Commercial Real Estate Analysis & Investment, Ch. 14 Flashcards
State the three key differences between accrual and cash flow accounting for real estate investments
State how to compute taxable income and income tax due for real estate investments
- Taxable Income = Net Operating Income (NOI) - Interest (I) - Depreciation Expense (DE)
- Income Tax Due = Taxable Income * Income Tax Rate
State how to compute PBTCF, EBTCF, and EATCF
- Property-level Before-tax Net Cash Flow (PBTCF) = Net Operating Income (NOI) -Capital Improvement Expenditures
- Equity-before-tax Cash Flow (EBTCF) = PBTCF - Debt Service (Both Interest and Principal)
- Equity-after-tax Cash Flow (EATCF) = PBTCF - Debt Service (Both Interest and Principal) - Income Tax = EBTCF - Income Tax
Note: EATCF can also be calculated using the equation Equity After Tax Cash Flow (EATCF) = Net Income After Tax - Capital Improvement Expenditures + Depreciation Expense - Debt Amortization (Adjusting Accrual to Reflect Cash Flow method)
State how to compute the tax upon sale of a real estate property
- Tax Upon Sale = (Resale Price - Gross Book Value) * Capital Gains Tax (CGT) + Accumulated Depreciation * Recapture Tax
- Gross Book Value = Original Price + Capital Improvements
- Accumulated depreciation recapture = Accumulated Depreciation * Recapture Tax
State the assumption of the PBT approach. How is property value computed with the PBT approach?
- PBT approach assumes marginal investors, IV = MV
- To calculate the property value, we simply look at the investor’s cash flows (PBTCF) and discount by the relevant current market rate of return based on similar projects
State the advantages of the PBT Approach
- Simple, because it avoids the need to estimate marginal tax rates (because it is before-tax)
- Also avoids the need to estimate impacts of leverage (because it is property level and not an equity cash flow)
- Avoids parameter estimation needed for tax/leverage calculations
- Mistakes are less likely because property-level before-tax calculations are more reliable and understood compared to equity/after-tax calculations
Describe the value additivity principle
- Value additivity principle - the value of a property must equal the sum of the values of all claims on the property’s cash flows
- The most common way to split cash flows using the value additivity principle is to split up the property and financing cash flows
- Adjusted Present Value (APV) = NPV(Property) + NPV(Financing)
- NPV(Property): NPV of the property transaction as if there were no debt
- NPV(Financing): Net value of the financing arrangements. Typically we can think of this as the NPV of borrowing from a loan
NPV(Financing) is typically largest for which of the following investors:
- Tax advantaged
- Marginal investor
- Tax disadvantaged
- The tax disadvantaged investor typically has the largest NPV(Financing) because of the largest benefit from their tax deduction
- (see the Clarence example in the video series for more info!).
State two reasons leverage reduces the effective tax rate.
[Note: This was seen on the “IRR summary” tab of the TIA spreadsheet]
- Leverage shifts the composition of the investor’s IRR away from ordinary income (35%) and towards the capital gain component (15%)
- With leverage, the interest expense is included as tax deductible as so we play less ordinary income since the interest expense lowers the tax bill
- Leverage magnifies the effect of the depreciation tax shields
- You get the same depreciation benefit in both the property and equity cases, but the impact is “magnified” for equity because of the smaller initial investment (250k equity initial investment vs 1m for property)
Explicitly write out the taxes before and after shields
- Tax (Before Shield) = NOI * Income Tax Rate
- Value of Tax Shields = Depreciation Tax Shield (DTS) + Interest Tax Shield (ITS)
- Depreciation Tax Shield (DTS) = Depreciation Expense * Income Tax Rate
- Interest Tax Shield (ITS) = Interest Expense * Income Tax Rate
- Tax (After Shields) = Tax (Before Shields) - Value of Tax Shields
- Tax (After Shield) = Income Tax
How can your after-tax cash flow be higher than your before-tax cash flow in a real estate investment?
- After-tax cash flow will exceed before-tax cash flow if there is a negative before-tax net taxable income in the property (accrual based).
- This can happen when:
- Depreciation Expense + Interest Expense > Net Operating Income
Adjusted Basis
Adjusted Basis = Initial Cost + Capital Improvement Expenditures - Accumulated Depreciation
The framework in this reading relies on three abiding principles
- Wealth maximization as the objectives of decisions
- Opportunity cost as the basis for quantifying wealth impacts
- Real estate investment decision making operates within a well-functioning asset market that tends toward equilibrium, providing evidence of the true opportunity costs
Tenancy-in-common (TIC) funds
- TIC funds can invest in a portfolio of properties
- TIC funds offer tax advantages
- Property investors can exchange their direct management investment in a property for units in a TIC fund which invests in a portfolio of properties
- The investor can then retire from direct management responsibility while deferring capital gains tax payment
- Disadvantages of TIC funds:
- TIC funds typically have management fees that can take a substantial portion of investment earnings
- TIC funds often lack liquidity
- Time constraints on tax benefits
