PROP 1020 / CHAPTER 1

Question 1

Real estate assets do have certain characteristics that are not, in aggregate, similar to many other investments. These features can have an impact on the level, timing, or riskiness of the future benefits of a real estate asset when compared to other investments. These differentiating asset characteristics include:

[LIST 4]

Answer 1

ANSWER:

• *1. Immobility
  2. Longevity (durability)**
• *3. Indivisibility
  4. Tax Benefits**

Question 2

What are the advantages of mortgage financing? Why would you borrow money if you have capital available?

Answer 2

- - 1 - -

In order to DIVERSIFY INVESTMENTS and REDUCE OVERALL RISK

- - 2 - -

When it is possible to BORROW AT AN INTEREST RATE LOWER than the return/yield of the investment.

In these cases, the greater the debt, the higher will be the anticipated rate of return on invested equity capital This is called financial leverage or trading on the equity.​

- - 3 - -

The investor anticipates an INCREASE in the general price level (INFLATION) and in the returns on real estate. In an inflationary environment, the purchase of property today with the use of DEBT FINANCING may increase investment yields as the payments on the loan are FIXED and the investor hopes to pay off the debt in “CHEAPER” (inflated) dollars.

- - 4 - -

An investor may use debt financing to save or RELEASE EQUITY FOR OTHER ACTIVITIES, e.g., a merchandising or manufacturing concern may prefer to use available funds in a business rather than to invest it in land and buildings.​

Question 3

COMPLETE THE SENTENCE: From an investment perspective, the important issue is not whether or not a real estate asset can be divided physically, but rather _ _ _ _ _

Answer 3

ANSWER: From an investment perspective, the important issue is not whether or not a real estate asset can be divided physically, but rather whether or not its ownership rights are divisible.

Question 4

Consider the following statement: The real estate market is considered efficient because all information affecting market price is available at the same cost to all investors.

(1) This statement is true.
(2) This statement is false; some investors may be capable of better acquiring and utilizing
market information because of their size.
(3) This statement is false because barriers to entry into a specific sub-market might arise from the localized nature of these markets and the resulting high information costs.
(4) Both Options (2) and (3) are correct.

Answer 4

Answer: 4

Options (2) and (3) are true statements. Two factors that can affect the efficiency of the real estate market are entry barriers and information inefficiencies. For a market to be efficient, all information affecting market prices should be available to all investors at the same cost. This is not true in the market because larger investment firms are better equipped to acquire and utilize market information than smaller firms and individuals. Entry into a particular local market requires substantial information with high costs.

Question 5

The __________ form of real estate ownership will allow for divisibility since the corporation can acquire the real estate asset and the individual investors can buy some or all of the shares.

Answer 5

The corporate form of real estate ownership will allow for divisibility since the corporation can acquire the real estate asset and the individual investors can buy some or all of the corporate shares.

Question 6

List four characteristics of real estate markets?

Answer 6

Characteristics of Real Estate Markets

localization

high information and transaction costs

discontinuous price information

government intervention

Question 7

COMPLETE THE SENTENCE: The lack of a centralized real estate exchange means that information must be obtained from _______at costs higher than generally necessary with the secondary sources found in centralized national investment markets.

Answer 7

COMPLETE THE SENTENCE: The lack of a centralized real estate exchange means that information must be obtained from PRIMARY SOURCES at costs higher than generally necessary with the secondary sources found in centralized national investment markets.

Question 8

EXPLAIN: DISCONTINOUS PRICE
INFORMATION?

Answer 8

Given the infrequent trading of individual real estate assets and the common indivisibility of ownership shares, the value of a specific property is not continuously established in an open real estate market.

Unlike financial assets traded in national security markets, investors in real estate generally do not receive a daily flow of price information indicating the market value of their holdings.

Question 9

__________ as well as the _______ involved in property transfers also tend to raise the transaction costs in real estate above those experienced in other investment markets.

Answer 9

Localized markets as well as the legal fees involved in property transfers also tend to raise the transaction costs in real estate above those experienced in other investment markets.

Question 10

EXPLAIN: The high information and transaction costs have an effect on the holding period in real estate investment.

Answer 10

High transaction costs make it relatively expensive for most investors to constantly buy and then sell assets after only short holding periods.

Unless there is a mis-pricing of the asset at the time of purchase, “flipping” a property can be profitable only if there is a large change in the value of the asset over a short period. In most investment situations, therefore, the typical holding period for a real estate asset tends to be longer than one year

Question 11

TRUE OR FALSE?

Debt financing may allow the purchase of real estate as a hedge against inflation

Answer 11

ANSWER:

TRUE

Question 12

The combination of _________and _______ of real estate assets has prompted governments to intervene in the operation of real estate markets

Answer 12

The combination of the IMMOBILITY and LONGEVITY of real estate assets has prompted governments to intervene in the operation of real estate markets.

Question 13

A competitive market, sometimes called a perfectly competitive market, has two characteristics:

Answer 13

A competitive market, sometimes called a perfectly competitive market, has two characteristics:

there are many buyers and many sellers in the market

and,

the goods offered by the various sellers are largely the same.

Question 14

SHORT NOTE: Perfect competition also assumes free entry and exit of resources and participants. There are no capital or information barriers to participating in a real estate market.

Finally, perfect competition requires that investors have complete information flows; all market participants have access to all available information that affects the returns/risks of properties in a real estate market

Answer 14

SHORT NOTE: Perfect competition also assumes free entry and exit of resources and participants. There are no capital or information barriers to participating in a real estate market.

Finally, perfect competition requires that investors have complete information flows; all market participants have access to all available information that affects the returns/risks of properties in a real estate market

Question 15

In the case of real estate markets, there are a number of inefficiencies (or imperfections) that may be observed which can reduce the efficiency of the market. These possible market imperfections can be divided into two interrelated groups: _______ and ___________

Answer 15

In the case of real estate markets, there are a number of inefficiencies (or imperfections) that may be observed which can reduce the efficiency of the market. These possible market imperfections can be divided into two interrelated groups: entry barriers and information inefficiencies.

Question 16

In a competitive real estate market, prices ________ any information affecting the value of real estate assets.

Answer 16

In a competitive real estate market, prices FULLY CAPITALIZE any information affecting the value of real estate assets.

Question 17

TRUE OR FALSE: The price adjustment in a competitive market commences upon announcement rather than actual implementation of the new information.

Answer 17

ANSWER: TRUE

Question 18

Explain the efficient market concept.

Answer 18

If the competitive market model is taken a step further and it is assumed that the full capitalization of information takes place very rapidly, then a real estate market is called “efficient”.

The efficient market concept is that real estate investors act quickly on any information they receive such that prices adjust rapidly upon receipt of the information.

Question 19

Investors can only expect to earn higher returns in an efficient real estate market by _ _ _ _ _ _

Answer 19

Investors can only expect to earn higher returns in an efficient real estate market by making riskier investments

Question 20

In the case of real estate markets, there are a number of inefficiencies (or imperfections) that may be observed which can reduce the efficiency of the market.

These possible market imperfections can be divided into two interrelated groups:

[LIST 2]

Answer 20

Entry barriers and information inefficiencies.

Barriers to entry into a specific real estate sub-market might arise from the LOCALIZED nature of these markets and the resulting high information costs of real estate investment, as well as possible capital constraints created by the INDIVISIBILITY of real estate assets.

Substantial information acquisition is required for entry into a particular local market.

Finally, one of the assumptions implicit in the efficient markets model is that all information affecting market price is available at the same cost to all investors.

However, some investors, because of their SIZE, may be capable of better acquiring and utilizing market information. LARGER INVESTMENT FIRMS could benefit from SCALE ECONOMIES in their real estate activities.

These investors may be able to exploit such economies to expand their information set and/or lower their information cost. Such economies would improve their expected returns relative to other participants in real estate markets.

Question 21

What are the five steps of the investment analysis process?

Answer 21

Five Step Process

Identify Investor’s Decision Framework

Collect Market Information

Perform Financial Analysis

Apply Selection Criteria

Make Investment Decisions

Question 22

The primary advantages that are attributed to investing in real estate include: <list></list>

Answer 22

The primary advantages that are attributed to investing in real estate include:

• *1. high returns;
  2. financial leverage;
  3. tax sheltering; and
  4. inflation hedge;**

Question 23

Consider the following statement: In a competitive market, tax shelters will be capitalized into property values.

(1) This statement is true because acquisition prices would rise by an amount equal to the
present value of the tax shelter.
(2) This statement is false because major market participants are sufficiently informed of tax shelters.
(3) This statement is true because tax-loss sheltering cannot increase the level of returns above the level without sheltering.
(4) None of the above is correct.

Answer 23

Answer: 1
This statement is true because acquisition prices would rise by an amount equal to the present value of the tax shelter. In competitive markets, one would expect the price of properties to be affected by any tax shelter benefits available in real estate markets. Investors will respond to the tax shelter benefits and bid up prices for these investments. Option (1) is correct; prices would rise to equal the benefit of the tax shelter.

Question 24

Financial leverage can be defined as _ _ _ _ _

Answer 24

Financial leverage can be defined as the use of fixed-cost debt in an investment designed to increase the return to the equity investor.

By employing funds having fixed charges that are not a function of the income or appreciation of the property, investors can gamble that the investment will generate sufficient revenue to not only pay the operating expenses of the property but also the required debt payments.

Question 25

An inflation hedge is an _ _ _ _

Answer 25

An inflation hedge is an investment that offers an investor protection against the loss of purchasing power resulting from the rising prices of goods and services to the degree that the investor’s equity increases in value at a rate equal to or greater than inflation.

Question 26

TRUE OR FALSE? US and Canadian studies conclude real estate is an effective inflation hedge?

Answer 26

ANSWER: TRUE

Question 27

The major disadvantages of a real estate investment include:

[LIST 4]

Answer 27

The major disadvantages frequently cited in the literature include:

• *1. financial risk;
  2. interest rate risk;**

3. illiquidity; and

4. management

Question 28

WHAT IS AN EXTERNALITY?

Answer 28

In economics, an externality is the cost or benefit that affects a party who did not choose to incur that cost or benefit.

For example, manufacturing activities that cause air pollution impose health and clean-up costs on the whole society​.

Question 29

IMMOBILITY & EXTERNALITIES

Answer 29

Land is physically immobile. It cannot be moved from one geographical location to another. Consequently, the real estate market is local in nature.

Also, due to its immobility, the value of a piece of real estate is directly affected by its surroundings, things external to itself. For instance, a very nice, well-maintained house will lose value if the neighborhood around it seriously declines.

Question 30

Consider the following statement: The benefits of financial leverage for real estate returns may be eroded if debt cost or overall operating expenses escalate.

• *(1) This statement is false.
  (2) This statement is true because if interest rates increase substantially on mortgage renewal, net operating income may be insufficient to service debt.
  (3) This statement is true because if vacancy rates or operating expenses increase substantially, return on equity will be reduced.
  (4) Both Options (2) and (3) are correct.**

Answer 30

Answer: 4
Financial leverage is the use of fixed-cost debt in an investment to increase the return to the equity investor. If revenue is sufficient to cover operating expenses and debt payments, the remaining income will be allocated to the equity investors, thus the benefit of financial leverage. The benefits will be lost if net operating income is insufficient to cover debt and operating expenses as a result of higher interest rates, higher vacancy rate, or higher operating costs. Options (2) and (3) are correct.