Real Estate Chapter 1

CHAPTER 1 THE NATURE OF REAL ESTATE AND REAL ESTATE MARKETS Test Problems 1. A market where tenants negotiate rent and other terms with property owners or their managers is referred to as a: b. User market 2. The market in which required rates of return on available investment opportunities are determined is referred to as the: d. Capital market 3. The actions of local, state, and federal governments affect real estate values d. All of the above 4. Approximately what portion of U.S. households own their own home? b. Approximately two-thirds 5. Of the following asset categories, which class has the greatest aggregate market value? d. Nongovernment real estate 6. Storm water drainage systems are best described as: b. Improvements to the land 7. What is the single largest asset category, in terms of value, in the portfolio of the typical U.S. household? a. Housing 8. Real estate markets differ from other asset classes by having all of the following characteristics except: d. Homogeneous product 9. Which of the following is not important to the location of commercial properties? c. Access to schools 10. Which of the following attributes of a home are the most difficult to observe and value? c. location attributes Study Questions 1. The term real estate can be used in three fundamental ways. List these three alternative uses or definitions. Solution: Real estate is most commonly defined as land and any improvements made to or on the land, including fixed structures and infrastructure components. The term is also used to describe the “bundle of rights” associated with the ownership and use of the physical characteristics of space and location. Finally, real estate may be described as the business activities related to the development, construction, acquisition, operation, and disposition of real property assets. 2. The U.S. represents about 6 percent of the earth’s land service, or approximately 2.3 billion acres. Who actually owns this land? What is the distribution of this land among the various uses (e.g., developed land, federal, land, forest land). Solution: Developed land, consisting of residential, industrial, commercial, and institutional land, represents approximately 6 percent of the total land in the U.S. Federal lands and water areas occupy about 23 percent of the land; crop land and CRP land represent about 21 percent; and pasture land comprises about 6 percent of the land. Finally, the remaining land is divided between range land and forest land, with each representing 21 percent of all U.S land. 3. Describe the value of U.S. real estate by comparing it to the values of other asset classes (e.g., stocks, bonds). Solution: As of September 2005, real estate (including owner-occupied housing, but excluding real estate held by non-real estate corporations) was the single largest asset class in the U.S., valued at approximately $23.4 trillion. Publicly traded corporate equities equated to about $17.2 trillion of the U.S. market. The value of mortgage debt is approximately $11.1 trillion. This is larger than the existing stock of both corporate and foreign bonds and the outstanding value of U.S. Treasury Securities. 4. How much of the wealth of a typical U.S. household is tied up in real estate? How does this compare to the role that assets and investments play in the portfolios of U.S. households? Solution: Real estate is the single largest asset in the typical U.S. household’s portfolio, representing approximately 30 percent of household wealth in September of 2005. In comparison, the total value of corporate stocks and mutual fund shares represents 16 percent of household assets. Pension reserves, excluding stocks, represent 17 percent of household assets. Deposits and money market funds represent 9 percent of household assets. 5. Real estate assets and markets are unique when compared to other assets or markets. Discuss the primary ways that real estate markets are different from the markets for other asset that trade in well-developed public markets. Solution: Real estate is unlike other asset classes because it is heterogeneous and immobile. Real estate assets have unique and distinctive characteristics, such as age, building design, and location. Real estate is also immobile; therefore, location is an important attribute. Because real estate assets are heterogeneous and immobile, real estate markets are localized. Potential users of real property and competing real estate are typically located in the same area or region. Additionally, real estate markets are highly segmented because of their heterogeneous nature. Therefore, potential users of a specific type of real property generally do not seek to substitute one property category for another. Finally, most real estate transactions are privately negotiated and have relatively high transaction costs. 6. Explain the role of government in real estate at the federal, state, and local level. Which has the most significant impact on real estate markets? Solution: Local government has the most influence on real estate markets. It affects the supply and cost of real estate through zoning and land use regulations, fees on new land development, and restrictive building codes. It also affects rental rates through the assessment of property taxes. Finally, local government affects the supply and quality of real estate through the provision of community infrastructure and through building codes. The Federal government influences real estate through income tax policy, housing subsidy programs, federal financial reporting requirements, fair housing laws, and disclosure laws. State government generally has the least influence on real estate. State government affects real estate through the licensing of real estate professionals, establishment of statewide building codes, the creation of fair housing and disclosure laws, and through numerous housing related subsides for low and moderate income households. In addition, the state may protect some environmentally sensitive lands from development. 7. Identify and describe the interaction of the three economic sectors that affect real estate value. Solution: The three economic sectors that influence real estate value are user markets, capital markets, and government. In real estate user markets, households and firms compete for physical location and space. This competition determines who will obtain the use of a specific property and how much will be paid for the use of this property. Capital markets provide the financial resources necessary for the development and acquisition of real estate assets. Real estate competes for resources against other investment opportunities in the capital market based on investor required rates of returns and risk considerations. Capital markets are segregated into two categories: equity interests and debt interests. Government influences the interaction between the user markets and capital markets through tax policy, regulations, provisions of services and infrastructure, subsidies and other means. 8. Real estate construction is a volatile process determined by the interaction of the user and capital markets. What signals do real estate producers use to manage this process? What other factors affect the volatility of real estate production? Solution: When real estate market prices exceed the cost of production, this signals producers to build, or add additional supply. As the supply of real estate increases, rental rates decline in the user market, which lowers property values and signals the real estate market to slow the production of real estate. Furthermore, shocks in the capital markets and the volatility of construction costs add to the volatility of real estate production. For example, higher interest rates adversely affect property values, all else equal, thereby reducing the attractiveness of new construction. Additionally, shortages of key building materials and organized labor disputes may contribute to the volatility of real estate production. CHAPTER 14 THE EFFECTS OF TIME AND RISK ON VALUE Test Problems 1. How much will a $50 deposit made today be worth in 20 years if the compound rate of interest is 10 percent? d. $336.37 2. How much would you pay for the right to receive $80 at the end of 10 years if you can earn 15 percent interest on alternative investments of similar risk? b. $19.77 3. How much would you pay today to receive $50 in one year and $60 in the second year if you can earn 15 percent interest on alternative investments of similar risk? a. $88.85 4. What amount invested at the end of each year at 10 percent annually will grow to $10,000 at the end of five years? b. $1,637.97 5. How much would you pay today for the right to receive nothing a year for the next 10 years and $300 a year for the following 10 years if you can earn 15 percent interest on alternative investments of similar risk? a. $372.17 6. What is the present value of $500 received at the end of each of the next three years and $1,000 received at the end of the fourth year, assuming a required rate of return of 15 percent? c. $1,713.37 7. If a landowner purchased a vacant lot six years ago for $25,000, assuming no income or holding costs during the interim period, what price would the landowner need to receive today to yield a 10 percent annual return on the land investment? c. $44,289.03 8. What is the present value of the following series of cash flows discounted at 12 percent: $40,000 now; $50,000 at the end of the first year; $0 at the end of year the second year; $60,000 at the end of the third year; and $70,000 at the end of the fourth year? d. $171,836 (without rounding, answer is $171,835.94) 9. Assume a property is priced at $5,000 and has the following income stream (year 1, $1,000; year 2, -$2,000; year 3, $3,000; and year 4, $3,000). Would an investor with a required rate of return of 15 percent be wise to invest at the current price? b. No, because the project has a net present value of -$1,954.91. 10. As the level of perceived risk increases, d. Values decrease and expected returns increase. Study Questions 1. Dr. Bob Jackson owns a parcel of land that a local farmer has offered to rent for the next 10 years. The farmer has offered to pay $20,000 today or an annuity of $3,200 at the end of each of the next 10 years. Which payment method should Dr. Jackson accept if his required rate of return is 10 percent? Solution: Dr. Jackson should choose the payment method that maximizes his net present value. If he chooses the lump sum payment, the net present value is simply the $20,000 he will receive today. If he chooses the annuity plan, the net present value will be only $19,662.61. N = 10 I = 10 % PV =? PMT = 3,200 FV = 0 Therefore, Dr. Jackson should choose the lump sum payment of $20,000. 2. You are able to buy an investment today for $1,000 that gives you the right to receive $438 in each of the next three years. What is the internal rate of return on this investment? Solution: This is simply a yield calculation problem. Like any time-value-of-money problem, we are given four inputs and are asked to solve for the fifth. In this case, we must solve for the interest rate as follows: N=3 I =? PV = -1,000 PMT = 438 Solving this setup tells us the above loan yields a 15 percent return. FV = 0 3. Calculate the present value of the income stream given below assuming a discount rate of 8 percent. What happens to value if the discount rate increases to 20 percent? Year 1 2 3 4 Incom e $3,000 $4,000 $6,000 $1,000 Solution: This problem is solved by entering the annual income stream and discount rate into the cash flow registers of any standard financial calculator and solving for the net present value. Assuming an 8% discount rate, the income stream is valued at $11,705.16. Alternatively, if the discount rate is 20%, the value of the income stream will be $9,232.25. 4. Calculate the IRR and NPV for the following two investment opportunities. Assume a 16 percent discount rate for the NPV calculations: Year 0 1 2 3 Project 1 Cash Project 2 Cash Flow Flow -$10,000 -$10,000 1,000 1,000 2,000 12,000 12,000 1,800 Solution: To solve this problem, simply enter each set of cash flows into the cash flow registers of your financial calculator and ask it to find the IRR. For Project 1, the internal rate of return is 16.16%, while for Project 2, the internal rate of return is 21.23%. The NPV for Project 1 is $36.29 and the NPV for Project 2 is $933.21. If these projects were independent, each IRR should be individually compared to the required rate of return to determine whether the investment should be made. However, if the projects are mutually exclusive and are of equivalent risk, Project 2 is preferred to Project 1. Addtionally, the higher NPV of Project 2 clearly makes this alternative the most attractive investment option because the investor’s net worth will increase by $933.21. 5. How much would you pay for an investment that provides $1,000 at the end of the first year if your required rate of return is 10 percent? Now compute how much you would pay at 8 percent and 12 percent rates of return. Solution: At 10%, an investor would be willing to pay $909.09. N=1 I = 10 PV = ? At 8%, an investor would be willing to pay $925.93. PMT = 0 FV = 1,000 N=1 I=8 PV = ? PMT = 0 FV = 1,000 PMT = 0 FV = 1,000 At 12%, an investor would be willing to pay $892.86. N=1 I = 12 PV = ? 6. Your grandmother gives you $10,000 to be invested in one of three opportunities: real estate, bonds, or zero coupon bonds. If you invest the entire $10,000 in one of these opportunities with the expected cash flows shown below, which investment offers the highest NPV? Assume an 11 percent discount rate is appropriate for all three investments Real Estate Bond Zero Coupon Year 1 $1,30 0 $1,00 0 $0 Year 2 $1,30 0 $1,00 0 $0 Year 3 $1,30 0 $1,00 0 $0 Year 4 $1,30 0 $1,00 0 $0 Year 5 $9,000 $11,000 $18,00 0 Solution: Entering the annual income stream and discount rate into the cash flow registers of our financial calculator, we obtain the following net present value calculations: real estate, (625.76); bond, (369.5); and zero coupon, 682.12. 7. If you purchase a parcel of land today for $25,000 and you expect it to appreciate 10 percent per year in value, how much will your land be worth 10 years from now? Solution: At a 10% discount rate, the investment will be worth $64,843.56 in ten years. N = 10 I = 10 PV = -25,000 PMT = 0 FV = ? 8. If you deposit $1 at the end of each of the next ten years and these deposits earn interest at 10 percent, what will the series of deposits be worth at the end of the 10th year? Solution: At a 10% discount rate, this series of payments, or annuity, will be worth $15.94 in ten years. N = 10 I = 10 PV = 0 PMT = 1 FV = ? 9. If you deposit $50 per month in a bank account at 10 percent interest, how much will you have in your account at the end of the 12th year? Solution: At a 10% discount rate, this series of payments, or annuity, will be worth $13,821.89 in 12 years. N = 144 I = 10/12 PV = 0 PMT = 50 FV = ? 10. If your parents purchased an endowment policy of $10,000 for you and the policy will mature in 12 years, how much is it worth today, discounted at 15 percent? Solution: At a 15% discount rate, the present value of this future payment is $1,869.07. N = 12 I = 15 PV = ? PMT = 0 FV = 10,000 11. A family trust will convey property to you in 15 years. If the property is expected to be worth $50,000 when you receive it, what is the present value of your interest, discounted at 10 percent? Solution: At a 10% discount rate, the present value of this future payment is $11,969.60. N = 15 I = 10 PV = ? PMT = 0 FV = 50,000 12. You want to buy a house for which the owner is asking $625,000. The only problem is that the house is leased to someone else with five years remaining on the lease. However, you like the house and believe it will be a good investment. How much should you pay for the house today if you could strike a bargain with the owner under which she would continue receiving all rental payments until the end of the leasehold at which time you would obtain title and possession of the property? You believe the property will be worth the same in five years as it is worth today and that this future value should be discounted at a 10 percent annual rate. Solution: This problem requires you to determine the present value of the house today if you are willing to purchase it for $625,000 five years from today. Using a 10% discount rate, the home is worth $388,075.83 today. N=5 I = 10 PV = ? PMT = 0 FV = 625,000 13. If someone pays you $1 a year for 20 years, what is the present value of the series of future payments discounted at 10 percent annually? Solution: At a 10% discount rate, the present value of this series of future payments, or annuity, is $8.51. N = 20 I = 10 PV = ? PMT = 1 FV = 0 14. You are at retirement age and one of your benefit options is to accept an annual annuity of $75,000 for 15 years. What lump sum settlement, if paid today, would have the same present value as the $75,000 annual annuity? Assume a 10 percent discount rate. Solution: At a 10% discount rate, the present value of this series of future payments is $570,455.96. This is the lump sum equivalent of receiving $75,000 for 15 years. N = 15 I = 10 PV = ? PMT = 75,000 FV = 0 15. What monthly deposit is required to accumulate $10,000 in eight years if the deposits are compounded at an annual rate of 8 percent? Solution: Assuming an 8% discount rate and a future value of $10,000, the monthly amount required to be deposited is $74.70. N = 96 I = 8/12 PV = 0 PMT = ? FV = $10,000 16. You are thinking about purchasing some vacant land. You expect to be able to sell the land ten years from now for $500,000. What is the most you can pay for the land today if your required rate of return is 15 percent? What is the expected (annualized) return on this investment over the 10-year holding period if you purchase the land for $170,000? Solution: The maximum amount you can spend to purchase this property is the present value of the future price, discounted at 15 percent for ten years. Using a financial calculator, this amount is $123,592.35. N = 10 I = 15 PV = ? PMT = 0 FV = $500,000 The expected annualized return on this investment can be solved using a financial to obtain for the interest rate that equates a present value of $170,000 to $500,000 in ten years. The annualized return of this investment is 11.39% N = 10 I=? PV = -170,000 PMT = 0 FV = $500,000 Alternatively, the cash flow function can be used to calculate the IRR of this investment, whereby the initial cash outflow at time zero is $170,000, the cash flows for the time period 1-9 is zero, and the cash flow received in year 10 is $500,000. Using this approach, the IRR is 11.39%. 17. You are considering the purchase of a small income-producing property for $150,000 that is expected to produce the following net cash flows: End of Year 1 2 3 4 Cash Flow $50,000 $50,000 $50,000 $50,000 Assume your required internal rate of return on similar investments is 11 percent. What is the net present value of this investment opportunity? What is the going-in internal rate of return on this investment? Solution: Using the cash flow function on a financial calculator and entering the information provided above, the NPV of this investment is $5,122.28. Alternatively, the NPV can be solved as follows: N=4 I = 11 % PV = ? PMT = $50,000 FV = 0 The present value of this series of payments is $155,122.28. Subtracting the amount of the cash outflow at period zero ($150,000), the present value is also $5,122.28. The going-in IRR for this investment is 12.59%. 18. Raw land at the edge of urban development that lacks the necessary permits for development is, in general, the most risky kind of real estate investment. Defend or refute this assertion. Solution: Evaluated against the two types of investment risk confronting real estate investors, uncertainty of costs and uncertainty of value, raw land lacking permitting can be viewed as the riskiest form of real estate investment. Raw land at the edge of urban development that lacks necessary permitting for development possesses a large degree of value uncertainty because the future cash flows are not established. The value of the land is typically dependent on future growth to create market potential that is not currently in existence. Additionally, the probability of this occurring is dependent on land use regulations and the actions of the local planning authority. The total cost required to acquire and develop the raw land is unknown at the time of purchase. Only urban redevelopment projects possess comparable cost uncertainty as raw land without permitting. 19. You are contemplating replacing your conventional hot water heater with a solar hot water heater system at a cost of $4,000. How should you define the potential benefits that you need to estimate? Solution: The potential benefit gained from this investment is a reduction in future utility costs. This purchase requires an analysis of the initial costs and the value of the future benefit received in the form of lower utility bills. The homeowner should consider whether to finance this $4,000 investment and, if so, how much to borrow. The homeowner should also analyze how financing this purchase impacts the present and future cash flows associated with the purchase of the solar hot water heating system.