ADDITIONAL QUESTIONS

ITEM SET - 1

Zoe Schulman is an alternative investments research analyst with Principal Investments, LLC, a
wealth management firm. In the past, the account managers at Principal were free to select real
estate investments without referring to a formal buy list, leading to inconsistent returns across client
portfolios. To ensure a more consistent approach, the firm would like to create an approved list,
which would provide a source of investment selections for all client portfolios.

From the investments already held in client portfolios, Schulman identifies the three largest REIT
holdings and asks the account managers to justify why these REITs were selected considering the
current economic cycle. She compiles Exhibit 1 and presents it in a report to her manager, Holden
Dwelley.

Exhibit 1
Characteristics of Major REIT Holdings and Account Managers’ Justifications
REIT Sector Region Justification
The industrial sector has a large labor force
1 Industrial Midwest United States
and is most sensitive to new job creation.
Although recent news of rising GDP is
beneficial to all sectors, the better-than-
2 Office Southwest United States
expected jobs report further enhances
prospects for the office property sector.
This sector has low sensitivity to new job
3 Hospitality Northeast United States creation and is resilient during times of
economic contraction.
Schulman determines that all three REITs use the historical cost method in their accounting
statements. In her analysis, she calculates and reports net asset value per share (NAVPS), instead of
book value per share (BVPS), as an absolute valuation metric and provides the following rationale
for this approach being her preferred one:

Reason 1: NAVPS accounts for the value of property not currently generating revenue.
Reason 2: NAVPS includes the added value of the management of the REIT.
Reason 3: NAVPS reflects the market value of the property portfolio rather than often stale
historical cost values.
Schulman collects financial data for all three REITs to calculate NAVPS. Exhibit 2 presents select
data that she uses for her evaluation of REIT 1.

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 Exhibit 2
Selected Data for REIT 1
Pro forma cash net operating income (NOI) for last 12
$320 million
months
Cash and equivalents $50 million
Land held for future development $70 million
Accounts receivable $25 million
Prepaid/other assets (excluding intangibles) $7 million
Total debt $1,700 million
Other liabilities $200 million
Shares outstanding 75 million

Estimated growth in NOI 5.00%

Capitalization rate 7.00%
Schulman submits a first draft of her report to Dwelley. He notes that she has failed to consider real
estate operating companies (REOCs) in current client portfolios for inclusion on the approved list.
She justifies the omission with the following reasoning:

 REOCs are more constrained in their use of leverage than REITs.

 REOCs are far less commonly traded in the United States than REITs.
 REOCs have more restrictive real estate investment choices.

When editing the report, Dwelley questions Schulman's reliance on NAVPS over a dividend
discount model (DDM) and notes the following characteristics of these valuation measures:
Characteristic 1:DDM reflects all earned income, whereas NAVPS only reflects income that is
retained by the property management company.
Characteristic 2: NAVPS is based solely on historical revenue and does not reflect upcoming income
growth expectations.
Characteristic 3: DDM uses discount rates consistent with the required rate of return for public
equity investment..
For a more comprehensive analysis, Schulman's report also presents relative valuation measures,
such as the ratio of price to funds from operations (P/FFO). Selected information for REIT 3 is
provided in Exhibit 3

Exhibit 3
Selected Information for REIT 3
Property net operating income $700 million
General and administrative expenses $70 million
EBITDA $630 million
Depreciation and amortization $30 million
Net interest expense $170 million
Net income available to common $430 million
Non-cash (straight-line) rent adjustment $15 million

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 Recurring maintenance-type capital
$33 million
expenditures and leasing commissions

Number of shares outstanding 140

Price per share $49

Question 1
Which of the account managers' justifications in Exhibit 1 regarding the selection of each of the
three REITs is most likely correct?
A. The justification for REIT 2
B. The justification for REIT 3
C. The justification for REIT 1

Question 2
Which of Schulman's reasons regarding her preferred approach to valuing REITs is most
likely correct?
A. Reason 2
B. Reason 3
C. Reason 1

Question 3
Using the data in Exhibit 2, the NAVPS of REIT 1 is closest to:
A. $39.76.
B. $40.69
C. $37.65.

Question 4
Which of Schulman's justifications for omitting REOCs from the approved list is most likely correct?
A. Her justification regarding leverage
B. Her justification regarding investment restrictions
C. Her justification regarding trading activity

Question 5
Which of Dwelley's characteristics of the DDM and NAVPS methods is most likely correct?
A. Characteristic 1
B. Characteristic 2
C. Characteristic 3

Question 6
Using Exhibit 3, the P/FFO for REIT 3 is closest to:
A. 13.5.
B. 16.7.
C. 14.9.

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 ITEM SET - 2

Jennifer Martin, CFA, is the owner of Martin Investment Management Inc., a boutique firm that
specializes in managing money for high-net-worth individuals. The firm specializes in real estate
and private equity investments. Martin has three client meetings today.
The first meeting is with Larry Smith. Smith is interested in a portfolio of private equity real estate
as a long-term investment. Specifically, he is interested in the risk–return characteristics of private
equity real estate portfolios versus those of stock portfolios. Martin advises Smith that private
equity real estate portfolios are generally riskier than stock portfolios and the expected returns are
lower.

Martin learns that Smith’s long-term goal when he retires is to purchase a multifamily property. For
example, there is one such property currently listed on the market. He plans on living in one unit
and renting out the rest. The rental income would provide Smith with the cash flow that he needs in
his retirement. He asks Martin to value the property based on the assumptions that the net
operating income is $125,000, the discount rate is 11%, and the growth rate is 6%. Martin decides to
use the direct capitalization method to value the property.

Martin’s second meeting is with Andre Metcalfe, an executive at a large national bank. Metcalfe is
interested in investing in publicly traded real estate securities. In particular, he is interested in
investing in securities that generate cash flow primarily from the sale of properties. Martin makes a
recommendation after doing some research.

Metcalfe asks Martin about economic factors that affect the value of real estate investment trusts
(REITs) that invest in different types of properties. Martin makes the following statements
regarding key economic drivers of the value of various REITs available in the market:

Statement 1: Job creation is less of a driver of value for industrial REITs than for office and
storage REITs.

Statement 2: Retail sales growth is less of a driver of value for office REITs than for
industrial and storage REITs.

Statement 3: Population growth is less of a driver of value for storage REITs than for
industrial and office REITs.

Martin’s third meeting is with James Wolfe, who is interested in investing in venture capital or
private equity funds. He is financially very comfortable and is thus willing to take on risk. Martin
has recently received some information about a new venture capital deal involving a software
company that may be of interest to Wolfe. Information about the software company for the venture
capital deal is provided in Exhibit 1.

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 Exhibit 1
Venture Capital Deal: Investment
Information
Terminal value (at time of
$1,000,000
exit)

Time to exit event 3 years

Amount of initial
$200,000
investment

Discount rate 40%

Wolfe is also interested in investing in private equity funds but is not familiar with how their
management compensation systems work. He wants to make sure that management stays
motivated and is focused on maximizing profits. Martin tells Wolfe that most private equity funds
have a mechanism in place that enables the management team to increase its equity allocation
depending on the company’s actual performance and the return achieved by the private equity
firm.

Question 1
Is Martin’s warning about investing in private equity real estate portfolios true?
A. No, private equity real estate portfolios are more risky than stock portfolios and have higher
expected returns
B. Yes
C. No, private equity real estate portfolios are less risky than stock portfolios and have lower
expected returns

Question 2
The value that Martin estimates for the multifamily property is closest to :
A. $2.08 million
B. $2.50 million
C. $1.14 million

Question 3
Based on Metcalfe’s goal for investing in publicly traded real estate securities, the most appropriate
recommendation that Martin could make is to purchase a:
A. REIT.
B. CMBS.
C. REOC

Question 4
Which of Metcalfe’s statements regarding REITs is least likely correct?
A. Statement 3
B. Statement 2
C. Statement 1

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Question 5
Based on the information in Exhibit 1, the pre-money valuation of the venture capital deal is closest
to:
A. $291,545
B. $364,431
C. $164,431

Question 6
In her discussion with Wolfe on private equity funds, the mechanism Martin mentions is most likely :
A. carried interest
B. a distribution waterfall
C. a ratchet

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 ITEM SET - 3

James Childress is chief investment officer of a large state retirement plan for public employees.
Historically, the plan has invested exclusively in traditional asset classes, such as stocks and bonds,
but faced with lower returns over the past several years, several board members have questioned
the current investment mix. Childress has suggested the addition of private equity (PE) to the plan's
portfolio, and one of the board members, Tom Riley, has asked for a meeting to become better
informed about this asset class. Childress asks one of his senior analysts, Sally Jenkins, to join him in
the meeting with Riley.
At the start of the meeting, Riley states that he is unfamiliar with private equity and would like to
understand some of the basic attributes of buyout funds and venture capital investments.
 Jenkins says, "Buyout funds typically invest in companies with stable cash flows and high
working capital requirements. Furthermore, buyout funds acquire most portfolio companies
through proprietary transactions with entrepreneurs.
 "Childress adds, "Venture capital investments are primarily funded with equity rather than
debt. Risk assessment can be difficult, and the target companies exhibit low cash burn rates."
Riley asks Childress to explain how a buyout fund can create value. Childress responds:
"Private equity funds primarily finance their acquisition of portfolio companies with equity. When
they do access credit markets, they do so on less favorable terms than comparable public
companies, but they can usually offset their relatively higher borrowing costs by re-engineering the
underlying portfolio companies to improve their overall profitability."
Riley asks for a practical example to illustrate the mechanics of a private equity investment that the
pension plan might undertake. Childress provides the information in Exhibit 1 as the basis of his
response.
Exhibit 1
Representative Example of a Private Equity Investment

Initial investment $2,500,000

Terminal value $30,000,000

Holding period Five years

Discount rate 55%

Founders’ required number of shares 1,250,000

Riley asks, "How exactly does the PE firm in your example generate cash flow when exiting the
investment?
Jenkins replies, "There are really three primary exit strategies that might be used:
 The initial public offering (IPO) is the preferred method because it produces the
highest valuation multiples at the lowest cost.
 Secondary market sales are another option. This option provides the second highest
valuation multiples after IPOs. Another advantage is providing the portfolio company
with the expertise of the new buyer or the ability to merge with another portfolio
company to realize synergies and add value to the portfolio company.

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  A third option is a management buyout (MBO), which has the advantage of requiring
relatively low amounts of leverage with the added benefit of aligning the interests of
the management team and the private equity fund."
Riley is interested in knowing how compensation for a private equity fund is structured. Jenkins
responds, "Hurdle rates are beneficial in that they align the interests of the limited partners (LPs)
and the general partner (GP)." She illustrates her point with the following example:
"If a fund has a hurdle rate of 9%, and the GP is paid carried interest at 20% of the portfolio
companies' profits on a deal-by-deal basis, the fund would not be paid anything if it initially invests
$50 million in a portfolio company that it exits in Year 3 for $65 million."

Question 1
Which of Jenkins's descriptions of the attributes of buyout funds is most likely correct?
A. Her description of working capital requirements
B. Her description of the method of acquisition
C. Her description of cash flows

Question 2
Which of Childress's characterizations of the attributes of venture capital funds is least likely correct?
A. His characterization of risk assessments
B. His characterization of capitalization preference
C. His characterization of cash burn rates

Question 3
Which of Childress's statements regarding value creation by private equity funds is most accurate?
A. The statement regarding method of financing
B. The statement regarding credit market terms
C. The statement regarding corporate re-engineering

Question 4
Using Exhibit 1, the number of shares the PE firm must own to earn its required rate of return
is closest to:
A. 1,676,502.
B. 426,502.
C. 3,663,522

Question 5
Which description of the various exit strategies mentioned by Jenkins is most accurate?
A. Her description of a secondary sale
B. Her description of an MBO
C. Her description of an IPO

Question 6
Jenkins's discussion and example concerning hurdle rates is most likely :
A. incorrect with respect to the purpose of using hurdle rates
B. incorrect with respect to the earning of carried interest.
C. correct.

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 ITEM SET - 4

Eric Silverman is a senior portfolio manager for the endowment of Sawyer University based in
California. Sawyer’s investment policy currently only allows allocations to domestic equity and
corporate bonds. The investment committee has tasked Silverman with assessing the endowment’s
foray into real estate investments. He is meeting with two of his team members to discuss the
assignment: Jenny Lin, a senior associate, and Rohan Dua, a senior financial analyst.

The endowment’s investment committee has asked Silverman to consider the implications of direct
real estate investments in the endowment portfolio. The committee’s view is that such investments
will likely generate income and capital appreciation but have no significant impact on portfolio risk
because of their high correlations with the existing investments.

Silverman has asked Dua to carry out some preliminary research on commercial real estate and to
report on his findings. Dua reports that commercial real estate property types include office
properties, industrial and warehouse space, and retail space. Dua indicates that demand for office
space depends on employment growth, whereas a strong economy drives demand for warehouse
space. Demand for retail space depends on the level of import and export activity.

Silverman and his team are evaluating an investment in an office property. They propose to use
three valuation methods: the discounted cash flow method (DCF), the cost approach, and the sales
comparison approach. There are four years remaining in the property lease and annual net
operating income (NOI) from lease payments is $750,000. When the lease rolls over in Year 5, there
is expected to be a one-time 15% increase in NOI. Information about the evaluation is provided in
Exhibits 1 and 2.
Exhibit 1
Selected Information to Evaluate Subject Property
Discount rate 7.50%
Terminal cap rate 5.50%
Market value of land $2,500,000
Replacement building costs $20,000,000
Curable physical depreciation costs $500,000
Incurable physical depreciation costs $3,500,000
Cost of modernizing heating and cooling system $1,200,000
Exhibit 2
Sales Comparison Information to Evaluate Subject Property
Size Age Price
(square feet) (years) Condition (per square foot)
Subject office property 12,000 7 Excellent
Comparable office property 1 8,000 10 Average $1,150
Comparable office property 2 14,000 4 Average $1,325

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To adjust for age, the price per square foot (PSF) of the comparable property is adjusted by 3% per
year of age difference. The adjustment for the condition of the office property is 14% for properties
in average condition.

Silverman asks the group to provide some characteristics of the three valuation methods. Lin
responds, “the DCF method takes into account cash flows that are relevant to investors and
incorporates the cyclical nature of the real estate market. The cost approach works best for newer
properties, whereas the sales comparison approach provides reliable value estimates in an active
real estate market in which there are numerous transactions.”

Question 1
The investment committee's view on direct real estate investment is least likely correct with regard
to:
A. income.
B. portfolio risk.
C. capital appreciation.

Question 2
Is Dua most likely correct with regard to the factors that drive demand for different commercial real
estate property types?
A. No, he is incorrect about retail space.
B. No, he is incorrect about industrial and warehouse space
C. Yes

Question 3
Based on the information provided and Exhibit 1, the value of the office property based on the DCF
approach is closest to:
A. $16,265,226
B. $14,254,549
C. $18,193,813

Question 4
Using the cost approach, the estimated value of the office property based on Exhibit 1 and other
information provided is closest to:
A. $17,300,000
B. $15,300,000
C. $14,800,000.

Question 5
Based on Exhibit 2 and other information provided, the value of the office property using the sales
comparison approach is closest to:
A. $16,834,500
B. $13,875,000.
C. $17,023,500

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Question 6
In her response to Silverman regarding the characteristics of the three valuation approaches, Lin
is least likely correct with respect to the:
A. sales comparison approach
B. DCF approach
C. cost approach

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 ITEM SET - 5

Shoshone Capital is a private equity firm that structures funds as limited partnerships for which it
serves as the general partner. The funds focus on buyouts of publicly traded companies. Shoshone
has produced a new marketing brochure that it will use to solicit capital investments. The first
section of the brochure describes the common characteristics of buyout investments, including the
following:

Characteristic 1: The target firms generally have experienced management teams.

Characteristic 2: The target firms often have the potential for substantial cost reductions.
Characteristic 3: The deals are generally arranged through relationships with the existing
shareholders.

Section 2 of the brochure discusses how Shoshone aligns its interests with those of the managers of
its portfolio companies.

Shoshone’s brochure provides an example of a typical acquisition, in which it purchased LUW, Inc.,
for $160 million. After the acquisition, LUW’s new capital structure consisted of $80 million in debt,
$65 million in preference shares, and $15 million in common equity. After six years, Shoshone sold
LUW, Inc., to another private equity firm for $285 million.

The brochure also provides an example of a private equity fund called Tensleep Fund, which has
committed capital of $150 million, a management fee of 2%, carried interest of 20%, and a hurdle
rate of 9%. Carried interest is paid on a deal-by-deal basis. In the example, the fund calls $100
million in commitments at the beginning of the first year and invests $40 million in Firm A and $60
million in Firm B. At the beginning of the second year, it calls the remaining $50 million and invests
it in Firm C. At the end of the second year, the investment in Firm B is sold for $70 million. At the
end of the third year, the fund’s investment in Firm A is worth $54 million, its investment in Firm C
is worth $40 million, and it has $46 million in cash.

The brochure concludes with the history of a second private equity fund called Pocatello Fund. The
first five years of this fund’s cash flows and distributions are presented in Exhibit 1.

Exhibit 1: Pocatello Fund Cash Flows and Distributions ($ millions)

Paid- Mgmt Operating NAV before Carried

NAV after Distributions
Year In Capital Fees Results Distributions Interest Distributions
2005 40 0.8 –3 36.2 36.2
2006 55 1.1 4 54.1 54.1
2007 80 1.6 11 88.5 88.5
2008 100 2 27 133.5 4.2 19 110.3
2009 125 2 34 167.3 6.6 38 122.7
Note: NAV is net asset value

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Question 1
Which of the characteristics listed in the brochure regarding buyout investments is least
likely correct?
A. Characteristic 3
B. Characteristic 1
C. Characteristic 2

Question 2
Which of the following clauses is most likely to be included in Section 2 of Shoshone's brochure?
A. Tag-along, drag-along rights
B. Reserved matters
C. Liquidation preference

Question 3
When LUW, Inc., was sold by Shoshone, which part of its capital structure most likely decreased in
size?
A. Common equity
B. Preference shares
C. Debt

Question 4
Compared with the exit route chosen, Shoshone's least likely alternate exit route for the LUW, Inc.,
investment would be a(n):
A. management buyout
B. initial public offering
C. liquidation.

Question 5
The carried interest paid to the general partner of the Tensleep Fund at the end of the second year
is closest to:
A. $2.0 million
B. $0.7 million
C. $0.

Question 6
In 2009, the total value to paid in of the Pocatello Fund is closest to:
A. 0.46×.
B. 1.44×.
C. 0.98×.

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 ITEM SET 6

Jeff Markgraf, CFA, is the managing director at Alpha Alternatives L.L.P. Markgraf has a successful
track record of investing in real estate for his institutional clients. Markgraf is seeking to diversify
his scope and is looking into investing in commodities and in private equity.

Markgraf reaches out to his college friend, Bill Small, who manages a private equity fund
specializing in leveraged buyouts. Markgraf asks Small about ways in which private equity funds
add value to their portfolio investments.

Markgraf concludes that futures contracts offer the best mechanism for him to gain exposure to the
commodities market. He seeks to develop further understanding of the components of total return
of aportfolio invested in commodity futures.

Markgraf observes that cattle prices are greater then the expected future spot prices while the corn
futures prices are less than the expected future spot prices. Markgraf also read that futures prices
may beinfluenced by weather.

Markgraf wants some exposure to precious metals and expects to use silver futures contracts to
accomplish this. Markgraf will roll over maturing contracts to the next shortest available contract.
Markgraf believes that silver will help diversify his overall portfolio, especially since silver futures
prices are less then silver spot prices.

1. Which of the following would be least appropriate as a part of Small’s response to Markgraf’s
question?
A. Optimizing financial leverage.
B. Creating operational improvement.
C. Incentivizing the general partner.

2. Which of the following factors is most to influence the price of a corn futures contract?
A. Interest rates.
B. Cattle futures prices.
C. Global demand and supply conditions.

3. Early frost in some parts of the country has resulted in damage to corn crops and a temporary
shortage in the supply of corn. Under the theory of storage, relative to the spot prices, futures
prices are most likely to:
A. Remain the same.
B. Increase.
C. Decrease.

4. When considering total return of commodities futures portfolio’s, the rebalancing effect is most
likely to be positive ad significant underwhich of the following conditions?
A. Commodity post prices are flat over the long term but volatile over the short term.

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 B. Convenience yield is low.
C. Storage costs are high.

5. Which theory is least likely to explain the pricing relationship in the cattle futures market?
A. The insurance perspective.
B. The hedging pressure hypothesis.
C. The theory of storage.

6. Markgraf’s position in silver futures contracts is most likely to produce a roll return that is:
A. Zero.
B. Negative.
C. Positive.

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 ITEM SET 7

Rita Larson, is an investment analyst for Siprah Properties, Inc. A group of wealthy investors, Ken
Lundy Chun Park and Kareem Shabaz, are interested in purchasing Parkway Terrace, a 120 unit
luxury apartment complex in South-eastern Florida. The current owners of Parkway Terrace have
agreed to sell the property for $40,000,000.

Siprah represents both the existing owners and the potential new owners and are privy to
additional information. Exhibits 1 and 2 show the information Larson has collected during her due
diligence.

Exhibit 1: Parkway Terrace Specifies

Parkway Terrace
Projected first year net operating income $3.3 million
Location/Condition Prime/Good
NOI growth rate 2.5%
LTV 75.0%
Loan Term 25 years
Loan Interest Rate 4.5%
Monthly Debt Service $166,750
Square footage 240,000
Expected holding period 10 years
Parkway Terrace Cost estimates
Effective age of building 10 years
Total economic life 50 years
Estimated value of land $12,500,000
Replacement cost (p.s.f.) $175.00
Developer’s profit (p.s.f) $15.00
Curable deterioration $5,000,000
Total obsolescence $4,000,000
Expected selling price in 10 yrs $60,000,000
Loan balance at end of 10 yrs $21,797,543

Exhibit 2: Recent Transactions of Luxury Apartment Building in South-eastern Florida

Building Craig Court Kenton Place Hester Oasis
Size in square feet 200,000 150,000 300,000
Age in years 7 10 13
Condition Fair Good Good
Location Prime Secondary Secondary
Age of transaction (in months) 9 5 16
Sales price $32,000,000 $24,000,000 $45,000,000
Projected NOI $2,560,000 $1,800,000 $3,150,000

Additional information:

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 Depreciation is 1.5% per year.
 Condition can be good, fair, or bad/ 7.5% is the adjustment needed per classification.
 Location can be prime, secondary or tertiary. Prime locations are the most sought-after and 7.5%
is the adjustment needed per classification.
 Market prices have been increasing at a rate of 0.50% per month.

Lundy states that all returns and ratios must exceed the minimum standards as listed below.

Minimum requirements
Levered required rate of return 20.0%
Debt Service Coverage Ratio 1.50X
Equity Dividend Rate 25.0%

Economic Outlook for Southeast Florida

 Home prices are expected to rise.
 Interest rates are expected to increase.
 Population growth is expected to be higher than in other areas as more wealthy retirees are
moving to the region.

The investor make the following statements about how to best approach this investment:

Key Lundy: “After we buy Parkway Terrace, we should offer shorter lease to take
advantage of market conditions.”
Chun Park: “I think that after we buy, we should offer long leases to lock-in tenants and
maximize profitability.”
Kareem Shabaz “If we buy, we should take advantage of the low interest rates by using as
much leverage possible.”

Larson is interested in using a real estate index in her analysis of suitability of real estate as an asset
class for several of Siprah’s clients. She notes that the firm subscribes to a proprietary index
provided by REIQ .The REIO index is as appraisal-based index that is very popular among real
estate professionals. Larson is concerned about appraisal lag in the index and wants to adjust the
index to remove this lag.

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1. The estimated value of the property using the direct capitalization approach is closet to:
A. $41.3 million.
B. $42.0 million.
C. $44.0 million.

2. The estimated value of the property using the sales comparison approach is closet to:
A. $37.6 million.
B. $42.2 million
C. $43.2 million.

3. Based on Lundy’s minimum requirements, the Parkway Terrace project is:

A. Not worth pursuing because the equity dividend rate is below the minimum required.
B. Worth pursuing because all three standards are met.
C. Not worth pursuing because the debt service coverage ratio is belowthe minimum required.

4. The estimated value of the property using the cost approach is closet to:
A. $28.5 million.
B. $41.0 million.
C. $45.0 million.

5. Which stated approach is least likely to result in an increase in potential returns?

A. Chun Park’s
B. Ken Lundy’s
C. Kareem Shabaz’s.

6. To correct for appraisal lag in the REIQ index, which of the following is the least appropriate
course of action for Larson?
A. ‘Unsmooth’ the index.
B. Use a transaction-based index.
C. Use more-recent appraisals.

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 ITEM SET 8

The New York-based Irwin Goldreich Schmidt (IGS) is a mid-sized private equity firm with $300
million capital raised from its investors. Amid a turbulent year, the firm has recently dropped its
unsuccessfull$100 million bid for a Norwegian media company and is now aggressively searching
for new venture or buyout investments in the Eurozone. After several months of intense search, IGS
believes it identified two potential investments:

1. Sverig, a rapidly expanding Swedish start-up construction company.

2. L’Offre, a struggling French department store in existence since the late 19th Century.

Following several rounds of successful negotiations, IGS makes a $20 million investment in Svering
and a $100 million leveraged buyout investment in L’Offre, committing to an additional $100
million for possible future capital drawdowns. It retains all of Sverig’smanagers but replaces
L’Offre’smanagement team with experienced IGS managers, many of whom are former company
senior executives.

IGS also steps up Sverig-L’Offre Private Equity Fund (SLPEF), a fund to mangers both firms. The
fund manger’s compensation is set at20% of profits net of fees. IGS also specifies that the manager’s
profits are calculated on the entire portfolio when portfolio value exceeds invested capital by 30%.

Despite the market’s recent turbulence, Severig’s original founderare extremelyoptimistic and
believe the firm could be sold for $400 million in six years. To achieve this, they speculate the firm
needs another capital infusion of $40 million in four years in addition to the $20 million capital
investment today. Given the high risk of the firm, SLPEF’s private equity investors decide that a
discount rate of 40% for the first four years and 30% for the last two years is appropriate. The
founders of Sverig want to hold 5 million shares.

1. If total proceeds net of fees to SLPEF are worth $180 million upon exit in a year, the fund’s
general partner (GP) under the total return using invested capital method would receive a
compensation of:
A. $0.
B. $12 million.
C. $36 million.

2. An appropriate equity valuation technique for Sverig and L’Offre, respectively, would be the:
Sverig L’Offre
A. Relative value approach Venture capital method
B. Venture capital method DCF method
C. DCF method Relative value approach

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3. Common risk factor(s) faced by both IGS investors and the managers of the private equity firm
is(are):
A. Market risk but not agency risk.
B. Agency risk but not market risk.
C. Both market and agency risk.

4. SLPEF’s general partner’s (GP’s) share of fund profits and management’s right to sell their equity
interest in the event of an acquisition, respectively, are called:
Profits to the GP Management’s right to sell
A. Carried interest Ratchet
B. Ratchet Distribution waterfall
C. Carried interest Tag-along, drag-along clause

5. Sverig’s post-money valuation at the first round of financing, using the NPV venture capital
method, is closet to:
A. $61.61 million.
B. $50.08 million.
C. $51.20 million.

6. The appropriate stock price after the first-round of financing for Sverig’s first-round investors is
closet to:
A. $6.24.
B. $8.32.
C. $6.02.

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 ITEM SET 9

Bill Henry, CFA, is the CIO of IS University Endowment Fund located in the United States. The
Fund’s total assets are valued at $3.5 billion. The investment policy uses a total return approach to
meet the return objective that includes a spending rate of 5%. In addition, the policy constraints
established make tax-exempt instruments an inappropriate investment vehicle. The Fund’s current
asset mix includes an 18% allocation top private equity. The private equity allocation is shown in
Exhibit 1.

Exhibit 1: IS University Endowment Fund’s Private Equity Investments

Private Equity Percentage Allocation
Venture capital 12%
Buyouts 56%
Special situations 32%

The private equity allocation is a mixture of funds with different vintages. For example, within the
venture capital category, investments have been made in five different funds. Exhibit 2 provides
details about the Alpha Fund with a vintage year of 2014 and committed capital of $1965 million.
The distribution waterfall calls for 20% carried investment when NAV before distributions exceeds
committed capital.

Exhibit 2: $195 million Venture Capital Alpha Fund ($ Millions)

Year Called-Down Management Operating Results
Fees
2014 $30 $0.45 -$10
2015 $25 $0.83 $55
2016 $75 $1.95 $75

The Alpha Fund is considering a new investment in Targus Company. Targus is a start-up biotech
company seeking $9 million of venture capital financing. Targus’s founders believe that, based on
the company’s new drug pipeline, a company value of $300 million is reasonable in five years.
Management at Alpha Fund views Targus Company as a risky investment (15% risk of failure) and
is using a discount rate 40%.

1. Which of the following risk factors will most likely impact the private equity portion of the
ISUniversity Endowment?
A. Lack of diversification.
B. Illiquid investments.
C. Taxation risk.

2. Using Exhibit 2, calculate the 2016 percentage management fee of the Alpha Fund.
A. 1.5%.
B. 2.0%.
C. 2.5.

80
3. Alpha Fund’s 2016 dollar amount of carried interest is closet to:
A. $0 million.
B. $10 million.
C. $20 million.

4. Which of the following is mostlikelya characteristic of a venture capital investment?\

A. The typical investment uses leverage.
B. Measurable risk.
C. Increasing capital requirements.

5. Using the single period NPV method (venture capital method), the post-money valuation of
Targus Company is closet to:
A. $48 million.
B. $50 million.
C. $55 million.

6. For this question only, assuming that the founders will hold 2.5 million shares and the post
money valuation is $90 million, the price per share for the venture capital investor is closet to:
A. $32.40.
B. $34.12.
C. $36.00.

81
 ITEM SET 10

Karen Westin, Kei Shinoya and Carlos Perez, partners at PacRim Investment Consultants, are
advising a client, the West Lundia Government Employees Pension Plan (WLGE), a large public
fund. In a previous meeting with the pension board of WLGE, thePacRim team made a
recommendation to increase the fund’s exposure to domestic real estate. Because of the WLGE
plan’s large size and in-house expertise, the pension fund has the capacity to invest in and manage a
wide variety of real estate investments. The currency in West Lundia is the West Lundian Dollar
(WL$).

West Lundian Commercial Real Estate Market Expectations

Commercial real estate prices have experienced a moderate increase over the past year after a
decade of unusually slow growth. Demand is expected to exceed supply over the next 10 years. The
current average commercial mortgage rate of 3.75% is low by historical standards and is expected to
stay relatively low for at least seven more years. The West Lundian economy is expected to enjoy an
above average growth rate.

Exhibit 1: West Lundia’s Economic Outlook

Expected Annual Relative to Other
Growth Rate Developed Countries
Job Creation 3.0% High
Population 1.8% High
Retail Sales 1.5% Low
Inflation 0.5% Low

Because of the favourable real estate conditions, the consensus was to consider equity investments
in real estate. Three options under considerations are:

Option 1: Direct investment, in an existing office building.

Option 2: Investment in a public equity REIT.

Option 3: Equity investment in a public REOC.

Option 1: Direct Investment

Expected NOI Years 1-7 WL$ 7.0 MM
Expected NOI Year 8 WL$ 8.5 MM
Required return on equity investment 10%
NOI growth rate after 8 years 3.25%

Option 2: REIT
Recent NOI WL$ 140.0 MM
Non-cash rents WL$ 5.0 MM
Full year adjustment for acquisition WL$ 5.0 MM

82
Other assets WL$ 50.0 MM
Total liabilities WL$ 300.0 MM
Current market price per value WLS 125.00
Shares outstanding 15 MM
Going-in cap rate 7.00%
NOI growth rate 2.50%

Option 3: REOC
Expected AFFO in Year 8 WL$ 13.5 MM
Holding Period 7 years
Present value of all dividends for 7 years WL$ 39.7 MM
Shares Outstanding 1.0 MM
Cap rate 7.0%
Growth rate (from Year 8) 2.50%

Additional Information
1. The office building under consideration has existing tenants with long term leases that will expire
in seven years.
2. The REOC terminal value at the end of seven years is to be based on a price-to-AFFO multiple of
12x.

1. Based on the information in Exhibit 1, the REIT sector that represents the least desirable
Investment is:
A. Industrial.
B. Office.
C. Apartments.

2. The estimated value of the office building (Option 1) using the discounted cash flow approach is
closet to:
A. WL$ 89 million.
B. WL$ 93 million.
C. WL$ 99 million.

3. Based on its estimated value using the asset value approach, the REIT identified in Option 2 is:
A. Fairly priced.
B. Selling at a discount.
C. Selling at a premium.

4. The most appropriate reason to choose Option 1 (direct investment) over Options 2 and 3 is that
Option 1 is likely to have the abilityto:
A. Use higher leverage.
B. Provide greater tax advantages.
C. Avoid structural conflicts of interest.

83
5. The estimated value per share of Option 3, REOC, using the discounted cash flow approach is
closet to:
A. WL$ 125.50.
B. WL$ 140.60.
C. WL$ 162.00.

6. Option 3 would be preferred over Option 2 is:

A. Liquidity of the investment is critical.
B. The investment must be efficient in terms of corporate taxes.
C. Capital appreciation is more highly valued than current income.

84
 ITEM SET 11

Julian Fuentes, CFA, analyses real estate investments for AI Partners (AIP), a private equity real
estate investment firm. Although AIP has primarily invested in non-residential commercial
property, they are considering a multi-family residential investment along with non-residential
commercial properties. Fuentes has been asked to prepare selected data on three potential
investment properties. Fuente’s results are presented in Exhibit 1.

Exhibit 1: Selected Property Data

Property #1 Property #2 Property #3
Property type Multi-family Office building Retail Centre
Occupancy 93% 92% 95%
Square feet or # units 325(u) 125,000(sf) 315,000 (sf)
Gross potential rent $3,900,000 $4,312,500 $2,765,850
Other income $ 25,000 $ 440,000 $ 780,000
Potential grossincome $ 3,925,000 $4,752,500 $3,545,850
Vacancy loss $ 273,000 $ 425,000 $ 138,293
Effective gross income $ 3,652,000 $ 4,327,500 $ 3,407,557
Property management $ 145,000 $ 172,500 $ 138,288
fees
Other operating $ 1,800,500 $ 2,163,750 $ 1,703,800
expenses
Net operating income $ 1,706,500 $ 1,991,250 $ 1,565,469
(NOI)

Other information:
1. Each property except Property #3 is located in an active market.
2. Property #2 is an older office building with architectural features characteristic of the period in
which it was constructed.
3. Property #2 is located in an area that is undergoing extensive renovation.

RadnaMargulies, AIP’s Chief Investment Officer, asks Fuentes to focus on the multi-family
opportunity presented as Property #1. This request is based on her forecast of pent-up demand in
the housing market. Fuentes forecasts net operating income for Property #1 for the first five years as
presented in Exhibit 2. A list of discounted cash flow valuation assumptions for an equity only
transaction is presented in Exhibit 3.

Exhibit 2: Property #1: Net Operating Income Forecast

Year 1 Year 2 Year 3 Year 4 Year 5
NOI $1,706,500 $1,774,760 $1,845,750 $1,919,580 $1,996,364

Exhibit 3: Property #1: DCF Assumptions

Investment holding period 5 years
Going-in capitalization rate 8.254%

85
 Terminal Capitalization rate 7.50%
Discount rate 9.50%
Income/value growth rate Constant

After reviewing valuation data for the three properties, Margulies requests that Fuentes discuss
funding terms with Amiable Life Insurance Company (ALIC) for property #1. Fuentes is offered a
rate of 5.5%, interest only, on a 5 year term loan. ALIC stipulates a maximum loan-to0-value (LTV)
of 70% and minimum debt service coverage ratio of 1.5x.

Fuentes receives an appraisal of $30 million for the value for Property #1.

1. Which property valuation aremost likely to be heavily affected by their unique characteristics?
A. Property #1 and Property #2.
B. Property #1 and Property #3.
C. Property #2 and Property #3.

2. Which property is likely to have the greatest operational risk resulting from management
expenses?
A. Property #1.
B. Property #2.
C. Property #3.

3. Which approach would an appraisal most likely use for valuing Property #2?
A. Cost approach.
B. Income approach.
C. Sales comparison Approach.

4. Based on Exhibits 2a and 3, the valuation for Property #1 based on the discounted cash flow
approach will be closet to:
A. $22,798,000.
B. $24,295,000.
C. $24,633,000.

5. Based on the appraised value, Amiable Life Insurance Company would be willing to loan a
maximum amount closet to:
A. $20.7 million.
B. $21.0 million.
C. $21.7 million.

6. AIP’s estimated return on equity on Property #1 using leverage as compared to return on equity
without using any leverage will most likely be:
A. Lower.
B. Greater.
C. The same.

86
 SOLUTION

ITEM SET - 1

Question 1
The justification for REIT 2 is correct: GDP growth is the top economic driver in all sectors. Job
creation also has a strong impact on the office sector.

Question 2
Reason 3 is correct. NAVPS is preferable to BVPS in valuing REITs because of the use of the
market value of assets. Although accounting values based on the fair value method also serve as a
useful valuation metric, those based on historical cost are generally not relevant.

Question 3

(US$ millions)
Next year’s NOI estimate 320 × 1.05 336
Capitalized value of operating real estate 336/0.07 4,800
Other assets 50 + 70 + 25 + 7 152
Minus liabilities 1,700 + 200 1,900
NAV 4,800 + 152 - 1,900 3,052
NAVPS 3,052/75 $40.69

Question 4
REITs are traded much more than REOCs in the United States; they comprise up to 97% of public
real estate equity securities.

Question 5
Characteristic 3 is correct because the discount rate (cap rate) used in NAV calculation is based on
private valuation of comparable properties. The discount rate used in DDM calculation is based on
the discount rate for a public equity investment.

87
Question 6
The calculation of FFO is based on net income after adding back amortization and depreciation.
$430
Net income available to common million
Depreciation and amortization $30 million
$460
FFO million
Number of shares outstanding 140

FFO per share 460/140 $3.29

P/FFO 49/3.29 14.9

88
 ITEM SET - 2

Question 1
Private equity real estate portfolios are less risky than stock portfolios and have lower expected
returns. Private equity real estate has bond-like characteristics because of the stream of lease
payments and at the same time has stock-like characteristics because of the dependency on the
strength of the overall economy when leases are renewed.

Question 2
$125,000/(11% – 6%) = $2.50 million.

Question 3
Real estate operating companies (REOCs) generate cash inflows primarily from the sale of
developed or improved properties, as opposed to recurring lease or rental income.

Question 4
Storage REITs are very sensitive to population growth. The greater the population, the greater the
demand for the storage of goods.

Question 5
$1,000,000/(1 + 0.4)3 – $200,000 = $164,431

Question 6
A ratchet enables the management team to increase its equity allocation depending on the
company’s actual performance and the return achieved by the private equity firm.

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 ITEM SET - 3

Question 1
Buyout funds seek out companies with stable cash flows. They generally invest in companies with
low working capital requirements and acquire portfolio companies via auction.

Question 2
Venture capital funds typically invest in companies with significant cash burn rates.

Question 3
Private equity funds increase value by taking on high levels of debt on favorable terms. They are
able to offset their borrowing costs by superior reorganization and re-engineering capabilities.

Question 4
The number of shares the PE firm must have to earn its required rate of return is determined as
follows:
Step Description Formula Calculation
Determine post-money
valuation.This amount
1 represents the present value of
the company once the initial
investment is made.
Determine ownership
fraction. This figure is the
2 fraction of the company the
investors must own to recoup
their initial investment.
Calculate the number of shares
3 required to maintain ownership
fraction.
Where
V = Terminal value
r = Discount rate
t = Holding period
I = Initial investment by PE firm
F = Proportion of shares owned by PE firm
x = Founders’ retained shares
y = Shares owned by investors to earn their required return

Question 5
Jenkins's description of a secondary sale is accurate.

90
Question 6
The internal rate of return (IRR) of the deal in the example is calculated as follows:

Solve for IRR with a financial calculator as follows: CF0 = -50; CF3 =65; IRR = 9.14%, where CF is
cash flow. Because 9.14% is higher than the hurdle rate of 9.0% and because the GP is paid on a
deal-by-deal basis, the GP would thus earn carried interest on the transaction.

91
 ITEM SET - 4

Question 1
The investment committee is correct in that direct real investment will likely generate income and
price appreciation, but their view on the diversification is incorrect. Real estate returns generally
have low correlations with returns on other assets classes, such as stocks and bonds, and thus allow
the endowment to diversify portfolio risk.

Question 2
Dua is correct about factors that drive demand for office space and industrial and warehouse space
but incorrect about retail space. Employment growth drives demand for office space while
warehouse space demand depends broadly on economic strength. The level of import and export
activity is more directly related to demand for industrial and warehouse space not retail space.
Demand for retail space depends on consumer spending, job growth and economic strength.

Question 3
Under the DCF approach the value of the office property is the sum of the present value of lease
payments (NOI) of $750,000 per year for 4 years plus the present value of the estimated resale value
in year 4.
PV of level NOI over 4 years
$750, 000 $750, 000 $750, 000 $750, 000
    $2, 511, 994.70
1.075 1.0752 1.0753 1.0754
Year 5 NOI = 750,000 × (1.15) = $862,500
Estimated resale value after 4 years =
$862, 500
 $15, 681, 818.18
0.055
PV of estimated resale value =
$15, 68, 818.18
 $11, 742, 553.76
1.0754

Question 4
The calculation of the estimated property value using the cost approach is shown in the following
table.
Market value (MV) of land $2,500,000
Replacement building costs $20,000,000
Curable physical depreciation costs $500,000
Incurable physical depreciation costs $3,500,000
Cost of modernizing heating and cooling system $1,200,000
Estimated property value $17,300,000
Estimated property value = MV of land + Replacement building costs – Curable physical
depreciation costs – Incurable physical depreciations costs – Cost of modernizing heating and
cooling system.

92
Question 5
Using the sales comparison approach, the price PSF of the comparable properties is adjusted
relative to the subject property to account for age and condition. For example, Property 1 is 10 years
old whereas the subject property is 7 years old. Because the subject property is newer by three
years, the price PSF of Property 1 is adjusted up by 3% per year for three years or 9%. Property 1 is
in average condition whereas the subject property is in excellent condition. Thus, the value of
Property 1 is adjusted up 14%, the adjustment factor provided for the condition adjustment. Thus,
the price PSF of Property 1 is adjusted up by 23% from $1150: Adjusted price PSF for Property 1 =
$1,150 × 1.23 = $1,415.50. A similar calculation is made for Property 2. The average adjusted price
PSF of both properties is $1,403. The value of the subject property is calculated by applying
$1,402.88 to the size of the property (12,000 square feet):
Value of subject property = $1,402.88 × 12,000 = $16,834,500. The following table shows the
calculations:
Adjustment Property 1 Property 2
Price PSF $1,150 $1,325
Age 9.0% –9.0%
Condition 14.0% 14.0%
Total 23.0% 5.0%
Adjusted price PSF $1,414.50 $1,391.25
Average price PSF $1,402.88
Estimated value $16,834,500

Question 6
While Lin is correct that the DCF method takes into account the cash flows that investors care
about, she is not correct in stating that DCF takes into account the cyclical nature of the real estate
market.

93
 ITEM SET - 5

Question 1
Characteristic 3 describes venture capital investments, which are commonly the result of
relationships between venture capitalists and entrepreneurs (existing shareholders or owners). Most
buyout transactions are auctions, which involve multiple potential acquirers.

Question 2
Tag-along, drag-along rights protect the interests of managers, not the private equity firm. Tag-
along, drag-along rights ensure any potential future acquirer of the company may not acquire
control without extending an acquisition offer to all shareholders, including the management of the
company.

Question 3
A common source of value creation in leveraged buyouts is debt reduction.

Question 4
Liquidation is the route chosen if the company is no longer viable.
The exit route used for LUW, Inc., was a secondary market transaction at a price that indicated a
strong company.

Question 5
Although the investment in Firm B produced a $10 million profit in two years, that figure
represents an annual return (internal rate of return, or IRR) of only 8.01% = (70 million/60
million)1/2 – 1, which is below the hurdle rate. The general partner will not receive any carried
interest payments until the fund's IRR exceeds the hurdle rate.

Question 6
Total value to paid in (TVPI) equals distributed to paid in (DPI) plus residual value to paid in
(RVPI), where DPI is the sum of distributions divided by paid-in capital [(19+38)/125] = 0.46 and
RVPI is NAV after distributions divided by paid-in capital (122.7/125) = 0.98. TVPI = 0.46 + 0.98 =
1.44.

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 ITEM SET - 6

1. C. Private equity funds add value to their portfolio investments in a variety including utilizing
optimal financial leverage, incentivizing portfolio company management and creating
operational improvements. Incentivizing the GP is a mechanism to reduce conflict interest
between LP and GP and not a mechanism to add value.

2. C. While the other factors to influence the futures price of corn, a consumable asset’s value is
most influenced by global supply and demand conditions.

3. C. The supply shortage would result in an increase in convenience yield, which will in turn
lowerthe futures price relative to the spot price. Note that the spot price would most likely
increase, but that is not the question. The question is specifically asking for futures price
relativeto the spot price.

4. A. Rebalancing to original fixed weights entails selling contracts that have appreciated in value
andpurchasing contracts that have lost value. In volatile markets, contracts that have risen in
value will be sold and contracts that have lost value purchased. This results in a significant
po0sitive return in markets that are flat in the long term andvolatile in the short term.

5. A. The case provides that the pricing in cattle future market reflects normal contango; futures
prices are higher than expected suture spot prices. The hedging pressure hypothesis can
explain normal contango pricing by suggesting that farmers that wish to hedge their
commodity price risk may be outnumbered by commodity consumers reducing their risk by
taking long positions in the futures market. The insurance perspective suggests that farmers
should dominate the hedging market, which results in normal backwardation and w2ould be
least likely to explain a normal contango pricing behaviour. The theory of storage relies be on
the convenience yield to predict the relationship between spot and futures prices; it links
storage costs and storability to the convenience yield. Existence of high inventory levels could
reduce the convenience yield and hence push futures prices higher, potentially leading to
normal contango.

6. C. Since futures price are less than spot prices, the roll return will be positive. Convergence will
createidentical spot and futures prices at maturity; maturing contracts will be replaced with
the next shortest futures contract, which will have a lower price.

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 ITEM SET - 7

1. C. Using direct capitalization:

Cap rate data:
Office building Craig Court. Kenton Place Hester Oasis
$2.56 / $32.0 $1.80 / $24.0 $3.15 / $45.0
Cap rate = 8.0% = 7.5% = 7.0%
The average cap rate for the three apartment buildings is 7.5%. The estimated value of Parkway
Terrance is calculated as the NOI of $3,300,000 dividend by the cap rate of 7.5% or $44.0 million.

2. B. Using the sales comparison approach:

Variable Craig Court KentonPlace Hester Oasis
Sale price $32,000,000 $24,000,000 $45,000,000
Size 200,000 150,000 300,000
Sale price per sq. ft. $160.00 $160.00 $150.00
Age adjustment -4.5% 0.0% +4.5%
Condition adjustment +7.5% 0.0% 0.0%
Location adjustment 0.0% +7.5% +7.5%
Date of sale adjustment +4.5% +2.5% +8.0%
Total adjustment +7.5% +10.0% +20.0%
$160 × (1 + 0.075) $160 × (1+ 0.100) $150 × (1 + 0.200)
Adjusted sales price psf =$172.00 =$176.00 =$180.00
Average sales price per square foot is $176.00. the sales comparison method estimates the
value of the property at 240,000 square feet × $176.00 = $42.2 million.

3. A.
Parkway Terrace Standards
NOI $3,300,000
Equity $10,000,000
Annual Debt Service $ 166,750 × 12 = $2,001,000
Equity Dividend Rate = ($3,300,000 - $2,001,000)/ 13.0% is less than
$10,000,000 = 13.0% 25.0%

DSCR $3,300,000/$2,001,000 1.65X exceeds 1.50X

= 1.65X
$3,300,000 - $2,001,00

Cash flows (PMT) =$1,299,000

Equity (PV) $10,000,000

$60,000,000 - $21,797,543 =
Sales Price – Outstanding $38,202,457

96
 Loan in 10 years (FV)
Sales Date (N) 10
Levered IRR 22.6% 22.6% exceeds 20.0%
1. LTV = 7% (given), Equity = 25% of million.
2. Levered IRR calculation: N = 10; PV = 10,000,000; PMT = 1,299,000;
FV = 38,202,457; CPT I/Y = 22.56%

4. B. Value of land (given) $12,500,000

Replacement cost, including constructor’s profit
Building costs (psf) $175
Total area 240,000 $42,000,000
Developer’s profit $15 $3,600,000
$45,600,000
Reduction for curable deterioration -$5,000,000
$40,600,000
Reduction for incurable deterioration
Total economic life 50
Remaining economic life 40
Effective age 10
Ratio of effective to total 20.0%
Reduction for incurable deterioration -$8,120,000
$32,480,000
Reduction for total obsolescence -$4,000,000
Total building value $28,480,000
Total Cost Estimate $40,980,000

5. A. The economic outlook on home prices and population trends indicate favourable conditions
forward. Shorter leases would allow rents to be adjusted upwards as demand for rentals
increases, so Lundy’s comment is correct. For a buyer of real estates, low interest rates along
with a loan-to-value (LTV) will maximize the potential for high levered returns. Tenants will
benefit in a high demand environment; this would not benefit the investors so Park’s
comment is incorrect.

6. C. Appraisal lag tends to smooth the reported returns of real estate indicates, resulting in an
Artificially low correlation with other asset classes.Appraisal lag can be mitigated by
unsmoothing the index or by using a transaction-based index. Using more-recent appraisals
still relies on appraisal-based data.

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 ITEM SET - 8

1. B. Invested capital in the fund was $20 million +$100 million = $120 million. Committed capital
was$120 million + $100 million + $100 million = $220 million. Since the fund was sold for $180
million, the fund earned a profit of $180 million - $120 million - $120 million = $60 million.
Under the total return using invested capital method, carried interest is paid to the GP only
after the portfolio value exceeds invested capital (by 30% as specified byIGS). Since the $180
million exceeds ($120 million) (1.3) = $156 million, the GP is entitled to carried interest.
Carried interest is calculated as:
$180 million - $120 million = $60 million. 20% of $60 million is $12 million.

2. B. The DCF method and relative value approach would be less appropriate for Sverig.
Given that Sverig is startupventure capital firm, it would be difficult to assess its future cash
flows and there are likely few comparables to benchmark against. Given that L’Offre has been
if existence for over a century, it likely has relatively stable and predictable cash flows. Several
comparables would also likely exist in the same industry. This would make either the DCF
method or relative value approach an appropriate valuation technique.

3. C. Market risk is the uncertainty in long-term macroeconomic factors, such as changes in interest
ratesand foreign exchange rates. If these changes adversely affect the private equity fund
firms, both the fund’s investors (limited partners) and the firms managers could see their
equity stake and investment declining. Agency risk refers to the possibility that the managers
of the portfolio (investee) companies may place their personal interests ahead of the interests
of the firm and of private equity investors.

4. C. The GP’s share in profits is referred to as carried interest and is generally set at 20% of net
profitsafter fees. A tag-along, drag-along clause would give management the right to buy an
equity stake upon sale by the private equity owners.
Ratchet specifies the equity allocation between the limited patterns (LPs) and management.
Distribution waterfall specifies how profits will follow to the LPs and also the condition under
which the GP may receive carried interest.

5. C. First, the $400 million terminal value must be discounted two years at 30% to the second
roundof financing:
$400million
POST2  = $236.686 million
(1.3)2
The second-round pre money valuation (PRE ) is calculated by netting the $40 million second-
round investment from the (POST ) calculation:
PRE2  POST2  INV2  $236.686 = - $40 million = $196.686 million.
Finally, the PRE valuation must be discounted back 4 years at 40% to arrive at the POST
valuation:
$ .
POST = = $51.199 million
( . )

98
6. A. Calculating the number shares for Sverig’s first-round investors requires a three-step
approach where:
 f is the fractional ownership for first-round investors.
 INV is the initial investment in Sverig by the private equity patterns.
 S is the number of shares owned by Sverig’s founders.
 S is the number of shares owned by the private equity LPs.
Step 1: Determine the fractional ownership for first-round investors ( f1 ):
INV $
f1  = = 39.06%
POST1 $ .

First-round investors thus own approximately 39.06% of the firm.

Step 2: Determine the number of shares first-round investors need to receive their fractional
ownership:
 f   0.3906 
S Pe  Se  1   5, 000, 000    3, 204, 792
 1  f1   1  0.3906 
To obtain a 39.06% stake in Sverig, first-round investors would have to receive
3,204,792 shares.

Step 3: Determine the stock price after the first round of financing ( P1 ):
INV1 $20million
P1    $6.24
S Pe1 3, 204, 792

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 ITEM SET - 9

1. B. The risk that the private equity portion of the IS University’s Endowment Fund would most
likelysuffer from is illiquidity. It can be difficult to trade the private equity investments
because they are usually not listed on secondary securities markets. The private equity
investments are diversified in terms of vintage and strategies. The IS endowment fund is
exempt from taxation on capital gains or dividends.

2. A. Percentage management fee = managementfee = management fee / paid-in capital

paid-in capital = ∑ called-down
2016 % management fee = 1.95 / (75 + 25 + 30) = 0.015

3. B. $195 million Alpha Fund (all data in millions)

Year Called Mgmt. Operating NAV before Carried Distributors NAV after
down Fees Results Distributions Interest Distributions
2014 30 0.45 -10 19.35 0
2015 25 0.83 55 98.72 0
2016 75 1.95 75 246.77 10.35 0 236.42

2014 NAV before distributions =30 – 0.45 + (-10) = 19.55

2015 NAV before distributions = 19.55 + 25 – 0.83 + 55 = 98.72
2016 NAV before distributions = 98.72 + 75 – 1.95 + 75 = 246.77
When NAV before distribution exceeds committed capital, the 20% carried interest is applied.
(246.77 – 195) × 0.2 = 51.77 × 0.2 = 10.35
In years 2017 and beyond, the 20% carried interest is applied to the change in NAV before
distributions. For example, if the 2017 NAV before distributions was 296.77, then the carried
would equal (296.77 – 246.77) × 0.2 = 50 × 0.2 = 10.
The NAV after distributions subtracts carried interest and distributions from NAV before
distributions.,

4. C. Venture capital investments require considerable capital to develop and grow. Companies
thatrequire venture capital usually have significant cash burn as they develop new products.
Venture capital investments are primarily funded through equity and utilize little or no debt.
Risk measurement of venture capital investments is difficult because of their short operating
history and required development of new markets and technologies.

5. C. post-money valuation = V / (1 − r)
V = $300 million; r = 40%; t = 5 years
post-moneyvaluation = 300 million / (1 + 0.4) = 55.78 million
Note that the adjusted discount rate incorporating the probability of failure is directly given
the question as 40%.

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6. A. The ownership proportion of the venture capital (VC) investor is f = INV / POST =
$9,000,000 / 90,000,000 = 0.10 or 10%.
shares = shares ( f 1 - f ) = 2,500,000 × (0.10 / 0.90) = 277,778
price = INV / shares = $9,000,000 / 277,778 = $32.40 per share

ITEM SET - 10

1. A.For industrial properties, the most important factor affecting economic value is retail sales
growth, which is expected to be low in West Lundia. The most important factor affecting
economic value for apartment REIT’s are job creation and population growth, which are both
expected to be high. For office properties, the most important factor is job creation, which is
expected to be high.

2. C. There are two components to this valuation. The first component is the cash flows for the first
seven years. The second component is the terminal value.
PV of CFs in years 1-7:
PMT = 7.0; I/Y = 10; N = 7. The PV = WL$34.08 million.
PV of terminal value:
An appropriate terminal cap rate can be calculated using the following equation:

cap rate = discount rate – growth rate = 10% - 3.25% = 6.75%.

The terminal value is calculated using the following inputs: WL$8.5 million divided by the
terminal cap rate of 6.75%. The value in year 7 is WL$125.93 million,
Discounting this value to the present:
FV = WL$125.93 million; N = 7, I/Y = 110 results in a present value of WL$64.62million.
WL$34.08 + WL$64.62 = WL$98.7 million.

3. C. NAVPSbased on forecasted NOI:

Option #2 (REIT) (in EL$ millions)
Recent NOI 140.0
Subtract: Non-cash rents -5.0
Add: Full-year adjustment for acquisition +5.0
Pro forma cash NOI 140.0
Projected NOI @ 2.5% growth 143.5
Estimated value of operating real estate @ cap rate of 7.0% 2050.30
Add: Other assets +50.0
Estimated gross value 2100.0
Subtract: Total liabilities -300.0
NAV 1800.0

NAVPS = 1800 / 15 = 120, which is lower than the current market price of WL$125.00.This
REIT is selling at a premium to NAVPS.

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4. C. Option 1 represents private investment in real estate, while Options 2 and 3 entail investing
Through public securities. Tax advantages can be enjoyed by direct investments in real estate,
as well as through public securities. Similarly, use of leverage can be pursued by all three
options. Option 1 does not have the problem of structural conflicts of interest that my be
present in REITs.

5. A. The terminal value estimate is 12.0 × WL$13.5 MM for end of year 7 or WL$162.0 MM. The
discount rate is the cap rate of 7.0% plus the growth rate of 2.5% or 9.5%. Discounting this
terminal value to find the present value: FV = WL$162.0 MM; I/Y = 9.5; N = 7; PV = WL$85.83
MM. Add the present value of all dividends of WL$39.7 MM for a total of WL$125.55. Divide
WL$125.53 MM by 1 million shares outstanding for a value per share of WL$125.53.

6. C. Investment in both, public REOCs and public REITs enjoy high liquidity, as shares of both
Trade on a stock exchange. Tax advantages favor REITs as REOCs are not tax advantaged.
REOCs are more reliant on capital appreciation due to their ability to reinvest cash flows,
while REITs tend to have higher current income.

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 ITEM SET - 11

1. C. While almost any private equity real estate investment will be unique (if for no other reason
than that they must be in different locations), residential properties tend to have the fewest
unique characteristics. Transactions-based indices tend to be more useful for residential
commercial property benchmarking than for non-residential commercial properties due to the
large amount of data required for many properties and the unique features of many non-
residential commercial properties.

2. C. Commercial uses with higher management involvement, such as restaurants, hotels, shopping
centres, also have higher operational risks. One way to check this given the specifies in this
case is to look at management fees as a percentage of effective gross income for the three
properties.
Property #1 3.97% ($145,000 / $3,652,000)
Property #2 3.99% ($ 172,500 / $ 4,327,500)
Property #3 4.06% ($138,288 / $3,407,557)
Therefore, Property #3 would be expected to have greater operational risk.

3. B. Property #2 is an older office building with unique characteristics that could not be easily
reproducedusing current architectural designs and materials. Therefore, the cost approach
would be less appropriate than the approach as a basis for appraisal. The sales comparison
approach would also be less suitable as the property is restively unique.

4. B. DCF valuation based on a required return of 9.5% is:

NOI Present Value
Year 1 $1,706,500 $1,558,447.49
Year 2 $1,774,760 $1,480,169.30
Year 3 $1,845,750 $1,405,822.60
Year 4 $1,919,580 $1,335,210.50
Year 5 $1,996,364 $1,268,145.64
Terminal value $27,150,550 $17,246,780.74
Property #1 value $24,294,576.27
Selected Calculation:
Terminal value is computed by applying the terminal cap rate to NOI in year 6. To estimate
NOI for year 6, we need a growth rate estimate. We are not given the growth rate directly, but
given the discount rate of 9.5% and the terminal cap rate of 7.5%, we can estimate the growth
rate to be 2%.
NOI 2 (1  g )
TV5 
Ct
$1,996,364(1  0.02)
= = $27,150,550.40
0.075
Note: Make sure that you use the uneven cash flow function to compute NPV using your
financial calculator.

103
5. A. The maximum loan amount will typically be based on the lower of loan-to-value (LTV) or
debtservice coverage ratio. Based on LTV of 70%, ALIC would be willing to loan $21 million
($30 million × 0.70). Based on a debt service coverage ratio of 1.5x, ALIC will loan just under
$20.7 million. ALIC will be willing to loan only an amount equal to the lower of these two
measures.
The calculation for maximum debt service based on a minimum debt service coverage ratio of
1.5x is:
NOI1
Maximum debt service =
DSCR
$ , ,
= = $1,137,666.67
.
Maximum debt service on an interest-only loan can be used to calculate the maximum loan
amount:
Maximum loan =
$ , , .
= = $20,684,848.48
.

6. B. AIP should earn a higher return on equity by financing part of its purchase price with a
mortgagebecause the cost of mortgage funds (5.5%) is less than the required return on equity
(9.5%). Including the mortgage funding in a weighted-average cost of capital (WACC) will
income the value over the purchase price required if only equity funding is used.

104