Deck 18: Investment Decisions: Ratios

Question 1

The equity dividend rate:

A) Incorporates income tax considerations.
B) Expresses before-tax cash flow as a percent of the required equity capital investment.
C) Expresses before-tax cash flow as a percent of the property's acquisition price.
D) Expresses net operating income as a percent of the required equity capital investment.

Answer 1

We are asked to choose the appropriate solution from the given options to complete the given statement.
The Equity Dividend Rate :
The correct answer is option B. Expresses before-tax cash flow as a percent of the required equity capital investment.
To calculate the equity dividend rate, divide the annual payment of dividends per share by the market price of a share. Using annual figures is preferable to stock because they could pay dividends on a different schedule than others. Remember that while most U.S. stocks pay dividends quarterly, many foreign stocks do not.

Question 2

You are considering the purchase of a quadruplex apartment. Effective gross income during the first year of operations is expected to be $33,600 ($700 per month per unit). First-year operating expenses are expected to be $13,440 (at 40 percent of EGI ). Ignore capital expenditures. The purchase price of the quadruplex is $200,000. The acquisition will be financed with $60,000 in equity and a $140,000 standard fixed-rate mortgage. The interest rate on the debt financing is 8 percent and the loan term is 30 years. Assume, for simplicity, that payments will be made annually and that there are no up-front financing costs.
a. What is the overall capitalization rate
b. What is the effective gross income multiplier
c. What is the equity dividend rate (the before-tax return on equity)
d. What is the debt coverage ratio
e. Assume the lender requires a minimum debt coverage ratio of 1.2. What is the largest loan that you could obtain if you decide that you want to borrow more than $140,000

Answer 2

Overall capitalization rate is the going-in capitalization rate on an acquired property. It is defined as:
(a) Calculate overall capitalization rate:
To calculate the overall capitalization rate first we need to find Net Operating Income (NOI) then divide the net operating income by the market price.
Effective Gross Profit (EGI) = $33,600
Operating expenses = $13,440
Next we divide NOI by the market price to get the overall capitalization rate.
Purchase price of the quadruple is $200,000
Hence the overall capitalization rate is 10.08 %
(b ) Calculate effective gross income multiplier:
Effective gross income multiplier is calculated by dividing the market price by EGI.
Effective Gross Income (EGI) = $33,600
Purchase price (or) market price = $200,000
Hence the effective gross income multiplier is 5.95.
(c) Calculate equity dividend rate (before-tax return on equity):
The acquisition will be financed with $60,000 in equity and a $140,000 standard fixed-rate mortgage.
Present value of mortgage loan is $140,000
Interest rate on the debt financing is 8%
Term of the loan is 30 years
We can solve for debt service amount using a financial calculator by doing the following:-
The debt service is $12,436
To calculate the before-tax cash flow subtracts the debt service from the NOI.
The before-tax cash flow is $7,724
To calculate the equity dividend rate, divide the before-tax cash flow by the equity invested.
The equity dividend rate is 12.87%.
(d) Calculate debt coverage ratio:
To calculate the debt coverage ratio, divide the Net Operating Income (NOI) by the debt service amount.
Net Operating Income (NOI) = $20,160
Debt service amount = $12,436
Plug the values into the equation.
Hence the debt service coverage ratio is 1.62.
(e) Calculate the largest loan amount that you could obtain if you decide to borrow more than $140,000:
Debt service must be such that the following relationship holds:
[OR]
Hence the loan amount is $189,189.18
Working notes:
The mortgage constant is the stated interest rate plus the first-year principal payment divided by the loan amount
, or 0.0888. Mortgage constant balance is the debt service amount.

Question 3

Ratio analysis:

A) Includes estimating the net present value of the investment opportunity.
B) Is generally adequate to fully assess an investment's expected return.
C) Requires cash flow estimates for the investment's entire expected holding period.
D) Serves as an initial evaluation of the adequacy of an investment's expected cash flows.

Answer 3

We are asked to choose the appropriate solution from the given options to complete the given statement.
Ratio analysis :
The correct answer is option D. serves as an initial evaluation of the adequacy of an investment's expected cash flow.
Cash Flow Ratios are used to assess the cash position of the business. Following are the main cash flow-based financial ratios and the calculations:
Formula:
(Source:
http://financelearners.blogspot.com/2011/06/cash-flow-ratios-analysis-formula.html)

Question 4

Why do Class B properties generally sell at higher going-in cap rates than Class A properties

Question 5

Assume a retail shopping center can be purchased for $5.5 million. The center's first year NOI is expected to be $489,500. A $4,000,000 loan has been requested. The loan carries a 9.25 percent fixed contract rate, amortized monthly over 25 years with a 7-year term. What will be the property's (annual) debt coverage ratio in the first year of operations

A) 1.40.
B) 1.19.
C) 0.84.
D) 0.08.

Question 6

Why might a commercial real estate investor borrow to help finance an investment even if she could afford to pay 100 percent cash

Question 7

Which of the following is not an operating expense associated with income-producing (commercial) property

A) Debt service.
B) Property taxes.
C) Fire and casualty insurance.
D) Janitorial services.

Question 8

You are considering purchasing an office building for $2,500,000. You expect the potential gross income ( PGI ) in the first year to be $450,000; vacancy and collection losses to be 9 percent of PGI; and operating expenses and capital expenditures to be 42 percent of effective gross income ( EGI ). What is the estimated Net Operating Income What is the implied first-year overall capitalization rate What is the effective gross income multiplier

Question 9

Use the following information to answer questions 8-9. You are considering purchasing an office building for $2,500,000. You expect the potential gross income ( PGI ) in the first year to be $450,000; vacancy and collection losses to be 9 percent of PGI; and operating expenses and capital expenditures to be 38 percent and 4 percent, respectively, of effective gross income ( EGI ). What is the implied first-year overall capitalization rate

A) 9.5 percent.
B) 10.0 percent.
C) 10.5 percent.
D) 11.0 percent.

Question 10

Use the following information to answer questions 1-3.
You are considering the purchase of an office building for $1.5 million today. Your expectations include the following: first- year potential gross income of $340,000; vacancy and collection losses equal to 15 percent of potential gross income; operating expenses equal to 40 percent of effective gross income; and capital expenditures equal 5 percent of EGI.
What is estimated effective gross income ( EGI ) for the first year of operations

Question 11

What distinguishes an operating expense from a capital expenditure

Question 12

Income multipliers:

A) Are useful as a preliminary analysis tool to weed out obviously unacceptable investment opportunities.
B) Are adequate as the sole indication of a property's investment worth.
C) Relate the property's price or value to after-tax cash flow.
D) None of the above.

Question 13

Use the following information to answer questions 8-9. You are considering purchasing an office building for $2,500,000. You expect the potential gross income ( PGI ) in the first year to be $450,000; vacancy and collection losses to be 9 percent of PGI; and operating expenses and capital expenditures to be 38 percent and 4 percent, respectively, of effective gross income ( EGI ). What is the effective gross income multiplier

A) 5.56.
B) 6.11.
C) 16.38.
D) 18.00.

Question 14

Use the following information to answer questions 1-3.
You are considering the purchase of an office building for $1.5 million today. Your expectations include the following: first- year potential gross income of $340,000; vacancy and collection losses equal to 15 percent of potential gross income; operating expenses equal to 40 percent of effective gross income; and capital expenditures equal 5 percent of EGI.
What is estimated net operating income ( NOI ) for the first year of operations

Question 15

Explain why income property cash flow is not the same as taxable income.

Question 16

The overall capitalization rate calculated on a potential acquisition:

A) Is the reciprocal of the net income multiplier.
B) Explicitly incorporates the effects of expected future rent growth.
C) Considers the risk associated with an investment opportunity.
D) All of the above are true.

Question 17

Given the following information, what is the required equity down payment • Acquisition price: $800,000
• Loan-to-value ratio: 75%
• Total up-front financing costs: 3%

A) $118,000.
B) $200,000.
C) $218,000.
D) $250,000.

Question 18

Use the following information to answer questions 1-3.
You are considering the purchase of an office building for $1.5 million today. Your expectations include the following: first- year potential gross income of $340,000; vacancy and collection losses equal to 15 percent of potential gross income; operating expenses equal to 40 percent of effective gross income; and capital expenditures equal 5 percent of EGI.
What is the estimated going-in cap rate ( R o ) for the first year of operations

Question 19

What is the basic shortcoming of most ratios and rules of thumb used in commercial real estate investment decision making

Question 20

The operating expense ratio:

A) Highlights the relationship between net operating income and operating expenses.
B) Shows the percentage of potential gross income consumed by operating expenses.
C) Expresses operating expenses as a percent of effective gross income.
D) Should reflect the cost of mortgage financing.

Question 21

Using the following information, compute net operating income ( NOI ) for the first year of operations. Use an "above-line" treatment of capital expenditures.
• Number of apartments: 10
• Rent per month per apartment: $900.00
• Expected vacancy and collection loss: 10 percent
• Annual maintenance: $18,000
• Property taxes: $9,000
• Property insurance: $7,000
• Management: $8,000
• Capital expenditures: $5,000
• Other operating expenses: $3,000
• Annual mortgage debt payments: $35,000

Question 22

An investment opportunity having a market price of $1,000,000 is available. You could obtain a $750,000, 25-year mortgage loan requiring equal monthly payments with interest at 7.0 percent. The following operating results are expected during the first year:
For the first year only, determine the:
a. Gross income multiplier.
b. Operating expense ratio.
c. Monthly and annual mortgage payment.
d. Debt coverage ratio.
e. Overall capitalization rate.
f. Equity dividend rate.