Real Estate Investment & Finance (Discussion Questions)
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. What would you like to do?
List the seven valuation criteria specific to real property.
- -Location and Construction
- -Production of Growth Capital
- -Production of Income
- -Response to Change
- -Enhancement of Activities Within a Building
Define investment ROI and capital ROI.
Depending on the type of investment and the goal of the investors, consideration is given to investment ROI (the return on the investment while it is being held) and/or to capital ROI (the return on the investment when they are done with it). Investment ROI may be considered cash flow, such as monies received as interest on a savings account or from a stock dividend. Capital ROI results from an investment's appreciation in value; art or sculpture, for example, would not have a cash flow but may increase significantly over a period of time.
Investment ROI - The return on an investment while it is being held.
Capital ROI - The return on an investment as appreciation in value over a period of time.
List the four standard financial evaluation techniques typically applied to investment / production decisions.
- The standard financial evaluation techniques typically applied to investment/production decisions include:
- -break-even analysis
- -payback analysis
- -net present value analysis
- -internal rate of return
Define utility and scarcity as they relate to real estate.
Utility: Real estate has the power of an economic good. It fills a human need or provides a desired service.
Scarcity: Real estate is limited. The quantity of land on planet Earth is fixed with little possiblity of creating more.
List the four government powers that affect real estate.
Government exerts significant influence over privately held real estate through zoning regulations and what has come to be called the four governmental powers doctrine.
The four governmental powers are:
1. Taxation: The right of state and local governments to collect money from real estate owners based on value. These taxes are called ad valorem levies.
2. Eminent Domain: The right of a government or properly authorized entity to take private property for public use. The right of eminent domain is exercised through a condmenation process, and the owner must be justly compensated for the taking of the property.
3. Escheat: The right of a government to take title to private property in the absence of legal heirs.
4. Police Power: The right of government to regulate the use of private property in the interest of public welfare, seafty, health, and morality.
What is the Rule of 72?
The Rule of 72 is an approximation of how many years will be required to double a capital investment. It is determined by dividing the yield into the number 72.
Assume you intend to make an investment and that you will leave the interest earned on that investment to accumulate as capital, that is, to compound. An example might be a certificate of deposit with a yield of 8% per annum. By dividing the yield (8 in this case) into the number 72, you will will have an approximation of how many years (9 in this example) will be required to double the amount of your original capital. Although the results are approximate, the effect of compounding is readily apparent.
Define yield and equity.
The total return on an ivnestment during the period it is held is called the yield. Generally, investments that emphasize yield produced over the holding period seek short-term goals, and those investments that emphasize appreciation seek long-term goals. High-yield and high-appreciation investments tend to feature low safety of principal.
The ability to sell an investment quickly for cash determines its liquidity. Liquidity is highly dependent on orderliness and stability in the secondary marketplace. Unexpected events often play a role in the liquidity of a particular investment. The closure of a lender, a bankruptcy, or a weakening in the real estate or securities markets can affect both price and liquidity. To be liquid, an investment must have a recognized market and there must be a pool of willing purchasers.
What is the business cycle?
Every individual, business, and political entity experiences periods of prosperity and ndeprivation, and periods of economice ascent and decline. Alternating periods of expansion and decline in economic activity make up a business cycle. Business activity cycles and recycles throughout the life of a market-driven economy. These cycles take place on microeconomic and macroeconomic levels.
List and explain three ways that the Federal Reserve System can affect interest rates.
The Federal Reserve System can affect interest rates by three means:
1. Jawboning - The process of jawboning is nothing more than using publications and other media to influence expectations. The manipulation of expectations, even in the public interest, is difficult, and jawboning is the least effective way to influence interest rates.
2. Discount Window Operations - When a commercial bank is not able to immediately meet an increased reserve requirement with cash or equivalents, the affected bank can borrow the necessary additional reserves from the district Federal Reserve Bank itself. This borrowing activity is known as discount window operations.
3. Open Market Operations - Open market operations are frequently used by the Federal Reserve to influence interest rates. Simply described, open market operations are the buying and selling of US treasury securities to vary the size of the money supply.
List the four principal methods of describing and demarcating real estate.
- The principal methods of describing real estate are:
- -The US Rectangular Survey System
- -The lot and block system
- -The metes and bounds system
- -The geodetic survey system
List the advantages and disadvantages of corporate ownership.
- The following are some of the advantages of corporate ownership:
- -Limited financial liability
- -Sound management
- -Company stability
- -Shareholder flexibility
- -More financial options
- Disadvantages include:
- -Double taxation
- -Limitations on capital accumulation
- -Extensive administrative paperwork
What are the two basic forms of REIT (real estate investment trust), and how does a REIT avoid paying income tax?
The two basic forms of REITs are equity trusts and mortgage trusts. Equity trusts are created for real estate ownership. This type of trust may use leverage or it may remain unleveraged. Mortgage trust REITs are organized to provide real estate financing of virutually all types , including long-term mortgages.
REITs pay no income tax on profits as long as the REIT pays a minimum of 95% of its profits annually to the holders of its shares of beneficial interest. The income received from the trust is thereby taxed one time only, as income to its owners.
List the six types of data necessary for accurate real estate evaluation.
- -Income and expense data
- -Market data
- -Physical data
- -Cost data
- -Financing data
- -Regulatory and miscellaneous data
Using the algebraic system of logic, solve the following problem: 7 - 3 + 2 x 4
7 - 3 + (2 x 4) = 12
Using the Polish Notation Logic, solve the following problem: 7 - 3 + 2 x 4
7 [enter] 3 [-] 2 [enter] 4 [x] [+] (result) 12
What are the four variables that affect the principal and interest portion of loan payments?
- Amortization Term [N]
- Interest Rate [I/YR]
- Principal Amount [PV]
- Periodic Payment [PMT]
Calculate the monthly payment amount of a 9% loan amortized over 30 years if the principal balance is $645,000.
- 1. [gold] [C ALL]
- 2. 12 [gold] [P/YR]
- 3. 9 [I/YR]
- 4. 30 [gold] [x P/YR]
- 5. 645000 [PV] [PMT]
- Result: -5,189.82
With a $645,000 loan with 9% interest amortized over 30 years, calculate the principal balance after one year.
Briefly define the highest and best use as it relates to real estate.
Highest and best use is that use of the land or improved real property that produces the greatest return. The true value of real estate is based on the market's perceiption of its most proper, probable, and profitable use. Also referred to as typical and most probable use, highest and best use is the appraiser's opinion of the property may be used to create the highest value.
List the ten criteria used to test the highest and best use of a property.
- 1. Legality
- 2. Profitability
- 3. Financial Feasibility
- 4. Physical Probability
- 5. Reasonableness
- 6. Environmental Acceptance
- 7. Appropriateness
- 8. Compatibility
- 9. Possibility
- 10. Competitive Uses
What is the difference between a gross lease and a net lease?
Gross leases require that the lessee pay a fixed rent to the landlord, and that the landlord then pay all operating expenses related to the proeprty. Net leases require that the tenant pay some or all of the operating expenses of the property.
What is a ground lease?
When a tenant leases a parecel of vacant land and pays for all improvements made on the site, the tenant does this in accordance with a ground lease. Typically, the rent received by the landowner also covers operating expenses.
Define cash-on-cash retrun, return on equity, and internal rate of return.
Masurement of cash-on-cash return, which is sometimes called the equity-dividend ratio, does not involve complex calculations. It is determineed by dividing all income received from an economic activity by the actual cash invested. This method can be easily calculated on both an annualized or total return basis.
Compare general and specific data.
General data refers to social, economic, governmental, and environmental trends that affect property value. This includes information on job growth or decline, changes in population, housing starts, and occupancy statistics.
Specific data refers to the information on the property (or its comparables) being appraised. This research relates to facts about the property's location, construction, condition, operation, financing, zoning, access, and tenancy.
Briefly explain what the market comparison approach to value is.
The market comparison technique of valuing a property uses information on sales of comparable properties. It is especially useful when there have been recent transactions for similar buildings. The principle of substitution influences value because it assumes that a purchaser will pay no more for a property than for the cost of a similar one with equal utility.
- The art in this approach is identifying comparable sold properties and obtaining correct information about the transactions. Comparables are then adjusted based on the following six general categories:
- 1. Time of Sale
- 2. Financing
- 3. Location
- 4. Site Characteristics
- 5. Improvement Characteristics
- 6. Unusual Conditions
Briefly explain what the cost approach to value is.
Through the cost approach to value, the appraiser determines the construction and land costs required to build a property with similar utility. The basic principle relates to the principle of substitution - a rational, informed purchaser will pay no more for a property than for the cost of producing a substitute building with equivalent utility and without undue delay.
- Three basic components are used to calculate value with the cost approach.
- 1. Determine the value of the vacant land.
- 2. Estimate construction costs of the physical structures
- 3. Subtract actual depreciation of the physical structures.
- Depreciation is used here to represent actual loss in value due to some cause or condition. It is not merely an accounting formula, but rather, it consists of the following three specific areas of depreciation:
- 1. Physical Deterioration
- 2. Functional Obsolescence
- 3. Economic or External Obsolescence
Define income capitalization and explain the IRV formulas.
The income capitalization approach is the process of converting NOI into a value estimate. Any rate that is applied to income and results in a capitalized figure is a capitalization rate. These rates are subject to change over time as they develop in the marketplace and are affected by local economic conditions and real estate practices. it is the appraiser's job to select a typical capitalization rate because the rate will markedly affect the value estimation.
Calculations are made using the elements of the IRV formulas - (I) Income, (R) Rate, and (V) Value - which solve for one of the elements if the other two factors are known. To find the market capitalization rate, the appraiser uses the following formula: R = I / V. Note that if any two of these factors are known, the third can be found; thus, an investor, appraiser, or other practitioner is also able to determine what fair and realistic price he or she should pay for a property in order to earn a return on the investment which is comparable with the typical market return. The valuer is also able to determine, based on market capitalization rates and the price paid for a property, whether or not the property's NOI is below or above average.
Define capitalization rate.
An income rate that reflects an investor's analysis of risk. It is used to convert a single year's net operating income expectancy into a price or value. An investor's cap rate is also considered the desired rate of return. Also called the cap rate.
Define building residual technique.
This real estate appraisal technique attempts to evaluate the income stream produced by a parcel of land and the improvements on it as separate entities. The building residual technique is used when an income stream attributable to the land is deducted from the property's NOI. In this case, the remaining income is the residual income attributable to the improvements. Conversely, the land residual is what remains after income attributable to the improvements is deducted from the property's NOI.
What is the main difference between the blended rate approach to investment and the weighted average cost of capital?
Because most real estate investments involve the use of leverage or significant, quantifiable opportunity costs, mortgage loan rates have a direct and profound effect upon cap rates. The typical reliance of real estate investors, on a combination of debt in relatively large proportion, and equity in relatively small proportion, makes the investor extremely sensitive to even small changes in mortgage loan rates. The combined use of mortgage loan and equity funding sources allows us to derive a cap rate through a blend of the mortgage loan cost and yield expectations of the investor.
The weighted average cost of capital (WACC) is capable evaluating the cost and tax implications of borrowed funds. it is also capable of calculating the cost of using equity funds and the impact of flotation costs upon the firm or a specific project. The WACC model treats the investment components in the same manner as the blended rate approach. The difference is that taxation and flotation impacts can be included.
What should an investor compare when evaluating the risk of a proposed real estate project?
Various economic cycle conditions should be compared including the probability of recession, growth or decline, and economic boom. Along with each of these, the average mortgage rate and its effect on the real estate project should be considered and compared with each stage in the economic cycle.
What are the five C's of credit?
Every properly trained loan officer knows the importance of the five C's of credit. When they are forgotten or ignored, the loan is generally in troble before it is made. The five C's of credit are:
- -Character: The borrower's moral commitment and willingness to repay the funds that are loaned.
- -Capacity: The ability of the borrower to repay the loan from normal and typical business sources.
- -Capital: The fundamental financial strength of the borrower.
- -Conditions: The condition of the economy as a whole and the present condition of the borrower's industry and market niche.
- -Collateral: The value of assets pledged to the lender as protection from loss in the event of default or conditions not anticipated when the loan was made.
What is an amortized loan?
In an amortized loan, debt service payments include both interest on the debt and principal reduction.
What is the equation for the loan constant?
Loan Constant = Annual Debt Service / Original Loan Amount
What is the debt service coverage ratio and how is it determined?
The debt service coverage ratio is a measure of the ability of a project to meet its debt service requirement. This ratio is determined by dividing the NOI during any given period of time by the debt service for the same period of time. If the ratio is 1:1, there is exactly enough NOI to meet the debt service with no margin for reduced income or greater than anticipated expenses. Similarly, a debt service coverage ratio less than 1:1 indicates there is not sufficient income to service the project debt.
What is a construction loan?
Constructino loans are extended to finance constructino of a real estate project. Typically, construction loans are made only after project feasibility studies are completed and plans and specifications have been made. The demonstrated ability to secure a commitment for permanent financing for the project may also be a condition for approvign a construction loan. Such loans are interim in character; that is, they are made for the length of time tha tis required to complete construction of the project and, perhaps, to meet a certain minimum level of leasing. Such laons are usually made in a series of advances, called draws, as construction progresses. These loans use the building under construction and the site itself as collateral.
What is a contract, and why must real estate contracts be in writing?
A contract is a legally enforceable agreement between two o more parties under which each party acquires certain rights from the other parties in the agreement. Although some contracts may be oral, contractrs for the sale of real estate must be in writing.
Explain the protection of the lender mortgage clause.
Under this clause, the mortgageee has the right, at its option, to inspect the proeprty and to take any action necessary to protect its interest.
Explain the mortgage clauses concerning acceleration and assignments of rents.
Under the acceleration clause, the lender has the right, at its option, to make the remainder of the entire debt due and payable immediately if the mortgagor fails to fulfill any of the covenants.
Under the assignments of rents clause, the lender has the right, at its optin. to directly collect rents or other compensation from the propety in the event the borrower fails to meet his or her obligations. You should note that such assignments are not enforceable in some states.
Explain kicker and bow tie loans.
The kicker loan, also called a participation loan, is defined as an additional interest payment benefit for the lender. In return for making a first mortgage loan at a favorable interest rate, the borrower agrees to pay the lender a portion of the cash flow from the property, but in the form of interest. The lender has a mortgage investment that provides higher than typical returns. The lender may also receive a portion of the increase in property value upon sale or refinance.
The bow tie, like the kicker, provides additional interest apyemtns from cash flow and also provides an equity participation in the project to the lender. Such financing can yield very high rates of return to the lender, who must be extremely careful of usury laws in the state in which the project is located. Such financing is not typical, but becomes more common during periods of high interest rates or when funds for real estate loans are scarce.
What is a convertible mortgage?
The convertible mortgage enables the lender, at its option, to convert all or part of the mortgage debt into equity in the project. The covnersion may not encompass all of the ownership, but the lender might be given a prearranged option to purchase the developer's total interest.
What is the Consumer Price Index, and how is it sometimes used in the real estate industry?
The Consumer Price Index is an attempt to statistically report the effect of inflation on the purchasing power of the US dollar. The CPI is one of the most widely cited statistics; it is therefore an easily used benchmark by which a landlord can measure and adjust rental rates to compensate for inflationary costs.
Define fixed and variable expenses.
Fixed expenses are those over which you have little control. Not that in this context, fixed does not mean unchanging. Examples of fixed expenses include insurance premiums and property taxes. Fixed expense items represent about one-third of total major building expenses in the US private sector.
Expenses that are influenced by occupancy levels and your professional management are called variable expenses. Examples of variable expenses include cleaning services, management and administration, general repairs and maintenance, roads and grounds maintenance, and utility costs. It is important to note that variable expenses may include some aspects you can control and others you cannot, such as utility costs, which may be reduced by astute energy management, but increased by utility rate hikes approved by outside parties.
Define net operating income.
The sum of all actual and probable income, less all operating expenses, is called NOI (net operating income). You must be careful to note that depreciation expense, income taxes, capital expenditures, and debt service are not considered when determining or forecasting NOI.
What is the future value of $100 at 10% interest in 7 years?
What is the present value of $100 ten years from now at a discount rate of 11.5%?
What is the future value of $125,000 compounded at 9% for four years?
Define the time value of money.
The concept of the time value of money requires that a rate of return be expected from capital invested over a period of time. Time value of money is the idea that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This core principle of finance holds that, provided money can earn interest, any amount of money is worth more the sooner it is received.
Why is the internal rate of return used and what is it particularly adaptable to?
If we want to know the actual rate of return on the investmentment, we must solve for the IRR. In this calculation, the presnt value components of the future cash flows match the initial investment. The calculation then determines the interest rate based on the remaining earned interest components of the future cash flow.s In the present value calculation, we obtain a dollar value for the total presnt value components; in the IRR calculation, we obtain an interest percentage from the earned interst components.
An IRR attempts to measure investment performance. I can be used to measure the performance of any investment during its holding period. This method of measurement is particularly adaptable to evaluating irregular income streams and periods when income is negative, such as during initial years of a venture requring substantial front-end investment.
Define net present value.
Net present value is the difference between the present value of capital outlays and the present value of all future cash flow benefits. When the initial investment is subtracted from the present value, the result is known as the NPV (net present value).
An investment of $250,000 generated the following annual cash flows. Calculate the net present value if the expected rate of return is 13%.
-Year 1: $35,000
-Year 2: $42,000
-Year 3: $45,000
-Year 4: $38,000
-Year 5: $40,000
-Year 6: $51,000
-Year 7: $57,000
-Year 8: $53,000
-Year 9: $48,000
-Year 10: $310,000
Given the conditions in the previous question, calculate the internal rate of return for that investment.
List some costs that are tax deductible for investment properties.
Tax deductions reduce taxable income, their value depends on the taxpayer's marginal tax rate, which rises with income.
The most common deductions for individuals are from home ownership. These items include mortgage interest and real property taxes.
Depreciation expense may be deducted for investment properties. Theortecially, depreciation systematically allocates the cost of a revenue-generating asset as an expense over an estimated useful life.
What are tax credits? Give some examples of them.
Tax credits directly reduce a person’s tax liability and hence have the same value for all taxpayers with tax liability at least equal to the credit. In addition, some credits are refundable; they are not limited by the taxpayer’s tax liability.
- -Rehabilitation Investment Tax Credit - Older buildings are eligible for a tax credit when they are rehabilitated, modernized, or remodeled.
- -Certified Historic Structure Tax Credit - A building can qualify for a larger tax credit for rehabilitation expenditures if it qualifies as a certified historic structure.
- -Low-Income Housing Tax Credit - Some buildigns may qualify for annual tax credits if they meet the requirements of low-income housing.
- -Energy Investment Credit - Applies to the expenses for equipment used to derive electricity from geothermal or solar sources.
- -Disabled Access Credit - Eligible for small businesses that pay or incur expenses to provide access to persons with disabilities.
- -Employer-Provided Child Care Facilities and Services Credit - 25% tax credit allowed for qualified expenses to provide employee child care.
How is capital gain calculated?
Sales Price - Adjusted Basis = Net Capital Gain
Net Capital Gain x Tax Rate = Net Tax Liability
How is the adjsuted basis arrived at?
Purchase Price + Improvements = Adjusted Basis
Explain a sale and leaseback.
Often, corporations will own their own plant, warehouse, or office building. This property may have been purchased several years in the past. Depreciation allowed under earlier accelerated depreciation methods has probably exhausted higher depreciation write-offs, while at the same time the property may have substantially appreciated in value. Sometimes in this situation, a corporation will sell its plant, warehouse, or office building but continue to occupy the facility and pay rent to the buyer. This is known as a sale and leaseback transaction.
What is a phantom gain?
- Phantom Gain refers to gain from an investment offset by the loss in the same investment. Even if the return is obvious, there is no true return on the
- investment, often because losses are not so apparent and can’t be seen at first glance.
A situation that arises when a gain on an investment is offset by a loss in the same investment, which usually comes from an income tax provision. Phantom gains are named as such because there is no actual return, although it may initially seem otherwise.
List the four general categories of physical factors (or forces that create them) that are part of a physical analysis.
- 1. Legal / Regulator Factors
- 2. Base Building Factors
- 3. Tenant Space Factors
- 4. Organizational Characteristics of Tenants or Occupants
What are the five criteria involved in physical analysis and feasibility?
- 1. Marketability
- 2. Functionality
- 3. Age
- 4. Renovation
- 5. Appropriateness
What should be kept in mind during the improvement analysis process?
- During the process of improvement analysis, you should keep the following considerations in mind:
- -Regulations and code compliance
- -The quality of materials, workmanship, and design of the improvement.
List the four stages, in order, of a property life cycle.
- The four stages in a property life cycle are:
- 1. Development
- 2. Routine Administration
- 3. Modernization / Rehabilitation / Conversion
- 4. Demolition
Define absorption rate.
The rate at which properties for sale or lease can be marketed in your locality is called the absorption rate. Low or negative absorption indicates an unhealthy prospect for new development. Conversely, high absorption rates indicate the existence of development opportunities.
What are capital expenditures and the general reasons for making them?
Strictly speaking, capital expenditures are those costs incurred by acquiring or upgrading assets that produce revenues. Capital expenditures are expected to produce a return in the form of increased value that appears on a corporate balance sheet. You should note that a capital expenditure is intended to be long-term in its contribution to revenue enhancement.
- The following are reasons for making capital investment decisions:
- -change in the volume of production
- -change to a new plant site
- -damage to equipment from outside causes
- -inadequacy of present equipment for production of product improvements
- -worker skill and learning time
- -working conditions and morale
Define life cycle costing.
- Life cycle costing is the application of systems analysis to compare alternative capital expenditures that are expected to produce benefits over a period of time greater than one year. LIfe cycle costing takes into account all of the current and future financial implications of a capital project, which include:
- -acquisition cost (capital expenditure)
- -annual expenses or savings
- -operating costs
- -maintenance costs
- -personnel expenses
- -one-time future expenses or income
- -overhaul costs
- -salvage costs
- -present value
A critical element of life cycle costing is the application of the principles of present value analysis.
What is the historical real interest rate used in life cycle costing, and when is it appropriate to set it higher?
Historically, real interest has been approximately 3% but when a firm classifies a project as high risk, or the cost of borrowing is high, it is approrpriate to use higher rates.
What are the benefits of chargeback systems?
Standard commercial real estate industry practices are used by facilities management to charge back facility-related services to internal customers. A chargeback system should fairly allocate facilties costs to the end users. The underlying principel of this system must be commercial comparability - to provide and bill services in a manner that closely approximates how tenants are addressed in the private sector.
A well-designed chargeback system can help a company become more fiscally responsible. This is primarily achieved through two primary benefits of chargeback systems - cost awareness and the elimination of the cookie-jar mentality.
What is the most critical element of any investment decision, and what is acceptance of it based on?
The most critical element of any investment decision is the willingness to accpet the risks involved. THe acceptance of such risks is based on the owner's business objectives. Each investor, whether an individual or a firm, uses a set of criteria to judge whether or not an investment is suitable in the context of these objectives.
Define core competencies.
Any successful business is created as a result of an idea or technique that produces a competitive advantage for the firm's owners and investors. The owner has learned something that others either had not realized or had failed to exploit - a niche in his or her market place - and capitalized on the opportunity. Such underpinnings of a firm are its core competencies. Exploiting core competencies simply means doing what the firm does best; that is, pursuing its advantages in the marketplace.
Briefly explain the advantages and disadvantages of the decision-making process in a firm with diffuse leadership.
Firms with diffuse leadership possess few management layers, but decision-making authority is sometimes so dispersed that investment decisions must be made by committees. By definition, committees are collaborative and labor intensive. Work can be slow and tedious. If market conditions require an immediate response, committee meetings may make the organization too cumbersome to respond quickly to opportunities that develop, and the firm may lose out. Committee work detracts from immediately profitable operations, and there may be long, costly delays in the decision process. However, committee decisions tend to favor analytical approaches to decisions and are not clouded by the judgments and prejudices of a single decision maker.
What is the proper approach when a company makes general or specific investment decisions?
There is no single best way to make either general or specific investment decisions. The approach must be specific to each company, multifaceted, adn combine all of the best analysis, planning, direction, and patience to see the investment through to a successful conclusion. An element or sheer courage is also involved in decision making. That is, taking a chance when you wish you had more information but there is no time to get it.
List the general activities that can lead to building a good reputation and retaining and attracting tenants.
- 1. Providing adequate services
- 2. Fulfilling a tenant's desire for comfort and convenience
- 3. Fostering a spirit of fair dealing
- 4. Properly using the tenant as a referral source
- 5. Using diplomacy when dealing with tenants
What would you like to do?
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