Alternative Investments【Reading 44】Sample following, require, management, 2012

jawz

Which of the following real estate investments is most appropriate for a retiree?

A) Warehouses.

B) Residential rentals.

C) Office buildings.

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Warehouses do not usually require a lot of maintenance or management involvement, thus making them attractive investments to moderately passive investors, such as retirees.

jawz

Which of the following types of real estate investments provides a total return that is relatively more heavily weighted toward periodic income?

A) Residential rentals.

B) Warehouses.

C) Office buildings.

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Warehouse investment returns tend to be mostly in the form of periodic income, with relatively little value appreciation. Office buildings and residential rental property each offer substantial returns in the form of both current income and value appreciation.

jawz

The risk associated with a non-constant rate of appreciation is most closely related to which of the following types of real estate investing?

A) Warehouses.

B) Raw land.

C) Office buildings.

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The rate of appreciation of raw land is not constant. This represents risk because a raw land investor may have to liquidate the investment before it has reached its expected appreciated value.

jawz

Ernesto Chavez, CFA is a principal in a real estate limited partnership, Luxury Apartments, Inc. and is in the process of evaluating apartment complexes in Fort Worth, Texas for a potential investment. His initial market research has shown good population and income growth in the Fort Worth area, and this property has an excellent track record. Chavez also controls other limited partnerships that hold various properties, including not only apartment complexes, but also office buildings, small strip shopping centers, warehouses, and one small motel. Chavez’s objectives for this investment are to earn returns from income and appreciation and to provide an inflation hedge. Chavez intends that his firm will manage the property themselves since it is a relatively small property. An analyst in the firm, Joe Howard, CFA has prepared a pro forma analysis for the Boat Club Luxury Apartments, one of the properties being evaluated by Luxury Apartments. Below are some of the details of the analysis.

Purchase price:		$1,000,000
NOI in Year 1:		$120,000
NOI growth rate:		3% per year
Depreciation:		$30,000 per year
Initial down payment:		25% of purchase price
Loan terms:		30 year fixed at 4.375%, monthly compounding
	Interest payable in Year 1:	$32,596
	Interest payable in Year 2:	$32,014
	Interest payable in Year 3:	$31,437
	Interest payable in Year 4:	$30,836
Investor's marginal tax rate:		34%
Investor's capital gains tax rate:		20%
Recaptured depreciation tax rate:		35%
Required return on equity capital (after tax):		14%
Investment horizon:		4 years
Market value at the end of 4th year:		922,368
Costs of sale:		8% of sales price

Chavez has determined that Luxury Apartments will purchase one of several apartment complexes from a set that the firm has compiled. Howard tells Chavez that since the cash flow patterns for apartment complexes have only one sign change, the optimal project will be the apartment complex with the highest estimated IRR. In comparing various real estate investment options, how would the principal characteristics of apartments best be characterized?

A) Passive, moderately liquid.

B) Moderately active, not very liquid.

C) Active, moderately liquid.

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Investing in an apartment complex would best be described as an active investment. Professional management may be required, although Chavez’s firm plans to manage the property themselves. (Study Session 13, LOS 44.a)

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Does an investment in an apartment complex meet Chavez’s investment objectives?

A) Yes.

B) No, apartments do not provide an inflation hedge.

C) No, apartments only provide returns from income.

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Apartments provide returns from income plus appreciation and provide an inflation hedge. Income comes from the collection of rent, while appreciation comes from increases in property value. Apartments provide inflation hedges because as leases expire during an inflationary period, extensions or new leases will be set at higher rates. (Study Session 13, LOS 44.a)

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Given the various inputs provided, the projected income taxes payable on the Boat Club Luxury Apartments project in Year 3 is closest to:

A) $19,517.

B) $2,203.

C) $22,396.

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Income taxes payable is computed by subtracting depreciation and interest from NOI to compute taxable income. Taxable income is then multiplied by the tax rate of 34% to compute income taxes payable. To compute NOI for year three, take the NOI given for year 1 and inflate it using the 3% growth rate for two years as follows:
NOIt−3 = NOIt−1(1+g)2 = 120,000 × 1.032 = 127,308
Taxable income is then:
taxable incomet−3 = NOIt−3 − depreciationt−3 − interestt−3 = 127,308 − 30,000 − 31,437 = 65,871
Income taxes payable is then:
income taxes payablet−3 = taxable incomet−3 × income tax rate = 65,871 × 0.34 = 22,396
For more clarification on the computation of income taxes payable, please refer to the table below.

Computation of Income Taxes Payable for Boat Club Luxury Apartments
	Year 1	Year 2	Year 3	Year 4
NOI (growth rate = 3%)	$120,000	$123,600	$127,308	$131,127
Less: Depreciation	($30,000)	($30,000)	($30,000)	($30,000)
Less: Interest	($32,596)	($32,014)	($31,437)	($30,836)
Taxable income	$57,404	$61,586	$65,871	$70,291
× Income tax rate	0.34	0.34	0.34	0.34
Income taxes payable	$19,517	$20,939	$22,396	$23,899

(Study Session 13, LOS 44.c)

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Given loan terms as described above, the amount of monthly debt service is closest to:

A) $3,781.

B) $3,745.

C) $2,203.

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Monthly debt service (i.e., the monthly loan payment) can be computed on the calculator using the TVM function. Remember with monthly compounding to adjust the number of periods and the interest rate for monthly compounding.
N: 360 (= 30 × 12)
PV: 750,000
I: 0.3646 (= 4.375 / 12)
PMT: CPT → 3,744.7339
(Study Session 13, LOS 44.c)

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The projected cash flow after taxes (CFAT) for Year 2 is closest to:

A) $59,972.

B) $55,543.

C) $57,721.

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The projected cash flow after taxes (CFAT) for Year 3 is $59,972. It is computed by taking the NOI, deducting the annual debt service and taxes payable.
CFATt−3 = NOI − debt service − taxes payable = 123,600 − 44,940 − 20,939 = 57,721
For more clarification on the computation of cash flow after taxes, please refer to the table below.

Cash Flow After Taxes (CFAT) Computation for Boat Club Luxury Apartments
	Year 1	Year 2	Year 3	Year 4
NOI	$120,000	$123,600	$127,308	$131,127
Less: Debt service	($44,940)	($44,940)	($44,940)	($44,940)
Pre-tax cash flow	$75,060	$78,660	$82,368	$86,187
Less: Taxes payable	($19,517)	($20,939)	($22,396)	($23,899)
CFAT	$55,543	$57,721	$59,972	$62,288

(Study Session 13, LOS 44.c)

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Is Howard’s statement regarding using the IRR method for selecting the optimal apartment complex CORRECT?

A) Yes.

B) No, the IRR method may yield multiple IRRs.

C) No, the NPV method should be used.

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The NPV method should be used when selecting the value maximizing project from a mutually exclusive set (e.g., only one of a set of possible investments may be accepted) as the IRR method may not select the value maximizing project. In this case, there is no concern for IRR yielding multiple rates as there is only one change in sign for the project cash flows. (Study Session 13, LOS 44.d)

jawz

A real estate investment is expected to have cash flows after taxes in each of the next three years equal to CAD70,000, CAD50,000, and CAD65,000, respectively. The initial equity investment in this property is CAD600,000 and the equity reversion after taxes (ERAT) at the end of year three is estimated to be CAD500,000. The internal rate of return (IRR) for this investment is closest to:

A) 5.0%.

B) 8.0%.

C) -7.8%.

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Using your TI BAII Plus:

[CF] [2nd] [CLR WORK]
600,000 [+/–] [ENTER] [↓]
70,000 [ENTER] [↓] [↓]
50,000 [ENTER] [↓] [↓]
565,000 [ENTER] [↓[↓] (note: CF3 = 65,000 + 500,000)
[IRR] [CPT] = 5.0056 percent

jawz

A real estate investment is expected to have cash flows after taxes in each of the next three years equal to CAD70,000, CAD50,000, and CAD65,000, respectively. The initial equity investment in this property is CAD600,000 and the equity reversion after taxes (ERAT) at the end of year-three is estimated to be CAD300,000. Assuming an after tax return on equity of 8 percent, the net present value (NPV) for this investment is closest to:

A) -CAD238,150.

B) CAD202,569.

C) -CAD202,569.

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NPV = -600,000 + 64,814.81 + 42,866.94 + 51,599.09 + 238,149.67
= -CAD202,569.48
Or, using your TI BAII Plus:

[CF] [2nd] [CLR WORK]
600,000 [+/–] [ENTER] [↓ ]
70,000 [ENTER] [↓] [↓]
50,000 [ENTER] [↓] [↓]
365,000 [ENTER] [↓[↓] (note: CF3 = 65,000 + 300,000)
[NPV] {8} [ENTER] [↓]
[CPT] = -CAD202,569.48

jawz

A real estate investment is expected to have cash flows after taxes in each of the next four years equal to GBP90,000, GBP55,000, GBP35,000, and GBP25,000, respectively. The initial equity investment in this property is GBP200,000 and the equity reversion after taxes (ERAT) at the end of year-four is estimated to be GBP100,000. Assuming an after tax return on equity of 8.5%, the net present value (NPV) and internal rate of return (IRR) for this investment is closest to:

NPV

IRR

A) GBP47,268 18%

B) GBP45,376 16%

C) GBP41,399 15%

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Using your TI BAII Plus:

[CF] [2nd] [CLR WORK]
-200,000 [+/–] [ENTER] [↓]
90,000 [ENTER] [↓] [↓]
55,000 [ENTER] [↓] [↓]
35,000 [ENTER] [↓] [↓]
125,000 (note: CF3 = 25,000 + 100,000)

[NPV] {8.5} [ENTER] [↓]
[CPT] = GBP 47,267.91
[IRR] [CPT] = 18.39%

jawz

A property was purchased for $550,000 and sold after six years for $850,000. Costs associated with the sale were $65,000 and the tax depreciation in each year was $20,000. At the time of the sale, $320,000 remained outstanding on the mortgage. The tax rate on recaptured depreciation is 28% and the long-term capital gains tax rate is 20%. The equity reversion after taxes for this property is closest to:

A) $365,600.

B) $449,400.

C) $384,400.

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Equity reversion after taxes (ERAT) = net selling price – mortgage balance – taxes.
First, compute taxes.
Recaptured depreciation = 6 × $20,000 = $120,000
Tax on recaptured depreciation = $120,000 × 0.28 = $33,600
Total gain on sale = net selling price – adjusted basis

Net selling price = sales price – cost of sale= $850,000 - 65,000 = $785,000
Adjusted basis = cost - accumulated depreciation = $550,000 - 120,000 = $430,000

Total gain = $785,000 - 430,000 = $355,000.
long-term capital gains tax

= capital gains tax rate × (total gain - recaptured depreciation) = 0.20 × (355,000 – 120,000) = 0.20 × 235,000 = $47,000

Total taxes payable

= tax on recaptured depreciation + tax on long-term capital gains = $33,600 + $47,000 = $80,600

ERAT = net selling price – mortgage balance – taxes = 785,000 - 320,000 - 80,600 = $384,400

jawz

Suppose you are evaluating an investment opportunity in an office building for which you have estimated the following financial characteristics:

• First year net operating income (NOI) = $75,000.
• Growth rate in net operating income = 5% per year.
• Tax depreciation = $10,000 per year.
• Annual interest expense = $9,000.
• Annual total debt service expense = $12,000.
• Equity investors marginal income tax rate = 36%.
• Investment horizon = four years.

The cash flows after taxes for years one and four are closest to:

A) CFAT1 = $51,480 and CFAT4 = $50,766.

B) CFAT = $42,840 and CFAT4 = $47,760.

C) CFAT1 = $42,840 and CFAT4 = $50,406.

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Taxes Payable Computation:
	Year-1	Year-2	Year-3	Year-4
NOI (g = 5%)	$75,000	$78,750	$82,688	$86,822
Less depreciation	(10,000)	(10,000)	(10,000)	(10,000)
Less interest	(9,000)	(9,000)	(9,000)	(9,000)
Taxable income	$56,000	$59,750	$63,688	$67,822
times tax rate	´0.36	´0.36	´0.36	´0.36
Income taxes payable	$20,160	$21,510	$22,928	$24,416
CFATt Computation:
	Year-1	Year-2	Year-3	Year-3
NOI (g = 5%)	$75,000	$78,750	$82,688	$86,822
Less debt service	(12,000)	(12,000)	(12,000)	(12,000)
Before tax cash flow	$63,000	$66,750	$70,688	$74,822
Less taxes payable	(20,160)	(21,510)	(22,928)	(24,416)
CFAT	$42,840	$45,240	$47,760	$50,406

jawz

Which of the following cash flow streams is most likely to have multiple IRRs?

Purchase Price

Cash Flow 1

Cash Flow 2

A) $1.0 million $1.0 million gain $0.1 million expense

B) $1.7 million $8.0 million gain $5 million gain

C) $1.8 million $10 million gain $9 million expense

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When there is a reversal in the sign of the cash flows, it is likely that there will be multiple IRR solutions. In fact, for the cash flow stream {-1.8; 10; -9} the IRRs are 13 and 343%.