These are the most important points for you to remember in this unit.
Investment Real Estate Terminology
- Cash Flow—the amount of money left over after all cash expenses have been deducted from the cash income of a property.
- Leverage—the use of borrowed funds to increase the investor’s yield.
- Positive leverage results if the percentage rate of return on the investment is greater than the interest rate paid.
- Negative leverage results if the percentage rate of return on the investment is less than the interest rate paid.
- Yield is the return on investment from all cash flows (including gain on sale) divided by the investment.
- Capital Gain (Loss)—when a capital asset is sold, the investor may have a capital gain or loss.
- If the asset has been held for 12 months or longer it is considered a long-term gain, and has lower tax rates.
- A short-term capital gain is property held for less than 12 months.
- Basis—the cost of the property plus any capital improvements less depreciation.
- Basis is deducted from the sale price of the property to calculate the gain on the sale.
- Appreciation—the increase in a property’s value over time.
- Equity—what the owner owns in a property. It is calculated by subtracting the mortgage balance from the property value.
- Liquidity—the ability to sell a property quickly without affecting its market price.
- Risk—the chance that an investor will lose all or part of the investment. Investors will require higher rates of return for riskier properties.
- Tax Shelter—shields an investor’s income from tax liability.
Types of investments
Advantages of Real Estate Investments
- rate of return,
- tax advantages,
- hedge against inflation,
- leverage, and
- equity build up.
Disadvantages of Investing in Real Estate
- Disadvantages to investing in real estate include:
- Illiquidity—liquidity is the ability to sell a property quickly without affecting its market price, illiquidity is the opposite.
- market is local in nature,
- A real estate investor who owns a large apartment complex is concerned about the local economy.
- need for expert help,
- Investors who purchase large properties will need experts to sort out the legal, accounting, marketing, and management issues.
- management, and
- May take the investor’s time, or the investor may need to hire a manager.
- The possibility that all or part of an investment will be lost.
- Static risks (like fire, windstorm, and vandalism) can be reduced by insurance.
- Dynamic risk comes from changes in the business environment and can be reduced by careful analysis and management.
Assessment of Risk
- Risks associated with general business conditions.
- Business risk is the risk that actual income or expenses will not be in line with the budget. It reflects the chance that the business will not be able to continue operations.
- Financial risk exposes the investor to the danger that the revenues of the property will not be enough to pay expenses and the mortgage.
- Purchasing-power risk means that the property value and operating income will not increase proportionately with inflation.
- Interest-rate risk is that associated with a rise in interest rate. Remember IRV? If rates increase, value decreases.
- Risks that affect return.
- Liquidity risk is the likelihood that the investment cannot be sold within a reasonable time, and that the property may be sold at a loss.
- Safety risk has two parts: market risk and risk of default.
- Market risk comes about from rapidly increasing interest rates. A 7% rate of return may be acceptable when a property is purchased, but if interest rates rise above 7%, investors may choose the other property and the value of the investment will fall.
- Risk of default is the risk that the income of the property will be less than the amount required to pay the debt service.
Nature of Business Brokerage
- Similarities to real estate brokerage.
- Business brokerage usually involves the sale of real property or an assignment of a long-term lease.
- Business brokers must be licensed by the Florida Real Estate Commission.
- Differences from real estate brokerage.
- The sale of a business usually involves assets other than real estate.
- Personal property includes cash in banks, accounts receivable, inventory, and equipment.
- Goodwill is an intangible asset. It’s the additional amount an investor would pay over and above the tangible value of the business’s assets because of its profitability.
- The value of the business may be less than, equal to, or greater than the value of the tangible assets. The “going concern” value may be higher than the value of the tangible assets if the company is profitable. If a business is doing poorly and may not continue in business, it has no going concern value.
- Markets for business enterprises are national because of investor interest in businesses.
- The broker will normally be well-versed in corporate finance, including knowledge of budgeting, working capital, and corporate stock.
- The broker will be familiar with accounting principles and will be able to analyze income statements, balance sheets, cash flows, and taxes.
- Valuation of Businesses—a business appraiser will use the three approaches to value that real estate appraisers use, along with an additional analysis—liquidation analysis.