Ch 16: Assignment - Real Estate and High-Risk Investments

Amit is considering buying a rental property that has been offered for sale for $275,000. Amit has specified the following objectives, expectations and estimates: He desires an after-tax rate of return of 6%. After expenses, the property is expected to generate after-tax cash flows of $5,000, $5,100, $5,200, and $5,300 over the next four years, respectively. The property is expected to appreciate in value, and he expects to sell it in four years for $300,000 (after expenses). Given these expectations and objectives, complete the following table to calculate the present value of the property using the discounted cash-flow method and the interest table provided. Year: After-Tax cash flow: present value of $1 at 6%: present value of after-tax cash floe 1: 5,000: ___: ___ 2: 5,100: ___: ___ 3: 5,200: ___: ___ 4: 5,300: ___: ___ sale price of property at the end of year 4: 300,000: ____: ___ *Present Value of property: ____ Assuming no changes in his estimates, if Amit purchases the property at the asking price of $275,000, he ___ meet his goals. If Amit still wants to consider buying the property but also pay a price that will enable him to meet his goals, he could consider ___.

0.9434 $ 4,717 0.89 $ 4,539 0.8396 $ 4,366 0.7921 $ 4,198 0.7921 $ 237,630 $ 255,450 will not raising the rents he planned to charge

Capital gain, capital improvements, and repairs relative toreal estate investment property When a real estate investment is sold, a capital gain is realized when the sale price is ___ the seller's original purchase price ___ the cost of ___. The cost of repairs is almost ___ tax deductible from the cash flow generated by the real estate investment. A capital improvement ___ the value of the property and a repair ___ the value of the property. Expenditures on the physical property itself fall into two categories: capital improvements and repairs. Complete the following table, and for each item, indicate if it describes a capital improvement or a repair: 1. Snow shoveling: 2. Replacing light bulbs: 3. Installing an alarm system: 4. Spring cleaning: 5. Replacing cheap, laminate countertops with custom granite countertops: 6. Adding an exercise room:

1. Repairs 2. Repairs 3. Capital improvement 4. Repairs 5. Capital improvement 6. Capital improvement

Vocabulary: Disadvantages of investing in real estate Terminology: Disadvantages of Investing in Real Estate Investing in real estate can be very lucrative. It is also risky. Before making a real estate investment, wise investors will make themselves familiar with the possible pitfalls of making such investments. Match the terms relating to disadvantages associated with real estate investments (on the left) with the descriptions or examples of those terms (on the right). Read all descriptions and examples before selecting the best match between each term and description. Type the corresponding letter of the description in the Answer column next to the correct term. These are not complete definitions and examples, but there is only one correct answer for each term. 1. Business risk 2. Foreclosures 3. Illiquidity 4. Complexity 5. Dealing with tenants 6. Management demands 7. Low current income 8. Unpredictable costs 9. Legal fees 10. High transfer costs

1. The investment may not be profitable. Any investment is a business risk. Real estate investors are not immune from circumstances that may cause them to lose money on their investment. 2. Seller's difficulty with selling property at a reasonable price when neighborhood prices become depressed. Increases in the number of property owners in a neighborhood who don't pay their mortgages to the point where they become subject to foreclosure, depresses the value of all properties in the community, especially values of similar properties. This happens regardless of how nice a particular property may be. 3. Limited market for real estate sales may cause a cash flow crunch. Real estate is more difficult to liquidate than other investments, such as stocks and bonds. A poor selling environment can make the relatively small market for real estate even more narrow than usual and tie up funds for a long time. 4. Requires that buyer conduct much more in-depth research than most other investments before buying. The complexity of covering all the bases before investing in real estate can be daunting. In order to maximize the chances of making a wise and profitable investment, a lot of research should be performed, including financial "what if" analyses of future revenues and expenses. 5. Enforce a no pets policy. Dealing with tenants can be very time-consuming, exhausting, and frustrating. Before accepting tenants, smart investors perform a background check. Once applicants become tenants, landlords must be available to address tenants' concerns about the premises or other tenants, may have to chase tenants down for overdue rent, or even conduct evictions. 6. The time needed to maintain proper records. Management demands—such as making sure the premises are maintained, the bills are paid, periodic visits to the property are conducted, and records are kept properly—can be more time-consuming than you might have anticipated. 7. Annual rental revenues may be barely more than expenses. If rents are low and expenses are high, there may be a cash crunch. Current income might be low or nonexistent from time to time. Remember that there are two ways to make money from a real estate investment—ongoing profit when revenues exceed expenses and the gain on the appreciation of the property when it is sold. 8. The heating system may suddenly fail and need immediate replacement. A wise real estate investor will have an emergency fund available from which to draw money to pay for unpredictable costs. They are inevitable, no matter how much planning is done prior to making the investment. Things break, and causes beyond investors' control can prompt unexpected expenses. 9. The cost of reviewing a purchase and sale agreement. The more complicated a transaction is, the more necessary the services of an attorney become to protect an investor. The legal fees of a real estate attorney can range from performing a title search and reviewing contracts before a purchase to helping with insurance claims, settling tenant disputes, or eviction proceedings after a purchase. 10. Buyer may incur costs, sometimes 6-7% of the sale price, simply because ownership changes hands. Transfer costs are generally high, 6-7% of the sale price of a real estate investment. These are costs associated with changing ownership.

Lei is going to buy real estate as an investment. She intends to use leverage in the hopes of earning a rate of return that is greater than her ___ tax costs of ___ to pay for the purchase. Alison and Amy each bought identical apartment buildings on the same day. They paid $200,000 and a year later sold them for $214,200. During the year, they made capital improvements costing $4,000. Repairs and maintenance totaled $3,000. Alison: Alison paid cash for her building. Alison's capital gain on the sale of the property is $___. Rounding your answer to the nearest two decimal places and disregarding expenses, Alison's rate of return is ___%. Note that Alison doesn't have a loan-to-value ratio because she didn't take out a loan to buy the property. Amy: Amy paid for her building with a cash down payment of $30,000 and a mortgage loan of $170,000. Amy's capital gain on the sale of the property is $___. Rounding your answer to the nearest two decimal places and disregarding expenses, Amy's rate of return is ___%. Rounding your answer to the nearest whole number, Amy's loan-to-value ratio is ___%.

After- Borrowing Funds 10,200 5.10 10,200 34.00 85

Amy just paid $600,000 for a real estate investment. The following table shows the range of monthly rent she believes she can receive. Complete the following table: Property: Purchase price: Monthly rent: Annual rent: Price-to-rent ratio #1 $600,000: $3,200 #2. 600,000: 4,100 #3. 600,000: 5,200

Annual Rent= Monthly rent *12 Price-to-rent= Purchase price / annual rent 38,400: 15.63 49,200: 12.19 62,400: 9.61

Alison owns two pieces of real estate. One is an oil field in Texas and the other is a downtown Chicago office building in which she leases space to several tenants. Which property is primarily an investment?

Both of these

Depreciation on real estate investments Depreciation is a tax deduction that recognizes an asset's ___ in value due to ___ wear and tear and obsolescence. Remember the following real estate-related IRS Guidelines when answering the questions that follow regarding Eileen's and Lei's real estate holdings. Be sure to round each of your answers to the nearest whole dollar. IRS Depreciation Guidelines Type of property: Number of years allowed Land0.0 Residential property27.5 Nonresidential property39.0 Eileen's Real Estate - Depreciation and Tax Consequences Eileen invested $350,000 in real estate ($297,500 for an apartment building and $52,500 for the land). The property enjoys full occupancy; tenants include families, students, and seniors. Eileen can deduct ___ in depreciation per year on her taxes. Eileen's rental income in the first year of ownership was $42,000. By occupying the 25% income tax bracket, she will save ___ in taxes by taking the depreciation deduction. Lei's Real Estate - Depreciation and Tax Consequences Lei invested $800,000 in real estate ($600,000 for an office building and $200,000 for its land). The property enjoys full occupancy; tenants include an assortment of businesses. Lei can deduct ___ in depreciation from her taxes. By the end of her first year of ownership, Lei earned $120,000 in rental income. If she pays income taxes at the rate of 25%, then she will save ___ in taxes by taking the depreciation deduction. Amy's Real Estate - Depreciation and Tax Consequences Amy purchased 10 acres of land in the country for $210,000 as an investment. She leases the property to a local nature club whose members use it for hiking and bird watching. As a result, Amy can deduct ___ in depreciation from her taxes. If the gross annual rental income on Amy's property is $21,000 and she is taxed at the marginal rate of 25%, then she will be able to save ___ on her taxes as a result of the depreciation deduction.

Decrease normal $10,818 2705 15385 3846 0 0

Madison holds many options. If she decides to exercise any of them, the transaction will be at a price Madison thinks is fair.

False

Paola is concerned there might be a potato blight that would cause the price of potatoes to decline. She wanted to protect the company from declining prices should there be a blight.

False

Paola is obligated to purchase potatoes from Riya today.

False

Sheryl holds a put option. If she exercises her option, Sheryl will buy the optioned asset.

False

Ahmad owns an apartment building and has recently had to lower the rent he charges, not only to attract new tenants but also to keep the ones he has. Which disadvantage of real estate investing is Ahmad most likely experiencing?

Interest rate risk

Based on your calculations, the ___ the price-to-rent ratio is, the better off Amy will be because she will have ___ cash for expenses related to owning the property. This will ___ the chances of Amy enjoying a positive cash flow.

Lower more increase

Rental Property - Income and Expenses The cash flow expected from a real estate investment should result from its rental income ___ any associated expenses. If there is a mortgage on the property, these expenses should ___ the principal and interest. If there is money left over after covering the investment's expenses, then the investment will generate a ___ cash flow. Eileen is considering investing in rental property and needs to calculate its recent rental yield. She knows this figure assumes that approximately ___ of annual rents will be used to pay expenses that ___ the rental property's mortgage debt. The purchase price of the property is $800,000. Assuming that annual rents remain constant at $40,000, Eileen calculates her rental yield would be ___ %. (If required, round your answer to two decimal places.) Note: For simplification in the next question, disregard possible tax benefits. If Eileen makes the investment, she will have an annual mortgage payment of $27,500. Based on her calculations, Eileen estimates that, after paying all expenses and the mortgage, the property will produce a ___ cash flow of $ ____ per year.

Minus include positive one half don't include 2.50 negative 7500

The tax effect of interest payments on loans to make real estate investments Eileen invested in residential real estate for $200,000 ($170,000 for the building and $30,000 for the land). She financed her purchase with a 25-year mortgage for $150,000 at an interest rate of 6%. A year has passed since her purchase. Eileen is now curious about how her taxes, cash flow, after-tax return, and after-tax yield would have been different if she had paid cash for the property. Eileen's files indicate the following information regarding her investment: • Rental revenues were $30,000 • The depreciation deduction was $6,182 • Eileen paid $8,927 interest on the mortgage • Eileen is in a 25% tax bracket Complete the following table. Assume that all factors except those described above remain constant. For the after-tax yields, round your answers to the nearest decimal and round all other answers to the nearest whole number. Enter all figures as positive numbers, and follow the guidance in the tables to perform the appropriate mathematical operations. 1. Gross rental income 2. Less: Annual depreciation deduction 3. Subtotal 4. Less: Interest expense for the year 5. Taxable income 6. Cash flow after paying interest 7. Less: Income tax liability 8. After-tax return 9. After-tax yield Because Eileen took out a mortgage to finance her investment, she was able to ___ her overall rate of return, compared to making the investment solely with cash. In the first year of ownership, it appears to have been a ___ strategy.

Paid cash: 1. 30000 2. 6183 3. 23818 4. 0 5. 23818 6. 30000 7. 5955 8. 24045 9. 12 Used Leverage: 1. 30000 2. 6182 3. 23818 4. 8927 5. 14891 6. 21073 7. 3723 8. 17350 9. 34.7 Increase Successful

Like any investment, investing in real estate should only be done after weighing its advantages and disadvantages to determine how they apply to a particular opportunity. What are some possible advantages of investing in real estate? Check all that apply.

Tax-deductible interest expense on mortgage loan AND Tax-deductible depreciation expense AND Low capital gains tax upon sale of investment AND Rental income from a vacation home lowers taxable income AND 1031 exchange (tax-free exchange) *NOT* Dealing with tenants, Unpredictable costs, Foreclosures, Illiquidity

Gabriella lost a lot of money trading in futures. Gabriella is among 90% of futures investors.

True

Madison made a lot of money trading in futures. Madison is among only 5% of futures investors.

True

Paola holds an option contract written by Riya. Paola notified Riya that she decided to exercise her option. Riya must honor Paola's decision.

True

Riya uses the futures contract to lock in a price that she can count on when she harvests and sells her potatoes.

True

Riya wrote the option and does not own the underlying stock. Riya wrote a naked option.

True

Sheryl invested in a futures contract 18 months ago. Her broker just made a margin call for Sheryl to provide additional money to maintain her stake in the contract. The price of underlying product fell since Sheryl bought the contract.

True

Sheryl let her option contract expire without exercising the option. Her decision is typical.

True

When Paola bought the option from Riya, she paid Riya a fee called a premium.

True

Alyssa just purchased a sweat equity property. Which of the following statements best describes her transaction? Alyssa's property:

came relatively cheap but has good underlying value; it needs a lot of repairs and cosmetic enhancements.

Price-to-rent ratio is used to measure ___ in a real estate market. When calculating the following ratios, round your answers to the nearest two decimal places.

current income

Elana recently invested in rental property and purchased her own home, both of which she financed with mortgages. Which of the following statements is most likely true? Elana's interest rate for her rental property was:

more than that for her personal residence.

Tabitha just invested in real estate through owner financing. Which of the following statements best describes her transaction?

no lending agency was involved.