LOS b: Determine the capitalization rate by the market-extraction method, band-of-investment method, and built-up method and justify the use of each technique in capitalization rate determination.

Q1. Spanos Klios analyzes investment opportunities for Central Europe Securities. Klios is considering proposals by several of Central Europe’s junior analysts.

Josef Klein wants to buy some real estate in Stuttgart and has put together a comprehensive packet on the project. Klein assigns an optimistic value to the project because it is located in an area densely populated with high-income residents. Klios finds the proposal intriguing, but is nervous about the leverage needed to make the deal work. Central Europe doesn’t like to borrow more than 80% of the value of any property, and Klein’s project would require borrowing 93% of the value of some of the properties.

Klios calls Klein in for a conference and asks him some questions about the realestate proposal, including how he valued the properties. Klein provides details about the deal which would be entirely financed via debt and Central Europe’s cash on hand. During the meeting, Klios takes notes based on Klein’s statements:

• Cash flows for the project would be negative in years one and two, during the initial construction, and in year five, when construction on the second phase is to begin.
• Klein used two methods to determine capitalization rates for the real-estate project, the market-extraction method and the band-of-investment method.
• Some of the property in question is under a tax lien, while other pieces have been poorly maintained. Klein believes these factors will allow Central Europe to knock 350 million euros off the owners’ asking price of about 2.1 billion euros.
• Klein has calculated two estimated values for the property, one using the gross income multiplier technique, and one using the direct income capitalization approach.
• Klein found three comparable properties. On average, these properties are selling at 3.2 times their gross income. Information related to each property are as follows:
• Property A – net operating income, $18 million; market value, $154 million.
• Property B – net operating income, $56 million; market value, $601 million.
• Property C – net operating income, $672 million; market value, $6.52 billion.

Klein then provides Klios with the following information related to the project:

After Klios finishes his meeting with Klein, he turns his attention to a proposal from Carlotta Graccos. She is proposing a venture-capital investment in two firms, retail group Belgarrique and the KinderWerks toy company. Klios reviews a fact sheet prepared by Graccos, considering a number of factors relating to both companies:

Klios knows most venturecapital proposals are risky, and he has several preferred methods to account for unusual risks. In this case, he wants to address the possibility that either or both of the companies under consideration might produce substantially lower profits than expected, as well as the chance that they might declare bankruptcy.

After reviewing the proposal from Graccos, Klios considers Svetlana Nordqvist’s recommendation of several hedge funds. Klios reads the proposal, but is concerned about whether the junior analyst has adequately considered the risks of the securities. He jots down a list of troubling items to discuss with Nordqvist in the morning:

• Many of the hedge funds’ securities are not traded on an exchange.
• Returns for two of the funds were unusually low last year.
• Valuation of some of the securities depend on complex and highly subjective models.
• Several of the fund managers have recently expanded their portfolios to new types of securities.
• Several of the funds have unusually low return volatility.

Klein is most likely proposing an investment in:

A)   office buildings and apartments.

B)   apartments and shopping centers.

C)   shopping centers and office buildings.

Q2. Klios uses the built-up method frequently, but is uncertain about its use for this project. Which of his concerns is most valid?

A)   He has enough information to accurately determine the capitalization rate without building a macroeconomic factor model.

B)   The project has no equity financing.

C)   The use of a sinking fund factor doesn’t adequately capture the project’s opportunity cost.

Thk!

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