GLENDALE APARTMENT BUILDING. A Case Study

Transcription

1 GLENDALE APARTMENT BUILDING A Case Study I. INTRODUCTION This case focuses on valuation and investor yield issues in the context of an income producing property: a three storey rental property with 24 residential units. The emphasis in this case is on the practical application of valuation techniques presented in earlier course work. In particular, the case will serve to assist students in developing skills with regard to discounted cash flow analysis, capitalization techniques and mortgage equity analysis. The case involves a rental building which may be listed for sale in the near future. The present owner wishes to establish the market value of his interest such that he will be in an approved position to assess the role of the property in his investment portfolio. In addition, although the property is not listed for sale, a potential purchaser is aware that the property may well be exposed to the market in the near future. This individual requires assistance in analyzing the property's investment value given assessment of future revenues, expenses, financing available, his personal tax position and his yield requirements. The first assignment, in a three assignment series, focuses on the preparation of an operating statement for the subject property, the development of a rational investment pro forma and the application of discounted cash flow techniques with the object of identifying the yield earned at a specified maximum bid price. Mortgage equity analysis is at the basis of the requirements for this assignment. Given an assumption of stable net operating income over a three year investment horizon, students are required to forecast annual before-tax flows and before-tax sale proceeds given three possible financing arrangements. Based on these data, the equity yield rate must be determined for each option and a recommendation as to the preferred financing alternative must be developed. Finally, given an investor specified minimum equity yield rate, the amount of capital appreciation over the holding period must be determined such that the investor earns his minimum desired rate of return on equity. The second assignment builds on the analysis developed in the first assignment. Here the major requirements include the incorporation of income tax implications in the determination of investment yield and value. In addition, the investor in question has stated his views as to present and future revenue and expense conditions and is again aware of three alternatives by which his (possible) purchase may be financed. This assignment requires a sound familiarity with regard to the development of investment pro formas and discounted cash flow analysis. In this vein, several variations of internal rate of return analysis, including "standard" internal rate of return, adjusted internal rate of return and financial management rate of return, are required. In both the first and second assignments, a knowledge of the precise implications of various financial structures is a prerequisite. Further, in the second assignment, an appreciation of income tax considerations (including capital cost allowance, recapture and income taxes on gains in value) is also required. Having identified, on the basis of discounted cash flow analysis, which financing alternative is most consistent with the investor's objectives, the second assignment concludes with an analysis to determine the necessary amount of capital appreciation to fully satisfy the investor's (after tax) yield requirements. This portion of the assignment requires the analyst to "work backwards" by first calculating the required after tax sale proceeds. Given this value, the required gross selling price is determined, accounting for income tax on recapture, income tax on the gain in value, discharge of the mortgage(s) in place and estimated closing costs. The third and final assignment requires a comprehensive analysis of the information available from several recent sales of apartment properties considered to be similar to the property presently listed for sale. In this assignment, students are required to create reconstructed operating statements and determine the capitalization 1

2 Appraisal and implied discount rates on the basis of these statements and the transaction price for each property. The necessary analysis is intended to lead to an improved understanding of the various inter-relationships that exist between anticipated yield on the one hand and cash flow and capital appreciation on the other. II. BACKGROUND INFORMATION This case focuses on issues related to the determination of the market and investment value of a rental apartment building named Glendale Apartments. This section provides background information which serves to place the analytical issues in a practical context by reviewing a variety of factors related to the principals involved, the property and the marketplace. Both the generalized housing market data and specific transaction data are hypothetical and are provided so that all students may work from the same information base. A. The Current Owner The property in question was acquired by the current owner, D. A. Cote, almost five years ago and is held in Mr. Cote's name in fee simple. At the time of purchase, Mr. Cote paid a total of $825, and financed the purchase be arranging for a five-year term wraparound mortgage funded by the vendor, Tenth Town Investments Ltd. The existing first mortgage, which had 96 months unexpired at the time, had an outstanding balance of $392,832.85, called for interest at the rate of 8% per annum, compounded semi-annually, not in advance, and specified constant monthly payments of $2, Given this most favourable set of mortgage terms (first mortgage rates were in the 10% to 11% range at the time), the parties agreed to finance the purchase in such a way that the (assumable) first mortgage was left in place. After several detailed sets of negotiations, the sale was finalized as follows: Total Price Paid $825, Assumption of Existing First 392, Net Proceeds from Vendor-Supplied Mortgage 232, Paid in Cash $200, The face value of the wraparound mortgage funded by Tenth Town was $625, and the parties agreed to a wraparound contract rate of 10.5% per annum, compounded semi-annually, not in advance. The wraparound mortgage provides for monthly payments, rounded to the next higher dollar, based on a 25 year amortization period and calls for a five year term. The full details of this second charge against title are presented in the Appendix to this case. For instance, Mr. Cote is unaware of the fact that the yield earned by Tenth Town Investments Ltd. on their (vendor) wraparound mortgage is slightly in excess of 14.75% per annum, compounded semi-annually, not in advance. At the time of the purchase and sale, the parties settled at an allocation to land and improvements of $300, and $525,000.00, respectively. In turn, the value of the improvements was allocated to two capital cost allowance classes: $55, in Class 8 and $470, in Class 3. These values have not been challenged by Revenue Canada Taxation and there is no reason to believe that they will be in the future. Mr. Cote has taken full advantage of the capital cost allowances available over his period of ownership although, given that the property is not a "tax shelter", he has only claimed capital cost allowance in conformance with standard rental rules. 2

3 The subject property is the only real estate investment held by Mr. Cote and it is thought that any increment in value will be afforded capital gains treatment should he sell. At present, he is evaluating his financial position and is contemplating selling the property. He has recently contacted Tera Real Estate Ltd., a firm specializing in investment property sales and is seriously considering their proposal to list the property for sale at $1,250, B. The Investor An investor, by the name of Richard Venot, known to be active in purchasing apartment properties in the area, has purchased several investment properties in the vicinity of the subject property and is convinced the area shows a high potential for capital appreciation. He has been in touch on a regular basis with a salesperson from Tera Real Estate Ltd. and is aware that the subject property may soon be put on the market. In considering the possible purchase, Mr. Venot wishes to ensure that he negotiates a price such that (given his estimates of revenue, expense, appreciation and the like) he earns not less than 15% before tax or 12% per annum as an after tax rate on any equity invested. Given that Mr. Venot has been active in the investment real estate market over the past ten years and that he has both purchased and sold numerous properties in recent years, there is little doubt that he will be required to treat any gains in value as income for the purposes of income tax liability. Mr. Venot is not "in the business" of renting nor is he involved in the day-to-day operations of the buildings he has purchased. C. The Subject Property: Legal, Physical and Financial Factors 1. Legal Characteristics Glendale Apartments, legally described as Lot 17 and 18, Block 123, District lot 177, Town of Metrotown, is held in fee simple by D. A. Cote, subject to a first mortgage in favour of the United Trust and Loan Company and a second (wraparound) mortgage in favour of Tenth Town Investments Limited. There are no other encumbrances on title. 2. Physical Characteristics The property is located mid-block at 150 West Newbury Avenue and has a site area of 14,000 square feet given the 100 by 140 foot site dimensions. The site is regular, has mature landscaping and is in conformance with the RM-3 zoning for the area and the general character of the neighbourhood. The specifics of the zoning by-law allow for a 55% site coverage ratio and a maximum 2.1 floor space ratio (F.S.R.). Given the details below, one can ascertain that the improvements conform to the existing zoning with an actual site coverage of 52.1% and an actual F.S.R. of The property, therefore, is within the basic zoning maximums and is considered to be the highest and best use. The improvements consist of a 30 year old, three storey with basement, wood-frame, rental apartment building. As is indicated in the rent roll, the structure has 24 rental units: 15 one-bedroom and 9 two-bedroom suites, ranging in size from 680 square feet to 880 square feet. Gross monthly rentals in the building are $455 to $500 for one-bedroom units and $600 to $645 for two-bedroom units. The basement level of the structure has a gross floor area of 7,300 square feet and accommodates 15 tenant parking stalls and 6 visitor stalls. In addition to the parking facilities and a communal storage area, the building's boiler and sprinkler room, electrical room and elevator lobby are located in the basement level. 3

4 Appraisal The main level has a gross building area of 7,350 square feet and contains a lobby area, seven one-bedroom units, a single two-bedroom unit and a laundry room. The net area of the main level is 5,800 square feet. The second floor of the building contains eight units: four one-bedroom and four two-bedroom units. The gross floor area of this level is 7,300 square feet and the net area is 6,290 square feet. The third floor of the building is very similar in layout to the second. This level also includes four one-bedroom and four two-bedroom units. The gross area is 7,000 square feet and the net area is 6,285 square feet. The total gross area of the building is 21,650 square feet; the net area is 18,375 square feet and, therefore, the building is 84.9% efficient. All suites have either a balcony or a ground level patio. Each suite has a living room, full bathroom, small storage area and a dining area. All kitchens are equipped with stainless steel sinks, a garburator, a built-in dishwasher, an electric range and a refrigerator. In terms of construction materials, the improvements have a poured, reinforced concrete foundation and wood-frame construction with poured concrete fire wall divisions. Interior walls are wood with lath and plaster, as are interior ceilings. Floor coverings are oak hardwood in halls, living rooms and bedrooms and vinyl tiles in kitchens, dining areas and bathrooms. In common areas, including hallways, staircases and the main floor lobby area, floor coverings are high density nylon carpeting. The structure has a stucco finish on the exterior and a flat, tar and gravel roof. Plumbing includes one full bathroom per suite and sprinklers in halls, staircases and the basement level. Electrical service is adequate with each suite metered separately. Heating is accomplished with electric baseboard units, which were installed eight years ago. Doors to each suite are fireproof, solid core, and windows are single glazed aluminum sash. The building has a single, four-stop elevator and two enclosed staircases in the front and rear of the building. 3. Location Factors Glendale Apartments is located in a relatively well-defined area immediately adjacent to the central business district of Metrotown known as the City Center rental market. Historically, this area has been characterized by above average rents and below average vacancies relative to the metropolitan averages. The subject property is in the "heart" of this rental submarket and is considered to be in a very desirable location for rental accommodation. 4. Financial Characteristics Glendale Apartments is fully occupied at present and has a relatively stable tenant base. Monthly rents, which are anticipated by the present owner over the coming year, are detailed in Exhibit 1, Glendale Apartments Rent Roll. These, as gross monthly rental values, range from a low of $ for one of the ground level onebedroom suites to a high of $ for third-floor, two-bedroom units. The exception to this is the caretaker's suite, which is made available to the building "super" at a monthly rental of $ Parking has been made available to tenants at $10.00 per month and, given that there is a waiting list for additional places, there is reason to believe that the parking rates levied are somewhat below market. Other properties in the area typically charge $15.00 per place per month and still encounter little (if any) income loss. Income from the basement level laundry equipment is expected to generate gross revenue of approximately $ each month as was the case in the current year. The monthly rental values are, in contrast, considered to be "at market", largely due to the professional management firm which oversees the rentals for the property. From the information provided, one can prepare an estimate of gross potential rental revenue for the subject property for the coming year. 4

5 The expenses incurred for the subject property (for the year just ending) have been summarized by Mr. Cote's accountant and are presented in Exhibit 2, Glendale Apartments Income Statement. This is a preliminary statement for Mr. Cote's fifth year of ownership which is about to end. Students should note that Mr. Cote has provided an agent from Tera Real Estate Ltd. with the information in Exhibits 1 and 2 for discussion with potentially interested purchaser/clients. Exhibit 1 GLENDALE APARTMENTS RENT ROLL Coming Year Floor Rent Suite Number Type Size Monthly Bedroom 700 s.f. $ Bedroom 710 s.f. $ Bedroom 710 s.f. $ Bedroom 680 s.f. $ Bedroom 720 s.f. $ Bedroom 720 s.f. $ Bedroom 720 s.f. $ Bedroom 840 s.f. $ Bedroom 700 s.f. $ Bedroom 710 s.f. $ Bedroom 710 s.f. $ Bedroom 710 s.f. $ Bedroom 880 s.f. $ Bedroom 860 s.f. $ Bedroom 860 s.f. $225* Bedroom 860 s.f. $ Bedroom 715 s.f. $ Bedroom 710 s.f. $ Bedroom 710 s.f. $ Bedroom 710 s.f. $ Bedroom 860 s.f. $ Bedroom 860 s.f. $ Bedroom 860 s.f. $ Bedroom 860 s.f. $645 * Note that Suite 207 is occuped by the building caretaker. The unit is very similar to Suite 205 and would likely command a similar rental value if exposed to the market. 5

6 Appraisal Exhibit 2 GLENDALE APARTMENTS Preliminary Statement of Income and Earnings for the Year About to End Rental Revenues $140,430 Miscellaneous Revenues 4,800 Total Revenues $145,230 Operating Expenses: Management 5,778 Caretaker's Salary* 3,014 Municipal Taxes, Insurance and Licences 17,000 Utilities 1,667 Garbage Collection and Water 1,389 Repairs and Maintenance 5,556 Miscellaneous Costs 2,778 Interest 61,113 Depreciation Expenses: Building 19,141 Equipment 1, ,774 Net Income Before Tax 26,456 Income Tax Expense 11,774 Net Income for Year $ 14,682 * The caretaker also benefitted from a rental arrangement where the monthly cost of his suite was approximately $ less each month than comparable units in the building. The indicated renumeration to the caretaker is net of this amount as is the rental revenue indicated above. D. Market Data for Metrotown Rental Housing The rental housing market in Metrotown has continued in the current year in relatively stable fashion. Interest rates have remained in the range experienced over the past years, with first mortgage money typically available at 11.5% to 12.5%. Government programmes affecting the market have not changed significantly and no new initiatives have been announced. The overall vacancy rate, which was 6% one year ago and 5.75% two years ago, was 5.5% at the end of the current year. The distribution of vacancies continues to be more than proportionately focused in the outlying districts and in newer buildings attempting to let at relatively higher rental levels. Net new construction over the year just ending amounted to less than 2% of the standing rental stock measured at the beginning of the year. While not surprising in light of the past three years' activity, this level of construction is only half of that experienced in the five-year period ending three years ago. Present conditions seem to support a conclusion of modest upward pressure on rental values and a medium term, but modest, upturn in rental construction activity is anticipated. At the present time, however, the rate of issuance of 6

7 building permits for rental accommodation in Metrotown is consistent with the experience over the past three years. The vacancy inventory of newly completed but unoccupied units has decreased modestly over the past year. Table 1 Completions, Absorptions and Vacant Inventory of Newly Completed Rental Apartments Metrotown and Metrotown City Center, Canada Vacant Inventory Area Quarter Completions Absorptions (end of quarter) Metrotown 1st Last Year 1, nd Last Year rd Last Year 807 1, th Last Year st This Year nd This Year 1, rd This Year th This Year City Center 1st Last Year nd Last Year rd Last Year th Last Year st This Year nd This Year rd This Year th This Year E. Indications of Market Activity in Metrotown This section is intended to provide specific information in connection with rental properties in Metrotown which have been exposed to the market over the past two years. In order to focus on the analytical issues, only two properties are discussed in this section. This is not intended to indicate, in any way, that a market value appraisal can be adequately based on a limited number of property analyses. Rather, the sales data and property data presented here are taken to be representative of a broader level of activity. That the data presented are limited to two sales is to allow appreciation of the appropriate skills and concepts and yet ensure that the required tasks are completed within the confines of a single assignment. 1. Uplands Green Uplands Green is a 42-unit rental apartment building located in a rental area of Metrotown which is approximately three miles east of the subject property. The property sold eight months ago for $1,900,000 subject to a first mortgage in the amount of $1,300,000. The mortgage in question was newly created, called for interest at the rate of 12% per annum, compounded semi-annually, not in advance, and stipulated monthly payments (based on a 25 year amortization) over a five year term. The improvements were completed 26 years ago and contain 28 one-bedroom units and 14 two-bedroom units. Like the subject property, all units were unfurnished. One-bedroom units average 725 square feet and two- 7

8 Appraisal bedroom units are, on average, 875 square feet. Average monthly rentals are $ and $ for the one and two-bedroom units, respectively. Each unit has a fridge, stove, dishwasher and garborator. Thermopane windows are installed throughout and each unit is separately metered. Parking is available in the form of 30 underground parking places, which are made available to tenants at $12.00 per month. Parking facilities are fully utilized year round. Laundry facilities are available on each floor of the three-story structure and typically generate $10.00 per unit per month in revenue. A five percent vacancy rate is considered appropriate for Uplands Green as the property is more distant from the central business district than the subject and is considered to be in an inferior location. Finally, operating costs (including replacement reserves) are estimated at 33% of effective gross income at the time of sale. 2. Hyatt Manor Hyatt Manor is a rental apartment building which, like the subject property, is located in the City Center area of Metrotown. Hyatt Manor has 40 one-bedroom and 26 two-bedroom units and sold four months ago for $2,700, The sale was completed with the purchaser assuming existing financing created 24 months earlier at a time when interest rates were considerably higher than is the case at present. A search of the Certificate of Title at the Land Titles Office has confirmed that the purchaser assumed an existing mortgage interest at the rate of 18% per annum, compounded semi-annually, not in advance, and requires monthly payments of "blended principal and interest" of $29, The loan has an absolute prepayment prohibition and the lender involved is known to be uninterested in negotiating buy-out arrangements. Table 2 Stock and Vacancy Characteristics of Existing Rental Apartments Metrotown Totals and City Center Area Total Rental Vacancies Vacancy Area Year End Apartment Stock in Stock Rate (%) Metrotown This Year 162,756 8, Year Ago 159,225 9, Years Ago 157,765 9, City Center This Year 7, Year Ago 6, Years Ago 6, Table 3 Average Rents for Existing Rental Apartments Metrotown City and City Center Area Area Year End 1 Bedroom 2 Bedroom Metrotown This Year $370 $462 1 Year Ago Years Ago City Center This Year $460 $610 1 Year Ago Years Ago APPENDIX 1 Amortization Schedule for Wraparound Loan 8

9 NAMES: COTE AND TENTH TOWN INVESTMENTS LOAN AMOUNT TO BE REPAID: $625, ANNUAL CONTRACT RATE: 10.5% CONTRACTUAL TERM YEAR(S) 5 FREQUENCY OF COMPOUNDING: 2 AND ADDITIONAL MONTH(S): 0 MONTH PAYMENTS ($) INTEREST ($) PRINCIPAL ($) BALANCE ($) 1 5, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

10 Appraisal MONTH PAYMENTS ($) INTEREST ($) PRINCIPAL ($) BALANCE ($) 37 5, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

11 APPENDIX 2 Amortization Schedule for Existing Financing NAMES: COTE AND TENTH TOWN INVESTMENTS AMOUNT OUTSTANDING UPON WRAPAROUND INITIATION: $392, NUMBER OF EXISTING MORTGAGES: 1 WRAPAROUND CONTRACTUAL TERM YEAR(S): 5 AND ADDITIONAL MONTH(S): 0 MONTH PAYMENTS ($) INTEREST ($) PRINCIPAL ($) BALANCE ($) 1 2, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

12 Appraisal MONTH PAYMENTS ($) INTEREST ($) PRINCIPAL ($) BALANCE ($) 37 2, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

13 APPENDIX 3 Net Investment Schedule for Wraparound Lender NAMES: COTE AND TENTH TOWN INVESTMENTS MONTH WRAPAROUND TOTAL BALANCE ON NET BALANCE ON BALANCE EXISTING FINANCING WRAPAROUND 1 624, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

14 Appraisal MONTH WRAPAROUND TOTAL BALANCE ON NET BALANCE ON BALANCE EXISTING FINANCING WRAPAROUND , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

15 GLENDALE APARTMENT BUILDING ASSIGNMENT No. 4 Equity Yield Analysis and Investment Value Assume you are a salesperson from Tera Real Estate Ltd. and that you are in the process of developing an analytical presentation for the potential purchaser, Richard Venot. In the course of two preliminary discussions, you have identified the following: (a) (b) (c) (d) Mr. Venot believes that one can reasonably accept the vendor's rent roll (Exhibit 1) providing the gross annual rent for one and two bedroom units does not exceed $8.50 and $9.00 per square foot, respectively. He has indicated that based on these rentals and his experience with other properties in the area, he believes he will "lose", on average, 4% of gross rental revenue due to vacancies and bad debts. With regard to expenses, he believes the expenses indicated in the preliminary income statement (Exhibit 2) will be representative of reality for the coming year if they are adjusted upwards by 8%. He would, however, add an additional item, an appliance lease/replace contract at an initial annual cost of $6, This expense would be in addition to the current repairs and maintenance budget allocation and would render unnecessary any replacement reserves which might otherwise be established. He has indicated that he would like to see a reconstructed operating statement and pro forma projections based on the above-described assumptions. Mr. Venot contemplates a three-year holding period and (at this time) thinks it reasonable to assume that gross rental and other income (parking and laundry revenues) will increase at an annual rate of 6% over this period. Expenses are expected to increase at a greater rate (8% per annum) over the same horizon. Mr. Venot anticipates no acquisition costs and thinks that, upon resale, he would incur closing costs of 5% of the gross selling price. He will consider offering, at most, $1,150, for the property and only if he believes he has a realistic probability of earning a minimum equity yield requirement of 15% per annum before tax. Given that the wraparound mortgage is reaching maturity and that the original first mortgage has three years unexpired, Mr. Venot is uncertain as to how to finance the purchase. Should he purchase the property and pay out the existing mortgage (which may be done without penalty or notice)? First mortgage money is presently available for 70% of the purchase price. Such a mortgage would require interest at a rate of 12% per annum, compounded semiannually, not in advance, and would stipulate monthly payments (rounded to the next higher cent) based on a 25 year amortization period. This mortgage (if arranged) would have a threeyear term to coincide with Mr. Venot's anticipated holding period. Should the first mortgage be left in place? A standard second mortgage would be required to bring the total debt financing to 70% of the price paid. Such a second mortgage would also be created with a three-year term and would require monthly payments of blended principal and interest (rounded to the next higher cent). In the case of a second mortgage, however, the rate of interest would be 15% per annum, compounded semi-annually, and would have a 25 year amortization period. As an alternative, Mr. Venot could pay out the first mortgage and enter a participation mortgage to bring total financing to 70% of the purchase price. The lender will accept a lower interest rate of 10% and an amortization of 30 years, in exchange for 5% of the annual NOI and 12% of the appreciation in market value. The 15

16 Appraisal participation in NOI is to be paid monthly and the share in the property's appreciation will be paid at the end of Mr. Venot's 3-year holding period. Given the above details, prepare the following to assist Mr. Venot in his assessment of the viability of the property as an investment. When submitting this assignment, ensure that you retain a copy as some of the analysis will prove helpful in completing subsequent assignments. Summary of Requirements Prepare the assignment in the form of a submission for the consideration of your client, Mr. Richard Venot, 120 South Hythe Avenue, Metrotown, Canada. Your submission should include a covering letter, which provides a summary of the major conclusions, a table of contents, and an analytical appendix, which documents the analysis undertaken. Be certain to organize the "analytical appendix" in such a way that the detailed responses to the three questions below are clearly identifiable. Marks Question 1: 30 Prepare an investment pro forma that is consistent with Mr. Venot's assessment of future revenues and operating costs for each of the possible financing arrangements: (a) (b) (c) the first mortgage is paid out and the purchase is financed with a new first mortgage. the first mortgage is left in place and a standard second mortgage is used to finance to a total loan to price ratio of 70%. the first mortgage is paid out and the purchase is financed with a participation mortgage to bring total financing to 70% of the purchase price. Include estimated before-tax sale proceeds (based on Year Four's net operating income capitalized at the acquisition rate) in the annual statement. Question 2: 20 Prepare an analysis and calculate the equity yield rate based on a $1,150, purchase price. Assume that the property resells, after three years, based on the implied acquisition capitalization rate. In this analysis, the three options to be considered are (a), (b) and (c) above. Question 3: 15 Based on the preferred financing alternative, calculate the required selling price and the implicit minimum annual rate of property appreciation that is required if Mr. Venot is to realize a before tax equity yield of 15%. Present your analysis and findings for each question in a professional fashion, clearly indicating any assumptions made. 10 Organization and Presentation (a) (b) Remember to include a covering letter and an analytical appendix. Include a table of contents to enhance organization. 16

17 GLENDALE APARTMENT BUILDING ASSIGNMENT No. 5 After Tax Yield Analysis and Investment Value Assume that, having completed the requirements of the First Assignment and after reporting to Mr. Vernot, you receive the following letter from your client: CONFIDENTIAL R. E. Analyst Tera Real Estate Ltd. 100 Main Street Metrotown, Canada Dear Analyst: Richard Venot 120 South Hythe Avenue Metrotown, Canada This Month, This Year Thank you for your recent submission in connection with the. After reviewing your analysis and thinking about the property's investment potential, I offer the following observations. First, I believe that given a proposed purchase price of $1,150, and the financing terms we reviewed, it seems that the property's income and expenses are such that I will reap little in the way of benefit from capital cost allowance during the course of my anticipated holding period. This, it seems to me, is sufficient cause to give consideration to an "aftertax" analysis. As a result, I would like you to incorporate my anticipated income tax treatment in your next submission. You may find it helpful to know that, should I purchase the property, I would allocate the purchase price to land and the two classes of improvements in the same percentage terms as was the case when the property was acquired by Mr. Cote five years ago. Further, and as I believe you are aware, I am a frequent trader in investment properties and cannot be so optimistic as to believe that I will be afforded capital gains treatment on any increment in value realized over my ownership period. On the basis of strict confidentiality (as is the case for all information I provide you), my marginal income tax rate is presently 52% and is likely to remain at this level. In addition, I have discussed the financing of the property with a private mortgage investor and believe I may be able to arrange for an 80% replacement first mortgage at an interest rate of 11.5% per annum, calculated semi-annually, with monthly payments based on a 25-year amortization period. Such a mortgage would, once again, have a three-year term to match my (unchanged) three-year anticipated holding period. However, crude calculations seem to indicate that a mortgage written with these terms, while reducing my equity requirement, may well result in negative cash flows in the first and (perhaps) second years. 17

18 Appraisal On the basis of the foregoing, I would ask that you reconsider the property's investment potential and yield. Specifically, I would ask that you incorporate, once again, the revenue and expense escalation assumptions I have referred to, the implications of the mortgage I believe can be arranged, and my income tax position in terms of capital cost allowance, recapture and tax exposure on any gains realized. I would ask that you, once again, base the estimate of gross selling price, three years hence, on the acquisition capitalization rate. Given the purchase price we have discussed earlier and the mortgage terms I have noted, I would like to know what my equity yield rate will be on a discounted, after tax basis. Should your analysis of cash flows reveal any negative values, I would ask that you account for the negative cash flows in the form of two additional investment yield measures which I am told may be used in such circumstances. The first has been referred to as an "adjusted" internal rate of return and the second is known as a "F.M.R.R.". I have been told that in order to undertake this form of analysis you may require some additional information. If I have to borrow over the short term to cover negative cash flows, I believe I can do so at 12% per annum, compounded annually. In the event that the property generates positive cash flows, I expect that I can reinvest such amounts at an annual rate of 9% regardless of the magnitude of the positive cash flows. If you would be so kind, please attempt to explain why these yield measures are used. I am unfamiliar with the measures, and I would find a brief explanation of each very helpful. Finally, if the "adjusted" internal rate of return analysis fails to generate an after tax yield rate of 12%, I should like to know the price at which the property would have to sell at the end of my three-year horizon such that an "adjusted" yield of 12% is achieved. Should your analysis indicate that on the conditions outlined above I would stand to earn an after-tax yield of more than 12%, I would like to know by what extent the gross selling price could fall and yet still leave my desired yield unharmed. In this way I feel I can get a clearer "picture" of the financial risk involved. Having considered other investment properties in which I have an interest, I have reached the conclusion that a yield rate of 12% per annum, after tax, is an absolute requirement. Given this requirement, I remain uncertain about to the degree of risk associated with realizing this yield and I am confident that your analysis will prove of great benefit. Your assistance in this matter is greatly appreciated. Yours very truly, Richard Venot ab/rav 18

19 Summary of Requirements Based on the specifics of the above letter, students are required to undertake the requested analysis, incorporating the assumptions and requirements of the client. The following questions are to be responded to in the form of a submission to the client. As was the case in the previous assignment, students are to submit: (a) (b) a covering letter which captures the principal conclusions and a table of contents; an analytical appendix which documents the analysis undertaken and elaborates on any assumptions deemed necessary or appropriate. Marks Question 1: 25 Prepare an investment pro forma which is consistent with Mr. Venot's assessment of future revenues, the anticipated cost of vacancy and bad debts, operating costs, annual debt service and income taxes payable. The "bottom line" on this pro forma statement should be net cash flow (i.e., after financing and after tax). The analysis should also include anticipated net (after tax) sale proceeds calculated in conformance with the client's instructions. Use the financing option discussed in the letter from Mr. Venot. Question 2: 25 Given the initial equity contribution required of Mr. Venot, calculate the following: (a) (b) (c) the "standard" internal rate of return. the "adjusted" internal rate of return. the "financial management" rate of return. Question 3: 15 Prepare a summary explanation of the "adjusted" internal rate of return and the financial management rate of return. In your explanation, indicate clearly how the F.M.R.R. differs from the "adjusted" internal rate of return. Question 4: 25 Based on an "adjusted" internal rate of return analysis, determine the minimum gross selling price Mr. Venot must realize three years hence if he is to receive an adjusted internal rate of return of 12%. Express your conclusion as a gross selling price at the end of the investment horizon. You must determine the required equity reversion and "build upward" to the gross selling price. Indicate the annual rate of property price appreciation from the current (proposed) price of $1,150, Present your analysis and findings for each question in a professional fashion, clearly indicating any assumptions made. Hint: To do this question, you need to review the steps necessary to derive the After-Tax Sales proceeds, from which the rate of return is determined. For this question, the rate of return on equity is given; therefore, using the steps in reverse you can work backward to determine the gross selling price. 19

20 Appraisal 10 Organization and Presentation: (a) (b) Include a covering letter and an analytical appendix to enhance presentation Include a table of contents to enhance organization 20

21 GLENDALE APARTMENT BUILDING ASSIGNMENT No. 6 Issues Related to Market Value Mr. Cote is seriously considering placing Glendale Apartments on the market and is concerned that he set an appropriate asking price. He is very familiar with the revenues and expenses associated with his property, however, he has no idea as to general rental market conditions. His responsibilities as a retail executive have been onerous over the past two years and, as a result, he has not had sufficient time to keep up to date with rental market conditions. He has commissioned a market value appraisal with a two-fold motivation. First, he wants to know the value of his rental property such that he can evaluate his potential tax liability upon sale. Second, should he elect to sell, he is concerned that he attach the "right" asking price to the property. The salesperson he has discussed the property with has suggested a list price in the neighbourhood of $1,250,000.00; however, Mr. Cote remains unconvinced this represents fairly the property's value in the marketplace. Marks Question 1: Capitalized Net Income in Perpetuity Versus Detailed Revenue and Expense Projections 45 The following is a summary of earlier course work from the Urban Land Economics Diploma Programme and is central to the appraisal of fee simple interests associated with income-producing property. An assumption that the net operating income will not be constant (and may vary from year to year) will not materially affect the final market value providing the appraiser is logically consistent and carries this assumption over to all comparables. Therefore, in the interests of brevity, incomes are assumed to be constant. The object of the first portion of this assignment is to explore the validity of the above statement and the conditions under which it pertains. (a) Prepare a five year pro forma statement for Uplands Green, to the level of net operating income, based on the information provided in the property description and recognizing the general market conditions affecting rental property investments in Metrotown. In addition, incorporate the appraiser's considered opinion that market participants: typically purchase with the object of holding for five years. believe that, on average, the market level of rental and other income will increase over the foreseeable future at an annual compound rate of 5% and that the operating expenses of a reasonably maintained rental building will increase at an annual compound rate of 7%. behave as though they believe that their rental property investments will sell at the end of their holding periods for a price based on the acquisition (implied first year) capitalization rate and, at the time of closing, will incur 5% closing costs. Use forecasted year 6 NOI for your calculation of gross selling price. (b) On the basis of the pro forma statement referred to above, determine the annual discount rate implied by the purchase price paid for Uplands Green, taking into account the impact of the 21

22 Appraisal assumed revenue and expense escalations. Hint: You are calculating the rate at which the initial price paid for the property will be "repaid" by the annual returns. Marks (c) (d) (e) (f) Question 2: Construct a similar operating statement and five year proforma for Glendale Apartments based on the assumptions outlined in (a) above. In the Glendale case, however, use a 4% vacancy rate to be consistent with case data. Estimate the market value of Glendale Apartments by applying the implied Uplands Green annual discount rate (calculated in part (b)) to Glendale's forecasted net operating income and forecasted net selling price. Apply the capitalization rate identified in Uplands Green to Glendale's stabilized net operating income to produce an estimate of market value. Based upon the outcomes of parts (d) and (e) above, discuss the validity of the quotation in question. In addition, provide a brief commentary as to the factors that would have an impact on an appraiser's ability to apply the constant and perpetual income assumption. Comparable Sales Subject to Conditions Requiring Adjustment 10 The subject property in this case, and the comparable sale analyzed in Question One, above, both have rental revenue which is consistent with the market. Hyatt Manor, in contrast, was rented at a level known to be "below market" at the time of sale. Furthermore, it would take two years to bring the rental structure in line with market rents. This information complicates the use of Hyatt Manor as a "comparable" in valuing the subject property. The price paid would reflect the fact that rental revenue over the initial period of ownership is likely to increase even if the market, in general, remains static. That is, the level of rents in Hyatt Manor would logically be expected to increase at a greater rate than the subject property, all other things being equal. Calculating the capitalization rate for the Hyatt Manor sale based on the purchase price and first year net operating income would tend to understate the "free and clear return" anticipated by the purchaser. This, of itself, would not present a problem if the subject property's rental structure was "under market" to a similar extent. However, this is not the case; Glendale Apartments is presently let at market. The result of applying the first year capitalization rate from Hyatt Manor to the subject property would be to overstate the value of the subject property on the basis of the available information. A second issue to be dealt with in the Hyatt Manor sale is the unattractive financing conditions attached to the sale. This would tend to invalidate an analysis focused on net operating income regardless of whether adjustments to the estimated net operating income flow were made to account for the issue discussed immediately above. In order to account for the differences in the financing of the "comparable" relative to the subject property, the analysis must focus on the implied equity yield. Thus, the appraiser must, in this instance, account for the differing financial structures with reference to mortgage equity analysis. Discuss how these problems could be addressed in such a way that the sales data from the Hyatt property sale could be used in valuing the subject property. (It is not necessary to perform any calculations.) Note that while the subject property has a very attractive first mortgage in place, in order to bring the overall level of the loan to a "typical" 70% level, a second mortgage (standard or wraparound) would be required such that the overall rate on debt would be in the 12% range. 22