CFA Level 1 - Alternative Investments Session 13 - Reading 44

CFA Level 1 - Alternative Investments Session 13 - Reading 44 (Notes, Practice Questions, Sample Questions) 1. Which of the following real estate investments is most appropriate fora retiree? A)Warehouses. (Explanation: Warehouses do not usually require a lot ofmaintenance or management involvement, thus making them attractiveinvestments to moderately passive investors, such as retirees)B)Residential rentals.C)Office buildings. 2. Which of the following types of real estate investments provides atotal return that is relatively more heavily weighted toward periodicincome? A)Residential rentals.B)Warehouses. (Explanation: Warehouse investment returns tend to bemostly in the form of periodic income, with relatively little valueappreciation. Office buildings and residential rental property each offersubstantial returns in the form of both current income and valueappreciation)C)Office buildings. 3. The risk associated with a non-constant rate of appreciation is mostclosely related to which of the following types of real estate investing?

A)Warehouses.B)Raw land. (Explanation: The rate of appreciation of raw land is notconstant. This represents risk because a raw land investor may have toliquidate the investment before it has reached its expected appreciatedvalue)C)Office buildings. 4. A property was purchased for $550,000 and sold after six years for$850,000. Costs associated with the sale were $65,000 and the taxdepreciation in each year was $20,000. At the time of the sale, $320,000remained outstanding on the mortgage. The tax rate on recaptureddepreciation is 28% and the long-term capital gains tax rate is 20%. Theequity reversion after taxes for this property is closest to: A)$365,600.B)$449,400.C)$384,400. (Explanation: Equity reversion after taxes (ERAT) = netselling price – mortgage balance – taxes.First, compute taxes.Recaptured depreciation = 6 × $20,000 = $120,000Tax on recaptured depreciation = $120,000 × 0.28 = $33,600Total gain on sale = net selling price – adjusted basisNet selling price = sales price – cost of sale= $850,000 - 65,000 = $785,000Adjusted basis = cost - accumulated depreciation = $550,000 - 120,000 =$430,000Total gain = $785,000 - 430,000 = $355,000.long-term capital gains tax= capital gains tax rate × (total gain - recaptured depreciation) = 0.20 ×(355,000 – 120,000) = 0.20 × 235,000 = $47,000Total taxes payable= tax on recaptured depreciation + tax on long-term capital gains =$33,600 + $47,000 = $80,600ERAT = net selling price – mortgage balance – taxes = 785,000 - 320,000 -80,600 = $384,400)

5. Suppose you are evaluating an investment opportunity in an officebuilding for which you have estimated the following financialcharacteristics: ● First year net operating income (NOI) = $75,000. ● Growth rate in net operating income = 5% per year. ● Tax depreciation = $10,000 per year. ● Annual interest expense = $9,000. ● Annual total debt service expense = $12,000. ● Equity investors marginal income tax rate = 36%. ● Investment horizon = four years. The cash flows after taxes for years one and four are closest to: A) CFAT1 = $51,480 and CFAT4 = $50,766B) CFAT = $42,840 and CFAT4 = $47,760C) CFAT1 = $42,840 and CFAT4 = $50,406 Explanation: (C) Taxes Payable Computation: Year-1 Year-2 Year-3 Year-4 NOI (g = 5%) $75,000 $78,750 $82,688 $86,822 Less depreciation (10,000) (10,000) (10,000) (10,000) Less interest (9,000) (9,000) (9,000) (9,000) Taxable income $56,000 $59,750 $63,688 $67,822 times tax rate ´0.36 ´0.36 ´0.36 ´0.36 Income taxes payable $20,160 $21,510 $22,928 $24,416 CFATt Computation:

Year-1 Year-2 Year-3 Year-3 NOI (g = 5%) $75,000 $78,750 $82,688 $86,822 Less debt service (12,000) (12,000) (12,000) (12,000) Before tax cash flow $63,000 $66,750 $70,688 $74,822 Less taxes payable (20,160) (21,510) (22,928) (24,416) CFAT $42,840 $45,240 $47,760 $50,406 6. Which of the following cash flow streams is most likely to have multiple IRRs? Purchase Price Cash Flow 1 Cash Flow 2 A) $1.0 million $1.0 million gain $0.1 millionexpense B) $1.7 million $8.0 million gain $5 million gain C) $1.8 million $10 million gain $9 million expense Explanation: When there is a reversal in the sign of the cash flows, it islikely that there will be multiple IRR solutions. In fact, for the cash flowstream {-1.8; 10; -9} the IRRs are 13 and 343% 7. Which of the following statements is most accurate regarding theevaluation of real estate investments that require relatively large cashexpenses during the life of the investment? A)The recommendation of the IRR and NPV methods are likely toconflict.B)Multiple internal rates may occur. (Explanation: When there is areversal in the signs of the investment’s cash flows, it is likely thatmultiple IRRs will exist. This renders the IRR evaluation approachineffective)

C)The IRR and NPV evaluation methods will conflict at relatively lowdiscount rates 8. Which of the following statements regarding the evaluation ofmutually exclusive projects using the NPV and/or IRR approaches isleast accurate? A)Whenever a conflict exists between the IRR and NPV approaches, theproject with the highest IRR should be selected. (Explanation:Whenever a conflict exists between the IRR and NPV approaches, theproject with the highest NPV should be selected)B)Multiple IRRs are likely to exist when there is a relatively large changein the direction of investment’s cash flows.C)Ranking conflicts between the IRR and NPV methods are likely toresult when the projects being evaluated have relatively largedifferences in the size of their cash flows 9. An investment consortium is evaluating two mutually exclusive realestate investment opportunities: a multi-unit apartment complex, and alocal shopping center. This investment group requires a 9% after-taxreturn on equity capital. For the apartment complex, net present value(NPV) and internal rate of return (IRR) analysis result in an NPV ofUSD7.5 million and an IRR of 11%. For the shopping center, the NPV isUSD6.8 million and the IRR is 14%. If the investors require an after-taxreturn of 9% on either investment, which of the two investments shouldbe undertaken? A)The apartment complex because it has the highest NPV. (Explanation:Since the projects are mutually exclusive, only one may be selected.When ranking conflicts exist between the IRR and NPV approaches, theproject with the highest NPV should be selected)B)The shopping center should be selected because it has the highest IRR.

C)Both investments should be undertaken because they both havepositive NPVs and their IRRs exceed the required return on equity