Flashcards in Chapter 17: Real Estate Investments & Business Opportunity Brokerage Deck (104)
A thorough analysis is critical when evaluating the potential of a real estate investment. Investment analysis must take into consideration land use controls, such as zoning, deed restrictions, and permitting requirements that affect the value of a property. Investment analysis considers economic forces, such as population growth, investment of foreign capital, and the impact of taxation on real estate investments. The most important factor underlying every investment decision is economic soundness.
The process of investment analysis begins with the search for and location of potentially desirable real estate investments that are based upon the investor’s personal objectives. Real estate licensees should be capable of evaluating the advantages and disadvantages of a potential real estate investment compared to alternative investments.
Advantages and Rewards
real estate investors can receive potentially significant rewards from real estate investments that include income generated by the property, a build-up of equity, appreciation in value, tax benefits, positive leverage, and prestige. Investment in real estate can also serve as a hedge against inflation when the property has level-payment mortgage where the payments remain the same, but the rental income increases with inflation.
disadvantages of investing in real estate include the illiquidity of property (it cannot be bought or sold as quickly as other assets), the local (immobile) nature of the real estate market compared to other types of investments that can be bought and sold in a variety of markets, the expense or overhead required to manage the property or hire a property manager, and the need for additional investment assistance from experts such as brokers, tax accountants, and other professionals.
Types of Investment Properties
2. Business Opportunities
agricultural property investors have many different motivations for investing in agricultural land. Some investors wish to personally engage in agricultural endeavors, while others may own the land and lease it to others for agricultural activities. Investors may also purchase agricultural land in the path of growth, allowing for lower taxes through agricultural exemptions, before ultimately selling or developing the property.
are typically smaller local businesses, such as barbershops, hair salons, print shops, corner stores, and boat rental businesses. Often an investor may be looking for a small business that he or she could own and manage, creating an income for him or herself. Business opportunities are normally values based upon applying a multiplier to the net income being produced by the business. Value may also be applied to intangible assets such as a business’s name or reputation in the community.
commercial investment properties include retail centers, such as regional shopping centers usually located near major transportation routes. Major retail centers attract anchor tenants that draw people to the center. Typically, these are the name-brand department stores in which people plan to shop. They are called generative functions, since they generate customer traffic to the center. Suscipient functions are businesses that attract passersby, such as card and gift shops, ice cream and novelty stores, and so on.
industrial investment properties involve manufacturing, assembly, and distribution. These properties are located most often near major transportation arteries. Weight-reducing operations, such as mining operations, prefer locations near the source of their raw materials. Weight-gaining operations, such as assembly plants, prefer locations close to their market areas in order to reduce transportation costs.
office investment properties are usually located in central business districts or professional office parks in suburban areas near their tenant base. Offices are usually good long-term investments since office tenants generally lease for extended periods.
Residential investment property is available in a wide range of prices. Important factors to be considered when selecting residential properties are location, availability of transportation, schools, and shopping. Typical residential investments include condominiums, villas, single-family homes, and apartment complexes.
Real Estate Investment Trusts (REITs)
A real estate investment trust (REIT) is a type of business trust that allows groups of investors to invest in income-producing property. A REIT provides a method for individuals to pool financial resources to invest in larger, professionally managed properties.
Investment trusts invest in office buildings, large apartment complexes, and retail centers.
Purchasing shares in a REIT is similar to purchasing shares in a mutual fund.
The amount realized, also referred to as net proceeds from sale, is expressed by the following formula:
Amount Realized = Sale Price – Costs of Sale
Sale price is the total amount the seller receives for the sale, including money, notes, mortgages, or other debts the buyer assumes as part of the sale. The costs of sale include brokerage commissions, relevant advertising, legal fees, seller-paid points, and other closing costs paid by the seller.
Or cost basis, is the original value of an asset for tax purposes. When purchasing a home, the basis includes the purchase price and any associated acquisition costs.
Basis is used to determine the gain or loss on the sale, exchange, or other disposition of a property.
Adjusted basis is a measurement of how much is invested in a property for tax purposes, including any IRS-allowed improvements, referred to as capital improvements. Examples of capital improvements include a new addition to the home, paving the driveway, replacing the roof, installing central air conditioning, and rewiring the home. By adding the cost of improvements to the basis, the amount of gain is reduced, thereby decreasing the amount of capital gains tax otherwise owed.
The adjusted basis may also include certain IRS-allowed reductions including such items as depreciation of investment property, casualty losses, and residential energy credits.
The basic formula for adjusted basis is
Adjusted Basis = Cost Basis + Increases - Decreases
Capital Gain/ Loss
A capital gain is an increase in the value of an asset, such as personal or investment property, that gives it a higher value than the cost of purchasing the asset. If a property sells for more than the purchase costs, there is a capital gain. A capital loss is incurred when there is a decrease in the value of an asset that gives it a lower value than the cost of purchasing the asset.
A capital gain or loss is not realized until the property is sold. A capital gain may be short term (one year or less) or long term (more than one year) and must be claimed on the investor’s tax return.
The capital gain formula
Gain = Amount Realized – Adjusted Basis
Cash flow is the movement of money into or out of a business or investment, measured over a period-of-time. Generally speaking, cash flow is the money that remains after all the income, such as rents, are collected and all the day-to-day expenses associated with owning the property are paid.
Cash Flow can be ongoing or
one-time. Ongoing cash flows are received by the investor throughout the investment holding period, as in rental income. One-time cash flows are sales proceeds received as a result of the sale of an investment property.
Positive Cash Flow
occurs when there is more money coming in than going out, resulting in money remaining.
Negative Cash Flow
occurs when there is more money going out than coming in, resulting in a deficiency that the investor or business owner must pay out of pocket.
What type of cash flow do most investors and business owners desire?
a positive cash flow in order to achieve a profit and a high rate of return on their investment. However, there are tax benefits to negative cash flows.
is an increase in the value of an investment over time. Investment property can appreciate in value for many reasons, such as inflation, supply and demand, and capital improvements. Most real estate investors purchase income property with the goal of realizing a positive cash flow and appreciation.
also referred to as cost recovery, is an income tax deduction that allows a taxpayer to recover the cost of investment property over a number of years.
A tax shelter is a legal method of minimizing or decreasing an investor’s taxable income, and therefore, his or her tax liability.
Depreciation of a real estate investment can reduce an investor’s taxable income and is, therefore, a form of tax shelter.
Equity is the difference between the current market value of a property and the amount the owner still owes on the mortgage. The initial down payment creates equity. Additional equity is created through principal reduction and appreciation.
Equity advantage for investor
One advantage of investing in real estate is the equity build-up that can occur on mortgaged rental property. An investor who collects rent from a tenant can use the rental income to pay expenses and reduce the principal amount of the loan, which can increase the equity in the property. Over time, the tenant essentially pays for the property to the benefit of the investor. Some investors consider equity build-up as a good use of cash flows when the interest rates on savings accounts and certificates of deposits are lower than the rate of return on the investment property.
Liquidity refers to an asset’s ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value. Cash is the most liquid asset.
A liquid asset can be sold rapidly with minimal loss of value. The essential characteristic of a liquid market is that there are ready and willing buyers and sellers at all times.