Real Estate Finance & Investments

Midterm I Solutions

Name: ID#:

There are two parts to this exam. A calculator (no smart phone, tablet, computer) 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. Which if the following is true about Proposition 13?

(a) Proposition 13 only applies to commercial real estate; it does not apply to home-
owners.
(b) Proposition 13 ensures that all property owners with comparable properties pay the
same amount of property tax.
(c) Proposition 13 led to an increase in the share of property taxes in overall tax revenue
in California.
(d) 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.
(e) Proposition 13 shifted the property tax burden from younger, new homeowners to
older, long-time homeowners, and from homeowners to commercial property owners.

2. Which of the following is false about rent control in Los Angeles?

(a) Rent control is designed to protect tenants from excessive rent increases.
(b) Los Angeles City Council passed rent control in 1978, and it applies to buildings
built before 1978.
(c) Rent control leads to high turnover in rent controlled units.
(d) Rent control does not address the overall scarcity of housing available to renters.
(e) Rent control reduces the landlords’incentive to make capital improvement expendi-
tures on rent controlled units.

3. Which of the following is false about the demand / supply in the Silicon Valley real estate
space markets?

(a) Commercial real estate supply is rigid (supply curve is vertical) in Silicon Valley in
the short run.

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 (b) Long run commercial real estate supply curve is most likely upward sloping in Silicon
Valley.
(c) In the last 5 years (2010-2015) Silicon Valley experienced 20% increase
in total employment, which led to short term increases in property rents.
However, if employment does not grow any further and stays at this level,
rents are expected to go back down to their 2010 levels in the long run.
(d) Despite the scarcity of land available for development, Silicon Valley can experience
large real estate cycles.
(e) If tech sector experiences a bad shock and shrinks by 20% (similar to the dotcom
bust of 2001), o¢ ce rents will most likely decline more than 20%.

4. Which of the following would imply low cap rates for industrial properties in Inland
Empire?

(a) The Trans-Paci…c Partnership trade agreement, if approved by Congress,

will potentially increase trade through the Port of Los Angeles, and in-
crease demand for industrial space after the agreement takes e¤ect.
(b) The demand for industrial properties is strongly related to the growth rate of the
U.S. economy.
(c) There are few constraints on the development of new industrial properties in Inland
Empire.
(d) The expected market risk premium is high.
(e) O¢ ce and industrial REITs are expected to have high returns.

5. Which of the following is false about property valuations?

(a) Rent growth slows down, and expense growth accelerates as the property gets older.
(b) For a given property, the growth rate of the net operating income (NOI)
increases over time.
(c) The going-out cap rate is usually higher than the going-in cap rate.
(d) Expense reimbursements (expense recovery income) usually go down after a new
lease is signed.
(e) Percentage rental income usually goes down after adjustments in base rents.

6. Let’s assume that you allocated $20,000 from your investment portfolio into a large REIT,
Starlink Property trust (SPT), on 1/1/2012, and you liquidated your investment on
12/31/2014. SPT paid annual dividends on the last day of each year, which you rein-
vested in SPT shares at the prevailing ex-dividend price (price after the dividend is paid)
. SPT’s ex-dividend price and dividend history is given as follows. What is your return
from this investment on a per year basis?
Date Price Dividend
1/1/2012 $100
12/31/2012 $110 $10
12/31/2013 $120 $10
12/31/2014 $90 $10

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 (a) -3.5%
(b) -2.0%
(c) 0%
(d) 5.7%
(e) 7.2%

Solution:

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110 + 10 120 + 10 90 + 10 3
= 1:057
100 110 120

7. An investor with a one year investment horizon purchases an industrial property for $1
million, …nances 75% of the purchase with debt and 25% with equity. The borrowing rate
is 6%. The states of the world for the following year are summarized below:
Probability Property value Rent
50% $1,200,000 $100,000
50% $800,000 $60,000
All cash ‡ows take place at the end of the year. Suppose that default is not an option.
What is the expected return on asset (ROA) and expected return on equity (ROE) for
this investor?

(a) 8% / 14%
(b) 7% / 12%
(c) 5.7% / 30%
(d) 12% / 18%
(e) 15% / 15%
Solution:
1200K + 100K
1 + ROAboom =
1000K
ROAboom = 30%
800K + 60K
1 + ROAbust =
1000K
ROAbust = 14%
E(ROA) = 50% 30% 50% 14%
= 8%
1200K 750K + 100K 45K
1 + ROEboom =
250K
ROEboom = 102%
800K 750K + 60K 45K
1 + ROEbust =
250K
ROEbust = 74%
E(ROE) = 50% 102% 50% 74%
= 14%

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 To con…rm the results, you may put the rd and ROE in the W ACC formula and
con…rm ROA :

W ACC = ROA = 6% 75% + 14% 25% = 8%

8. Suppose you are evaluating an industrial building as a possible investment. Currently, the
net market rent for such properties is $60,000 per year (to be paid annually, in arrears).
The market rents are expected to go up by 3% per year (inde…nitely). You think that the
required return for such an investment is 9% per year. The seller agrees, and you decide
to buy this property for $1 million.
Suppose the seller arranges a long term lease for the property with a strong credit tenant
during your negotiations to buy the property, but you still buy the property for $1 million.
Signing a long term lease increases the value of the property, therefore, you get a positive
NPV deal. Which of following statements is true in this context?

(a) The IRR (internal rate of return) of this investment is not 9% anymore.
(b) The value of the property increases, because the cash ‡ows covered by the lease
become more risky.
(c) The cash ‡ows generated by this property should be discounted at the internal rate
of return (IRR).
(d) You get a positive NPV, because the required rate of return is lower than
9% now.
(e) None of these statements is true.

9. Which statement is true about the use of leverage in real estate?

(a) Financial leverage normally allows you to increase your expected return by using
other people’s money, therefore sensible real estate investors should …nance most of
their purchases with a mortgage.
(b) The mortgage rate determines the opportunity cost of capital for property investors,
therefore serves as a discount rate to discount property cash ‡ows in a DCF valuation.
(c) Financial leverage normally increases the equity investor’s return (ROE),
even if they pay fair market value for the property.
(d) Financial leverage normally increases the expected return on asset (ROA) in a prop-
erty investment.
(e) Operating leverage does not have an e¤ect on the riskiness of equity investment.

10. Acer Properties is a REIT with no debt. It pays out all its earnings as dividends, and
its current dividend yield is 5%. Its dividends grow annually at 3%. Acer is considering
to buy a Downtown Long Beach o¢ ce building. Currently, such buildings sell at 7% cap
rate, and the annual expected growth in this property’s NOI is 2%. Next year, the NOI
from the o¢ ce building is expected to be $3.5 million. What is the cost of capital of Acer?
How much should Acer pay for this building?

(a) 8% / $50 million

(b) 8% / $70 million

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 (c) 9% / $58.3 million
(d) 7% / $70 million
(e) Cannot be determined from the information given.

Solution:

Cost of capital of Acer : r = c + g = 5% + 3% = 8%

OCC for the o¢ ce building : r = c + g = 7% + 2% = 9%
$3; 500; 000
VOf f iceBuilding =
9% 2%
= $50million

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. Park Forest is an apartment complex with 100 identical units that currently rent at
$25,000/year/unit. (Rent and all expenses are valid for the following year, and are paid at
the end of the year.) The rent includes utilities (variable operating expenses). The owner
pays for the real estate taxes ($500,000), insurance ($50,000/year), maintenance (3%
of property gross income), and utilities (variable operating expenses, $1000/year/unit).
Currently, 5% of the apartments are vacant.

(a) (7 points) What is the NOI of the apartment complex over the following year (year
1)?
(b) (10 points) You think that NOI will grow at the rate of 4% in the …rst 4 years (until
the end of year 5), 3% in the second 5 years, and 2% after that (inde…nitely), and
the discount rate is 8% (…xed for all years). You plan to sell the property at the
end of year 10. How much is the property worth today? What is the cap rate of the
property today? What is the projected going-out cap rate (at the end of year 10)?
(c) (3 points) What is the underlying reason for the di¤erence between the current
(going-in) and going-out cap rates?

Solution:

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 (a)

Property gross income (PGI) : $25; 000 100 = $2; 500; 000
Vacancy allowance : 5% $2; 500; 000 = $125; 000
E¤ective gross income (PGI) : $2; 375; 000
Operating expenses : $720; 000
(Property taxes) : ($500; 000)
(Insurance) : ($50; 000)
(Utilities) : ($1; 000 100 95% = $95; 000)
(Maintenance) : ($2; 500; 000 3% = 75; 000)
NOI : $1; 655; 000
Ye a r 1 2 3 ... 5 6 ... 10 11 12
(b) C a s h ‡o w 1; 655 1; 655 1:04 1; 655 1:042 1; 655 1:044 1; 655 1:044 1; 655 1:044 1; 655 1:044 1; 655 1:044
1:03 1:035 1:035 1:02 1:035 1:022

CF11
V10 =
r g
1:044 1:035 1:02
1; 655; 000
=
8% 2%
= $38; 156; 313
! !
CF1 1:04 5 CF6 1:03 5
1 V10
V0 = 1 + 1 +
8% 4% 1:08 8% 3% 1:08 1:085 1:0810
= $7; 115; 113 + $5; 727; 939 + $17; 673; 756
= $30; 516; 807
CF1 $1; 655; 000
c0 = = = 5:42
V0 $30; 516; 807
CF11 $1; 655; 000 1:044 1:035 1:02
c10 = = = 6%
V10 $38; 156; 313

(c) Going out cap rate is higher, due to declining growth in cash ‡ows. Lower growth
expectations lead to higher cap rates in year 10.

2. A 100,000 square feet industrial complex in Long Beach, CA is on sale for $30 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 1% per year during the lease term, net $10/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 1% per year). The market rent is expected to go up by 3% per
year. Currently, the yield curve is ‡at and the risk free rate is 2% per year. The market
risk premium is 5%, and the beta for this property is estimated at 0.8.

(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?
(b) How much is the building currently worth assuming that you will sell this property
at the end of year 10 at 4.5% cap rate? If you believe this result, would you buy this
property?

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Solution:

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

r = rf + RP
= 2% + 5% 0:8 = 6% !
5
$1; 000; 000 1:01
L1 = 1 = $4; 292; 483
0:06 0:01 1:06
$4; 292; 483 1:035
V = $4; 292; 483 +
1:065 1:035
= $32; 099; 817

You would buy the property.

(b) Value of the …rst lease (L1 ) is:
!
5
$1; 000; 000 1:01
L1 = 1 = $4; 292; 483
0:06 0:01 1:06

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

L2 = L1 1:035 = $4; 976; 164:

The reversion value (sale price) is:

N OI11 $1; 000; 000 1:0310

P10 = =
c10 4:5%
= $29; 864; 808

The value of the property is:

L2 P10
V = L1 + +
1:065 1:0610
= $24; 687; 315

You would not buy the property.