Lesson 1

Question 1

Payback period

Answer 1

The length of time required for the stream of cash flows produced by the investment to equal the original cash outlay. When deciding between investment options, and all other investment decision-making criteria being equal, the investment with the shortest payback period is considered the better investment.

Question 2

Characteristics of real estate assets (ILIT)

Answer 2

Immobility, longevity, indivisibility, tax benefits. These characteristics differentiate real estate assets from many other investments and can impact the level, timing, or riskiness of the future benefits of a real estate asset compared to other investments.

Question 3

Economic life

Answer 3

The period over which improvements to real property contribute to property value. The economic life of a real estate asset can be, and generally is, shorter than its physical life.

Question 4

Holding period

Answer 4

The time from purchase to the subsequent sale of an asset. Apartment and commercial properties have an average holding period of approximately 5 years.

Question 5

Characteristics of real estate markets (LHDG)

Answer 5

Localization, high information and transaction costs, discontinuous price information, government intervention

Question 6

Characteristics of competitive market

Answer 6

1) Many buyers and many sellers in the market 2) Goods offered by the various sellers are largely the same

Question 7

Characteristics of efficient market

Answer 7

1) Real estate investors act quickly on any information they receive 2) Prices adjust rapidly on receipt of the information

Question 8

Advantages of real estate investments (HFTI)

Answer 8

High returns, financial leverage, tax sheltering, inflation hedge

Question 9

When can higher returns exist in a market?

Answer 9

Higher than normal returns can only exist in a market if either the investments have greater risk or the market is non-competitive or non-efficient. In a competitive market, an investor can earn higher returns only by choosing riskier investments.

Question 10

Financial leverage

Answer 10

The use of fixed-cost debt in an investment to increase the return to the equity investor. They key element in financial leverage is having debt financing where costs are a set percentage of the loan amount and the lender does not otherwise participate in the benefit flows of the investment.

Question 11

Tax shelter

Answer 11

An investment that reduces or defers an investor’s income tax liability. Tax shelter benefits in a real estate investment can result from the investor being able to deduct from taxable income certain expenses that do not represent a cash outlay in the investment.

Question 12

Inflation hedge

Answer 12

An investment that offers an investor protection against the loss of purchasing power resulting from the rising prices of goods and services to the degree that the investor’s equity increases in value at a rate equal to or greater than inflation. Key characteristics of real estate that enable it to be a potential inflation hedge are supply inelasticity and responsiveness of rents to inflation.

Question 13

Disadvantages of real estate investments (FIIM)

Answer 13

Financial risk, interest rate risk, illiquidity, management

Question 14

Financial risk

Answer 14

The risk to an investor created by financial leverage. The higher the LTV ratio of the financing of an investment (assuming non-participatory debt), the great the variation of equity flows and returns from a change in NOI (or property appreciation) and the higher the level of financial risk

Question 15

Interest rate risk

Answer 15

The investment risk resulting from volatile interest rates. Interest rate volatility increases the risk in real estate investment by causing the cost of mortgage debt at renewal to be highly uncertain. The higher the degree of financial leverage, the greater the decline in rates of return from an increase in interest rates.

Question 16

Illiquidity: a) definition, b) 2 factors upon which liquidity in property markets is dependent

Answer 16

Inability of an asset to be readily converted into cash. The liquidity of property markets is dependent upon the number of participants in these markets and whether barriers to market entry exist in the form of capital constraints

Question 17

Management

Answer 17

Directing or conducting business affairs, including maintenance, repair, determination and receipt of revenues and payment of expenses, and leasing of real property

Question 18

Steps in the investment analysis process (ICPAM)

Answer 18

1. Identify investor’s decision framework
2. Collect market information
3. Perform financial analysis
4. Apply selection criteria
5. Make investment decisions

Question 19

Selection criteria categories

Answer 19

1. Basic or first year measures
2. Discounted cash flow techniques
3. Portfolio analysis

Question 20

Basic or first year measures

Answer 20

Limit the analysis to only the benefits and costs in the first year of the holding period

Question 21

Discounted cash flow techniques: a) vs first year measures, b) underlying concept

Answer 21

Go beyond the basic or first year measures by bringing into the analysis the projected net benefit flows after the first year of the investment. The concept underlying these techniques is that the value of a real estate investment is equal to the present value of future cash flows.

Question 22

Decision criteria (DCF techniques)

Answer 22

NPV ≥ 0
IRR ≥ investor’s target rate
Payback period ≤ investor’s target time frame

Question 23

Where a feasibility study may be useful

Answer 23

1. Developing a site
2. Site search
3. Investment consultant

Question 24

8 steps in the valuation process

Answer 24

1. Identification of the problem 2. Scope of work determination 3. Data collection and property description 4. Data analysis 5. Site value opinion 6. Application of the approaches to value 7. Reconciliations of value indications and final opinions of value 8. Report of defined value

Question 25

Mortgage constant

Answer 25

Annual debt service / loan amount

Question 26

Determinants of asset value

Answer 26

Level, timing, and riskiness of future benefits

Question 27

Real estate market imperfections

Answer 27

a) Barriers to entry: high information costs due to localized nature of real estate sub-markets, possible capital constraints created by the indivisibility of real estate assets
b) Information inefficiencies: localized sub-markets, varying levels of access to and cost of information between investors

Question 28

Advantages to real estate investment market of financial leverage

Answer 28

Reduces market inefficiency by lowering capital constraints and reducing effect of asset indivisibility as one of the barriers to entry, increasing participation in real estate investment markets