File: {Elsevier}Brown/Revises-II/3d/Brown-ch002.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:21pm Page: 30/38 in parameters. Remember also that the actual values have no meaning except in reference to other values calculated in the same way. The importance of the general model is that it achieves an optimum for all combinations of numerical values given the parameters. What we are interested in is what happens when equilibrium is disturbed. Assume you are considering a certain community for locating your business. You find the present condition (equilibrium for our purposes) of sign regulation as plotted in Figure 2-4. How does a change in the political landscape change your decision to locate? How does it change the fortunes of market participants? How does that change of fortune affect other business owners’ decisions to locate in the community? Taking aesthetic regulation as just one example of the restrictions on freedom of choice imposed by government, what would you expect the aggregate effect of numerous restrictions to be? A reduction in the value of g from the 3.1 shown in Table 2-1 to 2.3 results in a reduction in both allowed advertising, A ¼ 35.9375, and, as expected, utility, U ¼ 82,218, as shown in Figure 2-5. Combining the last two plots in Figure 2-6 shows the cost, in terms of lost utility, of reducing the effectiveness of advertising,g. It is this argument that TABLE 2-1 Numeric Values for Variables in Functions for Utility and Optimal Advertising ab gA 0 q .5 4.1 3.1 100 .07 43.0556 Advertising 358,071. Utility FIGURE 2-4 Maximum utility when allowed advertising, A, is optimal advertising, A*. 30 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch002.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:21pm Page: 31/38 may persuade the one vote an investor needs from the local council. If the vote is close and swing vote is rational, this argument may only need to ring true with that one member. Utility, U, changes with the change in allowed advertising, A, the efficiency of advertising, g, and community disutility for advertising (as expressed 35.9375 82,218. FIGURE 2-5 Utility from reduced advertising. A*A′ Advertising Utility Cost of Reducing g Utility Lost FIGURE 2-6 Reduction in advertising from the optimal and resultant loss in utility. Land Use Regulation 31 File: {Elsevier}Brown/Revises-II/3d/Brown-ch002.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:21pm Page: 32/38 through Env), b. The effect on utility of a change in allowed advertising is greatest when the efficiency is highest. This is reasonable as the merchants lose more and tax revenue falls more. IMPLICATIONS The implications of this exercise should be clear. 1. People make decisions on the margins. Marginal analysis is a very powerful tool for measuring the net effect of a tradeoff between two alternatives. Many, if not all, economic choices between two alternatives may be modeled on a cost–benefit basis provided one makes plausible assumptions about how people generate well-being, happiness or utility. 2. Any item on the list of development constraints mentioned in the introduction to this chapter could be substituted for the one illustrated here. The aggregate of all such constraints, if applied by a heavy-handed legislative body, can operate as a strong disincentive to entrepreneurial activity in a community. 3. Arguments for change and arguments for preservation are often equally persuasive, especially when couched in an emotional framework. Alternatively, a balanced, methodical approach to resolving these issues is preferable when rational people of good intent must agree on how change is to be implemented. A CASE STUDY IN AESTHETIC REGULATION The developer who appears at the city council meeting waving his arms and talking about utility functions runs the risk of having Security escort him outside the city hall. The power of the general result above is often lost in the day-to-day implementation of policy. What follows is an example of how the thinking described above may be employed to construct a good argument in a specific case. The fact situation involves an independent hardware store in a municipality in California. The store has been in the same location for over 15 years. The Excel worksheet that accompanies this chapter provides a detailed historical record of sales for the past five years. The store is located in a commercial project of approximately 22,000 square feet, of which the store itself comprises 40% of the area available for lease. The remaining 60% is leased to other tenants at approximately the same rental 32 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch002.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:21pm Page: 33/38 rate as the hardware store. A 30-foot-high, ‘‘pylon-style’’ interior illuminated sign occupies a spot on the perimeter of the project. The owner/operator of the store is not only a long-standing and admired member of the local community, but he holds an undergraduate degree from West Point and a Masters in Business Administration from Columbia University. Local city officials respect his integrity and business acumen such that any estimate he might be required to make of the impact of city regulatory action on his business would be viewed as factual and well reasoned rather than self-serving. Municipal revenue is generated from three sources. Local governments in California receive (1) a portion of state sales taxes equal to 1% of sales generated within their jurisdiction; (2) 12.8% of property taxes received by the county; and (3) a variety of grants-in-aid, revenue sharing, assistance, subventions, and pass-throughs from the state. Tax revenue generated from the hardware store operation over the past five years from the first two of these sources is calculated from the sales data and is also shown in the Excel worksheet. The city is too small to maintain its own police department. Therefore, the city contracts with the county sheriff ’s department for police protection. The contract calls for four patrol units, seven days per week with relief; two traffic units (one five days per week and one seven days per week); 2.39 units of ‘‘Special Purpose Officer’’ (vice, homicide, etc.) for a total annual cost of $1,245,761 including all overhead, vehicles, uniforms, and benefits. The county uses a computer-aided dispatch system which tracks the exact time a unit is actually operating in a contract city. If a unit is called out of the area to assist on a priority call in an adjacent area not covered by the contract, that ‘‘time out’’ is tracked and not billed. From this information, the county estimates a ‘‘beat factor’’ for billing quarterly and to assist the contract city in budgeting. The beat factor is based on the total number of working minutes per year for the entire force. The beat factor multiplied times the cost times the number of units results in the amount billed for the specific service. Insurance is billed separately. The contract detail is as follows: Service type Per unit Beat factor Net # Units Total Patrol $249,753 0.7452 $186,116 4 $744,464 Traffic–5 day $140,950 0.9487 $133,719 1 $133,719 Traffic–7 day $197,329 0.9487 $187,206 1 $187,206 Special purpose $72,463 1.0000 $72,463 2.39 $173,187 Insurance $7,185 Annual grand total $1,245,761 Land Use Regulation 33 File: {Elsevier}Brown/Revises-II/3d/Brown-ch002.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:21pm Page: 34/38 A conflict exists between the municipality and the property owner over the existing 30-foot pylon sign. As part of a city beautification effort, the city passed a sign ordinance limiting the height of commercial signs to eight feet. The ordinance provided for an amortization period, which has now passed, and the city ordered the sign removed. Existing parking requirements prevent dedicating any more land to the sign structure. If this were not so, its shorter replacement could be installed on a gently rising landscaped berm elevated above the parking lot grade, as is common in new developments. As it is now, vehicles may park adjacent to the sign. Because adjacent parked cars would block its visibility, the practical effect of any ordinance limiting sign height to eight feet is to eliminate nearly all of the commercially beneficial use of this sign. To simplify the calculation we make the following assumptions: 1. The sales revenue of the hardware store per square foot is representative of square foot sales revenue for the entire project. Therefore, sales and municipal revenues for the entire site are calculated by ‘‘grossing up’’ the sales from the hardware store. 2. The hardware store’s owner estimates sales will drop 25% if the sign is removed or replaced by a sign structure conforming to the new ordinance. This reduced revenue estimate is presumed to apply to other tenants equally. 3. There are approximately 40 signs remaining in the city affected by the sign ordinance. Because (1) this project is one of the larger projects among these sites and (2) not all projects experience the parking conflict which exacerbates the problem for this site, rather than a multiple of 40, one-quarter of the multiplier effect, a factor of 10 rather than 40, is applied to arrive at the total citywide effect of enforcing the ordinance on all non-conforming signs. 4. No cost of administration or litigation is considered. No cost of removal and replacement of the existing signs is considered. 5. No municipal revenue from the state other than sales tax is considered, although the financial health of the tenants and the landowner affects state income tax revenue and, therefore, the share of state grants to cities. 6. The maximum loss to the businesses is captured by the estimated 25% decline in revenue. This assumption may not hold in practice as many businesses operate at margins that would not accommodate such a sales decline. These businesses would fail, expanding the loss of municipal revenue to include the 75% expected to remain. No synergistic effect is considered. That is, the fact that the hardware store is the ‘‘anchor tenant’’ for this property and its fortunes have a large impact on the satellite stores is not considered. 34 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch002.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:21pm Page: 35/38 7. Property tax revenue is uniform throughout the sites affected. This is unlikely because of California’s Proposition 13, which indexes assessment and property tax levies on random transfers of title. However, the annual effect during the historical period for this site is small. As this property has been under the same ownership for a long time, the property taxes are uncharacteristically low. Relaxing this assumption would result in an increased cost of the enforcement calculation because other sites likely have transferred more recently and have higher assessments. 8. No consequential economics are considered. The site employs approximately 50 people. No calculation is made for loss of income by those who would be laid off due to a decline in sales, nor is the economic base multiplier applied to lost sales in order to approximate total community revenue loss. 9. Residual effects such as the decline in property values due to reduction in rental income (required if sales volume dropped) are ignored. These are presumed to be offset by claims of increased value brought about by the elimination of visual blight occurring with the removal of the sign. This assumption is very hard to justify for commercial property, as values are heavily dependent upon rental income. 10. The contract with the county for police services is expected to continue as written for the foreseeable future without alteration. No change in demand for service or rate at which service is charged is contemplated. Most of the above assumptions are generous in favor of the regulatory interest. If, using the data in the Excel worksheet and the above assumptions, the hardware store represents a normal sample of city retail activity and the coming five years would otherwise produce the volume shown for the past five years, the annual decline in municipal revenue would approximate $22,400 from the site in which the hardware store is located. Expanding that by a factor of ten to represent the entire city, the approximate annual cost of reducing the size and visibility of commercial signs is $224,000. This figure is roughly equal to 18% of the annual cost of police protection under the county contract. The cost of the county contract is based on the number of patrol units, a beat factor, and the number of days squad cars are provided to the city. Assuming that the city does not wish to institute a specific tax for payment of police services, any of these variables can be adjusted downward to allow for the income loss traceable to aesthetic regulation under the sign ordinance. Land Use Regulation 35 File: {Elsevier}Brown/Revises-II/3d/Brown-ch002.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:21pm Page: 36/38 A number of possibilities exist, only three of which are: 1. One of the four patrol units can be eliminated. 2. The beat factor can be manipulated to require patrol units to spend less time within the city limits. 3. In combination with other adjustments, weekend traffic patrol could be eliminated at a savings of $56,379 per year (the difference between 5 day and 7 day coverage). Any of the components of the police protection can be valued in ‘‘aesthetic units.’’ Assume that weekend traffic patrol is valued by the hour. The $56,379 cost for weekend coverage becomes $1,175 for a 48-hour period. In the case of our example, the loss in revenue associated with one sign ($22,400 per year) is equal to 19 hours of weekend police protection rendered weekly for one year. So the operative question becomes, do the citizens of this city prefer one unit of aesthetic value in the form of the removal of an oversized commercial sign or 19 hours of police protection during the weekend? This illustration represents one of an infinite number of possible combinations of benefits and costs that may be argued successfully in a regulatory setting. Although the mathematical elegance of the abstract model we started with is less apparent in the example, the thinking behind it remains one of optimization in the presence of constraints. Budgets are limited and resources are scarce, meaning that choices must be made. The general form of the model always reduces to a discussion of how costs and benefits are to be managed in a way that brings about the most good for the most number. In actual practice, there is much opportunity for field adjustment. The spreadsheet provided in the electronic files may be used to ‘‘tweak’’ the analysis in various ways. Suppose the 25% loss in sales is unconvincing. Change it to the number relevant to your circumstance and you have a different answer. Perhaps your regulatory issue is not signage, but lot line set-back distance or floor area ratios. These, too, lend themselves to an optimization problem, one of the most widely respected decision tools in and out of the business world. CONCLUSION The impact of governmental decisions at all levels cannot be ignored. At the local level the effect of restrictions on value may be positive or negative. The sign (positive or negative) of effects for the short run may differ from the sign of effects for the long run. Land users and policymakers must strike a balance between the competing interests represented in the private economic market 36 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch002.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:21pm Page: 37/38 and the market for public services and lifestyle. This chapter presents just one example of many. It is estimated that 80% of the decisions made by the typical Southern California City Council are land use decisions. In effect, this makes local politicians the largest real estate agent in the city. How well they do their job depends in part on how well they understand the consequences of their decisions. Good government arises from an informed citizenry. The tools of this chapter may be employed to shed light on a process vital to real estate investing. REFERENCES 1. Brown, R. J., and Sharp, J. M. (1998). America becoming ‘‘The Beautiful’’ again: Examining a century of aesthetic regulation. Proceedings of the Academy of Legal Studies in Business, San Diego. 2. Brown, R. J., and Sharp, J. M. (1996). The emerging fourth wave of aesthetic regulation: Beauty is in the pocket books of the beholder. Proceedings of the Academy of Legal Studies in Business, Quebec City. 3. Cheung, S. N. S. (1970). The structure of a contract and the theory of a non-exclusive resource. Journal of Law and Economics, 13, 49–70. 4. Coase, R. H. (1960). The problem of social cost. Journal of Law and Economics, 3, 1–44. 5. Costonis, J. J. (1982). Law and aesthetics: A critique and a reformulation of the dilemmas. Michigan Law Review, 80(3), 355–461. 6. Demsetz, H. (1967). Toward a theory of property rights. American Economic Review, 347. 7. Dukeminier, J. J., Jr. (1955). Zoning for aesthetic objectives: A reappraisal. Law and Contemporary Problems, 20, 218–237. 8. Eggertsson, T.(1990). Economic Behavior and Institutions. Cambridge University Press, London. 9. Manne, H. G. (1975). Economics of Legal Relationships: Readings in the Theory of Property Rights. New York: West Publishing. 10. Meiselman, A. (1985). The regulation of outdoor advertising: Balancing freedom of speech and aesthetics. Annual Survey of American Law, 671–697. 11. Posner, R. A. (1998). Economic Analysis of Law (5th ed.). Aspen Law and Business. 12. Tiebout, C. M. (1956). A pure theory of local expenditures. Journal of Political Economics, 64, 416–424 13. Titman, S. (1985). Urban land prices under uncertainty. American Economic Review, 75(3), 505–514. 14. Williams, S. F. (1977). Subjectivity, expression, and privacy: Problems of aesthetic regulation. Minnesota Law Review, 62, 1–58. APPENDIX: COMPARATIVE STATICS FOR CHAPTER 2 To test the model for optimality, we perform comparative statics and are only interested in the sign of certain derivatives. Land Use Regulation 37 File: {Elsevier}Brown/Revises-II/3d/Brown-ch002.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:21pm Page: 38/38 Comparative statics performed on Equation (2-10) have the correct sign. Equation (2-11a) shows that increases in g, the productivity of advertising, shifts the marginal benefit curve outward and results in increases in advertising, as expected. In Equation (2-12a), increases in b, the disutility for advertising, shifts the marginal cost curve inward and results in decreases in advertising (recall that 0 < a < 1 is what makes the numerator in both expressions negative). These expressions constitute the dilemma the city finds itself in when it reduces the efficiency of advertising or experiences an increase in disutility for advertising. A à g ¼À A 0 a À1ðÞab abÀgðÞþgðÞ 2 ð2-11aÞ A à b ¼ A 0 a À1ðÞag abÀgðÞþgðÞ 2 ð2-12aÞ We also have an intuitive result for the derivative of A* w.r.t. a. Increases in a represent an increase in the community’s preference for environmental regulation over the other forms of municipal services. The negative derivative indicates that an increase in a decreases advertising from the optimal. A à a ¼À A 0 bg abÀgðÞþgðÞ 2 ð2-13aÞ Below is the second derivative of utility with respect to advertising. As both numerators are negative, the second derivative is negative, indicating that we have a global optimum. (This is not surprising because all functions are strictly convex.) @ 2 Log U½ @A 2 ¼ a À1ðÞg A 2 À ab A ÀA 0 ðÞ 2 ð2-14aÞ 38 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch003.3d Creator: iruchan/cipl-un1-3b2-1.unit1.cepha.net Date/Time: 22.12.2004/3:22pm Page: 39/72 CHAPTER 3 The ‘‘Rules of Thumb’’ Threshold Performance Measures for Real Estate Investment Pluralities non est ponenda sine necessitate (approximately: Keep it simple, stupid). William of Occam, c. 1280–1349 INTRODUCTION This chapter deals with the initial measures used in the field to decide if one wants to collect more information and perform further analysis on a real estate investment opportunity. Even at this threshold stage, the analysis of data can enhance decision making. The availability of plentiful data for privately owned real estate investments is relatively new. As with any new tool, using it to full advantage depends on using it correctly. Rules of thumb, having their place in the acquisition of individual properties, can also play a role in data analysis. In that role one can reach preliminary conclusions about the market in which the target acquisition competes. In this chapter we will:  Look closely at the real estate equivalent to ratio tests used in corporate finance.  Make the connection between the simple, one-year, snapshot measures and the more elaborate, multi-period, analysis methods.  Suggest ways that data can be used to improve the value of rules of thumb.  Perform tests on data to determine the validity of representations made by real estate professionals and investors in the field.  Touch on the effect that extreme values have on data analysis. 39 [...]... size increases, the favored threshold measure is capitalization rate, to which we now turn 2 rrr ¼ 8:89802 7 À 1 ¼ 0:2711 48 Private Real Estate Investment Rent Increase % 80 60 40 20 0 0 100 200 300 400 FIGURE 3-3 Plot of rrr necessary for properties above equilibrium GRM FIGURE 3-4 Properties requiring rent raises to achieve equilibrium (See color figure.) FIGURE 3-4 Properties requiring rent raises...40 Private Real Estate Investment THRESHOLD PERFORMANCE MEASURES Rules of thumb are short cuts They are for the ‘‘tire kicking’’ stage of a search for a suitable property They give quick-and-dirty answers As such, they ignore many important aspects of investing Thus, the answers provided can easily be wrong However, we must start somewhere Rules of thumb are important for two reasons First, real estate. .. 46 Private Real Estate Investment more than cash and the corresponding seller valued the cash more than the property Market equilibrium is a somewhat cerebral concept Appreciating it requires blocking out what one may know about specific transactions and considering the overall market as a functioning system One must make the transition from dealmaker to market analyst to maximize the value of real estate. .. payment of principal Generally, real estate loan payments include principal and interest Thus, it is common to include amortization in the debt service shown on a real estate investment operating statement The corporate line item Earnings Before Interest and Taxes (EBIT) is replaced by Net Operating Income (NOI) in the real estate income statement Of course, these are general rules and exceptions apply... Building A includes furniture or utilities in the rent and the owner of Building B does not? A real estate investor should remember what business he is in He is in the business of renting enclosed space resting on a parcel of land He may also be in the ‘‘side’’ business of renting furniture, but that is a different business with different income and cost dynamics If you doubt this, compare the useful life... rent per square foot is somewhat helpful, but Los Angeles is a big area We still should conduct a rent survey close to our subject property We then know if rents in our neighborhood are above or below the general Los Angeles area and can inquire as to why this is so We then compare neighborhood rents to our subject property to determine what sort of rent change is desirable or feasible We are interested... might use the reported GRM for a reality check on the market in general To the buyer’s complaint that the seller’s price is too high, it is common for sellers to claim that rents are low and the buyer need only raise the rent to make the property pay off at the price the seller offers In general, tenants may be presumed to stay if rent increases are small and leave if they are large Our interest is in... are linear Few things as complex as a real estate investment can be explained with a single variable Yet the market persists in using these tools Let’s take them one at a time, examining their strengths and weaknesses The ‘‘Rules of Thumb’’ 43 THE GROSS RENT MULTIPLIER (GRM) An important feature of this rule is its accuracy Both of its components, price and rent, are usually reported correctly There... pursue more information on one project precludes devoting more time to another, possibly more profitable, pursuit The wise use of data can improve the value of threshold measures and increase search efficiency Second, the smallest income properties often trade in the market solely on the basis of threshold measures Thus, the decision to purchase a duplex might be based entirely on its gross rent multiplier... with Income Tax Consequences Included in that detail is a depreciation deduction, something that has special implications for real estate investment Although we will incorporate this into the model in Chapter 4, the reader is urged to consult a basic real estate investment text to become acquainted with these details before proceeding There are seven common rules of thumb; five primarily concern investors . 0.7452 $18 6 ,11 6 4 $744,464 Traffic–5 day $14 0,950 0.9487 $13 3, 719 1 $13 3, 719 Traffic–7 day $19 7,329 0.9487 $18 7,206 1 $18 7,206 Special purpose $72,463 1. 0000 $72,463 2.39 $17 3 ,18 7 Insurance $7 ,18 5 Annual. assumptions: 1. The sales revenue of the hardware store per square foot is representative of square foot sales revenue for the entire project. Therefore, sales and municipal revenues for the entire site. the satellite stores is not considered. 34 Private Real Estate Investment File: {Elsevier}Brown/Revises-II/3d/Brown-ch002.3d Creator: iruchan/cipl-un1-3b2 -1. unit1.cepha.net Date/Time: 22 .12 .2004/3:21pm Page: