Question 1

Suppose the lease on a certain space will expire at the beginning of 2010. You believe that the probability of the existing tenant renewing is 75 percent. If they renew, you will need to spend only an estimated $5.00/SF to upgrade his space. If they do not renew, it will take $20.00/SF to modernize the space and there would be 4 months of expected vacancy in that case. What expected cash flow forecast should you put in year 2010 of your pro-forma for this space, if you expect triple-net market rents on new leases in 2010 to be $20/SF?
A) zero.
B) $7.92/SF.
C) $9.58/SF. = PGI-VacAllow-E[TI] = $20 - 0.25*(4/12)*$20 - [0.75*$5.00+(1-0.25)*$20.00] = $20 - $1.67 - $8.75= $9.58.
D) $11.25/SF.
E) $15.00/SF.

Accepted Answer

The expected cash flow forecast is calculated by considering the probability of the tenant renewing and the associated costs, as well as the costs if the tenant does not renew. The calculation involves the potential gross income (PGI) minus vacancy allowance and expected tenant improvement costs (E[TI]). The correct calculation is $20 - $1.67 - $8.75 = $9.58/SF.

Question 2

The NOI is $1,000,000, the debt service is $800,000 of which $700,000 is interest, the depreciation expense is $250,000. What is the Before-tax Cash Flow to the equity investor (EBTCF) if there are no capital improvement expenditures or reversion items this period?
A) $50,000
B) $200,000 = $1,000,000 - $800,000 = PBTCF - DS.
C) $300,000
D) $750,000
E) Insufficient information to answer this question.

Accepted Answer

Before-tax Cash Flow (BTCF) to the equity investor is calculated as Net Operating Income (NOI) minus Debt Service (DS). Here, NOI is $1,000,000 and DS is $800,000. Therefore, BTCF = $1,000,000 - $800,000 = $200,000.

Question 3

What is the current market value of the property?
A) $7,000.
B) $1,000,000.
C) $1,428,571. = $100,000 / 0.07 .
D) $1,741,414.
E) Insufficient information to determine answer.

Accepted Answer

The current market value of the property can be calculated using the formula for determining the value based on a given income and capitalization rate. Here, if $100,000 is the annual income and 0.07 (or 7%) is the capitalization rate, the value is calculated as $100,000 / 0.07 = $1,428,571.

Question 4

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 8% (based on NOI with no capital reserve). You believe these other properties typically face capital expenditures on the order of 2% 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 1% per year. What discount rate should you apply to your subject property in your DCF valuation?
A) 6%
B) 7%= (8% - 2%) + 1% = (caprate - CI/V) + g = y + g .
C) 8%
D) 9%
E) 10%

Accepted Answer

The correct discount rate is 7%, calculated by adjusting the observed cap rate (8%) for the long-term capital expenditures (2%) and then adding the expected long-term growth rate (1%). This reflects the net yield (y) after accounting for capital expenditures, plus the expected growth (g) in net cash flows and property value.

Question 5

What is wrong with the following statement: Only a fool would invest in real estate without financing most of the purchase with a mortgage; borrowing allows you to increase your expected return by using other people's money!
A) The money you borrow comes from a bank, not "other people".
B) The statement is insulting to fools: even people of just slightly below average intelligence might not borrow.
C) Some people can't borrow due to poor credit rating, but that doesn't mean they're "fools".
D) The statement ignores the effect of borrowing on the investor's risk.
E) The statement is actually correct although stated in a too extreme form.

Accepted Answer

The statement overlooks the increased risk that comes with leveraging an investment through borrowing, which can amplify losses as well as gains.

Question 6

All of the following are true about the NPV and the IRR hurdle investment decision rules, except:
A) If the NPV and the IRR give a different decision recommendation, the IRR is more correct.
B) In most typical real estate circumstances the IRR hurdle rule will give the same investment recommendation as the NPV rule.
C) In comparing two mutually exclusive investments of different scale, the IRR rule can be misleading while the NPV rule will lead to a correct wealth-maximizing decision.
D) The IRR sometimes is indeterminate, whereas a unique NPV can always be calculated.

Accepted Answer

The IRR is not inherently more correct than the NPV when they give different decision recommendations. The NPV is generally considered the more reliable method for evaluating investments because it measures the absolute increase in wealth, while the IRR can be misleading in certain scenarios, such as non-conventional cash flows or mutually exclusive projects of different scales.

Question 7

Suppose you expect that one year from now, a certain property's before-tax cash flow (PBTCF = NOI - CI) will equal only $15,000 per year under a plausible pessimistic scenario or as much as $25,000 per year under a plausible optimistic scenario. If you borrow an amount such that the loan payments will be $10,000 per year (for certain), then what is your range of expected income return component (equity yield) under the no-leverage and leverage alternatives, assuming that the property price is $200,000 and the loan amount is $100,000?
A) It goes from a range of between 7.5% and 12.5% with no leverage to a range of between 2.5% and 7.5% with leverage.
B) It goes from a range of between 15% and 25% with no leverage to a range of between 5% and 15% with leverage.
C) It goes from a range of between 2.5% and 7.5% with no leverage to a range of between 15% and 25% with leverage.
D) It goes from a range of between 7.5% and 12.5% with no leverage to a range of between 5% and 15% with leverage.
E) Can't be determined from the information given.

Accepted Answer

The income return component (equity yield) without leverage is calculated by dividing the PBTCF by the total property price. With leverage, it's calculated by subtracting loan payments from the PBTCF and then dividing by the equity portion of the investment. Without leverage, the range is $15,000/$200,000 to $25,000/$200,000, which is 7.5% to 12.5%. With leverage, the range is ($15,000-$10,000)/$100,000 to ($25,000-$10,000)/$100,000, which is 5% to 15%.

Question 8

Which of the following is not one of the three approaches discussed in Chapter 11 to determine the appropriate discount rate or opportunity cost of capital in property valuation?
A) Historical evidence (such as the NCREIF Index total return history).
B) Survey evidence (based on what market participants and brokers say investors are looking for).
C) The average WACC in the REIT industry determined from REIT share price capital returns in the stock market combined with typical commercial mortgage interest rates. (This wasn't in Ch 11, and also you would need to use Total (not capital ) returns from REIT share prices.)
D) Empirical evidence of property cap rates plus typical rental growth minus depreciation, less typical capital expenditures as a fraction of property value.

Accepted Answer

Option C is not mentioned as an approach to determine the appropriate discount rate or opportunity cost of capital in property valuation in the context provided. The explanation within the option itself clarifies that this method was not discussed in Chapter 11 and also points out a methodological error in using capital returns instead of total returns.

Question 9

In the problem above, what is the after-tax cash flow to the equity investor if the income tax rate is 35%?
A) $32,500.
B) $182,500.
C) $195,000.
D) $650,000
E) Insufficient information to answer this question.

Accepted Answer

The answer of In the problem above, what is the...

Question 10

A tenant has a gross lease with an ''expense stop''of $2.75/SF. If the building has 200,000 square feet of leasable space, reimbursable operating expenses of $750,000, and the tenant rents 25,000 SF, then how much does the tenant owe the landlord in expense reimbursements (the total $ amount)?
A) $3.75/SF.
B) $25,000. : $750,000 / 200,000SF $\rightarrow$ Total OE/SF = $3.50. Less $2.50 stop $\rightarrow$ Tenant owes $1.00/SF * 25k SF.
C) $68,750.
D) $93,750.
E) Can't answer because it depends on the CPI adjustment in the lease.

Accepted Answer

The tenant owes $25,000 in expense reimbursements. This is calculated by first determining the total operating expenses per square foot ($750,000 / 200,000 SF = $3.75/SF), then subtracting the expense stop ($3.75 - $2.75 = $1.00/SF). Finally, multiply the remaining amount by the tenant's square footage (25,000 SF * $1.00/SF = $25,000).

Question 11

All of the following are typical "GIGO" mistakes in common application of the DCF method to real estate investment analysis except:
A) The growth rate in the rents is projected too high.
B) The level of required capital improvement expenditures, or the going-out cap rate, are projected too low.
C) The discount rate or going-in IRR is too high.
D) The going-in cap rate is projected too low.

Accepted Answer

The going-in cap rate is the rate of return that an investor expects to earn on a property at the time of purchase. It is used to calculate the present value of the property's future cash flows. If the going-in cap rate is projected too low, the present value of the property will be overstated, which could lead to a bad investment decision.

Question 12

Use the following information to answer the following two questions. You are making a 10-year cash flow pro-forma for a lender, on a non-residential commercial building which you have just purchased (on January 1) and plan to own for 10 years (the maturity of the loan you are requesting). The building has a single tenant in a 20-year lease that commenced at the time of building purchase (January 1).
-Purchase Price: $3,000,000 including $500,000 in assessed land value.
-Tenant Improvement Expenditures (all spent on building made at time of purchase, beginning of lease): $1,000,000.
-Leasing Brokerage Commission (paid at time of purchase, beginning of lease): $300,000.
-Capital Gains Tax Rate (on economic gain): 15%.
-Recapture Tax Rate: 25%.
-Ordinary Income Tax Rate: 35%.
Be completely realistic in your treatment of all sources of capital gains and recapture tax.
-What is the difference between the before-tax and after-tax reversion cash flow at the end of Year 10 in the pro-forma if you project net property resale proceeds at that time of $4,000,000?
A) $186,859.
B) $261,859.
C) $314,103.
D) $355,682.
E) None of the above.

Accepted Answer

The difference between the before-tax and after-tax reversion cash flow at the end of Year 10 in the pro-forma is $186,859. This is calculated as follows:Before-tax reversion cash flow = Net property resale proceeds - Purchase price - Tenant improvement expenditures - Leasing brokerage commission= $4,000,000 - $3,000,000 - $1,000,000 - $300,000= $700,000After-tax reversion cash flow = Before-tax reversion cash flow - Capital gains tax - Recapture tax - Ordinary income tax= $700,000 - ($4,000,000 - $3,000,000) * 15% - ($1,000,000) * 25% - ($700,000) * 35%= $700,000 - $150,000 - $250,000 - $245,000= $53,000

Question 13

What is the projected terminal (going-out) cap rate?
A) 6.56%.
B) 7.00%.
C) 8.00%. = $121,899 / $1,523,738 .
D) 10%.
E) Insufficient information to determine answer.

Accepted Answer

The terminal cap rate is calculated by dividing the net operating income (NOI) by the property's sale price. The given formula, $121,899 / $1,523,738, directly calculates the cap rate, leading to an 8.00% terminal cap rate.

Question 14

The table below shows the projected net 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 net cash yields) of 7%, then which statement below correctly describes the relative investment risk in the two properties? $$\begin{array}{l}
\text { Arnuel net cast flow prajectians for twaprapeties (\$1,000,000) }\
\begin{array} { | l | r | r | r | r | r | r | r | r | r | r | } 
\hline \text { Year: } & 1 & \mathbf { 2 } & 3 & 4 & 5 & 6 & 7 & 8 & 9 & 10 \
\hline \mathbf { A } & \$ 1.0000 & \$ 1.0000 & \$ 1.0000 & \$ 1.0000 & \$ 1.0000 & \$ 1.0000 & \$ 1.0000 & \$ 1.0000 & \$ 1.0000 & \$ 15.2857 \
\hline \mathbf { B } & \$ 1.0000 & \$ 1.0200 & \$ 1.0404 & \$ 1.0612 & \$ 1.0824 & \$ 1.1041 & \$ 1.1262 & \$ 1.1487 & \$ 1.1717 & \$ 18.6093 \
\hline
\end{array}
\end{array}$$
A) Property A is more risky.
B) Property B is more risky. Because it's got a higher expected total return E[r] at equilibrium in the market (FMV).
C) They both are equally risky.
D) Insufficient information to determine the answer.

Accepted Answer

Property B is more risky because it shows increasing net cash flows over time, indicating a reliance on future performance for returns, whereas Property A has consistent cash flows, suggesting less variability and therefore less risk.

Question 15

Use the following information to answer the following two questions. You are making a 10-year cash flow pro-forma for a lender, on a non-residential commercial building which you have just purchased (on January 1) and plan to own for 10 years (the maturity of the loan you are requesting). The building has a single tenant in a 20-year lease that commenced at the time of building purchase (January 1).
-Purchase Price: $3,000,000 including $500,000 in assessed land value.
-Tenant Improvement Expenditures (all spent on building made at time of purchase, beginning of lease): $1,000,000.
-Leasing Brokerage Commission (paid at time of purchase, beginning of lease): $300,000.
-Capital Gains Tax Rate (on economic gain): 15%.
-Recapture Tax Rate: 25%.
-Ordinary Income Tax Rate: 35%.
Be completely realistic in your treatment of all sources of capital gains and recapture tax.
-By how much would the tax on the reversion increase (looking only for the increment here) if the projected net resale proceeds were $4,500,000 instead of the $4,000,000 of the previous question?
A) $75,000.
B) $105,000.
C) $175,000.
D) $225,000.
E) None of the above.

Accepted Answer

The increase in projected net resale proceeds from $4,000,000 to $4,500,000 results in an additional $500,000 in economic gain. Since the capital gains tax rate is 15%, the tax on the reversion would increase by 15% of $500,000, which is $75,000.

Question 16

Which of the following should be true about the ex ante micro-level performance attribution (IRR parsing components) of this property investment?
A) The overall IRR will likely be negative due to a very large negative yield-change (YC) component.
B) The overall IRR will likely be positive due to positive components in all three performance attributes (IY, CFC, & YC).
C) The overall IRR will likely be negative, but at least the yield-change (YC) component will be positive.
D) The overall IRR will likely be positive due largely to the initial yield component (IY), but the yield-change (YC) component will be negative.
E) None of the above.

Accepted Answer

The overall Internal Rate of Return (IRR) for a property investment can be positive even if one component, such as the yield-change (YC) component, is negative, as long as other components like the initial yield (IY) are strong enough to outweigh the negative impacts. This reflects the multifaceted nature of real estate investment returns, where various factors contribute to the final outcome.

Question 17

Bob has $1,000,000 of his own equity capital available to make a real estate investment. He finds a bargain, a property with a market value of $1,100,000 that he can buy for $1,000,000. By how much can he enhance the market value of his net wealth by leveraging his purchase of this bargain property using borrowed money from a bank to finance 50% of his investment?
A) None. Conceptual question: NPV(fin) = 0 from MV perspective unless subsidized int. rate.
B) $50,000.
C) $100,000.
D) $200,000.
E) By 50%.

Accepted Answer

BBob's net wealth increases by the difference between the market value of the property and the cost of purchasing it. Since he buys the property for $1,000,000, which has a market value of $1,100,000, he immediately gains $100,000 in net wealth. The financing method (leveraging) does not change the market value of the property or his net wealth; it only affects the amount of his own capital used in the purchase. Therefore, leveraging does not enhance the market value of his net wealth beyond the initial gain from purchasing the property below market value. However, B is correct because leveraging allows him to use less of his own money (50% financed by the bank), effectively doubling the impact of his initial equity on his return, assuming the property's value does not change.

Quiz 10: The Basic Idea: DCF and NPV

The NOI is $1,000,000, the debt service is $800,000 of which $700,000 is interest, the depreciation expense is $250,000. What is the Before-tax Cash Flow to the equity investor (EBTCF) if there are no capital improvement expenditures or reversion items this period?

What is the current market value of the property?

What is wrong with the following statement: Only a fool would invest in real estate without financing most of the purchase with a mortgage; borrowing allows you to increase your expected return by using other people's money!

All of the following are true about the NPV and the IRR hurdle investment decision rules, except:

Which of the following is not one of the three approaches discussed in Chapter 11 to determine the appropriate discount rate or opportunity cost of capital in property valuation?

In the problem above, what is the after-tax cash flow to the equity investor if the income tax rate is 35%?

A tenant has a gross lease with an ''expense stop''of $2.75/SF. If the building has 200,000 square feet of leasable space, reimbursable operating expenses of $750,000, and the tenant rents 25,000 SF, then how much does the tenant owe the landlord in expense reimbursements (the total $ amount) ?

All of the following are typical "GIGO" mistakes in common application of the DCF method to real estate investment analysis except:

What is the projected terminal (going-out) cap rate?

Which of the following should be true about the ex ante micro-level performance attribution (IRR parsing components) of this property investment?