Fundamentals of Real Estate
Lecture 1
Spring, 2003
Copyright © Joseph A. Petry
www.cba.uiuc.edu/jpetry/Fin_264_sp03
What is real estate?

Real estate is defined as “land and all permanent
attachments to the land.”
–

2
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”
Why should we study it?

Real Estate dwarfs all other markets
Real Estate & Worldwide Wealth (1991 =
$43,845 Billion)
Stocks
Bonds
25%
19%
Cash
4%
Metals
3%
3
Real Estate-Non-US
35%
Real Estate-US
14%
US Real Estate Market
Farm
11%
Business
13%
Residential
76%
Why should we study it?

The financial returns are significant and can
offer substantial diversification benefits
Average Annual Return and Standard Deviation:
Real Estate Versus Other Assets (%), 1979-1999
Asset
Average Std. Dev.
NCREIF (NPI)
8.7
7.7
NAREIT
14.5
15.6
S&P 500
18.6
12.8
Russell 2000
16.6
17.8
Long-Term Gov't Bonds
10.9
13.7
Equally Weighted Portfolio
13.8
9.2
4
Source: REP, p 161.
NPI=US Pension Funds; NAREIT=publicly traded REITs
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.
–
–
5
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.
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).
–

6
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.
Time-Value-of-Money Operations

Terminology
–
–
–
7
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.
Time-Value-of-Money Operations

Terminology (cont’d)
–
–
–


8
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 TimeValue-of-Money Equations.
Don’t worry about the interest rate tables in the
book on pp. 27-29.
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.

9
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?
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 10th
year.
–
–

10
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 12th year?
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 $0.062745 (a little over 6 cents)
each year for 10 years at 10 percent interest, how much will
you have at the end of the 10th year?
–
Using your calculator: N=10, I=10%, PV=0, PMT=-0.062745,
FV=?
– CPT=$.9999937

11
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?
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 $1, which is due in five
years and can be discounted at 10 percent, how much is it
worth today?
–
–

12
Using your calculator: N=5, I=10%, PMT=0, FV=1, PV=?
CPT=$-.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%?
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

13
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?
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 $1 for five years and agree to repay
the debt annually with interest at a rate of 10 percent, how
much must you pay each year?
–
–
–

14
Using your calculator: N=5, I=10%, PV=1, FV=0, PMT=?
CPT=$-.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?