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Contents Preface vii p a r t 1 SETTING THE STAGE 1 1 The Nature of Real Estate and Real Estate Markets 2 Introduction 2 Real Estate: Some Basic Definitions 3 Real Estate: A Tangible Asset 3 Real Estate: A Bundle of Rights 5 Real Estate: An Industry and Profession 6 Real Estate and the Economy 7 Land Use in the United States 7 Real Estate and U.S. Wealth 8 Real Estate Markets and Participants 11 User Markets 11 Capital Markets 11 The Role of Government 12 The Interaction of Three Value-Determining Sectors 12 The Production of Real Estate Assets 14 Characteristics of Real Estate Markets 14 Heterogeneous Products 15 Immobile Products 15 Localized Markets 15 Segmented Markets 15 Privately Negotiated Transactions with High Transaction Costs 16 Summary 16 2 Value and Real Estate Decisions 20 Introduction 20 The Idea of Investment Value 21 Investment Value in Real Estate 22 Investment Value and Time 22 Investment Value and Nonmonetary Effects 23 Incremental Investment Value 24 Incremental Investment Value with Financing 26 Investment Value and Risk 26 Uncertainty of Costs 29 Uncertainty of Value 30 Managing Risk 31 Revisiting Three Investment Risk Scenarios 33 Risk, Investment Value, and Yield 33 A Portfolio Perspective on Real Estate Investment 34 Investment Value and Appraisal 35 Summary 36 3 The Effects of Time and Risk on Value 40 Introduction 40 The Time Value of Money 41 The Timeline 42 Terminology 43 Equations, Calculators, and Spreadsheets 43 Compounding Operations 44 Discounting Operations 49 Yields and Internal Rates of Return 54 Determining Required Returns 56 Comparing Investment Values to Acquisition Costs 58 Summary 60 Appendix: Solving Time-Value-of-Money Problems Using EXCEL 63 p a r t 2 SOURCES AND LIMITATIONS TO VALUE 69 4 Legal Foundations to Value 70 Introduction 70 The Nature of Property 71 The Nature of Rights 71 Real Property and Personal Property: The Problem of Fixtures 73 The Real Property Bundle of Rights 76 Possessory Interests (Estates) 76 Nonpossessory Interests 79 Forms of Co-Ownership 84 Indirect Co-Ownership through a Single Entity 84 Direct Co-Ownership 85 Timeshare 90 Rights Related to Water 91 Rights to Oil, Gas, and Minerals 91 Summary 93 Appendix: Property Rights Related to Water 96 xxi 5 Market Determinants of Value 99 Introduction 99 Market Misjudgments in Real Estate 99 Minimizing Market Errors 100 The Creation, Growth, and Decline of Cities 101 Where Cities Occur 101 The Economic Base of a City 102 Resources of a City: The Supply Side of Urban Growth 107 The Shape of a City 109 Demand for Proximity and Bid-Rent Curves 114 Bid-Rent Curves, Urban Land Use, and Land Value Contours 114 Changing Transportation, Changing Technology, and Changing Urban Form 114 Differing Location Patterns of Urban Land Use 119 Convenience ?Goods? and Central Place Patterns 119 Comparison Goods and Clustering 122 Industry Economies of Scale and Clustering 122 The Role of Urban Analysis in Real Estate Decisions 124 Summary 125 6 Government Controls and Real Estate Markets 129 Introduction 129 The Power of Government to Regulate Land Use 130 Monopolies, Externalities, and Other Market Distortions 130 Public Planning for Land Use Control 134 Comprehensive Planning 134 Challenges in Public Land Use Planning 136 Zoning and Other Tools for Public Land Use Control 137 Zoning 138 Building Codes 138 Subdivision Regulations 139 Zoning and Planned Administration 140 Modern Tools of Land Use Control 141 Private Restrictions 141 Environmental Hazards 142 Types of Hazardous Materials 143 Implications for Real Estate Investors 144 The Government?s Power of Eminent Domain 145 Public Use 146 Just Compensation 146 Inverse Condemnation and Regulatory Takings 147 The Power of Government to Tax Real Property 147 Mechanics of the Property Tax 148 Determining a Jurisdiction?s Budget and Tax Rate 149 Tax-Exempt Properties 149 Homestead and Other Exemptions 150 Calculating Tax Liability 150 Special Assessments 151 Nonpayment of Property Taxes 151 Criticisms of the Property Tax 152 Summary 152 7 Forecasting Ownership Benefits and Value: Market Research 157 Introduction 157 Market Research: The Weak Link of Real Estate Valuation 158 Market Segmentation 159 Real Estate Market Research as Storytelling 159 The Beginning Point: A Market-Defining Story 160 Initial Collection of Data 161 First Analysis 161 Refining the Research 161 A Reverse to Conventional Market Research 161 Three Examples of Market Research 162 Market Research Example 1: Elysian Forest, a Planned Unit Development 162 Market Research Example 2: Palm Grove Office Complex 169 Market Research Example 3: Plane Vista Apartments 171 Some Final Notes on the Process of Market Research 177 Improving One?s Capacity in Real Estate Market Research 178 Market Projections and Real Estate Cycles 178 Some Tools of Market Research 180 Geographic Information Systems (GIS) 180 Psychographics 182 Survey Research 182 Summary 183 p a r t 3 MARKET VALUATION AND APPRAISAL 187 8 Valuation Using the Sales Comparison and Cost Approaches 188 Introduction 188 Market Value, Investment Value, and Transaction Prices 190 The Appraisal Process 191 Definition of the Problem 192 Data Selection and Collection 193 Highest and Best Use Concepts 193 Three Conventional Approaches to Estimating Market Value 193 Reconciliation and a Final Estimate of Market Value 194 The Appraisal Report 194 Traditional Sales Comparison Approach 195 Comparable Sales Data 196 Sources of Market Data 196 Adjustments to Comparable Property Transaction Prices 197 Types of Adjustments 200 Sequence of Adjustments 200 A Note on the Selection of Comparables and Adjustments 203 Reconciliation to an Indicated Value Estimate 203 The Cost Approach 203 Accrued Depreciation 204 Final Reconciliation 206 Multivariate Regression Analysis 206 Interpreting the Regression Results 210 Summary 212 9 Valuation Using the Income Approach 216 Introduction 216 Direct Capitalization versus Discounted Cash Flow 217 Estimating Net Operating Income 218 Potential Gross Income 220 Effective Gross Income 221 Operating Expenses 222 Capital Expenditures 222 Net Operating Income 224 Using Direct Capitalization for Valuation 224 Abstracting Cap Rates from the Market 224 Understanding Capitalization Rates 227 Other Methods of Estimating Cap Rates 228 Reconciling Cap Rates and Estimating an Indicated Value 229 Gross Income Multiplier 230 Using Discounted Cash Flow Analysis for Valuation 232 A Word of Caution 233 Estimating Future Sale Proceeds 233 Levered versus Unlevered Cash Flows 234 Valuing Unlevered Cash Flows 234 Valuing Levered Cash Flows 236 Other Approaches 237 Final Reconciliation 238 Valuing Partial and Other Interests 238 Summary 239 p a r t 4 FINANCING REAL ESTATE OWNERSHIP 245 10 Real Estate Finance: The Laws and Contracts 246 Introduction 246 The Note 247 Interest Rate and Interest Charges 247 Adjustable Rates 248 Payments 250 Term 251 Right of Prepayment 251 Prepayment Penalties 252 Late Fees 252 Personal Liability 252 Demand Clause 252 Inclusion of Mortgage Covenants by Reference 253 The Mortgage 253 Description of the Property 254 Insurance Clause 254 Escrow Clause 254 Acceleration Clause 254 Due-on-Sale Clause 254 Hazardous Substances Clause and Preservation and Maintenance Clause 255 Deed of Trust 255 When Things Go Wrong 256 Default 256 Nonforeclosure Responses to Default 257 Foreclosure 258 Deficiency Judgment 259 Judicial Foreclosure versus Power of Sale 259 Bankruptcy and Foreclosure 260 Acquiring a Property with an Existing Debt 261 Real Estate Debt without a Mortgage 262 Regulation of Home Mortgage Lending 264 Equal Credit Opportunity Act 264 Truth-in-Lending Act 264 Real Estate Settlement Procedures Act 265 Home Ownership and Equity Protection Act 266 Other Laws Regulating Discrimination in Home Mortgage Lending 266 Summary 268 11 Mortgage Mechanics and Calculations 273 Introduction 273 Basic Computations 274 Payments 274 Loan Balance 275 Lender?s Yield 276 Effective Borrowing Cost (EBC) 277 Up-front Costs, Holding Period, and Effective Borrowing Cost 279 Fixed-Rate Mortgages 281 Level-Payment, Fully Amortized Mortgages 281 The Choice of Loan Term: A Question of Present Value 282 Alternative Amortization Schedules 284 Adjustable Rate Mortgages 286 The Mechanics of Adjustable Rate Mortgages 286 Initial Adjustment Periods, Rate Caps, and Other Options 288 Other Mortgage Types and Uses 291 Interest Rate Buydown 291 Wraparound Mortgages 292 Summary 294 12 Residential Mortgage Types and Borrower Decisions 299 Introduction 299 The Primary and Secondary Mortgage Markets 300 Conventional Mortgage Loans 301 Fixed-Rate Conventional Mortgages 301 Adjustable Rate Mortgages 302 Private Mortgage Insurance 303 Government-Sponsored Mortgage Programs 305 FHA-Insured Loans 305 VA-Guaranteed Loans 308 Other Mortgage Types and Uses 309 Purchase-Money Mortgage 309 Package Mortgage 309 Home Equity Loan 310 Reverse Mortgage 310 The Borrower?s Mortgage Loan Decisions 313 Mortgage Choice 313 Loan Size 314 The Refinancing Decision 315 The Default Decision 320 Summary 321 13 Sources of Funds for Residential Mortgages 325 Introduction 326 The Market for Residential Finance 326 Depository Lenders in the Primary Market 327 Savings Institutions (Thrifts) and Their Decline 327 Credit Unions 331 Commercial Banks 331 Nondepository Lenders in the Primary Market 332 Mortgage Bankers 333 Mortgage Brokers 337 Other Nongovernment-Sponsored Lenders 338 The Secondary Market for Residential Mortgages 338 Mortgage-Backed Securities 339 Purchasers of Residential Mortgages in the Secondary Market 340 Ginnie Mae (GNMA) 340 Fannie Mae 341 Freddie Mac 342 The Importance of Fannie Mae and Freddie Mac 343 Federal Home Loan Banks 345 Life Insurance Companies 345 Other Secondary Market Purchasers 345 The Lender?s Mortgage Loan Decisions 346 Traditional Home Mortgage Underwriting 346 Modern Home Mortgage Underwriting 347 Cash Down Payment Requirement 348 Home Financing for Marginal Borrowers 348 Affordable Housing Loans 349 Subprime Lending 350 Summary 351 14 Commercial Mortgage Types and Decisions 354 Introduction 354 Loan Documents and Provisions 355 The Note 355 The Mortgage 356 Common Types of Permanent Mortgages 357 Balloon Mortgages 357 Restrictions on Prepayments 359 Alternative Financing Arrangements 360 Floating-Rate Loans 360 Installment Sale Financing 360 Joint Ventures 361 Sale-Leasebacks 361 Other Products and Structures 362 Government-Sponsored Programs 362 The Borrower?s Decision-Making Process 363 Typical Loan Terms 364 Loan Size 366 Financial Risk 366 Increased Variability of Equity Returns from Leverage 366 Choosing among Alternative Financing Structures 370 The Prepayment and Default Decisions 371 Investment Valuation versus Market Valuation 411 Investment Value Calculation 412 Centre Point Office Building Example 412 Treatment of Capital Expenditures 414 Evaluating the Cash Flow Estimates 415 Effects of Debt Financing on Pro Forma Cash Flows 416 Why Do Investors Borrow? 416 Effect on Initial Investment 417 Effect on Cash Flows from Operations 418 Effect on Cash Flows from Sale 419 More Detailed Cash Flow Projections 419 Investment Valuation Using Discounted Cash Flow Models 421 Net Present Value 421 Internal Rate of Return 422 Comparing Net Present Value and the Internal Rate of Return 423 Effects of Debt on Return and Risk 424 Partnerships and Other Direct Forms of Ownership 425 Effects of Income Taxes 426 Effects on Discount Rate 428 Effects on Net Present Value and the Internal Rate of Return 428 Other Investment Criteria 429 Profitability Ratios 429 Multipliers 431 Financial Risk Ratios 432 Limitations of Ratio Analyses 434 Varying the Assumptions 434 Summary 435 17 Enhancing Value through Ongoing Management 440 Introduction 441 Owners as Managers 442 Functions of a Property Manager 442 Marketing the Property 442 Selecting Tenants 444 Signing Leases 445 Collecting Rent 447 Complying with Landlord-Tenant Laws 448 Maintaining Tenant Relations 448 Communicating with Owners 448 Repairing and Maintaining the Premises 449 Property Management Agreements 451 Management Fees 453 Professional Associations and Designations 454 Asset Management 455 The Development of a Profession 456 Asset Management Functions 456 Requesting a Permanent Loan 371 Loan Application Package 372 Channels of Submission 373 The Lender?s Decision-Making Process 373 The Property and the Borrower 374 Maximum Loan Amount 375 The Economic Justification 376 From Application to Commitment 376 Land Acquisition, Development, and Construction Financing 376 Summary 377 15 Sources of Commercial Debt and Equity Capital 382 Introduction 382 How Large Is the Commercial Real Estate Market? 383 Sources of Commercial Real Estate Equity Capital 384 Publicly Owned Commercial Real Estate 384 Privately Owned Commercial Real Estate 387 Forms of Ownership for Pooled Equity Investments 390 C Corporation 390 S Corporation 391 General Partnership 392 Limited Partnership 392 Limited Liability Company 393 Sources of Commercial Real Estate Debt 394 Mortgage Originators versus Long-Term Holders 395 Development and Construction Lending 396 How Information Standards Help Attract More Capital 396 ACloser Look at Real Estate Syndications 397 The Role of the Syndicator/Organizer 397 Regulation 397 Evaluating a Syndication Opportunity 399 A Closer Look at Real Estate Investment Trusts 399 The Growing Importance of Public Real Estate Markets 399 REIT Management 400 REIT Valuation 402 Measuring REIT Income 403 REIT Investment Performance 404 Summary 405 p a r t 5 INVESTMENT VALUATION 409 16 Valuing Investment Opportunities 410 Introduction 410 Licensing of Real Estate Brokers and Salespersons 499 Brokerage Licensing Administration 500 How to Obtain a Real Estate License 501 License Law Infractions 501 Certification of Real Estate Occupations 502 The Marketing Function 502 Market Segmentation and Specialization and Service 502 Commercial Brokerage 503 Residential Brokerage 503 International Aspects of Brokerage 507 Listing Contracts 508 Types of Listing Contracts 508 Open Listing 509 Exclusive Agency Listing 509 Exclusive Right of Sale Listing 510 Innovation in Brokerage 510 Listing Contract Provisions 511 Termination of a Listing Contract 511 Splitting the Commission 511 A Listing Situation?Example 512 Summary 518 20 Contracts for Sale and Closing 522 Introduction: The Most Important Document in Real Estate 522 Rights and Obligations of Sellers and Buyers 523 Requirements of a Contract for Sale 523 Competency of the Parties to Act 524 Lawful Intent of the Parties 524 An Offer and an Acceptance 524 Consideration 525 No Defects to Mutual Assent 525 A Written Real Estate Contract 525 Proper Description of the Property 526 Legal Title versus Equitable Title 526 The Form of the Contract for Sale 526 Simple Contract 527 Standard Form Contracts 527 Components of a Form Contract 529 Contracts with Contingencies 536 Assignment 536 Remedies for Nonperformance 537 Escrow 537 The Closing and Closing Statements 537 Role of the Brokers 537 Role of the Lenders 537 Real Estate Settlement Procedures Act 538 Preparation of Closing Statements 539 The Continuing Story of a Sale 542 Performance Evaluation and Compensation 457 A Closer Look at the Decision to Improve or Alter a Property 458 Demolition and Reuse 460 Managing Corporate Real Estate Assets 460 Summary 464 p a r t 6 ACQUIRING AND DISPOSING OF OWNERSHIP INTERESTS 467 18 Conveying Real Property Interests 468 Introduction 468 Deeds 469 Requirements of a Deed 469 Types of Deeds 472 Modes of Conveyance of Real Property 474 Voluntary Conveyance by a Deed 474 Involuntary Conveyance by a Deed 474 Voluntary Conveyance without a Deed 475 Involuntary Conveyance without a Deed 476 Real Property Complexity and Public Records 477 The Doctrine of Constructive Notice 477 Statute of Frauds 477 Recording Statutes 477 Actual Notice 478 Title 478 Title Search, Title Abstract, and Chain of Title 478 Evidence of Title 479 Land Descriptions 481 Metes and Bounds 481 Subdivision Plat Lot and Block Number 483 Government Rectangular Survey 483 Summary 486 19 Real Estate Brokerage and Listing Contracts 491 Introduction: Brokerage?The Best-Known Type of Real Estate Business 491 Real Estate Brokers as Market Facilitators 492 Economic Rationale for Employing a Broker 493 Law of Agency 494 Types of Agents 494 Fiduciary Responsibilities 495 Real Estate Agents 495 Problems in Real Estate Agency Relationships and Disclosures 497 Transaction Brokers 499 Operating Expenses versus Capital Improvements 588 Costs of Mortgage Financing 589 Depreciation Deductions 589 Tax Credits 594 Centre Point Office Building: Taxes from Operations 595 What Is a Tax Shelter? 596 Estimating Taxable Income from Sale 597 Fully Taxable Sale 597 Centre Point Office Building: Taxes Due on Sale 602 Net Benefits of Tax Depreciation 604 Effect of Taxes on Values and Returns 604 Complications Caused by Alternative Ownership Forms 606 Methods of Deferring Taxes on Disposition 606 Installment Sale 606 Like-Kind Exchanges 607 Tax Factors Affecting Homeowners 607 Summary 608 23 Risk Management in a Portfolio Context 614 Introduction 614 Sources of Risk 615 Microeconomic Risk Factors 617 Macroeconomic Risk Factors 617 The Concept of Variability 618 Specification of Risk Preferences 620 Measuring Project-Specific Risk 622 Variance and Standard Deviation 622 Return per Unit of Risk 624 The Use of Subjective Probabilities 624 Risk Management 624 Avoiding Risky Projects 625 Insurance 625 Due Diligence 625 Diversification as a Risk-Management Tool 626 The Portfolio Concept of Risk 627 Diversifiable Portfolio Risk 627 Covariance and Correlation 628 Examples of Diversifiable Risk 629 Basic Real Estate Diversification Strategies 630 Nondiversifiable Risk 631 Constructing an Efficient Portfolio 631 Why Are So Many Investors Not Well Diversified? 631 How Risky Is Real Estate? 633 Appraisal-Based Index of Unsecured Returns 633 Good Faith Estimate of Closing Costs 542 Steps before Closing 544 Steps at Closing 548 Summary 549 p a r t 7 ADVANCED TOPICS 553 21 Leases and Property Types 555 Introduction 555 Essential Elements of a Lease 556 Negotiated Lease Provisions 556 Use of the Premises 557 Lease Term 557 Rental Payments 558 Responsibility for Operating Expenses 559 Concessions 561 Alterations and Improvements 561 Assignments and Subletting 562 Lease Options 562 Other Common Clauses 564 Effective Rent 564 Broader Lease Considerations 566 Residential Rental Properties and Leases 567 Common Lease Provisions of Residential Rental Properties 568 Office Properties and Leases 569 Defining Rentable Space in Office Properties 570 Common Lease Provisions 571 Retail Properties and Leases 572 Defining Leasable Area in Rental Properties 573 Common Lease Provisions of Rental Properties 573 Industrial Properties and Leases 575 Common Lease Provisions of Industrial Properties 576 Hospitality Properties 577 Summary 577 22 Income Taxation and Value 582 Introduction 582 Objectives and Implementation of United States Tax Law 583 Comparing the Taxation of Individuals and Corporations 583 Four Classes of Real Property 583 Income Subject to Taxation 584 Tax Rates 586 Estimating Taxable Income from Operations 587 Cash Calculation versus Tax Calculation 588 Design 653 Financing 655 Construction 658 Marketing and Leasing 660 Operation 662 The ?Numbers? of Development 663 What Is It Like to Be a Developer? 665 What Does It Take to Enter Development? 667 Summary 668 REIT-Based Index of Securitized Returns 634 Historical Returns, Risk, and Correlations 634 Risk-Adjusted Discount Rate 637 Quantifying Required Risk Premiums with Asset-Pricing Models 638 Summary 640 24 Development: The Dynamics of Creating Value 645 Introduction 645 The Process of Development 646 Establishing Site Control 647 Feasibility Analysis, Refinement, and Testing 648 Obtaining Permits 649 Glossary 671 Photo Credits 686 Index 688
Library of Congress Subject Headings for this publication:
Real estate business -- United States.