Required investment returns and bid prices

Assignment Help Financial Management

Reference no: EM132031813

Rowe House is a newly-constructed 100-unit mixed income apartment complex. Upon full lease-up, 80 of the units will be rented at average market rents of $1,500 per month and the remaining 20 affordable units will be rented at average low-income rents of $500 per month. The initial lease-up should be completed by the closing of the acquisition.

In exchange for contracting with his management subsidiary to manage the property for a market-based management fee, the developer has personally guaranteed that the property will generate annual effective gross income of at least $1,500,000 during the first two years of operations. The long-run average vacancy rate for market-rate units in the submarket in which the property is located has been about 6%; for affordable units, the long-run average vacancy rate has been about 2%.

According to N.P. Venter, rental rates on the 80 market-rate units can be expected to increase by about 2% per year, while rental rates on the 20 affordable units can be expected to increase by only about half as much. Annual operating expenses1 and property taxes are budgeted at $4,500 per unit per year and can be expected to increase by about 3% per year. The standard tenant lease is for one year and does not permit the landlord to pass through increases in operating expenses or property taxes.

Due Diligence

Before laying out the relevant cash flows to analyze, Duna Wright took a moment to consider some of the broader assumptions he would use to generate such cash flows. Specifically, he assumed that:

• Investment decisions would generally be made on the basis of 10-year discounted cash flow analyses;

• In recognition of the high degree of uncertainty associated with forecasting future asset values, estimates of future sales prices would be based on eleventh year projected net operating incomes capitalized at a rates consistent with currently applicable discount rates minus the projected compound average annual change in property before-tax cash flow over the 10-year holding period;

• Costs of sale would be 2% of the estimated future sales prices;

• Projected annual capital (replacement) reserve funding would be expended on eachproperty in the year funded; and

• Due diligence and legal fees paid to third-parties would be approximately $100,000if Ottathe Money Managers were selected as the preferred buyer (i.e., “awarded”the deal)

Required Investment Returns and Bid Prices

Venter had earlier instructed Duna to establish appropriate bid prices for each property using unlevered pre-tax cash flows in conjunction with pre-tax discount rates that were consistent with the expected total returns for unlevered fully-leased institutional quality properties. That was a big help, thought Duna. Duna knew, however, that prevailing market capitalization rates 2 in the institutional property markets were in the 6% to 8% range, and that realistic growth expectations for operating cash flows and asset values were typically about 1% or so less than the expected rate of inflation. Duna also knew that the current yield on the 10-year U.S. Treasury Note was about 4.75% and the yield on the 10-year U.S. Inflation-Indexed Treasury Note was about 2.25%, which indicated to him that the U.S. debt markets expected an average annual rate of inflation of around 2.5% over the next ten years.

Duna understood that both the projected investment returns and bid prices applicable to each property would need to be presented in a summary matrix as part of a summary investment memorandum, which was not to exceed 4 pages of text. Included in the summary memorandum would be a discussion of (i) the projected annual net cash flows associated with investing in such properties, (ii) the proposed bid for the projects and corresponding projected investment performance (iii) any specific risk factors or other issues worthy of mention. Supporting financial analyses would be attached as exhibits.

FOOTNOTES

1. Consistent with multi-family industry practice, such operating expenses include Wheeler’s estimate of required annual replacement reserve funding of $300 per unit per year (escalated at 3% per annum) as an expense in calculating Net Operating Income.

2. Based on the first year’s projected net operating income.

Reference no: EM132031813

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