# Investment’s Taxable Income Assignment | Homework For You

1. Apply What You’ve Learned – Real Estate Investments

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Scenario: You are considering investing in real estate—both for the short-term cash flows and the potential long-term capital gains—and are evaluating both a commercial lease property (such as a strip shopping center or an office building) and a residential rental property (such as several rental houses or a small apartment complex). It is likely that you will invest in only one of these properties at this time.

The general data regarding these investments is as follows:

Property type Price Mortgage Expected Estimated
Rental income Depreciation expense resale
(per year) (per year) value
Strip shopping center \$800,000 \$448,000 \$136,016 \$7,692 \$912,000
Small apartment complex \$650,000 \$292,500 \$91,281 \$8,273 \$685,100

The first potential investment consists of a seven-store shopping center, which has a current market price of \$800,000. Of this amount, \$200,000 represents the cost of the land, and the balance, \$600,000, is attributable to buildings on the property. The second possible investment, which costs \$650,000, consists of a small four-unit apartment complex. \$195,000 of the investment’s total price is reflects the cost of land, and the remaining \$455,000 is associated with structures on the land. For both properties, you believe you can increase the rents 2% per year for each of the next four years, and expect to sell either property at the end that time. You desire a return of 7% on your investments.

One of the more important considerations associated with your investment is a property’s potential for generating a positive cash flow. One indicator of a property’s likelihood of generating a positive cash flow is the property’s rental yield. The best formula for computing a property’s rental yield is: Check all that apply.

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Rental yield (%) = [(Monthly rent / 2) / Purchase price] x 100

Rental yield (%) = [Annual rent / (Purchase price / 2)] x 100

Rental yield (%) = [((Monthly rent * 12) / 2) / Purchase price] x 100

In the equations above, the reason that the values are divided by two is that it is assumed that  half/one-quarter/200%/one-third of the purchase price/rental income is spent on expenses other than debt repayment.

The rental yield expected on the commercial property is 8.50105%/5.1006%/10.2012%/6.008%, while the expected yield on the residential property is 7.2016%/5.6173% /9.8302%/8.4259%. Based on their respective rental yields, the shopping center/apartment complex is a better investment.

Another indicator of their relative attractiveness as an investment is each property’s price-to-rent ratio. The shopping center has a price-to-rent ratio of 8.7641/4.7788/5.8817/104.0042, while the corresponding ratio for the apartment complex is 7.1209/4.7788/78.5688/8.7641.  Based on their respective rental yields, the Shopping Center/Apartment complex is a better investment.  From an investor’s perspective, a negative conclusion associated with an overly large ratio is that it suggests that property prices are very low/high. Similarly, a discouraging explanation for an overly large/small ratio is that rents and market prices are so close in value that a financially astute investor would rather rent than rent than purchase/purchase than rent a given property. The loan-to-value (LTV) for the shopping center is 0.5600/0.4500/0.3656/0.6892, but it is 0.6892/0.5600/0.3656/0.4500 for the apartment complex.

Assume that your expected annual operating costs—excluding your annual depreciation expense—for the commercial property will be 35% of your annual rental income. For the residential property, the annual operating costs (excluding depreciation expense) will be 20% of your annual rental income. The interest rates of the mortgages for the commercial and residential lease properties are expected to be 6% and 4%, respectively.

Given your other assumptions, complete the following two tables and then use your computations to answer several questions. Round all amounts to the nearest whole dollar. (Hint: Don’t round intermediate calculations. Also, don’t forget that capital gains are taxed at 15% if properties are sold for more than their original purchase price.)

Strip shopping center Year 1 Year 2 Year 3 Year 4
Annual rental income
Estimated resale value 0 0 0
Less: Annual operating expenses
Less: Annual depreciation expense
Less: Annual interest payments (6%) 26,880 25,536 24,192 22,848
Less: Taxes (25%)
Less: Capital gains tax (15%) 0 0 0
Net profit
Interest factor (7%) 0.9346 0.8734 0.8163 0.7629
PV of Cash flow
Total PV of Cashflows

The net discounted return expected from an investment in the shopping center—after deducting the cost of the investment—is \$30,991/\$830,991/\$55,784/\$24,793.

Now perform a comparable analysis for the residential lease property:

Small apartment complex Year 1 Year 2 Year 3 Year 4
Annual rental income \$91,281 \$93,107 \$94,969 \$96,868
Estimated resale value 0 0 0 685,100
Less: Annual operating expenses 18,256 18,621 18,994 19,374
Less: Annual depreciation expense 8,273 8,273 8,273 8,273
Less: Annual interest payments (4%) 11,700 11,115 10,530 9,945
Less: Taxes (25%) 13,263 13,775 14,293 14,819
Less: Capital gains tax (15%) 0 0 0
Net profit
Interest factor (7%) 0.9346 0.8734 0.8163 0.7629
PV of Cash flow
Total PV of Cashflows

The net discounted return expected from an investment in the apartment complex—after deducting the cost of the investment—is \$27,108 /\$10,843/\$660843/\$59,637.

Based on the results of your analysis, which of the following statements best reflects your decision regarding the commercial or residential lease opportunities?

As the shopping center has an NPV that is greater than that expected from the apartment complex, it is more financially sound to invest in the commercial lease property. Because the apartment complex is expected to generate a negative NPV, you should not consider making this investment.

Based on the numbers alone, you should prefer investment in the shopping center since it has a net present value that is greater than that expected from the residential lease property (the apartment complex).

Given that the apartment complex has an NPV that is greater than that expected to be generated by the shopping center, you should prefer to invest in the residential lease property.

As the apartment complex has an NPV that is greater than that expected from the shopping center, it is more financially sound to invest in the residential lease property. Because the shopping center is expected to generate a negative NPV, you should not consider making this investment.

Which of the following is not a tax-deductible expense for an investment property?

Interest on a mortgage loan

Maintenance and repairs

Lost rent resulting from vacancies

Tax-deductible expenses reduce/increase/have no effect on an investment’s taxable income, and have no effect/reduce/increase the return on your investment. Get Finance homework help today

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