Question

The portfolio manager of a real estate investment trust (REIT) purchased 8 parcels of land for $1 mil each exactly one year ago. Recently, an appraiser values 4 of the parcels at $1.5 mil each and the other 4 at $700000 each. The fiscal year of the company is identical to the calendar year and you can ignore any income received from the properties and taxes.

a.                What are the company’s accounting earnings and economic earnings if the company sells all the properties that have risen in value and keep the others at the end of the year?

b.         Referring to the policy expressed in a. above, does it mean that the company will always show a gain on its real estate investment activities? Explain.

Answer 1

a. What are the company’s accounting earnings and economic earnings if the company sells all the properties that have risen in value and keep the others at the end of the year?

The company’s accounting earnings = the market value of the parcels of land sold - the original purchase price of the parcels of land sold

If the company sells all the properties that have risen in value therefor 4 out of 8 parcels will be sold

Therefore,

The company’s accounting earnings = 4 * $1.5 million – 4 * $1.0 million

= $6.0 million - $ 4.0 million

= $2 million

The company’s economic earnings = the market value of all the parcels of land - their original purchase price

Therefore the company’s economic earnings will be the increase in the market value of the parcel of land, whether sold or not.

Therefore,

The company’s economic earnings = (4 * $1.5 million + 4 * $70,000) – 8 * $1.0 million

= $8.8 million - $ 8.0 million

= $0.8 million or $80,000

b. Referring to the policy expressed in a. above, does it mean that the company will always show a gain on its real estate investment activities? Explain.

Referring to the policy expressed above, although the company is trying to show a gain on its real estate investment activities but only they can delay the process by this method. If the market value of a piece of land falls, the company is in loss either they are selling the land or not. The market price of the land is the expected future cash flows from that investment and maybe it’s not that lucrative for the parcel of lands for which market value is falling. Even if company holds that land, they will get lower income from that land.