Basics of Investments

  • Dollars Out (Invested-Negative cash flow)
  • Dollars Back (Gains-positive cash flow)
  • Period of Time (Duration of Investment)
  • Yield and Return
  • Risk and Effort

Elements that Contribute to Investments

  • Geographic location
  • Size (square foot)
  • Appreciation/depreciation
  • Price (Asking and sales price)
  • Leverage (OPM Other Peoples Money)
  • Financing
    • Principal Reduction
    • Interest Expenses
    • Increase Cash flow
    • Reinvestment of positive cash flow
  • Tax issues
    • Tax Benefits
    • Tax Brackets
    • Capital Gain Tax
    • Other Tax Incentives
    • Income taxes are calculated by:
      • Income minus
      • Operating Expenses
      • Interest on mortgage
      • Depreciation (Cost recovery)
      • Equals Net Taxable
      • Times inventors tax bracket
      • Equals taxes due or tax savings if negative
  • Risk and Effort
  • Equity: It is created over time by:
    • Purchasing the property at a discount
    • Appreciation over time
    • Reduction of principal by monthly mortgage payment: Principals and interest is paid from rentals
    • Monthly and yearly positive cash flow of rentals: Can be invested in other instruments. Can be added to principal to even reduce higher payments of interests and thus faster increasing equity

Systems to Calculate Real Estate Investment

  • Cash Flow Calculations
    • (CFBT) Cash Flow Before Taxes
    • (CFAT) Cash Flow After Taxes
  • Price per square foot
    • The price of the property divided by the total square foot
    • Analysis geographic location and size
    • Unit size
    • Area – Geographic location
    • Property type (residential, condo, multifamily, retail, offices, other)
    • Timing- through years demand, supply and market conditions change affecting the price
  • GRM Gross Rent Multiplier
    • It is the price of the property divided by gross income
    • Mainly used in apartment complexes
    • It is like the Price earnings ratio in the stock market with the difference that P/E ratio deals with net earnings
    • It is a tool to quickly compare in a gross mode different properties for sale in the market. It is use by buyers and sellers to start understanding the financial outlook of properties.
  • CAP Rate- Capitalization Rate
    • Cap Rate=N0I/Price. Cap rate equals Net Operating Income divided by the sales price
    • It is the reverse of price earnings ratio in the stock market
    • It is used in commercial properties such as retail to compare qualities of different units or retail complexes
    • Classes of properties tend to sell at closer cap rates in micro-geographic areas
    • Important: Cap rates change with finance rates
    • In theory the cap rate tells you that without finance on the property, the pre-tax return on the building would be the cap rate
    • The lower the cap rate the higher value on that property
  • Cash on Cash
    • It is the first year pre-tax cash flow divide by the initial cash invested plus closing costs.
    • Analysis pre-tax dollars
    • It considers financing, leverage and operating expenses
  • Equity Rate of Return
    • It does analysis of the first year financial projections
    • It analysis the first year of:
      • Pretax cash flow
      • Principal reduction
      • Tax Benefits
      • Appreciation
      • Then divide by the first year investment dollars and closing costs
  • Absorption Rates
    • For different types of real estate product
    • For developers and also to understand the real estate cycle
    • It analysis:
      • Number of existing property
      • Number of new properties
      • Vacancies and new vacancies
      • Is the new vacancy factor higher or lower
      • Also, must analyze qualitative factors such as preference for new or rehabbed space
  • Compounding and Discounting
    • Compounding: look forward
      • It projects what you will have in the future if you know what you are starting with, the return you get and how long
    • Discounting: look backwards- from the future to the present
      • Use for goal setting
      • It tells you, how much the invetor needs to invest at a what rate and for how long, in order to reach his/her goal
  • IRR Internal rate of Return
    • The rate of discount at which the present value of future cash flows is exactly equal to the initial investment
    • It analysis:
      • CFAT Cash flow after taxes
      • Net proceedings resulting for sale (reversion)
      • Tax Obligations and costs of sale
  • NPV Net Present Value
    • It is the sum of the present values of future cash flows netted against the initial investment
    • The future cash flows are discounted to present values
    • It uses at appropriate discount rate which is the opportunity cost for the investor
    • It measures alternatives investment opportunities in today’s present dollars
  • MIRR Modify Internal rate of Return
    • Also know as the Financial rate of Return
    • It is the rate of discount at which the present value of future cash flows is equal to the initial investment
    • It assumes the reinvestment of the positive cash flows at realistic rates
    • It uses to reinvestment rates after tax yields
      • Safe Rate: easily attainable reinvestment rates-Tax Free Bonds
      • Reinvestment Rate: a low risk investment such as a low risk mutual fund