Real estate economics 156 Foldvary

Floyd and Allen chapter 19

Analyzing Income-Producing Properties

Advantages of real estate investment and speculation

After-tax cash flow from operations.

But can also get cash flow from interest and dividends.

Appreciation: after-tax equity reversion ATER.

Return of funds originally invested in the property, plus gains.

But can get appreciation also from stocks, commodities.

However, real estate provides also appreciation of the capital goods from renovation.

Portfolio diversification.

Real estate is relatively uncorrelated with stock and bond markets.

Can get the diversification with real estate stocks,

REITS, partnerships and mutual funds.

Real estate provides personal control of assets.

It also involves work and possibly stress.

Most don’t want it, so those who do can have greater gains.

Real estate offers leverage - the use of other people’s money.

One can also buy stocks and bonds on margin, but r.e. offers greater leverage.

There is also greater risk when property values fall.

But non-resource laws as in California make real estate a put option.

The risk is shared by the lender and the government.

One can also get leverage with options and futures contracts.

If the price of land were close to zero due to a high tax on the rent,

would leverage still be an advantage?

Disadvantages of real estate investing and speculation

Large amount of funds required for direct ownership.

There are risks:

falling prices, bad tenants, government actions, lack of liquidity, changing economic conditions.

But higher risks typically fetch higher returns.

Financial decision making

People maximize utility.

The objective is usually wealth maximization.

The NPV rule: use the net present value,

the present value of the cash inflows minus the cash outflows.

The required rate of return includes the pure interest and the risk premium.

One can also use the internal rate of return,

the discount rate that makes the NPV = zero.

The discounted cash flow model

P. 439: error: should include a plus sign after the first term.

Add the ATCF after-tax cash flow and the ATER after-tax equity reversion and subtract the initial equity.

See table on p. 441.

See also “cashflow” lecture note.

Potential gross income is the total income potential of the investment,

assuming all units pay rentals.

Property flipping

Like trading stocks.

Gain from either property improvement or land gains.

Find a house selling below typical prices due to superficial defects.

Make cosmetic improvements.

Many amateur buyers are subject to visual illusion.

Take advantage of appearance versus reality.