978-0134083308 Chapter 18 Solution Manual Part 2

nSuggested Answers to Discussion Questions

1. a. Setting objectives involves two steps. In the first, you would consider the differences in

the investment characteristics of real estate. In the second step, you would establish investment

b. One financial constraint is the risk-return relationship that is unique to each investor. Another

financial constraint is the amount of money the investor wants to invest and the IRR or NPV

c. The investor must decide the relevant time horizon. For a short-term investor, the quick drop in

mortgage interest rates and buoyant market expectations are a major determinant. For the

2–4. Answers will vary according to student choices.

5. a. Gold coins. Little or no collector value except for old or rare coins (see coins); quality and

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

b. Comparative grid:

Costs

Ease of

Purchase/Sale Commissions

Potential

Returns

c. Certificates would probably be the least risky way to invest in gold. In every case except coins,

d. Collectibles such as coins, stamps, posters, and cars have value because of their attractiveness to

nSolutions to Problems

1.

Alternative

X Y

(I) $7,500 Appreciation

Web Chapter 18 Real Estate and Other Tangible Investments 330

(II) $7,500 Depreciation

If the purchase is leveraged, gains are magnified but so are losses. There is obviously more risk

2. a. Net operating income (NOI)  Gross rental income  Vacancy and collection losses 

Property operating expenses, including property taxes and insurance

b. Year’s Income-Tax Computation

(1) (2) (3)

Year’s After-Tax Cash Flow (ATCF) Computation

(1) (2) (3)

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

3. a. Original Cost: $200,000 Annual Appreciation: 6%

Book Value: $137,000 Sales Commission: 5%

Year Value

Forecast Sale Price: $252,495.39

Selling Commission: $252,495.39 0.05  $12,624.77

Tax Payable on the Proposed Sale:

Capital Gain

Recaptured Depreciation

($200,000  $137,000  $63,000.00)

b. (Outstanding Mortgage Balance: $155,000)

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4. a.

3 4 R4 0

1 2

1 2 3 4

CF CF CF I

CF CF

NPV (1 ) (1 ) (1 ) (1 )r r r r

+ –

= + + +

+ + + +

0

I

1 2 3 4

$6,200 $8,000 $8,300 $8,500 $59,000 $55,000

NPV (1 14) (1 14) (1 14) (1 14)

[$5,439 $6,156 $5,602 $39,965] $55,000

$57,162 $55,000

$2,162

+ –

= + + +

+ + + +

= + + + –

= –

=

b.

Year 1 Year 2 Year 3 Year 4

Cash Flow 6,200 8,000 8,300 8,500

 59,000

 67,500

The instructor can take the students through an iterative process as described in the book until

The formula in cell B6 is =irr(B1:B5)

c. At a required rate of return of 14%, the net present value of the expected cash flows would equal

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

Using IRR analysis, the investment would have an IRR of 15.3%, which exceeds the required

nSolutions to Case Problems

Case 18.1Gary Sofer’s Appraisal of the Wabash Oaks Apartments

This case gives the student the opportunity to discuss various factors involved in analyzing a prospective

real estate investment and to apply the analysis to an investment decision.

a. First, Gary must establish and/or assure conformance with his financial and nonfinancial objectives

when pursuing investment property. Second, he must be sure that the Wabash Oaks Apartments are

the preferred investment and that the property rights meet expectations. Then, he must determine the

b. Demand relates to the population segment that will rent an apartment in the complex. It relates to the

people who will want and use the facility. Gary must look at the tenants and determine who are the

people who will rent the apartments. Vacancy rates are often available from local real-estate

associations or branches of local government.Low vacancy rates compared to historical averages

would indicate high demand.Then, he must evaluate the present and future prospects for this segment

Web Chapter 18 Real Estate and Other Tangible Investments 334

c. Gary should be aware that although the owner is probably not criminal or fraudulent, he or she is

trying to sell the apartment and, accordingly, will put his or her best foot forward to make the sale.

Therefore, Gary should perform an analysis using the data supplied by the present owner. He should

d. There is not enough information to do a meaningful cash flow analysis.To do so would require

interest payment on any loans*, depreciation, the investor’s tax rate, the rate at which rents are

Annual net operating income (NOI)

Market value (V) Market capitalization rate (R)

NOI $24,330 $18,380 *

$42,710

=

= +

=

*Mortgage payments are not considered an operating expense when calculating NOI.

R 9.62%

NOI $42,710

V $443,971

R .0962

=

= = =

We should keep in mind that this calculation assumes a perpetual, constant net income from the

property.

e. To answer this question, adjust the owner’s income statement to reflect certain financial expectations.

Estimated rents will be $437.50 per month for one-bedroom units and $525 per month for

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

Reconstructed Income Statement (2007)

*[(6  $437.50)  (6  $525)]  12 months

Using this adjusted NOI value, the market value of the apartment would be:

V=NOI

R=$38,746

0.0962 =$402,765

If Gary can purchase the apartments for $10,000 less than the original estimated market value, the

apartment’s cost would be $433,971 ($443,971  10,000). However, the estimated market value of

Case 18.2Analyzing Dr. Davis’s Proposed Real Estate Investment

Summary of Key Facts:

Web Chapter 18 Real Estate and Other Tangible Investments 336

a.

Years

(1) (2) (3)

After-Tax Cash Flows

Years

(1) (2) (3)

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

After-Tax Net Proceeds from Sale of the Building in Three Years (CFR3)

b.

0

I

 $200,000  $150,000  $50,000

3 R3

1 2

0

1 2 3

CF CFCF CF

NPV (1 ) (1 ) (1 )

$3,312 $4,754 $6,358 88,057 $50,000

(1 0.15) (1 0.15) (1 0.15)

($2,880 3,595 62,079) $50,000

$18,554

I

r r r

+

= + + –

+ + +

+

= + + –

+ + +

= + + –

=

The net present value is positive, and the investment is therefore acceptable.

c.

Year 1 Year 2 Year 3

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A spreadsheet solutions is shown below:

A B

)

The result of the formula in cell A4 is 28.5%

d. By assuming the existing mortgage, Marilyn would not really increase her return. This financing

would probably work against increasing her rate of return because the 60% greater initial cash outlay

e. Marilyn has accumulated relevant quantitative data and should be able to establish needed financial

parameters for use in the investment analysis. She also wants to diversify her investment portfolio

and reduce her tax liability. So, to a point, Marilyn has performed a fairly good investment analysis.