Real Estate Investment Final Exam

14:00-17:00, January 21, 2016

Lecturer: Dr. Xiaolong Liu
Exam reviewer: Prof. dr. Arno van der Vlist
Dr. Henk Brouwer

Note:
1.

This exam consists of four parts with 9 pages in total

2.

Provide your answer in English and within the answer box following each of the

essay and calculation questions

3.

For calculation questions, you need to show the calculation steps, and you do not

earn points if the calculation steps are missing, even if the result is correct
4.

Inconsistency in your answers will also lead to fewer points even if partly correct

5.

The exam will last for 3 hours

6.

Using toilet during the exam is NOT allowed

Good luck!

Part 1 True or False Questions (2 points each and 20 points in total)

Note: please mark T (=True) or F (=False) in front of the question number

1. Borrowers with fixed rate mortgages generally benefit if actual inflation is higher than
expected inflation. (T)
2. Prepayment penalties increase the lenders mortgage yield and discount points decrease it. (F)
(charging discount point increases the return to the lender)
3. ARMs eliminate all of lenders interest rate risk. (F) (within the interest rate reset period,
lender is still exposed to interest rate risk)
4. Homeowners should not borrow refinancing costs because the effective rate of refinancing
will be higher. (F) (this is obviously false)
5. The going-in cap rate must be lower than the going-out cap rate due to property depreciation
during the holding period. (F) (if the market interest rate drops substantially during the
holding period, going-in cap rate will be higher than the going out cap rate)
6. When using the cost approach to valuation, current market data for land values must be
obtained after knowing the cost of construction. (T)
7. Relating to the income approach in property valuation, the effective gross income is preferred
if substantial differences exist in vacancy rates across the properties being surveyed. (T)
8. Capitalization rate of newly constructed apartment building will be higher than that of
relatively old apartment building, which is comparable in all other aspects. (F) (due to the low
NOI in the initial years of the new building, cap rate is low as compared to seasoned
properties)
9. Expense stops shift the risk of increases in expenses to the tenants while allowing the
landlord to retain the benefit of any decrease in expenses. (T)
10. Using leverage increases the risk for equity investors, therefore, the equity return will
increase to compensate for this added risk (F) (this is only true if the project return is higher
than the cost of debt)

Part 2 Multiple Choice Questions (2 points each and 20 points in total)

Note: please indicate your choice in front of the question number

1. Which of the following is NOT a determinant of interest rates for single family residential
mortgages? (D)
(A)
(B)
(C)
(D)

The demand and supply of mortgage funds

Inflation expectations
Liquidity
The demand and supply of apartments

2. Which of the following would NOT result in an increase in housing demand? (C)
(A) Population growth
(B) Employment growth
(C) Higher interest rates
(D) Higher household income
3. Demand for a mortgage loan is considered as: (B)
(A) Stable demand
(B) Derived demand
(C) Interest rate demand
(D) Nominal demand
4. Which of the following descriptions most accurately reflects the risk position of an ARM lender
in comparison to that of a FRM lender? (D)
(A)
(B)
(C)
(D)

Interest Rate Risk

Higher
Lower
Higher
Lower

Default Risk
Higher
Lower
Lower
Higher

5. If an ARM index increased 15%, the negative amortization on a loan with a 5% annual payment
cap is calculated by: (D)
(A) Using the same payment as last year and deducting 5% from the principal balance
(B) Increasing the payment by 5%
(C) Totaling the difference between the payment as if no cap existed and the 5% capped payment
(D) Compounding the difference between the payment as if no cap existed and the 5% capped
payments
6. Which of the following clauses leads to higher risk for an ARMs lender? (C)
(A) Negative amortization is not allowed
(B) There is floor for payments
(C) Adjustment interval is longer than one year
3

(D) All of the above

7. Which of the following is TRUE regarding the incremental cost of borrowing? (B)
(A)
(B)
(C)
(D)

It should be less than the rate for a first mortgage

It should be compared to the cost of obtaining a second mortgage
It is used to calculate the APR for the loan
It is independent of loan-to-value ratio

8. The appraised value of a property usually represents the: (C)

(A)
(B)
(C)
(D)

Actual value of the property

Actual selling price of the property
Actual opinion of an appraiser
Actual replacement value of the property

9. Expenses for a 1,000 square meter office space are 6.00 per square meter. The lease specifies an
expense stop of 5.40. What is the total expense paid by the tenants? (C)
(A)
(B)
(C)
(D)

5,400
6,000
600
0

10. Which of the following would NOT be considered as an advantage of a sale-leaseback of land
from the perspective of a real estate fund that currently owns the land? (D)
(A) The sale-leaseback in effect provides 100% financing on the land
(B) Lease payments are tax deductible
(C) The sale-leaseback provides the same depreciation deductibility with a smaller equity
investment
(D) The land may appreciate over the holding period

Part 3 Knowledge Questions (10 points each and 30 points in total)

1. What is the prepayment risk? What are the three considerations that motivate lenders
charge prepayment penalty in practice?
Prepayment risk refers to the situation that, when interest rate falls, borrowers tend to prepay the loan
principal before the loan maturity date.
Why penalties?
1)lender may be trying to recover a portion of loan origination costs not charged to the borrower at
closing
2) an unanticipated inflow to the lender and may not be readily reinvested in periods when mortgage
rates are stable or are expected to decline
3) a technique lenders use to increase yields due to competitive lending terms
(this question is from the slide)

2. Why would an investor want to use debt to finance potential investment opportunities?
(List at least 3 motivations)
1. Not enough equity
2. Even with enough equity, borrowing is preferred in order to free up equity over other property
investments to achieve diversification
3. Take advantage of tax deductibility on interest payments
4. Realize leveraged return
(this question is from the slide)

3. What is a participation loan? Why would a lender want to make a participation loan?
Why would an investor want to obtain a participation loan?
A participation loan is where in return for a lower stated interest rate on the loan, the lender
participates in the income or cash flow from the property, e.g. potential gross income, NOI, CF after
regular debt service, sales proceeds or the appreciation in the value of property. The lenders rate of
return depends, in part, on the performance of the property. Participations are highly negotiable and
there is no standard way of structuring them.
A lenders motivation for making a participation loan includes how risky the loan is perceived relative
to a fixed interest rate loan. The lender does not participate in any losses and still receives some
minimum interest rate (unless the borrower defaults). Additionally, the participation provides the lender
with somewhat of a hedge against unanticipated inflation because the NOI and resale prices for an
income property often increase as a result of inflation. To some extent this protects the lenders real rate
of return.
An investors motivation is that the participation may be very little or zero for one or more years. This is
because the loan is often structured so that the participation is based on income or cash flow above some
specified break-even point. During this time period, the borrower will be paying less than would have
been paid with a straight loan. This may be quite desirable for the investor since NOI may be lower
during the first couple of years of ownership, especially on a new project that is not fully rented.

(This question is from the slide and the same as question 5 of Chapter 12)

Part 4 Calculation Questions (10 points each and 30 points in total)

1. An existing loan made 5 years ago for 80,000 @15% for 30 years (monthly payment
with PMT = 1,012). After 5 years, the loan balance on the existing loan is 78,977, and
interest rates fall such that a new loan of 78,977 is available @14% for 25 years (PMT =
951).
Suppose the prepayment penalty of 2% must be paid on the existing loan, and the new loan
requires an origination fee of 2,500 plus 25 for incidental closing costs. If the market
interest rate is 14%, should you refinance?
Cost of refinancing is -4105, PMT saving per month is 1012-951=61, number of months 25 x
12 = 300
PV= - 4,105 ; PMT=60.87 ; n=25 x 12=300; FV=0
return)

i = 17.57% (investment

Since this return is larger than the 14% market rate, you should refinance

(Slide 15, Week 3)

2. Use the following information to estimate the value of the subject property with the
direct capitalization method.
Subject Property

Price
Effective Gross Income

% Operating Expense

?
60,000

355,000
58,000

375,000
61,000

413,300
69,000

39%

48%

42%

41%

Cap Rate Approach

Subject
NOI
Cap rate

36,600

Comparable Properties

30,160

35,380

40,710

8.4%

9.4%

9.9%

Since operating expenses of the subject property is similar to comparable 2 and 3, the cap
rate for the pricing of the subject property should be between 9.4% and 9.9%.
Cap rate (subject property) = (9.4% + 9.9%)/2 = 9.65%
Price (subject property) = NOI / Cap rate = 36,600 / 9.65% = 379,275
GIM Approach
GIM 1 = 355,000/58,000 = 6.12 GIM 2 = 375,000/61,000=6.15 GIM 3 = 5.99
GIM subject property = (6.15+5.99)/2 = 6.07 Price (subject) = 60,000 x 6.07 = 364,200
(This question is from the slide)

3. A developer plans to construct an office building in one year with an estimated cost of
1,000,000. During the first year after the construction would take place, there are two possible
market scenarios which are as follows,
Scenario
Optimistic

Effective gross income

200,000

Operating expenses
50,000

Probability
60%

Pessimistic

100,000

25,000

40%

If the NOI grows at 2% per year after the first year, and the developer requires 12% return. How
much should the developer pay for the land if he is committed to develop the land irrespective of
the market condition? How much should the developer pay for the land if he will base the
development decision on the market condition? What is the worth of the option to wait to decide to
construct the building?
Land value without considering option value
E(NOI) = 0.6 x 150,000 + 0.4 x 75,000 = 120,000
Property value = E(NOI)/(12%-2%) = 1,200,000
Land value = property value construction cost = 200,000
The Land value today = 200,000 / 1.12 = 178,571
Land value considering option value
The value of the land at the end of the year if the NOI is $150,000 is as follows:
Property Value = 150,000 / (.12 - .02) = 1,500,000
Land value = 1,500,000 - 1,000,000 = 500,000
The value of the land at the end of the year if NOI is 75,000 is as follows:
Property Value = 75,000 / (.12 - .02) = 750,000
Land value = 750,000 - 1,000,000 < 0, so Land value = 0 since it would not be developed
because the property value if constructed is less than the construction cost
The expected land value in one year is therefore (.6 x 500,000) + (.4 x 0) = 300,000.
The Land value today = 300,000 / 1.12 = 267,857
Option value = 267,857 178,571 = 89,286

(Similar to the assignment problem 5 Chapter 13 and also the sample question in the slide)