CFA Level 1 - Alternative Investments Session 18 - Reading 74 LOS - f

CFA Level 1 - Alternative Investments Session 18 - Reading 74 LOS - f (Notes, Practice Questions, Sample Questions) 1. The gross rental income for an apartment building allowing for vacancies is $500,000. Estimated expenses total $200,000. If thecapitalization rate is 10%, the value of this building using the directcapitalization approach is closest to: A) $3,500,000.B) $2,500,000. C) $3,000,000. Explanation – NOI = 500,000 ? 200,000 = 300,000 MV = NOI / Capitalization rate = 300,000 / 0.10 = 3,000,000 2. All of the following variables might be factors when calculating the net operating income (NOI) for a property EXCEPT: A) collection losses.B) insurance. C) depreciation. Explanation – Insurance expenses and collection losses for a property are all factors in the NOI calculation. Depreciation isnot a factor when calculating NOI because a basic, underlyingassumption is that routine repairs and maintenance will keepthe property in its existing condition. 3. An investor is considering purchasing an office building that is currently 95% leased.

Gross potential rental income$105,000Insurance and taxes$9,000Repairs and maintenance$15,000Depreciation$11,000 What is the building's net operating income (NOI), based on the abovetable? A) $64,750.B) $81,000. C) $75,750. Explanation – NOI can be calculated as gross rental income minus vacancy losses, insurance and taxes, and repairs andmaintenance. Depreciation is not a factor in calculating NOI.NOI for the building is $105,000 – ($105,000 × 5%) - $9,000 -$15,000 = $75,750 4. Johnson is considering the purchase of Happy Valley Acres, a 300-unit apartment complex. She has hired Carson, CFA, to advise heron the investment. Carson has estimated the following data for HappyValley’s next accounting period: Potential rental income = $3.80 million.Vacancy rate = 3.5%.Insurance costs = $250,000.Financing costs = $940,000.Property taxes = $400,000.Utility expense = $120,000.Repair costs = $200,000.Depreciation = $350,000.Required return = 8%.

The property’s net operating income (NOI) and value should be closestto: NOI Value A) $2.70 million $33.75 million B) $2.83 million $33.75 millionC) $2.70 million $21.60 million Explanation – NOI = rental income × (1 ? vacancy rate) ? insurance costs ? property taxes ? utility expense ? repair costsNOI = $3.80 million × (96.5%) ? 250,000 ? 400,000 ? 120,000? 200,000 = 2.70 millionValue of building = 2.70 million / 0.08 = 33.75 million 5. The portfolio manager of a large real estate investment trust (REIT) has identified an office building as a potential investment. Based uponthe following data, what is its net operating income (NOI)? Gross potential rental income$235,000Estimated vacancy and collection loss rate6%Insurance and taxes$15,000Repairs and maintenance$17,000Utilities$12,500Cost of equity11% A) $150,550.B) $190,500. C) $176,400

Explanation – The NOI is $235,000 – ($235,000 × 6%) ? $15,000 ? $17,000 ? $12,500 = $176,400. The cost of equitynumber is not needed, because the NOI calculation isindependent of any financing arrangements 6. Net operating income (NOI) is calculated by subtracting which of the following from the property's gross potential rental income? A) Depreciation. B) Property taxes. C) Income taxes Explanation – NOI does not consider income taxes, financing charges, or depreciation 7. The income approach to valuing real estate is most similar to the following method of valuing common stock? A) Dividend discount model with zero growth. B) Dividend discount model with normal growth.C) Price-to-sales ratio. Explanation – The income approach for valuing real estate uses the following formula:Appraised Pricereal estate = annual net operating income(NOI) / Market Capitalization Rate (R)The dividend discount model (DMM) with zero growthapproach for valuing common stock uses the followingformula:Pricecommon stock = Dividend (D) / (Required Rate of Returnon the Stock (k) - Growth (g))When g = 0, the formulas simplify to:Appraised Pricereal estate = NOI / RPricecommon stock = D / kor, a period cash flow divided by a rate of return.

The DMM with normal growth would not be a correct responsebecause the income approach for real estate assumes aconstant (no growth) NOI stream to perpetuity 8. Jill Booton is evaluating an apartment building as a possible investment to add to her portfolio. She has been told that real estate is agood addition to a portfolio for diversification purposes. Jill will not beable to handle the maintenance issues at the complex and thus must hirea full-time maintenance employee at $35,000 per year. She will also hirea full-time manager at $40,000 per year. Property taxes are expected tobe $75,000 per year and insurance will be another $25,000. If fullyoccupied, the gross rental income from the property will be $850,000.Due to the location of the building, Jill estimates a very low vacancy rateof 3.5 percent annually. The net operating income of the property isclosest to: A) $825,250.B) $4,963,462. C) $645,250. Explanation – NOI = $850,000 – ($850,000 x 0.035) – $35,000 – $40,000 – $25,000 – $75,000 = $645,250 9. A property has a gross potential rental income of $740,000. Operating expenses, excluding insurance and property taxes, amount to30% of gross rents. Insurance and property taxes total $16,800. If themarket capitalization rate is 22%, the value of this property is closest to: A) $2,278,000. B) $1,727,000.C) $2,431,000. Explanation – Appraised Price = NOI / CAP = [(0.7 × 740,000) ? 16,800] / 0.22 = 2,278,182