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Chapter 16
SUMMARY OF REAL ESTATE INVESTMENT PRINCIPLES
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Basic Investment Principles
Investing is defined as giving up present
consumption in exchange for future benefits.
Investing is opposite of consumption
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Key Investment Factors
 Return
 Management
 Taxability
 Liquidity
 Risk
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Major Economic Characteristics of an Investment
•
•
•
•
•
•
Return can be in the form of money or amenities.
It may also vary over time & include reversion at transfer
•
A series of payments over a period of time.
•
A series of payments plus a large single payment.
•
A large single payment.
Management of the investment over the holding period.
Investors are interested in the after tax return.
Liquidity - real estate is considered illiquid.
Property may be sold or borrowed against.
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Investment Risks
a) Financial
b) Interest Rate
c) Purchasing Power
d) Social Change
e) Legal Change
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Real Estate as an Investment
 Normally produces slow recovery of profit &
initial investment over a period of years.
 The process of forecasting money received
annually, including resale, is called cash flow
analysis.
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Cash Flow
 The income received from an investment over a period
of time.
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Before-Tax Cash Flow—Economic Cash Flow
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
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Gross Scheduled Income
Less Vacancy & Rent Cost
Equals Gross Operating Income
Less Operating Expenses
Equals Net Operating Income (NOI)
Less Debt Service
Equals Before-Tax Cash Flow
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Net Spendable Income =
Before Tax Cash Flow - Taxes
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Annual Cash Flow Analysis
1. Gross Scheduled Income ($800 X 20 units X
12 mos.)
2. Plus: Other Income ($300 X 12 mos.)
3. Equals: Total Gross Income
$192,000
+
3,600
$195,600
4. Less: Vacancy/Credit Loss (5%)
9,780
5. Equals: Gross Operating Income
$185,820
6. Less: Annual Operating Expenses
43,100
7. Equals: Net Operating Expenses
$142,720
8. Less: Annual Debt Service
-126,370
9. Equals: Before-Tax Cash Flow
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$16,350
10.
11.
12.
13.
14.
15.
16.
17.
Tax Benefit Analysis
Net Operating Income (Line 7)
$142,720
Less: Interest (Loan 1) -119,700
Less: Interest (Loan 2) 0
Less: Cost Recovery (Depreciation) - 38,760
Equals: Real Estate Taxable Income or
$
0
Equals: Estimated Allowable Loss (If Loss)
$<15,740>
Times: Tax Bracket (times Line 14 or 15)
X
.38
Equals: Taxes Saved or Paid
$ 5,981
Net Spendable Income
18. Before- Tax Cash Flow (Line 9)
$ 16,350
19. Plus/Less Taxes Saved or Paid (Line 17)
+ 5,981
20. Equals: Net Spendable Income (After- Tax Cash Flow) $ 22,331
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Rental Real Estate
 Taxable income can represent an income or
loss
 Passive income and loss rules
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After Tax Cash Flow
 Net spendable income
 Plus or minus the taxes saved or paid
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Ownership Period Analysis
 Investment in large properties means a higher degree
of analysis.
 Multiyear analysis is used with the cash flow projected
for each year of the estimated holding period.
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Net Spendable Income
 Includes the Net Sale Proceeds
 Called reversion by appraisers
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Estimated Net Sales Proceeds
 Resale price
 Minus seller closing costs
 Minus loan balances
 Minus capital gain taxes
 Equals Net Sale Proceeds
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Cash Flow Analysis
 Estimate the first year’s Net Spendable Income (After-
Tax Cash Flow).
 Estimate each subsequent year’s Net Spendable
Income for the holding period
 Estimate the net sale proceeds.
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Key Economic Issues
 Offering price
 Amount of the cash investment
 Rate of return on the cash investment
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Techniques of Investors to Determine Purchase
Price
 Gross Rent Multiplier
 Asking Price / Gross Scheduled Income =Gross Rent Multiplier
 Capitalization Rate
 Net Operating Income (NOI) / Asking Price = Capitalization Rate
 Price Per Square Foot
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Rate of Return on cash invested
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
Rate of Return for the first year cash flow
Rate of Return for the holding period
–
–
Internal Rate of Return (IRR)
Financial Management Rate of Return (FMMR)
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First-year before-tax cash on cash rate
First-Year Before-Tax Cash Flow First-Year Before-Tax
=
Cash Invested
Cash-on-Cash Rate
Refer to the 20-Unit apartment case study shown as figure
16.1; the Before-Tax Cash Flow is $16,350, and the cash
invested is $500,000; thus:
$16,350 Before-Tax Cash Flow
$500,000 Cash Invested
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=
3.27% Before-Tax
Cash-on-Cash Rate
After-tax cash rate
First-Year Net Spendable Income First-Year After-Tax
=
Cash Invested
Cash-on-Cash Rate
Refer to the 20-Unit apartment case study; the Net
Spendable Income is $22,331, and the cash invested is still
$500,000; therefore, the After-Tax Cash-on-Cash Rate is:
Net Spendable Income $22,331
Cash Invested $500,000
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=
4.47% After- Tax
Cash on Cash Rate
Investing is defined as giving
up present consumption in
exchange for future benefits.
Give it a try. You might like it or
better explain it to others!
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