Reference no: EM132964254

Background Information

• It's 2008, the real estate market in the United States, amongst others, has recently severely crashed. The U.S. is in the midst of the worst recession since Black Tuesday marked the beginning of the ten-year Great Depression of 1929. There are millions of housing foreclosures all across the U.S. and real estate prices have dropped over 25% according to the Case-Shiller 10-City Composite Home Price Index; significantly more in some markets.
• In 2005, William Pierce (WP) began working as a real estate agent for a neighborhood real estate brokerage, Home Realty, that specialized in selling foreclosure properties for banks. Prior to the Great Recession, Home Realty typically listed a dozen or so foreclosure properties but thereafter would list anywhere from 100-150 foreclosure properties for several years after 2007. Given his experience with foreclosures and the depressed home values, WP decided that it would be a prudent decision to acquire an investment property that was in distressed condition, repair it, rent out the property, and sell once the real estate market improved.

The Market, Neighborhood, and Property

• Kalamazoo, Texas, the location of the investment property, is consistently ranked in US News's Best Places to live. It has a strong economy including 19 companies that are listed in the Fortune 500. Three of its universities are ranked in the top 100 of Forbes America's Top Colleges list. In a nutshell, you can assume that under normal economic conditions, Kalamazoo has a relatively strong economy and is a good market to invest in.
• WP was very familiar with the neighborhoods of Kalamazoo and explored many investment opportunities, more heavily weighing location, quality of construction, price, and rehabilitation costs, in selecting an investment property. After months of searching, he identified a property located at 1234 Kangaroo Ave, Kalamazoo, TX 12345.
• The property was well-located geographically. It was walking distance to and immediately southeast of downtown Kalamazoo, a 5-minute drive to the University of Texas which had a student population of over thirty-thousand, was in close proximity to other local colleges, the local professional football stadium, and a 10-minute drive to the high-income and trendy Uptown area. The problem was that it stood at the edge of a transitioning neighborhood called Saw Mill Village, known as a low-income area with a higher than usual level of non-violent crimes and immediately adjacent to the high-crime Prontopup neighborhood. Notably, there was some local commercial development across the street that seemed to improve the quality of the neighborhood.

The Opportunity

• 1234 Kangaroo Ave was a bank-owned 4-plex with two 1-bedroom units, one 2-bedroom unit, and one 3-bedroom unit that was for sale with an asking price of $165,000. WP estimated that an additional $60,000 would need to be set-aside for renovating the property into rentable condition with low-quality materials and finishes. Alternatively, WP contemplated redeveloping the units using much higher-quality materials and finishes that would cost $140,000; that he thought would result in higher rents and sale price when the market picked-up. Rents in the neighborhood ranged from $700-1,000 for 1-bedrooms, from $850-1100 for 2-bedrooms, and from $1000-1400 for 3-bedroom apartments; depending on the quality of the units. You should estimate a vacancy rate of either 5% or 10% and a sale price (in 10 years) of either $300,000 or $420,000 depending on quality of repairs.
• Property expenses included electricity for which the bill was $80/month/unit, the property had one gas meter for all four units and the average gas bill was $450/month, and the shared water/sewer/trash bill was $350/month for the 4-plex. In its current condition, you can estimate maintenance expense to be 10% (maybe more) of the gross rent due to the old age of the property, an insurance payment of $300/month for the property, property taxes of $299/month, and a management fee of 10% of gross rents. WP felt that he may be able to manage the property himself and save on the property management fee; you decide whether or not he should hire a property management company or not and discuss the reasoning behind your choice

Financing Considerations

Financing was much more difficult to obtain after the recession hit, but after talking with several lenders to explore financing options, he found two commercial lenders willing to provide a loan. The first lender was willing to provide a 70% loan-to-value (LTV) loan, amortized over 20 years, carrying a 6.8% interest rate, with a 5-year balloon payment. The second lender would provide an 80% LTV loan, amortized over 30 years, carrying an 8% interest rate, with a 10-year balloon payment. Both lenders would charge a 1% for loan origination and closing costs. You will need to decide which lender you recommend getting the loan from and discuss the reasons for your choice.

Valuation & Recommendation

• You are on William's real estate team and he has asked for you to build a valuation model, conduct an analysis, and make a recommendation of whether or not he should buy the 4-plex. Accordingly, you should develop a pro forma valuation model that clearly delineates revenues, vacancy rates, expenses, and financing considerations. WP expects his holding period for the investment will be 10 years; at which time he will sell the property.
• For the analysis, students should develop a pro forma valuation model that calculates Net Operating Income (NOI) and Free Cash Flow (FCF) over a 10-year horizon. Students should calculate the NPV, IRR, ROI, Cash-on-Cash return (equivalent to ROE), and going-in and exit cap rates.

Problem 1: Develop an Amortization table utilizing the information from above