LESSON 6. Real Estate Investment Analysis and Discounting

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1 LESSON 6 Real Estate Investment Analysis and Discounting Note: Selected readings can be found under "Online Readings" on your Course Resources webpage Assigned Reading 1. Real Estate Division Foundations of Real Estate Mathematics. Vancouver: UBC Real Estate Division. Chapter 9: Real Estate Investment Analysis and Discounting Recommended Reading 1. McIntosh, G Lecture 7: Present Value of Cash Flows and Lecture 8: Practice Problems. 2. Real Estate Division BUSI 121 Course Workbook. Vancouver: UBC Real Estate Division. "Introduction to Excel" (found in the Foreword section of this course workbook). 3. Excel Readings: The Course Resources webpage provides explanations of the basics of Excel and some advanced topics. This is highly recommended reading before you begin working on your projects. Learning Objectives Upon completion of this lesson, the student should be able to: 1. discuss the various techniques and terminology used in equity analysis; 2. calculate the present value and net present value of investments; 3. calculate present value ratios and profitability indices; 4. calculate the internal rate of return for an investment; 5. explain the implicit reinvestment assumption involved in yield calculations; and 6. compare different investment alternatives taking into account various reinvestment assumptions and investment time horizons. 6.1

2 Lesson 6 Review and Discussion Questions 1. Visit the financial website and find out the current price of a stock of your choice. Find out the price of the same stock one year ago and calculate your yield on investment if you had invested $100 in that stock one year ago. Post your results on the BUSI 121 discussion forum and discuss which stock seems to have been the best investment. 2. Many large projects that had a forecasted positive net present value have actually turned out to lose money (especially government projects). Do you think the planners of these projects made a mistake in their calculations? Discuss the pitfalls of using the NPV and IRR measures to decide on project viability. What are the underlying assumptions that affect the validity of these measures? 6.2

3 Real Estate Investment Analysis and Discounting ASSIGNMENT 6 CHAPTER 9: Real Estate Investment Analysis and Discounting Marks 1 mark per question. THE NEXT SIX (6) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: Janie Brown of Janie's Waffle Hut, has realized a large profit in the past three years, and now wishes to invest this money in an income producing property. Janie's financial advisor, Ryan, has detailed several possibilities that may meet her requirements. The forecasted cash flows and acquisition costs for each property are listed below. Year M N O P 1 $150,000 $ 0 $120,000 $250, , ,000-50, , , , ,000 Costs (Today) 300, , , , The internal rate of return on Investment M, expressed as an effective annual rate, is: (1) % (2) % (3) % (4) None of the above. 2. The internal rate of return on Investment N, expressed as an effective annual rate, is: (1) % (2) % (3) % (4) % 3. The internal rate of return on Investment P, expressed as an effective annual rate, is: (1) % (2) % (3) % (4) % 4. If the reinvestment rate is 12% per annum, compounded annually, the effective annual yield on Investment M is: (1) % (2) % (3) % (4) % 6.3

4 Lesson 6 5. If the reinvestment rate is 20% per annum, compounded annually, the effective annual yield on Investment O is: (1) 20% (2) % (3) % (4) % 6. If the reinvestment rate is 35% per annum, compounded annually, the effective annual yield on Investment P is: (1) % (2) % (3) 35.0% (4) % 7. Tinker Juarez is considering making an investment in real estate. He has two investment alternatives to consider. The first alternative offers no cash flows during the holding period, but returns $91, at the end of the holding period. The second alternative offers cash flows of $20,000 at the end of each year during the holding period. Either alternative requires a $58,125 investment today. The alternatives are summarized below: End of Year Alternative 1 Cash Flow Alternative 2 Cash Flow 0 -$58,125 -$58,125 1 $0 $20,000 2 $0 $20,000 3 $0 $20,000 4 $91, $20,000 What reinvestment rate on Alternative 2, expressed as an effective annual rate, would cause Tinker to be indifferent between these two alternatives based on the return on his investment? (1) 9% (2) % (3) % (4) There is no reinvestment rate for Alternative 2 which would make Tinker financially indifferent between the two alternatives. 6.4

5 Real Estate Investment Analysis and Discounting THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: AJ has recently witnessed his friend Liz's success with her real estate investments and he would like to pursue an investment of his own. At present, the reinvestment rate is j2 = 12% per annum. AJ has discovered a small inn that will provide him with the following cash flows for an investment of $70,000 today: 8. AJ's yield is: Year Cash Flow 1 $ 20,000 2 $ 28,250 3 $ 10,000 4 $ 10,750 5 $ 26,500 6 $ 19,000 Cost $ 70,000 (1) % (2) % (3) % (4) % 9. If AJ's reinvestment rate was instead 10% per annum, compounded semi-annually and his investment today was $100,000, his yield would be: (1) higher. (2) lower. (3) the same. (4) impossible to determine with the given information. 6.5

6 Lesson Jeff has carefully thought out his investment strategy and believes that he requires a yield of at least 10% per annum, compounded semi-annually. Jeff is currently examining the prospect of investing in a storage complex in Clearwater that will provide him with the payment schedule and acquisition costs outlined below. Given Jeff's desired yield on this project, calculate his net present value (NPV). Jeff's NPV is: (1) $ 55, (2) $ 7, (3) $ 1, (4) $ 62, Year Cash Flow 1 $ 11,000 2 $ 22,000 3 $ 9,500 4 $ 20,000 5 $ 3,000 6 $ 9,000 7 $ 1,000 Cost $ 55,000 THE NEXT FIVE (5) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: A real estate company is attempting to market three real estate investments. The forecasted cash flows and acquisition costs (at time zero) are shown below. Year A B C 1 0 $ 35,000 $ 150, ,000-35,000 3 $ 180, , ,000 Costs 100, , , The present value (rounded to the nearest dollar) at j1 = 12% on investment A - using single rates is: (1) $128,120 (2) $144,121 (3) $56,943 (4) $151, The net present value (rounded to the nearest dollar) at j1 = 8% on investment B - using single rates - is: (1) $25,898 (2) $29,503 (3) $46,007 (4) $22,

7 Real Estate Investment Analysis and Discounting 13. If the reinvestment rate is j1 = 9.5%, the net present value (rounded to the nearest dollar) at j1 = 21% on investment A is: (1) $101,605 (2) $137,098 (3) $1,605 (4) $37, If the reinvestment rate is j1 = 10%, the present value (rounded to the nearest dollar) at j1 = 21% on investment A is: (1) $60,105 (2) $101,605 (3) $135,237 (4) $45, If the reinvestment rate is j1 = 7.5%, the present value (rounded to the nearest dollar) at j1 = 16.75% on investment C is: (1) $160, (2) $228, (3) $159, (4) $207, Based on the projected cash flows shown below, calculate the net present value (NPV) if the investor requires a yield of j1 = 10%. The NPV is: (1) $ 56, (2) $ 9, (3) $ 9, (4) $ 59, Year Cash Flow 1 $ 10,800 2 $ 10,800 3 $ 12,275 4 $ 14,350 5 $ 10,800 6 $ 9,750 7 $ 13,540 Cost $ 47,

8 Lesson 6 THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: The Lanskys have recently invested $450,000 in a new condominium project. Below is a summary of the expected cash flows for phase 1, 2, and 3. (Due to be finished in years 3, 5, and 7 respectively) Phase End of Year Cash Flows 1 3 $275, $425, $675, What is the yield of their investment as an effective rate? (1) % (2) % (3) % (4) % 18. Due to a major earthquake in the area, phase 3 was delayed and completion did not occur until the end of year 8. How does this affect the return of the Lanskys investment? (1) increase the yield (2) decrease the yield (3) no change in yield (4) impossible to determine from information given alternatives. THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: 19. Ned Shred, founder of Shred Mountain Bikes, has made his fortune and is looking for a place to invest his wealth. Ned is considering investing in a mortgage by lending $250,000 to his sister Shelley. Ned will charge Shelley interest at 82% per annum, compounded semi-annually. The loan will have monthly payments based on a 20 year amortization and a 3 year term. The payments will be rounded up to the next higher cent. Ned has discovered that he can deposit all of the payments he receives from the loan into an account that bears interest at a rate of 9% per annum, compounded monthly. If Shelley makes all of her monthly payments on time, and Ned deposits all of all the payments into the account described above, what yield will Ned have earned on his investment at the end of the term of the loan? Express Ned's yield as a nominal rate per annum, compounded monthly. (1) % (2) % (3) % (4) 9% 6.8

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