End of Chapter 16 Questions and Answers

End of Chapter 16 Questions and Answers - End of Chapter 16...

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End of Chapter 16 Questions and Answers 1. What is the difference between the leverage ratio (LR) and the loan-to-value ratio (LTV)? How much greater property value can be purchased with a 75% LTV than with a 50% LTV? What is the LR associated with each of those two LTVs? Answer: Leverage ratio gives the ratio of property value to equity investment (LR=V/E) Loan to Value ratio gives the ratio of debt to property value (LR=L/V) Property value purchases with 75% LTV will be double the property value purchased with 50% LTV. LR will be 4 for LTV of 75% and 2 for LTV of 50% 2. What is meant by the “preferred” or “senior” lien of debt, and how does this affect the relative risk of the debt, the equity, and the underlying property? Answer: “Preferred” or “senior” lien of debt gives the holder the first right of return over the cash flow of underlying property. The holder of preferred lien has the least risk. The equity investor is left with the riskiest component of return from the underlying property. 3. How does the equity investor’s ability to control property management align the interests and incentives of the debt and equity investors in normal circumstances, so as to maximize total property value? [Hint: what are the implications of the fact that equity has the “residual” claim on property value?] Answer: Equity’s governance of the asset gives it the greater ability to influence the total value of the underlying asset (e.g., by management actions), while its residual claim causes any increment in this value to accrue to the value of the equity. If the equity owner manages the property well, they will reap the benefit; if they manage it poorly they will suffer the loss (at least up to a point). Thus, by giving the equity owner the primary management control, it is likely that the value of the underlying asset (the property) will be maximized. 3. What is wrong with the following statement: “Only a fool would invest in real estate
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End of Chapter 16 Questions and Answers - End of Chapter 16...

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