Assume that you need to invest $300,000 in single-family real estate as part of your diversified portfolio
Question:
Assume that you need to invest $300,000 in single-family real estate as part of your diversified portfolio strategy. The rules for investment are outlined in the table below.
For question number 1, in the table below, please fill in the correct quantity where you find “???”.
Then respond with your thoughts to the questions that follow. The exercise is for you to flesh out the pro forma results.
Q 1)
Assumptions: | You have found an area where you can buy houses for $300,000, | |||||
where the rents you receive amount to a 7% return after | ||||||
all maintenance, taxes, fees, and misc. expenses | ||||||
Lenders will let you mortgage up to 80% of house value at 3%, | ||||||
Constraint: | You only have $300,000 to invest, ignore closing fees, | |||||
And must invest as per one of the four scenarios below. | ||||||
Question: | What are your Returns on Equity (ROE) per year and Income per year | |||||
in each of the following investment scenarios? | ||||||
Also, ignore taxes and depreciation for simplicity. | ||||||
Total Equity Investment | $300,000 | |||||
Cost per House | $300,000 | |||||
ROA: | 7% | ? | ? | ? | ||
Cost of Debt | 3% | |||||
Scenario #1 | Scenario #2 | Scenario #3 | Scenario #4 | |||
# of Rental Houses Bought | 1 | 2 | 4 | 5 | ||
Multiplied by | ||||||
$300,000 per House = | $300,000 | $600,000 | $1,200,000 | $1,500,000 | ||
Amount of Mortgage on Each House | 0 | $150,000 | $225,000 | $240,000 | ||
Total Amount of Mortgage Debt | 0 | $300,000 | $900,000 | $1,200,000 | ||
Bal Sheet Accounting Equation | ||||||
Total Assets | $300,000 | $600,000 | $1,200,000 | $1,500,000 | ||
equal (=) | ||||||
Total Liabilities | 0 | ? | ? | ? | ||
plus (+) | ||||||
Total Equity | $300,000 | ? | ? | ? | ||
Abbrev. Inc Statement | ||||||
Operating Income (Assets x ROA) | $21,000 | ? | ? | ? | ||
minus (-) | ||||||
Cost of Debt ( x total mortgage amount) | $0 | ? | ? | ? | ||
equals (=) | ||||||
Net Income | $21,000 | ? | ? | ? | ||
ROE: | 7.00% | ? | ? | ? | ||
Add spaces below as needed to answer the questions.
Q 2)
What observations can you make about ROA, ROE, and the effects of leverage from this exercise? Which Scenario would you choose? First, I would choose scenario # 3. Finding the right mix of debt to income is very important and this scenario gives you that. Also, the higher the leverage the greater the risk for loss and profit.
Lastly, in this scenario, your operating income has the largest increase and the biggest jump in net income.
Q 3)
If the strategy employed in Scenario #4 had been executed in 2007, please talk about the likely outcomes versus the strategies of Scenarios #1 and #2. This scenario would have caused the investor to be bankrupt because of debt leverage. Whereas the debt in scenario 1 or 2 was more manageable. They would have probably survived the crisis because of low debt.
Expert Answer:
Scenario 1 Total Equity Investment 300000 Cost per House 300000 ROA 7 Cost of Debt 3 of Rental Houses Bought 1 Multiplied by 300000 per House 300000 A... View the full answer
