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REALIZATION RISKS

admin — Sun, 28 Mar 2010 15:50:53 +0000

First order price risks show themselves in their impact on the appraised value of holdings on the basis of marking their value to market prices. This does not take into account whether such values could actually be realized and how quickly. Specific realization risks include the following:

Liquidity and price impact. Liquidity and price impact risks are determined by the size of a bank’s position in a particular financial instrument against its trading volume. When liquidity is relatively thin and the position relatively large unwinding the position may have a direct adverse impact on market prices for the instrument. It is possible to unwind, liquidate or hedge positions virtually instantaneously in certain positions, such as foreign exchange, where markets are very deep. Other positions may be virtually impossible to unwind quickly. OTCs, for example, usually have only one market-maker and the holders of such contracts are exposed to both price impact and liquidity risks. Scheduled trading hours. Some markets, such as the foreign exchange market, are open for trading 24 hours a day, 7 days a week around the year. This is not the case with many exchanges that have definite trading hours, are usually closed at weekends and on local public holidays. Stock markets in some emerging markets open only one morning a week! Automatic dampers. Automatic dampers exist in many markets and are intended to stabilize prices of stocks that have gone into freefall. Trading in individual stocks is suspended when they fall by a specified amount (often referred to as limit-down) in a single trading session. Trading resumes after a defined cool-down period. In some markets other restrictions exist such as the prohibition of shorting stocks when prices are falling. Exchange suspension. In extreme circumstances exchanges, financial regulators or governments may act to suspend trading on exchanges or to prohibit certain otherwise legitimate financial transactions. Exchanges may be closed as a result of panic selling or for other reasons such as civil disorder or terrorist action. Stock markets in countries with tropical climates
are often forced to close as a result of natural weather conditions such as hurricanes or typhoons.
Market crashes. When prices of financial instruments fall sharply this can trigger further selling as a result of margin calls and prices hitting trigger levels of automated computer trading systems. In many market crashes trading volumes rise sharply and then collapse. At these moments of exceptionally high volumes exchange systems’ capacity is tested to the limits. If an exchange’s trading system crashes then all trading activities will grind to a halt. Settlement failures. Even when trades can be completed there remains the risk that they cannot be settled. Back-office settlement systems, both human and automated, are severely tested at these times. Most settlement failures require human intervention to resolve and may also have a knock-on effect with one failure leading to successive failures. It can take days to clear such backlogs. Counterparty risks. Counterparty risks are an ever-present concern for banks. Losses experienced by counterparties from a widespread collapse in asset prices may affect their ability to make the payments due on their trades and other exposures they have with the bank.
In “normal” circumstances realization risks need to be managed but are rarely the source of material losses. When markets crash, however, they become of vital importance. Realization risks are highest when their potential impact is greatest.

Net Operating Income

admin — Sat, 07 Mar 2009 09:40:16 +0000

Here’s a fast trick that many experienced investors use to estimate a potential value for an income-generating property. Multiply the annual net operating income (NOI) by ten; that will give you a very rough estimate value based on income for the property. Of course, this doesn’t work for hot or depressed areas.
The key in such a method is determining the net operating income. We begin with the gross income, which includes all revenues generated by the property. Gross income would include rent, laundry income, late fees and parking charges. From this gross income, we would subtract the operating expenses.
The NOI is the gross income minus the operating expenses (discussed above). Again, the NOI does not include mortgage and other debt servicing payments in its calculation. As noted above, the NOI also does not take into account capital improvements and acquisition costs. The operative term is “operating”: the net operating income consists of the gross operating income minus the operating expenses.

Carrying Costs

admin — Sat, 07 Mar 2009 09:38:51 +0000

Speculators and real estate investors who purchase property with the primary goal of reselling for profit must be especially concerned with the project’s carrying costs. Carrying costs refer to the net amount of expenditures that investors must outlay before the property is resold and profits are realized. The carrying cost usually excludes the purchase price and deducts operating income.
Unfortunately, uninformed real estate investors often look at just the purchase and resell prices. On the surface, buying a property for $100,000 and reselling it for $150,000 would seem like a no-brainer. This transaction, however, would be a disastrous decision if the carrying costs came to $60,000. Savvy investors know that the purchase price is only part of the total expenses required by a real estate investment. Carrying costs include the operating expenses, as well as the acquisition costs, mortgage payments, capital improvements and selling costs.
For example, you may be looking to buy a seemingly undervalued house for $100,000 and resell it within six months for $120,000. That would seem like a reasonable investment for a $20,000 profit.

Rule of thumb for quick buy-resale. In most cases, you must resell your property for a new price at least 11% more than your purchase price just to break even. Think about it! When you bought it, you probably had the typical total closing costs of about 3% of the purchase price. When you resell it, you can usually expect about 1.5% to 2% closing costs. On top of that, average commissions to real estate brokers will be about 5.5%. This doesn’t include the cost of your time or the lost interest income you would have been earning off the money you took out of your savings to make the down payment for the purchase. This rule of thumb also assumes that you sell it right away. Every day you have to wait to re-sell the property mean additional costs!
Understanding carrying costs is often the difference between success and failure as a real estate investor, particularly for speculators. Actually, a savvy investor may still be able to make the above project work by successfully eliminating some of the expenses and/or increasing income. For example, the investor may decide to rent out the garage for storage and the house to seasonal renters for additional income of $5,000 over six months. That would make it a more profitable endeavor. But be careful nevertheless.

Operating Expenses

admin — Sat, 07 Mar 2009 09:35:50 +0000

As the name suggests, operating expenses includes all regular expenses associated with the running of the property. They include scavenger (trash collection), janitorial, maintenance and management services, as well as utilities, fees, service contracts, supplies, taxes, insurance and advertising. The underlying theme to operating expenses is that they are costs involved with the day-to-day operations of the investment. It is also necessary for the beginning investor to understand the difference between operating expenses and those expenditures for the property that are not operating expenses. Just because you spend money on your property does not make that expenditure an operating expense. Understanding this difference could mean thousands of dollars in additional cash refunds from your tax withholdings.
You must remember that operating expenses do not include mortgage payments and other debt servicing. Not all properties have mortgage lien against them; and mortgages are actually part of the acquisition cost—not the operating cost. The following is a breakdown of typical costs which are considered operating expenses and others that are not.
Operating Expenses:

Maintenance and janitorial
Repair and decoration
Service contracts
Supplies
Scavenger services
Management fees
Accounting and administrative services
Advertising and leasing services
Insurance premiums
Real estate and corporate taxes
Government fees and licenses
Utilities (paid by owner)

Non-Operating Expenses:

Acquisition (closing) costs
Mortgages and debt servicing
Capital improvements
Equipment and fixtures
Marketing, selling costs

As you can see, capital improvements are separated from operating expenses. Unlike repairs, which serve to maintain the property’s current value, capital improvements are additional investments made to the property that will increase its value. For example, building additions, major renovations and installation of a security system are considered capital improvements, because they add to the value of the property. This distinction between repairs and capital improvements becomes very important when income taxes and capital gains come into play. Accurate identification of operating expenses is important for real estate investors, primarily because the operating expenses are necessary to determine the net operating income. Investors who are investing in real estate for its cash flow and income profits need to examine operating expenses carefully. Operating expenses are those costs that the investor can reasonably expect during the ownership of the property. A property’s income stream and operating profits are improved in one of two ways: increasing revenue or lowering operating expenses. Experienced investors will often focus on the operating expenses—looking for potential reductions and savings—when analyzing a potential cash flow investment. Another advantage with understanding the difference involves actual dollars and cents you can get through depreciation . The building (though not the land), fixtures and equipment can be depreciated.