Real Estate Finance & Investments

Midterm I Solutions

Name: ID#:

There are two parts to this exam. Financial calculator and 1 page (front/back) handwritten
notes are permitted.

Part I: Multiple Choice (10 Questions, 6 points each)

Select the best alternative answer in your judgement, based on what was taught in lectures, the
lecture notes, and the homework assignments. Clearly indicate your selection by …lling in the
appropriate circle on the answer sheet. If your selection is not clear, no points will be awarded.
Read each question carefully before answering.

1. Goodwill Property Trust (GPT) is an equity REIT that invests in o¢ ce and industrial
properties in Southern California. Currently, GPT is 50% debt …nanced. GPT manage-
ment estimates their cost of equity to be 12% and they can borrow at 6% in public debt
markets. GPT management is planning to change its …nancing to 60% debt, 40% equity
…nancing through debt-funded stock repurchases, without making a change in their prop-
erty portfolio, and they believe that GPT’s borrowing rate will not be a¤ected with this
change in capital structure. What will GPT’s expected return on asset (ROA) and return
on equity (ROE) be after the proposed change?

(a) 9% / 13.5%
(b) 10% / 12%
(c) 9% / 12%
(d) 9% / 9%
(e) 8% / 15%

Solution:

W ACC = ROA = 0:5 12% + 0:5 6% = 9%

ROA = 0:4 ROE + 0:6 6%
9% 3:6% = 0:4 ROE
ROE = 13:5%

2. After the proposed change in its capital structure, Goodwill Property Trust (GPT) is
considering to venture out of Southern California, and invest in an o¢ ce building in
Boston Financial District. The NOI of the building is projected to be $10 million in the
…rst year, and expected to go up at 2% per year (inde…nitely). Such buildings currently
trade at 6% cap rate. What is the maximum amount GPT can o¤er for this o¢ ce building
without destroying shareholder value?

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 (a) $76.9 million
(b) $87 million
(c) $125 million
(d) $142.9 million
(e) $166.7 million

Solution:

Since such buildings currently trade at 6% cap rate, this is the right cap rate for this building,
irrespective of who is bidding for the property.
$10 million
P = = $166:7 million
0:06

3. Which of the following is false about the use of leverage?

(a) High operating leverage typically leads to higher pro…ts in periods of high economic
growth.
(b) Financial leverage does not a¤ect asset (property) cash ‡ows.
(c) High …nancial leverage typically leads to lower equity returns while the economy
experiences a recession.
(d) Operating leverage does not a¤ect equity cash ‡ows.
(e) The borrowing rate of the property owner is typically lower than the required rate
of return in real estate equity investments.

4. Which of the following is part of operating expenses?

(a) Income taxes

(b) Tenant improvement expenditures
(c) Lease commissions
(d) Property taxes
(e) Interest expense

5. Currently, cap rates for industrial properties in Los Angeles area are around 4.5%, while
cap rates for similar properties in Columbus, Ohio are about 7.5%. Which of the following
statements is not consistent with this information?

(a) Investors demand a higher risk premium for investing in Columbus industrial prop-
erties (compared to LA properties).
(b) Demand for Los Angeles industrial space is expected to be more procycli-
cal than Columbus industrial properties.
(c) Los Angeles industrial properties are expected to experience faster rent growth com-
pared to Columbus properties.
(d) Future demand for Los Angeles industrial properties is expected to be higher than
similar properties in Columbus.

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 (e) The industrial properties in Columbus, Ohio are on average older than the properties
in Los Angeles market.

6. All of the following are common mistakes in commercial property DCF valuations and
leads to optimistic valuations, especially among those who have an interest in seeing a
transaction done, except:

(a) The going-out cap rate is usually projected too high.

(b) Rent and expense growth rates are mismatched. The future NOI growth rate is
projected too high.
(c) Expense reimbursements (expense recovery income) are projected to grow constantly,
even after big adjustments in rents.
(d) Percentage rental income is projected to grow constantly, even after big adjustments
in base rents.
(e) The discount rate is estimated too low.

7. Which of the following is false about the demand / supply in the real estate markets?

(a) Wichita, KS is the least land-constrained MSA in the U.S. Long run commercial real
estate supply curve is most likely ‡at in Wichita.
(b) Miami, FL is the most land-constrained MSA in the U.S. Long run commercial real
estate supply curve is most likely upward sloping in Miami.
(c) A permanent increase in employment in Miami, FL leads to short term
increases in property rents, but no change in rents in the long run.
(d) A permanent increase in employment in Wichita, KS leads to short term increases
in property rents, but no change in rents in the long run.
(e) Commercial real estate supply is rigid (supply curve is vertical) in the short run.

8. An apartment building has 50 identical units that rent at $30,000/year/unit. The rent
includes the utilities (variable operating expenses). The owner pays for the real estate
taxes (250,000), insurance ($20,000/year), maintenance (5% of property gross income),
and utilities (variable operating expenses, $1000/year/unit). On average, there is 6%
vacancy. Currently, the cap rates for such buildings are 5%. How much is the property
worth?

(a) 12,540,000
(b) 14,800,000
(c) 16,780,000
(d) 18,500,000
(e) 20,360,000

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 Solution:

Property gross income (PGI) : $30; 000 50 = $1; 500; 000

Vacancy allowance : 6% $1; 500; 000 = $90; 000
E¤ective gross income (PGI) : $1; 410; 000
Operating expenses : $392; 000
(Property taxes) : ($250; 000)
(Insurance) : ($20; 000)
(Utilities) : ($1; 000 50 94% = $47; 000)
(Maintenance) : ($1; 500; 000 5% = 75; 000)
NOI :
$1; 018; 000
N OI
V =
c
$1; 018; 000
=
5%
V = $20; 360; 000

9. Suppose you invest in a brand new apartment complex in Culver City. The NOI of the
complex is projected to be $500,000 in the …rst year. You think that NOI will grow at the
rate of 4% in the …rst 10 years, and 3% after that (inde…nitely), and the discount rate is
7% (…xed for all years). You plan to sell the property at the end of year 10. What is the
cap rate of the property today? What is the projected going-out cap rate (at the end of
year 10)?

(a) 3% / 3%
(b) 3.72% / 4%
(c) 3% / 4%
(d) 4% / 3.66%
(e) 4.23% / 5.5%

Solution:

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 Year 1 2 3 ... 10 11 12 ...
Cash ‡ow 500 500 1:04 500 1:042 500 1:049 500 1:049 1:03 500 1:049 1:032

CF11
V10 =
r g
$500; 000 1:049 1:03
=
7% 3%
= $18; 325; 140
!
10
CF1 1:04 V10
V0 = 1 +
7% 4% 1:07 1:0710
= $4; 125; 314 + $9; 315; 572
= $13; 440; 886
CF1 $500; 000
c0 = = = 3:72
V0 $13; 440; 886
CF11 $500; 000 1:049 1:03
c10 = = = 4%
V10 $18; 325; 140

10. Which if the following is false about Proposition 13?

(a) Proposition 13 is passed by California voters in 1978 with nearly 2/3 support.
(b) Proposition 13 applies both to residential and commercial properties.
(c) Since the passage of Proposition 13, in order to compensate for lower property tax
revenue, sales and income tax rates and indirect taxes and fees are increased in
California.
(d) Proposition 13 ensures that all property owners with comparable prop-
erties pay the same amount of property tax.
(e) Proposition 13 shifted the property tax burden from older, long-time homeowners to
younger, new homeowners, and from commercial property owners to homeowners.

Part II: 2 problems, 20 points each.

Please solve the following problems. Show all your work. The clear and well organized solutions
will be graded more leniently. Read each question carefully before answering. Do NOT write
on the back of the papers.

1. As an analyst at KGS Group, you are about to evaluate an o¢ ce building in South Lake
Union District in Seattle, near Amazon’s headquarter. The building is expected to bring
a steady cash stream in the next 5 years. The PBTCFs in the next 6 years are projected
to be $10 million per year, to be paid in arrears, and the building is expected to be sold
at the end of year 5. The cap rate at the time of sale is projected to be 7%, and selling
expenses will be 5% of the sale price. Here is what you know about risks and returns. . .

Zero-coupon treasury bonds maturing in 1 year are selling for $99 per $100 of par
value; 2-year bonds are selling for $96.1 and 3 year bonds are selling for $91.5.
Beyond three years, the yield curve is ‡at.

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 The asset beta of comparable properties is 0.5, the expected market risk premium is
6% per year.

(a) (10 points) Calculate the discount rate(s) that you will use in this property valuation.
Solution:
100
r1f = 1 = 1%
99
100 1=2
r2f = 1 = 2%
96:1
1=3
100
r3f = r4f = r5f = 1 = 3%
91:5

E (RPproperty ) = asset E (RPmarket )

= 0:5 6%
= 3%

r1 = r1f + RP
= 1% + 3%
= 4%
r2 = 5%
r3 = r4 = r5 = 6%

(b) (10 points) The asking price for the property is $150 million. Is it a good investment
opportunity?
Solution:
$10m
$10m $10m $10m $10m $10m 0:07 :95
NPV = $150m + + + + + +
1:04 1:052 1:063 1:064 1:065 1:065
= $150m + $143:9m
= 6:1m

No, it is not a good investment opportunity.

2. A 250,000 square feet industrial complex in Phoenix, AZ is on sale for $100 million. The
current tenant just renewed the lease for the next 5 years (industry practice is 5 year lease
terms). The lease will go up by 2% per year (in‡ation rate) during the lease term, net
$12/sqf in the …rst year to be paid in arrears (also current market rent), but is expected
to be leased at the market rate once the current lease expires (the rent within future lease
contracts is also expected to go up at the rate of in‡ation, 2% per year). The market rent
is expected to go up by 2.5% per year. Currently, the yield curve is ‡at and the risk free
rate is 2% per year. The risk premium on industrial properties is 3%.

(a) What is the value of this property, assuming that the buildings will be held and
rented inde…nitely (perpetually)? Would you buy this property?

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(b) How much is the building currently worth assuming that you will sell this property
at the end of year 10 at 5% cap rate? If you believe this result, would you buy this
property?

Solution:

(a) Value of the …rst lease (L1 ) and the total value (V ):

r = rf + RP
= 2% + 3% = 5% !
5
$3; 000; 000 1:02
L1 = 1 = $13; 492; 380
0:05 0:02 1:05
$13; 492; 380 1:0255
V = $13; 492; 380 +
1:055 1:0255
= $118; 862; 965

You would buy the property.

(b) Value of the …rst lease (L1 ) is:
!
5
$3; 000; 000 1:02
L1 = 1 = $13; 492; 380
0:05 0:02 1:05

The value of the second lease as of the end of year 5 (L2 ) is:

L2 = L1 1:0255 = $15; 265; 390:

The reversion value (sale price) is:

N OI11 $3; 000; 000 1:02510

P10 = =
c10 5%
= $76; 805; 073

The value of the property is:

L2 P10
V = L1 + +
1:055 1:0510
= $72; 604; 864

You would not buy the property.