The Complete Guide to Real Estate Finance for Investment Properties

How to Analyze Any Single-Family, Multifamily, or Commercial Property

Steve Berges

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118045800
• Edition: 1
• Topic: Business
• Subtopic: Real Estate
• Index: Business

This practical, real-world guide gives investors all the tools they need to make wise decisions when weighing the value and potential of investment properties. Written for old pros as well as novice investors, this friendly, straightforward guide walks readers step by step through every stage of property analysis. Whether you're buying or selling, investing in big commercial properties or single-family rentals, you'll find expert guidance and handy resources on every aspect of real estate finance, including:
* Proven, effective valuation techniques
* Finance tips for all different kinds of property
* How various financing strategies affect investments
* Structuring financial instruments, including leverage, debt, equity, and partnerships
* Measurements and ratios for investment performance, including capitalization rates and gross rent multiplier ratios
* Future and present value analysis
* How the appraisal process works
* Primary appraisal methods-replacement cost, sales comparison, and income capitalization-and how to know which one to use
* How to understand financial statements, including income, balance, and cash flow
* Case studies for single-family rentals, multifamily conversions, apartment complexes, and commercial office space
* A detailed glossary of important real estate terminology

Part 1

Real Estate Finance

Chapter 1

Introduction to Real Estate Finance

As investors continue to migrate from the stock market to the real estate market, the need for sound financial analysis of income-producing properties is greater than ever. Just as buying high-flying stocks with no regard to intrinsic values resulted in hundreds of thousands of investors losing their life savings, so will buying real estate with reckless disregard to property values result in a similar outcome. While an abundance of books have been written on how to buy and sell houses, the market is virtually devoid of any works that specifically address the topic of the principles of valuation as they apply to real estate. Notable exceptions include more expensive titles such as Real Estate Finance and Investments by Brueggeman and Fisher, with a list price of $125, and Commercial Real Estate Analysis and Investments by Geltner, boasting a list price of $114.

The Complete Guide to Real Estate Finance for Investment Properties: How to Analyze Any Single Family, Multifamily, or Commercial Property focuses on the concepts of financial analysis as they pertain to real estate and is intended to help fill the void that currently exists regarding this subject. This represents a marked contrast from the works previously referred to in three primary ways. First of all, the other works are much more expensive. Second, they have been written to appeal to a different audience in that they are written in a textbook format with both the student and the professional in mind. Finally, the other works deal with advanced theoretical principles of finance, which are of little value to the investor who most likely has no background in finance.

The Complete Guide to Real Estate Finance for Investment Properties, on the other hand, is designed to appeal to those individuals who are actively investing in income-producing properties, as well as to those who desire to invest in them. Furthermore, those same individuals who are now investors will at some point have a need to divest themselves of their holdings. Whether an investor is buying or selling, the basis for all decisions must be founded on the fundamental principles of finance as they apply to real estate valuations. The failure to understand these key principles will almost certainly result in the failure of the individual investor. At a minimum, it will place him or her at a competitive disadvantage among those who do understand them. Recall the myriad of investors who bought stocks for no other reason than that they received a so-called hot tip from a friend or coworker—and who later collectively lost billions of dollars. A similar outcome is almost certain for those individuals investing in real estate who fail to exercise sound valuation principles and act on nothing more than the advice of someone who has no business giving advice, such as a broker with a supposedly hot tip.

The Complete Guide to Real Estate Finance for Investment Properties is further intended to take the theories of real estate finance discussed in other books and demonstrate how they can be used in real-world situations. In other words, it is the practical application of these theories that really matters to investors. An in-depth examination of several case studies will provide the learning platform necessary for investors to make the transition from the theory of real estate finance to its practical application. Investor comprehension will be further augmented through the use of several proprietary financial models developed by me for the sole purpose of making sound investment decisions.

Now that I have established what this book is about, I’ll take a brief moment to establish what it is not about. The term finance as used throughout this book is generally intended to refer to principles of financial analysis and not to debt instruments such as loans or mortgages that are used for financing real estate. This is not a book about creative methods of borrowing money or structuring nothing-down deals. Hundreds of those types of books are already available, including a few of my own. My purpose in specifically defining what this book is not about stems from the misleading titles of some currently very popular real estate books that contain the word finance in their titles. Perhaps the phrase “real estate finance” means creative borrowing techniques to the authors who wrote them, but to professionals schooled in the principles of finance, the phrase encompasses a completely different body of knowledge. This is not to say, however, that financing mechanisms are not discussed in this book, for they certainly are. Debt and equity instruments are discussed out of necessity, as their respective costs must be properly understood for the purpose of measuring returns and values, as well as evaluating the implications of using different types of financial instruments for different types of transactions.

This book is organized into three parts, beginning with Part 1, which examines the principles of real estate finance. Chapter 1 introduces the world of financial analysis as it applies to real estate investments. Chapter 2 focuses on primary investment elements and their effect on financing. Chapter 3 then centers on secondary investment elements, and Chapter 4 focuses on still other investment elements and their impact on financing. Chapter 5 shifts to an examination of the various types of debt and equity instruments available and their impact on returns. Chapter 6 includes a discussion on various investment performance measurements and ratios, including return on investment, capitalization ratio, and debt service coverage ratio. Chapter 7 is devoted to a more advanced analysis of real estate investments and includes topics such as understanding present value and future value concepts, internal rate of return (IRR), calculations, and modern real estate portfolio theory. Chapter 8 explores the realm of the three most commonly used valuation methods for the different classes of real estate. Chapter 9 provides a discussion on financial statements, including how to more fully understand them and how you can use them to make prudent buy-and-sell decisions.

Part 2 takes most of the information discussed in Part 1 and uses it in a case study format. Chapter 10 examines real estate finance as it applies to the valuation of single-family houses. Chapter 11 provides an in-depth look at converting property from one use to another. Chapter 12 is a case study that examines a multifamily apartment complex and walks the reader through a comprehensive analysis. Finally, Chapter 13 demonstrates how understanding finance and the different valuation methods can provide significant opportunities to create value for the astute investor by converting a single-family property into a commercial office building.

Part 3 consists of an epilogue containing words of inspiration and several motivating ideas, appendixes, and an extensive glossary.

FINANCE AS A DISCIPLINE

If you are a business student, the first two years of college for both accounting and finance majors are nearly identical. Each requires the basic English, history, math, and general business studies. By the third year of college, however, the two disciplines begin to chart separate courses. While both subjects deal with numbers and money, they are quite different in the way they do so.

The accounting discipline, for example, centers on principles used primarily for bookkeeping purposes and is based on a body of rules referred to as the generally accepted accounting principles (GAAP). Although there is some disagreement by scholars of many of the more advanced rulings, the principles established in GAAP are nevertheless to be firmly applied and adhered to when recording entries. As a general rule, the accounting principles are rigid rules that must be applied for bookkeeping and tax purposes.

The discipline of finance, on the other hand, centers more on the valuation and use of money than on record keeping. Finance is an exploration into the world of micro- and macroeconomic conditions that impact the value of a business’s assets, liabilities, and investments. While there are certainly rules and laws that govern the principles of finance, it is a subject that remains fluid and dynamic. The expansion and contraction of businesses live and die by those who understand these laws and their effect on value.

Professors Lawrence Schall and Charles Haley, authors of Introduction to Financial Management (New York: McGraw-Hill, 1988, p. 10), further expound on the discipline of finance by asserting that “Finance is a body of facts, principles, and theories dealing with the raising (for example, by borrowing) and using of money by individuals, businesses, and governments.” In part, finance deals with the raising of funds to be used for investment purposes to help these various types of entities generate a return on their capital. In addition, the authors state (ibid., pp. 10-11):

The individual’s financial problem is to maximize his or her well-being by appropriately using the resources available. Finance deals with how individuals divide their income between consumption (food, clothes, etc.) and investment (stocks, bonds, real estate, etc.), how they choose from among available investment opportunities, and how they raise money to provide for increased consumption or investment.

Firms also have the problem of allocating resources and raising money. Management must determine which investments to make and how to finance those investments. Just as the individual seeks to maximize his or her happiness, the firm seeks to maximize the wealth of its owners (stockholders).

Finance also encompasses the study of financial markets and institutions, and the activities of governments, with stress on those aspects relating to the financial decisions of individuals and companies. A familiarity with the limitations and opportunities provided by the institutional environment is crucial to the decision-making process of individuals and firms. In addition, financial institutions and governments have financial problems comparable to those of individuals and firms. The study of these problems is an important part of the field of finance.

There you have it. Professors Schall and Haley have outlined some of the fundamental issues that financial managers in both private and public sectors deal with on an ongoing basis. Raising capital, whether debt or equity, is essential to the successful operation of a firm. What is even more essential is the proper management of that capital.

I recall very distinctly during my sophomore year of college being faced with the decision of choosing the accounting or finance discipline. At the time, I didn’t know any accountants and I didn’t know any financial analysts, so I wasn’t quite sure whom to turn to. What I did know, however, was that most of my colleagues were choosing the accounting route and encouraged me to do so as well. After all, that’s where all the jobs were, according to them. I didn’t really care if that’s where all the jobs were. All I cared about was becoming fully engrossed in a field in which I would be the happiest.

My assessment of accounting was that it was rather dry and boring. Accounting represented mundane and repetitive tasks governed by a rigid set of principles. It was the recording of a company’s income and assets that reflected its value at that specific moment in time. This is typically referred to in accounting circles as a “snapshot in time.” Quite frankly, snapshots bored me. I was more interes...