Reference no: EM131667049

Business Finance

Background information

As a management trainee in a renowned consultancy firm, you have been approached by a client regarding the valuation of an investment property in Albany, North Shore City, Auckland.

The client was recently contacted by a real estate agent who told him about a "rare" investment opportunity. This is one of 15 properties in a student hostel near Massey University's Albany campus. The apartments, constructed in 2010, are rented to students and seasonal workers. There is a body corporate and an on-site property manager looking after the operations, including the renting, cleaning and maintenance of the apartments.

The freehold apartment for sale is currently occupied by the on-site property manager, who has been in that job for about 7 years. The rent is paid by the body corporate (out of body corporate levies). There is a special lease agreement which requires, amongst other things, that this particular apartment can only be rented to the on-site property manager. Any buyers/owners of this apartment will be bound by this agreement.

The rent is reviewed every year, and any rent adjustment will be pegged to the inflation rate (CPI) in New Zealand. The current gross rent is 550 NZ dollars per week, for 52 weeks a year, payable in advance at the beginning of the week. The new rental review will be in one year. One good thing about this apartment, says the agent, is that there is almost no risk that the unit will be vacant any time, since the on-site manager must live in it.

The body corporate levy is currently 7300 NZ dollars per year, payable at year-end. Auckland Council rates are about 2500 NZ dollars per year (assume this too is payable at year-end). Being part of an apartment complex, the rules governing the value of the land are just too complicated for the agent to explain to the client (legal advice is recommended), but the real estate agent says (and the client agrees) that for all practical purposes, one should consider this as an investment property that will always be rented out, so the land value should not matter much, at least for the current purpose.

The client requires a return of 8% per year on this investment. His tax consultant says that some expense (e.g., depreciation on the chattels) are tax deductible for investment properties, but since the amount of money involved is relatively small, the tax deductions are probably negligible for the purpose of valuation. The client says he pays a marginal tax rate of 33% on any personal incomes.

In order to value the property, you know that you should value it on the basis of the net cash flows it can generate throughout its useful life. After some initial research, you find that a property in NZ can last up to 100 years, and, upon demolishing and rebuilding, can continue generating income almost indefinitely. The cost of demolishing and reconstructing an apartment of this type and size is NZ$ 200,000. This cost is expected to increase with inflation.

Task: Write a report addressed to the client. The written report should address the following questions (not necessarily in the same order).

1. Tell the client about the principles of valuation as you will apply them to this property (or any other asset). Be succinct and to the point.

2. Based on the information currently available, and by making and stating any necessary assumptions, calculate the value of this property. Clearly explain and justify the key inputs, and show your steps

3. Summarize your recommendation to the client regarding the value of the property.

Your report should demonstrate a correct understanding of finance concepts, a good grasp of the relevant issues, and critical/logical thinking. The report should be well structured and clearly written.