Introduction to Real Estate



Finance 264: Introduction to Real Estate

Valuation and Investor Analysis Project

You and your investment partners are considering your first real estate investment purchase. The real estate market has been very good lately, which unfortunately makes it challenging to find good properties. You know that certain property owners however, while not actively marketing their properties, would consider selling for a reasonable price. Your real estate broker has helped you to narrow down the search to three such apartment buildings in the Champaign-Urbana area: Celestial Heavens (CH, 35 total units); Mountain-Top Paradise Apartments (MTP, 22 units); Valley View Villas (VVV, 30 units). The amenities and other relevant characteristics are listed in the table below.

While you have a basic description of the properties, the owners have not provided detailed income or expense figures. Before you approach them, you would like to have a preliminary number in mind that you deem reasonable to pay, as they are sure to inquire. Only if they see that price as something they would consider, would it be worth their trouble to give you detailed income and expense figures.[1] To obtain this figure, you are going to have to make some major assumptions. On the income side, you have compiled market data regarding determinants of rent. You plan to use this information to develop a multiple regression model, which can be used to estimate the market rent by apartment. On the expense side, you have conducted preliminary market research to establish reasonable expenses for the properties. [2] Regarding financing of the purchase, you and your partners would like to finance this property at 80% LTV, at a fixed interest rate. [3]

Your objective is to arrive at reasonable final purchase prices for each of these properties. These final purchase prices should be presented in a brief one-page summary, along with summary financial figures for each property. In the appendix, you should provide detailed tables and brief comments (1 paragraph or less per comment) to describe your analysis. Include the regression results (Full Model, Reduced Model, Final Model), analysis, and conclusions. Show detailed financial tables for the life of the investment. This should include both before- and after-tax analysis.[4]

Property Characteristics

Amenities CH MTP VVV

Dishwasher Yes Yes Yes

Tennis Court No Yes No

Sauna Yes Yes Yes

Year Lease Only No Yes Yes

Utilities Included Yes No Yes

Extra Utilities Included No No Yes

Poor Neighborhood No No Yes

Furnished Yes Yes Yes

Bathrooms per Bedroom .5 1 .75

Bedroom Size (sq ft) 350 325 400

Location from City Center (miles) 3.5 5.7 1.5

Total Number of Units 35 22 30

Efficiency Apartments 0 5 5

One-Bedroom Apartments 15 7 15

Two-Bedroom Aparments 10 10 10

Three-Bedroom Apartments 5 0 0

Four-Bedroom Apartments 5 0 0

Recommended Sequence of Steps for Project

1. Determine market rent by apartment type using the multiple regression model. Use whichever model (“Full” or “Reduced”) your analysis indicates is most appropriate as the “Final” model.[5] Your results should correspond to your Mallard results.

2. Incorporate the income and other assumptions into your excel spreadsheet to begin analysis of alternative investments. Determine which loan is most advantageous under the circumstances. You should include the detailed analysis and decision in your appendix.

3. Estimate the market value of each property using the financial tools you have learned in this class, in as many ways as is reasonable. This is your range of possible values.[6] Now, weight each value as you deem appropriate to establish a single market price for each property. Briefly explain your rationale in the appendix.

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[1]Remember, this owner does not HAVE to sell. As a result, you should be thinking “win-win”. In this analysis we are only concerned with the figure itself, not what you might present initially for negotiating purposes.

[2]The following expense assumptions apply to the (first, second, third) properties respectively. Variable operating expenses are (25%, 20%, 23%) of EGI, Fixed operating expenses are (14%, 15%, 17%) of EGI, and Vacancies are (4%, 7%, 2.5%). Rental rates and property prices have both been consistently increasing by (1.5%, 2.5%, 1.0%) per year. Utilize the most rapid depreciation schedule allowable under current law. Assume the building will be purchased August 1st, 2003. Use the mid-month rule for depreciation. Assume a marginal tax rate of 28%, depreciation recapture rate of 25%, and capital gains tax rate of 20%. Assume a 10 year holding period for the investment. Assume the sale is fully taxable at that time. You should assume a 5% sales commission when the property is sold.

[3]Conversations with banks suggest you can borrow at 6.0% for 20 years, or at 6.5% for 25 years. Both loans have a balloon payment in 10 years. There are 2 points to be paid on the 6.0% loan and 1 point on the 6.5% loan. You should run your analysis using both of these loan figures, and determine which loan is preferable. Detail your analysis (calculations and reasoning) in the appendix. This should include the effective borrowing costs, impact on BTCF, ATCF, BTER and ATER of both rates, and a brief (1 paragraph) written rationale explaining your decision. Use the rate you selected for the remainder of your analysis.

[4] This should be presented professionally so your analysis and conclusions are easy to follow. You should assume you are writing this to the bankers who will be reviewing the analysis to determine if the project warrants a loan. Include a single print-out of your graded mallard quiz results as well. (Each student must turn the Mallard quiz in electronically.)

[5] This will require data preparation. You should create dummy variables (using the excel “IF” function) as necessary on a new worksheet, and use that worksheet to do your regression analysis. Follow the directions in the Mallard project homework (see the Homework page for the link by team) for the analysis. Note: when constructing dummy variables, it is typical to denote as the base case (all “0”s), the category which occurs most frequently in the data. The final Mallard question suggests you came up with another potential independent variable late in the game. As you have already conducted your partial F-test at this stage, decide on the inclusion of this variable in the final model based upon the individual t-test.

[6] You and your partners have agreed on a 12% minimum before-tax internal rate of return. You want at least an 8% EDR, and do not want to buy a property with more than a 6.5 annual GRM. Recognize that applying each of these return assumptions will likely produce different estimates of value.

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