17 INVESTING IN REAL ESTATE & OTHER INVESTMENT ALTERNATIVES CHAPTER OVERVIEW Traditionally, Americans have invested in real estate. We begin this chapter by classifying types of real estate investments as direct and indirect investments. We discuss the investment potential of commercial property and undeveloped land. Indirect real estate investments, such as real estate syndicates or limited partnerships, real estate investment trusts, first and second mortgages and participation certificates are discussed in depth. Then we present advantages and disadvantages of real estate investments. We close the chapter with investments in precious metals, gems, and other collectibles. Investing in gold, gold bullion, gold bullion coins, gold stocks, gold futures contracts, silver, platinum, palladium, and rhodium are all discussed in this section. Finally, collectibles, such as rare coins, works of art, antiques, stamps, rare books, sports memorabilia, rugs, Chinese ceramics, paintings, and other items that appeal to collectors and investors are discussed. LEARNING OBJECTIVES CHAPTER SUMMARY After studying this chapter, students will be able to: My Life LO 17-1 Identify types of real estate investments. Real estate investments are classified as direct or indirect. Direct real estate investments, in which the investor holds legal title to the property, include a home, a vacation home, commercial property, and raw land. Indirect real estate investments include real estate syndicates, REITs, mortgages, and participation certificates. My Life LO 17-2 Evaluate the advantages of real estate investments. Real estate investments may have these advantages: a hedge against inflation, easy entry, limited financial liability, no management headaches, and financial leverage. My Life LO 17-3 Assess the disadvantages of real estate investments. Real estate investments may have these disadvantages: declining values, illiquidity, lack of diversification, and the reduction or elimination of tax advantages. My Life L0 17-4 Analyze the risks and rewards of investing in precious metals, gems, and collectibles. Some investors prefer to invest in precious metals, such as gold, platinum, and silver; precious stones, such as diamonds; or collectibles, such as stamps, rare coins, works of art, antiques, rare books, and Chinese ceramics. Collectibles do not provide current income, and they may be difficult to sell in a hurry. 17-1 INTRODUCTORY ACTIVITIES • Point out the learning objectives (p. 591) in an effort to highlight the key points in the chapter. • Ask students to comment on the ’My Life’ feature for the chapter (p. 591). • Ask students for situations when real estate would be an appropriate investment for various personal and financial situations. • Discuss the relationship between hobbies and investing in collectibles. WHAT'S NEW TO THIS EDITION Updated Did You Know feature Updated Did You Know feature Revised, updated content: Home as an investment New Exhibit 17-2: U.S. home sales New Exhibit 17-3A: House price declines New Exhibit 17-3B: Increases in house prices Revised, updated content: Vacation home New Financial Planning for Life's Situations boxed feature Shows that home ownership in the United States soared to a historic high of 69.1 percent in 2005, but it dropped to 65.4 percent in 2012. Illustrates that home ownership is very low for people under 35, but it rises sharply as people enter their mid- 30s. Explains that about $7 trillion in household wealth was lost as average house prices decreased by nearly 33 percent from their peak in 2007. Shows that recent economic indicators suggest that the worse of the housing crisis is over. Displays the peak-to-trough home price declines for each state during the housing bust. Displays the increase in house prices since prices bottomed out in each state through June 2012. Provides updated information about the characteristics of vacation home investors. Cautions that investing in a foreclosure may be profitable, but make sure to protect your own property from being foreclosed. Explains that REITs invest in apartment buildings, 17-2 New content: REITs Updated Did You Know feature Revised and updated Financial Planning for Life's Situations feature New coverage: Disadvantages of real estate investments Revised and updated coverage: Precious metals Updated Exhibit 17-4: Gold prices Revised and updated Did You Know feature New Financial Planning for Life's Situations boxed feature New Dashboard feature hospital, hotels, industrial facilities, nursing homes and other properties. Illustrates how REITs invest in all types of properties (In 2012). Provides new information about Uncle Sam and His Family (the government securities). Points out that beginning in 2013, a new 3.8 percent tax on some investment income is imposed to fund the Affordable Care Act. Provides the latest information on the recent rise and fall in the prices of gold, silver, platinum, palladium, and rhodium. Illustrates how the price of gold has fluctuated from 1976 to 2012. Shows the biggest producers of gold in the world (2011). Questions if gold is a solid investment, and if so, what are several ways to invest in it. Explains the importance of investment diversification by including a variety of assets in your portfolio. CHAPTER 17 OUTLINE I. Investing in Real Estate A. Direct Real Estate Investments 1. Your Home as an Investment 2. Your Vacation Home 3. Commercial Property 17-3 4. Undeveloped Land B. Indirect Real Estate Investments 1. Real Estate Syndicates or Limited Partnerships 2. Real Estate Investment Trusts (REITs) 3. Investing in First and Second Mortgages 4. Participation Certificates II. Advantages of Real Estate Investments A. A Hedge Against Inflation B. Easy Entry C. Limited Financial Liability D. No Management Concerns E. Financial Leverage III. Disadvantages of Real Estate Investments A. Illiquidity B. Declining Property Values C. Lack of Diversification D. Lack of Tax Shelter E. Long Depreciation Period G. Management Problems IV. Investing in Precious Metals, Gems, and Collectibles A. Gold 1. Gold Bullion 2. Gold Bullion Coins 3. Gold Stocks B. Silver, Platinum, Palladium, and Rhodium C. Precious Stones D. Collectibles 17-4 CHAPTER 17 LECTURE OUTLINE Instructional Suggestions I. INVESTING IN REAL ESTATE (p. 592) • Real estate investments are classified as direct or indirect In direct investment, the investor holds legal title to the property. In indirect investment, the investors appoint a trustee to hold legal title on behalf of all the investors in a group. Direct Real Estate Investments (p. 592) Your home as an investment Your home is, first a place to live and second, it is an income tax shelter if you have a mortgage on it. Finally, it is a possible hedge against inflation. • Your vacation home after-tax cost of owning has risen since 1987. Just how much depends largely on whether the IRS views the place as your second home or as a rental property. • Commercial property refers to land and buildings that produce lease or rental income. The investment potential of commercial property, unlike that of undeveloped land or a personal residence, can be accurately measured. • Undeveloped Land: If land investments have promised tremendous gains, they have also posed enormous risks. • Use PPT slides 17-3 through 17-12. • Discussion Question: What are the attractive aspects of real estate investments? • Assignment: Have students talk to real estate brokers or people with investments about the changes in the Tax Reform Act of 1986 that affected this investment alternative. • Discussion Question: Why is the CPI frequently used as a reference to evaluate the return on an investment? • Use PPT slide 17-3. • Exercise: List the types of commercial property that could be a very attractive real estate investment in your community. • Exercise: Create a list of factors to consider when buying raw land. What future events can influence the value of the investment? • Exercise: Create a list of factors to consider when buying indirect real estate investments. • Use PPT slide 17-6. • Text Reference: Point out “Did You Know?” feature. (Home ownership in the United states p. 592) Indirect Real Estate Investments (p. 597) • The two basic methods of indirect real estate investments are real estate investment trust (REITs) and real estate syndicates. • A syndicate is a temporary association of individuals or firms, organized to perform a specific task that requires a large amount of capital. • A REIT is similar to a mutual fund or an investment company, and it trades on stock exchanges or over the • Use PPT slides 17-9 through 17-12. • Text Highlight: You may want to mention the “Did You Know” feature on p. 595 • Text Reference: Contrast the real estate syndicate (limited partnership) and the real estate investment trust (p. 598). • Transparency Master 17-1 shows six examples of 17-5 CHAPTER 17 LECTURE OUTLINE Instructional Suggestions counter. Investing in first and second mortgages. Investments of this kind may provide relatively high rates of return because of their special risk characteristics. Participation Certificates are equity investments in a pool of mortgages that have been purchased by one of the government agencies. participation certificates. • Software: The software that accompanies Personal Finance may be used to calculate yield on real estate investment. • Text Highlight: Point out the “Financial Planning for Life’s Situations” (p. 601) feature to understand various types of participation certificates. (Uncle Sam and his Family) • Practice Quiz 17-1 (p. 600) II. ADVANTAGES OF REAL ESTATE INVESTMENTS (p. 600) • Certain types of real estate investments may possess some of the following advantages. A Possible Hedge Against Inflation (p. 600) • Real property equity investments usually provide protection against purchasing power risk. Easy Entry (p. 600) • You can gain entry to a shopping center or a large apartment building by investing as little as $5,000 in a limited partnership. Limited Financial Liability (p. 600) • If you are a limited partner, you are not liable for losses beyond your initial investment. General partners, however, must bear all financial risks. No Management Concerns (p. 601) • You do not need to worry about paperwork and accounting, maintenance chores, and other administrative duties. • Use PPT slide 17-13. • Assignment: Have students prepare a short paper describing a portfolio of real estate investments they would consider now or in the future. • Exercise: Have students suggest exceptions to the advantages of real estate investments. • Text Reference: Point out the concept of financial leverage in real estate investments. (p. 601) Financial Leverage (p. 601) • Financial leverage is the use of borrowed money for investment purposes. • Practice Quiz 17-2 (p. 602) 17-6 CHAPTER 17 LECTURE OUTLINE Instructional Suggestions III. DISADVANTAGES OF REAL ESTATE INVESTMENTS (p. 602) • Real estate investments have several disadvantages. However, these disadvantages do not affect all kinds of real estate investments to the same extent. Illiquidity (p. 602) • Perhaps the largest drawback of direct real estate investments is the absence of large, liquid, and relatively efficient markets for them. Declining Property Values (p. 602) • During deflationary periods, the value of real estate investments may decline. Lack of Diversification (p. 602) • Diversification in direct real estate investments is difficult because of the large size of most real estate projects. Lack of a Tax Shelter (p. 602) • Investors cannot deduct their real estate losses from income generated from other sources. Long Depreciation Period (p. 602) • Under the new tax law, investors must use the straight-line depreciation method over 27 1/2 years for residential real estate and over 31 1/2 years for all other types of real estate. • Use PPT slide 17-14. • Exercise: Have students suggest exceptions to the disadvantages of real estate investments. • Exercise: Let students point out any areas in their neighborhoods where property values may have declined. • Text Highlight: Point out the effects of the Tax Reform Act of 1986 on real estate investments. (p. 602) Management Problems (p. 603) • Finding good tenants, buying new carpeting, fixing the furnace are just a few of the headaches that go with managing real estate investments. • Practice Quiz 17-3 (p. 603) 17-7 CHAPTER 17 LECTURE OUTLINE Instructional Suggestions IV. INVESTING IN PRECIOUS METALS, GEMS, AND COLLECTIBLES (p. 603 • When the economy picks up, some investors predict higher inflation, and therefore, invest in precious metals. Gold (p. 603) • Gold prices tend to be driven up by such factors as fear of war, political instability, and inflation. On the other hand, the easing of international tensions or disinflation causes a decline in gold prices. Gold Bullion (p. 603) • Gold bullion includes gold bars or wafers. Coin dealers, precious metal dealers, and some banks sell gold bullion. Gold Bullion Coins (p. 604) You can avoid storage and assaying problems by investing in gold bullion coins. Most brokers require a minimum order of 10 coins and charge a commission of at least two percent. Gold Stocks (p. 604) In addition to investing in gold bullion and gold bullion coins, you may invest in gold by purchasing the common stocks of gold mining companies. Gold Certificates (p. 605) Nowadays, gold certificate offer a method of holding gold without taking physical delivery. You save on storage and personal security problems and gain liquidify because you can sell portions of the holdings by telephoning the custodian bank. Silver, Platinum, Palladium and Rhodium (p. 605) Investments in silver, platinum, palladium, and rhodium like investments in gold, are used as a hedge against inflation and as a safe haven during political or economic upheavals. Remember, precious metals sit in vaults earning nothing. Precious Stones (p. 605) • Precious stones include diamonds, rubies, and emeralds. Diamonds and other precious stones appeal to investors because of their small size, easy • Text Reference: You may want to mention the ‘Did You Know’ feature on p.604. (The Biggest Gold Producer) • Use PPT slides 17-15 through 17-21. • Text Highlight: Point out the methods available to investors for investing in gold. (pp. 603- 605 • Discussion Question: What types of financial situations and economic circumstances would be appropriate for investing in gold? • Assignment: Have students monitor gold prices with data from The Wall Street Journal or other newspapers. • Exercise: Have students recommend situations that would be appropriate for investing in other metals. • Use PPT slides 17-17 and 17- 18 17-8 CHAPTER 17 LECTURE OUTLINE Instructional Suggestions concealment, great durability, and because of their potential as a hedge against inflation. Collectibles (p. 607) • Collectibles include rare coins, works of art, antiques, stamps, rare books, sports memorabilia, rugs, Chinese ceramics, paintings, and other items that appeal to collectors and investors. • Collectibles on the Net.Buyers can target obscure items with a few keystrokes, and sellers can reach a much larger, more varied market. However, the Net is best suited to smaller items. And prices are not necessarily cheaper on the Web. • Use PPT slide 17-19 through 17-21. • Current Example: Paint by Numbers: Visit the following Websites: www.portraitsinc.com; www.portraitsouth.com; www.theportraitsource.com; and www.portraitbrokers.com. • Text Highlight: Point the Financial Planning for Life's Situation feature: Preventing Fraud (p. 608) • Caveat emptor. Rare coin scams have increased, and many investors in rare coins have lost most of their investment as a result of fraudulent sales practices. Protect yourself by: Using common sense Not rushing into buying Knowing your dealer’s reputation Not relying on promises Getting a second opinion Being cautious about grading certificates Comparison shopping • Discussion Question: What economic and other factors should be the main concerns when selecting future investments? • Practice Quiz 17-4 (p. 610) CONCLUDING ACTIVITIES • Discuss YOUR PERSONAL FINANCE DASHBOARD: My Life Stages for Investing feature (p. 611) • Point out the summary of objectives and key terms in the text margin. (p. 612) • Discuss selected end-of-chapter Financial Planning Problems, Financial Planning Activities, Financial Planning Case, and Continuing Case. • Use the Chapter Quiz in the Instructor’s Manual. CHAPTER 17 QUIZ ANSWERS True-False Multiple Choice 1. T (p. 592) 6. B (p. 592) 2. T (p. 596) 7. A (p. 598) 3. F (p. 598) 8. C (p. 599) 4. F (p. 599) 9. D (p. 599) 5. F (p. 603) 10. A (p. 602) 17-9 Name ________________________________________ Date____________________________ CHAPTER 17 QUIZ TRUE-FALSE _____1. Home prices have generally climbed steadily over the years. _____2. A passive activity is a business or trade in which you do not materially participate, such as rental activity. _____3. A limited partnership or a syndicate is formed by limited partners who assume unlimited financial liability. 4 . If you want to speculate in real estate investments, invest in participation certificates. 5. Gold prices tend to fall by such factors as fear of war, political instability, and inflation. MULTIPLE CHOICE _____6. Direct real estate investments include a. limited partnerships. b. single family dwellings. c. syndicates. d. REITs. _____7. Which type of REIT invests in properties? a. Equity b. Mortgage c. Hybrid d. Preferred _____8. If you want a risk-proof real estate investment, invest in a. a vacation home. b. your own home. c. a participation certificate. d. commercial property. _____9. According to a federal law, REITs must distribute what percentage of their net annual earnings to shareholders? a. 65 b. 75 c. 85 d. 90 10. Which one of the following is a disadvantage of investing in real estate? a. Illiquidity b. A hedge against inflation c. Financial leverage d. Short depreciation period 17-10 SUPPLEMENTARY LECTURE: 17-1 How to Avoid Losing Your Money to Investment Frauds* Washington, D.C.—Every year, Americans lose more than a billion dollars to investments that turn out to be fraudulent. Companies engaged in fraud often operate a particular scam for a short time, quickly spend the money they take in, and then close down before they can be detected. They reopen under another name selling another investment scam. Fraudulent investment promoters are glib and resourceful. They may tell you that they have high-level financial connections; that they’re privy to inside information; that they’ll guarantee the investment; or that they’ll buy back the investment after a certain time. To close the deal, they may serve up phony statistics, misrepresent the significance of a current event, or stress the unique quality of their offering to deter you from verifying their story. The Federal Trade Commission suggests that potential investors can avoid losing their money if they could only recognize a phony sales pitch. Here’s what to listen for: • A “ground floor opportunity” for you to realize a better return on this investment than any other you’re involved in • Guarantees of big profits in a short time • Claims that no risk is involved • Lots of pressure to act now because the “market is moving” In addition, the FTC advises potential investors to: • Invest in opportunities you know something about. It’s unlikely you will make money in a business deal you can’t understand or verify. Don’t rely on the seller’s representation of the investment’s value. • Be skeptical about unsolicited phone calls about investments, especially those from out-of-state salespeople or companies you never heard of. If the deal sours, you may find it very hard to get your money back. • Get all the information you can about the company and verify the data. Before you invest with any company, check the seller’s materials with someone whose financial advice you trust. • Beware of testimonials. Fraudulent companies sometimes hire references to claim that the firm’s investments brought them sudden wealth. Ponzi schemes—where promoters use money from new investors to pay high returns to early investors—may explain the praises. • If in doubt, don’t invest. Before you invest, ask tough questions and get information from a variety of sources. If you can’t get solid information about the company and the investment, you may not want to risk your money. * Source: “Consumer Alert” issued by the Federal Trade Commission, the Bureau of Consumer Protection, the Office of Consumer and Business Education, and the American Securities Administrators Association. 17-11 For more information about investment scams, visit the FTC at www.ftc.gov on the Internet, or write: Investment Scams, Consumer Response Center, FTC, Washington, D.C. 20580. . 17-12 SUPPLEMENTARY CASE: 17-1 Preventing Fraud Looking for an online investment opportunity that is “unaffected by the volatile stock market,” guarantees “virtually unlimited profits,” “minimizes or eliminates risk factors,” and is “IRA approved”? “Forget it,” advises Jodie Bernstein, director of the Federal Trade Commission’s Bureau of Consumer Protection. “Claims that an investment is IRA approved are a tip-off to a rip-off. You must be just as careful when investing in opportunities touted on the Net as you are when you make other investments. You should check out these with state securities regulators and other investment professionals.” For more information about investing on the Internet, Bernstein suggests that you contact the following organizations: • Federal Trade Commission (http://www.ftc.gov/). • North American Securities Administrators Association, Inc.(http://www.nasaa.org/). • Commodity Futures Trading Commission (http://www.cftc.gov/). • National Association of Securities Dealers (http://www.nasd.com/). • Securities and Exchange Commission (http://www.sec.gov/). • National Association of Investors Corporation (http://www.better-investing.org/). • InvestorGuide (http://www.investorguide.com/). • InvestorWords (http://www.investorwords.com/). • The Motley Fool (http://www.fool.com/). • Alliance for Investor Education (http://www.investoreducation.org/). • The Online Investor (http://www.investhelp.com/). • National Fraud Information Center (http://www.fraud.org/). Questions: 1. What are some tip-offs to a rip-off? 2. Ask students to visit the above websites to seek information on preventing fraud. 17-13 ANSWERS TO PRACTICE QUIZZES, FINANCIAL PLANNING PROBLEMS, FINANCIAL PLANNING ACTIVITIES, FINANCIAL PLANNING CASE, AND CONTINUING CASE PRACTICE QUIZZES PRACTICE QUIZ 17-1 (p. 600) 1. What are the four examples of direct investments in real estate? The four examples of direct investments in real estate are your home, vacation home, commercial property, and undeveloped raw land. 2. What are the four examples of indirect investments in real estate? The four examples of indirect investments in real estate are real estate syndicates or limited partnerships, REITs, first and second mortgages, and participation certificates. 3. What is a syndicate? A REIT? A participation certificate? Real Estate Syndicates or Limited Partnerships. A syndicate is a temporary association of individuals or firms organized to perform a specific task that requires a large amount of capital. The syndicate may be organized as a corporation, as a trust, or, more commonly, as a limited partnership. A REIT is similar to a mutual fund or an investment company, and it trades on stock exchanges or over the counter. Like mutual funds, REITs pool investor funds. These funds, along with borrowed funds, are invested in real estate or used to make construction or mortgage loans. There are three types of REITs: equity REITs, which invest in properties; mortgage REITs, which pool money to finance construction loans and mortgages on developed properties; and hybrid REITs, combinations of mortgage and equity REITs. A participation certificate is an equity investment in a pool of mortgages that have been purchased by one of the government agencies. Maes and Macs are guaranteed by agencies closely tied to the federal government, making them just as secure as Uncle Sam’s own bonds and notes. PRACTICE QUIZ 17-2 (p. 602) 1. What are advantages of real estate investments? Some of the following may be advantages of real estate investments: a hedge against inflation, easy entry, limited financial liability, no management concerns, and financial leverage. 2. How is financial leverage calculated? Financial leverage is the use of borrowed funds for investment purposes. It enables you to acquire a more expensive property than you could acquire on your own. This is an advantage when property values and incomes are rising. Assume that you buy a $100,000 property with no loan and then sell it for $120,000. The $20,000 gain represents a 20 percent return on your $100,000 investment. Then assume instead that you invest only $10,000 of your own money and borrow the other $90,000 (90 percent financing). Now you have made $20,000 on your $10,000 investment, or a 200 percent return. 17-14 PRACTICE QUIZ 17-3 (p. 603) 1. What are disadvantages of real estate investments? Disadvantages of real estate investments include declining property values, illiquidity, lack of diversification, no tax shelter, long depreciation period, and management problems. 2. What depreciation method is used for residential real estate? Investors must use the straight-line depreciation method over 27½ years. PRACTICE QUIZ 17-4 (p. 610) 1. What are several methods for buying precious metals? Several methods for buying precious metals include gold, gold bullion, gold bullion coins, gold stocks, and gold futures contracts. 2. Why do precious stones appeal to investors? Precious stones appeal to investors because of their small size, easy concealment, great durability, and because of their potential hedge against inflation. 3. What are collectibles? Collectibles include rare coins, works of art, antiques, stamps, rare books, sports memorabilia, rugs, Chinese ceramics, paintings, and other items that appeal to collectors and investors. Each of these items offers the collector/investor both pleasure and the opportunity for profit. Many collectors have discovered only incidentally that items they bought for their own pleasure had gained greatly in value while they owned them. 4. How can you protect yourself from fraudulent practices in the collectibles market? • Use common sense when evaluating any investment claims, and do not rush into buying. • Make sure that you know your dealer’s reputation and reliability before you send money or authorize a credit-card transaction. • Do not be taken in by promises that the dealer will buy back your coins or that grading is guaranteed, unless you are confident that the dealer has the financial resources to stand behind these promises. • Get a second opinion from another source about grade and value as soon as you receive your coins. So, before you buy, find out what remedies you will have if the second opinion differs. • Be cautious about grading certificates, especially those furnished by coin dealers. Grading is not an exact science, and grading standards vary widely. • Comparison shop. Visit several dealers before buying. FINANCIAL PLANNING PROBLEMS (p. 613) 1. Calculating the Return on Investment. Dave bought a rental property for $200,000 cash. One year later, he sold it for $240,000. What was the return on his $200,000 investment? With a $200,000 investment, Dave made a profit of $40,000, which is a 20 percent return on his investment. ($40,000 divided by $200,000) 17-15 2. Calculating the Return on Investment Using Financial Leverage. Suppose Dave invested only $20,000 of his own money and borrowed $180,000 interest-free from his rich father. What was his return on investment? With a $20,000 investment (he borrowed $180,000), Dave made a profit of $40,000 ($240,000 - $200,000), which is a 200 percent return on his $20,000 investment. ($40,000 divided by $20,000). 3. Calculating the Rate of Return on Investment. Rani bought a rental property for $100,000 with no borrowed funds. Later, she sold the building for $120,000. What was her return on investment? Selling Price = $120,000 Purchase Price = 100,000 Profit = 20,000 Return on = Profit = $20,000 Investment Purchase Price $100,000 = .20 = 20 percent 4. Calculating the Rate of Return of Investment Using Financial Leverage. Suppose Shaan invested just $10,000 of his own money and had a $90,000 mortgage with an interest rate of 8.5 percent. After three years he sold the property for $120,000. a. What is his gross profit? b. What is his net profit/loss? c. What is the rate of return on investment? a. Shaan’s Gross Profit = Selling Price – Purchase Price = $120,000 – $100,000 = $20,000 b. Shaan’s Net Profit or loss = Gross Profit – Interest Paid for three years = $20,000 – ($7,650 × 3) = $20,000 - $22,950`= A loss of $2,950. c. Percent rate of return on investment= minus$2,950 divided by $20,000= minus 29.5 percent Problems 5 and 6 are based on the following scenario: Felice bought a duplex apartment at a cost of $150,000. Her mortgage payments on the property are $940 per month, $121 of which can be deducted from her income taxes. Her real estate taxes total $1,440 per year, and insurance costs $900 per year. She estimates that she will spend $1,000 each year per apartment for maintenance, replacing appliances, and other costs. The tenants will pay for all utilities. 5. Calculating Profit or Loss on a Rental Property. What monthly rent must she charge for each apartment to break even? Answer should be based on the following figures: Total mortgage cost after deducting interest is $819/month. 17-16 Total real estate tax is $120/month. Total insurance cost is $75/month. Total maintenance cost is $167/month. Total expense is $1181. Rent per apartment to break even is $1,181 ÷ 2 or $590.50/month. 6. Calculating Profit or Loss on a Rental Property. What must she charge to make $2,000 in profit each year? To earn $2,000 profit, she must add $83.33 to each apartment’s rent, for a total of $673.83 ($590.50 + $83.33). Problems 7 and 8 are based on the following scenario. Assume your home is assessed at $200,000. You have a $150,000 loan for 30 years at 6 percent. Your property tax rate is 1.5 percent of the assessed value. In year one, you would pay $9,000 in mortgage interest and $3,000 in property tax (1.5 percent on $200,000 assessed value). 7. Calculating Net Profit after Taxes. What is the total deduction you can take on your federal income tax return? $9,000 + $3,000 = $12,000 8. Calculating Net Profit after Taxes. Assuming you are in a 28 percent tax bracket, by what amount you would have lowered your federal income tax? $12,000 × 0.28 = $3,360 Problems 9 and 10 are based on the following scenario. Audra owns a rental house. She makes mortgage payments of $600 per month, which include insurance, and pays $1,800 per year in property taxes and maintenance. Utilities are paid by the renter. 9. Determining the Monthly Rent. How much should Audra charge for monthly rent to cover her costs? Audra pays $150 per month in property taxes and maintenance. In addition, she pays $600 per month in mortgage payment. Therefore, she must charge $750/month to cover her costs. 10. Determining the Monthly Rent. What should Audra charge for monthly rent to make $1,000 profit each year? 17-17 To make $1,000 profit each year, Audra must charge $83.33 extra ($1,000 ÷ 12 = $83.33). Therefore, she should charge $750 + $83.33 or $833.33. Problems 11 and 12 are based on the following scenario. In 1978 Juan bought 50 ounces of gold for $1,750 as protection against rising inflation. He sold half the gold in 1980 at a price of $800 an ounce. Juan sold the other half in 1982 when the price was $400 an ounce. 11. Calculating a Return on Investment. What was Juan’s profit in 1980 and in 1982? Juan’s cost in 1978 = $1,750 ÷ 50 ounces = $35 per ounce. In 1980, he sold 25 ounces at $800 an ounce for $20,000 ($800 × 25). Juan’s profit in 1980 was ($20,000 - $875) or $19,125. In 1982, Juan sold 25 ounces of gold at $400 an ounce for $10,000. His profit in 1982 was ($10,000 - $875) or $9,125. 12. Calculating a Return on Investment. What would Juan’s profit have been if he had sold all of his gold in 1980? If Juan had sold all of his gold in 1980, his profit would have been $38,250. $800 × 50 ounces = $40,000 His cost in 1978 was $1,750 Therefore, the profit would have been ($40,000 - $1,750) or $38.250. FINANCIAL PLANNING ACTIVITIES (p. 614) 1. Using the Internet to Obtain Information about Various Types of REITs. Many REITs now maintain a Web page on the Internet. Visit a few Websites of REIT companies discussed in this chapter and of the National Association of Real Estate Investment Trusts (NAREIT) at www.nareit.com. Then prepare a report that summarizes the various types of REITs available to investors. Students will find a wealth of information about equity REITs, which invest in properties; mortgage REITs, which pool money to finance construction loans and mortgages on developed properties; and hybrid REITs, combinations of mortgage and equity REITs. 2. Assessing the Prices of Single-Family Dwellings. Interview local real estate brokers and research current business magazines and the business section of the local newspaper to determine if the prices of single-family dwellings in your area have been increasing during the last 10 years. Prepare a written report indicating the reasons for the increase or decrease. Most likely, the interview and research will indicate that single-family home prices have generally been increasing steadily over the last ten years. However, there are a few geographical regions (the Northeast and California) where prices may have declined. 3. Assessing the Investment Potential of Commercial Real Estate. Research current commercial real estate sections of local newspapers. How many listings do you find for duplexes? For fourplexes and small apartment buildings? Prepare an analysis of the investment potential of these properties. 17-18 In most areas, there will be more listings for duplexes than for fourplexes and small apartment buildings. 4. Checking the Availability of Real Estate Limited Partnerships. Call a few real estate and stock brokerage firms in your area to find out if any real estate limited partnerships are available for investors. Students will find that many real estate and mortgage firms in most areas will sell real estate limited partnerships to investors. 5. Comparing Mortgage Rates and Terms of a Loan. Obtain the duplex mortgage rates from your local commercial bank, a savings and loan association, and a credit union. Compare these rates and such terms as the down payment, loan costs (points), loan length, and maximum amount available to determine which of the three offers the best financing. Perhaps this activity is best assigned to only a few students, especially if there are only a limited number of financial institutions in your community. Let the students compare the terms; probably the best source will be a savings and loan institution. 6. Checking Current Prices of Precious Metals. Listen to business news on radio or television. What are the current quotes for an ounce of gold and an ounce of silver? Are the prices of precious metals going up or down? How do the latest prices compare with the prices quoted in the textbook? What might be some reasons for fluctuations in the prices of precious metals? Precious metals prices fluctuate daily. These fluctuations are basically due to changes in the supply and demand for precious metals. FINANCIAL PLANNING CASE (p. 614) Bogus Brushstroke: Art Fraud Richard received a letter inviting him to participate in a drawing for a free original lithograph by a famous artist. He was asked to return a postcard with his name, address, and phone number. After he returned the postcard, he was telephoned for more information, including his credit card number. At some point, the caller asked Richard to buy a print, using such glowing terms as “fabulous opportunity,” “one-time offer,” “limited edition,” and “excellent work of a famous artist who was near death and that its value would increase after the artist’s death. He was assured that when the artist died, the company that the caller represented would gladly buy back the print at two to three times what he paid for it and that he could always resell the print elsewhere at a substantial profit. He was told that he would receive a certificate to the “authenticity” of the print. And he was promised a trial examination period with a 30-day money-back guarantee. Questions 1. Does the offer seem genuine to you? Explain your answer. No, the offer does not seem to be genuine. “Fabulous opportunity,” “onetime offer,” “limited edition,” and “excellent investment” are deceptive phrases, and any investor with common sense will not consider the letter seriously. 2. How can Richard protect himself against a phony offer? List at least five suggestions that you would give him. 17-19 • Use common sense in evaluating investment claims. • Do not rush into buying over the telephone. • Do not be taken in by telephone promises that the company will buy back the lithograph. • Be cautious about the “authenticity” of the print. • Never give your credit card number to telephone callers, unless you initiate the call. 3. If Richard bought the work of art and discovered fraud, how should he try to resolve his dispute with the company that sold it to him? Where should he complain if the dispute is not resolved? First, Richard should try to settle the dispute with the company executives. If that fails, Richard should contact regional office of the Federal Trade Commission, Better Business Bureau, an Attorney General’s office, and any other state consumer protection agency—and hope for the best. The Northeast region of the United States is weathering the storm better because of certain factors. The weak dollar is attracting some foreign buyers; historic architecture; good public transportation; wealthy homeowners looking for quaint suburbs; and the existence of many prestigious centers of higher learning. New England and the mid Atlantic states have held up well because of the region’s wealth, a relatively small number of sub-prime loans, and home prices that did not rise as much as in other parts of the country. CONTINUING CASE (p. 615) Investing in Real Estate 1. What are the advantages of investing in real estate as a Limited Partner for the Lawrences? As limited partners, the Lawrences are not liable for losses beyond their initial investment. They can gain entry by investing just $5,000 as limited partners. And of course, they have no management concerns. 2. What are the disadvantages of investing in real estate as a limited partner for the Lawrences? As limited partners, the Lawrences can not take part in the management of the partnership. Moreover, the minimum capital requirements for the total venture may be as high as $1 million or more, which is beyond the limits of a typical real estate investor. Daily Spending Diary (p. 615) Saving funds to buy additional real estate is a goal that I am considering Analysis Questions 1. What changes in your daily spending patterns could help you increase the amount you have available for investing? Student answers will vary. 17-20 2. When might you consider investing in real estate, precious metals, or collectibles? Student answers will vary. 17-21 TM 17-1 Examples of Participation Certificates 1. The Government National Mortgage Association (Ginnie Mae) 2. The Federal Home Loan Mortgage Corporation (Freddie Mac) 3. The Federal National Mortgage Association (Fannie Mae) 4. The Student Loan Marketing Association (Sallie Mae) 5. The State of New York Mortgage Agency (Sonny Mae) 6. The New England Education Loan Marketing Corporation (Nellie Mae) 17-22 Name ______________________________________ Chapt er 17: I nv est ing in R eal Est at e and Ot her I nv est m ent A lt er nat iv es 2. Investment in which the investor holds legal title to property. 4. Land and buildings that produce lease or rental income. 7. An equity investment in a pool of mortgages that have been purchased by one of several government agencies. 8. A firm that pools investor funds and invests them in real estate or uses them to make construction or mortgage loans. (abbreviation) 1. Investment in which a trustee holds legal title to property on behalf of the investors. 3. Rare coins, works of art, antiques, stamps, rare books, and other items that appeal to collectors and investors. 5. A temporary association of individuals or firms organized to perform a specific task that requires a large amount of capital. 6. A business or trade in which the investor does not materially participate. 7. The total amount of losses from a passive activity minus the total income from the passive activity. Across Down P A R T I C I P A T I O N C E R T I F I C A T E C O L L E C T I B L E S S Y N D I C A T E I N D I R E C T I N V E S T M E N T P A S S I V E L O S S D I R E C T I N V E S T M E N T R E I T C O M M E R C I A L P R O P E R T Y P A S S I V E A C T I V I T Y 1 2 3 4 5 6 7 8 Instructor Manual for Personal Finance Jack R. Kapoor, Les R. Dlabay , Robert J. Hughes, Melissa M. Hart 9780077861643, 9781260013993
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