2% CHAPTER 17: Real Estate Investments and Business Opportunity Brokerage

An example of an "intangible" asset for a business would be A. ovens and dishes used for the business. B. the number of tables filled every day. C. how many workers the business needs. D. the reputation or goodwill of the business.

D. the reputation or goodwill of the business.

Residential real estate investments

include properties such as houses, apartment buildings, townhomes, condos, and vacation properties. When used as an investment, another party remits rent for the opportunity to live in your property. The length of stay is determined by the rental agreement, the lease agreement, and the return on investment that the owner negotiates with the tenant. This type of investment is typically where real estate investors begin to learn the business, as they are less complex than other types of real estate investments.

Industrial real estate investments

include storage units, warehouses, car-washes, dry cleaners, and other special purpose real estate that generates income from customers where the business is not as concerned with how the property looks. Industrial properties are dependent upon location because they must be built in specific zones delineated by a local government. Fixture and equipment maintenance costs exceed normal real estate levels found in other types of commercial real estate, but their inherent scarcity often generates significant profits. Be vigilant and stay aware to any EPA requirements that must be considered when investing in such properties.

Capital Gain

is an income tax term for the taxable profit generated from the sale of the property or any capital asset.

Tax Shelter

is an income tax term meaning an investment that will shield or reduce income tax.

Risk

is chance of loss for an investor.

Liquidity

is how fast the property can be sold. Real estate is less liquid than stocks or bonds.

Cash Flow

is the amount of spendable income after the expenses from operating and interest are deducted from the gross income. Cash flow can be either positive or negative.

Equity

is the amount of value or interest that an owner has in the property over and above the loans attached to the property.

Capitalization

is the method of determining a property's value by considering the net annual income and the capitalization rate that the investor wants as a return.

Adjusted Basis

is the original cost basis of a property reduced by certain deductions and increased by certain improvements. The original basis determined at the time of acquisition is reduced by the amount of allowable depreciation or depletion allowances taken by the taxpayer, and by the amount of any uncompensated property losses suffered by the taxpayer. It is then increased by the cost of capital improvements plus certain carrying costs and assessments. The amount of gain or loss recognized by the taxpayer upon sale of the property is determined by subtracting the adjusted basis on the date of the sale from the adjusted sales price.

Capitalization Rate

is the percent of return for an investor on his money on an investment property.

Leverage

is the use of other people's money (borrowed funds) to spread the risk of investment.

A Going Concern Value

is the value of an existing business compared to a start-up business of the same type. The Existing Business Value takes into consideration good-will and name recognition.

debit/credit accounting method

used to reveal how income affects expenses within a business.

investment syndicates

when investors want to invest in real estate with others. are managed as General and Limited Partnerships.

The Balance Sheet

while the Income Statement shows changes (to income and expenses) over a certain period of time, the balance sheet shows the balances of assets, liabilities and owner's equity at a moment in time. The Balance Sheet is thus the component of the financial statements that provides a snapshot of a business at an exact point in time - it shows the balances of the various accounts on the day of any reporting period.

The individual or brokerage company must have specific skills to manage the sale of a business. These skills include:

- The Knowledge of Corporate Financing - Business Accounting - The Valuation of the Business - The Knowledge of Relevant Laws

Steps in the Sale of a Business

- The broker lists the business for sale. - The assets and liabilities that belong to the business are noted. - The value for the business is established, using some (or all) of the appraisal methods. - Subtract the liabilities (short- and long-term) from the value of the business. - Check to see if the business is a corporation. If it is, divide the value by the outstanding number of shares. - Market the business. - Find a buyer and write a purchase agreement. - Arrange for closing and close the transaction.

The difference between selling property and selling a business includes the following:

- Usually, business sale transactions involve more than a property being transferred. Personal property typically involves trade fixtures regulated by the concept of good-will (a.k.a. Blue Sky) regarding the business. - Trade fixtures include the necessary equipment for the operation of a business - i.e. racks and shelves for bookstores, store items for purchasable items, restaurant ovens and equipment, and desks and computers. These are tangible assets. - The value of the business may be less than, equal to, or greater than the value of the real estate. The Going Concern Value* may be different than the real estate value. - Markets for a business enterprise are typically wider in geographic scope than markets for individual parcels of land. - An additional measurement of a business value is the intrinsic "Good Will" of the business. Good Will is a part of the Going Concern Value* as it measures the business' name and customer history. This is called an Intangible Asset; it has no physical form. * A Going Concern Value is the value of an existing business compared to a start-up business of the same type. The Existing Business Value takes into consideration good-will and name recognition.

The advantages of real estate investments include:

1. A Good Rate of Return - Historically, real estate, through its appreciation and added improvements in the market place has typically yielded investors with a better return than that of stocks or bonds, and many other investments. 2. Tax Advantages - There are several tax advantages including tax shelters, depreciation, installment sale, capital gains and exchanges that benefit an investor as he seeks to reduce his federal income tax liability. 3. A Hedge Against Inflation - Because real estate usually increases in value over time, real estate investments are considered to be a vehicle that offsets inflation, since the property grows in the same direction as inflation. 4. Leverage - By using borrowed money, the investor is able to spread the risk of failure to others, thus cushioning the fall if there should be one. 5. Equity Buildup - As the loan is paid, the amount of money the investor has invested in the home increases, thus decreasing the loan and increasing the equity. In essence, it is a forced savings account.

When an investor looks at real estate investment risk, they consider the following General Business Conditions:

1. Business Risk - What is the business risk associated with this investment? Does it fit with my other investments? Do I have the management skills to handle this investment? 2. Financial Risk - What is my financial risk? Is the price appropriate to the risk level? Am I leveraging appropriately? Does this investment fit into my future financial plans? What are current economic conditions? Will this price generate the Cap Rate I seek? 3. Purchasing-Power Risk - Do I have the purchasing power to purchase this property? Do I want to consider partners in this venture? What kind of loan will I be able to secure? 4. Interest - Rate Risk - What is the near future interest-rate risk? Are market conditions driving prices up or down? Is the Cap Rate what I want to be consistent with my other holdings? How long can I hold this property without stress? How soon will I be able to sell this property at the appropriate price to get the cap rate I seek?

An investor also considers the risks that impact the Rate of Return:

1. Liquidity Risk - How soon can I sell this property? 2. Safety Risk - Market Risk - How much of this type property is there? What is the supply and demand? What will it cost me to sell the property? How is the overall market in the area? How saturated is the rental market? - Risk of Default - Does this property include well paying tenants? Can I count on them to pay their rent on time to support the payments? Have I considered unexpected contingencies (emergencies) and have they been factored into my financial analysis? Is the property to be held in my name only or in the name of a corporation?

There are multiple methods of appraising a business:

1. The Comparable Sale Analysis - sales of similar businesses 2. The Cost Approach - How much would it cost to duplicate this business? 3. The Income Capitalization Analysis: How much income the business generates when compared to expenses. 4. The Liquidation Analysis (in case of the bankruptcy of the current business) - How much would this business bring in an emergency sale?

Disadvantages of Investing in Real Estate

1. The Concept of Non-Liquidity - property can be difficult to sell quickly, if the market conditions are working against the sale, or the property hasn't sufficiently appreciated. As a result, an investor may not be able to sell quick enough at the price he needs. 2. The Market is Local in Nature - in the global economy of the 2010's, real estate remains affected by local influences and prices. A local property with local customs and prices, as well as local problems such as a plant closing or company layoffs. 3. The Need for Expert Help - an investor may need to hire help to maintain this property. These include experts who sell the property and contractors to help improve the property. It is difficult for an investor to be the only expert involved in improving the property. There will be a need (and an expense) to pay others. 4. The Management Effort - it takes time and energy to keep track of real estate investments. It takes professional vigilance to keep up with market trends and investment strategies. Real estate investing is often not for "the faint of heart." 5. The Risk - there is always the chance that the investment will fail; that the investor pays too much, or that physical concerns beyond the investor will diminish his rate of return. The higher the risk, the lower the price for property investments.

When a business has been in operation for a long time, what type of value does it have? A. Market value B. Going concern value C. Tax value D. Capital value

B. Going concern value

When an investor was analyzing the risks in a property, he was considering an 8% return on his investment compared to a 10% return. In terms of the purchase price, what will happen? A. The higher the risk, the lower the purchase price. B. The lower the risk, the lower the purchase price. C. The purchase price would be the same either way. D. The higher the risk, the higher the purchase price.

A. The higher the risk, the lower the purchase price.

The percentage which expresses the amount of risk that an investor is willing to make is called the A. cap rate. B. NOI. C. loan to value ratio. D. discount rate.

A. cap rate.

When an investor uses borrowed money to purchase a piece of investment property he is taking advantage of A. leverage. B. capital gain. C. depreciation. D. basis.

A. leverage.

Agricultural real estate investments

Agricultural properties involve land, which is sublet to allow for farming or ranching purposes. The growing scarcity of farmland over the past few years and the tightening of income have made the complexity of holding acreage difficult for today's farmers. Investors are purchasing shrinking acreage and making the land available to those who work the industry. Also, agricultural and natural resource investments provide many tax incentives and subsidies which make this investment process appealing to today's investors.

Real Estate Investment Trust (REIT)

Another form of real estate investment syndicate. These can be purchased through stockbrokers; it is just like buying mutual funds. The trust does not have to pay corporate income taxes as long as 95% of its income is distributed to its shareholders. Each trust must be a group of 100 (or more) members to be able to hold shares. REITs can be an equity trust, a real estate mortgage trust or a combination of trusts. REITs are involved when owning and managing office buildings, industrial buildings, retail outlets, hotels and multifamily units. Some REITs are equity based. This means that they pay shareholders rent from properties held in the REIT. They also generate capital gains when a REIT property is sold. Other REITs hold mortgages that provide mortgage money to developers. REITs are used for the basis of mutual funds. These trust groups must be sold and managed by a licensed stockbroker. Real estate professionals cannot sell shares unless licensed to sell securities.

Accrual accounting is where A. cash is counted as it comes in and goes out. B. future income and future debts are shown as they are received and invoiced. C. debts are allowed to remain unpaid. D. income is measured as it is collected.

B. future income and future debts are shown as they are received and invoiced.

What is an income tax term meaning an investment that will reduce or shield other money from income tax? A. Appreciation B. Capitalization C. Adjusted basis D. Tax shelter

D. Tax shelter

An investor was looking at a sixteen-unit apartment building. Four of the units rented for $600, four for $750, four for $725, and four for $800 per month. The building had monthly expenses of $1200. If the investor wants an 8% rate of return, how much should he pay for the building? A. $750,000 B. $1,000,000 C. $1,545,000 D. $1,725,000

C. $1,545,000

The term "NOI" MOST NEARLY means A. the amount of money in annual income. B. the amount of money left after the vacancy rate is deducted. C. the amount of money left after the vacancy rate and operating expenses are deducted. D. the amount of money left after the vacancy rate, operating expenses, and mortgage payments are deducted.

C. the amount of money left after the vacancy rate and operating expenses are deducted.

In analyzing the value of a business, the method that is used to determine the value if the business were to bankrupt is called A. cost approach. B. income approach. C. comparable sales approach. D. liquidation approach.

D. liquidation approach.

Which is NOT an advantage of investing in real estate? A. Good rate of return B. Hedge against inflation C. Equity buildup D. Lack of liquidity

D. Lack of liquidity Property lacks liquidity. Property is not always easy to sell in a quick fashion so if the market isn't right for sale or the property hasn't appreciated enough, the investor may not be able to sell as fast and at the price he seeks.

Cash Method

Income and spending are debited/credited at the time that they are received or paid. This process makes it difficult to plan for expenses that may affect future business. This then makes it difficult to properly appraise a business when future income and spending are needed in the analysis. Larger corporations choose not to use the Cash Method accounting system.

Mike seeks a Capitalization Rate of 14% from Joe's property he intends to buy. If three units are rented @ $450 per month, two units @ $550, and one unit @ $600 per month, what is the maximum sales price Mike should pay to meet his Cap Rate objectives? A. $21,600.95 B. $450,000.00 C. $261,428.57 D. $291,832.26

NET INCOME $3,050 per month x 12 = $36,600 Cap Rate 14% C. $261,428.57

The Cash-Flow Statement

The cash flow statement indicates the manner in which cash moves in and out of the business. This statement is a key accounting report. While an income statement might show a profitable performance, there might be nothing left in the bank. In this situation a business could not survive. Overspending on credit for the business occurs when your sales have been made on credit and no payments are made. It could also occur if an owner does not routinely review the cash flows of the business Comparing the budget to the cash flow statement helps the business owner adjust for unexpected expenses as the business year progresses.

The Income Statement

The income statement is also known as the Profit And Loss statement. It is a report showing the profit or loss for a business during a certain time period. It also reveals the income and expenses that resulted in the business' overall profit or loss. The amount of the profit or loss for a business during a certain period indicates the financial performance or health of the business.

Income Capitalization Approach

This is used for income generating properties such as apartments, retail centers, multi-tenant office buildings, etc. Steps Involved: 1. Estimate Annual Potential Gross Income. 2. Subtract an appropriate allowance for vacancy and collection losses to calculate the Effective Gross Income. 3. Deduct Operating Expenses. (This does NOT include debt service or mortgage payments). The result is the Net Operating Income (NOI). 4. Divide the Net Operating Income by the Capitalization Rate to determine market value. A property valued at $150,000 generates $750 per month. What is the annual percent of return? A. 6% B. 5% C. 9% D. 12% $750 x 12 = $9,000 $150,000 | Cap Rate 6% Be sure to annualize the income before calculating for the Cap Rate!

An apartment complex is valued at $480,000 applying a 12% Capitalization Rate. Find the value of the same property with a 10% Capitalization Rate. A. $400,000 B. $440,000 C. $520,000 D. $576,000

This problem has two steps. First find the net income using the 12% rate. Second, repeat the procedure using the same net income as the first part with the 10% cap rate to get new market value. Cap Rate 12% - $480,000 First, solve for Net Income - $480,000 x 12% = $57,600 Net Income Use the Net Income from the first part of the problem for the second part of the problem. Solve for the Cap Rate - $57,600 ÷ 10% = $576,000

The sale of a business valued more than $200,000 is categorized as

a real estate transaction. As such, the person listing the business for sale must be licensed by FREC.

The Balance Sheet is also affected at the time of the expense by

a) a decrease in Cash (if the expense was paid at the time the expense was incurred), b) an increase in Accounts Payable (if the expense will be paid in the future), or c) a decrease in Prepaid Expenses (if the expense was paid in advance). The Accrual accounting method also provides the investor with a Present Value and a decent opportunity to review the business' long-term liability outlook.

Commercial real estate investments

consist mostly of office buildings and retail establishments. Many small and large companies use office spaces for the conduct of their business. Tenants paying rent for space and for building maintenance, janitorial service, and other areas, make this a lucrative income source for an investor. In the retail investment arena, one could invest shopping malls, strip malls, and other retail storefronts. In some cases, the investor also receives a percentage of sales generated by the tenant store in addition to a base rent.

Business Opportunity Brokerage

consists of purchasing an established business. Although the investment in this type of product may not involve traditional real estate, it is considered a real estate investment because the business is housed within real property.

Appreciation

refers to a growth in value in the market over time. It is usually expressed as a percentage.

Accrual Method of accounting

shows future income as it is invoiced and future costs as bills are received. In this method of accounting, expenses (bills and office costs) are matched with revenue (earnings) on the income statement when the title transfers to the buyer, rather than at the time when expenses are paid.