Unit 5: Calculations

Practice Questions

Example 1

Calculating the value of the discounted cash flows from a real estate investment can act as a
validation or check on other valuation methods. This approach takes into account the
investor's individual tax bracket, depreciation and any interest payments.
Calculating NOI from a Real Estate Investment.

Solution:
Calculating NOI from a Real Estate Investment

Comparable Property:
NOI $135,000, which sold for $750,000

NOI = $135,000 - $5,000 - $5,000 = $125,000

NOI/(Transaction Price):
$135,000/$750,000 = 0.18

NOI/Cap Rate = $125,000/0.18 = $694,000

Which is the amount this property is being valued at.
Example 2: Sales Comparison Approach:

Looks at the characteristics of similar properties and how they are valued:

Characteristic Units Value

Number of rooms Number $25,000
Number of bathrooms Number $10,000
Distance to city Miles ($2,000)

The property you want to value has eight rooms, three bathrooms and is 10 miles from the
city.

The value would equal (8 * $25,000) + (3 * $10,000) + (10 * -$2,000)

= $200,000 + $30,000 - $20,000
= $210,000 based on similar property types

Example 3: Income Approach:

In this approach, the investor would estimate total real estate value based on the rate of
return from the property. Therefore, any potential rents expected from a lessee for use of
the property would be compared against similar property types.

Calculating After-tax Cash Flows

NOI = $125,000 Depreciation = $5,000
Mortgage payment = $60,000 Purchase price = $725,000
75% financing at 8% interest rate NOI growth rate = 4%
Marginal Tax Rate = 31%.

After-tax cash flow = Amount borrowed ($725,000 * .75) = $543,750.

First year's interest = ($543,750* .08) = $43,500.
After-tax income = ($125,000 - $5,000-$43,500) * (1-.31) = $52,785

To arrive at after-tax cash flow from after tax income, depreciation must be added and the
principal repayment of the mortgage payment must be subtracted.
Question 1

A real estate firm is evaluating an office building using the income approach. The real estate
firm has compiled the following information for the office building. All information is on an
annual basis.

Gross potential rental income $350 000

Estimated vacancy and collection losses* 4%
(*As a percentage of gross potential rental income)
Insurance and taxes $26 000
Utilities $18 000
Repairs and maintenance $23 000
Depreciation $40 000
Interest on proposed financing $18 000

There have been two recent sales of office buildings in the area. The first building had a net
operating income of $500,000 and was sold at $4 million. The second building had a net
operating income of $225,000 and was sold at $1.6 million.
A. Compute the net operating income for the office building to be valued
B. Use the income approach to compute the appraisal price of the office building

Solution
A:
Gross potential rental income minus estimated vacancy and collection costs, minus
insurance and taxes, minus utilities, minus repairs and maintenance.
NOI = 350 000 – 0.04 x 350 000 – 26 000 – 18 000 – 23 000
NOI = 269 000

B:
The capitalisation rate of the first office building recently sold in the area is:
NOI/(Transaction price) = 500,000/4,000,000 = 0.125

The capitalisation rate of the second office building recently sold in the area is:
NOI/(Transaction price) = 225,000/1,600,000 = 0.141

The average of the two capitalisation rates is 0.133.

Applying this capitalisation rate to the office building under consideration, which has an NOI
of $269,000, gives an appraisal value of:
NOI/(Capitalization rate) = 269,000/0.133 = $2,022,556

Question 2

An analyst is evaluating a real estate investment project using the discounted cash flow
approach. The purchase price is $3 million, which is financed 15% by equity and 85% by a
mortgage loan. It is expected that the property will be sold in five years. The analyst has
estimated the following after-tax cash flows during the first four years of the real estate
investment project.

Year 1 2 3 4
Cash Flow $60 000 $75 000 $91 000 $108 000

For the fifth year, that is, the year when the property would be sold by the investor, the
after-tax cash flow without the property sale is estimated to be $126,000 and the after-tax
cash flow from the property sale is estimated to be $710,000.
Compute the NPV of this project. State whether the investor should undertake the project.
The investor’s cost of equity for projects with level of risk comparable to this real estate
investment project is 18%.

Solution:
The after-tax cash flow for the property sale year is
$126,000 + $710,000 = $836,000.

At a cost of equity of 18%, the present value of the after-tax cash flows in years 1 through 5
is as follows:

$60,000/1.18 + $75,000/1.182 + $91,000/1.183 + $108,000/1.184 + 836,000/1.185 =

$581,225

The investment requires equity of 0.15 x $3,000,000 = $450,000.

Thus, the NPV = $581,225 - $450,000 = $131,225.
The recommendation based on NPV would be to accept the project, because the NPV is
positive.
Question 3

An investment firm is evaluating a real estate investment project using the discounted cash
flow approach. The purchase price is $1.5 million, which is financed 20% by equity and 80%
by a mortgage loan at a 9% pre-tax interest rate. The mortgage loan has a long maturity and
constant annual payments of $120,000. This includes interest payments on the remaining
principal at a 9% interest rate and a variable principal repayment that steps up with time.
The net operating income (NOI) in the first year is estimated to be $170,000. NOI is
expected to grow at a rate of
4% every year. The interest on real estate financing for the project is tax-deductible. The
marginal income tax rate for the investment firm is 30%. Using straight-line depreciation,
the annual depreciation of the property is $37,500.
A. Compute the after-tax cash flows in years 1, 2, and 3 of the project.
B. It is expected that the property will be sold at the end of three years. The projected
sale price is $1.72 million. The property’s sales expenses are 6.5% of the sale price.
The capital gains tax rate is 20%. Compute the after-tax cash flow from the property
sale in year 3.
C. The investor’s cost of equity for projects with level of risk comparable to this real
estate investment project is 19%. Recommend whether to invest in the project or
not, based on the NPV of the project.

Solution
A:
The amount borrowed is 80% of $1.5 million, which is $1.2 million. The first year’s interest =
9% of $1.2 million = $108,000. So,

After-tax net income in year 1 = (NOI - Depreciation - Interest) x (1 - Marginal tax rate)
= ($170,000 - $37,500 - $108,000) x (1 - 0.30) = $17,150

After-tax cash flow = After-tax net income - Depreciation - Principal repayment

and,

Principal repayment = Mortgage payment - Interest

= $120,000 - $108,000 = $12,000

so, After-tax cash flow in year 1 = $17,150 + $37,500 - $12,000 = $42,650.

New NOI in year 2 = 1.04 x $170,000 = $176,800.

We need to calculate the second year’s interest payment on the mortgage balance after the
first year’s payment.
This mortgage balance is the original principal balance minus the first year’s principal
repayment, or $1,200,000 - $12,000 = $1,188,000.
The interest on this balance is $106,920.

So,
After-tax net income = ($176,800 - $37,500 - $106,920) x (1 - 0.30) = $22,666

Principal repayment = $120,000 - $106,920 = $13,080

so, After-tax cash flow in year 2 = $22,666 + $37,500 - $13,080 = $47,086

New NOI in year 3 = 1.04 x $176,800 = $183,872. We need to calculate the third year’s
interest payment on the mortgage balance after the second year’s payment.

This mortgage balance is the original principal balance minus the first two years’ principal
repayments, or $1,200,000 - $12,000 - $13,080 = $1,174,920.
The interest on this balance is $105,743.

So,
After-tax net income = ($183,872 - $37,500 - $105,743) x (1 - 0.30) = $28,440

Principal repayment = $120,000 - $105,743 = $14,257

so, After-tax cash flow in year 3 = $28,440 + $37,500 - $14,257 = $51,683

B:
Ending book value = Original purchase price - Total depreciation during three years
= $1,500,000 - 3 x $37,500 = $1,387,500.

The net sale price = $1,720,000 x (1 - 0.065) = $1,608,200

Capital gains tax = 0.20 x ($1,608,200 - $1,387,500) = $44,140

After-tax cash flow from property sale = Net sales price - Outstanding mortgage - Capital
gains tax

Outstanding mortgage = Original mortgage - Three years’ worth of principal repayments, or

$1,200,000 - ($12,000 + $13,080 + $14,257) = $1,160,663

so,
After-tax cash flow from the property sale = $1,608,200 - $1,160,663 - $44,140 = $403,397
C:
The total after-tax cash flow for the property sale year is
$51,683 + $403,397 = $455,080.

At a cost of equity of 19%, the present value of the after-tax cash flows in years 1 through 3
is as follows:
$42,650/1.19 + $47,086/1.192 + $455,080/1.193 = $339,142

The investment requires equity of 0.20 x $1,500,000 = $300,000.

Thus, the NPV = $339,142 - $300,000 = $39,142.

The recommendation based on NPV would be to accept the project, because the NPV is
positive.

Multiple Choice Questions

1. A property speculator is considering an investment in land that will be developed. He

expects to invest R1 500 000 in the land. It will not be developed for three years, but
at the end of year 3, he expects a cash flow of R250 000. In years 4 and 5, the cash
flow will increase to R350 000, and at the end of year 5 he expects to sell the land for
R1 850 000. Due to the risky nature of the investment, he requires a 13.67% return.
The net present value of this investment is closest to:

A. –R33 000
B. R30 200
*C. R39 100
D. –R41 700

2. A real estate analysis estimates the market value of an income-producing property at

R2 560 000. The annual gross potential rental income is R686 000, the annual
property operating expenses and taxes are R178 800, depreciation is R60 000 and
the annual vacancy and collection losses are R89 400. What capitalization rate was
used by the analysis to assess the property at R2 560 000?

A. 10.50%
B. 12.80%
*C. 16.30%
D. 19.80%
3. Use the following information to calculate the potential gross income:

Number of Units: 150

Vacancy Rate: 5%
Bad Debt Allowance: 2%
Per Unit Annual Rent: $4,000
Operating Expenses: $98,000
Financing Costs: $85,000
Annual Depreciation: $15,000

A. $460,000
B. $570,000
C. $558,000
*D. $600,000

4. Use the following information to calculate the effective gross income.

Number of Units: 150

Vacancy Rate: 5%
Bad Debt Allowance: 2%
Per Unit Annual Rent: $4,000
Operating Expenses: $98,000
Financing Costs: $85,000
Annual Depreciation: $15,000

A. $460,000
B. $570,000
*C. $558,000
D. $600,000

5. Use the following information to calculate the net operating income.

Number of Units: 150

Vacancy Rate: 5%
Bad Debt Allowance: 2%
Per Unit Annual Rent: $4,000
Operating Expenses: $98,000
Financing Costs: $85,000
Annual Depreciation: $15,000
 *A. $460,000
B. $570,000
C. $558,000
D. $600,000

6. Use the following information to calculate the estimated value of the property if the
cap rate is 9.5%.

Number of Units: 150

Vacancy Rate: 5%
Bad Debt Allowance: 2%
Per Unit Annual Rent: $4,000
Operating Expenses: $98,000
Financing Costs: 85,000
Annual Depreciation: $15,000

*A. $4,842,100
B. $6,000,000
C. $5,873,700
D. $6,315,800

7. An analyst is assigned the task of evaluating a real estate investment project.

Purchase price is $700,000. Using the information in the table below, calculate the
after-tax cash flow for the sale of the property.

After-tax cash flow without property sale $33 546

Straight-line depreciation $18 700
Mortgage Payment $59 404
Cumulative Mortgage principle repayments until year 5 $20 783
80% financing at 10% interest rate
Marginal income tax rate 31%
Capital gains tax rate 20%
Forecasted sales price $927 000
Sales expense as a % of price 6%

A. $240 083
*B. $273 629
C. $175 000
D. $140 000
8. John Williams wants to purchase an apartment complex. The complex consists of 75
units each renting for $700 per month. The estimated vacancy and collection loss
rate is 7%. The insurance for the building is $40,000 annually and taxes are $22,000
annually. Utilities are $18,000 and the maintenance expense is $29,000. Assume a
market cap rate of 11%. Recent sales of nearby apartment complexes have resulted
in the following information.

Characteristics Units Slope Coefficient in $ per Unit

Proximity to downtown Miles -350,000
Proximity to
Blocks -500
public transportation
Building size Units +75,000

Williams' proposed apartment complex is 4 miles away from downtown and 6 blocks
away from the nearest public transportation. Using the sales comparison approach,
the value of the apartment complex is:

A. $4 060 000
*B. $4 222 000
C. $3 894 500
D. $3 754 000

9. An investor purchases a property for R1 000 000, financing 92% of the purchase
price. He plans to sell the property four years later for R1 200 000. The expected net
cash flows for the investment are as follows:

Year 1 R23 450

Year 2 R25 312
Year 3 R27 879
Year 4 (net of mortgage payoff) R261 450

Assuming a 9% cost of equity, the net present value (NPV) of the cash flows at the
time the property is purchased is closest to:

A. R340 000
B. R250 000
C. R200 000
*D. R170 000