Chapter17RealEstateandOtherTangibleInvestments61

Chapter17
RealEstateandOtherTangibleInvestments
.1

Outline

Learning Goals
I.

InvestinginRealEstate
A) InvestorObjectives
1. InvestmentCharacteristics
2. ConstraintsandGoals
B) AnalysisofImportantFeatures
C) DeterminantsofValue
1. Demand
2. Supply
3. TheProperty
a. RestrictionsonUse
b. Location
c. Site
d Improvements
e. PropertyManagement
4. PropertyTransferProcess
ConceptsinReview

II.

RealEstateValuation

62Gitman/JoehnkFundamentalsofInvesting,NinthEdition

A) EstimatingMarketValue
1. TheCostApproach
2. TheComparativeSalesApproach
3. TheIncomeApproach
4. UsinganExpert
B) PerformingInvestmentAnalysis
1. MarketValueversusInvestmentAnalysis
a. RetrospectiveversusProspective
b. ImpersonalversusPersonal
c. UnleveragedversusLeveraged
d. NOIversusAfterTaxCashFlows
2. CalculatingDiscountedCashFlows
3. CalculatingYield
ConceptsinReview
III. AnExampleofRealEstateValuation
A) SetInvestorObjectives
B) AnalyzeImportantFeaturesoftheProperty
C) CollectingDataonDeterminantsofValue
1. Demand
2. Supply
3. TheProperty

Chapter17RealEstateandOtherTangibleInvestments63

4. ThePropertyTransferProcess
D) PerformValuationofInvestmentAnalysis
1. TheNumbers
2. CashFlowofAnalysis
3. ProceedsfromSale
4. DiscountedCashFlow
5. Yield
E) SynthesizeandInterpretResultsofAnalysis
ConceptsinReview
IV. RealEstateInvestmentSecurities
A) RealEstateInvestmentTrusts(REITs)
1. BasicStructure
2. InvestinginREITs
B) OtherFormsofRealEstateInvestment
ConceptsinReview
V.

OtherTangibleInvestments
A) TangiblesasInvestmentOutlets
1. InvestmentMerits
B) InvestinginTangibles
1. GoldandotherPreciousMetals
2. Gemstones
3. Collectibles
ConceptsinReview

Summary
DiscussionQuestions
Problems
CaseProblems
17.1 GarySofersAppraisaloftheWabashOaksApartments
17.2 AnalyzingDr.DavissProposedRealEstateInvestment

64Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.2

Key Concepts

1.

Investinginrealestateandsettinginvestmentobjectives.

2.

Analysisofimportantfeaturesofrealestateinvestments.

3.

Determinantsofrealestatevalueandthepropertytransferprocess.

4.

Techniquesusedtoestimatemarketvalue.

5.

Considerationsandproceduresusedtoperforminvestmentanalysis.

6.

Demonstrationofacompleterealestateinvestmentanalysisofasmallapartmentbuilding.

7.

Formsofrealestateinvestmentsecurities,includingrealestateinvestmenttrusts(REITs).

8.

Theinvestmentcharacteristicsandsuitabilityofgoldandothertangibleassets,suchassilver,
gemstones,andcollectibles.

.3

Overview

Theroleofrealestateasaninvestmentvehicleandtheuseofappropriaterealestateinvestmentanalysis
techniquesarethesubjectsofthischapter.
1.

Arealestateinvestormustconsiderhowtheinvestmentcharacteristicsofrealestatedifferand
establishappropriateinvestmentconstraintsandgoals.

2.

Tomeaningfullyevaluatetheinvestmentpotentialofrealestate,theinvestormustanalyzethe
propertysimportantfeatures.Thisanalysisshouldinclude:(1)identificationofthephysical
property,(2)definitionoftheapplicablepropertyrights,(3)thetimehorizonfortheinvestment,and
(4)thedelineationofageographicarea.

3.

Theinvestorshouldaskanumberofquestionsrelativetodeterminingapropertysvalue.Answering
thesequestionsintelligentlyrequiresevaluationoffourmajordeterminantsofvalue:demand,supply,
theproperty,andthepropertytransferprocess.

4.

Marketvalueforarealestateinvestmentdiffers,foranumberofreasons,fromthatforstocksand
bonds.Thenatureofarealestateinvestmentmakesestablishingatruemarketvalueverydifficult,if
notimpossible.Aninvestorshouldrealizethatanyvalueestimateisprobablyonlyabestguess.
Marketvalueisusuallyestimatedusingoneormoreofthreeimperfectapproaches.Theseapproaches
are(1)thecostapproach,(2)thecomparativesalesapproach,and(3)theincomeapproach.Anexpert
canbeusedasasourceofadviceaboutthemarketvalueofproperty.

5.

Estimatesofmarketvalueareonepartofaninvestmentanalysis.However,duetothecomplexityof
arealestateinvestment,manyinvestorssupplementmarketvalueappraisalswithaninvestment
analysis.Theconceptofmarketvaluediffersfromaninvestmentanalysisinfourimportantways:(1)
retrospectiveversusprospective,(2)impersonalversuspersonal,(3)unleveragedversusleveraged,
and(4)netoperatingincome(NOI)versusaftertaxcashflows.

Chapter17RealEstateandOtherTangibleInvestments65

6.

Discountedcashflowtechniquesthatfindnetpresentvalueorcalculationoftheapproximateyield
helptodecidewhetheraproposedrealestateinvestmentiseconomicallyjustified.

7.

Usinganexampleofaprospectiverealestate(apartment)investment,thetextthenfollowsthe
processofanalysispresentedearlierinthechapterandappliesthevarioustechniquesofmarketvalue
andinvestmentanalysis.

8.

Realestateinvestmentsecuritiesarediscussed,includingrealestateinvestmenttrusts(REITs).
Emphasisisplacedontheeconomicworthoftheseinvestments,ratherthantheiruseastaxshelters
(whichhasgreatlydiminishedwithpassageoftheTaxReformActof1986).

9.

Thelastsectionofthechapterprovidesadiscussionoftangibleassetsasinvestmentoutlets.Topics
includegold,preciousmetals,gemstones,andcollectibles.Theinstructorshouldemphasizethe
specialnatureofmanyoftheseassetsandthespecialknowledgethatisneededtobeasuccessful
investor,sincethereturnfromtangiblescomesfrompriceappreciationalone.Knowingwhatyoure
buyingisakeyelementofsuccess.Identifyingsomeothercurrentlypopularcollectiblesbrings
realismintotheclassroomandtendstobeahitwithstudents.

.4

Answers to Concepts in Review

1.

Realestateispropertysuchasresidentialhomes,rawland,andincomeproducingpropertieslike
warehouses,offices,apartmentbuildings,cooperatives,andcondominiums.Tangiblesareinvestment
assetsotherthanrealestatethatcanbeseenortouched,likegold,gemstones,andcollectibles.

2.

Realestateandsecurityinvestmentsdifferinonefundamentalway.Realestateisanassetyoucan
touchorsee,whereasasecurityinvestmentisanonphysicalfinancialclaim.Realestate,ifproperly
selected,candiversifyaninvestmentportfoliobycontributingtofavorableportfolioriskreturn
tradeoffs.Aswithanyinvestment,aninvestorshouldevaluaterealestateintermsofitsriskreturn
characteristics.Heorsheshouldconsidertheproposedinvestmentinlightoftheeconomicand
politicalenvironment,andthenrelateittotheoverallportfolio.Byappropriateselection,realestate
investmentscandiversifytheportfolioandhelptominimizeitsriskand/ormaximizeitsreturn.

3.

Incomepropertiesarerentedorleasedpropertiesthatprovidetheowner(s)withregularrental
income.Speculativepropertiestypicallyincludelandandspecialpurposebuildings,suchas
churches,gasstations,andthelike.Thesepropertiesofferthechanceforsignificantreturnsbutalso
involveagreatdealofriskwithahighprobabilityofloss.Timingofthepurchaseandsaleofthese
propertiesfrequentlydeterminesthelevelofgainsorlossesincurredbytheinvestor.
Incomepropertiescanbeclassifiedaseitherresidentialorcommercial.Residentialpropertiesare
purchasedtoberentedtotenantswholiveinthemandincludesinglefamilyhouses,condominiums,
cooperatives,townhouses,andmultifamilyresidencessuchasapartmentbuildingsandcomplexes.
Commercialpropertiesareusedforbusinesspurposesandincludewarehouses,officebuildings,
factories,andshoppingcenters.

4.

Analyzingrealestaterequiresconsiderationofthefollowingfeatures:
(a) Physicalproperty:Asitesurveywillverifytheactualsquarefootage,andaninspectionof
buildingsand/orthesitewillrevealanypossibledefects.Asalescontractshouldaccurately
definethepropertyandlistanypersonalpropertyincludedinthesale.

66Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(b) Propertyrights:Thesaleofrealestateincludesdeeds,titles,easements,liens,etc.These,aswell
asthesaleorleaseagreements,shouldbereviewedbyanattorneybeforefinalizingthe
transaction.

Chapter17RealEstateandOtherTangibleInvestments67

(c) Timehorizon:Thetimeperiodoverwhichyouplantoholdthepropertyhelpsdecidethefactors
thatareimportantintheanalysis.Forexample,ashortterminvestorwillfocusonnearterm
interestrateforecasts,whilealongterminvestorwouldlookatpopulationtrends.
(d) Geographicarea:Characteristicsofthesurroundingneighborhoodaffectpropertyvalues,andit
isimportanttoknowhowlargeanareatoincludeinthemarketareaanalysis.
5.

Realestatedemandisinfluencedbytheareaseconomicbase,populationcharacteristicslike
demographicsandpsychographics,andthetermsandconditionsofavailablemortgagefinancing.
Theseandotherfactorsmakerealestatepricesdifficulttodetermine.
Realestatesupplyisinfluencedbyotherpropertiesthatcompeteinthesamemarket.Therefore,an
investormustanalyzeinvestmentalternativesinlightofthepricesofcompetitivepropertiesandtheir
features.
Demographicsreferstostatisticssuchashouseholdsize,agestructure,occupation,gender,and
maritalstatus.Psychographicsdescribespeoplesmentaldispositions,suchaspersonality,lifestyle,
andselfconcept.Botharepopulationcharacteristicswhichheavilyinfluencedemandforrealestate.
Theprincipleofsubstitutionincorporatestheideathatpeopledonotreallybuyorrentrealestateper
se,rathertheyjudgepropertiesasdifferentsetsofbenefitsandcosts.Thus,supplyisnotjust
influencedbycompetingpropertiesofthesamelocationandphysicalaspects,butbyallpropertiesin
allclassifications.

6.

Apropertyscompetitiveedgeisaffectedbyhowthepropertymeetstheneedsoftheinvestor.
Investorsshouldconsiderimportantpropertyfeatures.
(1) Restrictionsonuse.Investorsshouldnotinvestinapropertyuntiltheyhavedeterminedwhether
whattheywanttodowiththepropertyagreeswithallapplicablelaws.
(2) Location.Convenienceandenvironment,bothindicatorsofagoodlocation,increasetheprofit
potentialofarealestateinvestment.
(3) Site.Sitefeatureslikesizeandqualityareimportantconsiderationsinthecontextofwhatthe
investorsobjectivesforthepropertyare.
(4) Improvements.Improvementsmanmadeadditionstoasiteshouldbeaccuratelymeasured
andappropriatelybuiltintermsoftrafficflowandaccessibility.Also,amenities,style,and
constructionqualityareimportantindeterminingapropertyscompetitiveedge.
(5) PropertyManagement.Investorsshouldfindtheoptimallevelofmanagementbenefitsfora
propertyatthelowestcost.

7.

Realestatemarketsarenotefficientbecausethereisnogoodsystemforcompleteinformation
exchangeamongbuyersandsellers,andamongtenantsandlessors.Also,realestatereturnsare
partiallycontrolledbythepropertyownersthemselves.Profitsandcashflowsdependonhowwell
thepropertyismanagedandcanbesignificantlyinfluencedthroughnegotiationandpromotion
activities.Realestatemarketsaregenerallyilliquidandtendtoberegionalorlocal.Thismakes
marketresearchespeciallyimportantwhenconsideringrealestateinvestments.
Promotionreferstodisseminatinginformationaboutapropertytothebuyersegmentofthemarket.
Negotiationbetweenthebuyerandsellerdeterminesthefinaltransactionprice.Theinefficiencyof
therealestatemarketmakespromotionthroughadvertising,publicity,salesgimmicks,andpersonal
sellinganecessarypartofsellingaproperty.Also,negotiationisaffectedinaninefficiencymarket:
buyersandsellerswillhaveverydifferentideasaboutthevalueandpriceoftheproperty.

8.

Marketvalueistheprevailingpriceofaproperty,indicatinghowthemarketasawholehasassessed
thepropertysworth.Arealestateappraisalistheestimateofapropertyscurrentmarketvaluebased
oncertaininformationandtechniques.

68Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(1)uniquenessoftheproperty,(2)variationinthetermsandconditionsofsale,(3)imperfectionof
marketinformation,(4)timerequiredtoprovidemarketexposurepriortosale(manypropertiescan
onlybesoldquicklyatabargainprice),and(5)needforbuyerstosometimesactquicklyallmakeit
difficulttoascertainthetruemarketvalueofaproperty.Thus,astatedmarketvalueisonlyan
estimatesubjecttoavarietyofforceswhichmaycausesubstantialerrorintheestimationprocess.
Duetotheintangiblenatureoftheforceswhichaffectanddetermineanestimateofmarketvalueand
thehighprobabilityoferrorintheestimationprocess,onemightsaythattheactualmarketvalueofa
realestateinvestmentisthepriceatwhichapurchase/saletransactiontakesplace.Outsideoflegal
andethicalconstraints,themarketvalueisthebestpriceatwhichadealcanbemade.
9.

Thethreevaluationapproachescommonlyusedbyrealestateappraisersare:
(1) Costapproach:Valuebasedonthenotionthataninvestorshouldnotpaymoreforaproperty
thanitwouldcosttorebuilditattodayspricesforland,labor,andconstructionmaterials;
(2) Comparativesalesapproach:Valuedeterminedbycomparingsalespricesofpropertiessimilar
tothesubjectproperty(thisapproachreliesontheideathatthevalueofagivenpropertyisabout
thesameasthepricesforwhichothersimilarpropertieshaverecentlysold);and
(3) Incomeapproach:(directcapitalization)Calculatesvalueofapropertyasthepresentvalueof
allitsfutureincome.Itisappliedbydeterminingtheannualnetoperatingincome(NOI)fromthe
propertyanddividingitbythemarketcapitalizationrate,therateusedtoconvertanincome
streamintoapresentvalue.

10. Realestateinvestmentanalysisconsidersnotonlywhatsimilarpropertieshavesoldfor,butalso
looksattheunderlyingdeterminantsofvalue.
Realestateinvestmentanalysisdiffersfrommarketvaluein4differentways:
(1) Retrospectiveversusprospective:Marketvalueappraisalslookbackwardtoestimateapropertys
price,whereasaninvestmentanalysisforecastsrelevanteconomicfactors,demographicsand
psychographics,mortgagetermsandfinancing,andsourcesofcompetition.
(2) Impersonalversuspersonal:Amarketvalueestimaterepresentsanaverageviewofthemarket.
Buyerandsellerconstraintsandgoalsareincorporatedintoaninvestmentanalysiswhenvaluing
eachpropertystermsandconditionsofsale(orrent).
(3) Unleveragedversusleveraged:Simpleincomecapitalizationsdonotincorporatealternative
financingplans.Itassumesacashorunleveragedpurchase.Investmentanalysisexaminesvalue
includingtheconceptofleverage,accountingforthefactthatleveragecanmagnifyinvestor
returns.
(4) NOIversusaftertaxcashflows:Tomostinvestors,capitalizingNOItocalculatemarketvalueis
meaninglessbecausethemajorityofrealestateinvestorsfinancetheirpurchases.Investment
analysisusesaftertaxcashflows,netofallexpenses,taxes,anddebtservice.
11. Leverageistheuseofdebttopurchaseproperty.Itincreasesriskbecausetheloanobligationmustbe
repaid,andfailuretodosoresultsinforeclosureandlossofproperty.Ontheotherhand,leveragecan
alsoincreasereturnifthepropertycanearnmorethanthecostoftheborrowedfunds.

Chapter17RealEstateandOtherTangibleInvestments69

12. Netoperatingincome(NOI)istheincomefromincomeproducingrealestatethatremainsafter
subtractingvacancyandcollectionlossesandpropertyoperatingexpenses,includingproperty
insuranceandtaxes,fromapropertysgrosspotentialrentalincome.
Aftertaxcashflow(ATCF)istheannualcashflowearnedonarealestateinvestment,netofall
expenses,taxes,anddebtservice.ItiscalculatedbysubtractinganymortgagepaymentfromNOIand
adjustingthedifferencefortaxes.ATCFgivestheinvestoranestimateoftheamountofcashheor
shemightreceiveeachyearduringwhichtheinvestmentisheld.
RealestateinvestorsprefertouseATCFsbecauseittellsthemhowmuchcashwillberequiredtoput
intoatransaction,andhowmuchcashtheyarelikelytogetout.
13. Inrealestatetransactions,thenetpresentvalue(NPV)isthedifferencebetweenthepresentvalueof
cashflowsandtheamountofequityrequiredtomakeaninvestment.NPVtellstheinvestorwhether
theproposedinvestmentshouldbetaken(positiveNPV)ornot(negativeNPV).
Aninvestorcouldalsocalculatetheyieldtodeterminethesuitabilityofaninvestment.Iftheyieldis
greaterthantheappropriatediscountrate,theinvestmentshouldbemadeinthiscasetheNPVis
positive.
14. Thefivestepsintheframeworkforrealestateanalysisare:
(1) Setoutinvestorobjectives.Considerobjectivessuchasdiversificationofyourportfolio,desire
forcapitalgainsappreciation,location,andinvestorpersonality.
(2) Analyzeimportantfeaturesoftheproperty.Considerpropertysize,quality,andrestrictionson
use.
(3) Investigatethedeterminantsofpropertyvalue.Considerdemandandsupply,propertyfeatures
likelocationenvironmentandconvenience,andtherelativeefficiencyofthemarketwith
respecttothepropertytransferprocess.
(4) Performaninvestmentanalysis.Lookatacashflowanalysisbasedonthedeterminantsofvalue,
estimatetheproceedsfromafuturesaleoftheproperty,discountthesecashflows,andsubtract
themfromtheinitialequityinvestmentrequired(NPV).Finally,approximatetheyieldofthe
propertyinvestmentandcomparethistotherequiredreturn.
(5) Synthesizeandinterprettheresults.Weighthefeaturesanddeterminantsofpropertyvalue,and
examinetheinvestmentanalysisresultsinlightofyourinitialobjectives.
15. Depreciationisaprovisionintheincometaxlawsthatallowsinvestorsinrealestatetodeducta
portionoftheoriginalcostofbuildingseachyear.Depreciationprovidesataxshelterbyreducing
taxableincomeandtherebypermittinginvestorswhoactivelymanagethepropertyandmeetcertain
incomerequirementstoretainagreaterportionoftheircurrentincome.Incomepropertiespaying
currentincomearetheprimaryrealestateinvestmentsofferingtaxshelteringopportunitiestothose
whoqualify.
16. MakingarealestateinvestmentbasedsolelyonacceptableNPVandyieldvalueswouldbefoolish.
Thesenumbers,atbest,areestimatesandsubjecttothepossibilityofconsiderablevariation.Asnoted
inthischapter,therearenumerousfactorssuchasrestrictionsonuse,location,sitecharacteristics,
improvements,propertymanagement,andleveragethatmustbeconsideredandanalyzedbeforethe
realestateinvestmentdecisioncanbemade.Anyinvestorwishingtomakearealestateinvestment
withahighprobabilityofsuccessshouldthoroughlyanalyzethepropertyunderconsideration.This
analysis,however,isafairlycomplexprocessinvolvinganumberofconsiderationsandcertainlynot
basedononlytwoquantifiablemeasuressuchasNPVandyield.Note,however,thatthesesubjective
variablesshouldinfluencethecalculationofNPV.

70Gitman/JoehnkFundamentalsofInvesting,NinthEdition

17. Realestateinvestmenttrusts(REITs)areinvestmentcompaniesthatinvestinvarioustypesofreal
estateand/orrealestatemortgages.Theyraisefundsbysellingsharestoinvestorsandtradeonthe
NYSE,AMEX,andintheOTCmarket.ReturnsonREITshavevariedconsiderably;theytypically
earnareturnof1to2percentagepointsabovemoneymarketfundsandaboutthesamereturnas
highgradecorporatebonds.Theyarerequiredbylawtopayout95percentoftheirincomeas
dividends.Furthermore,theymustkeepatleast75percentoftheirassetsinrealestateinvestments
andholdeachinvestmentforatleast4years.
Fortheinvestor,REITsofferanattractivemechanismformakingrealestateproperty,mortgageor
bothpropertyandmortgageinvestments.Theyalsoprovideprofessionalmanagement,sharesthatare
publiclytraded,sometaxbenefits,andpossiblediversificationamongrealestateinvestments,
locations,andtypesofpropertyorsecurities.
ThebasictypesofREITsare:
(a) EquityREITs:whichinvestinpropertiessuchasapartments,officebuildings,shoppingcenters,
andhotels.ThesearethemostcommontypesofREITs.
(b) MortgageREITS:whichmakebothconstructionandmortgageloanstorealestateinvestors.
(c) HybridREITs:whichinvestbothinpropertiesandinconstructionandrealestatemortgageloans.
18. AccordingtotheInvestingInActionbox,theaccountinginanREITfirmisdifferentfromthatofa
typicalpubliccompany.Theequivalenttermforanearningspershare(EPS)inanREITisfunds
fromoperation(FFO).ThemaindifferencebetweenFFOandEPSisthatFFOaddsback
depreciation.FFOaremoreappropriateforanREITbecauserealestatehasnotdepreciated
historicallytothesameextentasmachinery,computers,andotherpersonalpropertyusedin
traditionalbusiness.
REITsaretypicallynicheplayers,focusingononegeographicareaandspecializinginoneproperty
typeapartments,factoryoutletmalls,shoppingcenters,officebuildings,mobilehomeparksetc.
Thepopularityofthedifferentpropertytypeskeepschangingwiththeeconomicconditions.Henceit
isrecommendedbuyingseveraltypesofREITstodiversifybothgeographicallyandintermsof
propertytype,becauseeachtypeofREITperformsdifferently.
19. Atangibleassetisonethatcanbeseenandtouchedandthathasformandsubstance.Manyinvestors
owntangibleinvestmentsbecausetheycanbeseenandtouched,whileotherspreferthembecauseof
theirscarcityvalue.Exceptforrealestate,tangibleassetsofferonlyoneformofreturn:Capital
appreciation.Investmentintangibleassetsisusuallymadewiththeexpectationofrisinginflation,
interestratesbarelyequalingorexceedingtherateofinflation,and/ortheexpectationofheightened
internationaltensions.Thesefactorscreateanunstableenvironment,whichisfavorableto
investmentsintangibleassets.Becausethereturnsontangibleassetsdependheavilyonan
appropriateenvironment,thetimingofbuyandsellactivitiesareveryimportanttoearninga
favorablereturn.
Thegeneraleconomicconditionscontributingtoprofitableinvestmentintangibleassetsinclude:
soaringinflation,highandvolatileinterestrates,andgrowinginternationaltensions.Eachofthese
situations,aloneorincombination,causeinvestorstoprefertoholdnonmonetaryassets,especially
gold.

Chapter17RealEstateandOtherTangibleInvestments71

20. Thethreemajorformsoftangibleinvestmentsare:goldandotherpreciousmetals,gemstones,and
collectibles.
Theonlysourceofreturnfrominvestingintangiblescomesfromappreciationinvalue.Investorsin
tangiblesfacesubstantialopportunitycostsintheformoflostincomethatcouldhavebeenearnedon
thecapital.Tangiblesalsofaceinsuranceandstoragecosts.
Thefuturepricesandreturnsoftangiblestendtobeaffectedbyoneormorekeyfactors:theinflation
rate,supplyoftheassets,anddomesticandinternationalinstability.Lowinflationandanincreasein
supplyrelativetodemandbothunfavorablyaffectthefuturepricesoftangibles.Also,intimesof
domesticandinternationalstability,investingintangiblesislessattractive.
21. VeteranCollectorsadvisenovicestopickafieldthatintereststhemsothattheyalsogetpleasure
fromwhattheyown.Expertspredictthatthenewtreasureswouldberelicsofthetwentiethcentury
technologyrevolutionlikeoldT.V.sandcomputers.Butfiguringoutwhatwillbenextyearshottest
collectibleisdifficult.Collectiblesrunincycles,andtodaysfadmaybeouttomorrow.Hence
collectingitemswhichinterestnoviceswouldatleastprovidethemwithpleasureontheirown,ifnot
fameandmoney.
22. Goldprovidesanexcellenthedgeagainstinflation.Apartfromgold,silverandplatinumarealso
popularmetals.Thepricesofallthesemetalsfluctuatewidely,andthereforetheyareconsidered
speculativeinvestments.
Gemstonesincludediamonds,rubies,andemeralds.Theyareprimarilythingsofbeautypurchasedby
thewealthyforaestheticreasons.Theinvestmentvalueofgemstonesisafunctionofquality,and
evaluationofqualitycanvaryfromdealertodealer.Becauseofhighcommissionsanddifficultiesin
resale,gemstonesareaspecialistsdomain.
23. Collectiblescovereverythingfromstampsandcoinstoantiquesandartwork.Theyderivetheirvalue
fromtheirbeauty,scarcity,andage.Popularformsofcollectiblesare:rarecoins,rarestamps,art
works,antiques,baseballcards,fantasyart,books,games,toys,comicbooks,posters,movie
memorabilia,andhistoricallettersandautographs.
Manykeyvariablesshouldbeconsideredwheninvestingincollectibles:
(1) Personalinterestandpleasureshouldnotcomeinthewayofinvestingincollectibles.The
investmentshouldbeevaluatedfromasoundeconomicviewpoint.Itemsthatarelikelyto
appreciatearethebestchoicesforinvestment.
(2) Ifanitemunderconsiderationisexpensive,itsvalueandauthenticityshouldalwaysbe
confirmedbyanexpertpriortopurchase.
(3) Collectiblesshouldbestoredinasafeplaceandinsuredagainstallrelevantperils.
(4) Collectiblesaregenerallynotveryliquid,theirresalemarketstendtobepoor,andtransaction
costscanbeveryhigh.Collectiblescanbeaseriousinvestmentonlyforknowledgeable
collectorswhoknowthehazardsofinvestingincollectibles.

72Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.5
1.

Suggested Answers to Discussion Questions

(a) Settingobjectivesinvolvestwosteps.Inthefirstyouwouldconsiderthedifferencesinthe
investmentcharacteristicsofrealestate.Inthesecondstep,youwouldestablishinvestment
constraintsandgoals.Thekeycharacteristicsofthetwoinvestmentcategorieshelptoanswerthe
question.Speculativepropertytypicallyincludesrawlandandinvestmentproperties.Returnsare
expectedtocomeprimarilyfromappreciationinmarketvalueofthepropertyduetolocationand
scarcity.Sincetheseinvestmentscarryheavyrisk,theymayoffertheinvestorhigherreturns.
Incomepropertyincludesresidentialandcommercialpropertiessuchashouses,condos,and
townhousesthatareconsideredresidential.Commercialpropertyincludesofficebuildings,
shoppingcenters,warehouses,andfactories.
(b) Onefinancialconstraintistheriskreturnrelationshipthatisuniquetoeachinvestor.Another
financialconstraintistheamountofmoneytheinvestorwantstoinvestandtheyieldor
discountedcashflowexpectedfromtheinvestment.Nonfinancialgoalsincludetheinvestors
technicalskills,temperament,repairskills,andmanagerialtalents.Manyinvestorsareopentoa
propertythatneedsfixingupwhileothersavoidtheextrawork.
(c) Theinvestormustdecidetherelevanttimehorizon.Withashortterminvestor,thequickdropin
mortgageinterestratesandbuoyantmarketexpectationsareamajordeterminant.Forthelong
terminvestor,populationgrowthmaybemoreimportant.
Becauserealestateisaspatialcommodity,thelocationofthepropertyiscriticaltoitsmarket
value.Theinvestormustdetermineforthemselveswhatspatialboundariesareimportantforthe
investment.

2.4. Answerswillvaryaccordingtostudentchoices.
5.

(a) Goldcoins:littleornocollectorvalue;qualityandamountofgoldinthecoinsaremostcritical
factors
Goldstocks:pricestendtomovedirectlywiththepriceofgold;mutualfundsofferprofessional
managementandgreaterportfoliodiversification.
Goldfutures:ashortterminvestmentstrategy
Goldcertificates:convenientandrelativelysafewaytoowngold;avoidsstatesalestax.
(b) Comparativegrid:
Costs
Coins

EaseofPurchase/Sale

Commissions

Potential
Returns
Uncertain

Fluctuatewith
sellers;Storage
involved
Negotiable

Relativelydifficultto
find

Nolimit

Relativelyeasy

Futures

Fixed
commission

Dependsonthe
priceofgold
Dependsonthe
priceofgold

Certificates

Nostorage

Commodity
exchangesmakeit
easy
Veryconvenient

Dependson
sizeoftrade
Fixed
Dependson
sizeoftrade

Dependsonthe
priceofgold

Stocks

Chapter17RealEstateandOtherTangibleInvestments73

(c) Certificateswouldprobablybetheleastriskywaytoinvestingold.Ineverycaseexceptcoins,
thereturnsaredirectlydependentonthepriceofgold.Sointhisalternativeinvestment,gold
pricesdriveeverything.
(d) Collectivessuchascoins,stamps,posters,andcarshavevaluebecauseoftheirattractivenessto
collectors.Theseinvestmentswouldbealternativestoinvestingingold.

74Gitman/JoehnkFundamentalsofInvesting,NinthEdition

.6

Solutions to Problems

1.
Alternative
(I)$7,500appreciation
InitialCashOutlay
Valueafter1Year:
BorrowedFunds:
InterestRate:
InterestPaid:
(a) Netreturnorgain:
(b) ReturnonEquity(ROE):

(II)$7,500depreciation
Valueafter1Year:

$50,000
$57,500
0
n.a.
n.a.

$50,0000.20$10,000
$57,500
$40,000
10.5%
$40,0000.105$4,200

$57,500$50,000
$7,500
$7,500/$50,000
15%

$42,500

$57,500$40,000$4,200
$10,000$3,300
$3,300/$10,000
33.0%

$42,500

(a) Netreturnorgain:

$45,500$50,000
$42,500$40,000$4,200
$7,500loss
$10,000$11,700loss
(b) ReturnonEquity(ROE):
$7,500/$50,000
$11,700/$10,000
15%loss
117%loss
Ifthepurchaseisleveraged,gainsaremagnifiedbutsoarelosses.Thereisobviouslymorerisk
introducedthroughborrowing.Taxtreatmentwouldreducethegainsandminimizethelossesfaced
byCharlesCook.

2.

(a) NetOperatingIncome(NOI)GrossrentalincomeVacancyandcollectionlossesProperty
operatingexpenses,includingpropertytaxesandinsurance
(1) Grosspotentialrentalincome$20,000
(2) Vacancyandcollectionlosses$20,0000.05$1,000
(3) Propertyoperatingexpenses$10,000
Year1NOI$20,000$1,000$10,000$9,000
Year2NOI$9,000($9,0000.06)$9,540
Year3NOI$9,540($9,5400.06)$10,112.40

Chapter17RealEstateandOtherTangibleInvestments75

b. YearsIncomeTaxComputation
NOI
Interest
Depreciation
TaxableIncome
MarginalTaxRate
Taxes()orTaxSavings()

(1)
$9,000
8,300
4,500
($3,800)
0.25
$950

(2)
$9,540
8,200
4,500
($3,160)
0.25
$790

(3)
$10,112.40
8,000.00
4,500.00
($2,487.60)
0.25
$612.90

YearsAfterTaxCashFlow(ATCF)Computation
NOI
MortgagePayment
BeforeTaxCashFlow
TaxSavings
Taxes()orTaxSavings()
3.

(a) OriginalCost:
BookValue:
Year
1
2
3
4

$200,000
$137,000
$200,000
$212,000
$224,720
$238,203.20

(1)
$9,000
8,500

$500
950
$1,450

(3)
$10,112.40
8,500
$1,612.40
612.90
$2,225.30

AnnualAppreciation:6%
SalesCommission:5%
Value
($200,0000.06)
($212,0000.06)
($224,7200.06)
+($238,203.200.06)

ForecastSalePrice: $252,495.39
SellingCommission: $252,495.390.05$12,624.77
TaxPayableontheProposedSale:
Forecastsaleprice
Less:Sellingcommission
Bookvalue
Totalgainonsales

(2)
$9,540
8,500
$1,040
790
$1,830

$252,495.39
12,624.77
137,000.00
$102,870.62

$212,000.00
$224,720.00
$238,203.20
$252,495.39

76Gitman/JoehnkFundamentalsofInvesting,NinthEdition

Capitalgain
($252,495.3912,624.77200,000)$39,870.62
RecapturedDepreciation
($200,000$137,000$63,000.00)
Taxonrecaptureddepreciation(25%)
Taxoncapitalgain($39,970.620.15)
Taxespayable

$15,750.00
$5,995.59
$21,745.59

(b) (OutstandingMortgageBalance:$155,000)
AfterTaxNetProceeds(CFR4):

4.

(a)

$252,495.39$12,624.77$155,000
$21,745.59$63,125.03

CF3
CF CFR4 I0
CF1
CF2

4
(1 r)1 (1 r)2 (1 r)3
(1 r)4
I 0 $55,000
n4
r 14% 0.14
NPV

$6,200
$8,000
$8,300 $8,500 $59,000

$55,000
1
2
(1 14) (1 14) (1 14)3
(1 14)4
[$5,439 $6,156 $5,602 $39,965] $55,000
$57,162 $55,000 $2,162

NPV

(b)
CashFlow

Year1
6,200

Year2
8,000

Year3
8,300

Year4
8,50059,00067,500

TheInstructorcantakethestudentsthroughaniterativeprocessasdescribedintheBookuntil
theyarrivedatadiscountratewhichmakestheNPV0.Thecorrectyieldfromtheinvestment
15.3%Usingthecashflowworksheetavailableonmanycalculators,theinputswouldbeYear0
$55,000,Year16200,Year28000,Year38300,Year467,500,andcomputetheyield
(i.e.,IRR).
(c) Atarequiredrateofreturnof14percent,thenetpresentvalueoftheexpectedcashflowswould
equal$2,162.Anotherwayoflookingatthisvalueisthatthepresentvalueoftheforecastcash
flowsexceedstheinitialinvestmentof$2,162.SinceitsNPVisgreaterthan$0,itsclearly
acceptable.
Usingyieldanalysis,theinvestmentwouldhaveayieldof15.3%,whichexceedstherequired
returnof14%.Sincetheyieldisgreaterthantherequiredreturn,itsclearlyacceptable.
Accordingtobothanalyticalmethods,theinvestmentisacceptable.Ifallotherinvestment
considerationsoftheparticularpropertymeetBeziesacceptancecriteria,sheshouldpurchaseit.

Chapter17RealEstateandOtherTangibleInvestments77

.7

Solutions to Case Problems

Case 17.1Gary Sofers Appraisal of the Wabash Oaks Apartments

Thiscasegivesthestudenttheopportunitytodiscussvariousfactorsinvolvedinanalyzingaprospective
realestateinvestmentandtoapplytheanalysistoaninvestmentdecision.
(a) First,Mr.Sofermustestablishand/orassureconformancewithhisfinancialandnonfinancial
objectiveswhenpursuinginvestmentproperty.Second,hemustbesurethattheWabashOaks
Apartmentsisthepreferredinvestment,thatthepropertyrightsmeetexpectations,andthen,hemust
determinetherelevanttimeperiodandgeographicareaofanalysis.Third,Garymustcollectdataon
thecharacteristicsofdemandandsupplyandconfirmthatthepresentandfutureoutlookforthemis
acceptable.Heshouldalsoconfirmthatthepotentialbenefitsfromthepropertymeethis
expectations.Then,heshouldanalyzeanddeterminehowthepropertyrightswillbetransferred.
Fourth,Mr.Sofershouldestimatethevalueoftheproperty.Heshouldperformavalueanalysisbased
onavailablehistoricalfinancialdataandonestimatedfuturefinancialdata.Finally,Garyshould
synthesizeallthestepsofhisanalysisandevaluatetheinvestmentbasedontheentirepackageof
collectedinformation.Hemusttheninterprettheinformationanddecidewhethertopurchasethe
apartmentcomplex.
(b) Demandrelatestothepopulationsegmentwhichwillrentanapartmentinthecomplex.Itrelatesto
thepeoplewhowillwantandusethefacility.Garymustlookatthetenantsanddeterminewhoare
thepeoplewhowillrenttheapartments.Then,hemustevaluatethepresentandfutureprospectsfor
thissegmentofthepopulationandforecastitsstabilityandgrowth.FromthisanalysisGarywill
betterunderstandwhotheapartmentsserveandhowanypresentorfuturechangesinthispopulation
segmentwillaffectthefinancialpositionoftheapartmentinvestment.Supplyisthealteregoof
demand.Itrelatestothecompetitioninthebusinessenvironment.Garymustlookatotherapartment
buildingsservingthesamepopulationsegmentasthepotentialinvestmentanddetermineifthe
competitionisstable.Hemustevaluatethepresentandfutureprospectsofanycompetitorsand
estimatehowthiscompetitionaffectsand/orwillaffecttheeconomicsuccessoftheproposed
investment.Finally,Garymustanalyzedemandandsupplywithrespecttoeachotheranddetermine
howtheywillprobablyaffecteachotherandhowtheywillaffectthepresentorfuturechangesinthis
populationsegmentwillaffectthefinancialpositionoftheapartmentinvestment.Supplyisthealter
egoofdemand.Itrelatestothecompetitioninthebusinessenvironment.Garymustlookatother
apartmentbuildingsservingthesamepopulationsegmentasthepotentialinvestmentanddetermineif
thecompetitionisstable.Hemustevaluatethepresentandfutureprospectsofanycompetitorsand
estimatehowthiscompetitionaffectsand/orwillaffecttheeconomicsuccessoftheproposed
investment.Finally,Garymustanalyzedemandandsupplywithrespecttoeachotheranddetermine
howtheywillprobablyaffecteachotherandhowtheywillaffectthepresentandfuturesuccessof
theproposedinvestment.
(c) Garyshouldbeawarethatalthoughtheownerprobablyisnotcriminalorfraudulent,heorsheis
tryingtoselltheapartmentand,accordingly,willputhisorherbestfootforwardtomakethesale.
Therefore,Garyshouldperformananalysisusingthedatasuppliedbythepresentowner.Heshould
thenplaywiththenumbers.Bymakingappropriatebestandworstcaseestimates,usingthe
ownersdataasareference,Garyshouldperformotheranalyses.FromsuchevaluationsGarywill
bettercomprehendthepresentandfuturefinancialoutcomesoftheinvestment.Healsowillreduce
thezealousnessand/oroptimismoftheownersstatementsandputthenumbersinamorerealistic
perspective.

78Gitman/JoehnkFundamentalsofInvesting,NinthEdition

(d) UsingtheNOIfromtheownersincomestatement,Garysestimatedcapitalizationrateof9.62%,
andtheincomeapproachfordeterminingmarketvalue,theestimatedmarketvalueoftheWabash
OaksApartmentswouldbe:
AnnualNetOperatingIncome(NOI)
MarketCapitalizationRate(R)
NOI $24,330 $18,380 *
$42,710

MarketValue(V)

*MortgagepaymentsarenotconsideredanoperatingexpensewhencalculatingNOI.
R 9.62%
NOI $42,710
V

$443,971
R
.0962
(e) Toanswerthisquestion,adjusttheownersincomestatementtoreflectcertainfinancialexpectations.
Estimatedrentswillbe$310permonthforonebedroomunitsand$350permonthfortwobedroom
units.Itisassumedthatpropertytaxeswillremainconstant,andallotherexpenseswillincreaseatan
annualrateof7%.Inaddition,amanagementfeeequalto5%ofeffectivegrossincome(EGI)willbe
deducted.
ReconstructedIncomeStatement(2004)
GrossPotentialIncome*
Less:Vacancy&CollectionLossesat4%
EffectiveGrossIncome(EGI):
OperatingExpenses:
Managementat5%ofEGI
Utilities($14,2601.07)
PropertyInsurance($2,7301.07)
Repairs&Maintenance($1,3901.07)
Propertytaxes
Less:TotalOperatingExpenses
NetOperatingIncome(NOI):

$71,280
2,851
$68,429
$3,421
15,258
2,921
1,487
4,790
27,877

$40,552

*[(9$310)(9$350)]12months[($2,790$3,150)12]$71,280
UsingthisadjustedNOIvalue,themarketvalueoftheapartmentwouldbe:
V

NOI $40,552

$421,538
R
.0962

IfGarycanpurchasetheapartmentsfor$10,000lessthantheoriginalestimatedmarketvalue,the
apartmentscostwouldbe$433,971($443,971$10,000).However,theestimatedmarketvalueof
theapartmentsusingtheadjustedfigureswouldonlybe$421,538.Usingthisroughanalysis,Gary
shouldnotpurchasetheapartmentcomplex,evenfor$433,971.

Chapter17RealEstateandOtherTangibleInvestments79

Case 17.2Analyzing Dr. Daviss Proposed Real Estate Investment

Thiscaseprovidesthestudentwithanopportunitytousequantitativemethodologytoevaluateareal
estateinvestment.
SummaryofKeyFacts:
TaxBracket:33%
EstimatedPurchasePrice:$200,000
HoldingPeriod:3years
GrossRents(PastYear):$32,000
OperatingExpenses(PastYear):$15,000
AnnualRentEscalation:10%
EstimatedAnnualOperatingExpenseIncreases:8%
EstimatedAnnualDepreciation:$7,272
Mortgage:$150,000at10.5%PerYearfor25Years
AnnualMortgagePayment:$16,995
LoanBalanceAfter3Years:$145,840
EstimatedAnnualPropertyAppreciationRate:9%
EstimatedValueAfter3Years:$259,000
SalesExpense:5%
BookValueofPropertyAfter3Years:$178,184
(a)

GrossRents
OperatingExpenses
NOI
Interest
Depreciation
TaxableIncome(Loss)
MarginalTaxRate
Taxes()orTaxSavings()

(1)
$35,200
16,200

$19,000
15,688
7,272
($3,960)
0.33
$1,307

Years
(2)
$38,720
17,496

$21,224
15,544
7,272
($1,592)
0.33
$525

(3)
$42,592
18,896

$23,696
15,384
7,272
$1,040
0.33
$343

AfterTaxCashFlows

NOI
MortgagePayment
BeforeTaxCashFlow
TaxesorSavings
AfterTaxCashFlow(ATCF)

(1)
$19,000
16,995
$2,005
1,307
$3,312

Years
(2)
$21,224
16,995
$4,229
525
$4,754

(3)
$23,696
16,995
$6,701
343
$6358

80Gitman/JoehnkFundamentalsofInvesting,NinthEdition

AfterTaxNetProceedsFromSaleoftheBuildingin3Years(CFR3)
ForecastSellingPrice(EstimatedValue
SellingExpenseat5%
MortgageBalanceOutstanding
NetProceedsBeforeTaxes
Capitalgain
(259,00012,950200,000)
RecapturedDepreciation(72723):
Taxonrecaptureddepreciation(25%)
Taxoncapitalgain(46,0500.15)
TaxesPayable
AfterTaxNetProceedsofSaleCFR3)
(259,00012,95012,362145,631)

$259,000
12,950
145,631
100,419
$46,050
$21,816
$5454
6,908
$12,362
$88,057

(b) I0$200,000$150,000$50,000
CF CFR3
CF1
CF2

3
I0
1
2
(1 r) (1 r)
(1 r)3
$3,312
$4,754
$6358 88,057
NPV

$50,000
1
2
(1 0.15) (1 0.15)
(1 0.15)3
($2,8,80 3,595 62,079) $50,000
$18,554
NPV

Thenetpresentvalueispositive,andtheinvestmentisthereforeacceptable.
(c)
CashFlow

Year1
3,312

Year2
4,754

Year3
6,35888,057
94,415

Chapter17RealEstateandOtherTangibleInvestments81

TheInstructorcantakethestudentsthroughaniterativeprocessasdescribedintheBookuntilthey
arriveatadiscountratewhichmakestheNPV0.Alternatively,theycanuseacashflowworksheet.
Thecorrectyieldfromtheinvestment28.5%
(d) Byassumingtheexistingmortgage,Marilynwouldnotreallyincreaseherreturn.Thisfinancing
wouldprobablyworkagainstincreasingherrateofreturnsincethe60%greaterinitialcashoutlay
(i.e.,$80,000versus$50,000)wouldfaroutweightheslightincreaseinannualaftertaxcashflow
attributabletothesmallermortgagepayment.Inaddition,thereductionininterestpaymentswould
increaseMarilynstaxliability,therebylesseningthepositiveimpactofthesmallermortgage
paymentonaftertaxcashflow.Forpurposesofthiscomparison,itwouldprobablybebestto
calculateandcompareapproximateyieldsundereachfinancingplan,andselecttheoneresultingin
thehighestyield.
(e) Marilynhasaccumulatedrelevantquantitativedataandshouldbeabletoestablishneededfinancial
parametersforuseintheinvestmentanalysis.Shealsowantstodiversifyherinvestmentportfolio
andreducehertaxliability.So,toapointMarilynhasperformedafairlygoodinvestmentanalysis.
Thereare,however,anumberoffactorsthatarenotpresentedandwhichshouldbeconsideredby
Marilyn.Sheshoulddetermineifrealestatebestfulfillsherinvestmentneedsand/orobjectives.
Furthermore,whataretheseneedsorobjectives?Marilynshouldprobablyuseaframeworkof
analysissimilartothatdepictedinFigure17.1.Sheshouldmakesurethatthevariouscategoriesofan
investmentanalysismeet,orapproximate,heracceptancecriteria.InthiswayMarilynwillincrease
theprobabilityofmakingasuccessfulrealestateinvestment.

.8

Outside Project

Chapter 17Analyzing Local Real Estate Demand and Supply

Everydayweparticipateintheeconomyandacquireinformationabouttheworldaroundus.Sometimes
wedonotfullyappreciatehowmuchvaluableknowledgewereallypossess.Thepurposeofthisprojectis
toanalyzetherealestateinvestmentpotentialofyourneighborhood.
ThesectioninthischapterentitledDeterminantsofValuelistsdemand,supply,theproperty,andthe
propertytransferprocessasimportantfactorsinrealestatevaluation.Sincewewanttolookatthe
neighborhood,notaspecificpieceofproperty,ananalysisofdemandandsupplyisallthatyouneedto
perform.Mortgageinformationcanbeobtainedfromalocalmortgagelendersuchasasavingsandloanor
bank.Dependingonthesizeofthecityyoulivein,theSundaynewspaperusuallyhasanextensivereal
estatesectionthatincludesmortgageinformationaswellasotherusefuldataandcommentsaboutthe
localrealestatemarket.
Asyouperformthisanalysis,followthequestionsandcommentsinthetextunderDemandand
Supplyandseehowwellyoucandoyourownanalysisbasedonyourknowledgeoftrendsinthearea,
thepeoplewholivethere,andwhatyouobserveaboutthedesirabilityofrealestateinvestment.Comment
ontherealestateinvestmentoutlookinthearea.Youmaywanttoaugmentyouranalysiswithinformation
availablefromthelocalChamberofCommerceoreconomicdevelopmentagency.