Private Real Estate Investment: Data Analysis and Decision Making_9 pot

Once again we confirm thefact that pursuing tax objectives for their own sake is counterproductive.Another is that the primary beneficiaries of some exchanges are brokers.Commissions mak

to justify the cost of an exchange An interesting empirical study wouldexamine a number of exchanges to determine if perhaps one should notexchange unless one acquires a property at least 1.5 or 2 times the size of thedisposed property.

Suppose our investor merely retained his original property for the sametotal time of 12 years Because he saves mid-holding period sales costs, he has

a higher return in both IRR (14.32%) and NPV ($36,314) terms

Note in Figure 7-5 that while the total sales price in the two strategies isgreater for the exchange strategy on the left, the owner’s share is greater on theright when no exchange takes place We see that under these assumptions theprimary beneficiary of the exchange is the broker

Several conclusions may be drawn from this Once again we confirm thefact that pursuing tax objectives for their own sake is counterproductive.Another is that the primary beneficiaries of some exchanges are brokers.Commissions make up the majority of real estate transaction costs In order tooffset these transaction costs, the investor must be able to achieve significanteconomic gains There is a limit to the benefits of releveraging via anexchange, and these benefits may not be sufficient to offset transaction costs

markets to determine how tax policy affects investor behavior However, arefinement is necessary For this data field to have maximum value, it isimportant to identify how the exchange fits into the transaction If the saleinvolved an exchange in which the seller was the last in a series and did notfurther exchange his property, there is a different effect than if the sellerbecame an acquiring party an a subsequent exchange Theoretically, thereshould be a cumulative effect The last seller who does not require anexchange may reap benefits from each party lower down in the chain,especially if the 45-day deadline is shorter with each successive transaction.There is no reason this must happen, but it should increase pressure in thesystem as the number of exchanges in a series grows if the deadline does growshorter We leave this interesting study to the game theorists.

What we suggest is not a trivial task for data collectors The result of anysuch effort would be to track transactions after the closing and tie multipletransactions together This is not an appetizing assignment, and we do notexpect it to be completed soon Until that is done, we will have to rely ontheory to study investor behavior in a tax environment that rewardsexchanging over sale and repurchase

CONCLUSION

After wading through a blizzard of numbers, sorting out complex calculations dependent on other variables, and running a variety ofhypothetical situations, there is one conclusion that is neither a surprisenor in doubt: The investor who adds entrepreneurial labor to increase his rate

sub-of return and delays his income tax for a long time is able to build terminalwealth faster

For investors where entrepreneurial issues do not apply and annual returnsare moderate, the conclusions are less certain Given the costs, explicit andimplicit, the investor who merely plods along with the rest of the economymust be very careful when undertaking an exchange Scale factors come intoplay The size of the acquired property relative to the disposed propertystrongly influences whether the cost of an exchange can be justified

In our continuing quest to understand real estate risk, exchanging plays aminor role There is an analogy to the debate over double taxation ofcorporate dividends A double taxation policy encourages borrowing, leading

to the additional risks in the securities market For real estate, a sequentialtaxation policy incrementally taxes each property in a series as it is sold Thisencourages more borrowing either for non-taxable refinance and repurchasestrategies that reduce investor efficiency by adding multiple locations or forborrowing to keep ownership levels where they would have been if a tax

deferred exchange strategy were available Either of these, while good newsfor banks, is not good news for society in general if borrowing is seen asadding unnecessary risk to the system It has been observed by many thattaxes are necessary to operate a civil society In the debate over which taxesprovide the most revenue and do the least harm to the market, it is generallyagreed that the best tax is the one that changes behavior the least Incometaxes have a poor record in this regard Capital gain taxes fare no better Thestudy of real estate tax deferred exchanges is fertile ground for watching thecontortions of investors bent on reducing their tax obligation.

A final note for policymakers may be in order Sections 1034 (applying tosingle family residences) and 1033 (applying to property subject to invol-untary conversion such as condemnation or casualty loss) provide differentsets of rules for the sale and reacquisition of property without the payment oftaxes There may be merit in the simplification of these various sections into asingle set of rules that acknowledges the benefits to society that accrue fromallowing land to remain untaxed in entrepreneurial and productive hands for

as long as possible For those countries in the beginning stages of formulatingtax policy, the clean slate they start with might first recognize the perverseincentives in the U.S tax code as written and avoid expensive pitfalls

If there is one conclusion that remains it is the idea that entrepreneurialeffort adds value not only to the investor’s terminal wealth, but to society’sbuilt environment The preservation of the nation’s housing stock and theoptimization of its commercial facilities depend on the wide dispersal ofownership among the most qualified investors Keeping those assets incapable hands for as long as possible would seem to benefit society the most

REFERENCES

1 Allen, M (1990) Creative Real Estate Exchange: a Guide to Win-Win Strategies Chicago, IL: National Association of REALTORS.

2 Internal Revenue Service IRS Revenue Ruling 72-456 26 CFR 1.1031(d)-1.

3 Sherrod, J R and Diggs, J B Merchantile Trust Company of Baltimore and Alexander C Nelson, Trustees of the Estate of Charles D Fisher v Commissioner of Internal Revenue Merchantile Trust Company v IRS, Docket # 68338.

4 Tappan Jr., W T (1989) Real Estate Exchange and Acquisition Techniques (2nd ed.) Englewood Cliffs, NJ: Prentice Hall.

C H A P T E R 8

The Management Problem

all that can be required of a trustee is that he conduct

himself faithfully and exercise sound discretion and observe

how men of prudence, discretion and intelligence manage

their own affairs—not in regard to speculation, but in regard

to the permanent disposition of their funds, considering the

probable income as well as the probable safety of the capital

to be invested

The Supreme Court of Massachusetts inHarvard College versus Amory (1830)articulating the Prudent Man Rule

INTRODUCTION

This chapter addresses what is known as ‘‘the agency problem,’’ recognizingthat when an agent holds someone else’s capital the agent’s objectives areoften different from the owner’s

In this chapter we will:

in multiple locations

the manager’s

arrange-ments common to the business of managing small investment properties

There is little debate that the ownership of real estate involves management.The debate is about (1) who shall do the management, (2) what manage-ment costs, (3) how one accounts for that cost, and (4) what managementarrangement is the most efficient We observe that some owner’s do their own

189

management Those who do add to their investment with each hour of laborapplied, hours that could have been applied to other activities, profitable orotherwise At a minimum, this has the effect of complicating the returncalculation Alternatively, to preserve both the integrity of the returncalculation and the owner’s peace of mind, one may contract for managementservices with a third party whose fee becomes a part of the expense schedule.

In this way management is charged against the property’s income before theowner’s return is calculated

Retaining a management firm sounds like a simple solution But propertysize and location complicate the matter There is a suspicion that so-called

‘‘professional’’ property management really isn’t Especially for small ties, the quality of property management can vary widely A significantliterature exists on the subject of agency, studying the separation ofownership and control This chapter is about what often forces thecombination of ownership and control

proper-THE PROPERTY MANAGER’S DILEMMA

A company offering property management services, like any firm, wishes tomaximize net profit by increasing revenue and lowering costs The ruleadopted to accomplish this is called the firm’s ‘‘production function.’’ Tocreate this function we assume that the firm generates revenue as managementfees and incurs two broad classes of expenses The first are in-house costsconsisting primarily of accounting services rendered to owners For simplicitythese are assumed to be fixed, The second involves dispatching an employee

to visit and inspect those properties under management These latter costs arevariable and will be referred to generally as ‘‘transaction costs’’ because eachvisit to a property involves a transaction that incurs, at a minimum, sometravel expense (hence these may also be considered ‘‘transportation costs’’).Important factors in these variable costs are the number of properties themanager chooses to manage, the size of those properties, and the distancebetween them

Initially, we will assume that management fees realized are calculated as arate per unit In actual practice the fee is charged as a percentage of income,something we shall address later For now, realized fees are computed bymultiplying a rate, g, by the number of units, u

Therefore, the net profit function, np, is

where

np ¼ net profits

g ¼ rate per unit at which fee income is realized

u ¼ number of units managed

ac ¼ accounting costs

tc ¼ transaction (transportation) costs, a function

Transaction costs are modeled as an increasing function of location countand distance:

from each other and the officeloc ¼ number of locations

Illustrating a model with many variables requires reducing their number byfixing some of the variables at specific values We use several datasets tofacilitate this Table 8-1 provides the datasets we will use in this chapter Thefirst two of these differ only in the value we give to the distance factor, d

As one might expect, at different remoteness factors, d, the steepness of the tcfunction varies over different numbers of locations in a portfolio containing afixed number of units As a consequence, of course, net profit is a decreasing

TABLE 8-1 Seven Datasets

function of the number of locations and the distance factor Using the d1 andd2 datasets, the plot in Figure 8-1 shows how the distance factor affects netprofits for the two specific values of d over a range of locations.

It may appear that what really matters is average building size But does it?Suppose that ac is a fixed resource that places an upper bound on the totalnumber of units that may be managed The optimization problem becomesone of finding an appropriate size building, given the fixed number of units

loc Theoptimal will always be the lowest number of locations The perfect job may bemanaging one large building, but the market does not always accommodatethat perfect outcome Management usually involves multiple locations.Incorporating the transaction cost function directly into the manager’s netprofit, by substituting Equation (8-2) into Equation (8-1), we have

Equation (8-4) is plotted in Figure 8-2 to show how net profit varies basedsolely on the number of units and locations, given fixed values of data d3 foraccounting costs, the fee per unit, distance, and transaction rates.

We can define net profit a second way, np2, this time in terms of a new

in terms of this new size variable, u ¼ loc size, in Figure 8-3 we plotEquation (8-5), a different representation of the manager’s net profit that usesd3 data and a function for u

The derivative with respect to location of this last net profit function

building size At first glance it appears in Equation (8-6) that np2 is dependent

on size because size is in its derivative

units0

2000040000

60000net profit

FIGURE 8-2 Manager’s net profit with changes in the number of units and locations.

While this is true, it is not true that np2maxis dependent on size Setting thederivative in Equation (8-6) equal to zero and solving the implicit function,the term – 0.025size ‘‘divides out,’’ leaving a function that has location as itsonly variable Optimal locations under these conditions are 15.4721, rounded

We reach the surprising conclusion that under these conditions building

When the distance between properties, d, increases, the number of optimallocations decreases as one might expect (Figure 8-4) This suggests theintuitively satisfying result that dense urbanization offers more managementefficiency than rural or sparsely urbanized areas, something we may haveguessed from things we learned in Chapter 1

We set aside these insights for the moment to address the other party’sproblem

size0

100000200000

300000net profit

FIGURE 8-3 Net profit with changes in the number of locations and building size.

1 This is not to say that larger buildings do not produce more net profit, something clearly evident from the plot in Figure 8-3 The plot shows that for all sized buildings, given that they are all the same as they are in our stylized example, the optimum number of locations is 15 The effect is more pronounced in larger buildings.

THE PROPERTY OWNER’S DILEMMA

Especially for small properties, management fees are usually calculated as apercentage of effective gross income (EGI) collected from tenants EGI isdefined as the actual receipts after vacancy and credit losses The manager has

a fiduciary obligation to maximize the owner’s net income With managementfees a percentage of the collected rent, the manager’s fee income is maximized

by collecting the most rent from tenants This conflict introduces a perverseincentive because tenants paying the highest rent often subject the property tomore intense use and often vacate after a short tenancy While the managershares in vacancy losses because his fee is based on collected income, increasedexpenses are borne solely by the owner The net income of both manager andowner are affected by vacancy rates But the owner’s interest in maximizingnet income considers expenses; while the manager’s interest in maximizing

For the moment we shall ignore the connection between higher rents andvacancy rates and deal only with the variable cost issue Later we will includethe vacancy factor to provide a more realistic result

204060Optimal Locations

FIGURE 8-4 Change in optimal locations as distance increases.

2 There is an even more perverse incentive in some management contracts that pay the manager a fixed fee when tenants turnover The problems this engenders are too obvious to address at any length here.

The owner’s net operating income, noi, is

for now will include vacancy)Variable costs, which include management fees, are modeled as anincreasing function of rent:

where

vc ¼ variable costs

mgt ¼ management fee, a percentage of rent

Substituting Equation (8-8) into Equation (8-7), we have

For the purposes of illustration we will use a 10% management fee Theplot in Figure 8-5 reveals that variable costs are constant after an initial steeprise

Another way of saying the same thing is from the perspective of noi Thederivative of noi with respect to rent in Equation (8-10) shows that the change

250 500rent20

175

300 vc

FIGURE 8-5 Variable costs as rent increases.

in noi becomes a constant 90% (100%–the 10% management fee) as rentincreases (the second term in Equation (8-10) goes to zero as r increaseswithout bound).

no tenants More generally, fewer tenants are available as rent rises

We now introduce the idea of vacancy Collected rent, cr, is a percentage ofthe (hoped for) scheduled market rent