Brueggeman Fisher Real estate Finance and investments Real estate Finance and investments fourteenth edition William B. Brueggeman JeFFrey D. Fisher Building the FRamewoRk to Reach the Right Real estate decisions The Fourteenth Edition of Real Estate Finance and Investments prepares students to understand the risks and rewards associated with investing in and financing both residential and commer- cial real estate. Factors such as legal issues that can impact the rights of lenders and investors, characteristics of various vehicles for real estate lending and investing, the importance of the local economy, and the goals of the lender or investor are detailed so that students can perform the right kind of analysis to make informed real estate finance and investment decisions. Key Features incluDe: New topics in various chapters have been added to provide coverage on important topics such as market analysis for projecting occupancy and rental growth, installment sales, tax- free exchanges, valuing REITs, and the current economic landscape. New concept boxes in select chapters provide information about recent trends in mortgage- backed securities and how the government has worked to add liquidity to mortgage markets, in addition to taking over the Federal Home Loan Mortgage Corporation. Student-friendly pedagogical features are integrated throughout the text, such as calculator hints with solutions. Traditional table solutions are also shown in the early chapters to aid in the understanding of the time-value of money. COURSESMART CourseSmart is a new way to find and buy eTextbooks. At CourseSmart you can save up to 50% of the cost of your print textbook, reduce your impact on the environment, and gain access to powerful web tools for learning. Try a free chapter to see if it’s right for you. Visit www.CourseSmart.com and search by title, author, or ISBN. Learn more about resources avaiLabLe to you at www.mhhe.com/bf14e 9 7 8 0 0 7 3 3 7 7 3 3 9 9 0 0 0 0 www.mhhe.com EAN ISBN 978-0-07-337733-9 MHID 0-07-337733-3 14th edition MD DALIM #1065290 01/10/10 CYAN MAG YELO BLK Confirming Pages Real Estate Finance and Investments bru77333_fm_i-xviii.qxd 1/13/10 10:5445 Page i Confirming Pages The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor FINANCIAL MANAGEMENT Adair Excel Applications for Corporate Finance Second Edition Block, Hirt, and Danielsen Foundations of Financial Management Thirteenth Edition Brealey, Myers, and Allen Principles of Corporate Finance Tenth Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Sixth Edition Brooks FinGame Online 5.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Sixth Edition Chew The New Corporate Finance:Where Theory Meets Practice Third Edition Cornett, Adair, and Nofsinger Finance:Applications and Theory First Edition DeMello Cases in Finance Second Edition Grinblatt (editor) Stephen A. 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Brueggeman, Ph.D. Corrigan Chair in Real Estate Edwin L. Cox School of Business Southern Methodist University Jeffrey D. Fisher, Ph.D. Charles H. and Barbara F. Dunn Professor of Real Estate Kelley School of Business Indiana University bru77333_fm_i-xviii.qxd 1/13/10 10:5445 Page iii Rev. Confirming Pages REAL ESTATE FINANCE AND INVESTMENTS Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the Americas, New York, NY, 10020. Copyright © 2011, 2008, 2005, 2002, 1997, 1993, 1989, 1981, 1977 by The McGraw-Hill Companies, Inc. All rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc., including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning. Some ancillaries, including electronic and print components, may not be available to customers outside the United States. This book is printed on acid-free paper. 1 2 3 4 5 6 7 8 9 0 WDQ/WDQ 1 0 9 8 7 6 5 4 3 2 1 0 ISBN 978-0-07-337733-9 MHID 0-07-337733-3 Vice president and editor-in-chief: Brent Gordon Publisher: Douglas Reiner Executive editor: Michele Janicek Director of development: Ann Torbert Senior development editor: Christina Kouvelis Editorial coordinator: Alyssa Otterness Vice president and director of marketing: Robin J. Zwettler Associate marketing manager: Dean Karampelas Vice president of editing, design and production: Sesha Bolisetty Project manager: Dana M. Pauley Lead production supervisor: Michael R. McCormick Designer: Matt Diamond Media project manager: Suresh Babu, Hurix Systems Pvt. Ltd. Typeface: 10/12 Times New Roman Compositor: Laserwords Private Limited Printer: Worldcolor Library of Congress Cataloging-in-Publication Data Brueggeman, William B. Real estate finance and investments / William B. Brueggeman, Jeffrey D. Fisher.—14th ed. p. cm.—(The McGraw-Hill/Irwin series in finance, insurance, and real estate) Includes index. ISBN-13: 978-0-07-337733-9 (alk. paper) ISBN-10: 0-07-337733-3 (alk. paper) 1. Mortgage loans—United States. 2. Real property—United States—Finance. I. Fisher, Jeffrey D. II. Title. HG2040.5.U5B78 2011 332.7'2—dc22 2009053484 www.mhhe.com bru77333_fm_i-xviii.qxd 1/20/10 10:5245 Page iv Rev. Confirming Pages Introduction to Real Estate Finance and Investments This book prepares readers to understand the risks and rewards associated with investing in and financing both residential and commercial real estate. Concepts and techniques in- cluded in the chapters and problem sets are used in many careers related to real estate. These include investing, development financing, appraising, consulting, managing real es- tate portfolios, leasing, managing property, analyzing site locations, and managing corpo- rate real estate. This material is also relevant to individuals who want to better understand real estate for their own personal investment and financing decisions. The recent turmoil in world financial markets, which has been closely tied to events in the real estate market, suggests that investors, lenders, and others who participate in the real estate market need to better understand how to evaluate the risk and return associated with the various ways of investing and lending. This requires an understanding of the legal issues that can impact the rights of lenders and investors, the characteristics of the various vehi- cles for lending and investing in real estate, the economic benefits of the loan or invest- ment, the importance of the local economy where properties are located, and the goals of the particular lender or investor. This book is designed to help students and other readers learn how to understand these factors, so that they can perform the right kind of analysis and make informed real estate finance and investment decisions. As the book’s title suggests, we discuss both real estate finance and real estate investments. These topics are inter-related. For example, an investor who purchases a property is making an “investment.” This investment is typically financed with a mortgage loan. Thus, the investor needs to understand both how to analyze the in- vestment and how financing the investment will impact its risk and return. Similarly, the lender, by providing capital for the investor to purchase the property, is also making an “investment” in the sense that he or she expects to get some rate of return on the money that has been loaned. Therefore, the lender also needs to understand the risk and return of making that loan. In fact, one of the risks associated with loaning money is that the lender may end up owning the property. So the lender needs to evaluate the prop- erty in many of the same ways as the investor purchasing the property. Organization of the Book From the above discussion it should be clear that many factors have an impact on the risk and return associated with property investments and the mortgages used to finance them. This is true whether the investment is in your personal residence or in a large income- producing investment such as an office building. Part I of the book begins with a discussion of the legal concepts that are important in the study of real estate finance and investments. Although a real estate investor or lender may rely heavily on an attorney in a real estate transaction, it is important to know enough to be able to ask the right questions. We focus on those legal issues that relate to real estate investment and financing decisions. Part II begins with a discussion of the time value of money concepts important for an- alyzing real estate investments and mortgages. These concepts are important because real estate is a long-term investment and is financed with loans that are repaid over time. This leads to a discussion of the primary ways that mortgage loans are structured: fixed rate and adjustable rate mortgage loans. Preface v bru77333_fm_i-xviii.qxd 1/20/10 04:29 PM Page v Confirming Pages Part III focuses on residential housing as an investment as well as loan underwriting for residential properties. This is relevant for individuals making personal financial decisions, such as whether to own or rent a home, as well as for lenders who are evaluating a loan and a borrower. Part IV covers many topics related to analyzing income property investments such as apartments, office buildings, shopping centers, and so on. These topics include under- standing leases, knowing how properties are appraised, and being able to analyze the po- tential returns and risks of an investment and how taxes impact the return. We also consider how to evaluate whether a property should be sold or renovated. Finally, we look at how corporations that are not in the real estate business per se, but that use real estate as part of their business, can decide whether to own or lease the property they use. While the first four parts focus on investing or financing existing properties, Part V dis- cusses how to analyze proposed projects, such as the development of an apartment or of- fice building or the development of land for sale to builders. It also discusses how projects are financed during the development period, which is different from the way properties are financed once construction is complete and they are occupied. Part VI discusses various alternative real estate financing and investment vehicles. We start with joint ventures, which allow different parties with different areas of expertise and different amounts of capital to join forces for the purpose of making a real estate invest- ment. For example, someone with development expertise who needs equity capital may en- ter into a joint venture with an investor who has capital to invest but doesn’t have the expertise to do the development. Next, we discuss the secondary market for both residen- tial and commercial mortgages and examine how mortgage-backed securities are struc- tured. This includes a discussion of the risks these investments pose, which is important to making sound investments. Part VI also includes a discussion of real estate investment trusts (REITs). These public companies invest in real estate and allow investors to own a diversified portfolio of real estate by purchasing shares of stock in the company. Finally, we discuss how to evaluate real estate in a portfolio that also includes other investments such as stocks and bonds. This includes understanding the diversification benefits of including real estate in a portfolio as well as ways to diversify within the real estate portfolio (in- cluding international investment). Wide Audience From the above discussion, one can see that this book covers many topics. Depending on the purpose of the particular course, not all of the topics will be covered. The focus of the course may lean toward an investor’s perspective (real estate investment) or a lender’s per- spective (real estate finance). Some courses will emphasize housing and residential real es- tate more than others, and some will have a different emphasis on development. This book is designed to allow flexibility for instructors and students to focus on those topics that are most important to them, so that it can meet the purpose of each unique course. Changes to the Fourteenth Edition Several new topics have been added to the fourteenth edition. Some of these were in response to the recent turmoil in the financial markets, caused in part by the problems associated with subprime mortgages. While the previous edition of the book discussed subprime mortgages, this edition adds further emphasis to the importance of proper underwriting of mortgage loans, whether they are subprime or not and whether they are for residential or commercial properties. Many new concept boxes have been added to provide information about recent trends in mortgage-backed securities and how the government has worked to add liquidity to mortgage markets, in addition to taking over the Federal Home Loan Mortgage Corporation. vi Preface bru77333_fm_i-xviii.qxd 1/13/10 10:5445 Page vi Rev. Confirming Pages The chapters that discuss the different ways mortgages can be structured have also been expanded, so that readers can understand all the ways in which a mortgage can be structured and the associated risks with each structuring. A new section on market analysis has been added to provide readers with a better un- derstanding of how data on the supply and demand for real estate can be used to project oc- cupancy and rental growth. For more advanced readers, a new concept box describes statistical techniques that can be used in market analysis. Also new to this edition, a discussion has been added that outlines the various owner- ship structures that can be used for ownership of investment property, along with the ad- vantages and disadvantages of each. Because investors often look for ways to defer capital gains taxes when selling invest- ment properties, a new section has been added on installment sales and tax-free ex- changes. This includes a discussion on how to evaluate whether these tax-deferral strategies are better than a regular sale. The chapter on real estate investment trusts (REITs) has been expanded to reflect the current economic landscape and also to include discussion on how to value a REIT. Since REITs are companies that invest in real estate, the value of the properties they hold is im- portant, but techniques commonly used to value corporations such as earnings multipliers and dividend discount models are also important. Finally, we have expanded the integration of financial calculators and Excel into the solutions of problems, since this is what is done in practice. The way that solutions are pre- sented has been simplified by using new notation introduced in this edition. Excel Spreadsheets and ARGUS Software The book is rigorous yet practical and blends theory with applications to real-world problems. These problems are illustrated and solved by using a blend of financial calculators, Excel spreadsheets, and specialized software designed to analyze real estate income property. Excel spreadsheets, provided on the book’s Web site at www.mhhe.com/bf14e, are an aid for stu- dents to understand many of the exhibits displayed in chapters throughout the text. By modi- fying these exhibits, students also may solve many end-of-chapter problems without having to design new spreadsheets. ARGUS Valuation DCF is used in several chapters to supplement the use of Excel spreadsheets to solve investment analysis and valuation problems. ARGUS data files, avail- able on the book’s Web site at www.mhhe.com/bf14e, replicate the examples in the book. An educational version of the ARGUS Valuation DCF software can be obtained for students using this book in their course. First the professor must send a list of students to ARGUS Software, and then individual students can request a license that allows them to use ARGUS Valuation DCF while they are enrolled in the course. Professors and students can contact ARGUS Software by sending an email to StudentLicense@argussoftware.com. Internet Tools and Assets Making informed real estate investment and financing decisions depends on being able to obtain useful information. Such information may include national and local market trends, interest rates, properties available for acquisition, financing alternatives, and the opinions of experts concerning the outlook for various real estate sectors. The Internet now provides a rich source of information to real estate investors and lenders. Knowing how to find information on the Web is an important part of the “due diligence” that should be done before making any real estate investments. This edition includes a number of Web App boxes that provide exercises that require finding relevant information on the Preface vii bru77333_fm_i-xviii.qxd 1/20/10 10:5245 Page vii Rev. Confirming Pages Internet. These Web App boxes provide practical examples of the types of data and other re- sources that are available on the Internet. The fourteenth edition also contains Web site ref- erences that students can use to research various real estate topics. In addition to research, these resources provide readers with an opportunity to remain current on many of the top- ics discussed in the book. The book’s Web site, located at www.mhhe.com/bf14e, contains additional helpful materials for students such as Web links, multiple-choice quizzes, Excel spreadsheets, ARGUS data files, and appendixes to the text. Using a password-protected instructor log-in, instructors can find a solutions manual, test bank, and PowerPoint presentations. Supplements Several ancillary materials are available for instructor use. These include: • Solutions Manual—developed by Jeffrey Fisher and William Brueggeman. • Test Bank—developed by Eric Fruits, Portland State University. • PowerPoint slides—developed by Joshua Kahr, Columbia University. Acknowledgments We would like to thank several people who contributed to recent editions by either being a reviewer or providing feedback to us in other ways that helped improve the current edition: viii Preface Edward Baryla East Tennessee State University Robert Berlinger, Jr. University Institute of Technology Roy T. Black Georgia State University Thomas P. Boehm University of Tennessee-Knoxville Thomas Bothem University of Illinois at Chicago Wally Boudry University of North Carolina-Chapel Hill Grace Wong Bucchianeri Wharton School, University of Pennsylvania Ping Cheng Florida Atlantic University John Fay Santa Clara University Michael Fratantoni Georgetown University Eric Fruits Portland State University Deborah W. Gregory University of Arizona Arie Halachmi Tennessee State University (USA) Sun Yat-Sen University (China) Barry Hersh NYU-SCPS Real Estate Institute Samuel Kahn Touro College Joshua Kahr Columbia University W. Keith Munsell Boston University Michael Schonberger Rutgers University-New Brunswick Tracey Seslen University of Southern California Carlos Slawson Louisiana State University Jan Strockis Santa Clara University bru77333_fm_i-xviii.qxd 1/20/10 10:5245 Page viii Confirming Pages In addition, we are grateful to Robert Martin, MAI, who helped prepare the ARGUS examples used in the book. Ron Donohue with the Homer Hoyt Institute helped revise the chapter on real estate investment trusts. Youguo Liang at Prudential Real Estate Investors provided significant input on the structure of joint ventures. Charles Johnson and Aaron Temple helped with Web references. Jacey Leonard helped prepare the Excel templates for the previous edition that were used in this edition. Anand Kumar helped with Web references and spreadsheets. Candi Duke helped in the preparation and submission of the manuscript. Ji’ Reh Kore helped with research on recent trends impacting the real estate finance industry, as well as with the preparation of the Solutions Manual. Deverick Jordan and Diem Chau also helped with the Solutions Manual and with chapter exhibits. Nathan Hastings helped update the legal chapters and provided input on the ownership structures used for real estate. We will miss the late Theron Nelson, who contributed to prior editions of the book, including creating the original version of several of the spreadsheet templates. We appreci- ate his contributions to this book and to the real estate profession. Our thanks to the book team at McGraw-Hill/Irwin for their help in developing the new edition: Michele Janicek, executive editor; Christina Kouvelis, senior developmental editor; Alyssa Otterness, editorial coordinator; Dean Karampelas, marketing manager; Suresh Babu, media project manager; Dana Pauley, project manager; Michael McCormick, lead production supervisor; and Matt Diamond, designer. We also continue to be indebted to people who have contributed to previous editions, especially the late Henry E. Hoagland, who wrote the first edition of this book, and Leo D. Stone, who participated in several editions. Finally, we thank all of the adopters of previous editions of the book, who, because of their feedback, have made us feel that we have helped them prepare students for a career in real estate. William B. Brueggeman Jeffrey D. Fisher Preface ix bru77333_fm_i-xviii.qxd 1/13/10 10:5445 Page ix [...]... bundled and creatively used to enhance value is one goal of this textbook The reader should refer to Exhibit 1–1 for an outline of these concepts Property Rights and Estates As pointed out above, the term real estate is used to refer to things that are not movable such as land and improvements permanently attached to the land, and ownership rights associated with the real estate are referred to as real. .. terms real estate and real property are sometimes used interchangeably However, as we will see, many of the property rights acquired when investing in real estate are independent and can be separated For example, real estate may be leased or pledged to others in exchange for rent or other consideration This may be done without giving up ownership Indeed, understanding the nature of property rights and. .. information related to title insurance www.ired.com—International Real Estate Digest—Provides information for most real estate professionals as well as real estate software and tools www.reals.com—This is a real estate directory for such subjects as commercial real estate, international real estate, and professional services www.homeglossary.com—This is an online real estate dictionary www.findlaw.com—A good... usually done by an attorney and is accompanied by a legal opinion Third, title insurance may be purchased to cover unexpected problems with the title 7 A deed is not the only way by which ownership rights in real property are conveyed Titles are also transferred by wills, court decrees, and grants of land from the government to private persons In addition, lawful title to property can be acquired by means... opposed to forcing the sale of the property Conclusion This chapter discussed legal considerations important in creating and defining various rights to real property This is important in the study of real estate finance since it is these rights that are purchased, sold, and mortgaged Thus, an understanding of the various rights associated with real estate is necessary to properly evaluate a real estate. .. CMOs and Derivative Securities 635 21 Real Estate Investment Trusts (REITs) 678 22 Real Estate Investment Performance and Portfolio Considerations 710 INDEX 739 bru77333_fm_i-xviii.qxd 1/13/10 10:5445 Confirming Pages Page xi Table of Contents PART ONE OVERVIEW OF REAL ESTATE FINANCE AND INVESTMENTS Chapter 1 Real Estate Investment: Basic Legal Concepts 1 Property Rights and Estates 2 Definition of Estate. .. Examples of Leasehold Estates There are two major types of leasehold estates: estates for years and estates from year to year There are two other types, but they are not common.4 Leasehold estates are classified on the basis of the manner in which they are created and terminated 4 Estate at Will: An estate at will is created when a landlord consents to the possession of the property by another person but... Nelson and Dale A Whitman, Real Estate Transfer, Finance and Development, 2nd ed (St Paul, MN: West Publishing, 1981), p 167 bru77333_ch01_001-015.qxd 12/18/09 03:04 PM Page 8 8 Part One Confirming Pages Overview of Real Estate Finance and Investments EXHIBIT 1–2 Flowchart: Ownership of Real Property Concept Discussion Ownership When a person or other legal entity has lawful possession of realty and real. .. about real estate law; however, a considerable amount of legal terminology is used in the real estate business It is very important to understand both the physical nature and property rights being acquired when making real estate investments In this chapter, we survey many important terms pertaining to real estate Additional legal terms and concepts will appear in later chapters of this book on a “need... practice, although the term realty is sometimes used, we generally use the term real estate to mean land and all things permanently attached Understanding the distinction between realty and personalty is important because our legal system has evolved in a way that treats the two concepts very differently For example, long ago in England, disputes over real estate usually involved issues such as rightful . Brueggeman Fisher Real estate Finance and investments Real estate Finance and investments fourteenth edition William B. Brueggeman JeFFrey D. Fisher Building the FRamewoRk to Reach the Right Real estate. Fourteenth Edition of Real Estate Finance and Investments prepares students to understand the risks and rewards associated with investing in and financing both residential and commer- cial real estate. . International Entrepreneurship: Managing and Financing Ventures in the Global Economy First Edition Robin International Corporate Finance First Edition REAL ESTATE Brueggeman and Fisher Real Estate Finance and Investments Fourteenth