Question 6

Rosemary Willums, age 55, recently inherited $2.2 million from the estate of her father. Willums is a nurse at a local hospital. Her husband, age 60, is partially disabled, but works from home on a contract basis as a project manager for a construction firm specializing in custom-designed residences. His consulting engagements are sporadic, however. For the past three years, the Willums’ combined annual after-tax income was $85,000. The Willums have one adult daughter who is single and economically secure. Other than the inheritance and their home (valued at $200,000), the Willums’ other assets consist of their modest personal retirement accounts (less than $100,000) and two small undeveloped tracts of land.

Willums has strong attachments to her two properties because her father helped her purchase them when she was first out of college. Her father was in the residential real estate business for many years and repeatedly told his daughter that “owning land is the only retirement plan you need.”

The Willums’ are financially conservative by nature; they used their recent windfall inheritance to pay off their only debt, a $125,000 home mortgage. Due to her husband’s knowledge of construction and the desire to have some income-producing property, Willums is considering two possible real estate ventures which would take advantage of her existing land.

One of Willums’ properties is a five acre waterfront tract at Dogwood Mountain Lake. It is suitable for low-density, upscale garden apartments. The property will accommodate approximately 10 units. Willums has decided to name the property Rosemary Cove (Cove). The original purchase price for the land was $25,000 but it has recently been appraised at $550,000.

Dogwood Mountain Lake is a large body of water within 5 hours of Washington D.C. The lake is well-known for its water quality, scenic beauty, golf courses, and bass fishing. The weather is temperate. The last five years have seen rapid development due to an influx of retirees from the north. Approximately one third of single family dwellings are full-time residences, although this number is rising as more people move to the area. The remaining lakefront homes are used primarily in the summer. Property values have soared - climbing, on average, more than 20 percent per year over the trailing five-year period. Although growing, the lake is in a rural area with few grocery stores, retail outlets, restaurants, or hospitals. The nearest community of any size is an hour away via car. There is no public transportation available. The local economy is based predominantly on tobacco and vegetable farming.

Willums also owns ten acres of farmland at a strategic crossroads near Dogwood Mountain Lake. She paid $5,000 for it thirty years ago; its current appraised value is $85,000. Most local residents and vacationers must pass through the intersection en route to the waterfront. Willums believes the location is ideal for a strip mall or shopping center of some type. Currently, there is no commercial development of any size within ten miles. She has decided to call the property Rosemary Junction.

Willums asked Josh Haskins, CFA, a financial planner and investment consultant, to discuss her alternatives and recommend a course of action. At their initial meeting Willums comments, “While I live in another area of the country now, I grew up in the lake region, therefore, I think I know it really well. So I feel secure starting with Rosemary Cove and then building Rosemary Junction. With those two projects I’d have good diversification, which would lower my risk, and I’d also have the added benefit of a dependable income stream with few management responsibilities. My father always made money on his real estate investments; I believe I will too. I could retire and my husband could stop worrying about his erratic income.”

Willums appears determined to go forward with Rosemary Cove. Haskins helped her put together the following estimates for the development:

  Cost to build apartments: $1,475,000

  Gross income in Year 1: $180,000

  Operating expenses in Year 1: $25,000

  Net operating income (NOI) growth rate = 5% per year

  Equity investment: 25% of project’s total cost – balance to be financed

  Loan terms: 20 years; 7% fixed rate; monthly payments

  Depreciation: Straight line; 27.5 years

  Marginal income tax rate: 35%

  Capital gains tax rate: 20%

  Depreciation recapture tax rate: 25%

  After-tax required return on equity capital: 12%

Part 1)

With respect to her comments to Haskins about the Cove and the Junction, Willums is:

A)   correct about risk and diversification; incorrect about management responsibilities.

B)   incorrect about risk and diversification; incorrect about management responsibilities.

C)   incorrect about risk and diversification; correct about management responsibilities.

D)   correct about risk and diversification; correct about management responsibilities.

Part 2)

Willums’ statements about the merits of real estate investment at Dogwood Mountain Lake are examples of which of the following behavioral tendencies?

A)   Familiarity and overconfidence.

B)   Behavioral modeling and endowment effect.

C)   Reference point and effects of past events.

D)   Overconfidence and behavioral modeling.

Part 3)

Which of the following statements reflects the best advice Haskins could give Willums at this time? Haskins should tell Willums to:

A)   proceed with the Cove, but not the Junction because her capital base is too small for the risks of the shopping center.

B)   proceed with both the Cove and the Junction to take advantage of the rapid growth in the area before any other competitors enter the market.

C)   consider how much of her net worth should be allocated to real estate prior to building either the Cove or the Junction.

D)   sell her lake properties because they have appreciated considerably, then invest the proceeds, along with her inheritance, in a well-diversified portfolio of stocks and bonds.

Part 4)

Assume Willums proceeds with the Cove. Her initial equity investment (EI) in the property is:

A)   $1,475,000.

B)   $368,750.

C)   $231,250.

D)   $375,000.

Part 5)

Assume Willums’ proceeds with the Cove and that she pays $77,902 in interest during Year 1. Which of the
following is closest to the Year 1 cash flow after taxes (CFAT)?

A)   $42,440.

B)   $58,370.

C)   $42,120.

D)   $58,690.

Part 6)

After four years, Willums accepts an offer of $2.7 million for Rosemary Cove. Because the property was not listed with a real estate agent, her sales costs are only $20,000. The outstanding mortgage balance is $1,005,769. Which of the following is closest to Willums’ equity reversion after taxes (ERAT)?

A)   $1,336,320.

B)   $1,396,350.

C)   $1,384,595.

D)   $1,117,575.

Part 6)

After four years, Willums accepts an offer of $2.7 million for Rosemary Cove. Because the property was not listed with a real estate agent, her sales costs are only $20,000. The outstanding mortgage balance is $1,005,769. Which of the following is closest to Willums’ equity reversion after taxes (ERAT)?

A)   $1,336,320.

B)   $1,396,350.

C)   $1,384,595.

D)   $1,117,575.

The correct answer was C) $1,384,595.

This question tested from Session 13, Reading 51, LOS c

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