great potential for default if the loan amount is deter-
mined, for example, by assuming a 95 percent occupancy rate and
lending 75 percent of a property’s capitalized value.
If the degree of business and management risk is assessed
and variation in the property’s income stream over time is highly
probable, less debt should be used.
Rating properties according to the expected stability of the
income stream permits lenders to loan an appropriate amount for
specific properties so total risk is not excessive. Although this would
be a new approach to financing real estate, it is similar to the ap-
proach used in home mortgage lending.
A prospective homebuyer cannot get a large loan just because
an expensive home is being purchased. This is true even though the
loan amount normally is limited to a percentage of the home’s value;
this allows the lender to foreclose on the asset in the event of a
default and sell it for an amount equal to or greater than the unpaid
loan balance. However, foreclosure and sale are the lender’s last
resort; lenders prefer to have the loan repaid as agreed.
To help ensure this result, lenders qualify the prospective
borrower’s ability to repay the loan by considering the applicant’s
current income and financial situation, credit history and employ-
ment record. If the applicant has an erratic income or employment
history or if an excessive proportion of the applicant’s current
monthly income is required to service the requested loan, the lender
refuses to grant the loan. Evaluating the stability of a commercial
I NVESTMENT BY DESI GN
112
property’s expected income stream is an entirely analogous analytical
problem.
As in home mortgage lending, the beginning point in
assessing the riskiness of a commercial property’s income stream is
developing a list of factors contributing to income stream fluctations.
The factors must be developed separately for each property type
(multifamily residential, office, retail, industrial). Furthermore, the
major property types must be subdivided into groups of properties of
varying size. Other property categories are possible. The important
point is to compare only like properties within the relevant market
area.
What factors are included? The following suggestions are a
starter list; they are not all-inclusive.
• Economic differences among market areas are important.
• Supply and demand conditions in the property’s market area
must be evaluated. Determine if an unmet need can be satis-
fied. How much vacant space exists currently in the market?
How likely is new space to enter the market? What is the
attitude of local planning authorities toward new space?
• The competitive position of the property must be assessed.
Evaluate the property’s site, age, size, construction quality and
design relative to similar properties.
• The property’s performance must be assessed. Analyze
occupancy, tenants’ credit quality, type of lease, average lease
rates and length of lease. When appropriate, tenant mix must be
evaluated.
• Additional factors must be considered for to-be-developed
properties. These include the developer’s reputation and
experience and the amount of pre-leasing. However, to-be-
developed properties should be scrutinized more than seasoned
properties because they have no market or operating history.
Many properties developed in the 1980s never achieved their
pro forma projections; perhaps to-be-developed properties
should be financed with more equity than seasoned properties
until their pro forma projections are achieved.
Identifying these factors is an ideal project for organizations
of real estate professionals. Once general agreement is reached about
which factors should be included and their relative importance, a
rating scale could be constructed.
Rating a property forces the analyst to consider carefully each
property characteristic in relation to other comparable properties in
ANALYZI NG RI SK AND THE USE OF DEBT
113
the market area. For example, “Retail Center A” with several “mom
and pop” tenants on month-to-month leases has a much less predict-
able income stream than “Retail Center B” with national credit
tenants on income long-term leases. Thus, Retail Center A receives a
lower score because it has more business and management risk. For
the more subjective factors, scaling may be difficult.
A property’s total score varies inversely with business and
management risk; a low score indicates more business and manage-
ment risk. When this is the case, the amount of debt financing should
be limited because the addition of financial risk creates excessive total
risk. For example, assume two properties are identical except for risk:
High-risk Low-risk
property property
Potential gross income $100,000 $100,000
Percentage allowed for oper-
ating expenses and debt
service x .60 x .90
Funds available for operating
expenses and debt service $60,000 $90,000
Operating expenses - 30,000 - 30,000
Available for debt service $30,000 $60,000
Divide by mortgage constant .1275 .1275
Allowable debt $235,294 $470,588
At any given mortgage constant, $60,000 will service twice
as much debt as $30,000. This approach allows the risky building
much less debt financing and achieves a result similar to what is
observed in other enterprises. Risky businesses qualify for less debt
than safer ventures.
Should an acceptable means of rating projects be developed,
the regulators might reduce the amount of capital required when
lenders grant an appropriate amount of credit to finance commercial
real estate. And even when debt financing is not used, an analysis of
a property’s business and management risk is useful. A proper
assessment of such risk assists in the assembly of all-equity portfo-
lios with a given risk level.
Finally, a project risk rating scale recognized by the market
would increase real estate’s liquidity. Illiquidity is a major real estate
risk; if illiquidity can be reduced, there is a positive impact on real
estate values.
I NVESTMENT BY DESI GN 114
10 Asset Management
Asset Management
Essentials
For the past several years, asset management has been much
discussed in real estate circles. Generally, this term describes a
decision-making technique for choosing a strategy to maximize the
value of an income-producing property.
This process is applied to a broad range of problems such as
analyzing the impact on value of a proposed property refurbishment
or considering the impact on value of gaining or losing a specific
tenant. Often competing strategies are under consideration, but the
one that maximizes the property’s value should be chosen.
Maximizing value is the goal of financial managers in many
industries outside real estate. For example, when financial managers
make plant expansion or product-line decisions, they often use
discounted cash flow analysis–a technique that helps select the
course of action giving the maximum present value.
Discounted cash flow analysis techniques have been adopted
by asset managers in the real estate industry for two basic reasons.
First, these techniques are made easy by powerful financial calcula-
tors and personal computers. Second, and much more important,
April 1993
Wayne E. Etter
ASSET MANAGEMENT 115
until recently, real property values appeared to increase without
management; the goal was to finance and build. Management of the
completed asset did not appear necessary.
Eventually, the degree of overbuilding and its effects became
obvious. Today, properties require management because an annual
increase in value can no longer be taken for granted. With excess
leasable space, competing successfully for tenants has become an
important goal of asset managers attempting to maintain or increase
property values. With this competition, the asset manager must
make a number of decisions that could affect the property’s value.
For example, how will refurbishing a property affect the occupancy
rate? Or, how will increasing or decreasing the rental rate affect
occupancy? These actions affect the income stream and, in turn, the
value of the property.
Analyzing the impact on value of such changes requires
accurate estimates of their impact on the future income stream.
When the effects are properly specified, discounted cash flow analysis
can be used to calculate whether the estimated change in the income
stream will have a positive or a negative effect on the property’s
value. Thus, there are two stages in the asset management process:
developing an asset management plan to generate the data necessary
for the analysis and analyzing the plan’s impact on the property’s value.
Developing the Asset Management Plan
Developing the asset management plan is the most impor-
tant part of the analysis because it is the basis for selecting the best
strategy. The plan enables the asset manager to quantify the differ-
ences between competing proposals and/or the status quo. The plan
must be developed in detail for each alternative strategy under
consideration and should include the following points.
First, the asset manager must have a comprehensive market
study for the property. The market study should provide information
about the types of space available in the market, the amount of space
available, the type of space being demanded, the changes expected in
the supply and demand for space and any currently unmet market
needs. Finally, the market study should provide an estimate of the
price prospective tenants (or buyers) are willing to pay for the space.
Second, a pro forma operating budget must be developed for
each alternative strategy being considered. The market study
provides information about the number of square feet to be leased
and the likely rental rate. Other data to be forecast for the holding
period include the expected operating expenses and the marketing
I NVESTMENT BY DESI GN 116
expense; the budget must emphasize both the need to provide
tenants with adequate services and cost control. Each budget will
become the basis for estimating that strategy’s effect on the property’s
present value and on its future selling price.
Third, any physical problems that need to be corrected before
the property can be leased (or sold) must be addressed. Likewise, are
there opportunities to upgrade the property through renovation or
refurbishment? The cost of both the necessary and optional changes
should be estimated carefully.
Fourth, a marketing plan must be developed. Without a plan
for action, nothing is likely to happen. The marketing plan should
cover the property’s image, strategies for positioning the property in
the market, pricing, marketing methods and materials and perfor-
mance standards. The marketing plan will have a cost; this cost
must be included in the pro forma operating budget.
Analyzing Each Strategy
The value of any asset, including income-producing real
estate, is equal to the present value of all the expected cash benefits,
discounted at the appropriate rate. Because present value mechanics
have been discussed previously, this discussion focuses on using
discounted cash flow analysis in asset management decisions. Using
discounted cash flow analysis to estimate a particular strategy’s
impact on value requires a clear understanding of what is to be
discounted and how to compare competing strategies.
Three different cash benefit streams can be discounted: net
operating income, before-tax cash flow and after-tax cash flow. The
calculation of these three measures is shown in the table.
Calculating the Cash Benefit Stream
Estimated potential gross income $210,000
Less estimated vacancy and collection allowance -21,000
Estimated effective gross income $189,000
Less estimated operating expenses -63,000
Estimated net operating income $126,000
Less estimated mortgage payment -99,180
Estimated before-tax cash flow $ 26,820
Less estimated income tax liability -1,447
Estimated after-tax cash flow $ 25,373
ASSET MANAGEMENT 117
When the net operating income is used to estimate the value
resulting from a particular strategy, no consideration is being given to
financing or taxes. Thus, the before-tax cash flow or after-tax cash
flow should be used when the asset manager’s decision involves
choosing among financing alternatives or analyzing tax impacts.
Because mutually exclusive strategies to maximize the
property’s value are being considered, the strategy producing the
largest net present value is chosen. Net present value is equal to the
present value of the expected income stream plus the present value
of the property’s estimated value at the end of the analysis period
minus the strategy’s cost. This result is compared with the net
present value of the property if no change is made.
When before-tax cash flow or after-tax cash flow from
operations and resale is chosen as the benefit stream to discount,
only the value of the equity interest is estimated; to estimate the
property’s value, therefore, the mortgage financing amount must be
added to the present value of the equity. To compare competing
strategies, each strategy’s cost must be subtracted from the
property’s estimated value. As before, the final value is compared
with the property’s value if no change is made.
The appropriate discount rate must be applied to the benefit
stream selected. In general, the following relationships should be
used as a guide in choosing the appropriate discount rate.
Cash benefit stream Appropriate discount rate
Net operating income Capitalization rate
Before-tax cash flow Before-tax, cash-on-cash return
After-tax cash flow After-tax return on equity
Sometimes the discount rate is estimated by examining
returns available from securities such as U.S. government bonds,
certificates of deposit or corporate bonds. Although such compari-
sons are interesting from a risk-return standpoint, the appropriate
discount rate should be obtained from the property market.
Once the detailed elements of the plan are developed, dis-
counted cash flow analysis may be used to choose the optimal
strategy. Today, however, discounted cash flow analysis is not as well
regarded as it once was.
For example, Cushman and Wakefield reports that “many
investors seem to have lost faith in cash flow forecasts and report
placing more emphasis on direct capitalization of current (as opposed
to forecasted) net operating income.” However, the poor investment
decisions of the past decade based on discounted cash flow analysis
I NVESTMENT BY DESI GN 118
Renovating an income-producing property is an ideal applica-
tion of asset management techniques. The first step in using
these techniques is the development of an asset management plan.
The plan should include a market study, a careful determina-
tion of the plan’s cost and an analysis of the renovation’s impact on
the income stream and the property’s value. Then, using the data
developed in the asset management plan, the decision maker must
determine if the renovation is justified by the increase in the
property’s value. This article demonstrates the application of asset
management techniques to the proposed renovation of St. Regis
Place, a Houston mixed-use complex.
The property, located in the Galleria-River Oaks area is a
242,909-square-foot, 325-unit apartment complex. In addition, a
54,975-square-foot office-retail development is on the site. The
complex was constructed in 1954 and needed substantial repair
when renovation was proposed in 1990.
The April 1990 monthly operating statement was typical of
the property’s performance prior to renovation.
Rental income
Apartments $108,982
Office-retail 26,182
Total $135,164
Operating expenses 76,222
Net operating income $ 58,942
Annualized net operating income $707,304
San Felipe Court:
A Successful
Renovation
Fall 1993
Wayne E. Etter
E.J. Cummins, Jr.
techniques resulted from flawed assumptions, such as unrealistic
occupancy and rental rates, rather than from the techniques them-
selves. The importance of making proper forecasts will be considered
in “A Matter of Assumptions.”
ASSET MANAGEMENT 119
Based on the actual rent collections and assuming 95 percent
of the total space was occupied, the average monthly rental rate for
the unrenovated apartments was 47.2 cents per square foot. The
average monthly rental rate for the unrenovated office-retail space
rate was 50.1 cents per square foot. Capitalizing the annualized net
operating income at 10 percent yields an estimated April 1990
market value of $7,073,040.
Asset Management Plan
The existing office-rental space tenants agreed to remain and
pay an increased rental rate after the renovation. However, a com-
prehensive study of the local apartment market was made to deter-
mine if sufficient tenant demand would exist for the renovated
apartments. The apartment market area contains multiple employ-
ment centers within five to ten minutes driving time of the site,
many retail attractions, hotels and several high-income residential
neighborhoods. The location of the complex relative to employment
was an important reason for tenants choosing to live there.
Within the market area there had been limited construction
of new apartments, some renovation of existing apartments and
some existing apartments being operated without renovation. Occu-
pancy rates generally in excess of 95 percent were found for each
category, indicating a strong demand for each.
However, monthly rental rates showed marked differences.
Depending on the size and type of unit, monthly rents in five newly
constructed apartment developments ranged from 85 cents to $1 per
square foot whereas monthly rents in five renovated apartment
developments ranged from 75 cents to 90 cents per square foot.
Monthly rental rates for apartments in five unrenovated develop-
ments ranged from 50 cents to 75 cents per square foot per month.
Thus, within one market area, demand came from three
distinct market segments or tenant types. Because of this, the
required rental rates for a renovated project seemed achievable in the
market area; current tenants would be replaced by other tenants
willing to pay higher rents.
To attain these higher rental rates, the property had to be re-
positioned in the market. This was to be accomplished in part by
renaming the complex–San Felipe Court–and renovating inside and
out. External renovation included:
• construction of a new facade;
• re-roofing, pool repair and parking improvements; and
• new security gate and landscaping.
I NVESTMENT BY DESI GN 120
Internal renovation included:
• new floor coverings;
• new appliances;
• new ceiling fans, light fixtures and mini-blinds;
• painting; and
• refinishing cabinets and counters.
The estimated cost of these renovations was $1.75 million.
In addition, the office space renovation was estimated to cost
$250,000 for a total of approximately $2 million. Thus, the
essential questions to be answered by the analysis are, first, whether
or not the renovation will increase the property’s value by more than
the renovation’s cost and, second, whether or not the expected
return on the incremental investment is sufficient.
To answer the first question, a pro forma December 1993
operating statement was prepared. By then, the renovation’s effect
on the property’s income stream was expected to be complete. A
68.6 cents estimated average monthly rental rate was used to figure
the rent collections for the renovated apartments, and a 68.8 cents
average monthly rental rate was applied to the renovated office-retail
space. These rental rates seemed achievable given the market study
findings. A 5 percent vacancy rate was assumed. The pro forma
statement was as follows:
Rental income
Apartments $ 166,636
Office-retail 37,823
Total $ 204,459
Less 5% vacancy 10,223
Effective gross income $ 194,236
Operating expenses 110,434
Net operating income $ 83,802
Annualized net operating income $1,005,624
Capitalizing the annualized net operating income at 10
percent yielded an estimated value of slightly more than $10 mil-
lion–a value increase of about $3 million between April 1990 and
December 1993.
Thus, a $2 million renovation was expected to increase
value by $3 million. Had the value increase been less than the
estimated renovation costs, the analysis would have ended at that
point.
ASSET MANAGEMENT 121
Of course, the sufficiency of the expected return on incre-
mental investment was another important consideration before
proceeding with the renovation. Estimating the return allowed the
expected return to be compared with those of other investment
opportunities. In this case, the incremental $2 million investment
was planned to take place during a 24-month period with the bulk of
renovation to be completed within 12 months. The $3 million
increase in value was assumed to be realized at the end of 42 months
to permit the calculation of the internal rate of return. In addition,
the change (positive or negative) in monthly net operating income
during the 42 months was treated as a positive or negative benefit, as
appropriate. The expected return on the incremental investment
was approximately 25.8 percent.
With San Felipe Court’s location and the market area de-
mand for space, the expected 25.8 percent return was considered
attractive given the low risk. The asset management plan was
adopted, financing was obtained and the renovation began. What
were the results?
Renovation Results
The renovations began in April 1990 and were largely
completed by September 1991, somewhat ahead of schedule.
Renovation costs totaled $1,821,463. The accompanying
graphs show an overview of the results achieved by the renovation
decision.
Figure 1: San Felipe Court Rent Collections
April 1990 to April 1993
I NVESTMENT BY DESI GN 122
Monthly rental collections through April 1993 are shown in
Figure 1. The increase in rental collections during the period demon-
strates that the asset management plan succeeded. The planned
increase in rental rates for the renovated property was achieved
because San Felipe Court’s location made it a desirable place to live,
and the renovation made tenants willing to pay higher rent to live
there.
In Figure 2, a three-month moving average of the property’s
estimated monthly change in value is compared to the cumulative
amount of renovation expenditure. The property’s monthly value
was estimated by capitalizing the annualized net operating income.
Then, the monthly change in value was estimated by subtracting
each month’s value from the estimated April 1990 value.
The property’s estimated value declined when the renovation
began as those units vacated for renovation did not generate rent. As
the renovation proceeded, however, rental collections and the
property’s estimated value began to increase. The goal of a $3
Figure 2. Estimated Value Change Compared
to Cumulative Renovation Expenditures
ASSET MANAGEMENT 123
A Matter
of Assumptions
Asset management generally describes the use of decision-
making techniques to choose a strategy for maximizing the value of
an income-producing property. (See previous article on page 114 for
overview.) Often, discounted cash flow (DCF) analysis is used to
help select the course of action that maximizes value. However, no
technique can yield a good decision if inappropriate assumptions are
used in the analysis. The importance of assumptions is the focus
here.
Today’s asset managers commonly use computerized DCF
analysis programs that calculate a property’s net operating income
(NOI) and the expense of maintaining the NOI; before-tax cash flow
and after-tax cash flow are not considered. These programs focus on
present and future leases on a tenant-by-tenant basis to estimate a
property’s value and require specific assumptions about the property
on a tenant-by-tenant basis. In addition to selecting a time period for
analysis, discount rate and a terminal capitalization rate, the
required assumptions for each present lease include:
1. current rental rate and rental growth rate,
2. estimated vacancy and collection loss,
3. current operating expense and operating expense growth rate
and
4. proportion of operating expense passed through to the tenant
according to the terms of the lease.
million value increase was reached in December 1992–one year
earlier than planned. Although the renovation and repositioning of
San Felipe Court was a success, a renovation can accomplish only
limited goals.
In general, overspending will not make an old property
competitive with new properties; after renovation, the property will
still be an old property. On the other hand, if renovation spending is
insufficient, the property’s planned repositioning will not be
achieved; repositioning the property requires more than performing
needed maintenance. Thus, the extent of the renovation must be
based on a carefully developed plan for the property.
Summer 1993
Wayne E. Etter
I NVESTMENT BY DESI GN 124
For a present tenant’s lease that expires prior to the end of
the analysis period or for a space that is currently vacant, additional
required assumptions include:
• items one to four if the current tenant is expected to renew the
lease,
• leasing commissions to secure the current tenant’s lease
renewal,
• time required to locate a new tenant if the current tenant does
not renew the lease or the space is currently vacant,
• alteration costs required to attract a new tenant,
• leasing commissions to secure the new tenant and
• items one to four for the new tenant.
With these data as inputs, the DCF program is used to
estimate the entire property’s annual NOI for the analysis period
and its reversion value at the end of the analysis period. The DCF
program is then used to calculate the present value of these future cash
benefits, i.e., the estimated property value.
The necessary assumptions appear rather straightforward
and well within the experience of most asset managers. Many users
might not question the effect of an individual assumption on the
final value estimate. However, they are important. To illustrate
their significance, the following example demonstrates the effect of
different assumptions on the present value of a single rental unit’s
NOI.
The Riverside Center is a multi-tenant retail building with
nine leasable units totaling 46,344 square feet. Unit 2 contains
5,221 square feet and is currently leased at a monthly rental rate of
45 cents per square foot; the lease has three remaining years. The
building manager estimates an annual 2 percent vacancy and collec-
tion loss.
Operating expenses are estimated to increase at an annual
rate of 5 percent; all operating expenses are passed through to the
tenant. A 2 percent commission will be paid for lease renewal; a 4
percent commission will be paid for a replacement tenant. All
renewals are based on three-year leases.
Typically, an asset manager might assume that the current
tenant in Unit 2 will renew the lease at a market rent, say 52 cents
per square foot per month, when the lease expires. Using these
assumptions to prepare a five-year analysis, the asset manager
produces the NOI forecast reported in Table 1. With a discount rate
of 12 percent, the estimated present value of Unit 2’s NOI is
$103,526.
ASSET MANAGEMENT 125
Table 1: NOI Forecast for Unit 2
Year 1 Year 2 Year 3 Year 4 Year 5
Gross Rental Income $28,193 $28,193 $28,193 $32,579 $32,579
Expected Expense Recapture 7,022 7,373 7,742 8,129 8,536
Gross Potential Income 35,216 35,567 35,935 40,708 41,115
Less: Vacancy and Collection Loss 564 564 564 652 652
Expected Effective Gross Income 34,652 35,003 35,372 40,057 40,463
Less: Turnover Rent Loss 0 0 0 0 0
Expected Expense Recapture Loss 0 0 0 0 0
Operating Expenses 7,022 7,373 7,742 8,129 8,536
Net Operating Income 27,630 27,630 27,630 31,927 31,927
Other Expenditures
Alterations 0 0 0 0 0
Commissions 0 0 0 1,955 0
Cash Flow After Other Expenditures 27,630 27,630 27,630 29,973 31,927
Present Value of Net Operating Income 104,768
Less Present Value of Other Expenditures 1,242
Total Present Value $103,526
Although any number of assumptions can be made about
Unit 2’s future, two are chosen to illustrate their effect on the
present value of Unit 2’s NOI. First, what if Unit 2 is vacated at the
end of year three and no replacement tenant is located? This would
not be an unusual assumption for a small retail property. Were this
to occur, not only would the unit not produce income in years four
and five, Unit 2’s pro rata share of operating expenses but also would
be borne by the owner during years four and five. Thus, NOI is
negative in years four and five. As reported in Table 2, the present
value of the NOI is $56,352–a significant reduction from the first
estimate of $103,526.
Second, what if Unit 2 is vacated by the current tenant at the
end of year three, but a replacement tenant is located? Again, this is
not an unusual assumption, but it does require the asset manager to
estimate the time needed to locate the new tenant.
With this assumption, the amount of rent and expense
recapture lost while the property is vacant can be estimated. Also,
the asset manager must estimate the per square foot cost of making
any property alterations necessary to meet the needs of the new
tenant.
Assuming three months are required to locate a new tenant
and make the necessary alterations at a cost of $3.47 per square foot,
the present value of the NOI is $84,303. These are critical assump-
tions. For example, if six months are required to locate another
I NVESTMENT BY DESI GN 126
tenant, and the alteration costs are $4 per square foot, the present
value of the NOI declines to $76,076. As shown in Table 2, both
present values sharply differ from that reported in Table 1.
Selecting the course of action that will maximize a property’s
value is another important use of such DCF programs. For example,
an asset manager may be negotiating a lease renewal with Unit 2’s
current tenant. If the lease is renewed at 52 cents per square foot per
month, and no alterations are required, the estimated present value
of the NOI is $103,526 as reported in Table 1. Suppose, however,
that the current tenant is negotiating for a lower rental rate.
If the current tenant does not renew the lease, a number of
results are possible. But, if the asset manager assumes that a re-
placement tenant can be found in three months if alteration costs of
$3.47 per square foot are incurred to satisfy the replacement tenant’s
requirements, the present value of Unit 2’s NOI will decline to
$84,303 as previously reported.
Table 2: A Comparison of Alternative Assumptions
Assumption Present value of NOI
1. Unit 2’s lease renewed by current tenant $103,526
2. Unit 2 vacated at the end of year 3 56,352
3. Unit 2 occupied by replacement tenant (1) 84,303
Unit 2 occupied by replacement tenant (2) 76,076
Using a DCF model, the asset manager can determine that
even if the current tenant’s monthly rental rate is reduced to 25
cents, it is sufficient to produce a present value equal to that of
seeking a new tenant if alterations are required. If the current tenant
agrees to a rate greater than 25 cents per square foot per month, and
no alterations are required, the property’s value will be greater than
if a new tenant is secured at 52 cents per square foot per month.
Rather ordinary assumptions have a significantly different
impact on the property’s value. In the example, a difference of about
$47,000 in the property’s value results from altering one assumption
about one rental unit.
Three observations seem warranted. First, each of the
example assumptions is ordinary; the user of a report based on the
DCF program might not question an asset manager who made any
one of them or appreciate the impact on value of such ordinary
ASSET MANAGEMENT 127
assumptions. Second, while it may be reasonable to assume a certain
future event, forecasting the details of that event may be difficult if
not impossible. For example, estimating the time required to re-lease
a unit and the per square foot costs of the alterations required to re-
lease it more than three years in the future is not likely to be accu-
rate. Third, when a DCF program is being used to estimate the
value of a larger property and these assumption are made for a large
number of tenants, the impact of the assumptions on the property’s
value may be significant.
Clearly, such DCF programs have the potential to produce
more accurate property value estimates. For an asset manager to
achieve that potential, however, requires considerable experience and
sophistication in making the required assumptions.
Buy or Lease?
The Commercial
Property Decision
January 1995
Wayne E. Etter
Fred F. Caldwell
The decision to buy or lease the space needed for conducting
the firm’s business activities is important. Although space costs are
significant business expenses, the buy or lease decision is more than
a financial decision. This article focuses on the analytical framework
for making this decision.
Although there are many variations, the buy or lease decision
typically arises in the following circumstances:
1. A business requires new or additional space. Its needs
can be satisfied by leasing space or by constructing or buying a single-
tenant or a multi-tenant building.
2. A business is currently leasing satisfactory space in a
single-tenant or a multi-tenant building and has the opportunity to
purchase the building.
The decision is a three-part process: the market analysis, the
financial analysis and other considerations.
Market Analysis
Real estate market research considers those factors that affect
the supply and demand for a particular type of space within the
I NVESTMENT BY DESI GN 128
specific market area. Conducting this research is a vital step in
deciding to buy or to lease because the property must be a good real
estate investment if it is purchased. Market information is crucial to
negotiating a competitive lease if the property is not purchased.
If rental rates are expected to rise (or fall) during the analysis
period, property values should rise (or fall) as well. When it is
concluded that rental rates and property values will increase, buying
the property is supported and vice versa. Because these conclusions
are so important for the financial analysis, the data used to reach
them must be carefully developed through market analysis.
For a basic outline of the real estate market research process,
see “Development by Design.”
Financial Analysis
In making the buy or lease decision, the financial analysis is
used to identify the financial advantage of one alternative over the
other. The principal focus of the analysis is to choose the alternative
that will provide the needed space at the least net cost. To determine
this, the present value of the after-tax cost and benefits of owning the
property is compared with the after-tax cost of leasing the space. All
other things being equal, the course of action with the least net cost
is chosen. Because lease payments, operating expenses, depreciation
and interest are deductible expenses, the analysis is usually made on
an after-tax basis.
When the choice is between buying or constructing a multi-
tenant building and leasing space, the consequences of becoming a
landlord are added to the analysis. By investing sufficient equity to
purchase or construct a multi-tenant building, the owner acquires
the present value of the after-tax income stream from the building’s
other tenants and the present value of the building’s after-tax cash
flow from resale and avoids the present value of the after-tax cost of
leasing space.
The firm’s required rate of return (or its cost of capital) is
used as the discount rate to calculate the present value of the cost to
lease and the cost to own. Because different firms have different
required rates of return (or cost of capital), they might use the same
assumptions about the costs and benefits of buying or leasing but
reach different conclusions about the best course of action.
The basic elements of a buy or lease analysis are illustrated
in the table. Assume the owner of an unincorporated business with
a 31 percent marginal tax rate can either purchase a building or lease
it for five years. If it is purchased for $100,000 plus $3,000 closing
ASSET MANAGEMENT 129
costs, the initial cash investment will be $28,000. The balance can
be financed with a $75,000, 9.5 percent, 20-year mortgage. The
building’s depreciable value is $83,000. The first year’s operating
expenses of $3,500 are estimated to increase 3 percent annually.
Because annual operating expenses, depreciation and interest are tax-
deductible, the actual annual cash outflow associated with purchas-
ing the building is the sum of the operating expenses and the mort-
gage payment less the tax shield provided by the deductible expenses.
To make an appropriate comparison with a five-year lease, it is
necessary to assume the property will be sold at the end of the fifth
year and to estimate the after-tax cash flow from resale. The
property’s estimated resale price at the end of the fifth year is
$116,000; the estimated after-tax cash flow from resale is $33,454.
If the building is leased for five years, the first year’s lease
payment will be $10,000. The following year’s lease payments are
scheduled to increase 3 percent annually. Annual lease payments
will be due in advance. The tenant will pay all operating expenses;
annual operating expenses are estimated to be the same as if the
building is purchased. Because the lease payments and the operating
expenses are tax deductible, the after-tax cost of leasing is the sum of
the lease payment and operating expenses less the tax shield pro-
vided by the deductible expenses.
Using a cost of capital of 10 percent, estimating the after-tax
cost of buying the property and leasing the property is illustrated in
the table. These calculations indicate a financial advantage for
buying the property; however, this advantage is dependent upon the
assumptions made about the resale of the property at the end of the
fifth year. Without the resale benefits, the total cost of leasing the
property is less than buying the property. Therefore, the assumption
of a 3 percent annual increase in the property’s value is critical. This
indicates the dependence of the financial analysis on the market
analysis.
The use of a resale assumption does not imply that the
property must be sold; rather, it is used to estimate the net equity in
the property so that buying can be compared with leasing over the
life of the lease.
Other Considerations
Because most leasing literature concerns leasing business
equipment, such as a truck, the buy or lease decision usually is
treated purely as a financial decision. Whether leased or purchased,
there is no difference in the truck’s ability to do the job. Thus, the
I NVESTMENT BY DESI GN 130
decision of whether to buy or lease a truck is about determining the
most financially advantageous way to gain the use of the truck for
the analysis period.
The decision of whether to buy or lease real estate is much
more than a financial decision, although the financial analysis is
important. The following points must be considered:
1. Business enterprises need space to conduct their business
activities, but in most cases, real estate is not their principal busi-
ness. If the firm leases needed space, it can adjust the amount of
leased space as market requirements change. If the firm owns real
estate, adapting quickly to changes in the market may be more
difficult because of the time required to plan and construct a property
or to buy a property when more space is needed or to sell the prop-
erty when less space is needed. A retailer, for example, may prefer to
lease space so that store locations can be changed in response to
market shifts.
On the other hand, an owner may enjoy greater flexibility in
using the property than a tenant. As space needs change, an owner
can make choices that support these needs.
2. If a multi-tenant building is constructed or purchased, the
business also becomes a landlord. Aside from the other conse-
quences of owning real estate, how will being a landlord fit in with
other business activities?
3. An existing building can be inspected to determine its
quality and its suitability for the business enterprise before it is
leased or purchased. In certain markets, an existing building’s
market value may be less than its replacement cost; if the space is
suitable for the business, it can be obtained at an attractive price.
How does buying an existing property differ from constructing the
property? A newly constructed property should have no functional
(or other) obsolescence and should be designed especially for the
user’s needs; however, when completed the new building may be
unsatisfactory and may have cost more than planned or both.
4. Balance sheet issues may be important to a company
making the buy or lease decision. For example, future borrowing
restrictions resulting from real estate debt may be a concern; if so,
leasing to keep real estate off the balance sheet may be an attractive
option.
Conclusion
The buy or lease decision melds the market and financial
analyses with other business considerations. This might result in a
ASSET MANAGEMENT 131
decision to lease even though purchasing the property appears to be
financially advantageous. The possibility of such an outcome
emphasizes the difference between purchasing real estate and other
business assets.
Buy or Lease Analysis
A. Buy A. Buy A. Buy A. Buy A. Buy
Y YY YYear 0 ear 0 ear 0 ear 0 ear 0 Y YY YYear 1 ear 1 ear 1 ear 1 ear 1 Y YY YYear 2 ear 2 ear 2 ear 2 ear 2 Y YY YYear 3 ear 3 ear 3 ear 3 ear 3 Y YY YYear 4 Y ear 4 Y ear 4 Y ear 4 Y ear 4 Year 5 ear 5 ear 5 ear 5 ear 5
Equity investment $28,000
Operating expense $ 3,500 $ 3,605 $ 3,713 $ 3,825 $ 3,939
Depreciation 2,043 2,128 2,128 2,128 2,128
I nterest 7,125 6,993 6,849 6,691 6,519
Total expense $12,668 $12,726 $12,690 $12,644 $12,586
Tax rate 0.31 0.31 0.31 0.31 0.31
Tax shield $ 3,927 $ 3,945 $ 3,934 $ 3,920 $ 3,902
Operating expense 3,500 3,605 3,713 3,825 3,939
I nterest 7,125 6,993 6,849 6,691 6,519
Principal 1,386 1,518 1,662 1,820 1,992
Tax shield (3,927) (3,945) (3,934) (3,920) (3,902)
Annual after-tax cost of
buying $ 8,084 $ 8,171 $ 8,290 $ 8,416 $ 8,548
After-tax cash flow resale $33,454
B. Lease B. Lease B. Lease B. Lease B. Lease
Y YY YYear 0 ear 0 ear 0 ear 0 ear 0 Y YY YYear 1 ear 1 ear 1 ear 1 ear 1 Y YY YYear 2 ear 2 ear 2 ear 2 ear 2 Y YY YYear 3 ear 3 ear 3 ear 3 ear 3 Y YY YYear 4 Y ear 4 Y ear 4 Y ear 4 Y ear 4 Year 5 ear 5 ear 5 ear 5 ear 5
Lease payment $10,000 $10,300 $10,609 $10,927 $11,255
Operating expense 3,500 3,605 3,713 3,825 3,939
Total expense $10,000 $13,800 $14,214 $14,640 $15,080 $3,939
Tax rate 0.31 0.31 0.31 0.31 0.31 0.31
Tax shield $ 3,100 $ 4,278 $ 4,406 $ 4,538 $ 4,675 $1,221
Lease payment 10,000 10,300 10,609 10,927 11,255
Operating expense 3,500 3,605 3,713 3,825 3,939
Less tax shield (3,100) (4,278) (4,406) (4,538) (4,675) (1,221)
Annual after-tax
cost of leasing $ 6,900 $ 9,522 $ 9,808 $10,102 $10,405 $2,718
I NVESTMENT BY DESI GN 132
C. Summary of the Analysis C. Summary of the Analysis C. Summary of the Analysis C. Summary of the Analysis C. Summary of the Analysis
Buying Buying Buying Buying Buying Leasing Leasing Leasing Leasing Leasing
Initial outlay $28,000 $ -0-
Present value of annual cost $31,387 $40,046
Total cost $59,387 $40,046
Present value of after-tax cash flow
from resale (20,772) -0-
Net cost $38,614 $40,046
Distressed Property
Decisions
April 1990
Wayne E. Etter
Scott Shaffer
Today, there are numerous distressed Texas properties. Many,
unable to generate sufficient net operating income (NOI) to service
debt, have been foreclosed and are in the hands of the original lender.
Further, the deterioration of the Texas commercial real estate market
resulted in the downfall of several of the state’s major commercial
banks and savings and loan associations (S&Ls).
In many cases, the problems of distressed properties can no
longer be solved by the particular financial institution that made the
loan. Instead, solving these problems is the responsibility of public
and private successor institutions. In addition to managing acquired
property, public agencies must wrestle with the larger issue of
disposing of entire institutions. While real estate literature has little
to offer with regard to the latter, much is known about the process of
analyzing distressed property.
Whether the final decision about these properties is made by
a private institution (commercial bank or S&L) or a public institu-
tion (the Federal Deposit Insurance Corporation or the Resolution
Trust Corporation), ideally, the decision will be made best if a proper
analytical approach is used to evaluate and manage these properties.
Losses suffered from nonfull repayment represent a signifi-
cant federal insurance problem that ultimately becomes a taxpayer
problem, but it is not related to the current market value of specific
ASSET MANAGEMENT 133
properties. Failure to grasp this distinction results in an overstate-
ment of the current real estate overhang and postpones the recovery
of Texas real estate markets. While national attention is focused on
the disposition of distressed real estate, similar energy has yet to be
spent on analyzing the institutional failures that contributed to the
crises. Analysis of such institutional problems is outside the focus of
this article.
Cost Considerations
The lender originally extends a loan with the expectation
that the borrower will repay it with interest. (Throughout the re-
mainder of this article, lender shall be used to denote the party to
whom the task of managing distressed real estate has fallen.) How-
ever, the analysis of a problem property requires recognizing that the
question has become one of selecting the course of action providing
the maximum recovery. In some cases, this solution will recover less
than the amount owed. Thus, the concept of sunk cost is an impor-
tant consideration for the lender in dealing with a problem property;
the amount owed is not unimportant, but it is not relevant for
making decisions. No future course of action can affect the amount
previously loaned; such actions can affect only the amount of recov-
ery. If a course of action is the best available solution, it must not be
rejected because it will not result in full repayment of the loan.
Opportunity cost also is important when considering holding
a nonperforming property or working with the borrower rather than
selling the property at its current value. If the property is sold, the
proceeds of the sale can be invested or loaned elsewhere to earn
profits for the lender. Thus, opportunity cost is the profit foregone
from other possible courses of action. Although the ultimate payoff
may be higher if the property is held, the opportunity cost of holding
the property must be considered. Finally, the out-of-pocket costs of
holding a nonperforming property or working with the borrower
must be considered. Utilities, insurance, property taxes, mainte-
nance, attorney fees, security and other costs of property manage-
ment must be considered.
Proceeding with the analysis first requires identification of
the problem. Is the principal reason for the property’s difficulty the
market (a lack of demand for space), physical or management? In
many cases, some element of each is involved; generally, however,
the most significant problem will be an apparent lack of demand for
the space. If the property is complete, but empty, there likely are
market problems. If the property is incomplete, it may be because
I NVESTMENT BY DESI GN 134
there would be insufficient tenants to successfully operate the
property.
Physical problems with ingress, egress, signage, visibility,
quality of construction and so forth inhibit leasing the property or
achieving the expected rental rate. The cost of correcting these
problems needs to be weighed against the probability that their
solution results in the property being leased. In some cases, the
property may be incomplete, and a decision must be made about
completing the property. Again, it is necessary to consider whether
the property can be leased when it is completed. The cost of elimi-
nating any environmental hazards also must be taken into account.
Management problems may exist as well. Developers with-
out adequate management skills may not be aware of possible
solutions or the need to test their feasibility. When this is the case,
lenders need to supply the expertise.
Solutions and Options
With the property’s primary problems identified, there are
four broad solutions available to the lender. The analytical problem is
not only to judge which of the proposed solutions is best but also to
decide whether or not the best solution makes the lender better off.
The first option is to sell the property “as is” for its cur-
rent market value. The property’s value may equal only the land
value because the improvement is deemed useless. Presumably this
results in a loss to the lender, but this may be the best course of
action if the project has little future. By disposing of the property, the
out-of-pocket holding costs and the opportunity costs of keeping it
will be avoided.
The second option is to hold the property or work with the
borrower to avoid default until market conditions improve. How-
ever, this option results in both out-of-pocket holding costs and
opportunity costs to the lender.
The third option is to advance the funds necessary to
improve the project, and then sell it. This may involve completing
or rehabilitating the property, initiating a new marketing program or
restructuring financial arrangements. This requires deciding whether
advancing the additional funds will make the project financially
feasible and whether the project’s value will increase by more than
the newly invested funds. As well as the added investment, this
option involves both out-of-pocket holding costs and opportunity
costs.
ASSET MANAGEMENT 135
The fourth option is the same as the third except that,
after advancing the funds necessary to improve the project, it is
operated rather than sold. This option involves the same consider-
ations as option three in determining if the additional funds will
make the project economically feasible and if the project’s value will
increase by more than the amount of the added funds advanced.
In considering the third and fourth options, lenders must
make economic judgments about the merits of acquiring a property
and investing adequate funds to cause it to perform at the highest
level possible in the current market. Over time the lender expects to
be rewarded by an enhanced market value for the property. Lenders
must be convinced that the property is a good investment at the price
paid for it: the sum of the property’s current market value plus
rehabilitation cost.
Economic Feasibility
Next, the economic feasibility of each proposed solution
must be established. An income property is economically feasible if
there is an adequate demand for the space and if it can generate
adequate NOI to support sufficient debt to finance the property
and provide a satisfactory cash return to its owner. Thus, ascer-
taining a proposed solution’s economic feasibility requires both
market research and financial feasibility analysis.
Market research is, of course, usually considered in connec-
tion with new developments. Developers, lenders and investors want
to know if there will be sufficient demand for the to-be-built space
for it to be taken up when the project is put on the market. But
market research also can play an equally important role for problem
properties.
In the case of many distressed properties, no market research
was carried out prior to the property’s development. Making the
decisions that were described previously requires considerable
dependence on a market study and, therefore, the first step with
almost all problem properties is to undertake a market study. For
such properties, the market research report should provide informa-
tion beyond that ordinarily found in a report prepared for new
developments.
Market research analyzes the supply and demand for space
within a given market and should provide answers to questions such
as:
• What types of space are available in the market?
• How much space of each type is available?
I NVESTMENT BY DESI GN 136
• What types of space users are in the market now?
• What types of space are being demanded?
• What changes in the demand for space are foreseen?
• What is the underlying cause of the expected change in future
demand?
• Is an expected increase in the demand for space because of the
expansion of businesses within the market area?
• Is an expected increase in the demand for retail shopping space
related to an increased residential population in the market?
• When will there be a need for additional space?
• Are there any current unmet needs for space?
If there is no unmet demand for space in the market area
that the property can supply now or later, the property should be sold
for its current value. If there is an unmet need for space that the
property can reasonably be expected to supply, the research should
provide an estimate of the number of square feet of space required,
the price that space users are willing to pay and an estimate of the
time required to lease.
The market study might show that the property is unsuited
for its intended use. If this conclusion is reached, the costs and
benefits of retro-fitting for conversion to another use must be
evaluated.
The report also should address the property’s physical
problems, if any. Are there physical shortcomings to correct before
the property can be leased at the anticipated rental rate?
Finally, the report should address the implementation of a
marketing plan for the property. Merely identifying an unmet need is
insufficient; the market must be aware of the available space.
Although the market study is an important test for possible
solutions, the analyst also must test the proposed solution’s financial
feasibility before implementing it. Given the current market value of
the property and the proposed solution’s cost, it is financially feasible
if the property can generate adequate net operating income to sup-
port sufficient debt to finance the property and provide a satisfactory
cash return to a potential buyer. The determination of financial
feasibility is dependent on the following information.
• Given a solution’s implementation, how much rent will the
project produce; what are the expected operating expenses; and
how much NOI will the project generate?
• Given current market conditions and lending requirements,
how large a loan will the NOI support?
ASSET MANAGEMENT 137
• Given the probable equity contribution of a potential buyer, can
the property be financed?
But even if a solution is found to be financially feasible, it
must be evaluated further by comparing the property’s expected
increase in value as a result of the proposed solution with the cost of
the proposed solution–is the increase in value greater than the cost of
improvements? If not, the property should be sold immediately for
its current market value. Making this decision is dependent on the
following information:
• What is the estimated maximum price a potential buyer will
pay for the property?
• Given the current market capitalization rate, what is the
estimated capitalized income value of the property?
• What is the estimated market value of the property now?
• What is the estimated cost of the solution?
• Will there be any special out-of-pocket holding costs?
Financially feasible solutions that require holding the prop-
erty until a higher market value is achieved must be tested with
discounted cash flow analysis. To pursue the final stage of the
analysis, it is necessary to estimate the following.
• How long must the property be held for the proposed plan to
work?
• What cash benefits will be received during the holding period?
• What is the estimated maximum price a potential buyer can
pay at the end of the holding period?
• What is estimated capitalized income value of the property at
the end of the holding period?
• What rate of discount should be applied to the expected cash
benefits during the holding period and the expected resale
proceeds? What is the opportunity cost of not selling the
property for its current value?
The solution chosen should be both economically feasible
and provide the greatest present value differential over immediately
selling the property for its current value plus the cost of the solution.
If none of the proposed solutions provides a positive present value
differential, it should be sold as is.
I NVESTMENT BY DESI GN 138
The Disinvestment
Decision
October 1990
Wayne E. Etter
Real estate investment is studied diligently, but
disinvestment (the decision to sell or hold a property) rarely is
considered. Unfortunately, lack of knowledge about disinvestment
can diminish an investor’s return because sometimes portfolio
performance is improved by selling a property and buying another
property or other asset with a higher expected return. This section
focuses on the fundamentals of making the decision to sell or hold
a property.
Fundamentals of Disinvestment
Although a holding period must be selected when estimating
a property’s net present value (NPV) or after-tax internal rate of
return on equity (ATIRRE), the decision to sell does not depend on
the expiration of the assumed holding period nor take place at some
predetermined time. An investor dare not make an investment
anticipating a seven-year holding period, for instance, and give the
property no further consideration for seven years. Instead, the
process of deciding whether to sell or hold the property should be
continual. Effectively, this process results in regular review of
current investments with the whole range of analysis techniques:
market research, financial feasibility study and discounted cash flow
diagnosis. Each of these techniques is used to make the disin-
vestment decision in the same way as in the investment decision.
The decision to sell or hold the property is made by compar-
ing the NPV or ATIRRE of
• selling the property and reinvesting the resale proceeds in a
property (or alternative investment) with equivalent risk to that
of
• continuing the investment in the property.
All other things being equal, the course of action with the
largest NPV or ATIRRE should be selected.
To compare, new investment opportunities are identified and
their expected cost and cash benefits estimated to determine their
expected NPV and ATIRRE. Then, these values are compared with
ASSET MANAGEMENT 139
the NPV and ATIRRE of the current property if it is kept by the
investor. Calculating these values involves estimating the property’s
current market value and its resale proceeds to estimate the current
equity investment in the property. In addition, after-tax cash flows from
operations during the anticipated holding period and from resale at the
end of the holding period are estimated.
An Example Calculation
This discussion focuses on the use of discounted cash flow
analysis in making the disinvestment decision (the fundamentals of
market research and financial feasibility analysis have been pre-
sented elsewhere).
An example property, purchased by an investor five years
ago, illustrates the analysis. The initial equity investment and the
estimated (pro forma) after-tax cash flows from operations and resale
at the time the property was purchased are presented in Figure 1.
Now, suppose the five-year period has elapsed. Although there is an
opportunity to sell this property for $450,000, the owner is consider-
ing keeping it because prospects seem promising. If the property is
retained for another five years, what is the estimated NPV and
ATIRRE?
Answering this question first requires identifying the current
equity investment. This is the amount that the investor can reinvest
elsewhere if the property is sold and is, therefore, the amount
committed to this property if it is kept. Put another way, this is the
opportunity cost of continuing the investment. Thus, when
estimating the rate of return and NPV of keeping the property, the
estimated after-tax cash flow from resale should be used as the
cost of the investment rather than the amount of the initial equity
investment.
Figure 1
(Based on Original Pro Forma
Rather than Actual Cash Flows)
Equity After-tax After-tax
Year Investment Cash Flow Resale Proceeds
0 $80,299
1 $7,695
2 8,574
3 9,374
4 10,191
5 $11,026 $161,453
Internal rate of return: 23.84%
Required rate of return: 15%
Net present value: $30,618
I NVESTMENT BY DESI GN 140
Although the original equity investment was $80,299 (see
Figure 1), the investor now has estimated recoverable equity of
$159,989 if the property is sold for $450,000 (see Figure 2); this is
the opportunity cost of holding the property. The increase from
$80,299 results from appreciation and repaying the loan.
Figure 2
(Based on Today’s Market Analysis)
Expected sales price $450,000
Less: Selling expenses 18,000
= Net sales price 432,000
Less: Unpaid mortgage balance 229,420
= Before-tax cash flow $202,580
Less: Capital gains tax 42,591
After-tax cash flow from resale $159,989
If the example property is held for another five years, the
estimated after-tax cash flow from operations and resale reported in
Figure 3 are expected. For this example, these cash flow projections
were estimated by continuing the original assumptions made for
growth rates and other variables.
Figure 3
(Based on Holding Property an Additional Five Years)
Equity After-tax After-tax
Year Investment Cash Flow Resale Proceeds
5 (end of year) $159,989
6 $11,879
7 12,749
8 13,635
9 14,537
10 $15,453 $219,791
Internal rate of return: 14.0%
Required rate of return: 15%
Net present value: -$5,785
The investor’s required return is 15 percent and continuing
to hold the property results in a negative NPV of -$5,785 and an
ATIRRE of 14 percent, which is less than the required rate of return
(Figure 3). Based on these calculations, the property should be sold
because it does not meet the investor’s requirements.
ASSET MANAGEMENT 141
Of course, even if the property’s NPV is positive and its
ATIRRE in excess of 15 percent, it should be sold if another invest-
ment opportunity offers a higher return with equivalent perceived
risk. Practically speaking, however, such a sale will not occur
unless the improvement in return is worthwhile.
Why would a property that had a positive NPV and an
acceptable ATIRRE at the time of acquisition be unacceptable now?
And, in particular, why is this true when the estimated after-tax cash
flows from operations and its market value are expected to increase
at the same annual rate during the next five years as the previous
five years? The answer is that the equity in the property has
increased relatively more than the expected benefits, causing the
NPV and ATIRRE to decline to unacceptable levels.
What about the property’s cash-on-cash return? The after-
tax, cash-on-cash return calculated with the initial equity investment
is reported in Figure 4. Because after-tax cash flow from operations
increases annually and the initial equity is held constant, there is the
appearance of increased cash-on-cash return. However, using the
opportunity cost of continuing the investment rather than the initial
equity as the denominator for years six through ten provides addi-
tional evidence of the investment’s decreased current return (Figure
4, column 2).
Figure 4
After-tax After-tax
Cash-on-Cash Return Cash-on-Cash Return
Year on Initial Equity (%) on Fifth Year Equity (%)
1 9.58
2 10.68
3 11.67
4 12.69
5 13.73
6 14.79 7.42
7 15.88 7.97
8 16.98 8.52
9 18.10 9.09
10 19.24 9.66
Another explanation of the property’s reduced return is that
by holding it the investor is not taking as much advantage of finan-
cial leverage as when the property was purchased. Financial leverage
is the use of debt to increase the investor’s ATIRRE; when debt is
used effectively, the return to equity increases as the proportion of
cost financed by debt increases. The original loan-to-value ratio was
I NVESTMENT BY DESI GN 142
75 percent; the current loan-to-value ratio is 51 percent (Figure 5).
The loan balance has decreased, the property’s value has increased
and the benefits of financial leverage have decreased.
Presumably, the property is appreciating because net operat-
ing income is increasing; this may result in an increasing debt-
coverage ratio and a decreasing break-even occupancy ratio for the
property (Figure 6). By selling the property and reinvesting the after-
tax resale proceeds, the investor can recapture the benefits of finan-
cial leverage in another property rather than provide the lender with
greater security.
Figure 5
Loan amount
= Loan-to-value ratio
Property value
$240,888
= 75% (year property purchased)
$321,197
$229,420
= 51% (current year)
$450,000
Finally, either a larger property or more than one property
might be purchased with the after-tax cash flow from resale. If a
property is appreciating and the debt is being reduced, then the
opportunity cost of continuing with the property increases with time.
Unless the expected benefits increase even faster than equity, at
some point the sale of the property will be attractive because the
equity freed from the property can be used to acquire properties with
greater returns than the property being held.
Figure 6
Debt Break-even
Year Coverage Occupancy
1 1.27 0.81
2 1.31 0.80
3 1.35 0.78
4 1.39 0.77
5 1.43 0.75
6 1.47 0.74
7 1.52 0.73
8 1.56 0.72
9 1.61 0.70
10 1.66 0.69
ASSET MANAGEMENT 143
Refinancing the Property
The foregoing example assumes the investor is willing and
able to sell the property if the NPV or ATIRRE of another option is
greater. Presumably, the investor can locate other investment oppor-
tunities that do meet the minimum requirements. In the real world,
however, this may not always be the case. For example, an investor
may be in a comfortable position with a property–it has a high
occupancy rate, a positive after-tax cash flow and is appreciating
nicely. Selling it to achieve a larger expected NPV in another property
may be viewed as risky and unappealing. Or, selling the current
property at a favorable price may be difficult because of market
inefficiencies; the characteristics of investment real estate preclude
its being bought and sold like securities.
An alternative to selling is to refinance the property. This
allows the investor to hold a known property while reducing the
equity investment and increasing the benefits of financial leverage.
For example, the owner of the example property could increase the
amount of debt to $283,500 and maintain a 1.25 debt coverage ratio;
this would reduce the equity investment (or opportunity cost) of
holding the investment to $107,373–a reduction of $52,616. If the
investment is continued for another five years, the estimated after-
tax cash flow from operation and sale also must be adjusted; the
larger loan amount results in larger interest payments and a larger
remaining mortgage balance at the end of the tenth year. These
changes are summarized in Figure 7.
Figure 7
Equity After-tax After-tax
Year Investment Cash Flow Resale Proceeds
5 (end of year) $107,373
6 $ 8,265
7 9,450
8 10,096
9 11,042
10 $12,009 $158,991
Internal rate of return: 16.2%
Required rate of return: 15%
Net present value: $4,928
The refinancing has a favorable effect on the property’s rate
of return. The estimated NPV is positive, and the ATIRRE is 16.2
percent. Because the investor’s required return is 15 percent, keeping
I NVESTMENT BY DESI GN 144
the property is now an acceptable option. In addition, the investor
has $52,616 to invest elsewhere, but an expected return of at least
15 percent must be obtained. However, the property should be sold
rather than refinanced if another investment opportunity offers a
higher return with equivalent risk.
145
I NDEX
About
the Authors
Wayne E. Etter is professor of finance with the Real Estate
Center and the Department of Finance at Texas A&M University.
He teaches in the Land Economics and Real Estate (LERE) program
in the College of Business and Graduate School of Business at Texas
A&M. After an early career in banking, he began his academic
profession at Ohio University. He came to Texas A&M in 1969.
Etter holds a Ph. D. in finance from The University of Texas
at Austin. He is the author of numerous articles and writes exten-
sively for the Center.
Andrew E. Baum holds the chair in land management at the
University of Reading, Reading, United Kingdom.
Fred F. Caldwell is president of CNI Commercial Real Estate
and Patrick Thomas Properties. He holds a Texas real estate broker’s
license.
E. J. Cummins, Jr. is the manager of the San Felipe joint
venture and holds a Texas real estate broker’s license.
Ivan W. Schmedemann has been head of the LERE program
since it began in 1972. He holds a Ph. D. in agricultural economics
from Texas A&M and is a professor in that department. His profes-
sional interests include appraisal and rural land economics. He
serves on the board of directors of the Natural Resources Foundation
of Texas.
Scott Shaffer is senior associate of CDS Research.
John Y. Massey is president of BYL International, Inc., a
consulting firm in international trade. He holds a Texas real estate
sales license and is a licensed U.S. Customshouse Broker.
Steve H. Murdock is director of the Texas State Data Center
and head of the Department of Rural Sociology, Texas Agricultural
Experiment Station, The Texas A&M University System.
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