# Investment Decisions

CHAPTER 18

Investment Decisions: Ratios

Test Questions

1.Income multipliers:

a. are useful as a preliminary analysis tool to weed out obviously unacceptable investment opportunities. 2.The overall capitalization rate calculated on a potential acquisition: a. is the reciprocal of the net income multiplier.

3.The operating expense ratio:

c. expresses operating expenses as a percent of effective gross income. 4.The equity dividend rate:

b. expresses before-tax cash flow as a percent of the required equity capital investment. 5.Ratio analysis:

d. serves as an initial evaluation of the adequacy of an investment’s expected cash flows. 6.Assume a retail shopping center can be purchased for $5.5 million. The center’s first year NOI is expected to be $489,500. A $4,000,000 loan has been requested. The loan carries a 9.25 percent fixed contract rate, amortized monthly over 25 years with a 7-year term. What will be the property’s (annual) debt coverage ratio in the first year of operations? b. 1.19

7.Which of the following is not an operating expense associated with income-producing (commercial) property? a. Debt service

Use the following information to answer questions 8-9.

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 38 percent and 4 percent, respectively, of effective gross income (EGI). 8.What is the implied first-year overall capitalization rate? a. 9.5 percent

9.What is the effective gross income multiplier?

b. 6.11

10.Given the following information, what is the required equity down payment? • Acquisition price: $800,000

• Loan-to-value ratio: 75%

• Total up-front financing costs: 3%

c. $218,000

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? Solution:

Item Amount

Potential gross income (PGI) $340,000

less: V&C allowance (at 15% of PGI) 51,000

Effective gross income (EGI) $289,000

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

Solution:

Item Amount

Effective gross income (EGI) $289,000

less: Operating expenses (OE) (115,600)

less: Capital expenditures (CAPX) (14,450)

Net operating income (NOI) $158,950

3.What is the estimated going-in cap rate (Ro) using NOI for the first year of operations? Solution: The overall cap rate is 10.6 percent ($158,950 / $1,500,000) 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. Effective gross income $200,000

Less operating expenses and CAPX$100,000

Net operating income $100,000

For the first year only, determine the:

a. Gross income multiplier

Solution: Market price / Effective gross income = $1,000,000 / $200,000 = 5.0 b. Operating expense ratio (including CAPX)

Solution: Operating expenses / Effective gross income = $100,000 / $200,000 = 0.50 or 50 percent. c. Monthly and annual payment

Solution: Monthly payment is $5,300.84. Annual...

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