Deck 9: Measuring Investment Performance: The Concept of Returns

Question 1

A seller has offered you a $1,000,000 interest-only 5 year loan at 6% (annual payments), when market interest rates on such loans are 8%. Basing your decision on market values, how much more should you be willing to pay for the property than you otherwise think it is worth, due to the financing offer?
(a) Zero, by definition.
(b) $26,497
(c) $79,854
(d) $98,412

Answer 1

A

Question 2

Which of the following is true about typical real estate investment (unlevered, at the direct property level) and inflation risk?
(a) Real estate investment appreciation returns do not generally keep pace with inflation in the long run, but real estate investment provides a hedge against inflation risk in that unexpected changes in inflation tend to be positively correlated with changes in property value in the short to medium term.
(b) Real estate investment appreciation returns generally at least equal the inflation rate in the long run, but real estate does not provide a good hedge against inflation risk in that unexpected changes in inflation do not tend to be positively correlated with changes in property value in the short to medium term.
(c) Real estate investment appreciation returns generally at least equal the inflation rate in the long run, and real estate investment provides a hedge against inflation risk in that unexpected changes in inflation tend to be positively correlated with changes in property value in the short to medium term.
(d) Real estate investment appreciation returns do not generally keep pace with inflation in the long run, and real estate does not provide a good hedge against inflation risk in that unexpected changes in inflation do not tend to be positively correlated with changes in property value in the short to medium term.

Answer 2

A

Question 3

All of the following are true about the "property before-tax (PBT) shortcut", except*:
(a) The PBT shortcut is useful not only because it simplifies the investment analysis but because it avoids the necessity of estimating after-tax parameters that may be difficult to observe without error.
(b) The shortcut is made possible by the existence of a reasonably well functioning market for the type of investment asset in question.
(c) The shortcut works for estimating market value always, and for estimating investment value for investors who are typical of the marginal investors in the relevant asset market.
(d) At the PBT level the investor's own subjective opportunity cost of capital can be used as the discount rate in order to estimate that investor's "investment value" (IV) for the property.

Answer 3

A

Question 4

The NOI is $40,000; there are $5,000 in tenant improvement expenditures paid for by the landlord; there is a $200,000 interest-only loan at 8 percent annual interest; the depreciable cost basis of this residential property is $300,000; the owner's tax bracket is 33 percent. What is the Equity After-Tax Cash Flow (EATCF)?
(a) $14,680
(b) $27,800
(c) $30,680
(d) $35,000

Question 5

Which statement is true ex ante?
(a) Leverage normally increases the owner's income return (cash yield) if you pay market value for the property.
(b) Leverage normally increases the owner's income return (cash yield) if you pay more than market value for the property.
(c) Leverage normally increases the owner's total return (including appreciation) if you pay market value for the property.
(d) Leverage normally increases the owner's total return (including appreciation) if you pay more than market value for the property.

Question 6

Suppose you analyze a particular deal and it appears that for an investment of $1,000,000 your client can obtain a positive NPV of over $500,000. Your client is typical of the type of high tax bracket individual investors who commonly purchase and sell this type of property, and indeed typically determine equilibrium prices in the asset market in which these properties are sold. What should you do?
(a) Reject the deal out of hand because it costs twice as much as its NPV.
(b) Phone your client right away on your cell phone and urge her to pounce on this deal before it "gets away" - the seller must have made a mistake in their offering price!
(c) Buy the property with cash, take out an 80% loan-to-value ratio mortgage, and laugh all the way to the bank with $200,000 of arbitrage profits!
(d) Sharpen your pencil, double-check your assumptions and analysis, try to find what is unique about your client.

Question 7

The table below shows two 10-year cash flow projections (in $ millions, including reversion) for the same property. The upper row is the projection that will be presented by the broker trying to sell the building, the bottom row is the realistic expectations. Suppose that it would be relatively easy for any potential buyers to ascertain that the most likely current market value for the property is about $10 million. What is the most likely amount of "disappointment" in the ex post annual rate of total return earned by an investor who buys this property believing the broker's cash flow projection?

(a) 0.00%
(b) 1.00%
(c) 3.00% = Presentation IRR - Realistic IRR = (10% + 3%) - (10% + 0%) = 13% - 10%.
(d) 26.68%

Question 8

You are trying to apply a multi-year DCF analysis to evaluate an investment property with some long-term leases in it. You observe that other properties with similar lease structure and risk have been selling at cap rates around 11% (based on NOI with no capital reserve). You believe these other properties typically face capital expenditures on the order of 1% of property value per year in the long run, and that given such expenditures their net cash flows and values would reasonably be expected to grow in the long run at about 3% per year. What discount rate should you apply to your subject property in your DCF valuation?
(a) The Treasury bond rate because of the long-term leases.
(b) 10%
(c) 13%
(d) 14%

Question 9

Normally, what relation should be most common between the expected "going-in" and expected "going-out" cap rate?
(a) The going-in cap rate should be higher than the going out.
(b) The going-out cap rate should be at least as high as the going-in rate.
(c) There is no particular relation between the two.

Question 10

Assuming riskless debt, if the return risk is ±15% with a 40% Loan/Value Ratio, then with a 80% Loan/Value Ratio the return risk is:
(a) ±7.5%
(b) ±15%
(c) ±30%
(d) ±45%

Question 11

After-tax cash flow will exceed before-tax cash flow whenever:
(a) Taxable income is negative.
(b) Capital expenditures exceed net operating income.
(c) The building is fully depreciated.
(d) Interest and depreciation expenses are less than net operating income.

Question 12

The table below shows the projected cash flows (including reversion) for Property A and Property B. If both properties sell at fair market value for a cap rate (initial and terminal cash yields) of 8%, then which statement below correctly describes the relative investment risk in the two properties?

(a) Property A is more risky. (A's going-in IRR = 8% + 3% = 11% = rf + RPA > rf + RPB = 8% = 8% + 0% = B's going-in IRR.)
(b) Property B is more risky.
(c) Both properties are equally risky.

Question 13

A non-residential commercial property which cost $500,000 is considered to have 30 percent of its total value attributable to land. The annual depreciation expense chargeable against taxable income is:
(a) $18,182
(b) $15,873
(c) $13,967
(d) $8,974

Question 14

All of the following are fundamental causal determinants of cap rates in the property asset market, except:
(a) The opportunity cost of capital (as determined in the capital market).
(b) The expected growth in property rents (as determined in the space market).
(c) The risk perceived for the property (as determined in the space and capital market).
(d) The net income divided by the property price.

Question 15

Total development costs (including sufficient profit for the developers) are $200/SF. Cap rates in the asset market are 10%. What is the "replacement cost rent" in this market?
(a) $20.00/SF.
(b) $16.00/SF.
(c) $12.50/SF.
(d) $10.00/SF.

Question 16

The difference between the net operating income (NOI) and the equity before-tax cash flow (EBTCF) is:
(a) Property Tax Expense and capital expenditures.
(b) The debt service and capital expenditures.
(c) Property taxes and income taxes.
(d) Interest expense and depreciation expense.

Question 17

The expected return on an investment in a property is inversely related to the price you pay for the property fundamentally because:
(a) The future cash flows the property can generate are independent of the price you pay for the property today.
(b) The return must include a risk premium.
(c) Inflation must be subtracted out.
(d) The investor faces a budget constraint.

Question 18

In which of the following situations would it be most appropriate to measure an investment manager's performance using the IRR rather than the time-weighted average periodic return?
(a) Client hires manager to place capital as soon as possible.
(b) Client requires a large proportion of its invested capital to be liquid at all times for withdrawal on demand.
(c) Client gives manager a line of capital with discretion over when to acquire and dispose of illiquid assets.
(d) All of the above.

Question 19

Which of the following is an example of "negative feedback" in the real estate system?
(a) Since the stock of built space cannot readily shrink, rents will fall when demand falls.
(b) Lenders make money by issuing loans, so they tend to keep the capital flowing to developers even during down markets.
(c) Real estate markets exhibit inertia, so market participants rationally extrapolate past rent trends into the future.
(d) Growth in space usage demand stimulates increased rents or improved prospects for future rents, which increases the present value of real estate assets, which improves the profitability of new development projects.

Question 20

Suppose the lease on a certain space will expire at the beginning of 2008. You believe that the probability of the existing tenant renewing is 50 percent. If he renews, you will need to spend only an estimated $5.00/SF to upgrade his space. If he does not renew, it will take $25.00/SF to modernize the space, even then you expect 6 months of vacancy. What expected cash flow forecast should you put in year 2008 of your pro-forma for this space, if you expect triple-net market rents on new leases in 2008 to be $20/SF?
(a) $17.50/SF
(b) $15.00/SF
(c) zero
(d) - $10.00/SF

Question 21

Consider an 8.5% loan amortizing at a 25-year rate with monthly payments. What is the maximum amount that can be loaned on a property whose net operating income (NOI) is $500,000 per year, if the underwriting criteria specify a debt service coverage ratio (DCR) no less than 125%?
(a) $2,789,406
(b) $3,409,091
(c) $3,844,614
(d) $4,000,000
(e) $4,139,619

Question 22

For the same property as above, suppose the underwriting criteria is a maximum loan/value ratio (LTV) of 75%, and we estimate property value by direct capitalization using a rate of 11% on the stated NOI. By this criterion what is the maximum loan amount?
(a) $2,789,406
(b) $3,409,091
(c) $3,844,614
(d) $4,000,000
(e) $4,139,619

Question 23

In comparing an adjustable rate mortgage (ARM) with a fixed rate mortgage (FRM):
(a) Both the borrower and lender bear more interest rate risk with the ARM than with the FRM.
(b) Both the borrower and the lender bear less interest rate risk with the ARM than with the FRM.
(c) The ARM borrower bears more interest rate risk, but the ARM lender bears less interest rate risk, than with the FRM.
(d) The ARM borrower bears less interest rate risk, but the ARM lender bears more interest rate risk, than with the FRM.

Question 24

Consider a 20-year (monthly-payment), 8%, $80,000 mortgage with 2 points prepaid interest up front. What is the "effective interest rate" or yield over the borrower's expected holding period if the borrower expects to hold the loan for 12 years?
(a) 8.00%
(b) 8.25%
(c) 8.31% N=240, I=8, PV=80000, FV=0; PMT= -669.15; 144=N; FV=-47344; RCL PV = 80000*0.98 = 78400 = PV; I = 8.31%.
(d) 8.56%