Dprofiler: January/February Sessions

Beck Technologies has invited a couple REAE@UTA students (1 or 2 students per session only) to attend upcoming training sessions. The training is two full days at Beck's headquarters in Dallas. You must attend the full two days and you are responsible for your own transportation. Also, please remember that you are an invited student guest and sitting-in on (expensive) training geared primarily for paying corporate customers (represent us well so we will be invited back in the future).

There are four upcoming sessions:

January 6 & 7
OR
January 21 & 22
OR
February 3 & 4
OR
February 17 & 18


If you would like to attend, please contact me at ahansz@gmail.com. Don't wait to sign up! These session fill-up quickly.

Dprofiler with RSMeans is software system used to design and produce cost estimates for new construction and development projects.

OGS Spring 2009 Scholarship Award

The UT Arlington Office of Graduate Studies (OGS) is pleased to announce the Spring 2009 OGS Scholarship Award. The Spring 2009 OGS Scholarship Awards are one-time, non-renewable scholarships designed to encourage former UT Arlington graduate students (last enrolled prior to Fall 2008) to return to UT Arlington to complete their graduate degrees and to influence newly admitted graduate students to enroll at UT Arlington in Spring 2009.

These scholarships—$1,000 for masters and $1,500 for doctoral students— will be awarded on a competitive basis for Spring 2009. Since these are competitive scholarships, non-Texas resident recipients will be entitled to pay at the much lower Texas resident tuition rate. Although the entire scholarship will be credited to each recipient’s student account in Spring 2009, non-Texas residents will also receive Texas resident tuition adjustments in Summer 2009.

Minimum qualifications for this scholarship:

• 3.0 (or higher) GPA.
For former UT Arlington graduate students, based on UT Arlington graduate GPA.
For new UT Arlington graduate students, based admissions GPA (as calculated by the Office of Graduate Studies).

• Must apply for Spring 2009 admission or readmission prior to submitting scholarship application.

• Unconditional admission or readmission to UT Arlington for Spring 2009. Note: Students provisional for transcripts showing final grades and degree may also apply.

• Must be a degree seeking master’s or doctoral student taking courses at UT Arlington in Spring 2009.

• Must be enrolled in at least 6 semester hours of UT Arlington graduate coursework in Spring 2009 as of census date (February 4, 2009).

• For former students, preference will be given to graduate students in their final (graduating) semester of enrollment, or enrolled in 5698 or 6999 courses.

Priority Deadline: December 1, 2008

If there are students that you want to recruit to your respective programs and you feel that this opportunity will influence their decision to enroll at UT Arlington in Spring 2009, we encourage you to submit recommendation letters (that include the their full name and ID number) on their behalf. You may send recommendation letters to UT Arlington Office of Graduate Studies; Attention Scholarship Committee; Box 19167; Arlington, Texas, USA 76019 or via e-mail to gradservices@uta.edu. Please place "Attention Scholarship Committee" in the subject line of your e-mail messages.

For additional details about the scholarship and a hyperlink to the application, visit http://grad.uta.edu/prospective/OGS_Spring_2009_Scholarship_Award.asp.

Southlake Town Square Trip

Special thanks to Southlake Town Square developer Brian Stebbins for showing the REAE@UTA students around this wonderful example of a successful mixed-use development today. Dr. Hayunga (our tallest faculty member) counted up to 80 undergraduate and graduate students (and perhaps a few party crashers).



Also, I would like to thank Steve Isbell for creating this opportunity for us for the third year in a row. Although it was a little chiller than prior years, this was a great opportunity!

The Vanishing January Effect: Evidence from REITs

Fahad Almudhaf
REAE 5311 Blog Post

The Vanishing January Effect: Evidence from REITs

Introduction:
Time patterns in stock returns are reported in a number of studies. Rozeff and Kinney (1976) find that the monthly return is the greatest during the month of January compared to other months of the year in NYSE. This is early evidence of the existence of seasonality in monthly stock returns. This anomaly is known as the “January effect” in the literature. Seyhun (1993) lists potential explanations for the January effect and classify them into two categories. The first group of explanations which is consistent with efficient markets includes omitted risk factors, seasonalities in the risk-return trade-off, insider trading hypothesis, risk and econometric mismeasurement problems. The second group of possible explanations is inconsistent with the efficient market and includes portfolio rebalancing/window dressing and tax-loss selling pressure.

Previous research has well documented many seasonal effects which exist in the stock market returns in the US and other international countries. Day of the week effect, holiday effect, January effect, and turn of the year effect are examples of such calendar effect anomalies. Such anomalies cast doubts to the “efficient market hypothesis”.

Our study examines seasonality in Real Estate Investment Trusts (REITs) returns in the US using more recent data collected from NAREIT. Our study covers the period from January 1972 to September 2008. Our empirical results support the existence of positive returns during the month of January relative to other months during the whole sample. However, the January effect disappears and turns into being statistically insignificant during the most recent period. The results of such a study are important for both investors and academicians. An investor can construct a trading strategy which uses observed seasonalities in real estate returns to earn excess returns. Such calendar anomalies contradict the “efficient market hypothesis” which is still debatable between financial economists.

Literature Review:
Few studies exist in the literature examining the existence of calendar anomalies in REITs compared with numerous studies covering calendar anomalies in stocks returns. Colwell and Park (1990) show that seasonality effects exist in real estate related investments as well. They document that average REIT returns on January are higher than the other months of the year in both equity and mortgage REITs. Their study covers the period from 1964 to 1986. They also find that January effect is much stronger in smaller REITs which is consistent with the inverse relation between size and January effect previously documented in stock returns by Banz (1981) and Reinganum (1983). Colwell and Park (1990) claim that the exact economic forces which drive this anomaly are undiscovered.

Redman, Manakyan and Liano (1996) extend the previous study by covering the period from 1986 through 1993. Their results show the existence of day-of-the-week effect, turn-of-the-month effect, and January effect in REITs. Average US REIT returns were higher in January and Friday through their sample. The results of their study provide evidence against the weak-form of efficient market hypothesis in REITs.

Friday and Peterson (1997) cover the period from 1974 to 1993. Consistent with previous studies, they observe January effect in all sizes of REITs and in all classification (Equity, Mortgage and Hybrid). They argue that the tax-loss selling hypothesis is more likely to cause the January effect in REITs than information effects. Their empirical results which support the Tax-loss selling hypothesis are consistent with inefficient REIT markets.

Cromwell, Friday and Yoder (2000) use stochastic dominance methodology to study return seasonality in equity REITs. They reconfirm the existence of the January effect in equity REITs. They also find that the January effect is stronger in small REITs than in large REITs. Their findings are inconsistent with the efficient market hypothesis.

More recently, Lee and Lee (2003) provide evidence that the January premiums decreased after the increase of institutional investment in the REIT market after the Revenue Reconciliation act of 1993. The decline in January premiums was lower in Mortgage REITs compared to Equity REITs. Their evidence is consistent with the tax-loss selling hypothesis and inconsistent with window-dressing hypothesis. They cover the period from 1972 to 2002. However, contrary to prior research Hardin et al. (2005) shows that the January effect turned to be statistically insignificant during the period 1994-2002.

Our study extends the previous literature by using more recent data from NAREIT all REIT. This will help us to know whether or not seasonalities in REIT returns still exist or if they vanished after being presented in the literature. We cover the period of 1972 through 2008. We then study sub-periods of the whole sample as a robustness check. In addition, we use the S&P REITs composite index to confirm our findings.

Methodology:
This study uses OLS as the estimation method. We run the regression for the following equation to test for REITs seasonal effects:

Rt = a1*D1t + a2*D2t + ... + a12*D12t (1)
Where Rt is the REIT return at time t. D(it) is the seasonal dummy variable which equals 1 if the return at time t corresponds to month i, and 0 otherwise. is the average monthly return on month i. D1 corresponds to January and D12 corresponds to December.

We then use the following regression equation to test for the January effect in US REITs:
Rt = C + a2*D2t + ... + a12*D12t (2)
Where the intercept C represents the average return for January and the coefficients (ai) indicates the difference in returns between the return of January and month i. A negative value of the dummy coefficients in equation (2) would be a proof of a January effect (Higher returns on the month of January relative to other months of the year).

Results:
Table 1 reports the results of tests from Equation 1 for calendar seasonal effects of US REITs during the whole sample. Results in Table 1 show evidence of statistically significant calendar seasonal effects in the months of January, March, July and December. We have positive statistically significant effects occurring in these four months.

Table 2 shows results of the estimated regression in equation 2 to test the existence of the January effect for the whole sample. Based on results shown in Table 2, average January returns exceeds average returns in all of the other months except March and December where the excess returns is statistically insignificant. This is inconsistent with previous results of researchers who found higher REITs returns in the month of January compared to all other months.

Tables 3 and 4 provide the results of equations 1 and 2 using sub-samples of our whole period. Results in these tables are much more interesting. More recent empirical evidence shows that January effect does not longer exist in US REITs. Returns in January are not significantly higher than other months anymore and that is consistent with Hardin et al. (2005). We see that it is statistically insignificant in the period 1993-2008.


Moreover, we have used another index to provide further support for our results. Using S&P REITs composite index covering the period from January 1990 to January 2008, we got similar results showing statistically insignificant positive returns in January. Table 5 shows results of equation 1 using the S&P REIT composite index. This confirms that US REITs return are not anymore higher in January compared to other months. Average REITs returns are positive and statistically significant in both May and October during our sample period and using S&P REITs composite index. These results are also consistent with the results of Hardin et al. (2005) who show that the January effect became statistically insignificant lately.

Using the Dow Jones Industrial Average (DJIA), Moosa (2007) finds that the January effect disappeared for stocks during the 1990-2005 period. Our results are consistent with his study. However, our study uses REITs indices and not stock indices to confirm the fact that the positive January effect in REITs has become statistically insignificant recently. This could happen because traders become more aware of such anomalies and begin exploiting them which cause the January anomaly to vanish.

Conclusion:
This study has tested for seasonality of monthly REITs returns in the US. It also investigated the existence of the January effect in US REITs. Our results show evidence of seasonality in US REITs returns. Results obtained indicate significant presence of the January effect (higher returns in January) for the whole period 1972-2008. Our whole period results are consistent with Colwell and Park (1990), Redman et al. (1996), Friday and Peterson (1997), Cromwell et al. (2000), Bley and Olson (2003), and Lee and Lee (2003).
However, our study confirms that more recently the January effect does not exist anymore which is consistent with Hardin et al. (2005).The publicity of such an anomaly in both academic literature and financial media may have caused the January premium in US REITs to vanish recently.

References:
Banz, R. (1981), “The Relationship between Return and Market Value of Common Stocks”, Journal of Financial Economics, 9, pp.3-18

Bley, J. and Olson D. (2003),”An analysis of Relative Return Behavior: REITs vs. Stocks” SSRN Working paper.

Colwell, P. and Park H. (1990), “Seasonality and Size Effects: The Case of Real Estate Related Investments” Journal of Real Estate Finance and Economics, 3, pp.251-259

Compton, W., Johnson, D. , and Kunkel , R. (2006) “ The turn-of-the-month effect in real estate investment Trusts (REITS)”Managerial Finance, Vol.32, No.12, pp.969-980

Cromwell, N., Friday, H., and Yoder J. (2000), “Equity REITs and the January Effect”, Journal of Alternative Investments, Spring 2000, V.2, I.4, pp.62-68

Fountas, S. and Segredakis K. (2002) “Emerging Stock market return anomalies: the January effect and the tax-loss selling hypothesis” Applied Financial Economics, Vol. 12, pp.291-299

Friday, H. and Peterson D. (1997), “January Return Seasonality in Real Estate Investment Trusts: Information vs. Tax-Loss Selling Effects”, The Journal of Financial Research, Vol. XX, No.1, pp.33-51

Hardin, W., Liano, K., and Huang G. (2005),”Real Estate Investment Trusts and Calendar Anomalies: Revisited”, International Real estate Review, V.8, No.1, pp.83-94

Lee M. and Lee M. (2003), “Institutional Involvement and the REIT January Effect over time”, Journal of Property Investment and Finance, Vol. 21, No.6, pp.435-449

Moosa, I. (2007) “The Vanishing January Effect”, International Research Journal of Finance and Economics”, Issue 7, pp.92-103

Redman, A., Manakyan, H., and Liano K. (1996), “Real Estate Investment Trusts and Calendar Anomalies” Journal of Real Estate Research, Vol. 14, pp.19-28

Reinganum, M. (1983) “The Anomalous Stock Market Behavior of Small Firms in January: Empirical Tests for Tax-Loss Selling Effects”, Journal of Financial Economics, 12, pp.89-104

Rozeff, M. S. and Kinney, W. R. (1976) “Capital seasonality: The case of stock returns”, Journal of Financial Economics 3, pp.379-402

Seyhun, H. (1993) “Can Omitted Risk Factors Explain the January Effect? A Stochastic Dominance Approach” Journal of Financial and Quantitative Analysis, 28, pp.195-212

Building Information Modeling

By: Alex Papavasiliou

Building Information Modeling: What is it?

Building Information Modeling (BIM), is an information/design/modeling technology defined by the American Institute of Architects (AIA) as “a model based technology linked with a database of project information”. There is not a standard definition or better stated, agreed upon definition of BIM, but the key element of the acronym should be the “I”. The information embedded in the three dimensional model is what will differentiate this technology from current design applications. BIM will cohesively integrate the entire life cycle of a building, design, construction and maintenance, into one single application.

The origin of building information modeling was conceptualized in the 1970’s by Professor Charles M. Eastman of the Georgia Institute of Technology. Eastman describes BIM “as the provision of rich, integrated information—from conception through design to construction and demolition of a building over its life cycle. It relies on object based, information rich 3-D modeling as the design of record and for as-constructed, as-built, and as-operated information. The benefits enabled by BIM will greatly change the ways buildings are designed, fabricated, and operated.” [i] Over the past several years the incorporation of laser scanning data into BIM has established additional applications that were previously not possible. Now that computing power is a non-issue the 3-D aspect has become an indispensable element of BIM.

Laser Scanning

Laser scanning is “the capturing of the shape and placement of physical objects in a digital format using 3D laser survey technology.”[ii] A laser scanner is set up and shoots a laser that spins 360 degrees and measures 210,000 points per second. Once completed you have digital reproduction accurate to the 1/100th of a millimeter. The integration of laser scanning and BIM was established in the energy field, specifically the oil and gas industry. Off-shore oil platforms can pump millions of dollars of oil a day. Any temporary shutdown can result in the loss of thousands and potentially millions of dollars of revenue. Furthermore, these structures are located miles away from the shore and are the definition of industrial design. Too many times the companies operating the oil platforms have faced extended down time due to a piece of machinery being too big to fit through openings or piping not constructed to the specific dimensions needed for operation. (For this discussion a segment of pipe is discovered to be leaking oil.) A temporary solution is put into place to stop the leak, while a pipe fabricator is constructing the necessary fitting. A few days later the replacement part arrives and oil production is temporarily halted for the installation. During the installation it is noticed that the fitting is not exactly lining up with the old pipe. This design error could have been avoided by scanning the current pipe fittings or if a model was already in existence, simply sending the model information to the manufacturer that would contain the exact measurements.

Anyone with access to the model constructed through building information modeling (BIM) can highlight individual elements of the structural support system, red, to access information pertinent to that member. In this case, users could see the number of bolts used and find out whether or not the element required painting and whether it had been shipped by the supplier. The completed upper deck and canopy, below, precisely match the BIM model.[i][i]

Capabilities and Uses in Real Estate

There are infinite advantages and emerging capabilities of BIM; three will be discussed in this examination. One advantage of BIM is that architects, engineers, and other design professionals can create a complete three dimensional model that clients can “walk through”, rotate to every imaginable angle, and zoom in during the design/redesign process. There is an infinite array of cost savings associated with this ability. For example, real estate developers can have a true feel for the project they are developing by seeing what the end product will look like before the final design is complete. This is currently available, but not at this level of detail and not in a virtual fashion. Being able to see the building and creating a virtual walk through should lead to less design changes once the project is under construction. Another example is a conversion of an old industrial facility into a new office, retail, or residential use. You have a company scan the building inside and outside. Now you have a digital reproduction accurate to the 1/100th of a millimeter that is intergraded into a model. Armed with this reproduction, the designing can begin instantly because every aspect of the building is available in a digital format; window sizes, door openings, utility placement, the list goes on and on.

http://www.noreast1.com/danvers2.jpg Courtesy of Merdian Associates, Inc.

Another related benefit is that clients do not necessarily have to visit the construction site in person. During the construction period, 3-D models would be continually updated and available for viewing through the web to monitor progress. Now real estate executives have the ability to “walk” floor by floor and room by room, each week to view the new multi-million dollar office building located in Singapore, from their office in the United States.
Another related benefit is that clients do not necessarily have to visit the construction site in person. During the construction period 3- models would be continually updated and available through the web to see the progress.

After the building is completed, a final building model will be constructed. You no longer have to have paper plans, AutoCAD files, maintenance records and various other documents. Your model is now the central depository for all information related to the building. In this final model, there is now the ability to provide every minute detail of construction, maintenance records, and finish out items. Here is an example analysis of the 28th floor of the new office building in Singapore. (The following example also illustrates a pre-construction use.) With a few clicks of the button you can determine the exact size of all the rooms. Let’s go one step further; next thing you wish to know, what flooring materials are used on this floor. Click again and you have a list of all the flooring: carpet, bathroom tile, break room tile, wood floor in lobbies, exposed cement in storage closets. Click again on the particular material, and now a list pops up and provides information on the vendor it was purchased from, who manufactured the product, the cost of the product, when it was cleaned last, and any other information a building manager would wish to include. Having this amount of information will have substantial impact on the future management and maintenance of the asset.

Conclusion

BIM is becoming more and more commonplace in the architectural, engineering and construction industries. It has shown much promise in reducing construction costs and time. But with any new technology there are many issues to overcome. Currently the biggest obstacle is the lack of an industry standard. Most companies in this field are promoting their platform but lack the necessary integration elements needed to make it universal. You have competing laser scanning software and BIM platforms. ArchiCAD and AutoDesk Revit are the industry leaders. The companies that have leverage over the software, architectural, engineering and contracting firms are the public and private building developers. Taking the lead to push for a universal standard is the General Services Administration of the United States federal government. The GSA has realized the savings associated with a successful integration of all the disciplines associated with the design, construction and operation of new building facilities. It will be only a matter of time when you will hear about training session for BIM in the 3rd floor computer lab.

[1] http://www.todaysfacilitymanager.com/tfm_06_11_factech.php
[1] http://www.state.gov/documents/organization/97752.pdf
[1] http://pubs.asce.org/magazines/CEMag/2008/Issue_05-08/article1.htm
http://www.vrcontext.com/walkinside/24-movies-2.html#Technologie

The US Housing Crisis, Economy and Stock Market

Hum Nath Panta

REAE 5311, Blog

Introduction

Current economic crisis in the United States of America is a by-product of sub-prime mortgage crisis in the US which has spread around the world. Sub-prime loan is a loan provided to borrowers who have low credit ratings and other factors that suggest a chance of defaulting on debt payment. Sub-prime loans have a higher interest rate than prime rate provided on traditional loans. Statistics shows that housing market started declining at the end of 2005. Simultaneously the Federal Reserve Bank started raising interest rate to tackle inflation at the end of 2005. This trend continued until the second quarter of 2007. Rising interest rates caused extremely difficult situation for existing as well as new home owners. As lending rates continued to rise, the cost of monthly mortgage payments rose significantly. As a result, many American homeowners were unable to pay for the homes they could never afford in the first place.

Raising interest rates not only created problems for existing home owners, but also had an effect in reducing the overall demand for new and existing houses. So, when mortgage became more expensive, only fewer Americans could afford houses. As a result, housing market started dropping thereby ending the housing market boom that lasted for a half decade. Moreover, when home owners realized that the home prices had started dropping and that could decline further, a number of home owners exit the market. Specifically, a large number of speculators exit the market at the first place. Then gradually, a large number of home owners could not keep their homes with lower market value compared to the mortgage value leading to excess supply of both existing and new homes and all this has caused significant drop in housing price and a record high foreclosure. As a result, US stock market in particular, and US economy as a whole, is suffering from bubble burst in the US housing market.

The Current Situation of Housing Market

It is very difficult to claim the exact date when the US housing market started declining. However, technical analysis of housing starts data shows that housing market started slowing during the first quarter of 2005. Housing starts dropped by 6.7 percent in March 2005 compared to the same period in 2004. Then we can observe short term jump until November 2005. By observing graphical presentation of housing starts and permits (see Figure 1), and housing starts percent change from a year ago (see Figure 2), we can clearly see that housing market started slowing at the end of 2005. Graphical presentation just gives an overview of downturn in the housing market but does not give a clear indication of actual housing bubble burst. Based on the previous statistics on housing starts change, we can define recession in housing market or housing bubble burst if housing starts change from a year ago is more than 10 percent persistently. For example, during 1974 housing crisis, August 1973 to June 1975 housing starts declined every single month by more than 10 percent from a year ago. Same pattern can be observed during 1991 recession when housing market was hard hit. Percent decline in housing starts from a year ago indicates that housing starts declined by over 10 percent every single month starting April 2006. Therefore, I want to test the hypothesis that housing market started declining from April 2006. To test this hypothesis, I created housing bubble dummy variable that takes value of 1 if observation occurs during the month of April 2006 to August 2008. Otherwise the housing bubble variable takes 0. I used seasonal dummy model with AR (2) process to test the hypothesis that housing market started slowing down from April 2006. Regression output shows that the housing bubble variable is negative and statistically significant at 1 percent significance level. (See regression output in Table 1).

Existing home sales statistics indicates that home sales rose 5.5 percent to seasonally adjusted annual rate of 5.18 millions units in September 2008 from the level of 4.9 million in August 2008. The existing home sales also increased by 1.4 percent in September 2008 from September 2007. However, price of existing homes is down 9 percent in September 2008 verses September 2007 (National Association of Realtors, 2008, also see Figure 3 and 4).Thus, housing market has not started stabilizing rather the downturn is continuous. The relentless downturn in home prices has left nearly one in six US homeowners owing more than the home is worth, raising the possibility of a rise in defaults. The more home prices drop, the more people feel less rich and thus people decrease their spending on goods and services. In addition, the result of home owners being underwater creates more pressure on already sluggish economy. Moreover, having more homeowners under water is likely to mean more eventual foreclosure since it is hard for borrowers in financial trouble to finance or sell their homes and pay off their mortgage if their debt exceeds their home value. Foreclosed homes also tend to lower the value of other homes in neighborhood (Hagerty and Simon, Wall Street Journal, October, 2008). According to the Mortgage Bankers Association in Washington, U.S. foreclosures rose at the fastest rate in almost three decades, to a record 2.75 percent of all mortgages, in the second quarter of 2008. According to RealtyTrac Foreclosure report released in September, 2008, home foreclosures rose 26.7 percent in August from a year earlier. An estimated one in every 416 homes is in some stage of foreclosure (Homan, 2008). Thus housing crisis is an ongoing vicious circle, is affecting every sector of on the US economy.

Housing Market and the US Economy

Real estate market is one of the very important contributors to the US economy. It generates over 28 percent of the US gross domestic product (GDP), creates about 9 million jobs, and generates nearly 70 percent local government revenues (Ling and Archer, 2008). Moreover, real estate market constitutes the single largest asset class in the US. The estimated total market value of real estate is approximately 23.4 trillion which includes owner-occupied housing, investable commercial real estate, and land excluding non real estate corporation and real estate owned by governmental agencies (Ling and Archer, 2008). These statistics indicate the importance of real estate in the US economy.

Real estate market has a very significant contribution to the US GDP through construction spending. According to contribution of office, in 2005 $1.14 trillion in construction spending contributed $3.9 trillion to US GDP. Of the $1.14 trillion, an estimated $148 billion was spent on construction of non-governmental offices, industrial warehouses and retail buildings. Therefore, each dollar in new construction spending increases GDP by $3.42. Detailed information about construction spending is presented in Figure 5. Therefore, real estate market has a very important contribution to the US economy.

Almost every financial institution is venerable due to sub-prime mortgage crisis. Financial institutions have written off billions of dollars bad debt. So the current credit market situation is really tight. Tight credit markets have further exasperated economic downturn. In this situation, as companies find it harder to secure financing, business spending is likely to be constrained and this is more likely to cause more layoffs in near future. According to Bureau of Statistics, the unemployment rate increased to 6.1% in September 2008, up from less than 4.5% in January, 2008. The unemployment rate is expected to increase in the next 12 months. According to US Census Bureau, new orders for manufactured goods in August 2008 decreased by $18.6 billion or 4.0 percent to$444.4 billion (See Figure 6). Thus, the overall prospect of the US economy is suffering mainly due to housing crisis.

Housing Crisis and Financial Institutions

There is no doubt that housing crisis has hit harder to homeowners. Thousands of homeowners are forced to walk away from their homes mainly for two reasons. First, it is very hard to get affordable refinancing. Second, the sharp decline of home prices has made homeowners more inclined to default their loans as the home value is far less than the mortgage balance. In other words, loan to value ratio has increased very significantly, which creates incentive for homeowners to walk away form their homes.

Financial institutions, banks, insurance companies, hedge funds and individual investors who have a significant portion of mortgage-backed securities are hit even harder from the free fall of housing prices. According to Richard J. Fox, majority of mortgage-backed securities received an “AAA” rating by various rating agencies. This triple A ratings enabled financial institutions to sell their mortgage-backed securities to countless banks, insurance companies, hedge funds, individual investors. These investors believed that they would be able to earn higher rate of return from the mortgage-backed securities compared to other financial instruments with the same ratings until the housing bubble burst started showing its real effect last year.

Now the financial industry is facing a great challenge in history. This crisis has caused a severe blow to the world economy. The current crisis is even more severe than any other crisis after the world depression of 1929 in the sense that the whole credit market around the world is frozen. Some banks and insurance companies have already bankrupted. Without government intervention, several banks and institutions would fail. Still nobody knows how many banks, financial institutions, insurance companies will fail in the near future. So this credit crunch caused by the housing bubble burst has severely damaged the world economy.

Financial institutions and banks are heart of economy. Sound financial system and people’s trust towards the system are crucial to the economic prosperity. They are missing in current world economy. For the first time Bear Stearns, a New York based investment bank collapsed there by being the first victim of the sub-prime mortgage crisis in the US. Then it was followed by IndyMac Bank. The US government is doing all it can do to protect the financial system. However, banks and financial institutions are crumbling. Another blow to the US credit market is failure of investment bank Lehman bothers followed by the failure of Washington Mutual and Wachovia bank. Without the government intervention, nations’ largest insurance giant American International Group, Inc (AIG), mortgage giants Freddie Mac and Fannie Mae would have clasped. It would have devastating effect on the US financial and stock market. For the first time Japan's Yamato Life Insurance filed for bankruptcy in October 10, 2008 with USD 2.7 billion in liabilities, to become the first financial sector casualty of US credit crisis in Japan. Thus, the housing bubble has crippled not only the US economy but also has spread rapidly throughout the world.

Housing Crisis and Stock Market

Over the past three years, construction spending has been decreasing continuously. According to U.S Census Bureau, total construction in July 2008 has decreased by 4.8 percent compared to July 2007. Residential construction spending has decreased by 27.1 percent in July 2008 form the same period last year. So, the total private construction decreased by 9.2 percent in July 2008 compared to the same period in 2007. This means the economy lost $78,264 millions total private construction spending in July 2008 compared to the same period in 2007. This figure is equivalent to $276,663 millions loss in the US GDP in 2008. Therefore, the housing crisis has caused significant damage to the US economy.

Sound economy is the heart of stock market. The housing crisis has severely affected the US economy. Consequently, currently stock market is facing a great challenge. This effect comes from economic downturn and the destruction of financial system. As of October 8, 2008 Dow Jones Industrial Average, S&P 500 and NASDAQ have lost all 5 years of gain. In other words, 5 year returns of Dow Jones Industrial Average, S&P 500 and NASDAQ are negative 3.87, 4.72 and 8.10 percent respectively (See Figure 7). Millions of American people have lost more than two third of their retirement investment value. In fact, the world economy is facing the greatest crisis since the great depression of 1929. Investors have lost confidence in the market. Market is melting down each and every day. Technical indicators indicate that the economies around the globe are on the verge of sliding down to deep recession led by the US financial crisis. According to economist.com, the financial crisis has broadened and intensified, the global economy has begun to suffocate, and global recession is almost certainly underway. Current credit crunch is a pure by-product of sub-prime mortgage crisis. Thus, housing crisis has caused a significant damage to the world economy in general and stock market in particular.

What can be done?

Housing crisis is the heart of current crisis. However, the current crisis has spread beyond the housing sector. I believe that stabilization of housing prices is necessary to the economy at large. Therefore, it is necessary to adopt measures to stabilize or stop the decline of housing prices to stop and repair the current failing financial system. Once the economy realizes stabilization in housing prices, it will immediately result multiplier effects. Housing recovery will stop further foreclosures and loan defaults in the first place. Moreover, it is necessary to make sure that credit is available in the market so that market starts functioning naturally. Such measures gradually normalize economic activities.

To stabilize housing prices and credit market, government and responsible authorities should regulate housing and credit market effectively. Government should freeze or lower monthly mortgage payment for those home owners unable to afford monthly payments for at least some times. Government also has to make sure that affordable credit is available to new entrants in the housing market. Housing market and financial institutions should be strictly regulated to prevent repetition of the crisis in financial and housing industry in distant future. If necessary, government should also provide insurance for new mortgage to guarantee banks investment on such loans to normalize credit market. Primarily in open market economy, market itself corrects if any anomalies and disparities appear. However, government intervention is necessary to increase confidence in housing and credit market which is the heart of the current crisis in stock market.

Conclusion

Economies around the world have been suffering from cyclical effects from time to time. The current US housing crisis is one example of cyclical effects. The US economy suffered from housing slump in 1974. However, the current housing crisis is completely different from the previous housing slump since many players such as banks, financial institutions, insurance companies, hedge funds, and individual investors are directly involved in this crisis. The current housing crisis is not only the meltdown of real estate market but has stained the whole financial system. Governments around the globe are doing their best they can do to prevent further deterioration in the credit market, however these measures have not been effective. I think no government intervention can cure this crisis right away. Government intervention needs some time to have effects. Market is more about psychology. Therefore, any measures adopted by government should be directed towards restoring the trust in financial system and reduction of psychological fear in the market.

Reference

Hagerty and Simon (2008), The Financial Crisis: Housing Pain Gauge: Nearly 1 in 6 Owners 'Under Water' - More Defaults and Foreclosures Are Likely as Borrowers With Greater Debt Than Value in Their Homes Are Put in a Tight Spot, Wall Street Journal, October 8, 2008.

Ling, D. C. and Wayne R. Archer (2008), Real Estate Principles: A Value Approach, 2nd edition, McGraw-Hill/Irwin, Inc. 2008

NAIOP Research Foundation, < http://www.naiop.org/foundation/home.cfm

http://www.realtor.org/press_room/news_releases/2008/ehs_rise_on_affordability, http://www.naiop.org/foundation/contdev.pdf >

National Association of Realtors, 2008, <http://www.realtor.org/research.nsf/pages/EHSdata >

Phil Izzo, Economists Expect U.S. Crisis to Deepen, October 1, 2008

<http://finance.yahoo.com/banking-budgeting/article/105935/Economists-Expect-U.S.-Crisis-to-Deepen>

Timothy R Homan (2008), U.S. Pending Home Re-sales Rise 7.4% as Prices Drop, October 8, 2008. <http://www.bloomberg.com/apps/news?pid=20601087&sid=avsj6v77XbhI&refer=home>

The Economists <http://www.economist.com/finance/displayStory.cfm?story_id=12382253&source=features_box_main&ref=patrick.net >

U.S Census Bureau, Press Release, August 2008, <http://www.census.gov/const/www/prpage.html>

U.S.News and World Report, Retirement Savers Lost $2 Trillion

<http://biz.yahoo.com/usnews/081008/08_retirement_savers_lost_2_trillion_in_the_stock_market.html?.&.pf=retirement >.

Arlington’s Economic Base: Butler to the World’s Economy

The conception of every city became from some function in which it served the economic world. The economic base (EB) is the function served. The EB is often called the export base because the EB in inherently a description of exported goods and services that are purchased by others outside of the subject city much like a heart exports blood (Archer, Ling 122). The easiest way to understand the basic economics of a city is to draw it down to a lower common denominator for comparison, such as a butler to a household.

When guessing what the EB of a city is, one may be surprised at the answer. Take a moment and write down your best guess of the foremost EB of Dallas, Fort Worth, and Arlington Texas as individual cities (answers at end of essay). Arlington exists to serve the world’s economy much like a butler exists to serve the needs of a household. Arlington, as an economic servant, has specific skills and resources which are employable. Transportation, management, information, and wholesale industries are Arlington’s primary EB which fosters growth, secondary activities, and wealth. Arlington’s EB was its means for successful conception and is the mean for its continued existence.

The economic base is determined by an indicator called the location quotient (Archer, Ling 126). The location quotient is computed by dividing the national employment average of a certain industry by the city’s employment average of the same industry. If the outcome is larger than 1.2, the industry is considered to be producing a surplus capable of export (Hansz). Arlington’s EBs had location quotients of 1.652, 1.563, 1.351, and 1.318 respectively. The data used to provide the aforesaid information was drawn from American Fact Finder and is derived from 2000 decennial census (http://factfinder.census.gov/ ).

These 2000 figures, however, probably point to an EB that is quite different than the EB during Arlington’s conception. About 150 years ago Arlington drew its growth and prosperity from EBs such as frontier center, agricultural center, horse racing, and gambling (http://www.ci.arlington.tx.us%20/history/index.html). As quantified by the location quotient, these qualities would have to be substantially unique to Arlington for them to constitute an EB. For instance, if every city and town offered gambling, no person would bother to come to Arlington to spend their money, and therefore Arlington would not receive their “paycheck for butler services” rendered to the world.

As previously stated, the EB fosters growth, secondary activities, and wealth. To measure the fostering potential of the EB the EB Multiplier (EBM) is used. The EBM = Total Employment / EB Employment. Arlington’s EMB = 175,452/38,852 = 4.52. For every EB employee there are 4.52 times more employees in the subject city (4.52emb X 38,852eb= 175,452te. Mathematically this formula expresses how the EB drives local economic activities (Archer, Ling 123). The greater the EBM, the greater influence EB has on the city’s economic activity as a whole, viz., employment. Following this logic, if ten EB employees are laid off, Arlington’s total job population would decrease by forty five employees.

If Arlington wants to maintain its position as a butler to the world, it must maintain skills and resources that are employable. Certainly the EB activities of Arlington 150 years ago (frontier center…gambling) do not serve as an EB today. Between the historical reference and today Arlington has adapted by adopting new skills and resources to continue growing. The alternative to growth is a potential six foot decline.

Growth in a city adds to the secondary activities that exist to support the EB. Some examples are restaurants, hotels, flower shops, hair shops, pet stores, and dry cleaners. In the example of Arlington, growth of the EB provides for 4.52 times the result toward the total employee population.

The aforesaid conditions are directly related to wealth. As a city grows economies of scales develop, and the retention of value amidst this competitive advantage become more possible and numerous. Many individuals and companies realize this, and keep their ear close to the track to see what may be coming or not to avoid danger and embrace opportunity. Cities realize the value of the EB and acknowledge that the decline of the EB may be an albatross that is very hard to shake. A healthy economy is sought and desired. Ignoring the root of these fruits can, however, be catastrophic. The EB must be considered.

The EB of a city can and will change. As it is the root of growth, secondary activities, and wealth, it must be considered. The disappearance of any one of Arlington’s EBs would produce 4.5 times as much damage to the employment base (on average). This decrease will also translate into a decline in the population as: Basic Employment X EBM X Population/Employment = Population (Hansz). Businesses and governments on all levels are aware of this, and therefore take the aforesaid into consideration.

An example of a company that considered the EB is the Texas Commerce Bank – Arlington in the 1981 Arlington Statement of Economic Conditions, prepared by Moore Diversified Services, Inc. (Moore). The statement described major businesses, growth, secondary activities, and many sets of data. “Major businesses are of importance in evaluating the economic viability of a municipality because they: 1) Are Employers of the City’s residents. 2) Represent a large contribution to the tax base. 3) Trigger economic multipliers and generators “(Moore 2-5). This document is a good representation of how company can employ the EB to help a business make an educated decision.

A parallel example of an entity that has considered the EB is the State of Texas though the Texas Economic Development Corporate Expansion and Recruitment, published on June 26, 2002 the publication “Doing Business in Texas” explicitly cites the implications of the EB. “In 2001, Texas exported $4,455 in merchandise for every man, woman and child in the state. That figure is more than 72% higher than the comparable U.S. average of $2,591 in per capita exports” (Texas 12). This is a unique business activity that directly related to employment, economy, and population. This statement substantiates the fruits of all growth, secondary activity, and wealth.

In conclusion, the EB is extremely important when considering the continued existence of a city. Growth, secondary activities, and wealth are all function of an EB. By ignoring the EB an entity exposes themselves to great risk and foregoing the opportunity of comprehensive and intelligent forecasts. The EB is the root of the fruit tree. The city’s EB is much like a Butler, exporting skills and resources to serve the world beyond the city’s boundaries. A positive EB produces growth, secondary activities, and wealth. A negative EB leads a city toward a pit that is six feet deep

Dallas EB: Management @ 1.97 (58% Female) w/ a component EBM of 936 (information derived census 2000 data): (http://factfinder.census.gov/)

Fort Worth EB: Transportation @ 1.46 (71% Male) w/ a component EBM of 22(information derived from census 2000 data): (http://factfinder.census.gov/)

Works Cited

US. Census Bureau. Ed. System Support Division. Feb 2008. October 27, 2008 <http://factfinder.census.gov/ >

City of Arlington, Texas. Ed. City of Arlington April 2008. October 27, 2008 <http://www.ci.arlington.tx.us%20/history/index.html>

Archer, Wayne. R, and Ling, David, C. Real Estate Principles: A Value Approach. New York: McGraw, 2008.

Hansz, Andrew. J. Ph.D. CFA. Oct 28, 2008 Lecture. “REAE 5311.” Real Estate Analysis, Dept. of Real Estate and Finance. University of Texas at Arlington.

Moore Diversified Services, INC. The 1981 Arlington Statement of Economic Conditions. Dallas: Moore, 1981.

Texas Economic Development. Doing Business in Texas. Austin: Texas, 2002.

Works Consulted

State of Texas, Office of the Attorney General. Handbook on Development laws for Texas Cities. Austin: Texas, 2000.

Wyman, Sherman and Weaver, Robert. Texas Economic Development in Transition: Opportunities for Public-Private Collaboration. Arlington: UTA, 1989.

December Dprofiler classes in Dallas

Beck Technologies has invited a couple REAE@UTA students (1 or 2 students per session only) to attend upcoming training sessions. The training is two full days at Beck's headquarters in Dallas. You must attend the full two days and you are responsible for your own transportation. Also, please remember that you are an invited student guest and sitting-in on (expensive) training geared primarily for paying corporate customers (represent us well so we will be invited back in the future).

There are two upcoming sessions:

December 2 and 3

OR

December 18 and 19


If you would like to attend, please contact me at ahansz@gmail.com. Don't wait to sign up! These session fill-up quickly and the November sessions are closed. (We had a couple students who wanted to join a November training session and the class was already filled to capacity.)

Dprofiler is software system used to design and produce cost estimates for new construction and development projects.

REAE@UTA Intro to Argus Session

This Saturday from 11 AM to about 1 PM+/-in computer Lab 7 (room 349E), we will have an introductory session to the real estate investment analysis software package called Argus. Argus is a very useful program for developing and maintaining complicated discounted cash flow models. This program is used extensively in commercial property investment, development, management, and valuation. Anyone is invited, all you need is your UTA computer account information. Special thanks to Argus Software, Inc. for donating the software for students to use in the REAE@UTA computer lab.

Southlake Town Square: November 15th

Below are some comments and instructions from Steve Isbell regarding the Southlake, Town Square field trip on Saturday, November 15th 11 AM (sharp) at the Southlake Court House steps (1400 Main Street, Southlake, TX):

From Southlake Town Square

Link to the development's website www.southlaketownsquare.com

Southlake is a wonderful development. It is nationally well known and is looked upon as "the way to do things." Developer Brian Stebbins has given tours to countless city officials from all over the world; many communities look at this development and say "We want that."

There are countless things to do at Southlake Town Square, including many restaurants, shopping, Starbucks and a movie theatre. The first phase, which is where we'll meet, has a wonderful green space. (Green space in developer lingo is space that doesn't directly generate any "green," if you know what I mean!)

Please encourage your students to try and enjoy the afternoon after the tour by strolling around on their own, observing the people, studying the pedestrian traffic, and noting general personality of the place. If they can get below the surface on this, I think it's a great study and learning resource for the "creation of space."

In my opinion, key points that were necessarily in place for this development were: (a) public/private partnerships, (b) non-traditional way of looking at trade areas, (c) a patient developer, and (d) a one in a thousand guy with a one in a thousand location, which equals a one in a million development.

Here's hoping for good weather!!! But in case of inclement weather, please have your students check this link the morning of the tour, www.strat-eq.com/Field_Trip.htm for the status and an alternate meeting place, if applicable. (The link is dead now and will be until a day or two before the tour.)

Please dress business like but for outside weather (be comfortable but we should look a little professional). You should also have a notebook and pen to take notes. Have your questions ready. Last year, Mr. Stebbins answered many questions and had some great career advice for aspiring real estate investors and developers. Finally, please consider carpooling.

Please make sure to thank both Brian Stebbins and Steve Isbell for this wonderful opportunity. This is the third year that we have had this exclusive visit with one of the premier real estate developers and developments in the country. We hope to be invited back next year.

UrbanPlan Finale: City Council

Great work with the UrbanPlan this year! This semester's UP project came to a conclusion this past Saturday with presentations to the City Council.

There were some good plans this semester, but one team in particular really painted a vivid vision of their development idea to the City Council. Good work Vicki, Stephen, Tracy, Will, and Georgia!

From UrbanPlan City Council

Special thanks to Phillip Bankhead, John Molnoskey, and all the Urban Land Institute volunteers (facilitators and council members)!

Bubble; not a bubble? - Arlington, Texas

You might be interested in a widely cited report by the Center for Economic Policy and Research. Please visit the following link:

http://www.cepr.net/index.php/publications/reports/the-changing-prospects-for-building-home-equity

An interesting aspect of this report is the Rule of 15. This rule-of-thumb defines a normal (non-bubble) residential housing market as home prices that are approximately equal, or less, than 15 times the annual gross rent. For example, the average rental rate in Arlington is roughly $850 per month or $10,200 per year. $10,200 times 15 would indicate an average residential property value of about $150,000, which corresponds to the actual average residential transaction price in Arlington, Texas --> Not a bubble.

However, in some other areas of the country, we have witnessed a great divergence between the residential rental market and transaction prices (these are the "Bubble" markets). This report defines a bubble as locations where the average transaction price is 18 or more times greater than the average annual gross rent. Most of these bubble markets are located on the West Coast and the Northeast. Check out the report for more details.

Thanks Will!

Special thanks to Will Pinkerton for coming to campus today to speak about some of the New Urbanism concepts that he is implementing in his Dallas-based development business. It was very refreshing to hear that some of these practical concepts are being valued in the marketplace.

Will is a graduate of the MSRE program and has made great progress as a individual developer. Will has accomplished everything he spoke and wrote about as a graduate student. Keep up the good work and come back to visit us on a regular basis! Many of our students are very interested in your recent projects.

Income Tax Implications of Real Estate for the Small Investor

Wade A. Dennis
REAE 5311 Blog Post

Introduction

There are a multitude of investment options available to investor’s these days. An investor can put their money to work in such vehicles as stocks, bonds, certificates of deposit, and if they are really risk averse they can leave their funds in an interest bearing savings account. But what about investing in real estate? What are the advantages of putting one’s money to work in real property assets?
Many benefits are commonly cited for investing in real estate. Among these are that real estate provides for diversification of one’s portfolio, current income from the net cash flow of the property, amortization of the mortgage loan balance, providing capital appreciation, the use of leverage to maximize return on equity, the tax benefits of depreciation, the favorability of capital gains over ordinary income, and finally, real estate serves as an excellent hedge against inflation. (Masters 2000, 32)
As with any investment, the tax consequences of any transaction needs to be taken into account in order to maximize profits and cash flows. Long-term financial planning, which includes effective tax planning, is necessary for maximizing wealth. Not taking the effect of income tax rules and regulations into account in one’s financial planning can have very negative effects on one’s cash flows. For example, ineffective tax planning could lead to the loss of the Sec. 1031 tax deferred exchange benefit resulting in the taxation of a capital gain resulting from a property sale.
So, for the investor contemplating real estate, what are some of the income tax implications? Several areas will be addressed: Passive activity limitations, depreciation, and Sec. 1031 exchanges.

Business Entity?

Before addressing these areas, one of the most important questions to deal with, not just for tax reasons but also for liability issues, is the business form of the investment, or what type of business entity to hold the real asset in. “The choice of which business form to adopt, as a vehicle to invest in commercial real estate, is critical to the success of the real estate investor.” (Haight and Singer 2005, 49) Many individual investors seek to have their real estate holdings in subchapter S-Corporations, limited partnerships, and limited liability companies (LLC’s). The reason is twofold. One, these forms of ownership provide for the liability protection of the owner(s). The personal assets of the owner(s) are shielded from creditors in the event of mortgage default or bankruptcy, except where the individual serves as the general partner of the limited partnership. The investor’s liability is limited to his/her basis in the business entity, as well as his/her share of any non-recourse debt held by the entity. Secondly, these flow-through entities avoid the double taxation of income of the C Corporation, as well as allowing for the distribution of cash flows tax free! (Technically speaking, income generated in these flow-through entities is taxed at the individual level whether or not cash is distributed, which is why cash distributions are not taxable to the individual.) It is not advisable for the investor to operate as a sole proprietor due to the lack of liability protection, nor is it advisable to hold real estate in a C Corporation because of the loss of preferential capital gains treatment and the above mentioned double taxation of income.

Passive Activity Limitations[i]

Real estate activities are viewed as passive activities in the Internal Revenue Code. For example, Code Sec. 469(c)(2) defines passive activities to include any rental activity. The general rule in passive activity limitations is that income generated in rental activities are included in the taxpayer’s ordinary income and taxed and the individual’s marginal tax rate while losses are deductible only against passive income. The limitation is that losses generated in passive rental activities cannot be used to offset either active or portfolio income. In the event that the taxpayer has passive activity losses and no other passive activity income, said losses are “suspended and carryover to future years where they can offset passive income in those years.” (Pope, Anderson and Kramer 2008, 9-26) On the other hand, if the investor owns multiple properties and one property has current income, this income can be offset with losses generated by other properties thereby minimizing the taxes owed.


Depreciation

Depreciation is often cited as one of the benefits of investing in real estate.[ii] But what is depreciation? Depreciation is the “systematic allocation of the cost of an asset over its economic life.” (Pope, Anderson and Kramer 2008, 10-2) That is, the code allows taxpayer’s to take a deduction against current income for a prorated portion of the cost of an asset. For example, nonresidential real property, such as an office building, is Code Sec. 1250 property and as such has a class life of 39 years and each year the taxpayer would be allowed a deduction equaling 1/39th of the cost of the asset. Residential real property, such as apartment buildings, is also Code Sec. 1250 property but it would be depreciated over 27.5 years.
Two benefits of deprecation should be readily apparent. One, taxpayers are allowed deductions based on the full purchase price of the asset and not just on their equity portion. Because of the high capital requirements of investing in real estate and the scarcity of dollars at the investor’s level, most real properties are mortgaged at loan-to-value (LTV) ratios commonly between 70-80%. For example, suppose a taxpayer invests in an office building for $1,000,000 and obtains a mortgage with an LTV of 75%. This taxpayer would receive a loan of $750,000 and would be required to put up equity capital of $250,000. Based on current rules, the taxpayer would be allowed an annual deduction of $25,641 ($1,000,000/39 years) as opposed to $6,410 ($250,000/39 years) if the depreciation deduction were limited to actual cash expended to purchase the property.
Secondly, it is a non-cash deduction against current income. The cash was expended upfront in purchasing the property and yet every year the taxpayer is able to include in their net rental income this non-cash expense. In the above example, the taxpayer did not spend $25,641 and yet he/she is able to take this deduction against current income thereby reducing taxable income and the resultant taxes paid. The beauty of depreciation is that a property can be generating positive cash flow and yet there be little or no taxable income. (Wendt 1969, 79) Taxpayers are able to convert some of the ordinary income (which can be taxed as high as 35%) generated by the property to capital gains (which are taxed at the lower rate of 15%) through depreciation deductions.
While depreciation has its benefits, there is one drawback that without effective tax planning can come back to bite you. This drawback is the depreciation recapture rule and is found in Sec. 1250 of the Code. The basic rule is that if Sec. 1250 property is sold or disposed of at a gain, that portion of the gain due to excess depreciation would be treated as Sec. 1250 ordinary gain. In other words, a portion or even all of the gain would be converted from capital gain taxed at the lower rate of 15% to ordinary income taxed at the taxpayer’s highest marginal tax rate. Excess depreciation is the “excess of the actual amount of accelerated deprecation over the amount that would be deductible under the straight-line method.” (Pope, Anderson, and Kramer 2008, 13-12 – 13-13) Accelerated depreciation refers to the double-declining (200%) or 150% declining balance methods of depreciation. For example, using the 200% DB method of depreciation in our example above would result in a deduction of $51,282 ($25,641*2) in year 1 and in this case the excess is $25,641 and would be taxed as ordinary income.
Since all real property placed in service after 1986 is required to be depreciated using the straight-line method, Sec. 1250 depreciation recapture rarely comes into play. Congress therefore enacted the Unrecaptured Sec. 1250 gain rule. This rule states that any long-term capital gain resulting from the sale or disposition of Sec. 1250 property “due to depreciation other than excess depreciation is unrecaptured Sec. 1250 gain taxed at a maximum rate of 25%.” (Pope, Anderson and Kramer 2008, 13-12) Basically, that portion of the gain due to depreciation deductions would be taxed at the 25% rate rather than the current capital gains rate of 15%. While depreciation does provide positive benefits to the taxpayer during the holding period of an asset, it can get cost one in the end.


Sec. 1031 Exchanges

This brings up the biggest tax advantage for holding real estate assets in one’s portfolio, and it is known as the Sec. 1031 exchange. Sec. 1031 of the Internal Revenue Code covers like-kind exchanges, and this provision of the code allows taxpayers to defer the tax on the capital gain resulting from the sale or disposition of real property. In order to qualify for Sec. 1031 treatment the Code specifies that replacement “property be identified and that exchange be completed not more than 180 days after transfer of exchanged property”.[iii] The taxpayer has 45 days after disposition of property to identify the replacement property and complete this exchange in 180 days.[iv] If this requirement is not met then the benefit of Sec. 1031 is lost and any gain would be taxable with the provisions for depreciation recapture in full effect.
Note that this is a tax deferred exchange and not a tax free exchange. The gain on the sale is deferred in that the basis of the new property is written down by the amount of the gain. In our example above, suppose that our investors sold the property that they purchased for $1,000,000 at a gain of $500,000, and entered into a non-taxable exchange by acquiring a like-kind asset for $2,000,000. The purchase price of $2,000,000 would be adjusted downward by $500,000 and the new property would have a tax basis of $1,500,000. If this property were later sold for $2,500,000, the resulting gain would be $1,000,000, not $500,000. Through this provision of the Code taxpayers are able to shield capital gains from taxation and increase cash flow available for other investments. In this case our investors saved $75,000 ($500,000*0.15) in taxes by utilizing Sec. 1031. Another benefit of Sec. 1031 is that it can be used indefinitely. A taxpayer can roll over real estate assets multiple times thereby shielding income from taxes, and in the event of death, if the taxpayer is still in possession of a 1031 asset, this asset can be bequeathed to an heir. In this event, the basis in the asset would be adjusted to fair market value thereby excluding the accumulated capital gains from taxation. Sec. 1031 tax deferred exchanges are very powerful tools for increasing wealth, cash flows, and also very useful in estate planning.


Conclusion

Real estate investing offers many tax advantages for the small taxpayer. Among these benefits are depreciation, Sec. 1031 like-kind exchanges, and the preferential treatment of capital gains over ordinary income. Investing in real estate can be a vital part of the overall financial plan of any investor seeking to provide both current income and for maximizing one’s wealth. In addition, real estate can be used in estate planning and passing on one’s legacy to heirs, thereby contributing to the continued prosperity of one’s family.

Footnotes
[i] The following discussion of passive activity limitations assumes that the taxpayer is not engaged in a real property trade or business and does not actively participate in rental real estate activities. In the event of active participation, the taxpayer may offset up to $25,000 of non passive income with passive activity losses generated from rental real estate activities. See Code Sec. 469 (i).
[ii] See for example, http://www.mortgage-investments.com/Investors_in_Real_Estate/tax_benefits_of_owning_investment_real_estate.htm, http://www.christinawhipple.com/General-Interest/Real-Estate-Investing-Generates-Big-Tax-Benefits.html, http://www.therealestatefoundation.com/investing-benefits/investment-real-estate-tax-shelter/, and http://www.inman.com/buyers-sellers/columnists/real-estate-investing-generates-big-tax-benefits.
[iii] Code Sec. 1031(a)(3).
[iv] Code Sec. 1031(a)(3)(A) and Sec. 1031(a)(3)(B).

Bibliography
Greer, Gaylon E. and Michael D. Farrell, “Investment Analysis for Real Estate Decisions” 2nd Ed. USA: Longman Financial Services Publishing, 1988.
Kyle, Robert C. and Jeffrey S. Perry, “How to Profit from Real Estate: Investing under the New Rules.” USA: Longman Financial Services Publishing, 1988.
Masters, Nicholas. “How to Make Money in Commercial Real Estate for the Small Investor.” New York, NY: John Wiley & Sons, Inc., 2000.
Pope, Thomas R., Kenneth E. Anderson and John L. Kramer, eds. “Prentice Hall’s Federal Taxation 2008: Comprehensive.” Upper Saddle River, NJ: Pearson Prentice Hall, 2008.
Haight, G. Timothy, and Singer, Daniel D. “The Real Estate Investment Handbook.” Hoboken, NJ: John Wiley & Sons, Inc., 2005.
Wendt, Paul F. and Alan R. Cerf. “Real Estate Investment Analysis and Taxation” New York, NY: McGraw-Hill Book Company, 1969.