The first part talks about different real estate investments like Raw Land, Warehouses, Office Apartments, Residential Apartments, Shopping Malls and Hotels/Motels. The most illiquid is Raw Land, followed by Shopping Centers and Hotels.
The most passive investment is a Warehouse because of the long term lease involved.
Next, we learn how to calculate Cash Flow after Taxes (CFAT) and Equity Reversion After Taxes (ERAT) and then use these along with the NPV and IRR formula to make real estate investment decisions.
For the calculation of CFAT, we use the following steps-
1. Calculate taxes payable using: (Net Operating Income (NOI)- Interest(I)- Depreciation (D))* Marginal Income Tax Rate = Taxes Payable.
2. Then, NOI- Annual Debt Service- Tax payable (from Step 1) = CFAT
ERAT is calculated for the last year of the investment, after it is sold. The recaptured depreciation needs to be calculated-
- When net selling price (Selling price- selling expenses) > Original cost, then the recaptured depr= total accumulated depreciation. (Since the investment has appreciated, the entire depr. needs to be recaptured).
- If Net Selling Price < Original cost, then Recaptured Depr < Accumulated depr. and is calculated as (Net selling price- Adjusted Book Value = Realisd Capital Gain).
The format for arriving at the total tax on realized gain is-
Sales Price
-Expenses associated with Sales
======
= Net Sales price
- Book Value (Original Value- Accum. Depr)
=========
Realized Gain
Now, the tax on realized gain= Tax on Recaptured Depr + Tax on Long term capital gain.
So, calculate the tax on recaptured depr= Tax rate on Recap. Depr * The recap. depr (as illustrated above).
Then, the long term capital gain that should be taxed at the Capital gains tax rate- Realized gain- Recaptured depr. . Then calculate the tax on long term capital gain by using the tax rate for capital gains * total long term capital gain.
ERAT is calculates as Sales price- Sales costs- total mortgage payments- Total taxes (incl. recap. depr. tax and long term cap. gains tax).
The third part of the reading is about NPV and IRR. Same old stuff! For calculating them, use CFAT for the cash flows, and also discount ERAT for the terminal year. The discount rate that is used is called the after-tax discount rate. In case of a conflict, go for NPV (like we learned before).
THE END!
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Tags: RealEstate Valuation, CFA, Finance, Equity Valuation, Business
