978-0134083308 Chapter 18 Solution Manual Part 1

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Chapter 2 Securities Markets and Transactions 15

Web Chapter 18

Real Estate and Other Tangible Investments

nChapter Outline

Learning Goals

I. Investing in Real Estate

A. Investor Objectives

1. Investment Characteristics

2. Constraints and Goals

B. Analysis of Important Features

1.Physical property

2.Property rights

3.Time horizon

4.Geographic area

C. Determinants of Value

1. Demand

2. Supply

3. The Property

a. Restrictions on Use

b. Location

c. Site

d. Improvements

e. Property Management

4. Property Transfer Process

Concepts in Review

II. Real Estate Valuation

A. Estimating Market Value

1. The Cost Approach

2. The Comparative Sales Approach

3. The Income Approach

4. Using an Expert

B. Performing Investment Analysis

1. Market Value versus Investment Analysis

a. Retrospective versus Prospective

16 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

b. Impersonal versus Personal

c. Unleveraged versus Leveraged

d. NOI versus After-Tax Cash Flows

2. Calculating Discounted Cash Flows

3. Calculating the Internal Rate of Return

Concepts in Review

III. An Example of Real Estate Valuation

A. Set Investor Objectives

B. Analyze Important Features of the Property

C. Collect Data on Determinants of Value

1. Demand

2. Supply

3. The Property

4. Property Transfer Process

D. Perform Valuation and Investment Analysis

1. The Numbers

2. Cash Flow Analysis

3. Proceeds from Sale

4. Discounted Cash Flow

5. Internal Rate of Return (IRR)

E. Synthesize and Interpret Results of Analysis

Concepts in Review

IV. Real Estate Investment Securities

A. Real Estate Investment Trusts

1. Basic Structure

2. Investing in REITs

B. Other Forms of Real Estate Investment

Concepts in Review

V. Other Tangible Investments

A. Other Tangibles as Investment Outlets

1. Investment Merits

B. Investing in Tangibles

1. Gold and Other Precious Metals

2. Gemstones

3. Collectibles

Concepts in Review

Summary

Key Terms

Discussion Questions

Problems

Chapter 2 Securities Markets and Transactions 17

Case Problems

18.1 Gary Sofer’s Appraisal of the Wabash Oaks Apartments

18.2 Analyzing Dr. Davis’s Proposed Real Estate Investment

nKey Concepts

1. Investing in real estate and setting investment objectives

2. Analysis of important features of real estate investments

3. Determinants of real estate value and the property transfer process

4. Techniques used to estimate market value

5. Considerations and procedures used to perform investment analysis

6. Demonstration of a complete real estate investment analysis of a small apartment building

7. Forms of real estate investment securities, including real estate investment trusts (REITs)

8. The investment characteristics and suitability of gold and other tangible assets, such as silver,

gemstones, and collectibles

nOverview

The role of real estate as an investment vehicle and the use of appropriate real estate investment analysis

techniques are the subjects of this chapter.

1. A real estate investor must consider how the investment characteristics of real estate differ and

establish appropriate investment constraints and goals.

2. To meaningfully evaluate the investment potential of real estate, the investor must analyze the

property’s important features. This analysis should include: (1) identification of the physical

property, (2) definition of the applicable property rights, (3) the time horizon for the investment,

and (4) the delineation of a geographic area.

3. The investor should ask a number of questions relative to determining a property’s value.

Answering these questions intelligently requires evaluation of four major determinants of value:

demand, supply, the property, and the property transfer process.

4. Market value for a real estate investment differs, for a number of reasons, from that for stocks and

bonds. The nature of a real estate investment makes establishing a true market value very difficult,

if not impossible. An investor should realize that any value estimate is probably only a best guess.

Market value is usually estimated using one or more of three imperfect approaches. These approaches

are: (1) the cost approach, (2) the comparative sales approach, and (3) the income approach. An

expert can be used as a source of advice about the market value of property.

5. Estimates of market value are one part of an investment analysis. However, due to the complexity

of a real estate investment, many investors supplement market value appraisals with an investment

analysis. The concept of market value differs from an investment analysis in four important

ways: (1) retrospective versus prospective, (2) impersonal versus personal, (3) unleveraged

versus leveraged, and (4) net operating income (NOI) versus after-tax cash flows.

18 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

6. Discounted cash flow techniques that find net present value or calculation of the approximate yield

help investors decide whether a proposed real estate investment is economically justified.

7. Using an example of a prospective real estate (apartment) investment, the text then follows the

process of analysis presented earlier in the chapter and applies the various techniques of market

value and investment analysis.

8. Real estate investment securities are discussed, including real estate investment trusts (REITs).

Emphasis is placed on the economic worth of these investments, rather than their use as tax

shelters (which has greatly diminished with passage of the Tax Reform Act of 1986).

9. The last section of the chapter provides a discussion of tangible assets as investment outlets.

Topics include gold, precious metals, gemstones, and collectibles. The instructor should emphasize

the special nature of many of these assets and the specific knowledge that is needed to be a successful

investor, since the return from tangibles comes from price appreciation alone. Knowing what you’re

buying is a key element of success. Identifying some other currently popular collectibles brings

realism into the classroom and tends to be a hit with students.

nAnswers to Concepts in Review

1. Real estate is property such as residential homes, raw land, and income-producing properties like

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

3. Income properties are rented or leased properties that provide the owner(s) with regular rental

income. Speculative properties typically include land and new construction projects which are

Income properties can be classified as either residential or commercial. Residential propertiesare

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

b. Property rights. The sale of real estate includes deeds, titles, easements, liens, zoning restrictions,

Chapter 2 Securities Markets and Transactions 19

c. Time horizon. The time period over which you plan to hold the property helps decide the factors

d. Geographic area. Characteristics of the surrounding neighborhood affect property values, and it

5. Real estate demand is influenced by the area’s economic base, population characteristics like

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

Demographicsrefers to statistics, such as household size, age structure, occupation, gender, and

marital status. Psychographics describes people’s mental dispositions, such as personality, lifestyle,

The principle of substitution incorporates the idea that people do not really buy or rent real estate

6. A property’s competitive edge is affected by how the property meets the needs of the investor.

a. Restrictions on use. Investors should not invest in a property until they have determined whether

b. Location. Convenience and environment, both indicators of a good location, increase the profit

c. Site. Site features like size and quality are important considerations in the context of what the

d. Improvements. Improvements—man-made additions to a site—should be accurately measured

e. Property management. Investors should find the optimal level of management benefits for a

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. It is true that more information

20 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

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

8. Market value is the prevailing price of a property, indicating how the market as a whole has

assessed the property’s worth. A real estate appraisal is the estimate of a property’s current market

value based on certain information and techniques that may include the following:

These limitations all make it difficult to ascertain the true market value of a property.

Thus, the estimated market value established by an appraisal is only an estimate subject to a

variety of forces that may cause substantial error in the estimation process. Some buyers, for

9. Real estate appraisers commonly use one of three valuation approaches:

a. Cost approach. Value based on the notion that an investor should not pay more for a property

b. Comparative sales approach. Value determined by comparing sales prices of properties similar to

c. Income approach (“direct capitalization”). Calculates value of a property as the present value of

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 property’s

Chapter 2 Securities Markets and Transactions 21

(2) Impersonal versus personal. A market value estimate represents an average view of the market.

(3) Unleveraged versus leveraged. Simple income capitalizations do not incorporate alternative

(4) NOI versus after-tax cash flows. To most investors, capitalizing NOI to calculate market value is

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

12. Net operating income (NOI) is the income from income-producing real estate that remains after

After-tax cash flow (ATCF) is the annual cash flow earned on a real estate investment, net of all

Real estate investors prefer to use ATCFs because it tells them how much cash will be required to

13. In real estate transactions, the net present value (NPV) is the difference between the present value of

An investor could also calculate the IRR to determine the suitability of an investment. If the IRR is

14. The fivesteps in the framework for real estate analysis are:

(1) Set out investor objectives. Consider objectives such as diversification of your portfolio, desire

(3) Investigate the determinants of property value. Consider demand and supply, property features

(4) Perform an investment analysis. Look at a cash flow analysis based on the determinants of value,

(5) Synthesize and interpret the results. Weigh the features and determinants of property value, and

22 Smart/Gitman/Joehnk • Fundamentals of Investing, Thirteenth Edition

15. Depreciation is a provision in the income tax law that allows investors in real estate to treat a portion

16. Making a real estate investment based solely on acceptable NPV and IRR values would be foolish.

These numbers, at best, are estimates and subject to the possibility of considerable variation. As noted

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

For the investor, REITs offer an attractive mechanism for making real estate property, mortgage, or

The basic types of REITs are:

(1) Equity REITs, which invest in properties such as apartments, office buildings, shopping centers,

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

The general economic conditions contributing to profitable investment in tangible assets include:

Chapter 2 Securities Markets and Transactions 23

19. The three major forms of tangible investments are: gold and other precious metals, gemstones, and

collectibles.

The future prices and returns of tangibles tend to be affected by one or more key factors: the

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

Gemstones include diamonds, rubies, and emeralds. They are primarily things of beauty purchased

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,

Many key variables should be considered when investing in collectibles:

(1) Personal interest and pleasure should be strictly separated from economic analysis. The

(2) If an item under consideration is expensive, its value and authenticity should always be

(4) Collectibles are generally not very liquid; their resale markets tend to be poor, and transaction