Chapter 9 Real Estate and Other Assets

Why is a home a good inflation hedge? Should a home be included as an asset if its occupants aren't sure they could sell it? Explain.

A home is a good inflation hedge because: a) It historically has been positively correlated with inflation when inflation moves up sharply. b) Fundamentally, the cost of new homes rise when inflationary-induced increases in labor and materials up. Sales prices generally have to follow the boost, although a lag is possible, because no one will build a home unless a profit is expected. If no homes are built, demand for homes from population growth will force overall real estate prices to rise to the point at which profits can be made on building and selling new homes. A home is still an asset even if there is no expectation of sale because: a) A reverse mortgage can be obtained for funds that will allow one to stay in the home for the rest of one's life. b) You may change your mind or be compelled to sell due to financial or health reasons. c) The house is an asset that can be given to heirs.

What are the significant characteristics of a mortgage?

Characteristics of a mortgage include: a) Principal - total amount borrowed b) Interest - interest rate paid to lender c) Term - the life of the loan d) Frequency of payments- how often payments are collected will affect the total amount paid e) Taxes - Property taxes based on location f) Insurance - homeowners insurance is an additional required expense

Why is investing in gold appealing?

Investing in gold is appealing as it is negatively correlated with the performance of financial investments and thus acts as a hedge. Gold can also do well in periods of high inflation and high uncertainty.

In what cause would you to suggest direct ownership over private partnership? Why?

Direct ownership can be preferable when a greater degree of control is wanted over the property. In addition direct ownership is much more liquid than a private partnership as there does not need to be a formal discussion and agreement in order to proceed. Direct ownership may be an attractive option to a doctor with a private practice as it can provide substantial upside.

Why do people purchase a home?

Homes have a combination of three factors in purchasing: a) Shelter b) Leisure as a relaxing place which also allows individual expression in decorating. c) Investment - well maintained homes appreciate over time.

What do commodities protect against? What is the downside to commodity investment?

In addition to labor costs, broad commodities costs can cause inflation and therefore commodities can be a hedge of inflation. The downside of commodities is that they do poorly when the overall economy struggles as there is less spending and therefore less demand for goods.

How should exchange traded funds (ETF) and other commodities be treated from an investment standpoint? What is their main value? Explain

Investors should treat commodities as hedges against inflation, however commodities should not be looked at or treated the same as traditional investments. Commodities are not meant to be used as long-term growth investments.

Compare and contrast the value in owning a home versus investing in real estate investment trusts (REITs).

One of the main differences in home ownership versus REITs is the level of ownership. REITs can be publicly privately owned investment companies whereas a home is privately owned. REITs pay out in high-dividend yields while homes pay out in the various benefits it provides including shelter, leisure, tax benefits and often times appreciation in value. REITs have the advantage of being more accessible and retaining a higher degree of liquidity as REIT funds can be traded on the stock market whereas selling a home would require various legal fees, appraisers, advertising, repairs, and many other aspects as well.

Why is the home often a better investment than renting? Under what circumstances would renting be preferred?

Purchase of a home is better than renting because: a) It provides a tax deduction for mortgage interest and real estate taxes. b) It provides a tax deferral on gains until sale. c) There is no taxation on the first $250,000 of gains when one individual owns it and $500,000 if two or more people own it. Renting is more attractive than buying when: a) You expect a decline in the price of a home. b) You will only be holding it for a short time and therefore might have to sell when prices are weak. c) You don't want the responsibility of owning a property. d) You are in a low tax bracket and therefore the tax benefits for ownership are not so substantial.

What is the cap rate's significance in terms of real estate?

The cap rate can be thought of as the cash yield based on the property's purchase price.

What is involved in establishing the cap rate?

The cap rate is determined by the following formula: Cap rate = Net operating income (EBITDA)/ building value.

If you had to select one method of valuation for real estate, which would it be? Why?

The comparable sales method of valuing real estate would be preferred. The comparable sales method is the most popular type since earnings are generally not considered in most homes. Comparable sales method looks at the sale of recent similar properties to establish the property value.

Is the home likely to be a good investment? Explain.

Well taken care of homes in good neighborhoods tend to grow at a rate modestly ahead of inflation. There are tax benefits for upkeep and on sale of the premises which add to their attractiveness.