10 Part A - Unlevered 11 1401 Mineral Road is a two-story, three-unit building in a...

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10 Part A - Unlevered 11 1401 Mineral Road is a two-story, three-unit building in a desirable urban neighborhood near a large university campus that you are entertaining purchasing and holding as a long-term investment. It is currently listed for $390,000 or $130,000 per unit. The first floor contains a 2BR/1BA unit rented for $1,450 per month. The second floor contains two 1BR/1BA units. The front unit has a private balcony and is rented for $1,150 per month, and the other unit is rented for $1,100 per month. The seller's representative provided you with historical income data suggesting that the seller has collected about $35 per month from each tenant in the form of late fees, pet fees, and laundry income. The property also has a detached garage accessible from the alley that one of the tenants currently rents for an additional $50 per month. A local property manager you met at the wedding of a mutual friend who manages several buildings in this neighborhood told you that the rentals rates at the building appear reasonable and that vacancy rates have historically hovered around 5.00% with some seasonable variability around the beginning and end of the fall semester. Historically, rents have increased by about 5% per year, while other income tends to remain flat, increasing maybe 1% per year. As a back-of-the-envelope measure, operating expenses in this market typically run at about 35% of effective gross income. 13 Part A - Questions 1 14 What is the EGI in year 1? 15 2 16 3 What effective gross income multiplier does this imply based on the list price for the property? What is the NOI in year 1? 17 4 What cap rate does that imply based on the list price for the property? 18 5 What is the gross income multiplier implied by the list price? Assuming you hold this investment for five years and you anticipate you can sell the property at a capitalization rate of 7.50% based on pro-forma income, how much do you expect to sell the 19 6 property for? 20 If closing costs are typically about 5% of the sale price for a seller, what are your expected net 7 proceeds from the sale at the end of year five? 12 21 22 24 Part A - Answers $43,947 8.87 $28,565 732.00% 8.43 $485,117 If your investment criteria dictate that the property needs to generate a target yield of 9.50% per 8 year, what is the maximum you could pay for this property while still meeting that objective? 9 Would you purchase this property at its current list price? What is your projected internal rate of return (IRR), assuming you purchase the property for its 10 list price? Part B - Levered As part of your due diligence, you connected with your loan officer. They can offer you a loan at a 5.75% interest rate, a 75% loan-to-value ratio, with monthly payments calculated based on a 25-year amortization period. You would also be expected to buy down 0.75 point(s) of the loan amount to secure that interest rate. Your broker also told you that you should budget an additional $5,500 for other closing costs. Part B-Questions $460,861 $300,689 No 732.00% 27 28 Part B-Answers 29 1 12 30 Considering the data above, how much cash should you budget to make this investment? What is your expected annual debt service payment? 31 3 What is your equity dividend rate in year 1? 32 4 What is your before-tax cash flow in year 3? 33 34 16 35 If your lender stipulated that you must maintain a debt coverage ratio of at least 1.25, is your 5 expected NOI in year 1 sufficient to maintain this? 17 36 B 37 38 39 40 41 At the end of five years, how much will you still owe on the mortgage? What is your effective cost of borrowing if you sell the property and pay off the loan at the end of year 5? Assuming that your investment criteria are such that you need to earn 12.00% on your equity investment, what is the leveraged net present value (NPV)? 9 What is the leveraged internal rate of return (IRR)? Suppose you decide not to sell your property and instead, refinance your loan balance at the end of year 5. Could you maintain your lender's debt coverage ratio of 1.25 in year 6 if interest rates 10 increase by 300 basis points, all other terms being equal? Part C - After-Tax During a routine discussion, you learned from your accountant that any income earned from investments outside your retirement accounts would be taxed at 35%, barring any significant financial changes. A portion of the taxes owed for the annual income generated from this property can be deferred through the depreciation of the improvements. The points paid to the lender to secure your loan can also be amortized and deducted from your income. It is also important to remember that mortgage interest is also tax deductible. Your accountant explained that when you sell the property at the end of the five-year holding period, you should budget for a depreciation recapture tax rate of 25% and that any capital gains earned from the sale of the property will be taxed at 20%. A quick review of the public records revealed that the building is currently assessed for $390,000, of which the city allocated $331,500 to the improvements. The remainder is allocated to the underlying land. Part C-Answers 42 43 Part C-Questions 44 11 How much will you pay in mortgage interest in year 1? 45 2 How much will you pay in mortgage interest in year 3? 46 3 What is your taxable income (or loss) in year 2? 47 4 What is your anticipated after-tax cash flow in year 2? 48 5 What is your after-tax equity dividend rate in year 1? 49 6 If you can only claim 11.5 months' worth of depreciation in your investment's first and last year, how much depreciation do you expect to claim over the holding period? 50 7 51 8 How much should you anticipate owing in depreciation recapture tax upon selling the property? What will your adjusted basis be upon selling the property? 52 9 Assuming that your investment criteria are such that you need to earn 12.00% on your equity investment, what is the leveraged, after-tax net present value (NPV)? 53 :10 What is the leveraged, after-tax internal rate of return (IRR)? 54 10 Part A - Unlevered 11 1401 Mineral Road is a two-story, three-unit building in a desirable urban neighborhood near a large university campus that you are entertaining purchasing and holding as a long-term investment. It is currently listed for $390,000 or $130,000 per unit. The first floor contains a 2BR/1BA unit rented for $1,450 per month. The second floor contains two 1BR/1BA units. The front unit has a private balcony and is rented for $1,150 per month, and the other unit is rented for $1,100 per month. The seller's representative provided you with historical income data suggesting that the seller has collected about $35 per month from each tenant in the form of late fees, pet fees, and laundry income. The property also has a detached garage accessible from the alley that one of the tenants currently rents for an additional $50 per month. A local property manager you met at the wedding of a mutual friend who manages several buildings in this neighborhood told you that the rentals rates at the building appear reasonable and that vacancy rates have historically hovered around 5.00% with some seasonable variability around the beginning and end of the fall semester. Historically, rents have increased by about 5% per year, while other income tends to remain flat, increasing maybe 1% per year. As a back-of-the-envelope measure, operating expenses in this market typically run at about 35% of effective gross income. 13 Part A - Questions 1 14 What is the EGI in year 1? 15 2 16 3 What effective gross income multiplier does this imply based on the list price for the property? What is the NOI in year 1? 17 4 What cap rate does that imply based on the list price for the property? 18 5 What is the gross income multiplier implied by the list price? Assuming you hold this investment for five years and you anticipate you can sell the property at a capitalization rate of 7.50% based on pro-forma income, how much do you expect to sell the 19 6 property for? 20 If closing costs are typically about 5% of the sale price for a seller, what are your expected net 7 proceeds from the sale at the end of year five? 12 21 22 24 Part A - Answers $43,947 8.87 $28,565 732.00% 8.43 $485,117 If your investment criteria dictate that the property needs to generate a target yield of 9.50% per 8 year, what is the maximum you could pay for this property while still meeting that objective? 9 Would you purchase this property at its current list price? What is your projected internal rate of return (IRR), assuming you purchase the property for its 10 list price? Part B - Levered As part of your due diligence, you connected with your loan officer. They can offer you a loan at a 5.75% interest rate, a 75% loan-to-value ratio, with monthly payments calculated based on a 25-year amortization period. You would also be expected to buy down 0.75 point(s) of the loan amount to secure that interest rate. Your broker also told you that you should budget an additional $5,500 for other closing costs. Part B-Questions $460,861 $300,689 No 732.00% 27 28 Part B-Answers 29 1 12 30 Considering the data above, how much cash should you budget to make this investment? What is your expected annual debt service payment? 31 3 What is your equity dividend rate in year 1? 32 4 What is your before-tax cash flow in year 3? 33 34 16 35 If your lender stipulated that you must maintain a debt coverage ratio of at least 1.25, is your 5 expected NOI in year 1 sufficient to maintain this? 17 36 B 37 38 39 40 41 At the end of five years, how much will you still owe on the mortgage? What is your effective cost of borrowing if you sell the property and pay off the loan at the end of year 5? Assuming that your investment criteria are such that you need to earn 12.00% on your equity investment, what is the leveraged net present value (NPV)? 9 What is the leveraged internal rate of return (IRR)? Suppose you decide not to sell your property and instead, refinance your loan balance at the end of year 5. Could you maintain your lender's debt coverage ratio of 1.25 in year 6 if interest rates 10 increase by 300 basis points, all other terms being equal? Part C - After-Tax During a routine discussion, you learned from your accountant that any income earned from investments outside your retirement accounts would be taxed at 35%, barring any significant financial changes. A portion of the taxes owed for the annual income generated from this property can be deferred through the depreciation of the improvements. The points paid to the lender to secure your loan can also be amortized and deducted from your income. It is also important to remember that mortgage interest is also tax deductible. Your accountant explained that when you sell the property at the end of the five-year holding period, you should budget for a depreciation recapture tax rate of 25% and that any capital gains earned from the sale of the property will be taxed at 20%. A quick review of the public records revealed that the building is currently assessed for $390,000, of which the city allocated $331,500 to the improvements. The remainder is allocated to the underlying land. Part C-Answers 42 43 Part C-Questions 44 11 How much will you pay in mortgage interest in year 1? 45 2 How much will you pay in mortgage interest in year 3? 46 3 What is your taxable income (or loss) in year 2? 47 4 What is your anticipated after-tax cash flow in year 2? 48 5 What is your after-tax equity dividend rate in year 1? 49 6 If you can only claim 11.5 months' worth of depreciation in your investment's first and last year, how much depreciation do you expect to claim over the holding period? 50 7 51 8 How much should you anticipate owing in depreciation recapture tax upon selling the property? What will your adjusted basis be upon selling the property? 52 9 Assuming that your investment criteria are such that you need to earn 12.00% on your equity investment, what is the leveraged, after-tax net present value (NPV)? 53 :10 What is the leveraged, after-tax internal rate of return (IRR)? 54