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AFX3355 Property Investment Tutorial 2 – Solution guidelines

2.1. What are the three major components of the “real estate system”? How does the
development industry link the asset market to the space market?
Answer: The three major components are the real estate space market, the real estate asset market,
and the real estate development industry. The development industry links the asset market
to the space market by taking financial capital from the asset market and converting it into
physical capital (buildings) which add to the supply side of the space market.

2.2. Describe three ways in which participants in the real estate system must be forward-looking
in time, that is, anticipating future responses to current changes in the system, in order for
the system to function well at maintaining the balance between supply and demand in the
space market.
Answer: Looking at the diagram in Exhibit 2-2, you can see that there are four “objects” market
participants (especially investors, the participants in the asset market) need to try to
forecast:

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(i) The economic base underlying the demand side of the space market;

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(ii) The space market itself (interaction between supply and demand in that market)

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so as to forecast future operating cash flows from buildings;

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(iii) The development industry (so as to forecast future additions to supply in the

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space market); and
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(iv) The capital market (e.g., changes in interest rates). If this question were on a
test, you could get full credit for describing any three of these four.
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2.3 What is a negative feedback loop? Give an example of a negative feedback loop
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within the real estate system shown in Exhibit2-2.

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Answer: In the “Space Market” rents and occupancy rates can provide a signal to the “Asset
Market” about comparative yields. If rents increase, yields will increase and lead to
higher property prices supported by investors in the “Asset Market”. The higher
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prices will, in turn, make the addition of new space more attractive for developers.
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2.4 Describe each of the quadrants in the four-quadrant diagram. Set up the four-
quadrant diagram, carefully labeling each quadrant.
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Answer: See Section 2.3 and Exhibit 2-3 of GM and lecture slides.
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2.5 Long-run equilibrium in the four-quadrant diagram is characterized by a fixed stock

of space (in the northeast quadrant), yet the southwest quadrant shows that new
construction is taking place. What is going on?
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Answer:
In equilibrium, the stock of space is constant but there is new construction to replace that part
of the existing stock that is worn out or depreciated.

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2.6. Suppose user demand for space in a certain market grows from 4 to 5 million square
feet (MSF) at $10/SF net rent. Assuming property market cap rates remain constant
at 10%, show on a four-quadrant diagram similar to Exhibit 2-4a the short- and
long-run effects of this change on user demand. [Hint: You can answer qualitatively
or recognize that specific quantitative answers will depend on the shapes and slopes
of the curves (i.e., the elasticities) in each quadrant.]

Answer: Like Exhibit 2-4a in Chapter 2. The result is long-run rents at least as high as the
original rents, and an increase in the stock of built space in the market, but the long-run
rent level is less than the possible short-run spike in rents before supply has time to
expand through the development process. While the increase in usage demand will
always result (other things being equal), in an increase in supply of built space, it will
not necessarily result in a long-run increase in rents. This will depend on the shape of
the long-run marginal cost function depicted in the “southwest” quadrant. If this line is
not outward-sloping (to the west), rents will not rise in the long run. Only if rents do not
rise in the long run will the long run stock of occupied space rise all the way from 4 to

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5MSF. If rents rise in the long run, the increase in occupied space will be less than 1

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MSF in the long run, due to the long run price elasticity of demand for space usage.

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Q 2.7 In Question 2.6, in what sense do rents “overshoot” the new long-run equilibrium

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level? What about for the short-run? Why does this happen? What role does forward-

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looking behaviour play in terms of the extent of overshooting?
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Answer:
Due to fixed supply in the short-run, increased demand leads to increased rents. Some
rents may be prevented from rising due to contractual obligations set out in leases. New
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leases and leases coming up for rent reviews will be able to adjust to new market
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conditions quickly and capitalise on the scarcity of space. The extent to which rents rise
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in the short run will depend on conditions in the market. Some of the existing space may
be underutalised and it may be possible to use space that is currently supplying a different
usage market by quickly converting it at relatively low cost. In very tight market
conditions it may be necessary to add significant new space to meet the growth in demand
and in these circumstances rents are likely to rise sharply in the short run.
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The trend in higher rents will trigger new construction and it is the amount of new
construction that will determine the new long-run equilibrium rent. Participants in the
market who are forward looking will attempt to accurately forecast the amount of space
required to satisfy the changed conditions in the usage market (i.e. the market growth
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from 4 to 5 million square feet). If additional supply of space exceeds long run demand
the new equilibrium rent may well be less than the original equilibrium rent.
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2.8. Suppose investor demand for real estate assets grows in the sense that prevailing cap rates
(OARs) in the property asset market will fall from 10% to 8%. Assuming that usage
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demand remains constant in the space market, show on a four-quadrant diagram, similar to
Exhibit 2-4b, the short- and long-run effects of this change in investor demand. [Hint: You
can answer qualitatively or recognize that specific quantitative answers will depend on the
shapes and slopes of the curves (i.e., the elasticities) in each quadrant.]

Answer:
Given net rents, a lower cap rate means an increase in property values as the line in the
northwest quadrant linking rent to price shifts down to the left (i.e., the slope decreases).

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Higher property values relative to development costs indicates that developers will plan to
add new supply. Assuming forward-looking behavior, however, property values will not
move as high as current property income divided by the new lower cap rate would suggest,
since market participants realize that there will eventually be downward pressure on rents
(explained below) as new supply is added to the space market. Supply cannot be adjusted
quickly, and when it does increase, it will be added in ‘‘lumpy’’ increments. Over time,
as new space is added to the market, without any change in the demand for space, rents
must fall (we are moving down the demand curve in quadrant 1 in the northeast east corner)
until we are back in equilibrium with cost = value. The net result is that over the long term,
a shock to capital markets can have a permanent effect on real estate space markets even
though the demand for space did not change.

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Tutorial 2: Solution guide - Additional exercises

1. When a corporate analyst evaluates projects for investment by the company the
financing of the project is not considered. Explain the reason for this approach.

When a property investor is analysing the feasibility of a property for acquisition

the financing structure is taken into consideration. Explain why this approach is
important for property investors.

The corporate analyst is concerned with ranking projects for consideration by

management. How these projects are financed has no impact on their performance
as the financing decision is made independently of specific projects, that is, the
debt structure of the company is based on a specific project.

Most property purchases are carried out using a proportion of debt finance, that is,
the property will be used as collateral to secure debt. Different types of property
are subject to different lending criteria, for example, residential property is

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relatively low risk whereas office buildings carry higher risk for lenders. Lending
policies change over time depending on market conditions. The amount and type

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of finance that an investor can borrow, using the property as security, will have

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implications for the performance of the investment. The return on the investment

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(the property) is generally not be affected by its financing. Changing conditions in
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the debt market and the demand for space may however, have significant
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implications for the investor. An increase in the cost of debt and a fall in demand
for space in this usage market may force the investor to sell the property below
market value if financial distress is severe. The performance of the investment
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under conditions of a forced sale could differ to a situation where there is no debt
funding and the need to sell the property below market value does not arise.
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2. Distinguish between ROA (return on assets) and ROE (return on equity). Which is
more important for (a) the vendor and (b) the purchaser?
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ROA = CFO/ Purchase price. It is not affected by financing.

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ROE = CFAF/ Equity. It is sensitive to financing.

The vendor is interested in getting the highest price for the property. The seller is
not concerned with how the purchaser finances the acquisition; hence the focus is
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on ROA. A high ROA will signal to a prospective purchaser that the property is
producing ‘good’ cash flows.
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The purchaser will focus on ROE as the focus is on return on funds outlaid and the
opportunity cost.
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3. An investor has received the following information from a selling agent:

Purchase price $2,248,000
NOI (net operating income) $248,440
Capital Improvements $24,000
Structural reserves $12,400

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The anticipated financing structure is for an 80% mortgage with monthly

payments of principal and interest, an interest rate of 8% pa for a term of 25 years.

(i) Calculate CFO (cash flow from operations), CFAF (cash flow after
financing), ROA and ROE.

(ii) How sensitive to mortgage interest rates is the ROA and ROE (use
interest rates of 7% and 9% to compare).
Financing Cost - annual Interest rate 8% 7% 9%
Loan amount (80% of purchase price) $1,798,400.0
Investor's equity $449,600.0
Monthly Payment - P & I ($13,880) ($12,711) ($15,092)
FC - Annual debt servicing ($166,564) ($152,529) ($181,105)
CFO = NOI - Capital Imp. - Reserves $212,040 $212,040 $212,040
CFAF = CFO - FC $45,476 $59,511 $30,935
ROA = CFO/Purchase price 9.43% 9.43% 9.43%

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ROE = CFAF/Equity 13.24% 6.88%

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10.11%

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(iii) If NOI increases by 4%, what is the effect on ROA and ROI, assuming
the mortgage interest rate remains at 8%? What are the implications of

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your answer for the investor?
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ROA - increase NOI by 4% 9.87%
ROE - increase NOI by 4% 12.33%
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4. The typical information set made available for commercial property by a vendor
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or his selling agent includes:

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• Gross rental income for current year if occupied

• Lease term and options
• Section 32
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Explain how this information can assist a potential purchaser.

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What additional information about the property would be desirable and how
would you obtain these data?
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The gross rent and the information contained in the Section 32 (see below) will enable a
potential purchaser to calculate the ROA and also the ROE (providing information of
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financing has been obtained). The lease terms and options provide information of the
term of the tenancy, rent reviews and any special conditions that may exist between lessor
and lessee. This information is usually sufficient to enable a potential purchaser to do a
BOE (back-of –the-envelope) analysis.
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Additional information: knowledge of location, state of the local rental market, quality of
existing tenant, on-going maintenance and renovation costs, mortgage availability and
interest rate environment, position of property cycle for this type of property, and general
state of the economy.

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What is the Section 32 Vendors Statement? A legal document

The Section 32 Vendors Statement is a document provided by the vendor (seller) of real estate to an
intending purchaser.

Its name comes from Section 32 of the Sale of Land Act, which requires a vendor to provide certain
information to a purchaser BEFORE a contract of sale is signed.

In general terms, if the vendor fails to provide the information set out in Section 32 of the Sale of Land Act
before the contract is signed, the purchaser will be able to cancel the contract. Of course, there are
exceptions to this general rule, and purchasers should not assume that any “technicality” will allow them to
end the contract.

It is most important that legal advice from a qualified lawyer be obtained before a contract is signed, as the
opportunities to end the contract can be severely limited.

In recent years the information required in a Section 32 Vendors Statement has been expanded and
extended. Interpretation of the Section 32 requirements, particularly those relating to building works
undertaken by an “owner-builder” can be quite confusing. In addition, failure to comply with some of the
rules can attract huge monetary penalties.

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Who must sign the Section 32? Statement by the vendor
The only person who is required to sign the Section 32 is the vendor. However, most estate agents will tell

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purchasers that they too must sign it.

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When must the Section 32 be provided? Pre-contract disclosure

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The Section 32 must be provided to an intending purchaser BEFORE the contract is signed.
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What's in the Section 32? Basic information in the Section 32
The following list contains some of the more basic information to be found in the Section 32 Vendors
Statement. It should be noted, however, that much depends on the type of property being purchased, and
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further information may be required in particular circumstances. (Remember, legal advice from a qualified
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lawyer should always be sought regarding the information contained in the Section 32, and what
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information it does NOT there, but SHOULD BE there):

Statutory warnings to the purchaser.
Vendor’s details.
Title details.
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Information regarding building permits issued in the past 7 years.

Particulars of owner-builder warranty insurance.
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If the vendor is the owner-builder who completed the building works there should be a written
inspection report (which lists any defects) in the Vendor’s Statement.
Particulars of any mortgages or “charges” over the land (i.e. debts charged against the land).
Information regarding covenants, easements and any other restrictions on title, whether or not they
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appear on the title.

Planning information, particularly where zoning restricts land use.
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Information regarding outgoings payable by the owner of the property.

Disclosure of any notices or orders issued by the authorities, regarding such matters as fencing, road-
widening, sewerage etc..
Advice as to road access if there is no access to the property by road.
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Information as to services connected to the property.

But what’s NOT there?

Remember, it’s all very well to receive a Section 32 Vendor’s Statement that discloses no adverse
information about the property – but the question remains as to what SHOULD be there, but IS NOT there!

Further information is available at the web link:

http://www.lawyersrealestate.com.au/conveyancing/section.asp

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