Real Estate Investment Appraisal and Investment Analysis

Table of Contents

PREFACE

UNIT ONE
THE NATURE OF REAL POPETY INVESTMENT
1.1.Defining an Investment
1.2.Investment Objectives
1.3.Investment Features
1.4.Types of Investment
1.5. The Idea of Real Estate Investment
1.6.Characteristics Real Property Investment
1.7.Specific Advantages to Investing in Real Estate
1.8.Specific Disadvantages Relating To Real Estate Investment

UNIT TWO
THE TIME VALUE OF MONEY
2.1.Introduction
2.2.Interest Rates
2.3.The Future Value of a Lump Sum (FV)
2.4. Present Value of a Lump Sum (PV)
2.5.The Future Value of Annuity
2.6.The Present Value of Annuity
2.7.Accumulation of Future Sum ( Sink Fund)
2.8.Determining Yields or Rates of Return on Investments
Unit Summary

UNIT THREE
ESTIMATING AND PROJECTING CASH FLOW
3.1. Cash Flows
3.2.Cash and Cash Equivalents
3.3.Benefits of Cash Flow Statement
3.4. Classification of Activities for the Preparation of Cash Flow Statement
3.5.Types of Cash Flows in an Investment Appraisal
3.6.Estimating Net Operating Income Based on Market Condition
3.7.Estimating Net Operating Income Based on Lease / Contract Condition
3.8.Projecting Cash Flows
Unit Summary

UNIT FOUR
REAL ESTATE INVESTMENT DECISION CRITERIA
4.1.Motivations for Investing
4.2.Real Estate Investment Financial Analysis
4.3.Economic Analysis
4.4.Social Impact Assessment (SIA)
4.5. Feasibility Study
4.6.Environmental Impact Assessment (EIA)
Unit Summary

UNIT FIVE
RISK DETERMINATION, MEASUREMENT, AND ANALYSIS
5.1. Types of Risk and Importance of Risk Analysis
5.2. Accounting for Risk in Discounted Cash Flow Model
5.3. The Variance a Risk Measure
Unit Summary

UNIT SIX
REAL ESTATE INVESTMENT ETHIOPIA
6.1. Historical Development of Real Estate Developing Companies in Ethiopia
6.2. Real Estate Investment Laws and Practices

Reference

PREFACE

This textbook is offered as a basic knowledge module for Land & Real Property Valuation undergraduate program students in the Dire Dawa University. It comprises an aggregate of selected topics with the aim of enabling learners gain fundamental knowledge in areas related to investment analysis, time value of money, cash flows, real estate investment decision, real estate investment risk measurement, and analysis.

The study of investments is importance to every individual. In recent years, the field of investments has seen a variety of new opportunities and philosophies. The real estate investment has been very “hot” since 2000 and gives every indication of remaining so throughout at least the middle of the decade. As a result of government tax and monetary policies, real investment provides excellent risk-return opportunities that enable many individuals to build a secure foundation for their wealth. In addition, most high income individuals are overinvested in the stock market. The portfolio of these individuals would benefit from diversification into commercial real estate. Unlike equity securities, commercial real estate often generates a substantial and predictable cash flow over time. The compounding effect of this cash flow can significantly enhance the performance of most investment portfolios.

Throughout this module about six major units are constituted in this module in order to help students gain the required knowledge, skill and attitude domains. The first unit is designed to expose students to the nature of real property investment. It addresses the idea and characteristics of real property investment. In the second unit, the basic concepts and method of computation of the time value of money are presented by discussions of the single cash flow, series cash flow, interest rate and sinking fund. The intention of the unit is to help students develop the basic knowledge of the time value of money in investment analysis general and real property investment.

The third unit deals with the conceptual and theoretical discussions of governance and the Ethiopian governance structure particularly focusing on the current government. It is structured to enable students develop the skills, knowledge and attitudes required for adopting the most appropriate manner of governing and exercising control or authority over actions of citizens in various public institutions and to apply an accepted system of regulation to moderate behaviors towards achieving better performances in the institutions over which they preside. The fourth unit of the module deals with public service delivery and change management in the public sector. In this unit, emphasis shall be given to characteristics of public service, citizen center service delivery, the need for change and models of change, change management tools, resistance to change, and mechanisms of overcoming it. The fifth unit addresses the concepts and theories of ethics, social responsibilities, and corruption in public sector. This unit particularly presents topics like ethical theories, ethical behaviors, social responsibilities, types and causes of corruption and mechanisms of combating it. Finally, the module shall be winded up with the discussion of professionalism in the civil service.

Objectives of the textbook:

Your goals upon the completion of this Investment Analysis course is:-

- Understanding basic concepts of real property investment theory and analysis.
- Analyzing the various property investment decision criteria.
- Developing skill on different types of cash flow analysis.
- Developing skill to analyze the profitability of property investment decision.

UNIT ONE

THE NATURE OF REAL POPETY INVESTMENT

1.1.Defining an Investment

For most of your life, you will be earning and spending money. Rarely, though, will your current money income exactly balance with your consumption desires. Sometimes, you may have more money than you want to spend; at other times, you may want to purchase more than you can afford. These imbalances will lead you either to borrow or to save to maximize the long-run benefits from your income. When current income exceeds current consumption desires, people tend to save the excess. They can do any of several things with these savings. One possibility is to put the money under a mattress or bury it in the backyard until some future time when consumption desires exceed current income. When they retrieve their savings from the mattress or backyard, they have the same amount they saved.

Another possibility is that they can give up the immediate possession of these savings for a future larger amount of money that will be available for future consumption. This tradeoff of present consumption for a higher level of future consumption is the reason for saving. What you do with the savings to make them increase over time is investment. Those who give up immediate possession of savings (that is, defer consumption) expect to receive in the future a greater amount than they gave up. Conversely, those who consume more than their current income (that is, borrowed) must be willing to pay back in the future more than they borrowed.

From our discussion, we can specify a formal definition of investment. Specifically, an investment is the current commitment of dollars for a period of time in order to derive future payments that will compensate the investor for (1) the time the funds are committed, (2) the expected rate of inflation, and (3) the uncertainty of the future payments. The “investor” can be an individual, a government, a pension fund, or a corporation. Similarly, this definition includes all types of investments, including investments by corporations in plant and equipment and investments by individuals in stocks, bonds, commodities, or real estate. In all cases, the investor is trading a known dollar amount today for some expected future stream of payments that will be greater than the current outlay.

At this point, we have answered the questions about why people invest and what they want from their investments. They invest to earn a return from savings due to their deferred consumption. They want a rate of return that compensates them for the time, the expected rate of inflation, and the uncertainty of the return.

Therefore, Investment is the commitment of money that have been saved by deferring the consumption and purchasing an asset, either real or financial with an expectation that it could yield some positive future returns. There is an excess of investment avenues, each associated with varied risk-return trade-offs. Every investment way is diverse in its characteristic, which makes the investment decision attractive. The investor thus needs to carefully analyze each of its characteristics and build a basket of assets that suits his risk profile and complies with his objectives and goals. Hence, investment decision making is a fascinating task to the investor.

Investment is defined as a commitment of funds made in the expectations of some favorable rate of return. If the investment exercise is properly undertaken, the return will be corresponding with the risk the investor assumes. (Fischer 2008: 2) Investment is an acquisition of a financial product or other item of value with anticipation of favorable future returns. Investing is a serious subject that can have a major impact on investors’ future wellbeing. Investors have series of investment avenues and each of them differ in terms of risk, return, safety, security, regular income and various other parameters. The investor has to choose proper investment avenue, depending upon his specific need, risk preference and expected returns. (Kothari 2013: 476-480). Investment has got two attributes – time and risk. The sacrifice takes place in the present and is certain. The reward to be received in future is generally uncertain. In some cases, the time element dominates, as in case of government securities. Either time or risk or both are important. (F Sharpe W et al. 1996)

Investment decision-making process is concerned with how an investor should proceed in making a decision about what marketable securities to invest in, how extensive an investment should be and when the investment should be made. Investment is a sacrifice of current rupees for future rupees. Investors’ investment pattern has witnessed a metamorphic change and this change can be attributed to changing scenario of investment alternatives available. Investors have started investing more in modern financial products like equity, mutual funds than the ordinary financial product like term deposits, post office deposits, etc. (Warne 2012 )

The challenges confronted by the investors are taking right investment decisions. The varied investment opportunities poses a challenging questions to the investors, like, why, where, how, how much and when to invest. Hence investment involves complex decision making process with regard to choosing the investment avenue with the expectation of returns with or without making thorough analysis. The return on such investment depends on investor’s preferences towards various investment avenues, his ability to take risk and also his demographic characteristics.

Post-second world war, economic growth has received considerable attention by economists, who raised the question of whether growth is determined by aggregate demand or aggregate supply. In the demand-determined growth theory, investment determines savings through multiplier effect and that it plays a crucial role in determining the growth rate of productivity. In contrast, the supply-determined theory suggests that savings determines investment and therefore the direction of any economic policy should be, at the very least, to increase the amount of private savings which would result in lower interest rate and which, in turn, would increase investment.

Investments and portfolio decisions are taken within the framework provided by a complex of financial institutions and intermediaries which together comprise the capital market. It is this market which provides the mechanism for channelizing current savings into investment in productive facilities, i.e., for allocating the country’s capital resources among alternative uses. In effect the financial market provides an economy’s link with the future, since current decisions regarding the allocation of capital resources are a major determining factor of tomorrow’s output. The crucial role played by the financial markets in shaping the pattern and growth of real output imparts a social significance to individual investment and portfolio decisions.

Investment strategy is so different from the hundreds or perhaps thousands of other strategies. The reason for differentiation is its unique blend of both traditional and modern investment concepts, and its focus on the individual investor. It is equally important to understand the criteria used by the investors to evaluate any investment and make decision. Today, the investor lives in a more complex and contradictory world than before. Making money is not easier. At the same time, holding on to it, has never required more ingenuity. Taxes, inflation, a stop-and-go economy, a mind-boggling array of investments, the high cost of “expert” advice, all create a formidable obstacle course to investment success.

Investment strategy reaches out to the individual investor and explains how these new findings can be used to develop successful investment strategies. The investment strategies basically depend upon the; Investment Environment. Risk, Inflation and Rates of Return, Taxes, Institutions, Cost of Investing and etc. The study of investments is of growing importance to every individual. In recent years, the field of investments has seen a variety of new opportunities and philosophies. While, these new approaches have aroused considerable debate among the members of the investment community, and have added a much needed quantitative aspect to investment management, some are nevertheless too hypothetical and unrealistic to be of much aid to a sound investment management program. Investing still remains primarily an art and cannot totally be reduced to a buy, hold and sell statistical equation.

Investments can be a fascinating and stimulating field of study for those who are interested in gaining knowledge and expertise in investment decision making. The same basic investment principles and procedures apply to both the individual investor and the institutional investor. The study of investments prepares the individual to operate in the securities markets either on his own behalf or on behalf of other investors through pension funds, mutual funds, and trust departments of banks, insurance companies or other indirect investing by the individual. The study of investments presupposes that an investor has specific objectives. An individual’s desire to participate in a program presupposes that he wants to accumulate assets and expand his net worth. However, the financial goals for an investment program differ widely among individual investors, depending upon the investor’s financial needs and, to a significant extent, their social, family and moral views of the use of money.

Some investors participate in investment programs to accumulate money for the sake of accumulation and have no special need or goal. They derive satisfaction from the experience of successful investing. Some view investment as a means of providing a fund for their children’s college education, supplementary retirement income, or fulfilling other financially related needs. Others view investment as a means of increasing sources of funds for future family members, religious organizations that need expanding funds to better serve their objectives, and for community related organizations and programs that need private funding. Whatever the goal of the investor, the purpose of the study of investments is to equip the individual so that he will make investment decisions intelligently.

1.2.Investment Objectives

The investor needs to define his objectives so that he moves in that direction. The main investment objectives are increasing the rate of return and reducing the risk.

Increasing the Rate of Return

Return is the ultimate objective in any investment program. Many investments have two components of return, namely, capital gain or loss and some form of income – interest, dividend, etc. The investor shall always intend to maximize the returns on the investment.

Reducing the Risk

Risk assessment is one of the most important aspects of modern financial management. Before embarking on any investment, a person should understand both the expected returns and the likely riskiness of those returns. Risk is generally referred to as “chance of loss” and the risk has numerous subsets. Total risk refers to overall variability of the returns of the financial asset. The total risk has two principal components, namely, un-diversifiable risk and diversifiable risk

Un-diversifiable risk is the risk that must be come by virtue of being in the market. The risk arises from systematic factors that affect all securities of a particular type. Diversifiable risk can be removed by proper portfolio diversification. The risk arises due to company-specific events or factors. The investor shall aim to reduce the risk to the possible extent.

1.3.Investment Features

Following are the various investment features,

Rate of Return

Risk

Safety

Liquidity

Hedge against inflation

Return

Investors always expect a good rate of return from their investments. Rate of return could be defined as the total income the investor receives during the holding period stated as a

Return = & ( )

Risk

Risk of holding securities is related with the probability of actual return becoming less than the expected return. Investment’s risk is just as important as measuring its expected rate of return because minimizing risk and maximizing the rate of return are interrelated objectives in the investment management.

An investment whose rate of return varies widely from period to period is risky than whose return that does not change much. Every investor likes to reduce the risk of his investment by proper combination of different securities.

Safety

The selected investment avenue should be under the legal and regulatory frame work. If it is not under the legal frame work, it is difficult to represent the grievances, if any. Approval of the law itself adds flavor of safety. Even though approved by law, the safety of the principal differs from one mode of investment to another.

Liquidity

Marketability of the investment provides liquidity to the investment. The liquidity depends upon the marketing and trading facility. If a portion of the investment could be converted into cash without much loss of time, it would help the investor meet the emergencies. Stocks are liquid only if they command good market by providing adequate return through dividends and capital appreciation.

Hedge against Inflation

Since there is inflation in almost all the economy, the rate of return should ensure a cover against the inflation. The return rate should be higher than the rate of inflation; otherwise the investor will have loss in real terms. The return thus earned should assure the safety of the principal amount, regular flow of income and be a hedge against inflation.

1.4.Types of Investment

In general term investment may classified as financial assets and property assets. The society’s material wealth is a function of productive capacity of the economy. The production capacity refers to the quantum of goods and services its members can create. This capacity is a function of real assets of the economy, namely, land, buildings, plant, machinery, intellect etc. On the contrary, financial assets, such as stock, bonds, etc either in material or dematerial form, do not contribute directly to the productive capacity of the economy. These assets are the means by which individuals or institutions hold their claims on real assets.

Real assets generate net income to the economy and the financial assets define the allocation of income or wealth among investors. Investor’s return on financial assets derives from the income generated from the real assets, which were financed by issuance of those securities. The securities, that are financial assets to the investors, are the liabilities to the issuers of such securities.

1.4.1. Financial Assets

Financial assets have specific characteristics that distinguish them from physical and intangible assets. These characteristics are,

- Monetary value
- Divisibility
- Convertibility
- Reversibility
- Liquidity

Monetary Value

Financial assets are exchange documents with an attached value. Their values are denoted in currency units determined by the government of an economy.

Divisibility

Financial instruments are divisible into smaller units. The total value is represented in terms of divisions that can be handled in a trade. The capital of a firm is collected through financial instruments that are issued in a unit format (shares). Each unit represents a face value of the total capital. The divisibility characteristics of financial assets enable all players, small or big, to participate in the market.

Convertibility

Financial assets are convertible into any other type of asset. For instance, a borrowing can be converted into capital. A firm might issue, in the first place, a debt instrument, which is to be repaid after the specific duration. At the end of the period, the firm could five the investor an option to convert it into a share of the company. This characteristic of convertibility gives flexibility to financial instruments. Financial instruments need not necessarily be converted into another form of financial assets; they can also be converted into any other type of asset.

Reversibility

This implies that a financial instrument can be exchanged for any other asset and logically the so formed asset may be transferred back into the original financial instrument.

Liquidity

Liquidity is the distinct feature of financial asset. The financial instruments can be converted into cash at ease, due to the existence of a strong secondary market. The financial assets are quite liquid thereby, making the financial instruments tradable and exit at any point of time.

1.4.2. Real Estate Investment

Economists refer to investment as anything that adds to productive capacity. In other words, activities that make use of resources today in order to secure greater production in the future. For example, a business may put funds into new equipment or into building a new factory, either way it is making an investment to increase capacity in the future. In financial terms investment is the sacrifice of present capital for future gain, typically in the form of income and/or capital.

A key attraction of owning property is its suitability as an investment, particularly over the long term. It ranks alongside equities and bonds as a major component of any investment portfolio. Property is a tangible and durable asset so investment in property is typically viewed as a relatively long-term activity in comparison to equities and bonds (Sayce et al., 2006). Investors rely on a combination of income and capital growth to generate required return and property benefits from real growth in rent and capital value; each operates in a separate submarket and is affected by different forces, so it is possible that rental growth may be strong one year because of high demand by tenants while capital growth may be limited because of sluggish demand from prospective investors.

1.5. The Idea of Real Estate Investment

The world of real estate is rich with investment decisions, but not all of these truly concern real estate. True real estate decisions are about acquiring, financing, using, improving, and disposing of actual real estate assets (land and its permanent structures). In contrast to these decisions are management or operational choices that coincidentally arise from involvement with real estate. For example, a residential real estate brokerage company must make a host of decisions about operating the business-personnel recruitment and compensation, marketing methods and strategies, equipment decisions, and organizational decisions. But these decisions are not really about real estate. Rather, they are the kind of decisions that any organization must make to reach its goals, and are not our concern here. This module is about the investment valuation of real estate assets.

1.5.1.Investment value and Time

Real estate investment decisions, like all investment decisions, involve present costs and the value of future benefit~ (usually quantified as cash flows). However, in finding the value of future benefits we cannot simply add them up. A moment's thought makes it clear that benefits 10 years from now, for example, are not as valuable as the same benefits received immediately. So we must have a way of converting future benefits to their equivalent value in immediate cash. The generally accepted method for doing this conversion is known as discounting. This procedure is fundamental to good investment valuation when a long time horizon is involved, such as in real estate. Discounting is explained in depth in unit 2. Suffice it to say now that the value of future benefits from a real estate investment must be equated through discounting to an equivalent current (present) value, which can then be compared to the immediate cost.

1.5.2.Investment Value and No monetary Effects

Even if the costs and benefits of an investment are no monetary, the decision problem is still to weigh the costs against the value of the benefits. Perhaps the main example of a no monetary: real estate investment is the choice of a home. A home satisfies many needs beyond simple physical shelter, and many 0f these benefits are very difficult to quantify.

The location of a home determines access to places of work, to recreation and sports opportunities, to places of worship, to community and commercial services, and to the social network of the household. Perhaps above all, for families with children, the location of a residence determines the schools and social environment to which children have access. In addition, the immediate neighborhood of a home determines the surroundings the household experiences, including the level of crime, pollution, noise, traffic, and the image or aura of the neighborhood. Under these complex circumstances, homebody or renters typically will not be able to measure explicitly the future benefits of a dwelling. But they will still judge whether the value of the "package" of expected benefits exceeds its cost. Indeed, buyers and renters likely will compare cost to the value of the benefit "package" among several dwellings, seeking to find the one that is affordable and offers them the greatest net difference.

For example, suppose a family searching for a home has narrowed the choice to two residences. The houses are very similar and affordable, and each seems to be at least worth the seller's asking price to the family. Dwelling A is Birr 140,000, but is in a struggling public school district, while dwelling B is Birr 160,000, but is in an exceptionally successful public school district. Having children, the family could conceivably have several reactions to the choice. If the family places high value on access to good public schools, it may regard choice B as superior, judging that the incremental value of the superior schools is greater than the Birr 20,000 house price differential. On the other hand, the family may already have determined that the children will not attend public school, making the difference in school district largely irrelevant, and making choice A the more attractive of the two. A third possibility is that, based on a careful assessment of the school situation, the family judges the difference in schools to be transitory, reducing the value of the superior school district and thus the value advantage of the more expensive house. The point is that each time a household makes a choice of a residence, it implicitly makes value comparisons and value judgments, even though the values are not measured explicitly. Thus, the purchase of a residence involves an investment valuation.

When a large part of the costs or benefits of a real estate investment valuation are no financial, as with a residence choice, estimating the value of the benefits requires many kinds of information. For a residence, important information will include accessibility to the locations and services critical to the needs of the household, any trends or changes occurring in the immediate and surrounding neighborhoods, prospective changes in roads or land uses in the area, school quality, school district boundaries, restrictive covenants for the subdivision, crime rates in the area, and other information about factors affecting the "package" of no financial benefits from a prospective residence. Part of the role of a knowledgeable real estate agent can be to assist in obtaining this information. There are, however, limits to how much one can rely on the advice of a real estate agent because of the legal nature of the agency function.

1.5.3.Incremental Investment value

Frequently, real estate investment decisions involve incremental changes in existing real estate. For example, a homeowner may consider installing more insulation, double pane windows, or a more efficient heating and cooling system in order to reduce utility cost. In such cases the future benefits are the projected reductions in utility bills, while the cost is the price of immediate installation or conversion. So the investment analysis involves the following steps:

1. Obtain reliable information on resulting reductions utility costs. One must be very careful in this step to obtain realistic estimates. Most utility companies can be quite helpful in verifying the credibility of savings estimates provided by a vendor, or in referring one to agencies that can assist.
2. Obtain credible estimates of installation costs. In many instances, multiple estimates are desirable because different vendors may be able to offer different ideas about the most cost-effective configuration of equipment to install. As an example, the authors have seen estimates for plumbing projects that vary by a factor of three simply because of different ideas about how to make incremental changes in the plumbing system.
3. Compare the incremental value to the 'incremental costs involved. This will be done by discounting the stream of future utility cost savings to a present value. If the value exceeds the immediate cost, the project is a good investment.

Incremental real estate investment decisions are quite common. For homeowners, there may be incremental decisions regarding additions to an existing residence, upgrading landscaping, remodeling bathrooms, remodeling a kitchen, or rewiring. In most cases, the cost of such home improvements can be quantified within a useful range. Obviously, what is more difficult is to quantity the value of the resulting benefits. Nevertheless, countless households do make such improvements, having judged the no monetary value of the improvement project to exceed its estimated cost.

Owners of income-producing real estate also make incremental investment decisions. Income-producing property includes apartments and other rental residential, retail, office, hospitality, industrial, and many types of specialty properties. The most extensive example would be expansion of a property by adding an additional building. Less extensive incremental investments might include rewiring an office building to support modern electronics and communications, refurbishing a lobby, painting, re landscaping, improving parking areas, installing additional lighting, installing additional security systems and devices, installing more efficient heating or cooling systems, adding insulation, and replacing furnishings. Many incremental investment decisions for income-producing property are made as part of property management.

With income producing real estate, the measure of benefits is much simpler than with homes. The central benefit criterion is how the investment affects rental net income (income after expenses), and therefore value, and this can come about through several avenues. For example, an additional building would be expected to provide more space to rent and greater future net revenue. Many other improvements might make the property more beneficial to tenants, making them more willing to accept rent increases and perhaps less likely to move. Others may reduce operating expenses. For example, investments in improved fire safety or improved security may reduce the annual cost of hazard and liability insurance.

All of these kinds of incremental investments for income-producing properties have in common the objective of increasing net income. Thus, step 1 in the analysis of incremental investments for commercial real estate focuses on estimating the resulting increases in net revenue. Step 2 seeks to estimate the cost of the improvement, as in any investment analysis. Step 3 of the analysis converts the projected net revenue changes to incremental present value so that they can be compared to their cost. If an analysis of the proposed investment shows that the value of net revenue increases exceed cost, then the owner is made better off (wealthier) by engaging in the project

1.6.Characteristics Real Property Investment

Real property has a number of distinguishing features as a form of investment.

Real property interests are heterogeneous, in other words each one is unique or different. Although two properties can appear similar, there are usually differences in their size, layout, standard of repair, amenities, etc. which, even if small, will result in their values being different. Even where two buildings are identical in every way, they will not occupy exactly the same plot of land or position within a development and this too can influence value.

Property is relatively durable and so property investment is long-term in nature. Although buildings do depreciate with age, they do have long life spans compared to most other types of capital assets. In addition, the value of the land on which the building stands will often increase in value with time, which largely offsets any decrease in the value of the building.

Costs of buying and selling are relatively high. Estate agents, surveyors and solicitors fees will be incurred, all of which are subject to Value Added Tax (VAT). Stamp Duty Land Tax (SDLT) is an additional burden.

Time involved in buying and selling can be lengthy. The property must be marketed and a suitable purchaser found. Then the terms of the transaction need to be negotiated and agreed and the finance arranged. Finally, the legal documentation must be written, agreed and signed before a deal is completed.

Proof of ownership is sometimes difficult. The exact boundary of the land to be sold or let can be hard to define due to the plans on the deeds being inadequate. Resolving such boundary and title disputes can be costly and time-consuming.

Property is not easily subdivided and thus large amounts of capital are required to purchase. Whereas an investor can usually invest relatively small amounts of cash in other forms of investment, this facility is not available with property investment, where tens or hundreds of thousands, or even millions of pounds, may be required.

There may be substantial management problems. Property needs to be kept insured, repaired, maintained and decorated. Rents must be collected and business rates, Council Tax and other taxes paid, where applicable. Rent reviews need to be implemented and agreed. The investor will therefore generally need to appoint a management surveyor, or agent, to undertake these tasks on his or her behalf. The fees so incurred will of course eat into the financial returns from the investment. Property is subject to significant amounts of government legislation which can quite frequently be amended, repealed or replaced. The laws affecting landed property are many, complex and varied, and there is seldom a year when modifications or changes do not take place.

There is no single national market and property markets can be imperfect. Unlike stocks and shares, where there is a single central market (the Stock Exchange) through which deals are conducted, and which acts as a barometer of market conditions, there is no such system for knowledge of the market’. This, of course, is where professional valuers fulfill a role, obtaining and analyzing this information and presenting the results to their clients. Even then, some property transactions are treated confidentially and non-involved parties can find it impossible to obtain information on them.

The supply of property in the short term for any type of use is relatively fixed, or inelastic. An increase in demand will therefore produce larger proportionate changes in price than if the supply was more elastic.

Property is considered a good ‘hedge against inflation’ (Millington 2000: 32) in the long term as capital and rental incomes historically have a good record of maintaining their value in real terms. Rent reviews help in this respect to maintain the real value of an owner’s income flow from a property let to a tenant, in that the income can be increased at regular intervals to keep it in line with current market values. Few, if any, other investments offer this opportunity for regular and sustained income growth.

1.7.Specific Advantages to Investing in Real Estate

I. Financial Leverage

“Give me where to stand, and I will move the earth.” said Archimedes, referring to the notion that with a long enough lever he could move the earth itself. The power of leverage is that great. This is as true in finance as it is in physics. Leverage is simply the extent to which debt is used to finance real estate. For example, let us assume that an individual purchases a house for $100,000. If bank mortgage financing is available, the owner may put down as little as 5% of the purchase price and borrow the rest ($5,000 equity and a $95,000 mortgage). Now, let us assume that the house rises in value to $110,000. This results in a gain of 10% on the house. By employing leverage, the owner of the house experiences a gain of 200%. This is due to his $5,000 equity investment growing to $15,000. Leverage makes the investor’s money work harder.

Leverage is not unique to real estate. Stockbrokers typically offer “margin” financing on stocks bought through their brokerage. However, more leverage is generally available for real estate investment. This is because that while the commercial real estate market certainly has its ups and downs, it has nothing like the volatility of the stock market. Lenders feel more secure about their ability to recover their obligations when the value of those obligations is secured by a mortgage to real property whose value stays relatively constant. Successful real estate investors optimize (not maximize!) their leverage.

The general rule is “Borrow to buy, sell for cash.” More leverage can make a good investment a great investment. Wise real estate investors generally look for those properties that provide the most financing. That is why single-family residences make such attractive investments. The government, in its desire to encourage home ownership, has created a set of institutions and policies to encourage individuals to purchase homes even with almost nothing down.

While such programs are often targeted for the poorest and most disadvantaged in our society, there is a lot of carryover that can benefit almost anyone. Even outside residential properties, an eager seller can be interested in “taking back some paper” to minimize the investor’s upfront cash requirements.

To optimize leverage, many investors have a specific strategy that they use in identifying investment opportunities. This involves acquisition strategies that minimize the cash necessary to get into a project and divestiture strategies that look to all cash exits. Such strategies would include minimizing the down payment, borrowing the down payment, extending the life of the loan, and borrowing interest only with a balloon payment for the principal.

The reason investors want to optimize leverage, rather than maximize it, is that increased leverage brings about increased risk. In this case the additional risk comes from the fixed obligations to pay interest (and perhaps principal.) Real estate investing always involves juxtaposing an uncertain cash flow coming in against a certain cash flow that must be paid out. Where this cash flow coming in is used to fund the cash flow going out (as is usually the case), this raises the possibility that the funds that were supposed to come in do not. This then puts the highly leveraged investor in a hard place. Money can fail to come in because the lessee is unable to pay, an argument with the lessee goes to court (the legal process is unbelievably slow and typically works to the disadvantage of the creditor), or the lessee, for some other reason, does not want to pay.

Compelling such a person to pay is typically a long and arduous process, and while this process goes on, no money is coming in. Thus, how much leverage to use is ultimately a decision the investor makes based upon his or her preferred trade-off between risk and return.

II. Inflation Resistance

Real estate values tend to rise with inflation. In fact, much real estate often rises faster than inflation because it is in relative limited supply compared to other consumer goods and services. Because real estate supply tends to be inelastic (insensitive to prices), as demand increases prices will rise faster in this sector. Of course, a word of caution is necessary. Not all real estate rises in lockstep with inflation. There are variations in the price of real estate between regions, within regions, within states, within cities, and even within neighborhoods. Much depends on location and the demand for property at that location. Great care must be exercised in the selection of specific commercial real estate opportunities.

III. Tax Advantages

Real estate ownership is encouraged by the tax system. Two important advantages come into play here. The first is interest costs. The second has to do with the concept of depreciation. Both of these factors combine to make real estate investing very attractive. Interest costs can be fully tax deductible for your personal residence (up to a limit) or for any commercial real estate investment. This means the cost of funds is reduced by your marginal tax rate. As a home owner, if you finance a house at 8% and you are in the 40% tax bracket, your real cost of financing the house will be 8%

(1 – 0.4) = 4.8%.

The second important tax advantage to owning real estate is the ability to depreciate any property (the buildings, not the land) being rented. Depreciation is a legitimate (noncash) deduction used to offset revenue that would otherwise be subject to taxes. This means you can show a loss on your real estate investment, use that loss to reduce your personal income, and thus lower your taxes. Anything to do with taxes tends to be a bit tricky and depreciation is no exception. Real estate rental is considered a passive activity and losses from a passive activity can only be used to offset passive income (not wages and salaries).

However, if an individual actively participates in managing the rental property (as evidenced by selecting tenants, collecting rents, visiting the property, and doing maintenance all of which are tax deductible in themselves), then the individual may deduct up to $25,000 from earned income, provided he or she does not have adjusted gross income in excess of $100,000 when the amount of loss that can be deducted is phased down to where adjusted gross income reaches $150,000 and no loss at all may be applied to earned income. There are a number of other constraints here having to do with marital status, and the like. There is also something called an Alternative Minimum Tax (ATM) to consider. An investor needs to consult with a tax professional to see how he or she may be impacted by the tax code. If an investor can write off $25,000 of paper losses due to depreciation and is in the 40% tax bracket, then he or she will receive a tax saving—a bottom line—of $10,000 in real dollars.

IV. Debt in an Inflationary World is Good

Commercial real estate investors are debtors. They borrow money now to pay it back later. In an inflationary environment this confers a tremendous advantage to the buyer. In theory, interest rates adjust for the level of inflation by adding an inflation premium to the real rate of interest. In the real world, this adjustment process appears slow and uncertain. There have been a number of times within the past two decades where the rate of inflation exceeded the nominal rate of interest.

Monetary history suggests a pattern in the world of modern finance where debtors have benefited from borrowing more valuable dollars and paying back with less valuable dollars. The value of a dollar (or any unit of currency) is ultimately determined by what it will buy. What it will buy is determined by the price level of goods and services that, in turn, is determined by the demand for and supply of those goods and services. While government statistics show little inflation in the first few years of the decade, these indices do not necessarily reflect the buying pattern of real estate investors. It may be argued that broadbased indices (such as the Consumer Price Index), which rely on fixed market baskets of goods and services really understate the true level of inflation relevant to business decision makers.

There are a number of possible causes of inflation. One of the most common causes of inflation can result from the money supply increasing as a result of increasing government debt. Government debt increases because politicians basically find that, when they vote for benefits for people, they get congratulated for doing a good job by those people affected. When they vote for more taxes, they generally get voted out of office. Therefore, politicians tend to spend more without generating the needed tax revenues. The only way that can be done is to create more debt. What is the future for inflation in the United States? The effects of inflation are so powerful and pervasive that economists see inflation as a primary factor in redistributing wealth in our society. The real question is which side of this transfer will you be on?

1.8.Specific Disadvantages Relating To Real Estate Investment

i. Less Liquidity

Liquidity in finance refers to the ability of an asset to be exchanged for cash without loss of value. Publicly traded stocks have good liquidity. (That is the purpose of having “stock markets.”) Commercial real estate investments typically do not. If you have invested in a small office building and the time has come to liquidate that investment, it cannot be done overnight, or, at least, it cannot be done overnight without great loss of value.

Of course, much will depend on prevailing supply and demand conditions. It is possible that an investor will decide to liquidate in a period of high demand and short supply. In that case, a sale may be arranged in a few weeks. If the decision is made to liquidate, when market conditions are adverse, then arranging a sale may take months or years.

ii. Difficulties in Determining Property Value

This issue is closely related to liquidity. If real estate is inherently illiquid, that means it takes time to realize the property’s value. But what is its value anyway? This is certainly an area that it is easy to disagree on. When investors are selling a commercial property, they are really selling a stream of income. Valuing this stream of income requires two factors to be considered. First, one must quantify the stream of income itself, and secondly, one must determine the risk associated with that stream of income.

iii. Overextended Borrowing

Leverage is a good thing, but too much leverage can be a bad thing. Leverage increases the potential return on a project, while at the same time increasing the risk associated with that project. This is why it is better to optimize leverage than maximize it. Too much borrowing jeopardizes the success of a real estate investment as surely as too little leverage. It is a matter of balance to be decided by the investor’s taste and preference for the trade-off between risk and return.

iv. Management Expertise Required

Where ownership of the property is direct, the real estate investor is going to need to be involved with searching for the project, evaluating the project, financing the project, and (if acquired) managing the project. Even where the real estate investment involves a sale–leaseback arrangement and there is no property to search for, and the evaluation is cut and dry, the project will still not manage itself. There are always ongoing issues to be dealt with between the lesser and lessee. Real estate investment is not a passive activity. It requires active, focused, intense participation or things are likely to go terribly wrong. Real estate investment is not for the detached.

UNIT TWO

THE TIME VALUE OF MONEY

2.1.Introduction

“One dollar today is worth more than one dollar tomorrow” Why?

Because

- Capital can be employed productively to generate return
- Individuals, in general, prefer current consumption to future consumption
- In an inflationary period a dollar today represents greater real purchasing power than a dollar a year after.

As individuals, we often face decisions that involve saving money for a future use, or borrowing money for current consumption. We then need to determine the amount we need to invest, if we are saving, or the cost of borrowing, if we are shopping for a loan. As investment analysts, much of our work also involves evaluating transactions with present and future cash flows.

When we place a value on any security, for example, we are attempting to determine the worth of a stream of future cash flows. To carry out all the above tasks accurately, we must understand the mathematics of time value of money problems. Money has time value in that individuals value a given amount of money more highly the earlier it is received. Therefore, a smaller amount of money now may be equivalent in value to a larger amount received at a future date. The time value of money as a topic in investment mathematics deals with equivalence relationships between cash flows with different dates. Mastery of time value of money concepts and techniques is essential for investment analysts.

The chapter is organized as follows: Section 2 introduces some terminology used throughout the chapter and supplies some economic intuition for the variables we will discuss. Section 3 tackles the problem of determining the worth at a future point in time of an amount invested today. Section 4 addresses the future worth of a series of cash flows. These two sections provide the tools for calculating the equivalent value at a future date of a single cash flow or series of cash flows. Sections 5 and 6 discuss the equivalent value today of a single future cash flow and a series of future cash flows, respectively. In Section 7, we explore how to determine other quantities of interest in time value of money problems

2.2.Interest Rates

In this chapter, we will continually refer to interest rates. In some cases, we assume a particular value for the interest rate; in other cases, the interest rate will be the unknown quantity we seek to determine. Before turning to the mechanics of time value of money problems, we must illustrate the underlying economic concepts. In this section, we briefly explain the meaning and interpretation of interest rates.

Time value of money concerns equivalence relationships between cash flows occurring on different dates. The idea of equivalence relationships is relatively simple. Consider the following exchange: You pay $10,000 today and in return receive $9,500 today. Would you Quantitative Investment Analysis accept this arrangement? Not likely. But what if you received the $9,500 today and paid the $10,000 one year from now? Can these amounts be considered equivalent? Possibly, because a payment of $10,000 a year from now would probably be worth less to you than a payment of $10,000 today. It would be fair, therefore, to discount the $10,000 received in one year; that is, to cut its value based on how much time passes before the money is paid.

An interest rate, denoted r, is a rate of return that reflects the relationship between differently dated cash flows. If $9,500 today and $10,000 in one year are equivalent in value, then $10,000 − $9,500 = $500 is the required compensation for receiving $10,000 in one year rather than now. The interest rate the required compensation stated as a rate of return is $500/$9,500 = 0.0526 or 5.26 percent.

Interest rates can be thought of in three ways. First, they can be considered required rates of return that is, the minimum rate of return an investor must receive in order to accept the investment. Second, interest rates can be considered discount rates. In the example above, 5.26 percent is that rate at which we discounted the $10,000 future amount to find its value today. Thus, we use the terms ‘‘interest rate’’ and ‘‘discount rate’’ almost interchangeably.

Third, interest rates can be considered opportunity costs. An opportunity cost is the value that investors forgo by choosing a particular course of action. In the example, if the party who supplied $9,500 had instead decided to spend it today, he would have forgone earning 5.26 percent on the money. So we can view 5.26 percent as the opportunity cost of current consumption.

The rate of exchange between future consumption (future dollars) and current consumption (current dollars) is the pure rate of interest. Both people’s willingness to pay this difference for borrowed funds and their desire to receive a surplus on their savings give rise to an interest rate referred to as the pure time value of money. This interest rate is established in the capital market by a comparison of the supply of excess income available (savings) to be invested and the demand for excess consumption (borrowing) at a given time. If you can exchange $100 of certain income today for $104 of certain income one year from today, then the pure rate of exchange on a risk-free investment (that is, the time value of money) is said to be 4 percent (104/100 – 1).

The investor who gives up $100 today expects to consume $104 of goods and services in the future. This assumes that the general price level in the economy stays the same. If investors expect a change in prices, they will require a higher rate of return to compensate for it. For example, if an investor expects a rise in prices (that is, he or she expects inflation) at the rate of 2 percent during the period of investment, he or she will increase the required interest rate by 2 percent. In our example, the investor would require $106 in the future to defer the $100 of consumption during an inflationary period (a 6 percent nominal, risk-free interest rate will be required instead of 4 percent).

Further, if the future payment from the investment is not certain, the investor will demand an interest rate that exceeds the pure time value of money plus the inflation rate. The uncertainty of the payments from an investment is the investment risk. The additional return added to the nominal, risk-free interest rate is called a risk premium. In our previous example, the investor would require more than $106 one year from today to compensate for the uncertainty. As an example, if the required amount were $110, $4, or 4 percent, would be considered a risk premium.

Economics tells us that interest rates are set in the marketplace by the forces of supply and demand, where investors are suppliers of funds and borrowers are demanders of funds. Taking the perspective of investors in analyzing market-determined interest rates, we can view an interest rate r as being composed of a real risk-free interest rate plus a set of four premiums that are required returns or compensation for bearing distinct types of risk:

r = Real risk-free interest rate + Inflation premium + Default risk premium + Liquidity premium + Maturity premium

- The real risk-free interest rate is the single-period interest rate for a completely riskfree security if no inflation were expected. In economic theory, the real risk-free rate reflects the time preferences of individuals for current versus future real consumption.
- The inflation premium compensates investors for expected inflation and reflects the average inflation rate expected over the maturity of the debt. Inflation reduces the purchasing power of a unit of currency the amount of goods and services one can buy with it. The sum of the real risk-free interest rate and the inflation premium is the nominal risk-free interest rate.
- The default risk premium compensates investors for the possibility that the borrower will fail to make a promised payment at the contracted time and in the contracted amount.
- The liquidity premium compensates investors for the risk of loss relative to an investment’s fair value if the investment needs to be converted to cash quickly. Many bonds of small issuers, by contrast, trade infrequently after they are issued; the interest rate on such bonds includes a liquidity premium reflecting the relatively high costs (including the impact on price) of selling a position.
- The maturity premium compensates investors for the increased sensitivity of the market value of debt to a change in market interest rates as maturity is extended, in general (holding all else equal). The difference between the interest rate on longermaturity, liquid Treasury debt and that on short-term Treasury debt reflects a positive maturity premium for the longer-term debt (and possibly different inflation premiums as well). Using this insight into the economic meaning of interest rates, we now turn to

a discussion of solving time value of money problems, starting with the future value of a single cash flow.

Simple versus Compounded Interest

Under a simple interest rule, money invested for a period of time from 1 year accumulates interest proportional to the total time of the investment. So after 2 years the total interest due are 2r times the original investment and so forth. In other words the investment produces interest equal to r times the original investment every year. The account grows linearly with time. The account value at any time is just the sum of the original amount (the principal) and the accumulated interest which is proportional to time.

Simple interest = (1+rn)

Whereas, under a compound interest money left in account is multiplied by (1+r) after one yea, in the second yea it grows by another facto of (1+r) 2 and after n years such an account will be grow to (1+r)n times its original value. It’s the process of the interest earned from interest.

Compound interest may computed through

- A single Compound ( once a year)

Single compound interest = (1+)

- An Interval Compounding ( Semi annually, quarterly, monthly or daily)

Interval Compound = (1+)

- A Continuous Compounding

Continuous compound = (e= 2.718282 constant)

2.3. The Future Value of a Lump Sum (FV)

In this section, we introduce time value associated with a single cash flow or lump-sum investment. We describe the relationship between an initial investment or present value (PV), which earns a rate of return (the interest rate per period) denoted as r, and its future value (FV), which will be received N years or periods from today.

The following example illustrates this concept. Suppose you invest $100 (PV = $100) in an interest-bearing bank account paying 5 percent annually. At the end of the first year, you will have the $100 plus the interest earned, 0.05× $100 = $5, for a total of $105. To formalize this one-period example, we define the following terms:

- PV = present value of the investment

- FVN = future value of the investment N periods from today

- r = rate of interest per period

- For N = 1, the expression for the future value of amount PV is

FV1 = PV(1 + r)

For this example, we calculate the future value one year from today as FV1 = $100(1.05) = $105. Now suppose you decide to invest the initial $100 for two years with interest earned and credited to your account annually (annual compounding). At the end of the first year (the beginning of the second year), your account will have $105, which you will leave in the bank for another year. Thus, with a beginning amount of $105 (PV = $105), the amount at the end of the second year will be $105(1.05) = $110.25. Note that the $5.25 interest earned during the second year is 5 percent of the amount invested at the beginning of Year 2.

Another way to understand this example is to note that the amount invested at the beginning of Year 2 is composed of the original $100 that you invested plus the $5 interest earned during the first year. During the second year, the original principal again earns interest, as does the interest that was earned during Year 1. You can see how the original investment grows:

- Original investment = $100.00
- Interest for the first year ($100 × 0.05) = 5.00
- Interest for the second year based on original investment ($100 × 0.05) = 5.00
- Interest for the second year based on interest earned in the first year (0.05× $5.00 interest on interest) = 0.25
- Total = $110.25

The $5 interest that you earned each period on the $100 original investment is known as simple interest (the interest rate times the principal). Principal is the amount of funds originally invested. During the two-year period, you earn $10 of simple interest. The extra $0.25 that you have at the end of Year 2 is the interest you earned on the Year 1 interest of $5 that you reinvested.

Future Value of Single Compounding

The interest earned on interest provides the first glimpse of the phenomenon known as compounding. Although the interest earned on the initial investment is important, for a given interest rate it is fixed in size from period to period. The compounded interest earned on reinvested interest is a far more powerful force because, for a given interest rate, it grows in size each period. The importance of compounding increases with the magnitude of the interest rate. For example, $100 invested today would be worth about $13,150 after 100 years if compounded annually at 5 percent, but worth more than $20 million if compounded annually over the same time period at a rate of 13 percent.

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