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Real Estate Investment and International Financial Management - Assignment Example

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The paper "Real Estate Investment and International Financial Management" is a wonderful example of an assignment on finance and accounting. Real estate appraisal or property valuation usually involves the determination of the value of a property (Joseph, 2006). Usually, the value of the property is the market value…
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Name………………………………………………………………….xxxxxx Title………........................... Real Estate Investment- A Capital Market Approach Institution……………………………………………………………..xxxxxx Instructor………………………………………………………………xxxxxx Course………………………………………………………………….xxxxxx @ 2010 Real Estate Investment- A Capital Market Approach Assessment task 1 Real estate appraisal or property valuation usually involves determination of the value of a property (Joseph, 2006). Usually the value of the property is the market value. The market value is the value at which the property trades in a competitive market. There are other types of values. To begin with, there is the value- in- use which is the net present value of a cash flow that the property generates in future. This value may either be higher or lower than the market value. Two, the insurable value which is the value of the property that is to be covered under an insurance policy. There is also the liquidation value which is the value of a property to be considered incase of liquidation. The liquidation value is usually less than the market value because the seller wants to dispose the asset fast to pay all his obligations. Finally, we have the investment value which relates to a particular investment and this value is usually higher than the market value. There are three approaches of valuing property or appraising real estate. One is the cost approach which involves the cost of land and the depreciated value of any improvements done on the property. All these costs are summed up so as to come up with value of the property. The other approach is the sales comparison approach which involves the buyer comparing prices and then choosing the price that best suits his expectations. Finally, there is the income approach used to value commercial and investment properties. The income expected from a property is capitalized using capitalization rates or discounted cash flows (DFC). The DFC model is widely used for valuing investments of high value. In our case, let’s use the income approach using assumed figures of the following listed properties in Australia to show valuation.   Property cash flow Discount rate @ 15% 5years Net present value 1 Sydney cove properties 895,000 0.4972 444,994           2 Mc Grath 760,000 0.4972 377,872           3 CBRE 1,850,000 0.4972 919,820           4 Ray white 2,700,000 0.4972 1,342,440           5 LJ Hoocker 780,000 0.4972 387,816           6 Meriton 630,000 0.4972 313,236 For the above case, the cash flow is the amount of money that the investor expects to get in five years time while the net present value is the current price of the asset discounted at the rate of 15%. Risk of returns occurs when there is a deviation between the expected return and the actual return. This means that the actual return is less than the expected return. This risk can be measured using the standard deviation.   Property expected return Actual return deviation (x) x2 1 Sydney cove properties 15% 18% 3 9             2 Mc Grath 20% 18% -2 4             3 CBRE 25% 26% 1 1             4 Ray white 18% 18% 0 0             5 LJ Hoocker 17% 17% 0 0             6 Meriton 14% 12% -2 4               Total       18   standard deviation       4 In the table above, we have made assumptions regarding the expected rate of return and the actual returns to come up with a standard deviation of four. According to Jeff Madura (2009), standard deviation is given by the formulae below: Standard deviation = √ ∑ (x2) Where: √∑x2 is total of the square of the deviation to the square root. Sources from Gregory Conner (2010) indicate that when it comes to the risk of a portfolio, we use weights or probabilities as shown below:   Property x2 probabilities weighted risk 1 Sydney cove properties 9 0.25 2.25           2 Mc Grath 4 0.1 0.4           3 CBRE 1 0.3 0.3           4 Ray white 0 0.1 0           5 LJ Hoocker 0 0.05 0           6 Meriton 4 0.2 0.8             risk of a portfolio     3.75 The probabilities they should add up to 1(0.25 + 0.1 +0.3+ 0.1 + 0.05 + 0.2). CAPM is used to determine the required rate of return on a security or asset. The required rate of return is what an investor expects from an investment. There are two types of risks, the market risk or the non-diversifiable risk and the diversifiable risk. CAPM is mainly concerned with the market risk or the non-diversifiable risk which is very sensitive. That’s why a rational investor may choose a portfolio of assets which are risky but giving very high returns. When it comes to the diversifiable risk, the risk is said to be reduced because of the large number of individual assets in the portfolio. According to the rule of risk and diversification, the more the number of assets in a portfolio, the less the risk. There are several assumptions made by the capital asset pricing model. One, it assumes that there are no transaction costs and taxes. This assumption does not concur with the reality since the costs are in most cases taken into consideration. Another basic assumption is that it assumes that investors can borrow and lend funds at a risk-free rate. Also, CAPM assumes that investors are well diversified across a wide range of investments so as to spread risk. CAPM assumes that all the investors are price takers meaning that they cannot influence prices. This assumption is not justifiable since there are determinants of prices such as the forces of demand and supply. For instance, when the demand of an asset is very high the prices go up and vice versa. The relationship of property demanded and the prices is therefore a linear one. CAPM assumes that the properties or assets that the investors are dealing with are highly divisible into small units. This is on the contrary as some of the property like buildings cannot be divided. Land is however divisible into small portions. Another assumption of capital asset pricing model (CAPM) is that it assumes that information is available to all investors at the same time. The assumption is not justifiable when it comes to reality as some may get the information when it’s released, while other at a later time or day. There is also the assumption that all the investors are risk averse such that they stay away from highly risky investments. Let’s say an investor has two investments in which to choose, he is likely to take the one with minimum risk. This assumption is not practical in most cases because investor would rather take a risky investment for higher returns. This aspect of being wise in making choices is called being rational. CAPM has some shortcomings as well. Stock indices are mistaken as a sum up of all the investments held by an investor. A portfolio should comprise of all the assets held by an investor and not stock only. The other shortcoming of CAPM is that it takes variance on returns to be an adequate measure of risk. In reality, there are other factors that are used to determine risk in relation to the investor’s preferences. Another shortcoming of CAPM is that it assumes that the variations of returns to be normally distributed. This assumption is not justifiable when it comes to the reality because of the frequent market fluctuations like inflation. Another shortcoming of CAPM is that it assumes investors to only optimize one portfolio. In reality, you will find out that there are individual investors holding multiple portfolios. In CAPM investors expectations are believed to match the true results of returns. This is not true as there maybe overvaluation or undervaluation of returns making the market look inefficient. Finally, the capital asset pricing model does not seem to explain why there are variations of returns. It just gives arbitrary figures without any explanations. Expected return rate can be calculated using the capital asset pricing model (CAPM) and it’s given by the formulae below: Expected rate of return= Risk free rate (Rf) + beta (market return - risk free rate)   Property Market return (Rm) Risk free rate (Rf) expected return         = Rf + 4 (Rm - Rf) 1 Sydney cove properties 6 3 15           2 Mc Grath 6 5 9           3 CBRE 4 2 10           4 Ray white 8 7 11           5 LJ Hoocker 5 4 8           6 Meriton 5 4 8           Note that in the CAPM model the beta is the measure of risk, therefore based on our assumption, our beta is 4. The expected rate of return of a portfolio is calculated using weights according to Levy (2009) as shown below:   Property expected return Weights weighted return rates     = Rf + 4 (Rm - Rf)     1 Sydney cove properties 15 10% 1.5           2 Mc Grath 9 30% 2.7           3 CBRE 10 10% 1           4 Ray white 11 20% 2.2           5 LJ Hoocker 8 25% 2           6 Meriton 8 5% 0.4             expected rate of return of a portfolio     9.8 In the above case, we assume that a portfolio consists of a certain percentage of an investment. For example, we can assume that Ray White is made up of 20% of buildings. This percentage is what we term to as the weights. Assessment task 2 Step 1 Supposing a rational investor has 100m and wants to invest that money in a portfolio. The kind of portfolio the investor should have needed to consist of that property that has high returns as this is his investment objective. High returns are said to be associated with high risks. It said the higher the returns, the higher the risk. Below is a table showing commercial property consisting of high returns.   Property Amount (million)       1 Sydney cove properties 20       2 Mc Grath 15       3 CBRE 22       4 Ray white 10       5 LJ Hoocker 18       6 Meriton 15 Step 2 The assets above have been assumed to be valued using their market values. The market value is what is sometimes interchanged with the open market value or the fair value. Before we saw that there are several ways of real estate appraisal or valuation. That is by using the discounted cash flows, the cost approach and the sales comparison technique. Step 3   Property Amount (million) market rate (Rm) risk-free rate (Rf) expected return           (Rf + 1 ( Rm - Rf)             1 Sydney cove properties 20 10% 5% 10%             2 Mc Grath 15 9% 4% 20%             3 CBRE 22 7% 3% 26%             4 Ray white 10 10% 7% 13%             5 LJ Hoocker 18 15% 8% 25%             6 Meriton 15 12% 4% 23% The table above assumes a beta of one when calculating the expected return using the CAPM model. One assumption of CAPM is that it assumes the beta of market portfolio to be one. Shown Below is the calculations of the expected returns of the whole portfolio using weights based on assumptions.   Property Amount (million) expected return weights weighted returns       (Rf + 1 ( Rm - Rf)                 1 Sydney cove properties 20 10% 30% 3%             2 Mc Grath 15 20% 50% 10%             3 CBRE 22 26% 50% 13%             4 Ray white 10 13% 25% 3%             5 LJ Hoocker 18 25% 25% 6%             6 Meriton 15 23% 50% 12%               Expected return of a portfolio       47% The weighted risk of a portfolio is shown below:   Property expected return actual return x x2 probabilities weighted risk     (Rf + 1 ( Rm - Rf)                                           1 Sydney cove properties 10% 8% -2 4 0.10 0                 2 Mc Grath 20% 22% 2 4 0.20 1                 3 CBRE 26% 24% -2 4 0.15 1                 4 Ray white 13% 15% 2 4 0.25 1                 5 LJ Hoocker 25% 20% -5 25 0.15 4                 6 Meriton 23% 23% 0 0 0.15 0                   risk of a portfolio           7 Step 4 Under the capital asset pricing model (CAPM), we have the security market line (SML) which graphs individual assets and not a portfolio. The security market lie (SML) represents the relationship between returns and risk. The returns are plotted against as a function of beta or risks. The returns are graphed on the y-axis while beta is plotted on the x-axis. The risk premium is determined using the slope of the SML graph. Risk premium is given by beta (market risk – risk free rate). If an individual asset falls above this line then it’s said to be undervalued (Joseph Phillips 2004). This is because the investor expected more for an inherent risk. On the other hand, if the asset falls below the security market line, the asset is said to be overvalued since the investor expects less for a risk assumed. There is a question on what is the difference between the capital asset pricing model and the security market line. The difference is CAPM gives rise to SML which is a single factor model. Though CAPM is single factor model, it represents risks and returns of a portfolio while SML represents risks and returns of a single or individual asset. In these two models, the aspect of risk and diversification is taken into consideration. Risk of individual assets is high since diversification is not taken into consideration as much as their returns seem to be also high. When it comes to risk of a portfolio, it seems to be less since it has been diversified. The returns of a portfolio are also less because an investor would rather have so many assets of smaller returns in a portfolio in order to spread risk. When it comes to diversification, one would rather include so many properties which give a lower return in a portfolio so as to spread the risk. In diversification, it is believed that more the number of assets in a portfolio the lower the risk. References Jeff Madura (2009) International Financial Management. Page 3 Gregory Connor, Lisa Goldberg and Robert Korajczyk 2010. Portfolio Risk Analysis. Page 4 Levy, 2009 Uncertainty, risky assets and portfolio choice. Joseph F. Schram, 2006 Real estate appraisal. Page 1 Read More
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