UCLA ECON 103 - Chap011 (1) (11 pages)

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Chap011 (1)



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Chap011 (1)

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Pages:
11
School:
University of California, Los Angeles
Course:
Econ 103 - Introduction to Econometrics
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Chapter 11 Investment Analysis and Taxation of Income Properties Solutions to Questions Chapter 11 Investment Analysis and Taxation of Income Properties Question 11 1 What are the primary benefits of investing in real estate income property Net Income Dollars left over after collecting rent and paying expenses but before considering taxes and financing costs Property Sale Expecting a price increase over a specified holding period increases investor return Diversification Reduces overall risk to hold many types of investments Taxes Preferential tax benefits Taxable income is often less than before tax cash flow Question 11 2 What factors affect a property s projected NOI Expected market rents and vacancy rates Expenses associated with operating the property Nature of any leases on the property Question 11 3 What factors would result in a property increasing in value over a holding period Inflation This causes rents as well as the final sale price to be higher Demand Increased demand for space may increase value if the supply of space doesn t increase as well Question 11 4 How do you think expense stops and CPI adjustments in leases affect the riskiness of the lease from the lessor s point of view There is less risk for the lessor with expense stops and CPI adjustments in leases CPI Adjustments The risk of unexpected inflation is shifted to the lessee Expense Stops The risk of increases in expenses is shifted to the lessee while allowing the lessor to retain the benefit of any decrease in expenses Question 11 5 Why should investors be concerned about market rents if they are purchasing a property subject to leases Even if the investment is an existing building that has already been leased the income can be affected when the existing leases expire and are renewed at the market rent at the time Question 11 6 What is meant by equity The investor s initial equity in the project is equal to the purchase price less the amount borrowed The amount of equity an investor has in a property may change over time if the property value and loan balance changes E g if the property value increases and the loan balance is reduced through amortization the investor s equity increases Question 11 7 What are the similarities and differences between an overall rate and an equity dividend rate Difference The overall rate relates the entire NOI to the value of the property The equity dividend rate relates the BTCF or equity dividend in the first year to the initial equity investment Similarity Neither one of these is a measure of investment yield because they do not take into account future income from operations or resale of the property at the end of the holding period Both are based on a single year usually the first year Question 11 8 What is the significance of a debt coverage ratio It is a ratio of the NOI to the mortgage payment that indicates the riskiness of a loan It is the degree to which the NOI from the property is expected to exceed the mortgage payment Lenders typically want a debt coverage ratio DCR to be at least 1 2 11 1 Chapter 11 Investment Analysis and Taxation of Income Properties Question 11 9 What is meant by tax shelter The term tax shelter refers to an investment that allows a taxpayer to reduce taxable income Although most of the tax shelter benefits of real estate were removed by the Tax Reform Act of 1986 depreciation deductions still provide some shelter in that they are non cash deductions that reduce taxable income Interest deductions on the mortgage also serve to reduce and in a sense shelter taxable income Question 11 10 How is the gain from the sale of real estate taxed The entire taxable gain from the sale of real estate is taxed at the same rate as ordinary income It is still important to keep track of capital gains losses and ordinary income gains losses This is due to TRA rules for passive investors and properties acquired prior to 1986 Question 11 11 What is meant by an effective tax rate What does it measure An effective tax rate is a tax rate that takes into account the effects of depreciation and time value of money It measures the actual difference between the BTIRR and the ATIRR This difference is the effective tax rate and can be less than the actual marginal tax rate This difference is also due to the fact that the interest on the mortgage loan is deductible Question 11 12 Do you think taxes affect the value of real estate versus other investments Yes Not all investments are treated alike when it comes to federal income taxes Thus taxes must be considered when comparing returns for investments which are not taxed in the same manner Investments that have the same before tax return may have quite different after tax returns Question 11 13 What is the significance of the passive activity loss limitation PALL rules for real estate investors The PALL rules are important because in general passive losses cannot be used to offset income from another category Because any tax loss from real estate is usually considered a passive loss it can not be used to offset income from other sources such as active income from salaries and wages or portfolio income from interest or dividends Solutions to Problems Chapter 11 Investment Analysis and Taxation of Income Properties Problem 11 1 ASSUMPTIONS Current Market Rent Gross square feet of building Net rentable square feet of building Projected Increase in Market Rent Management costs Estimated increase in CPI Vacancy rate starting year 4 17 00 50 000 50 000 3 00 5 00 3 00 10 00 11 2 per s f s f s f per year of Effective Gross Income per year per year Chapter 11 Investment Analysis and Taxation of Income Properties Tenant Sq ft Tenant 1 Tenant 2 Tenant 3 Total 20 000 15 000 15 000 50 000 Rent per s f Current Remaining Expense stop Rent term yrs per s f 15 00 300 000 15 50 232 500 17 00 255 000 787 500 3 4 5 CPI adjustment 4 00 4 50 5 00 50 00 50 00 50 00 Summary of Expense Information Dollars Property tax Insurance Utilities Janitorial Maintenance 100 000 10 000 75 000 25 000 40 000 per s f 2 00 0 20 1 50 0 50 0 80 increase increase increase increase increase 3 00 3 00 3 00 3 00 3 00 per year per year per year per year per year Subtotal before mgt 250 000 5 00 before management expenses Management 39 375 0 79 Total 289 375 5 79 a EGI 11 3 5 00 of EGI Chapter 11 Investment Analysis and Taxation of Income Properties Base Income Year Tenant 1 Tenant 2 Tenant 3 Total base 1 300 000 232 500 255 000 787 500 CPI Adjustment Tenant 1


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