Study Questions

Use the following information to answer questions 1 - 3:

You are considering the purchase of an office building for $1.5 million today. Your expectations include the following: first-year potential gross income of $340,000; vacancy and collection losses equal to 15 percent of potential gross income; operating expenses equal to 40 percent of effective gross income and capital expenditures equal 5 percent of EGI. You expect to sell the property five years after it is purchased. You estimate that the market value of the property will increase four percent a year after it is purchased and you expect to incur selling expenses equal to 6 percent of the estimated future selling price.

1. What is estimated effective gross income (EGI) for the first year of operations?

2. What is estimated net operating income (NOI) for the first year of operations?

3. What is the estimated going-in cap rate (Ro) using NOI for the first year of operations?

4. An investment opportunity having a market price of $1,000,000 is available. You could obtain a $750,000, 25-year mortgage loan requiring equal monthly payments with interest at 7.0 percent. The following operating results are expected during the first year.
For the first year only, determine the:

a. Gross income multiplier

b. Operating expense ratio (including CAPX)

c. Monthly and annual payment

d. Debt coverage ratio

e. Overall capitalization rate

f. Equity dividend rate

5. You are considering the purchase of a quadruplex apartment. Effective gross income (EGI) during the first year of operations is expected to be $33,600 ($700 per month per unit). First-year operating expenses are expected to be $13,440 (at 40 percent of EGI). Ignore capital expenditures. The purchase price of the quadruplex is $200,000. The acquisition will be financed with $60,000 in equity and a $140,000 standard fixed-rate mortgage. The interest rate on the debt financing is eight percent and the loan term is 30 years. Assume, for simplicity, that payments will be made annually and that there are no up-front financing costs.

a. What is the overall capitalization rate?

b. What is the effective gross income multiplier?

c. What is the equity dividend rate (the before-tax return on equity)?

d. What is the debt coverage ratio?

e. Assume the lender requires a minimum debt coverage ratio of 1.2. What is the largest loan that you could obtain if you decide to borrow more than $140,000?

6. Why do Class B properties generally sell at higher going-in cap rates than Class A properties?

7. Why might a commercial real estate investor borrow to help finance an investment even if she could afford to pay 100 percent cash?.

You are considering purchasing an office building for $2,500,000. You expect the potential gross income (PGI) in the first year to be $450,000; vacancy and collection losses to be 9 percent of PGI; and operating expenses and capital expenditures to be 42 percent of effective gross income (EGI). What is the estimated Net Operating Income? What is the implied first year overall capitalization rate? What is the effective gross income multiplier?

What is the overall capitalization rate?

What is the effective gross income multiplier?

9. What distinguishes an operating expense from a capital expenditure?

10. Explain why income property cash flow is not the same as taxable income.

11. What is the basic shortcoming of most ratios and rules of thumb used in commercial real estate investment decision making?