Real Estate Finance Study Set 1

Business

Quiz 13 :

Risk Analysis

Quiz 13 :

Risk Analysis

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Why is the variance (or standard deviation) used as a measure of risk What are the advantages and disadvantages of this risk measure
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Variance:
Variance is a basic mathematical concept that helps in analysis. The variation found in a set of data from its mean is quantified by using this measure. It is ascertained by first deducting the mean from each value, and after that squaring, summing and averaging the distinctions to create the dispersion.
Reason of using variance as a measure of risk:
When we consider a lower risk in investment, less deviation in returns is been estimated and vice versa if the risk are higher. In order to measure the overall extent of the risk present in such an investment, variance is been used. Variance also tells about the relation of mean value which is expected rate of return with actual rate of returns over the period.
Advantage and disadvantages of risk measure through variance:
The various advantages of risk measurement through variance are:
• It makes computation easier for ascertaining the risk in an investment.
• It is one of the key measures of asset allocation.
• It helps investor in emerging best portfolios by optimizing the return volatility trade off in investment portfolios.
The various disadvantages of risk measurement through variance are:
• When variance is used for computation, the resultant outcome of higher and lower expected returns are considered same.
• The interpretation of these data is not an easy task.

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What is meant by the term 'overage' for retail space
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In a lease agreement the lessee has to pay a fixed rent for using the property of the lessor at the agreed upon rent.
For any lease agreement, a minimum amount of rent is paid by the tenant. The rent which is paid above the fixed rent in the lease is known as 'overage'. The rent is calculated as a percentage of the sales incurred by the tenant. This occurs only when the sales exceeds the predetermined breakeven. Hence in this case the total rent would be the summation of minimum rent and the overage rent.

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Mike Riskless is considering two projects. He has estimated the IRR for each under three possible scenarios and assigned probabilities of occurrence to each scenario. img Riskless is aware that the pattern of returns for Investment II looks very attractive relative to Investment I; however, he believes that Investment II could be more risky than Investment I. He would like to know how he can compare the two investments considering both the risk and return on each. What do you suggest
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Internal rate of return (IRR):
It is the rate at which the sum of cash outflows and cash inflow values becomes zero at initial year. This rate helps to determine the selection of a project. If the internal rate of return of a project comes higher than the company's required rate of return, then company takes the project.
Computation of expected return:
Expected return can be computed with the help of estimated before tax internal rate of return (BTIRR) and the probability percentage in each state of economy.
For Investment I:
Estimated BTIRR for investment I in optimistic state of economy is
img , in most likely state is
img , and in pessimistic state is
img . Probability percentage in optimistic state is
img , in most likely state is
img , in pessimistic state is
img Calculation of expected return is given in below excel.
img Fig (1)
The resultant figure from the excel sheet is given below.
img Fig (2)
Computation of expected return:
Expected return can be computed with the help of estimated before tax internal rate of return (BTIRR) and the probability percentage in each state of economy.
For Investment II:
Estimated BTIRR for investment II in optimistic state of economy is
img , in most likely state is
img , and in pessimistic state is
img . Probability percentage in optimistic state is
img , in most likely state is
img , in pessimistic state is
img Calculation of expected return is given in below excel.
img Fig (3)
The resultant figure from the excel sheet is given below.
img Fig (4)
Hence, the expected return for investment I is
img and of investment II is
img Computation of variance and standard deviation:
Calculate the difference between estimated and expected return, square the resultant deviation, then multiply it with the probability percentage and at last sum of all the product will be the variance. To calculate the standard deviation, under root the value of variance.
For Investment I:
Estimated BTIRR for investment I in optimistic state of economy is
img , in most likely state is
img , and in pessimistic state is
img . Probability percentage in optimistic state is
img , in most likely state is
img , in pessimistic state is
img Calculation of variance and standard deviation is given in below excel.
img Fig (5)
The resultant figure from the excel sheet is given below.
img Fig (6)
For Investment II:
Estimated BTIRR for investment II in optimistic state of economy is
img , in most likely state is
img , and in pessimistic state is
img . Probability percentage in optimistic state is
img , in most likely state is
img , in pessimistic state is
img Calculation of variance and standard deviation is given in below excel.
img Fig (7)
The resultant figure from the excel sheet is given below.
img Fig (8)
Hence, the variance and standard deviation for investment I is
img and
img respectively, and of investment II is
img and
img respectively.
Comparison between Investment I and II:
The projected BTIRR is higher for Investment II by
img img . Standard deviation is moreover high for investment II vs. investment I by
img img . According to the calculated data, Investment II has a higher expected BTIRR but is also riskier. It cannot be concluded that which among these two investments is better one. It can be said that Investment II dominates Investment I because in none of the scenario the returns of Investment II are lower than Investment I.

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What is the difference between business risk and financial risk
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Use the same information as in problem 3. Now assume a loan for $1.5 million is obtained at a 10 percent interest rate and a 15-year term. a. Calculate the expected IRR on equity and the standard deviation of the return on equity. b. Contrast the results from ( a ) with those from problem 3. Has the loan increased the risk Explain.
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What is meant by partitioning the internal rate of return Why is this procedure meaningful
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How does the use of scenarios differ from sensitivity analysis
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A developer plans to start construction of a building in one year if at that point rent levels make construction feasible. At that time the building will cost $1,000,000 to construct. During the first year after construction would take place, there is a 60 percent chance that NOI will be $150,000 and a 40 percent chance that the NOI will be $75,000. In either case, NOI would be expected to increase at 2 percent per year after the first year. How much should the developer be willing to pay for the land if he wants a 12 percent rate of return
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What is meant by a ' real option'
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What is a risk premium Why does such a premium exist between interest rates on mortgages and rates of return earned on equity invested in real estate
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Two investments have the following pattern of expected returns: img Investment A requires an outlay of $110,000 and Investment B requires an outlay of $120,000. a. What is the BTIRR on each investment b. If the BTIRR were partitioned based on img what proportions of the BTIRR would be represented by each c. What do these proportions mean
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What are some of the types of risk that should be considered when analyzing real estate and other categories of investment
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An investor has projected three possible scenarios for a project as follows: Pessimistic - NOI will be $200,000 the first year, and then decrease 2 percent per year over a five-year holding period. The property will sell for $1.8 million after five years. Most likely - NOI will be level at $200,000 per year for the next five years (level NOI ) and the property will sell for $2 million. Optimistic - NOI will be $200,000 the first year and increase 3 percent per year over a five-year holding period. The property will then sell for $2.2 million. The asking price for the property is $2 million. The investor thinks there is about a 30 percent probability for the pessimistic scenario, a 40 percent probability for the most likely scenario, and a 30 percent probability for the optimistic scenario. a. Compute the IRR for each scenario. b. Compute the expected IRR. c. Compute the variance and standard deviation of the IRR s. d. Would this project be better than one with a 12 percent expected return and a standard deviation of 4 percent
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