Topic 5 - Direct Investment - Property

Question 1

How does the effect of tax affect our choice of investment in direct property?

Answer 1

• tax makes more of a difference with property than with other investments
• the effect of tax can make some direct investments in property more worthwhile than initially perceived

Question 2

What are the main characteristics of property?

Answer 2

• the land value that an apartment is built on is relevant
• zoning determines what you can do with different land
• ALWAYS more illiquid than any other class of investment
• transactions upon buying/selling are high relative to other investments
• gearing = leverage = ‘in debt’

(003)

Question 3

Differentiate between direct and indirect property investment.

Answer 3

• in property law, the name on the title is the owner
• indirect ownership reduces risk but also reduces return because of high management fees

Question 4

Characteristics of residential property:

Answer 4

• the capital value of property rises and falls fastest in capital cities
• negative gearing means that your outlays on an investment property exceed your inflow
• favourable for high-rate taxpayers because the loss can be offset against their income tax
• but for most taxpayers, their marginal tax rate is 45% which means that for every $1 spent with a view to getting a tax return, they only get 45c back
• spending money to save tax only makes sense if your savings are going to be 50% of the cost (incur a loss even then)

(005)

Question 5

What are some characteristics of commercial property?

Answer 5

• higher yields than residential property > not so obvious!
• the rent that you can expect on a commercial property relative to the purchase price is higher than for residential property because businesses can afford outlays that individuals cannot
• but landlords may not be prepared to lower asking rents to residential levels and instead allow commercial properties to remain vacant
• ‘quality’ is about the reliability of a tenant

Question 6

Differentiate between real estate investment trusts (REITs) and unlisted property trusts (UPTs).

Answer 6

• ‘distributions’ are similar to dividends
• the legal difference between a company and a trust: complex
• but both aim to conceal the real owner: the trustee is the apparent owner but the beneficiary is the real one

Question 7

What’s the difference between mortgage, mezzanine and hybrid funds?

Answer 7

Question 8

Describe the unit pricing of property funds, yield versus rate and property investment in an economic downturn.

Answer 8

• yield is a different concept from rate
• rate is the face value (stable denominator): income over capital, e.g. 5% coupon rate on a bond means that you get $5 for every $100 face value of the bond
• yield ALWAYS means numerator (interest/dividend/income/rent) over MARKET PRICE
• when the market price goes up, the yield goes down and vice versa
• most investors are more interested in market price over income
• only interested in income because of its effect on market price and capital gain
• in an economic downturn, investment in property may be more secure

(010)

Question 9

Describe the example.

Answer 9

Question 10

What are the benefits of investing in a property fund?

Answer 10

• A property fund may own various types of properties
• A trust may specialise in retail, office, industrial, commercial or leisure and tourism properties
• A trust may also diversify across the various types of property
• Managers are usually fund managers
• Properties are owned by unitholders
• Properties are held in trust by the managers
• Managers may be entitled to performance incentives
• Property funds are primarily a yield investment
• Capital growth a secondary priority
• REIT index shows volatility of 60% of All Ordinaries index
• UPTs have less volatility than a listed property fund as they are less liquid
• Property trusts hold properties worth about $175 billion (2007)
• Many types of property funds
• Growth a reflection of demand for ways to invest in property and for diversification of investments
• Property fund investment carries risks – e.g. Westpoint Ltd
• Investors need to seek independent research into quality and reliability of a particular property fund

Question 11

What are the main taxation advantages of investing in property?

Answer 11

Question 12

Regarding the taxation of property investment, what do income and deductions consist of?

Answer 12

Question 13

What are the tax advantages of investing in a property fund?

Answer 13

Question 14

What are tax-advantaged distributions on property investments?

Answer 14

Question 15

What is the impact of tax deferral on a yearly basis?

Answer 15

Question 16

Describe the example.

Answer 16

Question 17

Describe the example.

(If the assessable amount of the capital gain is $26 040)

Answer 17

Question 18

How is the valuation of property different to valuing shares and bonds?

Answer 18

Question 19

What are the three methods that may be used to estimate a market value in property investments?

Answer 19

Question 20

What does the net present value analysis of a property investment require?

If the cost of capital is 10% and you expect to get $100,000 per year, what is your capital value?

Answer 20

cost of capital (capitalisation rate/discount factor) is 10%

expect to get $100,000 per year

capital value = 10 x $100,000 = $1 million

Question 21

List the advantages and disadvantages of homeownership.

Answer 21

Question 22

Describe the graph.

Answer 22

• the housing affordability index relates average household income to the capital value of property
• the relative price of housing has gone up in recent years

Question 23

What issues do we need to consider renting versus homeownership?

Answer 23

Question 24

What sort of deposit do you need to finance the purchase of a property?

Answer 24

Question 25

List the different loan types for financing the purchase of property investment.

Answer 25

Question 26

Describe the diagram.

Answer 26

Figure 6.3 indicates Standard Variable Loan (SVL) rates for the period 1993 to 2013.

Interest rates increased gradually until 2008, fell as a result of the global financial crisis, then started to move up again in 2010, but have fallen again since 2010.

Question 27

How does the goods and services tax (GST) apply to property investments?

Answer 27

Question 28

What are the taxation implications for renting out your own home?

Answer 28

Question 29

What are the tax implications of the death of a homeowner?

Answer 29

• MR = main residence

Question 30

What are the taxation implications of a family breakdown on a family home?

Answer 30

Question 31

Questions for the exam will include:

• an optional calculation question:

how much do you need to save in order to acquire a deposit; what is the mortgage repayment on a given sum for a given number of years for a given interest rate

Make sure we know:

• different types of property
• property trusts
• different types of indirect/direct property investment
• advantages and disadvantages of owning versus renting

Answer 31

Question 32

If you were planning to invest in property as a general asset class, list three positive characteristics and two negative characteristics that property investments are likely to possess.

Page 202 of textbook

Answer 32

Positive:

• Tangible form of investment
• Scarcity of land
• Returns generally a combination of both income and capital growth
• Returns generally less volatile than shares
• A higher level of gearing is possible

Negative:

• Directly held property relatively illiquid
• Difficult to diversify
• Entry and exit costs can be relatively high

Question 33

Jodie wants to invest in an unlisted property trust. Explain how the units are valued.

Page 207 of textbook

Answer 33

An unlisted property trust’s units are valued by the following:

1. First, the net asset value is determined by the market value of property held by the fund less any mortgage debt owner to lenders.
2. The net asset value is divided by the number of issued units to get a unit price.
3. The unit price will have a manager’s fee deducted for handling the redemption or transfer of units.

Question 34

Compare the features of investing in an A-REIT and a UPT.

Pages 204 - 205

Answer 34

A-REIT (listed real estate investment trust) and UPT (unlisted property trust) as investment vehicles are similar - they are structures to hold property assets managed by a responsible entity on behalf of unitholders who receive distributions from the property assets.

How A-REIT and UPT differ is that A-REIT is listed on the ASX while UPT is not. Being listed on the ASX means A-REIT are relatively more liquid than a UPT as units are bought or sold on the stock exchange between public buyers and sellers. This compares with UPT where units are bought and sold (redeemed) from the responsible entity which may result in delays in processing the requests, especially during periods of crisis or when UPTs have cash flow problems (e.g. from holding too much debt).

Because A-REITs are listed, their values fluctuate more than UPTs. As such UPTs reflect a more stable form of investment, provided responsible entities are able to provide adequate liquidity for redemptions.

Question 35

Why might an A-REIT that holds a number of commercial properties in its portfolio be considered a safer investment than one that holds a single commercial property?

Pages 204 - 205

Answer 35

The attraction of investing in a REIT that holds a number of commercial properties is the diversification effect of a better average return and lower level of risk in the long term.

Holding a number of commercial properties in a property trust enables a manager to have tenants operating in different forms of commercial activity which may insulate the trust from a significant downturn in economic activity in some sectors of the economy whereas others may be relatively less affected.

In addition, the trust may diversify its assets across different capital cities, regional areas and types of commercial activity.

Question 36

Describe the risk and return of investing in a mezzanine fund.

Page 206

Answer 36

Mezzanine funds are loans to developers to fund their projects.

The loans are required from developers as they may not be able to borrow enough from typical lenders such as banks.

As such, to attract investors, mezzanine funds offer higher rates of interest though this return is also risky since it is only made provided the project’s aims are delivered.

Question 37

A financial institution offers Fatima the choice between a standard variable loan (SVL) of 5.23% or a 2-year fixed-rate at 4.89% and then SVL after 2 years. Advise her of the issues and which loan to accept.

See page 223 on types of loans

Answer 37

Fatima may be enticed to accept the fixed-rate loan but runs the risk of interest rates falling lower than 4.89% within the two-year time frame.

Her dilemma is whether to take the risk of a rising interest rate or anticipating that interest rates will stay below 4.89% for the next two years.

Given that the two-year rate is lower and provides some interest rate certainty, Fatima may be advised to take the fixed-rate loan.

Question 38

If your grandparents were considering a HEC loan contract, what are the main things that you suggest they should take into consideration?

See page 223 of textbook

Answer 38

Home equity conversion (HEC) loan - they should consider:

1. The accumulated debt
2. the terms when the loan is to be repaid
3. the possibility of negative equity
4. responsibility for maintenance and repairs
5. the standard of upkeep
6. and the need for independent financial advice.

Question 39

Edwina bought her house in September 1984 for $54 000. She died in 2012 and left the house to her only daughter, Claire. Claire wants to rent it but is worried about the CGT implications. What advice would you give her?

Page 227 of the textbook

Answer 39

The sale of the house will attract CGT if sold by the daughter after renting it out for a period. The cost base of the house will be the market value at the time of the transfer of ownership to the daughter.

Question 40

Nerida recently purchased a rental property for $350 000. She expects that she should be able to charge rent based on a gross return of 6% p.a.

(a) What is the amount of gross rent that she would charge?
(b) If Nerida is told that ongoing costs of owning the property (without considering the interest costs on a loan) amount to $3,500 p.a., calculate her net income return after costs.
(c) Assuming Nerida has not borrowed any funds to acquire the property and her marginal tax rate is 30% (ignore Medicare levy), calculate her after-tax return on the rental income.
(d) If, instead, Nerida borrowed $200 000 on interest-only terms to acquire the property and has to pay interest of 6.5% p.a., what is the taxation implication for Nerida?
* Gross rent calculated illustrated on page 210*

Answer 40

The gross amount of rent Nerida would charge is 350,000*6%= $21,000.

(b)

Gross rent $21,000.00

less On-going costs $3,500.00

= net gain $17,500.00

Nerida’s net income return after costs is $17,500.

(c)

After tax return = net rent*(1-tax rate) = $17,500*(1-0.3) = $12,250.00

Nerida’s after tax-tax return on the rental income is $12,250.

(d)

Gross rent $21,000.00

Less costs:

Interest $13,000.00 (6.5% of $200,000)

On-going costs $3,500.00

Total costs $16,500.00

= net gain $4,500.00

Tax on $4,500 @30% = $1,350.00

Hence, the tax effect for Nerida is that $1,350 in income tax is paid.

Question 41

Georgie and Teresa are contemplating buying a house for which they will need a $200 000 loan. They find a suitable lender who offers them the funds at a nominal annual 6.5% fixed rate and advises a 25-year loan.

(a) What is the monthly repayment for a 25-year loan?
(b) How much interest is paid over 25 years?

Answer 41

(a)

i = 0.065/12 = 0.005416667

n = 25*12 = 300

PV = 200,000

PV = (PMT [1 - (1 + i)^-n]) / i

200,000 = (PMT [1 - (1 + 0.005416667)^-300) / 0.005416667

PMT = 200,000 / [1 - (1 + 0.005416667)^-300) / 0.005416667

(1 + i)^-n = (1 + 0.005416667)^-300 = 0.19778

PMT = 200,000 / [1 - (0.19778) / 0.005416667]

PMT = 200,000 / 148.102

PMT = $1,350.41 per month

(b)

1,350.41 x 300 - 200,000 = $205,123.00

The interest paid over 25 years is $205,123. Note that the interest paid over 25 years is higher than the principal borrowed.

Question 42

Graham takes out a $120 000 HEC loan on his fully-owned $600 000 house. The interest rate is 8.5% compounded monthly. Graham dies and the house is sold after exactly 10 years. How much is the outstanding debt?

See the example on page 224

Answer 42

FV = PV (1 + i)ⁿ

Monthly interest rate = 0.085/12 = 0.007083

n = 10 x 12 = 120

FV of HEC Loan = 120 000 (1.007083)¹²⁰ = $279,907

Question 43

Todd and Wesley are two friends who met at university and, during their summer vacation, decided to develop a property together. Their plan is to buy a property that they can renovate and paint, then obtain a tenant and sell the property in 3 years when, with improved value, the property could be sold for a substantial gain.

They are currently considering two property choices. The anticipated net income for each property for each year is shown in the following table:

Todd and Wesley will borrow most of the funds required to purchase whichever property that they decide to develop, but regardless of interest payments, they want to know which property is the best value for them to invest in.

Property A requires an outlay of $280 000 to acquire the property and initial costs of $60 000 to upgrade the property before it could be rented. It is expected that they can sell the property at the end of the 3-year period for $420 000.

Property B requires an outlay of $250 000 and initial costs of $40 000. They expect to sell the property in 3 years for $390 000.

The rate of return they could obtain from an alternative investment choice is 8% p.a.

Using the information provided:

Questions

1. Calculate the net present value of acquiring, developing and selling property A.
2. Calculate the net present value of acquiring, developing and selling property B.
3. Which property would you advise them to purchase? Explain why.
4. What questions would you consider if they decided not to undertake the property purchase but to invest in the alternative investment choice?

Answer 43

(1) NPV of Property A
- (280,000+60,000) +22,000/1.08+23,000/(1.08)^2+24,000/(1.08)^3+420,000/(1.08)^3

= - 340,000 + (20370.37 + 19718.79 + 19051.97 + 333409.54)

= -340,000 + 392,550.68 = $52,550.68

(2) NPV of Property B

minus(250,000+40,000)+24,000/1.08+25,000/(1.08)^2+26,000/(1.08)^3+390,000/(1.08)^3

• 290,000 + (22222.22 + 21433.47 + 20639.64 + 309594.57)
• 290,000 – 373889.90 = $83,889.90
  (3) It would be advisable to purchase Property B as its net present value is higher than Property A and so provides a higher current cash value.

(4)

• How stable is the rate of return and is it more stable than the projected cash flows of the properties?
• Are there any initial, ongoing or exit costs in taking the alternative investment?
• What is the income/capital gains composition of the return?

Question 44

Which of the following statements regarding loan types is incorrect?

Select one:

a. Capped loans provide some certainty to the borrower regarding interest rates for a specified period before they revert to standard variable loans.
b. Equity loans require the borrower to undergo an approval process each time they wish to borrow from this facility.
c. 100% offset loans benefit from potentially decreasing interest expenses for the borrower if used wisely.
d. None of the above.

Answer 44

b. Equity loans require the borrower to undergo an approval process each time they wish to borrow from this facility.

Question 45

Alice sells a property in 2017 for $300,000 that she has held for five years. She bought the property for $200,000 and during the period of ownership she claimed a building depreciation allowance of $8,000 each year. Given a marginal tax rate of 46.5% (including the Medicare levy) the relevant tax to be paid relating to the sale will be:

Select one:

a. $32,550
b. $27,900
c. $65,100
d. $46,500

Answer 45

a. $32,550

Question 46

A tax-free component and a tax-deferred component are two taxation benefits associated with the income derived by a property. The tax-deferred component:

Select one:

a. derives from depreciation of furniture and fittings and provides tax relief for a period of seven years.
b. derives from building depreciation allowances and the accumulated sum reduces the cost base of the property when it is sold.
c. derives from depreciation of furniture and fittings and the accumulated sum adds to the cost base of the property when it is sold.
d. derives from building depreciation allowances and provides for tax relief for a period of five years.

Answer 46

b. derives from building depreciation allowances and the accumulated sum reduces the cost base of the property when it is sold.

Question 47

What is the valuation approach which is described as follows: “An estimated market value made by comparing recent sales figures to provide a return required by investors based on the income stream paid to investors less normal operating expenses”?

Select one:

a. The direct comparison approach.
b. The securitisation approach.
c. The cost approach.
d. The capitalisation approach.

Answer 47

d. The capitalisation approach.

Question 48

Mortgage funds:

Select one:

a. provide opportunities for capital growth returns for investors.
b. will increase their loan-to-value ratio the relatively higher the risk of the borrower.
c. are a relatively illiquid investment at least in the early periods after issue.
d. both a and b.

Answer 48

c. are a relatively illiquid investment at least in the early periods after issue.

Question 49

The Net Present Value (NPV) approach:

Select one:

a. is a suitable form of analysis for property investments.
b. would include net rental income as cash outflows as part of NPV analysis.
c. results in a greater positive NPV / lower negative NPV when a relatively higher discount rate is used.
d. both b and c.

Answer 49

a. is a suitable form of analysis for property investments.

Question 50

When providing advice to a client on whether it is best for them to rent or buy a family home based only on financial grounds, the advice:

Select one:

a. will favour the buying option in times of relatively low-interest rates and current flat housing prices.
b. will favour the buying option in times of relatively tight rental markets.
c. both a and b.
d. none of the above.

Answer 50

a. will favour the buying option in times of relatively low-interest rates and current flat housing prices.

Question 51

Increases in capital city house prices may be the result of:

Select one:

a. lower levels of immigration.
b. the policy of state governments to limit the supply of land by means of zoning.
c. the threat of higher taxation policy on property investment.
d. a decrease in office jobs in city areas.

Answer 51

b. the policy of state governments to limit the supply of land by means of zoning.

Question 52

Where a single homeowner dies in 2017 and bequests their family home which was originally purchased in 2005 to a beneficiary:

Select one:

a. the home will be subject to a potential capital gains tax liability if sold by the beneficiary within 1 year following the death of the homeowner using the original purchase price as the cost base.
b. the home will be exempted from a potential capital gains tax liability if sold by the beneficiary within 2 years following the death of the homeowner.
c. the home will be valued at its market value at the date of death of the homeowner and subject to sale on any subsequent disposal by the beneficiary.
d. none of the above.

Answer 52

b. the home will be exempted from a potential capital gains tax liability if sold by the beneficiary within 2 years following the death of the homeowner.

Question 53

As compared to an A-REIT, an unlisted property trust is likely to:

Select one:

a. be smaller in size holding less properties.
b. have relatively more debt as a proportion of the total trust assets.
c. both a and b.
d. none of the above.

Answer 53

c. both a and b.

Question 54

A characteristic of property is:

Select one:

a. returns may comprise income but not capital.
b. entry costs and exit costs can be relatively low.
c. it is generally regarded as an intangible form of investment.
d. it is generally regarded as an illiquid form of investment.

Answer 54

d. it is generally regarded as an illiquid form of investment.

Question 55

The capitalisation approach results in:

Select one:

a. a higher market value the greater the capitalisation rate used for a given net rental income stream.
b. lower market value the greater the capitalisation rate used for a given net rental income stream.
c. lower market value the lower the capitalisation rate used for an increasing net rental income stream.
d. both a and c.

Answer 55

b. lower market value the greater the capitalisation rate used for a given net rental income stream.

Question 56

The income to be declared in the income tax return which relates to property investment consists of the gross rental income from the tenant. The deductions that can offset the income include:

Select one:

a. a capital expense such as the addition of an air conditioner to the property.
b. a portion of the set-up costs of borrowing the funds which are allowed to be deducted over a 3-year period.
c. a capital depreciation allowance of 4.0% of the cost of the building is allowable for 40 years.
d. interest on the loan taken out to purchase the property.

Answer 56

d. interest on the loan taken out to purchase the property.

Question 57

A person’s equity in their own home valued 10-years after initial purchase:

Select one:

a. will rise with principal loan repayments on borrowings assuming housing prices at least remain constant.
b. is the difference between the current market value of the home and the amount initially borrowed on a principal and interest home loan.
c. is the difference between the current market value of the home and their initial purchase price.
d. will decrease with principal loan repayments on borrowings assuming housing prices at least remain constant.

Answer 57

a. will rise with principal loan repayments on borrowings assuming housing prices at least remain constant.

Question 58

Establishing a market value for older buildings is more problematic using the:

Select one:

a. cost approach.
b. direct comparison approach.
c. capitalisation approach.
d. both a and b.

Answer 58

a. cost approach.

Question 59

The NTA of an unlisted property trust assuming all other items are held constant:

Select one:

a. will increase in situations where the fund manager decides to repay the principal on outstanding debt from surplus cash holdings.
b. will increase in situations where the fund manager decides to revalue upwards the amount included in the balance sheet for goodwill attached to a prominent property held by the fund.
c. is used by fund managers to determine the current value of units in the trust before adjusting for any management fees.
d. both a and c.

Answer 59

c. is used by fund managers to determine the current value of units in the trust before adjusting for any management fees.

net tangible asset (NTA) = net asset value

Question 60

Property trusts:

Select one:

a. are taxpaying entities.
b. can make tax-deferred distributions to individual unitholders who benefit differentially on an after-tax basis depending on their personal marginal tax rate.
c. can withhold income distributions to unitholders in any year depending on the trusts expected cash flow requirements for the following period.
d. both b and c.

Answer 60

b. can make tax-deferred distributions to individual unitholders who benefit differentially on an after-tax basis depending on their personal marginal tax rate.

Question 61

An example of direct property investment is:

Select one:

a. John is a registered investor in a listed real estate investment trust.
b. Jenny is a member of a private property syndicate.
c. Jill holds units in an unlisted property trust.
d. James is the registered owner of a commercial property.

Answer 61

d. James is the registered owner of a commercial property.

Question 62

Tax-deferred distributions from property trusts:

Select one:

a. are only available to unitholder recipients where they have held their investment in the property trust for at least 12 months.
b. are declared by the unitholder recipient as income in the tax return in the year of receipt.
c. are used by the unitholder recipient to decrease the cost base of the investment in the property trust.
d. are used by the unitholder recipient to increase the cost base of the investment in the property trust.

Answer 62

c. are used by the unitholder recipient to decrease the cost base of the investment in the property trust.