1. What is the difference between nominal returns and real returns?

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1 End of Chapter 11 Questions and Answers 1. What is the difference between nominal returns and real returns? Answer: Nominal returns include inflation while real returns have inflation netted out. For example, a nominal return of 12% during a year of 3% inflation has provided a real return of approximately 9%. 2. Two sources of real estate returns occur every year while two others are only observed when the property is sold or refinanced. Explain the timing of the four potential returns. Answer: Real estate returns in form of rental cash flows and tax-shelter (or postponement) occur every year. Returns due to equity buildup and price appreciation are observed on sale or refinancing for the property. From a timing perspective the before tax cash flow plus or minus tax savings or taxes due can be treated as one final source of returns during the operational stage of ownership. The appreciation and equity buildup both result in before tax proceeds at the time of sale based on an estimate of the selling price less transactions costs and the mortgage balance. Depreciation and improvements need to be considered in calculating the taxes due at the sale in order to derive the after tax proceeds or residual from resale. 3. Why is it hard to find an investment with above average cash flow yield and an above average prospect for price appreciation? Answer: It is impossible to find a real estate property that has both relatively high current income and relatively high appreciation. This is because both would create extremely high total returns and investors in an efficient market will bid up the prices until yields decline to market required levels. 4. What is the difference between direct and indirect real estate investment? Give examples. Answer: The term direct real estate investment refers to buying buildings directly with no active market for the trading of interests in the building. This is the way most real estate is owned, whether it is rented out or occupied by the owner. Owners have control over management decisions and are considered active investors. The term indirect refers to owning the investment via the public markets and securities that may be traded, also known as the securitized market. Here investors are passive and do not have any direct day to day control over the operation of the properties. A common indirect or public way to own real estate is through real estate investment trusts or REITs. 5. True/False explain: When there is no financing on a property the NOI (net Operating Income) is the same as the cash flow. Answer: True

2 NOI is the annual return on the property prior to financing, also known as the unlevered return. To get the cash flow, debt service is subtracted from NOI to pay for any mortgage financing where the debt service includes both principal and interest owed. If there is no financing there is no debt service and the NOI is same as cash flow. 6. Why is it difficult to measure total returns on direct real estate investments? Answer: For direct real estate there is no active market within which current market values can be abstracted so we need to estimate total returns based on using cash flows instead of dividends and an estimate of the change in value based on an appraisal of the underlying real estate. The problem with using appraised values in that such appraisals have been demonstrated to historically lag real market values and also to be smoothed such that the volatility of the return stream is underestimated. 7. What is the most commonly used estimate of total returns for real estate? Define it in words. Answer: For real estate the internal rate of return or IRR is a frequently used estimate when making investment decisions or comparing past performance of real estate to stocks and bonds. The traditional levered IRR is that return which discounts all future returns back to present value such that they equal the initial equity investment. The total return internal rate of return calculation works as follows: CF 1 CF 2 CF T Projected Resale CF T $Initial Equity = PV e = irr (1 +irr) 2 (1 + irr) T (1 + irr) T The cash flows (before tax or after tax) are projected for the entire holding period. CF is the cash flow from the year 1 or 2 all the way through year T noted in subscript. IRR here refers to the internal rate of return in decimal form solved by iteration such that the discounted sum of all future returns equals exactly the initial equity. T is the last year of the holding period. 8. True/false Explain: Stocks are higher risk than real estate but provide higher appreciation potential. Answer: True. The value of stocks is based on the investor s belief on its future earnings, which is unpredictable. On the other hand, real estate valuation is based on current and future earnings, which are more predictable. This subjects stocks to higher risk than real estate. Higher risk requires higher returns and historically stocks have had a higher appreciation potential.

3 9. Compare the cash flow returns likely on real estate, growth stocks and bonds. Answer: The following tables gives the comparison: Source of Return Bonds Stocks Direct Real Estate Current return Coupon usually paid twice a year. Tax sheltered return 1 Future return Total returns None unless municipal bond. Difference between par value when redeemed, usually $1,000, if this exceeds current market value at the time of maturity or before through a sale if the market value goes up because of declines in required yields. Yield to maturity considering the initial price, coupon and known terminal value. Dividends paid periodically, over market price, known as the current return. None. Price changes over time net of transactions cost. Dividends plus price change in a given year indicate total return for that year. Dividends and expected price changes over time will produce an uncertain estimate of an annualized yield to maturity. Cash flow from rents less expenses and debt servicing if any. Taxable income may be less than cash flow providing some tax benefits. Appreciation in value net of transactions costs, if any, plus equity buildup through debt principal repayment, if any. Cash flow after tax, if relevant, and net equity expected at the time of sale produce an overall estimate of the annualized yield known as the internal rate of return 10. How do the get rich in real estate seminars typically provide above market returns? What are the typical assumptions they make to convince the naïve investor? Answer: Although the real estate seminars claim to provide above market returns, in reality they don t. Among the assumptions that are seldom revealed by these get-rich-quick authors are the following: 1 Tax shelter is really tax postponement in that eventually taxes will need to be paid, yet there is a present value benefit of deferring taxes and possibly taxation at a lower capital gains rate.

4 Everyone else is stupid and you can out smart them. Everyone else does less homework on the market then you will do. If you manage the property yourself you can make more money, and your time is worthless anyway since you have nothing else to do. You can leverage the property to 100% with no money down. 11. List some possible categories of risk and then explain which of these are most controllable by the investor? Answer: Categories of risk: 1. Economic risks 2. Business Risk or Management Risks 3. Financial Risk 4. Liquidity Risks 5. Political Risks Management risks are most controllable by investor as it can change the persons managing or train them to work efficiently. Financial risk is controlled through varying the level of leverage. 12. What is a liquidity premium and is this return requirement part of the required total yield for both direct and indirect real estate investments? Answer: Liquidity risks are related to the ability to convert the asset to cash quickly while preserving capital. The premium required by investor to take this risk is called liquidity premium. Real estate liquidity risks are significant for all direct investments. Transactions costs are high compared to other investments. There is no control over this risk except to lower price resulting in a loss of capital. Indirect real estate investment does not face much liquidity premium, as these interests can be traded freely on the market. 13. How efficient do you believe US real estate markets are? Answer: Markets are efficient to the extent that all of the available information is reflected in the current market prices. Efficient markets have no trading (buying or selling) based on inside information. Efficient markets consider all of the expectations influencing demand or supply. Efficient markets do not require universal agreement as not everyone needs to hold real estate or think it is a good investment for their risk preferences, but among those interested in buying, selling, or holding there are no informational advantages. Over the last few decades the quality and quantity of current market information has substantially improved due to the efforts of the larger brokerage and property management firms like CB Richard Ellis, Grubb and Ellis, Colliers International and others as well as the major data vendors like CoStar, Reis, Torto-Wheaton and others. As the quality and timeliness of real estate data has improved real estate markets have

5 become more efficient, especially among the larger assets of $10 million and up where sophisticated institutional investors dominate the market. 14. Name one advantage of using a partnership for a single real estate investment. Answer: By structuring partnership contracts a single real estate investment can cater to different investor requirements, hence partnerships are formed to benefit from this discretionary allocation mechanism. For example: one investor may want current returns and another may want future wealth. By structuring an investment with various contractual interests (securities or mortgages) that direct the return priorities to different investors multiple investors can achieve their objectives.