Final Exam FRL 3062-01: Fundamentals of Real Estate
Please answer the questions below and submit them on Canvas to the assignment created for this midterm exam. Remember to submit your full Excel spreadsheet so that I can see your calculations for each answer to give you partial credit.
You want to become a successful multifamily housing developer. Your plan is to start small and grow the business over time. You’re looking for a small multifamily property that you can buy, manage, and someday redevelop into a bigger property. You spot this five-unit property on the market at 1288 San Gabriel Blvd in San Gabriel, CA:
This building was constructed in 1949. It has 12 beds, 9 baths, 4,900 SF, and a lot of 0.37 acres. The seller is offering it for $1.98 million. To determine whether this is a good deal, you want to build a detailed financial model. You make the following assumptions:
- The average monthly rent for the building will be $2,300 in year 1, and it will grow 3% per year.
- Property prices in this neighborhood will grow 3.5% per year.
- Based on this information, what direction will cap rates move in? Is this a reasonable assumption? Where are we “in the cycle” right now? Do you agree with this forecast?
You also make the following assumptions:
- The current market is a little weak. You plan to offer every tenant a free month of rent to keep them loyal in year 1, but you don’t plan to renew this offer in year 2 and beyond.
- Every year, with the turnover in the market, you assume one unit will be vacant for half a year. When that vacancy appears every year, you’ll have to pay 5% of NOI to your leasing broker to fill it.
- You have an operating expense ratio of 45%, but tenants pay for utilities, which cost 20% of EGI.
- It’s an old property. You see a lot of deferred maintenance. You plan to set aside 30% of NOI every year for renovations.
- You plan to hold the building for six years, at which point you’ll sell it and pay 2% in selling expenses.
- You expect this type of investment to earn an 8% annual return.
- Using the PBTCFs and the advertised purchase price…
- …what is the property value?
- …what is the NPV?
- …what is the IRR?
- Based on this information, is it a good deal? Should you buy the property?
You show your calculations to your mentor in the industry, and he says you’re making a mistake.
You can make more money by continuing to defer maintenance. He says your tenants will thank you because the units will be cheaper. He advises you to do the bare minimum and let the building deteriorate. We’ll call this “Option A.”
- Please copy-and-paste your model onto a second tab and change the assumptions to see whether this approach will improve your investment. Following your mentor’s advice, reduce the renovations to 5% of NOI, the operating expense ratio to 35%, and the rental growth to 2.5% per year.
- How does this change your property value, your NPV, and your IRR?
- Do you think this strategy is ethical? Would you follow your mentor’s advice? Why or why not?
Let’s consider one more scenario. We’ll call this “Option B.” Your long-term goal is to redevelop this property into a bigger, more profitable building. Please copy-and-paste your original financial
model from question #3 onto a third tab and change the assumptions for this scenario:
- You get a 15-year, IO loan with a 6.3% interest rate. You convince the lender to give you
80% LTV so that you can purchase and redevelop the property.
- In year 1, you kick out all your tenants for construction to proceed. You then spend 75% of
the purchase price to double the size of the building. You now have 10 units. For the
remaining years, your vacancy rate stays the same as what you calculated previously.
- Because the building is newer, you won’t need to spend as much on maintenance or
renovations. The operating expense ratio drops to 35%, and the renovations are 10% of
NOI.
- This beautiful new building commands higher rents. Instead of growing 3%, the rent jumps
30% in year 2, and then it grows 3% every year after that.
- Your CAGR isn’t useful anymore because the building has changed so much. So, when you
resell the property, you have to revalue it with a cap rate. I’m not going to give you a cap
rate. I want you to make your own assumption.
- Using these new assumptions…
- …what is the NPV for your equity investment?
- …what is the levered IRR?
- What terminal cap rate did you assume? Why did you pick that number?
- Comparing this approach to your previous approach, would you prefer the first investment strategy or the second investment strategy? Do you have enough information with just these numbers to make the decision?
Extra Credit: Do you think the lender got a good deal? Put yourself in their shoes. Would you have made the same offer? Would you have changed any of the terms? Based on what’s happening in the commercial lending market right now, do you foresee any risks that concern you? What underwriting metrics would you use? Can you calculate any of them with the information above?
If so, do they change your opinion of the deal?