Answers to Concepts in Review

1. Real estate is property such as residential homes, raw land, and income-producing properties like warehouses, offices, apartment buildings, cooperatives, and condominiums. Tangibles are investment assets other than real estate that can be seen or touched, like gold, gemstones, and collectibles. 2. Real estate and security investments differ in one fundamental way. Real estate is an asset you can touch or see, whereas a security investment is a nonphysical financial claim. Real estate, if properly selected, can diversify an investment portfolio by contributing to favorable portfolio risk-return trade-offs. As with any investment, an investor should evaluate real estate in terms of its risk-return characteristics. He or she should consider the proposed investment in light of the economic and political environment, and then relate it to the overall portfolio. By appropriate selection, real estate investments can diversify the portfolio and help to minimize its risk and/or maximize its return. 3. Income properties are rented or leased properties that provide the owner(s) with regular rental income. Speculative properties typically include land and special-purpose buildings, such as churches, gas stations, and the like. These properties offer the chance for significant returns but also involve a great deal of risk with a high probability of loss. Timing of the purchase and sale of these properties frequently determines the level of gains or losses incurred by the investor. Income properties can be classified as either residential or commercial. Residential properties are purchased to be rented to tenants who live in them and include single-family houses, condominiums, cooperatives, townhouses, and multifamily residences such as apartment buildings and complexes. Commercial properties are used for business purposes and include warehouses, office buildings, factories, and shopping centers. 4. Analyzing real estate requires consideration of the following features: a. Physical property. A site survey will verify the actual square footage, and an inspection of buildings and/or the site will reveal any possible defects. A sales contract should accurately define the property and list any personal property included in the sale. b. Property rights. The sale of real estate includes deeds, titles, easements, liens, etc. These, as well as the sale or lease agreements, should be reviewed by an attorney before finalizing the transaction. c. Time horizon. The time period over which you plan to hold the property helps decide the factors that are important in the analysis. For example, a short-term investor would focus on near-term interest rate forecasts, while a long-term investor would look at population trends. d. Geographic area. Characteristics of the surrounding neighborhood affect property values, and it is important to know how large an area to include in the market area analysis. 5. Real estate demand is influenced by the areas economic base, population characteristics like demographics and psychographics, and the terms and conditions of available mortgage financing. These and other factors make real estate prices difficult to determine. Real estate supply is influenced by other properties that compete in the same market. Therefore, an investor must analyze investment alternatives in light of the prices of competitive properties and their features. In the years following 2007, the collapse of a housing bubble and subsequent banking crisis, a large number of foreclosed properties have greatly affected both supply and demand. Some of these properties may present exceptional opportunities but also entail higher than normal risk.

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Demographics refers to statistics, such as household size, age structure, occupation, gender, and marital status. Psychographics describes peoples mental dispositions, such as personality, lifestyle, and self-concept. Both are population characteristics that heavily influence demand for real estate. The present state of the economy and events of the recent past may also affect how people feel about owning real estate. The principle of substitution incorporates the idea that people do not really buy or rent real estate per se, rather they judge properties as different sets of benefits and costs. Thus, supply is not just influenced by competing properties of the same location and physical aspects but by all properties in all classifications. 6. A propertys competitive edge is affected by how the property meets the needs of the investor. Investors should consider important property features. a. Restrictions on use. Investors should not invest in a property until they have determined whether what they want to do with the property agrees with all applicable laws. b. Location. Convenience and environment, both indicators of a good location, increase the profit potential of a real estate investment. c. Site. Site features like size and quality are important considerations in the context of what the investors objectives for the property are. d. Improvements. Improvementsman-made additions to a siteshould be accurately measured and appropriately built in terms of traffic flow and accessibility. Also, amenities, style, and construction quality are important in determining a propertys competitive edge. e. Property management. Investors should find the optimal level of management benefits for a property at the lowest cost. 7. Real estate markets are not efficient because there is no good system for complete information exchange among buyers and sellers and among tenants and lessors. Also, real estate returns are partially controlled by the property owners themselves. Profits and cash flows depend on how well the property is managed and can be significantly influenced by negotiation and promotion activities. Real estate markets are generally illiquid and tend to be regional or local. This makes market research especially important when considering real estate investments. Promotion refers to disseminating information about a property to the buyer segment of the market. Negotiation between the buyer and seller determines the final transaction price. The inefficiency of the real estate market makes promotion through advertising, publicity, sales gimmicks, and personal selling a necessary part of selling a property. Also, negotiation is affected in an inefficient market: buyers and sellers will have very different ideas about the value and price of the property. A sellers asking price may be influenced by what she initially paid for the property or the amount of an outstanding mortgage, while buyers will be more focused on current market conditions. 8. Market value is the prevailing price of a property, indicating how the market as a whole has assessed the propertys worth. A real estate appraisal is the estimate of a propertys current market value based on certain information and techniques.

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(1) Uniqueness of the property, (2) variation in the terms and conditions of sale, (3) imperfection of market information, (4) time required to provide market exposure prior to sale (many properties can only be sold quickly at a bargain price), and (5) need for buyers to sometimes act quickly all make it difficult to ascertain the true market value of a property. Thus, a stated market value is only an estimate subject to a variety of forces that may cause substantial error in the estimation process. Due to the intangible nature of the forces that affect and determine an estimate of market value and the high probability of error in the estimation process, one might say that the actual market value of a real estate investment is the price at which a purchase/sale transaction takes place. Outside of legal and ethical constraints, the market value is the best price at which a deal can be made. 9. The three valuation approaches commonly used by real estate appraisers are: a. Cost approach. Value based on the notion that an investor should not pay more for a property than it would cost to rebuild it at todays prices for land, labor, and construction materials. b. Comparative sales approach. Value determined by comparing sales prices of properties similar to the subject property (this approach relies on the idea that the value of a given property is about the same as the prices for which other similar properties have recently sold). c. Income approach (direct capitalization). Calculates value of a property as the present value of all its future income. It is applied by determining the annual net operating income (NOI) from the property and dividing it by the market capitalization rate, the rate used to convert an income stream into a present value. 10. Real estate investment analysis considers not only what similar properties have sold for but also looks at the underlying determinants of value. Real estate investment analysis differs from market value in four different ways: (1) Retrospective versus prospective. Market value appraisals look backward to estimate a propertys price, whereas an investment analysis forecasts relevant economic factors, demographics and psychographics, mortgage terms and financing, and sources of competition. (2) Impersonal versus personal. A market value estimate represents an average view of the market. Buyer and seller constraints and goals are incorporated into an investment analysis when valuing each propertys terms and conditions of sale (or rent). (3) Unleveraged versus leveraged. Simple income capitalizations do not incorporate alternative financing plans. They assume a cash or unleveraged purchase. Investment analysis examines value including the concept of leverage, accounting for the fact that leverage can magnify investor returns. (4) NOI versus after-tax cash flows. To most investors, capitalizing NOI to calculate market value is meaningless because the majority of real estate investors finance their purchases. Investment analysis uses after-tax cash flows, net of all expenses, taxes, and debt service. This process is similar to capital budgeting analysis, studied in financial management and corporate finance courses. 11. Leverage is the use of debt to purchase property. It increases risk because the loan obligation must be repaid, and failure to do so results in foreclosure and loss of property. On the other hand, leverage can also increase return if the property can earn more than the cost of the borrowed funds. The use of leverage magnifies both positive and negative returns, intensifying the risk-return relationship. 12. Net operating income (NOI) is the income from income-producing real estate that remains after subtracting vacancy and collection losses and property operating expenses, including property insurance and taxes, from a propertys gross potential rental income.

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After-tax cash flow (ATCF) is the annual cash flow earned on a real estate investment, net of all expenses, taxes, and debt service. It is calculated by subtracting any mortgage payment from NOI and adjusting the difference for taxes. ATCF gives the investor an estimate of the amount of cash he or she might receive each year during which the investment is held. Real estate investors prefer to use ATCFs because it tells them how much cash will be required to be put into a transaction and how much cash they are likely to get out. 13. In real estate transactions, the net present value (NPV) is the difference between the present value of cash flows and the amount of equity required to make an investment. NPV tells the investor whether the proposed investment should be taken (positive NPV) or not (negative NPV). An investor could also calculate the yield to determine the suitability of an investment. If the yield is greater than the appropriate discount rate, the investment should be madein this case, the NPV is positive. 14. The 5 steps in the framework for real estate analysis are: (1) Set out investor objectives. Consider objectives such as diversification of your portfolio, desire for capital gains appreciation, location, and investor personality. (2) Analyze important features of the property. Consider property size, quality, and restrictions on use. (3) Investigate the determinants of property value. Consider demand and supply, property features like locationenvironment and convenienceand the relative efficiency of the market with respect to the property transfer process. (4) Perform an investment analysis. Look at a cash flow analysis based on the determinants of value, estimate the proceeds from a future sale of the property, discount these cash flows, and subtract them from the initial equity investment required (NPV). Finally, approximate the yield of the property investment and compare this to the required return. (5) Synthesize and interpret the results. Weigh the features and determinants of property value, and examine the investment analysis results in light of your initial objectives. 15. Depreciation is a provision in the income tax law that allows investors in real estate to deduct a portion of the original cost of buildings each year. Depreciation provides a tax shelter by reducing taxable income and thereby permitting investors who actively manage the property and meet certain income requirements to retain a greater portion of their current income. Income properties paying current income are the primary real estate investments offering tax sheltering opportunities to those who qualify. 16. Making a real estate investment based solely on acceptable NPV and yield values would be foolish. These numbers, at best, are estimates and subject to the possibility of considerable variation. As noted in this chapter, there are numerous factors, such as restrictions on use, location, site characteristics, improvements, property management, and leverage that must be considered and analyzed before the real estate investment decision can be made. Any investor wishing to make a real estate investment with a high probability of success should thoroughly analyze the property under consideration. This analysis, however, is a fairly complex process involving a number of considerations and certainly not based on only two quantifiable measures such as NPV and yield. Note, however, that these subjective variables should influence the calculation of NPV.

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17. Real estate investment trusts (REITs) are investment companies that invest in various types of real estate and/or real estate mortgages. They raise funds by selling shares to investors and trade on the NYSE, Amex, and the OTC market. Returns on REITs have varied considerably; they typically earn a return of one to two percentage points above money market funds and about the same return as high-grade corporate bonds. They are required by law to pay out 95% of their income as dividends. Furthermore, they must keep at least 75% of their assets in real estate investments and hold each investment for at least four years. For the investor, REITs offer an attractive mechanism for making real estate property, mortgage, or both property and mortgage investments. They also provide professional management, shares that are publicly traded, some tax benefits, and possible diversification among real estate investments, locations, and types of property or securities. The basic types of REITs are: (1) Equity REITs, which invest in properties such as apartments, office buildings, shopping centers, and hotels. These are the most common types of REITs. (2) Mortgage REITs, which make both construction and mortgage loans to real estate investors. (3) Hybrid REITs, which invest both in properties and in construction and real estate mortgage loans. 18. A tangible asset is one that can be seen and touched and that has form and substance. Many investors own tangible investments because they can be seen and touched, while others prefer them because of their scarcity value. Except for real estate, tangible assets offer only one form of return: capital appreciation. Investment in tangible assets is usually made with the expectation of rising inflation, interest rates barely equaling or exceeding the rate of inflation, and/or the expectation of heightened international tensions. As has been evident in recent years, deep political divisions that create uncertainty around governments ability to deal with important economic matters can also strengthen the market for precious metals, art, and other tangibles. These factors create an unstable environment, which is favorable to investments in tangible assets. Because the returns on tangible assets depend heavily on an appropriate environment, timing buying and selling activities is very important to earning a favorable return. The general economic conditions contributing to profitable investment in tangible assets include: soaring inflation, high and volatile interest rates, growing international tensions, and seemingly irreconcilable political divisions. Each of these situations, alone or in combination, causes investors to prefer to hold nonmonetary assets, especially gold. 19. The three major forms of tangible investments are: gold and other precious metals, gemstones, and collectibles. The only source of return from investing in tangibles comes from appreciation in value. Investors in tangibles face substantial opportunity costs in the form of lost income that could have been earned on the capital. Tangibles also face insurance and storage costs. The future prices and returns of tangibles tend to be affected by one or more key factors: the inflation rate, supply of the assets, and domestic and international instability. Low inflation and an increase in supply relative to demand both unfavorably affect the future prices of tangibles. Also, in times of domestic and international stability, investing in tangibles is less attractive. 20. Gold provides an excellent hedge against inflation. Apart from gold, silver and platinum are also popular metals. The prices of all these metals fluctuate widely, and therefore they are considered speculative investments.

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Gemstones include diamonds, rubies, and emeralds. They are primarily things of beauty purchased by the wealthy for aesthetic reasons. The investment value of gemstones is a function of quality, and evaluation of quality can vary from dealer to dealer. Because of high commissions and difficulties in resale, gemstones are a specialists domain. 21. Collectibles cover everything from stamps and coins to antiques and art work. They derive their value from their beauty, scarcity, and age. Popular forms of collectibles are: rare coins, rare stamps, artworks, antiques, baseball cards, fantasy art, books, games, toys, comic books, posters, movie memorabilia, and historical letters and autographs. Many key variables should be considered when investing in collectibles: (1) Personal interest and pleasure should not get in the way of investing in collectibles. The investment should be evaluated from a sound economic viewpoint. Items that are likely to appreciate are the best choices for investment. (2) If an item under consideration is expensive, its value and authenticity should always be confirmed by an expert prior to purchase. (3) Collectibles should be stored in a safe place and insured against all relevant perils. (4) Collectibles are generally not very liquid; their resale markets tend to be poor, and transaction costs can be very high. Collectibles can be a serious investment only for knowledgeable collectors who know the hazards of investing in collectibles.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 18