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A piece of land can be purchased today for $200,000. If the investor can lease the...

A piece of land can be purchased today for $200,000. If the investor can lease the land as a hunting preserve for annual rent that will pay all real estate taxes and insurance, should the investor take out a $160,000 loan at 12% to purchase the land? The investor predicts that she can sell the land in ten years for triple the purchase price, at which time she will have to pay off the principal and interest ($496,936) on the loan. Is this a favorable spread?

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Answer #1

In order to find out if the described process is a favourable spread or not one need to do a NPV (Net Present Value) analysis.

Purchase Price today = $ 200000

Amount borrowed today = $ 160000

Owner's Expense = 200000 - 160000 = $ 40000

Inetrest Rate =12 %

Principal + Interest Repaid after 10 years = $ 496936

Therefore, PV of the Loan Repayment = 496936 / (1.12)^(10) = $ 160000

Total Expense = PV of Loan Repayment + Owner's Expense = 160000 + 40000 = $ 200000

Sale Price after 10 years = 3 x Purchase Price = 3 x 200000 = $ 600000

PV of Sale Price = 600000 / (1.12)^(10) = $ 193183.942

NPV = PV of Sale Price - Total Expense = 193183.942 - 200000 = $ - 6816.058

As NPV is negative, it is not a favourable spread.

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