| Financial concepts in real estate can be frightening; | | | | each source of financing used by the investor). |
| these fears can be eased by understanding some | | | | 3.Calculate the product of the cost of capital |
| simple concepts: | | | | times the capital structure for each source of |
| Three key financial concepts must be clearly | | | | financing |
| identified prior to calculating the desirability of a | | | | 4.The sum of all the products will give the |
| real estate investment, which are the required | | | | Weighted Average Weight Cost of Capital |
| rate of return, the time value of money and | | | | These methods are typically more applicable to |
| depreciation. The required rate of return primarily | | | | advance real estate investors. Real and serious |
| reflects the investors required rate of return. | | | | investors might finance their real estate |
| Whereas the concept of time value of money is | | | | endeavors using different sources of financing, |
| that any specified amount of cash to be received | | | | whereas small investors typically only use one |
| at some date in the future is not the equivalent | | | | form of financing. |
| of the same amount of cash held at an earlier | | | | The concept of time value of money is that any |
| date. A sum of cash to be received in the future | | | | specified amount of cash to be received at some |
| is not as valuable as the same sum on hand | | | | date in the future is not the equivalent of the |
| today. | | | | same amount of cash held at an earlier date. A |
| In order to calculate the required rate for a real | | | | sum of cash to be received in the future is not |
| estate investment the following steps most be | | | | as valuable as the same sum on hand today, |
| taken: identify the sources of financing that will be | | | | because cash on hand today can be invested to |
| used to fund the investment, calculate the cost of | | | | earn income. |
| capital for each of the sources of financing, | | | | When estimating the desirability of a real estate |
| calculate the Weighted Average Weight Cost of | | | | project all dollar values must be first comparable |
| Capital. Investors use different source of financing | | | | since a dollar received today is worth more than |
| for their real estate investment project. Most | | | | a dollar received in the future. Therefore in order |
| commonly mortgages are used, but there are | | | | to measure the desirability of a real estate |
| other options such as owners financing and | | | | project all dollar flows must be moved out to a |
| lease-buy-options. | | | | common future date or back to the present. To |
| Once the sources of funding have been identified | | | | move dollar amounts to the future one calculates |
| the cost of capital of each source of financing | | | | the dollar amount compound interest and to |
| must be calculated. These calculations vary | | | | move dollar amounts back to the present one |
| depending on the type-financing source. There are | | | | calculates the dollar amount present value. Time |
| two real and important concepts that must be | | | | value of money can become an important |
| identified before starting to calculate the cost of | | | | strategic factor in planning and presenting real |
| capital of each type of source of financing, these | | | | estate projects. |
| are taxes and flotation costs. When an investor | | | | When money is moved to the future the initial |
| borrows money to finance the purchase of a real | | | | amount of money is known and the goal is to try |
| estate asset, the interest expense is deductible | | | | to determine how much that sum of money will |
| for federal income tax calculations. This means | | | | grow in a certain number of years when |
| that the amount from revenue that will be used | | | | compounded at a specific rate. Whereas when |
| to pay interest to your lender should not be | | | | money is moved back to the present the goal is |
| taxed. On the other hand flotation costs are the | | | | to determine the value in today dollars of a sum |
| transaction costs incurred. Transactions costs | | | | of money to be received in the future. |
| must be deducted from the real estate | | | | In summary more than one source of financing |
| investment proceed before calculating the cost of | | | | for real estate projects, when doing so there are |
| capital. | | | | some concepts that need to be considered, such |
| The cost of capital of all the individual sources of | | | | as the weighted average weight cost and time |
| financing combined together gives the weighted | | | | value of money. Advance investors with large real |
| average cost of capital. To estimate the weighted | | | | estate projects typically use different sources of |
| average cost of capital of a real estate project | | | | financing, as opposed to smaller investors who |
| the following elements need to be known: | | | | typically finance their projects using mortgages. |
| 1.Estimate the cost of capital of all the sources of | | | | Using a mix of financing sources can provide a |
| financing used to fund the real estate project | | | | boarder platform of opportunities, but it also |
| 2.Estimate the capital structure of each source of | | | | complicates the calculations when assessing the |
| financing (capital structure is the proportions of | | | | desirability of the project. |