1. Apply What Youve Learned - Real Estate Investments

Scenario: You are considering investing in real estateboth for the short-term cash flows and the potential long-term capital gainsand 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:

The first potential investment consists of an office building with ten offices, which has a current market price of $800,000. Of this amount, $200,000 represents the cost of the land, and the balance, $600,000, is attributable to buildings on the property. The second possible investment, which costs $650,000, consists of a tract of land containing three rental houses. $195,000 of the investment's total price is reflects the cost of land, and the remaining $455,000 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 propertys potential for generating a positive cash flow. One indicator of a propertys likelihood of generating a positive cash flow is the propertys rental yield. The best formula for computing a propertys rental yield is: Check all that apply.

In the equations above, the reason that the values are divided by two is that it is assumed that _________ of the _________ is spent on expenses other than debt repayment.

The rental yield expected on the commercial property is__________ , while the expected yield on the residential property is ___________ . Based on their respective rental yields, the ____________ is the better investment.

Another indicator of their relative attractiveness as an investment is each propertys 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 investors 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_________ a given property.

The loan-to-value (LTV) for the office building is _______ , but is ____________ for the rental homes tract.

Assume that your expected annual operating costsexcluding your annual depreciation expensefor 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: Dont round intermediate calculations. Also, dont forget that capital gains are taxed at 15% if properties are sold for more than their original purchase price.)

Tax-deductible expenses __________ an investments taxable income, and____________ the return on your investment.

Estimated resale value Property type Small office building Price $800,000 $650,000 Mortgage $448,000 $292,500 Expected Rental income Depreciation expense (per year) (per year) $136,016 $7,692 $91,281 $8,273 $912,000 $685,100 Rental homes Rental yield (%) = [((Monthly rent* 12)/2) / Purchase price] x 100 Rental yield (%) = [(Monthly rent * 12) / (Purchase price / 2)] x 100 Rental yield (%) = [(Annual rent / 2) / Purchase price] x 100 Year 1 Year 2 Year 3 Year 4 Small office building Annual rental income Estimated resale value 0 Less: Annual operating expenses Less: Annual depreciation expense Less: Annual interest payments (6%) 26,880 25,536 24,192 22,848 0 Less: Taxes (25%) Less: Capital gains tax (15%) 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 office building-after deducting the cost of the investmentis Now perform a comparable analysis for the residential lease property: Rental homes Year 1 Year 2 Year 4 Year 3 $94,969 Annual rental income $91,281 $93,107 $96,868 Estimated resale value 685,100 19,374 18,256 18,621 18,994 Less: Annual operating expenses Less: Annual depreciation expense 8,273 8,273 8,273 8,273 Less: Annual interest payments (4%) 11,115 11,700 13,263 0 10,530 14,293 0 9,945 14,819 13,775 Less: Taxes (25%) Less: Capital gains tax (15%) Net profit Interest factor (7%) PV of Cash flow Total PV of Cash flows 0.9346 0.8734 0.8163 0.7629 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 or residential lease opportunities? 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. O 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 (the 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. 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. Which of the following is not a tax-deductible expense for investment property? The repayment of principal on a mortgage loan Depreciation Capital improvements Estimated resale value Property type Small office building Price $800,000 $650,000 Mortgage $448,000 $292,500 Expected Rental income Depreciation expense (per year) (per year) $136,016 $7,692 $91,281 $8,273 $912,000 $685,100 Rental homes Rental yield (%) = [((Monthly rent* 12)/2) / Purchase price] x 100 Rental yield (%) = [(Monthly rent * 12) / (Purchase price / 2)] x 100 Rental yield (%) = [(Annual rent / 2) / Purchase price] x 100 Year 1 Year 2 Year 3 Year 4 Small office building Annual rental income Estimated resale value 0 Less: Annual operating expenses Less: Annual depreciation expense Less: Annual interest payments (6%) 26,880 25,536 24,192 22,848 0 Less: Taxes (25%) Less: Capital gains tax (15%) 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 office building-after deducting the cost of the investmentis Now perform a comparable analysis for the residential lease property: Rental homes Year 1 Year 2 Year 4 Year 3 $94,969 Annual rental income $91,281 $93,107 $96,868 Estimated resale value 685,100 19,374 18,256 18,621 18,994 Less: Annual operating expenses Less: Annual depreciation expense 8,273 8,273 8,273 8,273 Less: Annual interest payments (4%) 11,115 11,700 13,263 0 10,530 14,293 0 9,945 14,819 13,775 Less: Taxes (25%) Less: Capital gains tax (15%) Net profit Interest factor (7%) PV of Cash flow Total PV of Cash flows 0.9346 0.8734 0.8163 0.7629 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 or residential lease opportunities? 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. O 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 (the 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. 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. Which of the following is not a tax-deductible expense for investment property? The repayment of principal on a mortgage loan Depreciation Capital improvements