I need help with quaetion 1 and 2. Case Study below

1. What are the evaluation criteria results in scenarios A, B, and C?

2. What are your retirement income recommendations for Matt and Rosie? What are alternative options, if any?

The Rental Opportunity and Current Portfolio

Matt and Rosie are an affluent retired couple who missed two opportunities to invest in a second home as an investment and rental property. The first missed opportunity was a beach condo in Fiji that cost USD 10,000 in 1990. Today the condo is worth USD 2 million. The second missed opportunity was a beach condo in Mexico that cost USD 50,000 in 2000. Today the condo is worth USD 1 million.

Matt and Rosie believe the Airbnb trend will continue as long as travel rebounds from the recent COVID-19 pandemic. Matt found a newly renovated condo complex in Hawaii, built in 1990, with the prices ranging between USD 500,000 and USD 700,000, depending on the square footage. The maintenance cost is USD 500 to USD 700 per month. Matt believes a second home will appreciate in value and that the short-term rental income will supplement their retirement income.

Matt has held 3,604 shares of PepsiCo Inc (NASDAQ: PEP) in his investment portfolio since 2000. The cost basis for PEP is USD 41.47 per share. PEP is 26% of Matts investment portfolio. Matt would prefer not to take out any loans to invest in the condo in Hawaii. Rosie recently inherited USD 300,000, and Matt would like to use the inheritance and the sale of PEP shares to finance the purchase. Matt estimates that the net cash flow from this short-term rental will be USD 500 per month.

Matt and Rosies portfolio comprises 26% of PEP, 18% in cash (includes the inherent cash), and 56% in other stocks. Based on their recent risk tolerance answers, the recommended allocation is a balanced portfolio with: 54% stock, 42% bonds, and 4% cash. The associated benchmark index is as follows:

Cash: Ibbotson U.S. 30-day Treasury Bills.

Bond: Ibbotson Intermediate-Term Government Bonds Total Return.

Stock: S&P 500 Total Return.

The Three Stages of a CAPEX Evaluation

To evaluate a performance analysis of a dividend stock like PEP, a qualified financial planner can use the annualized return to compare with benchmarks, such as S&P 500. However, an unbiased evaluation using CAPEX can help businesses and investors avoid emotional financial decisions or behaviors when evaluating short-term rental property investment. Businesses often use CAPEX to assess if one should buy, upgrade, or renovate projects that have a long, useful life (more than one year), such as a real estate building, machine, tools, or software. For retirees in particular, taking the emotion out of investment decisions could help mitigate unrecoverable retirement resource risks later in life. For Matt and Rosie, an unbiased evaluation will assist them in determining if short-term rental property investment can meet their retirement goals.

The process of evaluating a CAPEX project has three stages. The first stage is to forecast five to ten years of net cash flow from the CAPEX project. The second stage is using the annual net cash flow to evaluate selected criteria. The third stage is to perform scenarios analysis. The results allow the investors to have unbiased expected return comparisons with different types of investment such as short-term rental property investment.

Stage 1: Forecast Five to Ten Years of Net Cash Flow From CAPEX Project

Forecasting five to ten years of the net cash flow involves three steps:

Determine the initial cash outlay.

Determine the operational net cash flow.

Determine the terminal value of the investment

Determine Initial Cash Outlay

The initial cash outlay is equal to the costs associated with up-front expenses necessary to make the short-term rental operational. The costs may include the propertys purchase price, real estate closing costs, possible renovation or upgrade of the property, initial marketing costs, and/or working capital. The initial cash outlay is denoted as year 0 in Table 1 on Excel 1. Matt and Rosie agreed to use USD 500,000 as the purchase price to assess the short-term rental property investment viability.

Determine the 10-Year Operational Net Cash Flow

Tangle assets that have more than one year useful life use a depreciation table to deduct the expenses. Most residential rental property tends to depreciate over 27.5 years (IRS, 2020). However, investors may not hold the property for perpetuity. For the evaluation, 10 years of the operational cash flow will suffice. The operational net cash flow line items are included in Table 1, which takes into consideration the costs of vacancy and management fees to determine the net revenue. Depreciation (straight line or double-declining method), interest expenses, and income taxes are subtracted from the net revenue to arrive at net income. However, the net income does not represent the real cash movement. Therefore, principal payments must be subtracted while non-cash items, such as depreciation, determine net cash flow from the project for one year.

The costs in vacancy (when the property is not being rented) and the property management fee are two major expenses or reductions from the potential revenue of short-term rental income. Both the vacancy rate and management fee fluctuate based on the local rental activities. In 2018, the size of the vacation rental market in Hawaii was estimated at USD 1.4 billion (HTA, 2020b). From this same report, the ADR for a vacation rental was listed at USD 262 per night compared with a USD 278 ADR for a hotel during the same timeframe. This less expensive rate, coupled with travelers trending preference for vacation rental properties, will only lead to an increased demand for the rental properties.

Besides considering ADR collected from renters, one must consider the occupancy percentage. For a single property rented by only one party, the occupancy percentage is calculated by dividing the number of nights in a time period that were rented by the total number of nights in the same time period in the geographic area. Hawaii has historically had higher hotel occupancy rates versus mainland United States. In 2019, the hotel occupancy rate for Hawaii was 81.2% (HTA 2020a) compared with a national U.S. occupancy rate of 66.2% (STR, 2020). Only New York City and San Francisco maintained a higher occupancy rate in 2019.

For absentee owners, full-service property management companies are contracted to rent the property, communicate with guests, and maintain and clean the property. While the structure of these firms fees to the owners may vary, most common property management costs range from 20% to 40% of the monthly rental revenue (iGMS, 2020). According to rented.com (2021), the average maintenance fee in the United States is 28%, but may be slightly higher in beach and mountainous locations. The effectiveness of the property management company to advertise the rental and optimize rental pricing and occupancy is also important. In AirDNAs listing of top property management companies, occupancy ranged between 54% to 70%, and ADR ranged from USD 277 to USD 738 (AirDNA, 2021).

Tax liabilities for the CAPEX project include local property taxes and federal and state entity income taxes. The property tax at the local level involves a commercial real estate rental concept of triple net lease (TNN), where the tenant is responsible for real estate property tax, property insurance, and maintenance. To simplify the CAPEX process, authors assume the short-term rental investment will mimic the TNN concept. Hence the property tax, insurance, and maintenance are part of the revenue (are included in the costs charged to the tenant) that the tenant pays. For the federal and state entity income tax, the authors are using 21% tax percentage, which is current at the time of this writing, plus the Hawaii state entity income tax at 6.4% for a total of 27.4%.

Recommendation on Short-term Rental Investment Opportunity

Table 4 is a template for comparing scenarios A, B, and C. You may use this template to present side-by-side scenario comparisons for Matt and Rosie to easily compare which scenario will best meet their retirement income goal of USD 500 per month. Use the preceding instructions to calculate the expected retirement income.

Table 4. Scenario Comparisons (USD)
	Scenario A	Scenario B	Scenario C
Short-term rental investment	Yes	Yes	No
Funding 1) cash	300,000	300,000	300,000
Funding 2) sell PEP	200,000	n/a	n/a
Funding 3) 30-year mortgage	n/a	200,000	n/a
Evaluation criteria & expected retirement income (or net cash)