The paper "Real Estate Investment Issues" is a wonderful example of a Business Case Study. The main aim of this report is to locate and assess the investment potential of at least three income-producing properties over a 10 year holding period. We want to invest £ 500,000 in the portfolio. Several aspects will be considered such as market and portfolio appraisal, financial strategy and portfolio evaluation. Market and portfolio appraisal Portfolio appraisal is concerned with property valuation and this is important because properties are different plus they differ from each other in their location.
The value of the property in the appraisal is considered to be the market price. That is the reason why it becomes crucial to evaluate the market portfolio when appraising properties. It is not easy to carry out property appraisal and that is the reason why in real practice the relevant laws require it to be carried out by a licensed or certified appraiser. When choosing a portfolio, rational investors choose properties that give high returns though risky. Using the separation theorem, the investors expect the market prices to fall; causing the expected returns to rise up until the resulting tangency portfolio reaches a non-zero proportion.
Therefore, there are three things that happen when the market reaches equilibrium due to the prices not adjusting. To begin with, investors are assumed to hold risky assets. Two, the current market price of the assets reaches a level where the number of shares demanded equals the number of shares outstanding. Finally, the risk-free rate comes to a level where the amount borrowed equals the amount lent. Therefore, the market portfolio is said to occur at the point of tangency or equilibrium.
The market portfolio usually has a relationship with the capital asset pricing model (CAPM). CAPM considers non-diversifiable risk and risk-free assets. The riskiness of the assets is measured using beta (β ) It’ s not necessarily for investors to consider only the risky assets, they can involve so many properties of fewer returns in their portfolio so as to spread risk. The act of spreading risk is commonly referred to as diversification of risk. Therefore, considering the aspects of market and portfolio appraisal, the properties that are to be appraised will be greatly influenced by market forces, location, and type. The properties to appraise are located in London, the U. K.
they include the peach properties U. K limited, London property management and River homes properties. Therefore, we make an assumption that the investor buys properties as follows: 250,000 in London property management 150,000 in peach properties 100,000 in River homes Financial strategy A strategy is a game plan on how best a rational investor is to source his or her finances so as to buy a property. There are different ways in which an investor may raise his or her finances.
The common sources are debt and equity finances. Both sources are reliable even though looking into some aspects, one source is most preferred than the other. For instance, debt is mostly preferred because it is cheaper as it does not involve floatation costs like equity. Also, the procedures for obtaining debt are not as complex as those involved in obtaining equity. You find out that most investors may use both sources but using different levels such as a debt to equity ratio of 0.7:0.3.
In this ratio, debt forms a larger portion of the finances compared to equity. With the rising demand to appraise properties, additional skills to determine the interest rates have also emerged. There are the income approach and the capitalization approach for appraisal purposes. The income-based approach of valuation is the present value of future benefits or cash flows. On the other hand, the capitalization approach is given by the net operating income over the capitalization rate. The overall capitalization rate is made up of two components: the required rate of return or the interest rate and the return on investment (recapture of principle). The overall capitalization rate in an income appraisal has to be determined by selecting any of the three methods of determining the rate.
They include the mortgage equity method, internal rate of return (IRR) and the sales method. The IRR is the required rate of return of investment and at this point, the NPV of costs is equal to the NPV of benefits for the investment. In most cases, the internal rate of return (IRR) is considered to be an interest rate and not an overall capitalization rate.
Therefore, IRR is the most suitable method to calculate the interest rate as it considers the time value of money. The only demerit associated with the IRR is that it does not apply well for homogeneous investments. The interest rate for net present value (NPV) analysis should be able to result in high values of discounted cash flows. In reality, you find out that the higher the rate of interest the lower the values of the discounted cash flows. For a 10 year holding investment, the appropriate rate of interest ranges from 12% to 12.2.
In our analysis, we are to use the rate of 12% which is a safe rate as it avoids negative NPV. Portfolio evaluation A real estate investment has two major cash flows: the rentals amounts received during the holding period and the amount received after the termination of the investment property after the holding period (reversion). To begin with, let’ s consider the cash flows received during the holding period. The portfolio evaluation is to be carried out using the income capitalization approach which takes into account the discounted cash flows (DFC).
In case the NPV method of discounted cash flows is be used for each property as shown: Let us consider the second source of cash flows which is the equity reversion. Reversion is the amount of cash realized from the sale of the property after subtracting the selling expenses, mortgage balances, remaining amortization of original qualified financing costs and the balanced reduced by taxes owed on the sale. Reversion has three components: The selling price- the selling price is the net amount received from the sale of the property after the selling expenses so as to include any remaining unamortized costs of finances which were there during the original purchase. Cash flow before tax at the sale (CBBT) - this is arrived at after deducting the remaining mortgage balance from the selling price above. Cash flow after tax at the sale- calculated after deducting the tax liability from (CBBT).
If there is no tax liability but instead a tax-saving then add it. Therefore, the total gain on the Conclusion and recommendations Using NPV, the results give positive NPV, therefore, they are all worth investing in.
A rational investor should consider the following ranking when investing: River homes London property management peach properties Using the reversion cash flows, the investor should invest using the following ranking: London property management peach properties River homes The rankings of the two types of cash flows are very different as shown above thus bringing a lot of controversies. Between the two methods of estimating cash flows, the NPV is the most appropriate method. This is because it discounts its cash flows, unlike the reversion method which only considers the rental yields (Brigham and Daves, 2009).
Therefore, it is recommendable for investors to use the NPV to consider the viability of the investments. You also find out that the River homes have the lowest values of properties in its portfolio but are ranked as number one using the NPV. Therefore, the investor should not always be driven by the high returns to be expected from a property. Sometimes, the rule that states that the higher the returns; the riskier the assets should not always apply. Therefore, it is recommendable to consider the properties which are of low values. The final portfolio should be London property management considering the two methods of estimating cash flows.
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