Deck 8: Present Value Mathematics for Real Estate

Question 1

Other things being equal, call option value is greater under all of the following conditions except:

A) Longer time until the option expires.
B) Greater volatility in the underlying asset value over time.
C) Greater current value of the underlying asset.
D) Greater exercise price in the option.

Answer 1

D

Question 2

The NPV investment decision rule is applicable even in the case of a real option, such as a real estate development investment decision, because:

A) The NPV rule states that any investment with a positive NPV should be undertaken.
B) The real options nature of development enables a negative NPV investment to be rational.
C) The NPV rule will insure that a development project that presents a higher IRR will be chosen over one that presents a lower IRR.
D) The NPV rule requires making the decision that maximizes the NPV over all mutually exclusive alternatives, and building today versus waiting are mutually exclusive alternatives on a given piece of land.

Answer 2

D

Question 3

Consider the following situation in which the market's expected return to investment in vacant land is 15% per annum:

In the above situation, which of the following is not true:

A) The land is today worth at least $104.
B) The optimal strategy is to hold the land undeveloped for now.
C) The HBU next year is likely to be a slightly larger or more upscale building than the current HBU today.
D) The source of the option premium is uncertainty or volatility regarding future values.

Answer 3

C

Question 4

Consider the following situation in which the market's expected return to investment in vacant land is 15% per annum:

In the above situation,

A) The option premium is due purely to the "growth premium".
B) The option premium is due purely to the "irreversibility premium".
C) The option premium is due neither to the "growth premium" nor the "irreversibility premium".
D) There is no "option premium".

Question 5

The "option premium" is:

A) The excess of the option value over its immediate exercise value.
B) The risk premium in the required investment return to option investment.
C) The excess of the option value over the current value of the underlying asset.
D) Difficult to quantify using the Samuelson-McKean Formula.

Question 6

An "Expense Stop" provision in a lease:

A) Puts a limit on the amount of building operating expenses the tenant must pay.
B) Puts a limit on the amount of building operating expenses the landlord must pay.
C) Puts a limit on the amount of building operating expenses the property manager must pay.
D) Puts a limit on the total operating expenses of a building.

Question 7

All of the following distinguish the typical real option on land development from the typical financial option on securities, except:

A) The land development option is perpetual.
B) The underlying asset value in the land development option can only be observed with "noise".
C) Exercise of the land development option adds to the supply side of the market in which the underlying asset trades.
D) The underlying asset in the case of the land development option typically pays income to the former option holder only upon exercise of the option.

Question 8

The main difference between applying real option theory to real estate development and applying it to many typical industrial corporate capital budgeting problems is that:

A) The typical industrial corporation is a publicly traded firm whose stock price rapidly reflects the investment value of the firm.
B) The typical industrial capital budgeting question faces a "use it or lose it" finite window of opportunity for the investment.
C) There is usually a reasonably well functioning market in real estate for the development option in the land market), which allows the opportunity cost of the option exercise to be easily quantified in the NPV calculation.
D) In the typical industrial corporation only the market value of the investment decision can be estimated, not the investment value, which makes it necessary to wait for an NPV substantially greater than zero.

Question 9

Describe the call option model of land value. What is the "underlying asset" in this model? What is the "exercise price"? What is the typical maturity of the land development option?

Question 10

According to the Graaskamp model, what are the four "disciplines" or professional perspectives involved in the real estate development process?

Question 11

In the classical construction loan:

A) The developer borrower) owes no cash payments to the bank until the loan comes due upon completion of the construction project.
B) The developer pays interest only during the construction phase.
C) The developer pays both interest and some principle to begin to amortize the construction loan during the construction phase.
D) The developer and construction lender share equally in all payments to construction contractors during the construction phase.

Question 12

Based on the following information, develop a front door "Simple Financial Feasibility Analysis" SFFA) for this project estimating the required minimum market gross rent per SF that will support development.
• 40,000 NRSF office building project.
• Acquisition & construction cost = $1,500,000;
• Estimated operating costs to landlord) = $100,000/yr.
• Projected stabilized occupancy = 95%.
• Permanent loan available on completion @ 9% interest-only loan) with 130% debt service coverage requirement on the net operating income, and 75% maximum loan-to-value ratio.
1500000 X .75 = 1125000 Max loan
1125000 X .09 = 101250/yr debt svc
101250 X 1.3 = 131625 Required NOI
131625 + 100000 = 231625 Required EGI
231625 / .95 = 243816 Required PGI
243816 / 40000 = $6.10 / SF Gross rent required.

Question 13

What is the Effective Rent under 10% discount rate assumption) for a 7-year net lease with rent fixed at $20/SF, in which the landlord agrees to give the tenant one year free rent up front and to pay for $10/SF worth of tenant improvements?

A) $14.40
B) $15.84
C) $16.26
D) $18.13
E) $20.00

Question 14

It is possible conceptually to distinguish two underlying sources of option-based land value over and above the current difference between the value of the best building that could currently be built on the site and the construction cost exclusive of land) of that building, the underlying reasons why it makes sense to wait before immediately commencing a positive-NPV construction:

A) Systematic risk, and idiosyncratic risk.
B) Competing demand for the site, and competing supply of other similar sites.
C) Growth expectations of the value of the evolving highest and best use HBU) for the site, and irreversibility of construction once it is begun building today is mutually exclusive with building tomorrow on the same site.
D) The time value of money, and the risk premium necessary to compensate investors for land value risk.

Question 15

The classical model of land value as a "real option" is what type of option model?

A) A finite-maturity European put option.
B) A finite-maturity European call option.
C) A perpetual American put option.
D) A perpetual American call option.

Question 16

Suppose a construction project anticipates end-of-month draws of $400,000, $300,000, and $600,000 consecutively. What will be the balance owed at the end of the third month if the interest on the loan is 7% per annum compounded monthly), and no payments of either principal or interest are required during the construction period?

A) $1,306,430.
B) $1,314,051.
C) $1,378,960.
D) Cannot be computed with the information given.

Question 17

In option valuation theory all of the following are true except:

A) The "underlying asset" refers to what is obtained upon the exercise of a "call option" or what is given up on the exercise of a "put option").
B) The "exercise price" is the value of what must be paid by the option holder when the option is exercised.
C) A "European option" can be exercised anytime prior to its expiration date, while an "American option" can only be exercised at the time of its expiration.
D) A "compound option" is an option on an option.

Question 18

According to real option theory, even if construction were instantaneous, it might be optimal not to immediately build a project whose value currently exceeds its construction cost, because:

A) There is sufficient probability that the value of the project will rise sufficiently in the future, and building today is mutually exclusive with building in the future.
B) There is sufficient probability that the value of the project will fall sufficiently far in the future such that you would lose money if you built it today.
C) There is never any reason to exercise a call option before its expiration date.
D) The cost of construction can be invested at a rate less than the cap rate or current cash yield) of the completed project.

Question 19

All of the following relate most directly to the benefit side of the real estate development NPV equation, except:

A) The construction and absorption budget.
B) The operating budget.
C) The projected cap rates in the built property market.
D) The rents in the built property market.

Question 20

The major advantage of real option theory over the decision tree approach for analyzing land value and development decision making is:

A) Option theory is simpler and less prone to making mistakes.
B) Option theory allows a more detailed and realistic model of complex development staging and design alternatives.
C) Option theory is a complete economic model based on the concept of market equilibrium, and therefore does not require as much prior knowledge about the opportunity cost of capital discount rates or expected returns).
D) Decision tree analysis does not allow for the time-to-build time required for construction), and assumes that future values follow a normal or Gaussian) distribution with no autocorrelation "efficient markets assumption").

Question 21

A "Step-up" provision in a commercial property lease means:

A) Provides for the tenant to move to a higher floor.
B) Adjusts the rental payments to changes in inflation.
C) Specifies in advance the absolute dollar amounts by which the rental payments will increase, no matter what happens to inflation.
D) Requires the tenant to pay specified increases in the building's operating expenses.

Question 22

The term "Gross lease" means:

A) A disgusting lease.
B) The tenant pays the building operating expenses.
C) The landlord pays the building operating expenses.
D) The property manager pays the building operating expenses.

Question 23

Suppose a lease has a 75% CPI-Adjustment each year. If last year's rent was $20/SF and the CPI has increased from 155 to 161, what is the new rent this year?

A) $20.50
B) $20.58
C) $20.77
D) $21.00
E) $21.20