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: Expected Estimated Rental income Property type Small office building Rental homes $450,000 Price Mortgage $750,000 $420,000 $202,500 (per year) $90,008 Depreciation expense (per year) $7,212 resale value $915,000 $40,810 $5,727 $468,900 The first potential investment consists of an office building with ten offices, which has a current market price of $750,000. of this amount, $187,500 represents the cost of the land, and the balance, $562,500, is attributable to buildings on the property. The second possible investment, which costs $450,000, consists of a tract of land containing three rental houses. $135,000 of the investment's total price is reflects the cost of land, and the remaining $315,000 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 9% 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 (%) -[((Monthly rent 12)/2)/ Purchase price] x 100 Rental yield (%) [(Annual rent/2)/ Purchase price] x 100 Rental yield (%) - [(Monthly rent/2)/ Purchase price] x 100 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. of the The rental yield expected on the commercial property is Based on their respective rental yields, the while the expected yield on the residential property is is the better investment. Another indicator of their relative attractiveness as an investment is each property's price-to-rent ratio. The office building has a price-to-rent ratio of , while the corresponding ratio for the rental homes tract 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 Similarly, a discouraging explanation for an overly ratio is that rents and market prices are so close in value that a are very financially astute investor would rather The loan-to-value (LTV) for the office building is but is a given property. for the rental homes tract. 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.) Small office building Annual rental income Estimated resale value Less: Annual operating expenses Less: Annual depreciation expense Year 1 $ Year 2 Year 3 0 Year 4 Less: Annual interest payments (6%) 25,200 23,940 22.680 21,420 Less: Taxes (25%) Less: Capital gains tax (15%) 0 0 Net profit $ S Interest factor (9%) 0.9174 0.8417 0.7722 0.7084 PV of Cash flow S $ $ Total PV of Cash flows i S The net discounted return expected from an investment in the office building-after deducting the cost of the investment-is Now perform a comparable analysis for the residential lease property: Rental homes Annual rental income: Year 1 Year 2 Year 3 Year 4 $40,810 $41,626 $42,459 $43,308 Estimated resale value 0 0 0 468,900 Less: Annual operating expenses 8,162 8,325 8,492 8,662 Less: Annual depreciation expense 5,727 5,727 5,727 5,727 Less: Annual interest payments (4%) 8,100 7,695 7,290 6,885 Less: Taxes (25%) 4,705 4,970 5,238 5,509 Less: Capital gains tax (15%) 0 0 0 Net profit $ $ Interest factor (9%) 0.9174 0.8417 0.7722 0.7084 PV of Cash flow $ Total PV of Cash flows S The net discounted return expected from an investment in the rental homes tract-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 of opportunities? Based on the numbers alone, you should prefer an investment in the office building since it has a net present value that is greater than that expected from the residential lease property (rental homes tract). As the office building has a NPV that is greater than that expected from the rental homes tract, it is more financially sound to invest in the commercial lease property. Because the rental homes tract is expected to generate a negative NPV, you should not consider making this investment. O Given that the rental homes tract has a NPV that is greater than that expected to be generated by the office building, you should prefer to invest in the residential lease property. As the rental homes tract has a NPV that is greater than that expected from the office building, it is more financially sound to invest in the residential lease property. Because the office building is expected to generate a negative NPV, you should not consider making this investment. Which of the following is not a tax-deductible expense for investment property? The repayment of principal on a mortgage loan O Capital improvements Depreciation Tax-deductible expenses an investment's taxable income, and the return on your investment