Question

Assume that the price of real estate is determined by P=PV(all cash flows generated by the

real estate). After you have graduated you work for some years and can save some money.

You decide to invest in a house which you want to rent out for a rate of 12,000 pound per

month. Assume that the rental rate will increase with 1.2% per year (which is 0.1% per

month). (For the sake of simplicity, also assume that there are no further costs involved e.g.

renovating or repair).

a) As the market risk of renting out the house is low, you think that a discount rate of 5.5%

(APR with monthly compounding) would be appropriate. What is the price of the house

under the assumption that the cash flows from rent will last forever?

b) If discount rate is 1% lower than 5.5% what is the price of the house?

c) You want to make the valuation of the house more realistic by assuming that the time

horizon for the valuation should be 50 years. Again, you assume that the house will generate

SEK 12,000 rental income per month for the next 50 years, and the rental income is assumed

to grow by 1.2% per year (or 0.1% per month). What is the value of the house with a discount

rate of 5.5% APR with monthly compounding?

d) Make the same assumptions as in (c) but assume a 1% lower discount rate. What is the

price of the house?