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1 The Complete Guide toREAL ESTATEFINANCEforINVESTMENTPROPERTIESHow to Analyze Any Single-Family, Multifamily, or Commercial PropertySTEVE BERGESJohn Wiley & Sons, 7/6/04 11:46 AM Page 7/6/04 11:46 AM Page viThe Complete Guide toREAL 7/6/04 11:46 AM Page 7/6/04 11:46 AM Page iiThe Complete Guide toREAL ESTATEFINANCEforINVESTMENTPROPERTIESHow to Analyze Any Single-Family, Multifamily, or Commercial PropertySTEVE BERGESJohn Wiley & Sons, 7/6/04 11:46 AM Page iiiCopyright 2004 by Steve Berges. All rights by John Wiley & Sons, Inc., Hoboken, New simultaneously in part of this publication may be reproduced, stored in a retrieval system, or transmitted in any formor by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except aspermitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the priorwritten permission of the Publisher, or authorization through payment of the appropriate per-copy feeto the Copyright Clearance Center, Inc.

2 , 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400,fax (978) 646-8600, or on the web at Requests to the Publisher for permissionshould be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hobo-ken, NJ 07030, (201) 748-6011, fax (201) of Liability/Disclaimer of Warranty: While the publisher and author have used their best effortsin preparing this book, they make no representations or warranties with respect to the accuracy or com-pleteness of the contents of this book and specifically disclaim any implied warranties of mer-chantability or fitness for a particular purpose. No warranty may be created or extended by salesrepresentatives or written sales materials. The advice and strategies contained herein may not be suit-able for your situation. The publisher is not engaged in rendering professional services, and you shouldconsult a professional where appropriate.

3 Neither the publisher nor author shall be liable for any lossof profit or any other commercial damages, including but not limited to special, incidental, conse-quential, or other general information on our other products and services please contact our Customer Care Depart-ment within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax(317) also publishes its books in a variety of electronic formats. Some content that appears in printmay not be available in electronic books. For more information about Wiley products, visit our website at of Congress Cataloging-in-Publication Data:Berges, Steve, 1959 The Complete Guide to real estate finance for investment properties : how to analyze any single-family, multifamily, or commercial property/Steve 0-471-64712-8 (cloth)1. Real property Valuation.

4 2. Real estate investment Rate of return. 3. Real property Residential real estate Finance. 5. Apartment houses Finance. 6. Commercial real estate Finance. I. Title: Real estate finance for investment properties. II. '24 dc22 Printed in the United States of 9 8 7 6 5 4 3 2 7/6/04 11:46 AM Page ivIt has been said that there are angels here among us. This bookis dedicated to my sister, Melanie, who is one of them. Angelsare special messengers of God who have come to minister to theneeds of His children here upon the earth. I have observed mysister s unwavering devotion to her family, friends, and faiththroughout her entire life. Not once have I ever heard her com-plain of the heavy burdens she bears. She has instead chosen totake the high road by walking in faith and humility. She alwayshas a smile on her face and uplifting words of encouragementfor my family.

5 I know that the light and joy that radiate from hercountenance are truly that of an angel. My heart cries out ingratitude to her. My lips praise her name. My spirit is upliftedbecause of her. Thank you, Melanie, for your example of loveand charity for all of us who are privileged to be a part of yourlife. Thank you for being an angel here among 7/6/04 11:46 AM Page 7/6/04 11:46 AM Page vi vii CONTENTSPart 1 Real Estate Finance1 Chapter 1 Introduction to Real Estate Finance3 Finance as a Discipline6 The Relevance of Finance as It Applies to Value9 Chapter 2 Primary investment Elements and Their Effect on Financing Strategies13 Time Horizon13 Volume of investment Activity18 Type of Property21 Chapter 3 Secondary investment Elements and Their Effect on Financing Strategies27 Cost of Funds28 Amortization Period31 Amount of Funds Borrowed35 Chapter 4 Additional investment Elements and Their Effect on Financing Strategies43 Loan Duration43 Loan Fees46 Prepayment Penalties54 Chapter 5 Structuring Financial Instruments61 Leverage61 Debt64 Equity67 Partnerships69 Blended Financing and the Weighted Average Cost of 7/6/04 11.

6 46 AM Page viiChapter 6 Real Estate investment Performance Measurementsand Ratios81 Net Income Return on Investment84 Cash Return on Investment85 Total Return on Investment86 Net Operating Income87 Capitalization Ratio89 Debt Service Coverage Ratio92 Operating Efficiency Ratio93 Gross Rent Multiplier98 Operating Ratio99 Break-Even Ratio100 Chapter 7 Advanced Real Estate investment Analysis103 Future Value Analysis103 Present Value Analysis108 Net Present Value Analysis111 Internal Rate of Return113 Chapter 8 The Valuation of Real Property121 Appraisal Defined121 The Nature of Price and Value122 Three Primary Appraisal Methods123 Replacement Cost Method123 Sales Comparison Method126 Income Capitalization Method128 Chapter 9 Financial Statements and Schedules133 Income Statement136 Balance Statement143 Statement of Cash Flows148 Part 2 Case Study Review: Practical Application of Valuation Analysis153 Chapter 10 Case Study 1: Single-Family Rental House155 Test 1: Comparable Sales Analysis157 Test 2: Cash Flow Analysis162 Chapter 11 Case Study 2: Single-Family to Multifamily Conversion175 Exploring Alternative Possibilities175 The Relationship between Risk and Reward180 Contents viii 7/6/04 11:46 AM Page viii Contents ix Chapter 12 Case Study 3: Multifamily Apartment Complex189 Chapter 13 Case Study 4: Single-Family Conversion to Commercial Office Building203 Part 3 Epilogue and Appendixes229 Chapter 14 Epilogue: Destined for Greatness231 Prior Works231 Destined for Greatness233 Appendix A B 7/6/04 11:46 AM Page 7/6/04 11:46 AM Page xThe Complete Guide toREAL 7/6/04 11:46 AM Page 7/6/04 11:46 AM Page xiiPart 1 Real Estate 7/6/04 11:34 AM Page 7/6/04 11.

7 34 AM Page 2 Chapter 1 Introduction to Real Estate FinanceAs investors continue to migrate from the stock market to the realestate market, the need for sound financial analysis of income-producing properties is greater than ever. Just as buying high-flyingstocks with no regard to intrinsic values resulted in hundreds ofthousands of investors losing their life savings, so will buying realestate with reckless disregard to property values result in a similaroutcome. While an abundance of books have been written on how tobuy and sell houses, the market is virtually devoid of any works thatspecifically address the topic of the principles of valuation as theyapply to real estate. Notable exceptions include more expensivetitles such as Real Estate Finance and Investmentsby Brueggemanand Fisher, with a list price of $125, and Commercial Real EstateAnalysis and Investmentsby Geltner, boasting a list price of $ Complete Guide to Real Estate Finance for investment Prop-erties: How to Analyze Any Single Family, Multifamily, or Commer-cial Propertyfocuses on the concepts of financial analysis as theypertain to real estate and is intended to help fill the void that currentlyexists regarding this subject.

8 This represents a marked contrast fromthe works previously referred to in three primary ways. First of all,the other works are much more expensive. Second, they have beenwritten to appeal to a different audience in that they are written in atextbook format with both the student and the professional in , the other works deal with advanced theoretical principles of 3 7/6/04 11:34 AM Page 3finance, which are of little value to the investor who most likely hasno background in Complete Guide to Real Estate Finance for InvestmentProperties,on the other hand, is designed to appeal to those indi-viduals who are actively investing in income-producing properties,as well as to those who desire to invest in them. Furthermore, thosesame individuals who are now investors will at some point have aneed to divest themselves of their holdings.

9 Whether an investor isbuying or selling, the basis for all decisions must be founded on thefundamental principles of finance as they apply to real estate valu-ations. The failure to understand these key principles will almostcertainly result in the failure of the individual investor. At a mini-mum, it will place him or her at a competitive disadvantage amongthose who do understand them. Recall the myriad of investors whobought stocks for no other reason than that they received a so-calledhot tip from a friend or coworker and who later collectively lostbillions of dollars. A similar outcome is almost certain for thoseindividuals investing in real estate who fail to exercise sound valu-ation principles and act on nothing more than the advice of some-one who has no business giving advice, such as a broker with asupposedly hot Complete Guide to Real Estate Finance for investment Prop-ertiesis further intended to take the theories of real estate financediscussed in other books and demonstrate how they can be used inreal-world situations.

10 In other words, it is the practical application ofthese theories that really matters to investors. An in-depth examina-tion of several case studies will provide the learning platform neces-sary for investors to make the transition from the theory of realestate finance to its practical application. Investor comprehensionwill be further augmented through the use of several proprietaryfinancial models developed by me for the sole purpose of makingsound investment that I have established what this book isabout, I ll take a briefmoment to establish what it is notabout. The term financeas usedthroughout this book is generally intended to refer to principles offinancial analysis and not to debt instruments such as loans or mort-gages that are used for financingreal estate. This is not a book about Real Estate Finance for investment Properties 4 7/6/04 11:34 AM Page 4creative methods of borrowing money or structuring nothing-downdeals.