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Fundamentals of Real Estate Lecture 1 Spring, 2002 Copyright © Joseph A. Petry www.cba.uiuc.edu/jpetry/Fin_264_sp02

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2 What is real estate? Real estate is defined as “land and all permanent attachments to the land.” – From a market perspective, Real Estate is an economic good, which like other goods exchanged in markets, it is bought, leased, used, rehabilitated and sold as a way to maximize wealth. The value of real estate is impacted by legal restrictions on that land. Consequently, when we try to estimate the value of real estate, we are valuing the “ownership rights to land and all permanent attachments to the land”

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3 Why should we study it? Real Estate dwarfs all other markets

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4 Why should we study it? The financial returns are significant and can offer substantial diversification benefits

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5 Why should we study it? Structure of ownership suggests that it is an extremely inefficient market It offers many different scales of ownership and involvement. – Easily accommodates those interested in creating a small business, those who want to work for a large corporation, as well as those who want to create a personal empire. – Offers flexible lifelong employment opportunities in the service end of the business: brokerage, appraisal, mortgage brokerage, market analysis, law.

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6 How do we value real estate? Income properties are bought and sold on the strength and durability of the current and future value of the Net Operating Income (NOI). – NOI is the amount of income from a property which remains after paying all operating expenses but before paying mortgage expenses. As a result, we will be spending a lot of this semester estimating and valuing cash flows.

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7 Time-Value-of-Money Operations Terminology – Present Value (PV): The value of money in period 0. “Taking the present value of inflows” means converting future money returns to what they would be worth now (i.e. in period 0). – Future Value (FV): The value of money in some period beyond period 0. “Taking the future value of money” means converting money received in the current period (or some prior period) to what it would be worth in the future – Lump sum: a one-time receipt or expenditure occurring in a given period.

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8 Time-Value-of-Money Operations Terminology (cont’d) – Ordinary Annuity: A common amount of money received at the end of every period (I.e. a series of equal lump sums). – Compounding: The technique applied to calculate future value from a set of present and future values. – Discounting: The technique applied to calculate the present value from a set of future values. See table on last page of today’s handout for Time- Value-of-Money Equations. Don’t worry about the interest rate tables in the book on pp. 27-29.

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9 Time-Value-of-Money Equations Operation 1: Future Value of a lump sum – How much will $1 be worth at some future time if invested at a given interest rate? Example A: If you deposited $1 today at 10% interest, it would be worth approximately $2.59 10 years from now. – Using your calculator: N=10, I=10%, PV=-1, PMT=0, FV=? – CPT=2.5937 – Notice if you switch PV to +1, CPT=-2.5937 – Also note that you can find any one of the values, if you know all of the others. Try finding N. Try finding I. Example B: If you purchase a parcel of land today for $25,000, and you expect it to appreciate 10 percent per year in value, how much will your land be worth 10 years from now?

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10 Time-Value-of-Money Equations Operation 2: Future Value of an Annuity – How much will a series of $1 payments invested each period be worth at some future time? Example A: If you deposit $1 at the end of each of the next 10 years, and these deposits earn interest at 10 percent, the series of deposits will be worth $15.94 at the end of the 10 th year. – Using your calculator: N=10, I=10%, PV=0, PMT=-1, FV=? – CPT=$15.93742 Example B: If you deposit $50 per month in a savings and loan association at 10 percent interest, how much will you have in your account at the end of the 12 th year?

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11 Time-Value-of-Money Equations Operation 3: Sinking Fund Factor – How much must be deposited each period at a given interest rate to accumulate $1 at some future time? Example A: If you deposit $0.062745 (a little over 6 cents) each year for 10 years at 10 percent interest, how much will you have at the end of the 10 th year? – Using your calculator: N=10, I=10%, PV=0, PMT=-0.062745, FV=? – CPT=$.9999937 Example B: If you wish to accumulate $10,000 in a bank account in eight years, and the account draws 15 percent compounded monthly, how much must you deposit each month?

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12 Time-Value-of-Money Equations Operation 4: Present Value of a Lump Sum – How much is $1, due at some point in the future, worth today when discounted at a given interest rate/required rate of return? Example A: If someone owes you $1, which is due in five years and can be discounted at 10 percent, how much is it worth today? – Using your calculator: N=5, I=10%, PMT=0, FV=1, PV=? – CPT=$-.620921 Example B: If your parents purchased an endowment policy of $10,000 for you and the policy will mature in 12 years, how much is it worth today, discounted at 15%?

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13 Time-Value-of-Money Equations Operation 5: Present Value of an Annuity – How much is $1 per period for a given length of time worth today when discounted at a given interest rate? Example A: If someone pays you $1 per year for 20 years, how much is the series of future payments discounted at 10% worth to you today? – Using your calculator: N=20, I=10%, PMT=1, FV=0, PV=? – CPT=$-8.51356 Example B: You have just purchased 100 shares of stock in a publicly traded real estate company that invests in apartment complexes. The company is expected to pay quarterly dividends of $1.50 per share. You expect the stock to be worth $75 per share at the end of 5 years. If you use a 14% discount rate, what is the stock worth to you today?

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14 Time-Value-of-Money Equations Operation 6: Capitalization Rate & Mortgage Constant – How much must be paid each year to pay back (amortize) a debt of $1, including interest at a given rate? Example A: If you borrow $1 for five years and agree to repay the debt annually with interest at a rate of 10 percent, how much must you pay each year? – Using your calculator: N=5, I=10%, PV=1, FV=0, PMT=? – CPT=$-.263797 – What if you wanted to repay the loan monthly? Example B: You want to purchase an $80,000 house. Your real estate salesperson believes you can get a 29 year, 80% loan at 15%. How much would your monthly payments be?

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© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Discounted Cash Flow Valuation (Formulas) Chapter Six.

© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Discounted Cash Flow Valuation (Formulas) Chapter Six.

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