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End of Chapter 11 Questions and Answers

End of Chapter 11 Questions and Answers - End of Chapter 11...

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End of Chapter 11 Questions and Answers 1. What is the difference between nominal returns and real returns? Answer: Nominal returns include inflation while real returns have inflation netted out. For example, a nominal return of 12% during a year of 3% inflation has provided a real return of approximately 9%. 2. Two sources of real estate returns occur every year while two others are only observed when the property is sold or refinanced. Explain the timing of the four potential returns. Answer: Real estate returns in form of rental cash flows and tax-shelter (or postponement) occur every year. Returns due to equity buildup and price appreciation are observed on sale or refinancing for the property. From a timing perspective the before tax cash flow plus or minus tax savings or taxes due can be treated as one final source of returns during the operational stage of ownership. The appreciation and equity buildup both result in before tax proceeds at the time of sale based on an estimate of the selling price less transactions costs and the mortgage balance. Depreciation and improvements need to be considered in calculating the taxes due at the sale in order to derive the after tax proceeds or residual from resale. 3. Why is it hard to find an investment with above average cash flow yield and an above average prospect for price appreciation? Answer: It is impossible to find a real estate property that has both relatively high current income and relatively high appreciation. This is because both would create extremely high total returns and investors in an efficient market will bid up the prices until yields decline to market required levels. 4. What is the difference between direct and indirect real estate investment? Give examples. Answer: The term direct real estate investment refers to buying buildings directly with no active market for the trading of interests in the building. This is the way most real estate is owned, whether it is rented out or occupied by the owner. Owners have control over management decisions and are considered active investors. The term indirect refers to owning the investment via the public markets and securities that may be traded, also known as the “securitized market”. Here investors are passive and do not have any direct day to day control over the operation of the properties. A common indirect or public way to own real estate is through real estate investment trusts or REITs.
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