Your financial advisor just recommended you acquire and hold a real estate property for a period of
Question:
Your financial advisor just recommended you acquire and hold a real estate property for a period of 5 years.You wish to calculate the profitability and your rate of return on your equity investment before acquiring the asset, by modelling the future free cash flows and the net present value of this investment.
Main facts and assumptions:
1.The expected annual inflation rate is 1.5%.
2.The expected annual rent (including inflation) increases by 3% every year.
3.The building will require about $200,000 in structural improvements in year 3.
4.A concierge will be hired part time to manage the building. His annual salary will be $20,000 for year 1 to 3, and $25,000 for years 4 and 5.
5.All invoices receivable and payable will be paid at the time of their receipt (i.e., no change in working capital).
6.The applicable personal tax rate is 40% (note that only 50% of capital gains are taxable).
7.You will be able to borrow from the bank 80% of the acquisition price (excluding legal costs and land transfer tax). The expected annual rate of interest on the debt will be 4% and the term of the mortgage will be 25 years with an option to repay the balance at year 5 (which you will exercise given your proceeds of disposition).
8.Your equity cost of capital is 10%.
9.The expected exit price will be equal to 1.2 time the initial acquisition price.
10.The vacancy rate will be nil for all 5 years.
Requirements
Step 1: Select an actual residential or commercial real property that is on the market right now on Centris (www.centris.ca) or on the website of a real estate broker. Print a PDF of the appropriate listing. Please use the data provided in the listing (e.g. utilities expenses, real property taxes, broker fees).
Step 2: Build a financial model presenting the free cash flows ("FCF") available to equity holders on an annual basis, generated from the project over the holding period of 5 years (including the net cash flows from operations and the proceeds of disposition). Further compute the annual rate of return on your investment and net present value.
Important: Please insert the following inputs on top of your model: annual rent, long term debt ratio and exit price. Your model and computations should adjust automatically in the event of a change in these inputs. This will be required to perform the sensitivity analysis (see step 3).
Step 3: Prepare a table presenting a sensitivity analysis on the net present value and equity rate of return in respect of the following inputs:
-Rent/month: 0.75X, 1.0X, 1.5X
-Long term debt ratio:20%, 40%, 60%
-Proceeds of disposition in year 5: 0.5X, 1.5X, 2.0X
Step 4: List your mains assumptions (other than those listed above) and explain your findings/recommendations to your financial advisor in a Word document of 750 - 1,250 words (maximum 2 pages). Feel free to add any comment that you may deem relevant in that context.
Income Tax Fundamentals 2013
ISBN: 9781285586618
31st Edition
Authors: Gerald E. Whittenburg, Martha Altus Buller, Steven L Gill