Study Session 13 - Alternative Investments

Question 1

What are some characteristics of Real Estate Investments?

Answer 1

1. Heterogeneity - ie no two properties are exactly the same. This is b/c of differences in size, location, age, tenants, lease terms etc
2. High unit value - b/c real estate is indivisible, the unit value if significantly higher than stocks or bonds
3. Active management - active property management by the owner or property management company is required
4. High transaction costs - buying and selling is costly becasue it involves appraisers, lawyers, brokers and construction personnel
5. Depreciation and desirability - buildings wear out, they can become less desireable b/c of location, design or obsolescence
6. _Cost and Availability of capital _- The level of interest rates and available capital can affect values
7. Lack of Liquidity
8. _Difficulty in determining price _

Question 2

Real Estate is commonly classified into these two buckets…..

Answer 2

• Residential
• Non-Residential

Question 3

What are some reasons to invest in Real Estate?

Answer 3

1. Current Income
2. Capital Appreciation
3. Inflation Hedge
4. Diversification
5. Tax benefits

Question 4

What are the principal risks of investing in Real Estate?

Answer 4

1. Business Properties
2. New property lead time
3. Cost and availability of capital
4. Unexpected inflation
5. Demographic factors
6. Lack of liquidity
7. Environmental issues
8. Availability of information
9. Management expertise
10. Leverage

Question 5

For the 4 main types of Commercial Properties, what is the main factor that determines value?

Answer 5

1. Office - demand is heavily dependent on job market
2. _Industrial _- demand is heavily dependent on the overall economy, especially import/export activity
3. Retail - demand is dependent on consumer spending
4. Multi Family - Demand depends on population growth, especially in the age that generally rents

Question 6

Appraisers use these three approaches to valuing real estate..

Answer 6

1. Cost Approach
2. Sales Comparison Approach
3. Income Approach

Question 7

Describe the Cost Approach to Real Estate Valuation

Answer 7

1. The premise is that a buyer would not pay more for a property than it would cost to purchase the land and construct a comparable building.
2. Value is derived by adding the value of the land to the current replacement cost of a new building less adjustments for estimated depreciation and obsolescence
3. Is most useful when the subject property is relatively new
4. Often used for unsual properties or properties where comparable tranactions are limited

Question 8

Describe the Sales Comparison Approach to Real Estate Valuation

Answer 8

1. Premise is that a buyer would pay no more for a property than others are paying for similar properties
2. The sale prices of similar (comparible) properties are adjusted for differences with the subject property
3. Is most useful when there are a number of properties similar to the subject that have recently sold

Question 9

Describe the Income Approach to Real Estate Valuation

Answer 9

1. Value is based on the expected rate of return required by a buyer to invest in the subject property
2. Value is equal to the present value of the subject’s future cash flows
3. Most useful in commercial real estate transactions

Question 10

How do you calculate the Implied Land Value?

Answer 10

= Value of property once construction is completed - cost construction costs (including profit to the developer)

Question 11

What are the two different valuation methods used in the Income Approach and explain them….

Answer 11

1. Direct Capitalization Method - value is based on capitalizing the first year NOI of the property using a capitalization rate
2. Discounted Cash Flow Method - value is based on the present value of the property’s future cash flows using an appropriate discount rate

Question 12

What is NOI (Net Operating Income) and how is it calculated?

Answer 12

The amount of income remaining after subtracting vacancy and collection losses, and operating expenses from potential gross income

Question 13

What is the capitalization rate (cap rate) and how is it calculated??

Answer 13

Question 14

How do you calculate the discount rate used in the Discounted Cash Flow Method?

Answer 14

= cap rate + growth rate

Question 15

Describe the Layer Method, which is a variation of the term and reversion approach

Answer 15

1. One source (layer) of income is the contract (term) rent that is assumed to continue in perpetuity
2. The second layer is the increase in rent that occurs when the lease expires and the rent is reviewed

Question 16

Using the discounted cash flow methods requires making these estimates and assumptions…..

Answer 16

1. Project income from existing leases
2. Lease renewal assumptions
3. Operating expense assumptions
4. Capital expenditure assumptions
5. Vacancy assumptions
6. Estimated resale price
7. Appropriate discount rate

Question 17

Describe the Cost Approach

Answer 17

The cost approach involves estimating the market value of the land, estimating the replacement cost of the building, and adjusting for depreciation and obsolescence.

Is often used for unusual properties or properties where comparable transactions are limited

Question 18

What are the 3 steps in using the cost approach?

Answer 18

1. Estimate the market value of the land. Often done using the sales comparison approach
2. Estimate the building’s replacement cost
3. Deduct depreciatiom including physical deterioration, function obsolescence, locational obsolescence and economic obsolesence

Question 19

What are the two ratios lenders often use to determine the maximum loan amount on a specific property?

Answer 19

1. Debt Service Coverage Ratio (DSCR)
2. Loan-to-vale (LTV)

Question 20

How are the debt service coverage ratio (DSCR)

and loan to value (LTV) calculated?

Answer 20