1. Apply What You've Learned - Real Estate and High-Risk Investments Scenario: You are considering Investing in real estate-both for the short-term cash flows and the potential long-term capital gains-and are evaluating both a commercial lease property (such as a strip shopping center or an office building) and a residential rental property (such as several rental houses or a small apartment complex). It is likely that you will invest in only one of these properties at this time. The general data regarding these investments is as follows: Estimated resale Property type Expected Rental income Depreciation expense (per year) (per year) $95,872 $8,654 Price Mortgage value Strip shopping center $900,000 $504,000 $972,000 Small apartment complex $600,000 $270,000 $76,877 $7,636 $621,600 The first potential investment consists of a seven-store shopping center, which has a current market price of $900,000. of this amount, $225,000 represents the cost of the land, and the balance, $675,000, is attributable to buildings on the property. The second possible investment, which costs $600,000, consists of a small four-unit apartment complex. $180,000 of the investment's total price is reflects the cost of land, and the remaining $420,000 is associated with structures on the land. For both properties, you believe you can increase the rents 2% per year for each of the next four years, and expect to sell either property at the end that time. You desire a return of 7% on your investments. One of the more important considerations associated with your investment is a property's potential for generating a positive cash flow. One indicator of a property's likelihood of generating a positive cash flow is the property's rental yield. The best formula for computing a property's rental yield is: Check all that apply. Rental yield (%) = [(Annual rent / 2) / Purchase price] x 100 Rental yield (%) = [(Annual rent / 2) / Purchase price] x 100 O Rental yield (%) = [((Monthly rent * 12)/2) / Purchase price) x 100 Rental yield (%) = ((Monthly rent * 12) / (Purchase price / 2)] x 100 of the is In the equations above, the reason that the values are divided by two is that it is assumed that spent on expenses other than debt repayment. while the expected yield on the residential property is The rental yield expected on the commercial property is Based on their respective rental yields, the is the better investment. Another indicator of their relative attractiveness as an investment is each property's price-to-rent ratio. The shopping center has a price-to-rent ratio of while the corresponding ratio for the apartment complex is . Based on this data, the is the better investment. From an investor's perspective, a negative conclusion associated with an overly large ratio is that it suggests that property prices are very similarly, a discouraging explanation for an overly ratio is that rents and market prices are so close in value that a financially astute investor would rather V a given property. The loan-to-value (LTV) for the shopping center is but is for the apartment complex. Assume that your expected annual operating costs-excluding your annual depreciation expense-for the commercial property will be 35% of your annual rental income. For the residential property, the annual operating costs (excluding depreciation expense) will be 20% of your annual rental income. The interest rates of the mortgages for the commercial and residential lease properties are expected to be 6% and 4%, respectively. Given your other assumptions, complete the following two tables and then use your computations to answer several questions. Round all amounts to the nearest whole dollar. (Hint: Don't round intermediate calculations. Also, don't forget that capital gains are taxed at 15% if properties are sold for more than their original purchase price.) Strip shopping center Year 1 Year 2 Year 3 Year 4 Annual rental income $. Estimated resale value 0 0 0 Less: Annual operating expenses Less: Annual depreciation expense Less: Annual interest payments (6%) 30,240 28,728 27,216 25,704 Less: Taxes (28%) Less: Capital gains tax (15%) 0 0 0 Net profit $ $ $ Interest factor (7%) 0.9346 0.8734 0.8163 0.7629 PV of Cash flow $ $ $ Total PV of Cash flows The net discounted return expected from an investment in the shopping center-after deducting the cost of the Investment-is Now perform a comparable analysis for the residential lease property: Small apartment complex Year 1 Year 2 Year 3 Year 4 Annual rental income $76,877 $78,415 $79,983 $81,582 Estimated resale value 0 0 0 621,600 Less: Annual operating expenses 15,375 15,683 15,997 16,316 Less: Annual depreciation expense 7,636 7,636 7,636 7,636 Less: Annual interest payments (4%) 10,800 10,260 9,720 9,180 Less: Taxes (28%) Less: Capital gains tax (15%) 12,058 12,554 13,056 13,566 0 0 0 Net profit $. $ $ Interest factor (7%) 0.9346 0.8734 0.8163 0.7629 PV of Cash flow $ $ S Total PV of Cash flows $ The net discounted return expected from an investment in the apartment complex-after deducting the cost of the investment-is Based on the results of your analysis, which of the following statements best reflects your decision regarding the commercial or residential lease opportunities? As the shopping center has a NPV that is greater than that expected from the apartment complex, it is more financially sound to invest in the commercial lease property. Because the apartment complex is expected to generate a negative NPV, you should not consider making this investment. As the apartment complex has a NPV that is greater than that expected from the shopping center, it is more financially sound to invest in the residential lease property. Because the shopping center is expected to generate a negative NPV, you should not consider making this As the shopping center has a NPV that is greater than that expected from the apartment complex, it is more financially sound to invest in the commercial lease property. Because the apartment complex is expected to generate a negative NPV, you should not consider making this investment. As the apartment complex has a NPV that is greater than that expected from the shopping center, it is more financially sound to invest in the residential lease property. Because the shopping center is expected to generate a negative NPV, you should not consider making this Investment. Given that the apartment complex has a NPV that is greater than that expected to be generated by the shopping center, you should prefer to invest in the residential lease property. Based on the numbers alone, you should prefer an investment in the shopping center since it has a net present value that is greater than that expected from the residential lease property (apartment complex). Which of the following is not a tax-deductible expense for investment property? Lost rent resulting from vacancies Interest on a mortgage loan Maintenance and repairs Tax-deductible expenses an investment's taxable income, and the return on your investment. 1. Apply What You've Learned - Real Estate and High-Risk Investments Scenario: You are considering Investing in real estate-both for the short-term cash flows and the potential long-term capital gains-and are evaluating both a commercial lease property (such as a strip shopping center or an office building) and a residential rental property (such as several rental houses or a small apartment complex). It is likely that you will invest in only one of these properties at this time. The general data regarding these investments is as follows: Estimated resale Property type Expected Rental income Depreciation expense (per year) (per year) $95,872 $8,654 Price Mortgage value Strip shopping center $900,000 $504,000 $972,000 Small apartment complex $600,000 $270,000 $76,877 $7,636 $621,600 The first potential investment consists of a seven-store shopping center, which has a current market price of $900,000. of this amount, $225,000 represents the cost of the land, and the balance, $675,000, is attributable to buildings on the property. The second possible investment, which costs $600,000, consists of a small four-unit apartment complex. $180,000 of the investment's total price is reflects the cost of land, and the remaining $420,000 is associated with structures on the land. For both properties, you believe you can increase the rents 2% per year for each of the next four years, and expect to sell either property at the end that time. You desire a return of 7% on your investments. One of the more important considerations associated with your investment is a property's potential for generating a positive cash flow. One indicator of a property's likelihood of generating a positive cash flow is the property's rental yield. The best formula for computing a property's rental yield is: Check all that apply. Rental yield (%) = [(Annual rent / 2) / Purchase price] x 100 Rental yield (%) = [(Annual rent / 2) / Purchase price] x 100 O Rental yield (%) = [((Monthly rent * 12)/2) / Purchase price) x 100 Rental yield (%) = ((Monthly rent * 12) / (Purchase price / 2)] x 100 of the is In the equations above, the reason that the values are divided by two is that it is assumed that spent on expenses other than debt repayment. while the expected yield on the residential property is The rental yield expected on the commercial property is Based on their respective rental yields, the is the better investment. Another indicator of their relative attractiveness as an investment is each property's price-to-rent ratio. The shopping center has a price-to-rent ratio of while the corresponding ratio for the apartment complex is . Based on this data, the is the better investment. From an investor's perspective, a negative conclusion associated with an overly large ratio is that it suggests that property prices are very similarly, a discouraging explanation for an overly ratio is that rents and market prices are so close in value that a financially astute investor would rather V a given property. The loan-to-value (LTV) for the shopping center is but is for the apartment complex. Assume that your expected annual operating costs-excluding your annual depreciation expense-for the commercial property will be 35% of your annual rental income. For the residential property, the annual operating costs (excluding depreciation expense) will be 20% of your annual rental income. The interest rates of the mortgages for the commercial and residential lease properties are expected to be 6% and 4%, respectively. Given your other assumptions, complete the following two tables and then use your computations to answer several questions. Round all amounts to the nearest whole dollar. (Hint: Don't round intermediate calculations. Also, don't forget that capital gains are taxed at 15% if properties are sold for more than their original purchase price.) Strip shopping center Year 1 Year 2 Year 3 Year 4 Annual rental income $. Estimated resale value 0 0 0 Less: Annual operating expenses Less: Annual depreciation expense Less: Annual interest payments (6%) 30,240 28,728 27,216 25,704 Less: Taxes (28%) Less: Capital gains tax (15%) 0 0 0 Net profit $ $ $ Interest factor (7%) 0.9346 0.8734 0.8163 0.7629 PV of Cash flow $ $ $ Total PV of Cash flows The net discounted return expected from an investment in the shopping center-after deducting the cost of the Investment-is Now perform a comparable analysis for the residential lease property: Small apartment complex Year 1 Year 2 Year 3 Year 4 Annual rental income $76,877 $78,415 $79,983 $81,582 Estimated resale value 0 0 0 621,600 Less: Annual operating expenses 15,375 15,683 15,997 16,316 Less: Annual depreciation expense 7,636 7,636 7,636 7,636 Less: Annual interest payments (4%) 10,800 10,260 9,720 9,180 Less: Taxes (28%) Less: Capital gains tax (15%) 12,058 12,554 13,056 13,566 0 0 0 Net profit $. $ $ Interest factor (7%) 0.9346 0.8734 0.8163 0.7629 PV of Cash flow $ $ S Total PV of Cash flows $ The net discounted return expected from an investment in the apartment complex-after deducting the cost of the investment-is Based on the results of your analysis, which of the following statements best reflects your decision regarding the commercial or residential lease opportunities? As the shopping center has a NPV that is greater than that expected from the apartment complex, it is more financially sound to invest in the commercial lease property. Because the apartment complex is expected to generate a negative NPV, you should not consider making this investment. As the apartment complex has a NPV that is greater than that expected from the shopping center, it is more financially sound to invest in the residential lease property. Because the shopping center is expected to generate a negative NPV, you should not consider making this As the shopping center has a NPV that is greater than that expected from the apartment complex, it is more financially sound to invest in the commercial lease property. Because the apartment complex is expected to generate a negative NPV, you should not consider making this investment. As the apartment complex has a NPV that is greater than that expected from the shopping center, it is more financially sound to invest in the residential lease property. Because the shopping center is expected to generate a negative NPV, you should not consider making this Investment. Given that the apartment complex has a NPV that is greater than that expected to be generated by the shopping center, you should prefer to invest in the residential lease property. Based on the numbers alone, you should prefer an investment in the shopping center since it has a net present value that is greater than that expected from the residential lease property (apartment complex). Which of the following is not a tax-deductible expense for investment property? Lost rent resulting from vacancies Interest on a mortgage loan Maintenance and repairs Tax-deductible expenses an investment's taxable income, and the return on your investment