Problem 1: Suppose you buy a home for 25% down. You have to borrow the rest.

Your rich friend, Z, buys the same priced home next door to you with all cash, and
borrows no money. Suppose housing prices double overnight! You and Z are excited
and sell the house! Note: the price of the house is irrelevant, but you can assume 100.
Do not include any other cash flows, such as mortgage interest, transaction costs,
taxes, costs of carry, brokerage fees, closing costs, commissions, etc. (20% of total
points)
a. What is your return of investment?

100/25 = 300%

b. What is Z's return of investment?

100/100 = 100%

Problem 2: Customers X and Y each bought the homes you and Z had sold (see
Problem 1). Each home costs 200. Like you, X bought with 25% down. Like Z, Y
bought all cash, not financing anything. Unfortunately for them, the next day, housing
prices dropped 25%. (20% of total points)
a. What is X’s return on investment?

(150-200)/50 = -100%

b. What is Y’s return on investment?

(150-200)/200 = -25%

Problem 3: Referring to the previous problem, how does leverage affect returns?
Specifically, what are the returns for your investment, and for X’s investment? (10% of
total points)
Highly levered projects shouldn’t necessarily be altogether avoided; investors should ensure
that they understand the amount of leverage used and are adequately compensated for the
level of risk. 85% leveraged deal should be rewarded far more than in the 75% leveraged deal,
all other things being equal. Also, when the investment plan is executed and the property is
sold, make sure that they receive a majority of the profits until they have achieved an
acceptable return for the risk, before splitting the upside with the sponsor.

Your Leverage Return: 75/ (200-75) = 60%

X Leverage Return: 50/ (150-50) = 20%

Problem 4: When using leverage, is it possible to lose more than 100%? (10% of total
points)
Yes, it’s possible.

Home Equity = Home Asset Price – Mortgage Liability (if any) and Equity = Asset – Liability

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 Leverage return = L/A When your Asset price is lower than your Liability, you will lose more than
100%

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