Apply What Youve Learned - Real Estate and High-Risk 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:

Property type	Price	Mortgage	Expected		Estimated
			Rental income	Depreciation expense	resale
			(per year)	(per year)	value
Strip shopping center	$750,000	$420,000	$90,008	$7,212	$915,000
Small apartment complex	$450,000	$202,500	$40,810	$5,727	$468,900

The first potential investment consists of a seven-store shopping center, 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 small four-unit apartment complex. $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 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.

Rental yield (%) = [((Monthly rent * 12) / 2) / Purchase price] x 100

Rental yield (%) = [(Annual rent / 2) / Purchase price] x 100

Rental yield (%) = [(Monthly rent * 12) / (Purchase price / 2)] x 100

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 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 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 shopping center is , but is for the apartment complex.

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.)

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%)	25,200	23,940	22,680	21,420
Less: Taxes (28%)
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

The net discounted return expected from an investment in the shopping centerafter deducting the cost of the investmentis .

Now perform a comparable analysis for the residential lease property:

Small apartment complex	Year 1	Year 2	Year 3	Year 4
Annual rental income	$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 (28%)	5,270	5,566	5,866	6,170
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

The net discounted return expected from an investment in the apartment complexafter deducting the cost of the investmentis .

Based on the results of your analysis, which of the following statements best reflects your decision regarding the commercial or residential lease opportunities?

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.

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.

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).

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.

Which of the following is not a tax-deductible expense for investment property?

Maintenance and repairs

Interest on a mortgage loan

Lost rent resulting from vacancies

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