Real Estate Exam 1

What is the relationship between a discount rate (or IRR) and a capitalization rate? What causes differences between them?

A capitalization rate is equal to the difference between the discount rate and the expected growth in income. In other words, changes in income over the economic life of the property are ignored when using a capitalization rate.

What is meant by an effective tax rate? What does it measure?

An effective tax rate is a tax rate that takes into account the effects of depreciation and time value of money. It measures the actual difference between the BTIRR and the ATIRR. This difference is the effective tax rate and can be less than the actual marginal tax rate. This difference is also due to the fact that the interest on the mortgage loan is deductible.

What is a capitalization rate? What are the different ways of arriving at an overall rate to use for an appraisal?

An overall rate or overall capitalization rate is the rate on the overall property (debt and equity). One way of arriving at an overall rate is to use the band of investment approach. This is based on taking into consideration the investment criteria of both the lender and the equity investor involved in a project. This is done by taking a weighted average of the equity dividend rate expected by the investor and the mortgage loan constant (expressed on an annual basis) required by the lender. Two different ways of arriving at an overall rate are the direct capitalization approach and the present value method.

Estates

Based on Rights: Possession vs. Not in Possession Based on Possession and Use: Freehold vs. Leasehold

What are the similarities and differences between an overall rate and an equity dividend rate?

Difference: The overall rate relates the entire NOI to the value of the property. The equity dividend rate relates the BTCF (or equity dividend) in the first year to the initial equity investment. Similarity: Neither one of these is a measure of investment yield because they do not take into account future income from operations or resale of the property at the end of the holding period. Both are based on a single year, usually the first year.

Why should investors be concerned about market rents if they are purchasing a property subject to leases?

Even if the investment is an existing building that has already been leased, the income can be affected when the existing leases expire and are renewed at the market rent at the time.

What factors affect a property's projected NOI?

Expected market rents and vacancy rates Expenses associated with operating the property Nature of any leases on the property

Why do you think appraisers usually use three different approaches when estimating value?

If perfect information was available, then theoretically the same value should result regardless of the methods chosen, be it cost, market, or income capitalization. Even with imperfect information, there should be some correspondence between the three approaches to value, which is the reason appraisal reports will typically contain estimates of value based on at least two approaches to determining value.

What factors would result in a property increasing in value over a holding period?

Inflation: This causes rents as well as the final sale price to be higher. Demand: Increased demand for space may increase value if the supply of space doesn't increase as well.

What is the significance of a debt coverage ratio?

It is a ratio of the NOI to the mortgage payment that indicates the riskiness of a loan. It is the degree to which the NOI from the property is expected to exceed the mortgage payment. Lenders typically want a debt coverage ratio (DCR) to be at least 1.2.

What are the primary benefits of investing in real estate income property?

Net Income: Dollars left over after collecting rent and paying expenses but before considering taxes and financing costs. Property Sale: Expecting a price increase over a specified holding period increases investor return. Diversification: Reduces overall risk to hold many types of investments. Taxes: Preferential tax benefits. Taxable income is often less than before-tax cash flow.

Is a cap rate the same as an IRR? Which is generally greater? Why?

No. The cap rate is the relationship between the current NOI and present value. The IRR is the return on all future cash flows from the operation and sale of the property. Usually, the IRR is greater than the cap rate.

What is the significance of the passive activity loss limitation (PAL) rules for real estate investors?

The PALL rules are important because, in general, passive losses cannot be used to offset income from another category. Because any tax loss from real estate is usually considered a passive loss, it can not be used to offset income from other sources such as active income from salaries and wages or portfolio income from interest or dividends.

How is the gain from the sale of real estate taxed?

The entire taxable gain from the sale of real estate is taxed at the same rate as ordinary income. It is still important to keep track of capital gains/losses and ordinary income gains/losses. This is due to TRA rules for passive investors and properties acquired prior to 1986.

What is meant by equity?

The investor's initial equity in the project is equal to the purchase price less the amount borrowed. The amount of equity an investor has in a property may change over time if the property value and loan balance changes. E.g., if the property value increases and the loan balance is reduced through amortization, the investor's equity increases.

What is the economic rationale for the sales comparison approach? What information is necessary to use this approach? What does it mean for a property to be comparable?

The rationale for the market approach (otherwise known as the sales comparison approach), lies in the principle that an informed investor would never pay more for a property than what other investors have recently paid for comparable properties. The sales comparison approach to valuation is based on data provided from recent sales of properties highly comparable to the property being appraised. For a property to be comparable, the sale must be an "arm's-length" transaction or a sale between unrelated individuals. Sales should represent normal market transactions with no unusual circumstances, such as foreclosure, sales involving public entities, and so on.

What is the economic rationale for the cost approach? Under what conditions would the cost approach tend to give the best value estimate?

The rationale for using the cost approach to valuing (appraising) properties is that any informed buyer of real estate would not pay more for a property than what it would cost to buy the land and build the structure. The cost approach is most reliable where the structure is relatively new and depreciation does not present serious complications.

What is meant by a tax shelter?

The term "tax shelter" refers to an investment that allows a taxpayer to reduce taxable income. Although most of the tax shelter benefits of real estate were removed by the Tax Reform Act of 1986, depreciation deductions still provide some "shelter" in that they are non-cash deductions that reduce taxable income. Interest deductions on the mortgage also serve to reduce and in a sense shelter taxable income.

How do you think expense stops and CPI adjustments in leases affect the riskiness of the lease from the lessor's point of view?

There is less risk for the lessor with expense stops and CPI adjustments in leases. CPI Adjustments: The risk of unexpected inflation is shifted to the lessee. Expense Stops: The risk of increases in expenses is shifted to the lessee while allowing the lessor to retain the benefit of any decrease in expenses.

If investors buy properties based on expected future benefits, what is the rationale for appraising a property without making any income or resale price projections?

Using the direct capitalization approach, this technique is a very simple approach to the valuation of income producing property. The rationale is based on the idea that at any given point in time, the current NOI produced by a property is related to its current market value. A survey of other transactions including sales prices and NOI (NOI ÷ sales prices) indicates the cap rate that competitive investments have traded for. This survey provides cap rates that indicate what investors are currently paying relative to current income being produced. A parallel in equity securities markets would be earnings yield (or earnings per share ÷ price) or price earnings multiples (price ÷ earnings per share).

Do you think taxes affect the value of real estate versus other investments?

Yes. Not all investments are treated alike when it comes to federal income taxes. Thus, taxes must be considered when comparing returns for investments which are not taxed in the same manner. Investments that have the same before-tax return may have quite different after-tax returns.

Real assets are heterogeneous

all properties are different