Question

A Lusaka Businessman is considering a real estate investment so as to take advantage of the ever-rising demand for student accommodation in the City. A six-roomed house, strategically located between University of Lusaka and University of Zambia, is on the market.

He is likely to get it at K200,000 in addition to a further K50,000 that will immediately be spent on modifications to the kitchen, livingroom, and toilets to accommodate the additional usage. Under the most likely scenario, the remaining four rooms will each accommodate two bed spaces. Each bed space will yield K500 per month after recovering all expenses.

Assuming full occupancy throughout the year and a growth rate in line with GDP growth of 4% per year in property values and an inflation annual adjustment of 6% in net rentals:

a) Calculate the expected annual returns for each year over a five year holding period.

b) What is the annual average return over the holding period?

c) What is the investment’s average annual compound return?

d) Comment on the relationship of (B) and (C).

e) Calculate the investment’s volatility over the period.

Answer 1

a) Year 1

Initial Investment: 200,000+50,000=250,000

Rental Income from Bed Space every year: 500*4*12=24,000

Year 1 Return on Investment: 24,000/250,000=0.096=9.6%

Year 2

Value of Property after taking into account 4% growth in GDP=250,000*1.04=260,000

Rental Income after taking into account inflation of 6%=24,000*1.06= 25,440

Year 2 Return on Investment: 25,440/260,000=0.0978=9.78%

Year 3

Value of Property after taking into account 4% growth in GDP=260,000*1.04= 270,400.00

Rental Income after taking into account inflation of 6%=25,440*1.06= 26,966.4

Year 3 Return on Investment: 26,966.4/270,400.00=9.97%

Year 4

Value of Property after taking into account 4% growth in GDP=270,400*1.04= 281,216.00

Rental Income after taking into account inflation of 6%=26,966.4*1.06= 28,584.38

Year 3 Return on Investment: 28,584.38/281,216.00=10.16%

Year 5

Value of Property after taking into account 4% growth in GDP=281,216.00*1.04= 292,464.64

Rental Income after taking into account inflation of 6%=28,584.38*1.06= 30,299.45

Year 3 Return on Investment: 30,299.45/292,464.64=10.36%

b) Therefore, average annual return over holding period

9.6+9.78+9.97+10.16+10.36/5=9.976%

c) Average annual compound return:

(1.0976*1.0978*1.0997*1.1016*1.036)^1/5-1=9.975%