The purpose of this research is to provide an overview of the value of real estate investment. For this overview, individual and corporate real estate investments are considered separately.
INDIVIDUAL INVESTMENT IN REAL ESTATE
The Tax Reform Act (TRA) of 1986, specifically, and other federal laws have changed the rules under which real estate in-vestments must function. A primary characteristic of real estate investments in the contemporary environment must be the earning of an income on the investment through the operation of the venture (Tax Management, Inc., 1987, p. 18.5). A real estate investment may no longer be designed solely for the purpose of gaining tax write-offs.
While the TRA of 1986 will reduce taxes for high income
earners, a need still exists for acceptable ways to shelter high incomes. The tax reform requires that real estate tax shelters be designed with objective and realistic prospects that such ventures will earn profits. Aside from that provision, a tax sheltering potential for real estate investments continue to exist.
A tax shelter is defined as an investment vehicle which
permits the “tax benefits inherent in an investment to flow through directly to the investor and which also permits the cash-flow inherent in an investment to flow directly to the
investor, thereby avoiding double taxation” (Goldberg, 1984, p. 69).
Unfortunately, in the past, the tax shelter concept has been abused. Congress defines an abusive tax: shelter as a “syndication that uses tax laws to accomplish results not intended by Congress” (Goldberg, 1984, p. 70). A clearer definition of an abusive tax shelter is one in which the economic aspects of an investment are subordinate to its tax benefit aspects (Brennan, 1984, p. 237). The following example may be used to illustrate the differences between (1) an investment, (2) a tax shelter, and (3) an abusive tax shelter:
1. In an ordinary commercial real estate investment, an investor would purchase a duplex for $150 thousand cash. In such an investment, all of the rental income would go directly to the investor, who would be able to charge a depreciation expense against the income in the determination of tax liability.
2. To purchase the same duplex as a tax shelter, the investor would leverage the purchase. With a 20 percent cash down payment, the investor still receives the depreciation deduction, and also is able to deduct interest expense on that portion of the purchase price which was financed. The economic aspects of the investment are diluted, because some of the rental income must be used to pay on the purchase note or mortgage.
Nevertheless, the investment is as economically viable as it was with a full cash payment for the purchase price. The investor, however, has gained leverage and tax benefits.
3. An abusive tax shelter could be structured on the same duplex. If the building were purchased for $150 thousand by a tax shelter sponsor, it could then be sold to a group of investors for $250 thousand. The investors could be required to invest $30 thousand in cash, and to sign notes in the amount of $220 thousand, which could, in turn, be converted into a mortgage payable to the sponsor at an above market interest rate. In a low-leveraged deal, the investors would deduct unjustified depreciation and interest charges from their taxable income. All of the rental income would be applied to debt service, and the inflated sales price to the investors would insure that the deal would never be an economically viable investment. As an added inducement, the tax shelter sponsor might permit investors to accrue some of the interest charges on the mortgage, although they (the investors) would still be able to charge the full amount of the interest against their taxable income. This type of real estate tax shelter was used often prior to 1985.
The 1984 tax reform law prohibited the type of abusive tax shelter described above. Tax shelter sponsors, however, have not been stopped. They have a variety of asset types, which may be structured into overvalued abusive tax shelters (Walbert, 1985, p. 86). Strengthening the laws against abusive tax shelters has slowed their sale, but it has not stopped such sales (Bradley, 1985, p. 564).
The TRA of 1986 requires that residential real property acquired for investment be depreciated over a 40-year period (Lipman, 1985, p. 5). A similar requirement exists for nonresidential investment property (Lipman, 1985, p. 5). In
both instances, only the straight-line depreciation procedure be used (Lipman, 1985, p. 5). This provision is significantly different from the prior procedure, in which an accelerated option permitted some investors to depreciate their properties over a much shorter time period. This provision all but insures that real estate investments in the contemporary environment must be able to earn their own way, as opposed to providing accelerated cash flows and tax shelters. As a result the real property depreciation provisions in the TRA of 1986, the cash flow from real property investments gained through depreciation will be stretched over much longer time periods. Considering the time value of money, real estate investments will likely become less attractive to many investors (Brigham, 1984, pp. 42-51).
With respect to real estate investment under the TRA of 1986, investor types are differentiated by investment intent. Investment intent refers to whether or not the investor in real property will actually use the property, as opposed to simply attempting to reap financial benefits. Individuals and companies who purchase properties for the purpose of either renting them or leasing them to others (or simply to resell) are in the financial benefits classification. For the investor group seeking primarily financial benefits, the revised depreciation procedures will reduce the cash flow available to such investors in the early years subsequent to the acquisition of real property, when compared to what would have been available under the prior law.
Changes in the way in which capital gains are treated under the TRA of 1986 also affect real estate investment. The elimination of special tax treatment for capital gains in the TRA of 1986 provides an incentive for some tax payers to switch from a corporation type of organization to a partnership. Depending upon the level of income, capital gains may be taxed as high as 34 percent under a corporation form of organization, where the maximum applicable tax under a partnership (at individual rates) would be 28 percent. This provision is significant to real estate investors, depending upon how real estate investment ventures are structured.
CORPORATE INVESTMENT IN REAL ESTATE
The acquisition of and investment in real estate is an increasingly important consideration for corporations. Criteria for such acquisition and investment have been brought under intensive review, as a result of the federal income tax reform enacted in 1986.
There exist corporate-level objectives for the acquisition of an investment in real property. These corporate level objectives, however, represent a composite of the more specialized objectives of various organizational functions,
with respect to the acquisition of and investment in real property. The essential objective of all of an organization’s functions concerned with the acquisition of or the investment in real property is the same. That objective is to improve the strategic performance of the corporation. Subsidiary objectives, however, tend to vary, according to organizational function (Nourse, 1986, p. 2).
With respect to real estate acquisition and investment, the corporate financial officer tends to focus on (1) budget constraints, (2) capital allocations, and (3) return on investment (Keating, 1986, p. 1). The corporate financial officer is vitally concerned with such factors as (1) the aggregate internal rate of return of real property investments, (2) uncertainty, and (3) sensitivity (Conroy, 1986, pp. 5-10).
The aggregate internal rate of return is a tool, which serves as an index, which permits a comparison of the investment per-formances of diverse investments (Rodino, 1987, p. 40). The aggregate internal rate of return integrates considerations of (1} supply, (2) demand, (3) interest rates, (4) growth and expansion, (5) inflation, and (6) taxation (Rodino, 1987, p. 40). Taxation considerations are of particular significance in the mid-1980s.
Under the law in effect prior to the 1986 tax reform legislation, real property was depreciated (on a straight-line basis) over an 18-year time period. That prior low, however, permitted the optional use of accelerated depreciation schedules, which enabled investors to deduct a greater proportion of the total depreciation on real property in early years of the life or ownership of the property. The effect of the accelerated depreciation option was to defer federal income taxes to some point in the future, when interest in the property is terminated. In the interval, the investor had tax-free use of the funds, which would eventually be used to pay the taxes due.
As noted in the discussion related to individual investment in real estate, subsequent to the effective date of the 1986 tax reform law, real property must be depreciated over a 40-year time period, using a straight-line procedure. Further, accelerated depreciation on real property is not permitted, and depreciation over a period less than 40-years will be permitted only in those circumstances where an investor can demonstrate that the life of the property will be less than 40-years (Lipman, 1985, p. 5).
With respect to real estate acquisition and investment, the corporate real estate investment officer tends to focus on (1) constraints associated with the real estate market, (2) resource availability, and (3) investment terms (Conroy, 1986, pp. 5-10). The corporate real estate investment officer is directly concerned with (1) real estate market diversity, (2) property types, risk, and property values (Rodino, 1987, pp. 40, 43). With respect to the determination of property values, the corporate real estate investment officer is directly concerned with real estate appraisal.
Real estate accounts for a greater proportion of the total value of all assets in the United States than does any other single asset classification. Thus, the correct valuation of these assets is of inestimable importance to the overall economy of the country.
Value appraisals of real estate are required for a variety of business transactions (Allison, and Brown, 1984, p. 5). The most prevalent of these transactions are those involving (1) prospect-ive purchase, sale, or lease, (2) a long-term loan secured by real estate, (3) the purchase of insurance on real estate, (4) real estate taxation, and (5) governmental condemnation proceedings. For such transactions, real estate appraisal is expected to provide “a sound judgment as to the various alternate uses to which the property may be put, and its probable worth in money” (Allison, and Brown, 1984, p. 5).
The central task of real estate appraising, thus, is the estimation of value. Value, in this context, refers to the worth of real estate in exchange for money. Parties to business transactions involving real estate rely on real estate appraisal to provide competent and unbiased estimates of value, upon which they may “act in good faith . . . with substantial confidence” (Allison, and Brown, 1984, p. 5). Thus, two “separate, competent, objective appraisals should produce final value estimates with regard to the same property on the same day that are consistent within a range of approximately 5% or less” (Allison, and Brown, 1984, p. 5).
Value in real estate appraisal is used in an objective
context. Thus, it refers to market value (Allison, and Brown, 1984, p. 6). Market value is concerned with the present worth of future benefits, and is predicated on the following assumptions with respect to real estate, a real estate transaction, and the parties to a real estate transaction: (1) the estimated amount is the highest money price for which the property is likely to sell in a competitive market; ( 2) a reasonable time is allowed for exposure of the property on the open market; (3) payment will be made in cash or equivalent, or on the basis of finance terms prevailing at the time of the appraisal; (4) both buyer and seller are
typically motivated, so that price is not affected by undue stimulus; (5) both parties to a transaction act prudently and knowledgeably, and have knowledge of the various uses available for the property in question (Allison, and Brown, 1984, p. 6).
It is important to note that market value in real estate appraisal is based, in large part, on the highest and best use doctrine (Allison, and Brown, 1984, p. 8). This doctrine is interpreted to mean the
reasonable and probable use that will support the highest present value . . . as of the . . . date of the appraisal. Alternatively, that use, from among reasonably probable and legal alternative uses, found to be physically possible, appropriately supported, financially feasible, and which results in the highest value (Boyce, 1985, p. 110).
Real estate appraisal is also based on the principle of
substitution (Allison, and Brown, 1984, p. 9). The principle
of substitution holds that “a prudent purchaser will pay no more for any real estate than the cost of acquiring an equally desirable substitute on the open market (Boyce, 1985, p. 293).
As a result of the TRA of 1986, real estate investments
must be able to pay their own way on an economic basis, without regard to either (1) tax savings, or (2) cash flow through accelerated depreciation. This provision of the TRA of 1986 has a greater effect on individual investments in real estate, than it does on corporate investments in real estate. Corporate real estate investments have always, and continue to be dependent upon investment criteria other than accelerated depreciation, and tax sheltering. Nevertheless, real estate investments in the mid-1980s continue to be viable investments for both individuals and corporations, if they are entered into for motives of economic gain to be derived directly from the property, as opposed to tax shelter, and accelerated depreciation gains.