glendale apartment building a case study i ...glendale apartment building 3 the subject property is...

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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 threestorey rental property with 24 residential units. The emphasis in this case is on the practical application ofvaluation techniques presented in earlier course work. In particular, the case will serve to assist students indeveloping skills with regard to discounted cash flow analysis, capitalization techniques and mortgage equityanalysis.

The case involves a rental building which may be listed for sale in the near future. The present owner wishesto establish the market value of his interest such that he will be in an approved position to assess the role of theproperty in his investment portfolio. In addition, although the property is not listed for sale, a potentialpurchaser is aware that the property may well be exposed to the market in the near future. This individualrequires 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 thesubject property, the development of a rational investment pro forma and the application of discounted cash flowtechniques with the object of identifying the yield earned at a specified maximum bid price. Mortgage equityanalysis is at the basis of the requirements for this assignment. Given an assumption of stable net operatingincome over a three year investment horizon, students are required to forecast annual before-tax flows andbefore-tax sale proceeds given three possible financing arrangements. Based on these data, the equity yield ratemust be determined for each option and a recommendation as to the preferred financing alternative must bedeveloped. Finally, given an investor specified minimum equity yield rate, the amount of capital appreciationover the holding period must be determined such that the investor earns his minimum desired rate of return onequity.

The second assignment builds on the analysis developed in the first assignment. Here the major requirementsinclude the incorporation of income tax implications in the determination of investment yield and value. Inaddition, the investor in question has stated his views as to present and future revenue and expense conditionsand is again aware of three alternatives by which his (possible) purchase may be financed. This assignmentrequires a sound familiarity with regard to the development of investment pro formas and discounted cash flowanalysis. In this vein, several variations of internal rate of return analysis, including "standard" internal rateof return, adjusted internal rate of return and financial management rate of return, are required. In both the firstand 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 costallowance, 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 consistentwith the investor's objectives, the second assignment concludes with an analysis to determine the necessaryamount of capital appreciation to fully satisfy the investor's (after tax) yield requirements. This portion of theassignment 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, incometax 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 recentsales of apartment properties considered to be similar to the property presently listed for sale. In thisassignment, students are required to create reconstructed operating statements and determine the capitalization

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and implied discount rates on the basis of these statements and the transaction price for each property. Thenecessary analysis is intended to lead to an improved understanding of the various inter-relationships that existbetween 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 apartmentbuilding named Glendale Apartments. This section provides background information which serves to place theanalytical issues in a practical context by reviewing a variety of factors related to the principals involved, theproperty and the marketplace. Both the generalized housing market data and specific transaction data arehypothetical 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 inMr. Cote's name in fee simple. At the time of purchase, Mr. Cote paid a total of $825,000.00 and financed thepurchase be arranging for a five-year term wraparound mortgage funded by the vendor, Tenth Town InvestmentsLtd. 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, andspecified constant monthly payments of $2,900.00. Given this most favourable set of mortgage terms (firstmortgage rates were in the 10% to 11% range at the time), the parties agreed to finance the purchase in sucha way that the (assumable) first mortgage was left in place. After several detailed sets of negotiations, the salewas finalized as follows:

Total Price Paid $825,000.00

Assumption of Existing First 392,832.85

Net Proceeds from Vendor-Supplied Mortgage 232,167.15

Paid in Cash $200,000.00

The face value of the wraparound mortgage funded by Tenth Town was $625,000.00 and the parties agreed toa wraparound contract rate of 10.5% per annum, compounded semi-annually, not in advance. The wraparoundmortgage provides for monthly payments, rounded to the next higher dollar, based on a 25 year amortizationperiod and calls for a five year term. The full details of this second charge against title are presented in theAppendix to this case. For instance, Mr. Cote is unaware of the fact that the yield earned by Tenth TownInvestments 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 $300,000.00and $525,000.00, respectively. In turn, the value of the improvements was allocated to two capital costallowance classes: $55,000.00 in Class 8 and $470,000.00 in Class 3. These values have not been challengedby Revenue Canada Taxation and there is no reason to believe that they will be in the future. Mr. Cote has takenfull advantage of the capital cost allowances available over his period of ownership although, given that theproperty is not a "tax shelter", he has only claimed capital cost allowance in conformance with standard rentalrules.

Glendale Apartment Building

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The subject property is the only real estate investment held by Mr. Cote and it is thought that any increment invalue will be afforded capital gains treatment should he sell. At present, he is evaluating his financial positionand is contemplating selling the property. He has recently contacted Tera Real Estate Ltd., a firm specializingin investment property sales and is seriously considering their proposal to list the property for sale at$1,250,000.00.

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 areashows a high potential for capital appreciation. He has been in touch on a regular basis with a salesperson fromTera Real Estate Ltd. and is aware that the subject property may soon be put on the market. In considering thepossible purchase, Mr. Venot wishes to ensure that he negotiates a price such that (given his estimates ofrevenue, expense, appreciation and the like) he earns not less than 15% before tax or 12% per annum as an aftertax rate on any equity invested. Given that Mr. Venot has been active in the investment real estate market overthe past ten years and that he has both purchased and sold numerous properties in recent years, there is littledoubt 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 haspurchased.

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, isheld in fee simple by D. A. Cote, subject to a first mortgage in favour of the United Trust and Loan Companyand a second (wraparound) mortgage in favour of Tenth Town Investments Limited. There are no otherencumbrances 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 giventhe 100 by 140 foot site dimensions. The site is regular, has mature landscaping and is in conformance with theRM-3 zoning for the area and the general character of the neighbourhood. The specifics of the zoning by-lawallow for a 55% site coverage ratio and a maximum 2.1 floor space ratio (F.S.R.). Given the details below, onecan ascertain that the improvements conform to the existing zoning with an actual site coverage of 52.1% andan actual F.S.R. of 2.06. The property, therefore, is within the basic zoning maximums and is considered tobe 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 $500for 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 tenantparking stalls and 6 visitor stalls. In addition to the parking facilities and a communal storage area, thebuilding's boiler and sprinkler room, electrical room and elevator lobby are located in the basement level.

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The main level has a gross building area of 7,350 square feet and contains a lobby area, seven one-bedroomunits, a single two-bedroom unit and a laundry room. The net area of the main level is 5,800 square feet. Thesecond floor of the building contains eight units: four one-bedroom and four two-bedroom units. The grossfloor 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-bedroomand four two-bedroom units. The gross area is 7,000 square feet and the net area is 6,285 square feet. The totalgross area of the building is 21,650 square feet; the net area is 18,375 square feet and, therefore, the buildingis 84.9% efficient.

All suites have either a balcony or a ground level patio. Each suite has a living room, full bathroom, smallstorage area and a dining area. All kitchens are equipped with stainless steel sinks, a garburator, a built-indishwasher, an electric range and a refrigerator. In terms of construction materials, the improvements have apoured, 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, includinghallways, 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 fullbathroom per suite and sprinklers in halls, staircases and the basement level. Electrical service is adequate witheach suite metered separately. Heating is accomplished with electric baseboard units, which were installed eightyears ago. Doors to each suite are fireproof, solid core, and windows are single glazed aluminum sash. Thebuilding 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 businessdistrict of Metrotown known as the City Center rental market. Historically, this area has been characterized byabove average rents and below average vacancies relative to the metropolitan averages. The subject propertyis in the "heart" of this rental submarket and is considered to be in a very desirable location for rentalaccommodation.

4. Financial Characteristics

Glendale Apartments is fully occupied at present and has a relatively stable tenant base. Monthly rents, whichare anticipated by the present owner over the coming year, are detailed in Exhibit 1, Glendale Apartments RentRoll. These, as gross monthly rental values, range from a low of $455.00 for one of the ground level one-bedroom suites to a high of $645.00 for third-floor, two-bedroom units. The exception to this is the caretaker'ssuite, which is made available to the building "super" at a monthly rental of $225.00. Parking has been madeavailable to tenants at $10.00 per month and, given that there is a waiting list for additional places, there isreason to believe that the parking rates levied are somewhat below market. Other properties in the area typicallycharge $15.00 per place per month and still encounter little (if any) income loss. Income from the basementlevel laundry equipment is expected to generate gross revenue of approximately $250.00 each month as was thecase in the current year. The monthly rental values are, in contrast, considered to be "at market", largely dueto 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 subjectproperty for the coming year.


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The expenses incurred for the subject property (for the year just ending) have been summarized by Mr. Cote'saccountant and are presented in Exhibit 2, Glendale Apartments Income Statement. This is a preliminarystatement for Mr. Cote's fifth year of ownership which is about to end. Students should note that Mr. Cote hasprovided an agent from Tera Real Estate Ltd. with the information in Exhibits 1 and 2 for discussion withpotentially interested purchaser/clients.

Exhibit 1

GLENDALE APARTMENTS RENT ROLL

Coming Year

Floor Rent Suite Number Type Size Monthly

1 101 1 Bedroom 700 s.f. $470102 1 Bedroom 710 s.f. $470103 1 Bedroom 710 s.f. $470104 1 Bedroom 680 s.f. $455105 1 Bedroom 720 s.f. $470106 1 Bedroom 720 s.f. $475107 1 Bedroom 720 s.f. $475108 2 Bedroom 840 s.f. $600

2 201 1 Bedroom 700 s.f. $475202 1 Bedroom 710 s.f. $485203 1 Bedroom 710 s.f. $475204 1 Bedroom 710 s.f. $475205 2 Bedroom 880 s.f. $625206 2 Bedroom 860 s.f. $625207 2 Bedroom 860 s.f. $225*208 2 Bedroom 860 s.f. $625

3 301 1 Bedroom 715 s.f. $500302 1 Bedroom 710 s.f. $500303 1 Bedroom 710 s.f. $500304 1 Bedroom 710 s.f. $500305 2 Bedroom 860 s.f. $645306 2 Bedroom 860 s.f. $645307 2 Bedroom 860 s.f. $645308 2 Bedroom 860 s.f. $645

* Note that Suite 207 is occuped by the building caretaker. The unit is very similar to Suite 205and would likely command a similar rental value if exposed to the market.

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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 5,778Caretaker's Salary* 3,014Municipal Taxes, Insurance and Licences 17,000Utilities 1,667Garbage Collection and Water 1,389Repairs and Maintenance 5,556Miscellaneous Costs 2,778Interest 61,113Depreciation Expenses:

Building 19,141Equipment 1,338 118,774

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 wasapproximately $370.00 less each month than comparable units in the building. The indicatedrenumeration 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. Interestrates have remained in the range experienced over the past years, with first mortgage money typically availableat 11.5% to 12.5%. Government programmes affecting the market have not changed significantly and no newinitiatives have been announced. The overall vacancy rate, which was 6% one year ago and 5.75% two yearsago, was 5.5% at the end of the current year. The distribution of vacancies continues to be more thanproportionately focused in the outlying districts and in newer buildings attempting to let at relatively higher rentallevels.

Net new construction over the year just ending amounted to less than 2% of the standing rental stock measuredat the beginning of the year. While not surprising in light of the past three years' activity, this level ofconstruction is only half of that experienced in the five-year period ending three years ago. Present conditionsseem 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


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building permits for rental accommodation in Metrotown is consistent with the experience over the past threeyears. The vacancy inventory of newly completed but unoccupied units has decreased modestly over the pastyear.

Table 1Completions, Absorptions and Vacant Inventory of Newly Completed Rental Apartments

Metrotown and Metrotown City Center, Canada

Area Quarter Completions Absorptions (end of quarter)Vacant Inventory

Metrotown 1st Last Year 1,001 850 5702nd Last Year 921 911 5803rd Last Year 807 1,012 3754th Last Year 677 721 331

1st This Year 998 787 5422nd This Year 1,044 995 5913rd This Year 785 805 5714th This Year 575 675 471

City Center 1st Last Year 18 0 182nd Last Year 32 40 103rd Last Year 0 10 04th Last Year 0 0 0

1st This Year 24 11 132nd This Year 50 40 233rd This Year 18 24 174th This Year 0 5 12

E. Indications of Market Activity in Metrotown

This section is intended to provide specific information in connection with rental properties in Metrotown whichhave been exposed to the market over the past two years. In order to focus on the analytical issues, only twoproperties are discussed in this section. This is not intended to indicate, in any way, that a market valueappraisal can be adequately based on a limited number of property analyses. Rather, the sales data andproperty data presented here are taken to be representative of a broader level of activity. That the data presentedare limited to two sales is to allow appreciation of the appropriate skills and concepts and yet ensure that therequired 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 isapproximately three miles east of the subject property. The property sold eight months ago for $1,900,000subject to a first mortgage in the amount of $1,300,000. The mortgage in question was newly created, calledfor interest at the rate of 12% per annum, compounded semi-annually, not in advance, and stipulated monthlypayments (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-

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bedroom units are, on average, 875 square feet. Average monthly rentals are $415.00 and $560.00 for the oneand two-bedroom units, respectively. Each unit has a fridge, stove, dishwasher and garborator. Thermopanewindows are installed throughout and each unit is separately metered. Parking is available in the form of 30underground parking places, which are made available to tenants at $12.00 per month. Parking facilities arefully utilized year round. Laundry facilities are available on each floor of the three-story structure and typicallygenerate $10.00 per unit per month in revenue. A five percent vacancy rate is considered appropriate forUplands Green as the property is more distant from the central business district than the subject and is consideredto be in an inferior location. Finally, operating costs (including replacement reserves) are estimated at 33% ofeffective 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 areaof Metrotown. Hyatt Manor has 40 one-bedroom and 26 two-bedroom units and sold four months ago for$2,700,000.00. The sale was completed with the purchaser assuming existing financing created 24 monthsearlier at a time when interest rates were considerably higher than is the case at present. A search of theCertificate of Title at the Land Titles Office has confirmed that the purchaser assumed an existing mortgageinterest at the rate of 18% per annum, compounded semi-annually, not in advance, and requires monthlypayments of "blended principal and interest" of $29,300.00 The loan has an absolute prepayment prohibitionand the lender involved is known to be uninterested in negotiating buy-out arrangements.

Table 2Stock and Vacancy Characteristics of Existing Rental Apartments

Metrotown Totals and City Center Area

Area Year End Apartment Stock in Stock Rate (%)Total Rental Vacancies Vacancy

Metrotown This Year 162,756 8,952 5.51 Year Ago 159,225 9,555 6.02 Years Ago 157,765 9,071 5.75

City Center This Year 7,039 273 3.91 Year Ago 6,950 278 4.02 Years Ago 6,950 255 3.7

Table 3Average Rents for Existing Rental Apartments

Metrotown City and City Center Area

Area Year End 1 Bedroom 2 Bedroom

Metrotown This Year $370 $4621 Year Ago 342 4332 Years Ago 323 400

City Center This Year $460 $6101 Year Ago 428 5702 Years Ago 404 536

APPENDIX 1Amortization Schedule for Wraparound Loan


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NAMES: COTE AND TENTH TOWN INVESTMENTS

LOAN AMOUNT TO BE REPAID: $625,000.00

ANNUAL CONTRACT RATE: 10.5% CONTRACTUAL TERM YEAR(S) 5FREQUENCY OF COMPOUNDING: 2 AND ADDITIONAL MONTH(S): 0

MONTH PAYMENTS ($) INTEREST ($) PRINCIPAL ($) BALANCE ($)

1 5,802.07 5,352.82 449.25 624,550.752 5,802.07 5,348.97 453.10 624,097.653 5,802.07 5,345.09 456.98 623,640.674 5,802.07 5,341.18 460.89 623,179.785 5,802.07 5,337.23 464.84 622,714.946 5,802.07 5,333.25 468.82 622,246.127 5,802.07 5,329.24 472.83 621,773.298 5,802.07 5,325.19 476.88 621,296.419 5,802.07 5,321.10 480.97 620,815.4410 5,802.07 5,316.98 485.09 620,330.3511 5,802.07 5,312.83 489.24 619,841.1112 5,802.07 5,308.64 493.43 619,347.68

13 5,802.07 5,304.41 497.66 618,850.0214 5,802.07 5,300.15 501.92 618,348.1015 5,802.07 5,295.85 506.22 617,841.8816 5,802.07 5,291.52 510.55 617,331.3317 5,802.07 5,287.14 514.93 616,816.4018 5,802.07 5,282.73 519.34 616,297.0619 5,802.07 5,278.29 523.78 615,773.2820 5,802.07 5,273.80 528.27 615,245.0121 5,802.07 5,269.28 532.79 614,712.2222 5,802.07 5,264.71 537.36 614,174.8623 5,802.07 5,260.11 541.96 613,632.9024 5,802.07 5,255.47 546.60 613,086.30

25 5,802.07 5,250.79 551.28 612,535.0226 5,802.07 5,246.07 556.00 611,979.0227 5,802.07 5,241.30 560.77 611,979.0228 5,802.07 5,236.50 565.57 610,852.6829 5,802.07 5,231.66 570.41 610,282.2730 5,802.07 5,226.77 575.30 609,706.9731 5,802.07 5,221.84 580.23 609,126.7432 5,802.07 5,216.88 585.19 608,541.5533 5,802.07 5,211.86 590.21 607,951.3434 5,802.07 5,206.81 595.26 607,356.0835 5,802.07 5,201.71 600.36 606,755.7236 5,802.07 5,196.57 605.50 606,150.22

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37 5,802.07 5,191.38 610.69 605,539.5338 5,802.07 5,186.15 615.92 604,923.6139 5,802.07 5,180.88 621.19 604,302.4240 5,802.07 5,175.56 626.51 603,675.9141 5,802.07 5,170.19 631.88 603,044.0342 5,802.07 5,164.78 637.29 602,406.7443 5,802.07 5,159.32 642.75 601,763.9944 5,802.07 5,153.82 648.25 601,115.7445 5,802.07 5,148.26 653.81 600,461.9346 5,802.07 5,142.67 569.40 599,802.5347 5,802.07 5,137.02 665.05 599,137.4848 5,802.07 5,131.32 670.75 598,466.73

49 5,802.07 5,125.58 676.49 597,790.2450 5,802.07 5,119.78 682.29 597,107.9551 5,802.07 5,113.94 688.13 593,419.8252 5,802.07 5,108.05 694.02 595,725.8053 5,802.07 5,102.10 699.97 595,025.8354 5,802.07 5,096.11 705.96 594,319.8755 5,802.07 5,090.06 712.01 593,607.8656 5,802.07 5,083.96 718.11 592,889.7557 5,802.07 5,077.81 724.26 592,165.4958 5,802.07 5,071.61 730.46 591,435.0359 5,802.07 5,065.35 736.72 590,698.3160 5,802.07 5,059.04 743.03 589,955.28


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APPENDIX 2Amortization Schedule for Existing Financing


AMOUNT OUTSTANDING UPON WRAPAROUND INITIATION: $392,832.85

NUMBER OF EXISTING MORTGAGES: 1 WRAPAROUND CONTRACTUAL TERMYEAR(S): 5AND ADDITIONAL MONTH(S): 0


1 2,900.00 2,576.28 323.72 392,509.132 2,900.00 2,574.15 325.85 392,183.283 2,900.00 2,572.02 327.98 391,855.304 2,900.00 2,569.86 330.14 391,525.165 2,900.00 2,567.70 332.30 391,192.866 2,900.00 2,565.52 334.48 390,858.387 2,900.00 2,563.33 336.67 390,521.718 2,900.00 2,561.12 338.88 390,182.839 2,900.00 2,558.90 341.10 389,941.7410 2,900.00 2,556.66 343.34 389,498.3911 2,900.00 2,554.41 345.59 389,152.8012 2,900.00 2,552.14 347.86 388,804.94

13 2,900.00 2,549.86 350.14 388,454.8014 2,900.00 2,547.56 352.44 388,102.3615 2,900.00 2,545.05 354.75 387,747.6116 2,900.00 2,542.93 357.07 387,390.5417 2,900.00 2,540.58 359.42 387,031.1218 2,900.00 2,538.23 361.77 386,669.3519 2,900.00 2,535.85 364.15 386,305.2020 2,900.00 2,533.47 366.53 385,938.6721 2,900.00 2,531.06 368.94 385,569.7322 2,900.00 2,528.64 371.36 385,198.3723 2,900.00 2,526.21 373.79 384,824.5824 2,900.00 2,523.76 376.24 384,448.34

25 2,900.00 2,521.29 378.71 384,069.6326 2,900.00 2,518.80 381.20 383,688.4327 2,900.00 2,516.30 383.70 383,304.7328 2,900.00 2,513.79 386.21 382,918.5229 2,900.00 2,511.26 388.74 382,529.7830 2,900.00 2,508.71 391.29 382,138.4931 2,900.00 2,506.14 393.86 381,744.6332 2,900.00 2,503.56 396.44 381,348.1933 2,900.00 2,500.96 399.04 380,949.1534 2,900.00 2,498.34 401.66 380,547.4935 2,900.00 2,495.71 404.29 380,143.2036 2,900.00 2,493.05 406.95 379,736.25

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37 2,900.00 2,490.39 409.61 397,326.6438 2,900.00 2,487.70 412.30 378,914.3439 2,900.00 2,484.99 415.01 378,499.3340 2,900.00 2,482.27 417.73 378,081.6041 2,900.00 2,479.53 420.47 377,611.1342 2,900.00 2,476.78 423.22 377,237.9143 2,900.00 2,474.00 426.00 376,811.9144 2,900.00 2,471.21 428.79 376,383.1245 2,900.00 2,468.39 431.61 375,951.5146 2,900.00 2,465.56 434.44 375,517.0747 2,900.00 2,462.71 437.29 375,079.7848 2,900.00 2,459.85 440.15 374,639.63

49 2,900.00 2,456.96 443.04 374,196.5950 2,900.00 2,454.05 445.95 373,750.6451 2,900.00 2,451.13 448.87 373,301.7752 2,900.00 2,448.19 451.81 372,849.9653 2,900.00 2,445.22 454.78 372,395.1854 2,900.00 2,442.24 457.76 371,937.4255 2,900.00 2,439.24 460.76 371,476.6656 2,900.00 2,436.22 463.78 371,012.8857 2,900.00 2,433.18 466.82 370,546.0658 2,900.00 2,430.11 469.89 370,076.1759 2,900.00 2,427.03 472.97 369,603.2060 2,900.00 2,423.93 476.07 369,127.13


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APPENDIX 3Net Investment Schedule for Wraparound Lender


MONTH WRAPAROUND TOTAL BALANCE ON NET BALANCE ONBALANCE EXISTING FINANCING WRAPAROUND

1 624,500.75 392,509.13 232,041.622 624,097.65 392,183.28 231,914.373 623,640.67 391,855.30 231,785.374 623,179.78 391,525.16 231,654.625 622,714.94 391,192.86 231,522.086 622,246.12 390,858.38 231,387.747 621,773.29 390,521.71 231,251.858 621,296.41 390,182.83 231,118.589 620,815.44 389,841.73 230,973.7110 620,330.35 389,498.39 230,831.9611 619,841.11 389,152.80 230,688.3112 619,347.68 388,804.94 230,542.74

13 618,850.02 388,454.80 230,395.2214 618,348.10 388,102.36 230,245.7415 617,841.88 387,747.61 230,094.2716 617,331.33 387,390.54 229,940.7917 616,816.40 387,031.12 229,785.2818 616,297.06 386,669.35 229,627.7119 615,773.28 386,305.20 229,468.0820 615,245.01 385,938.67 229,306.3421 614,712.22 385,569.73 229,142.4922 614,174.86 385,198.37 228,976.4923 613,632.90 384,824.58 228,808.3224 613,086.30 384,448.34 228,637.96

25 612,535.02 384,069.63 228,465.3926 611,979.02 383,688.43 228,290.5927 611,418.25 383,304.73 228,113.5228 610,852.68 382,918.52 227,934.1629 610,282.27 382,529.78 227,752.4930 609,706.97 382,138.49 227,568.4831 609,126.74 381,744.63 227,382.1132 608,541.55 381,348.19 227,193.3633 607,951.34 380,949.15 227,002.1934 607,356.08 380,547.49 226,808.5935 606,755.72 380,143.20 226,612.5236 606,150.22 379,736.25 226,143.97

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MONTH WRAPAROUND TOTAL BALANCE ON NET BALANCE ONBALANCE EXISTING FINANCING WRAPAROUND

37 605,539.53 379,326.64 226,212.8938 604,923.61 378,914.34 226,009.2739 604,302.42 378,499.33 225,803.0940 603,675.91 378,081.60 225,594.3141 603,044.03 377,661.13 225,382.9042 602,406.74 377,237.91 225,168.8343 601,763.99 376,811.91 224,952.0844 601,115.74 376,383.12 224,732.6245 600,461.93 375,951.51 224,510.4246 599,802.53 375,517.07 224,285.4647 599,137.48 375,079.78 224,057.7048 598,466.73 374,639.63 223,827.10

49 597,790.24 374,196.59 223,593.6550 597,107.95 373,750.64 223,357.3151 596,419.82 373,301.77 223,118.0552 595,725.80 372,849.96 222,875.8453 595,025.83 372,395.18 222,630.6554 594,319.87 371,937.42 222,382.4555 593,607.86 371,476.66 222,131.2056 592,889.75 371,012.88 221,876.8757 592,165.49 370,546.06 221,619.4358 591,435.03 370,076.17 221,358.8659 590,698.31 369,603.20 221,095.1160 589,955.28 369,127.13 220,828.15


15


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 ananalytical presentation for the potential purchaser, Richard Venot. In the course of two preliminary discussions,you have identified the following:

(a) Mr. Venot believes that one can reasonably accept the vendor's rent roll (Exhibit 1) providingthe gross annual rent for one and two bedroom units does not exceed $8.50 and $9.00 persquare foot, respectively. He has indicated that based on these rentals and his experience withother properties in the area, he believes he will "lose", on average, 4% of gross rental revenuedue to vacancies and bad debts. With regard to expenses, he believes the expenses indicatedin the preliminary income statement (Exhibit 2) will be representative of reality for the comingyear if they are adjusted upwards by 8%. He would, however, add an additional item, anappliance lease/replace contract at an initial annual cost of $6,000.00. This expense would bein addition to the current repairs and maintenance budget allocation and would renderunnecessary any replacement reserves which might otherwise be established. He has indicatedthat he would like to see a reconstructed operating statement and pro forma projections basedon the above-described assumptions.

(b) Mr. Venot contemplates a three-year holding period and (at this time) thinks it reasonable toassume that gross rental and other income (parking and laundry revenues) will increase at anannual rate of 6% over this period. Expenses are expected to increase at a greater rate (8% perannum) 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.

(c) He will consider offering, at most, $1,150,000.00 for the property and only if he believes hehas a realistic probability of earning a minimum equity yield requirement of 15% per annumbefore tax.

(d) Given that the wraparound mortgage is reaching maturity and that the original first mortgagehas three years unexpired, Mr. Venot is uncertain as to how to finance the purchase. Shouldhe purchase the property and pay out the existing mortgage (which may be done withoutpenalty 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 semi-annually, not in advance, and would stipulate monthly payments (rounded to the next highercent) based on a 25 year amortization period. This mortgage (if arranged) would have a three-year 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 debtfinancing to 70% of the price paid. Such a second mortgage would also be created with a three-year term andwould require monthly payments of blended principal and interest (rounded to the next higher cent). In the caseof a second mortgage, however, the rate of interest would be 15% per annum, compounded semi-annually, andwould have a 25 year amortization period.

As an alternative, Mr. Venot could pay out the first mortgage and enter a participation mortgage to bring totalfinancing to 70% of the purchase price. The lender will accept a lower interest rate of 10% and an amortizationof 30 years, in exchange for 5% of the annual NOI and 12% of the appreciation in market value. The

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16

participation in NOI is to be paid monthly and the share in the property's appreciation will be paid at the endof 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 theproperty as an investment. When submitting this assignment, ensure that you retain a copy as some of theanalysis 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, 120South Hythe Avenue, Metrotown, Canada. Your submission should include a covering letter, which providesa summary of the major conclusions, a table of contents, and an analytical appendix, which documents theanalysis undertaken. Be certain to organize the "analytical appendix" in such a way that the detailed responsesto the three questions below are clearly identifiable.

MarksQuestion 1:

30 Prepare an investment pro forma that is consistent with Mr. Venot's assessment of future revenues and operatingcosts for each of the possible financing arrangements:

(a) the first mortgage is paid out and the purchase is financed with a new first mortgage.(b) 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%.(c) 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 theacquisition rate) in the annual statement.

Question 2:

20 Prepare an analysis and calculate the equity yield rate based on a $1,150,000.00 purchase price. Assume thatthe property resells, after three years, based on the implied acquisition capitalization rate. In this analysis, thethree 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 annualrate 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 assumptionsmade.

10 Organization and Presentation

(a) Remember to include a covering letter and an analytical appendix.

(b) Include a table of contents to enhance organization.


17


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, youreceive the following letter from your client:

Richard Venot120 South Hythe AvenueMetrotown, Canada

This Month, This Year

CONFIDENTIAL

R. E. AnalystTera Real Estate Ltd.100 Main StreetMetrotown, Canada

Dear Analyst:

Thank you for your recent submission in connection with the Glendale Apartment Building. After reviewingyour analysis and thinking about the property's investment potential, I offer the following observations.

First, I believe that given a proposed purchase price of $1,150,000.00 and the financing terms we reviewed, itseems that the property's income and expenses are such that I will reap little in the way of benefit from capitalcost allowance during the course of my anticipated holding period. This, it seems to me, is sufficient cause togive consideration to an "aftertax" analysis. As a result, I would like you to incorporate my anticipated incometax 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 landand the two classes of improvements in the same percentage terms as was the case when the property wasacquired by Mr. Cote five years ago. Further, and as I believe you are aware, I am a frequent trader ininvestment properties and cannot be so optimistic as to believe that I will be afforded capital gains treatment onany increment in value realized over my ownership period. On the basis of strict confidentiality (as is the casefor all information I provide you), my marginal income tax rate is presently 52% and is likely to remain at thislevel.

In addition, I have discussed the financing of the property with a private mortgage investor and believe I maybe able to arrange for an 80% replacement first mortgage at an interest rate of 11.5% per annum, calculatedsemi-annually, with monthly payments based on a 25-year amortization period. Such a mortgage would, onceagain, have a three-year term to match my (unchanged) three-year anticipated holding period. However, crudecalculations 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.

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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 Ihave referred to, the implications of the mortgage I believe can be arranged, and my income tax position in termsof 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 knowwhat my equity yield rate will be on a discounted, after tax basis. Should your analysis of cash flows reveal anynegative values, I would ask that you account for the negative cash flows in the form of two additionalinvestment yield measures which I am told may be used in such circumstances. The first has been referred toas an "adjusted" internal rate of return and the second is known as a "F.M.R.R.". I have been told that in orderto undertake this form of analysis you may require some additional information. If I have to borrow over theshort term to cover negative cash flows, I believe I can do so at 12% per annum, compounded annually. In theevent that the property generates positive cash flows, I expect that I can reinvest such amounts at an annual rateof 9% regardless of the magnitude of the positive cash flows. If you would be so kind, please attempt to explainwhy these yield measures are used. I am unfamiliar with the measures, and I would find a brief explanation ofeach very helpful.

Finally, if the "adjusted" internal rate of return analysis fails to generate an after tax yield rate of 12%, I shouldlike 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 wouldstand to earn an after-tax yield of more than 12%, I would like to know by what extent the gross selling pricecould fall and yet still leave my desired yield unharmed. In this way I feel I can get a clearer "picture" of thefinancial risk involved. Having considered other investment properties in which I have an interest, I havereached the conclusion that a yield rate of 12% per annum, after tax, is an absolute requirement. Given thisrequirement, I remain uncertain about to the degree of risk associated with realizing this yield and I am confidentthat your analysis will prove of great benefit.

Your assistance in this matter is greatly appreciated.

Yours very truly,

Richard Venotab/RAV


19

Summary of Requirements

Based on the specifics of the above letter, students are required to undertake the requested analysis, incorporatingthe assumptions and requirements of the client. The following questions are to be responded to in the form ofa submission to the client. As was the case in the previous assignment, students are to submit:

(a) a covering letter which captures the principal conclusions and a table of contents;

(b) an analytical appendix which documents the analysis undertaken and elaborates on anyassumptions deemed necessary or appropriate.

MarksQuestion 1:

25 Prepare an investment pro forma which is consistent with Mr. Venot's assessment of future revenues, theanticipated 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). Theanalysis should also include anticipated net (after tax) sale proceeds calculated in conformance with the client'sinstructions. 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) the "standard" internal rate of return.

(b) the "adjusted" internal rate of return.

(c) 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 ofreturn. In your explanation, indicate clearly how the F.M.R.R. differs from the "adjusted" internal rate ofreturn.

Question 4:

25 Based on an "adjusted" internal rate of return analysis, determine the minimum gross selling price Mr. Venotmust realize three years hence if he is to receive an adjusted internal rate of return of 12%. Express yourconclusion as a gross selling price at the end of the investment horizon. You must determine the required equityreversion and "build upward" to the gross selling price. Indicate the annual rate of property price appreciationfrom the current (proposed) price of $1,150,000.00. Present your analysis and findings for each question in aprofessional 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, fromwhich the rate of return is determined. For this question, the rate of return on equity is given; therefore, usingthe steps in reverse you can work backward to determine the gross selling price.

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10 Organization and Presentation:

(a) Include a covering letter and an analytical appendix to enhance presentation

(b) Include a table of contents to enhance organization


21


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 anappropriate 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 havebeen onerous over the past two years and, as a result, he has not had sufficient time to keep up to date withrental market conditions. He has commissioned a market value appraisal with a two-fold motivation. First, hewants 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. Thesalesperson 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.

MarksQuestion 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 andis 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) willnot materially affect the final market value providing the appraiser is logically consistent andcarries this assumption over to all comparables. Therefore, in the interests of brevity, incomes areassumed to be constant.

The object of the first portion of this assignment is to explore the validity of the above statement and theconditions under which it pertains.

(a) Prepare a five year pro forma statement for Uplands Green, to the level of net operatingincome, based on the information provided in the property description and recognizing thegeneral 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 overthe foreseeable future at an annual compound rate of 5% and that the operatingexpenses of a reasonably maintained rental building will increase at an annualcompound rate of 7%.

• behave as though they believe that their rental property investments will sell at the endof 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. Useforecasted 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 rateimplied by the purchase price paid for Uplands Green, taking into account the impact of the

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assumed revenue and expense escalations. Hint: You are calculating the rate at which theinitial price paid for the property will be "repaid" by the annual returns.

(c) Construct a similar operating statement and five year proforma for Glendale Apartments basedon the assumptions outlined in (a) above. In the Glendale case, however, use a 4% vacancyrate to be consistent with case data.

(d) Estimate the market value of Glendale Apartments by applying the implied Uplands Greenannual discount rate (calculated in part (b)) to Glendale's forecasted net operating income andforecasted net selling price.

(e) Apply the capitalization rate identified in Uplands Green to Glendale's stabilized net operatingincome to produce an estimate of market value.

(f) Based upon the outcomes of parts (d) and (e) above, discuss the validity of the quotation inquestion. In addition, provide a brief commentary as to the factors that would have an impacton an appraiser's ability to apply the constant and perpetual income assumption.

MarksQuestion 2: 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 rentalrevenue which is consistent with the market. Hyatt Manor, in contrast, was rented at a level known to be "belowmarket" at the time of sale. Furthermore, it would take two years to bring the rental structure in line withmarket rents. This information complicates the use of Hyatt Manor as a "comparable" in valuing the subjectproperty. The price paid would reflect the fact that rental revenue over the initial period of ownership is likelyto 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 thesubject property, all other things being equal. Calculating the capitalization rate for the Hyatt Manor sale basedon 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 rentalstructure was "under market" to a similar extent. However, this is not the case; Glendale Apartments ispresently let at market. The result of applying the first year capitalization rate from Hyatt Manor to the subjectproperty 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 thesale. This would tend to invalidate an analysis focused on net operating income regardless of whetheradjustments to the estimated net operating income flow were made to account for the issue discussed immediatelyabove. In order to account for the differences in the financing of the "comparable" relative to the subjectproperty, the analysis must focus on the implied equity yield. Thus, the appraiser must, in this instance, accountfor 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 propertysale could be used in valuing the subject property. (It is not necessary to perform any calculations.) Note thatwhile the subject property has a very attractive first mortgage in place, in order to bring the overall level of theloan to a "typical" 70% level, a second mortgage (standard or wraparound) would be required such that theoverall rate on debt would be in the 12% range.


23

ASSIGNMENTS No. 4, 5, AND 6


Guide

by

Daniel UlinderHead, Real Estate Studies

British Columbia Institute of Technology

© University of British ColumbiaFaculty of Commerce and Business Administration

Real Estate Division

Assignment No. 4 Guide Glendale Apartment BuildingGlendale Apartment Building

1 © 2019 UBC Real Estate Division

GLENDALE APARTMENT BUILDINGAssignment No. 4

Guide

A complete response to question one requires three pro forma statements, complete to the level of before taxcash flow. In the preparation of these statements, the following items should be adequately accounted for:

• Base year gross rental revenue should be taken from Exhibit One (presented in the Case Statement)with an adjustment to the rental revenue from the caretaker's suite. Note should be made that thegross rental value on a square foot basis does not exceed the limits indicated by the client.

• Other income (parking and laundry revenues) is estimated for the base year on the basis of $15.00per month per parking stall; the indicated market level given little, if any, (as stated in the case)likelihood of loss. Laundry revenues are to be taken as $250.00 per month in the base year and bothtypes of "other income" are to be escalated at an annual rate of 6 percent in subsequent years.

• Gross rental revenue is also escalated in the second, third and fourth years at 6%.

• The cost of vacancy is estimated at 4% of gross rental revenue.

• Operating costs are escalated at 8% on an annual basis. Base year operating costs are taken as thoseappearing in the Vendor's preliminary income statement for the year just ending, adjusted upwardsby 8 percent. Note that salary to the caretaker has been restated to account for the change in therental value attached to the caretaker's suite. An additional item (in lieu of replacement reserves)is included in response to the client's instructions.

Given these details, base year revenues and operating expenses are as follows:

Suite Type Size Monthly Rent Gross p.a. Rent p.s.f.

101 1 Bedroom 700 s.f. $470 $5,640 $8.06102 1 Bedroom 710 s.f. $470 $5,640 $7.94103 1 Bedroom 710 s.f. $470 $5,640 $7.94104 1 Bedroom 680 s.f. $455 $5,460 $8.03105 1 Bedroom 720 s.f. $470 $5,640 $7.83106 1 Bedroom 720 s.f. $475 $5,700 $7.92107 1 Bedroom 720 s.f. $475 $5,700 $7.92108 2 Bedrooms 840 s.f. $600 $7,200 $8.57

201 1 Bedroom 700 s.f. $475 $5,700 $8.14202 1 Bedroom 710 s.f. $485 $5,820 $8.20203 1 Bedroom 710 s.f. $475 $5,700 $8.03204 1 Bedroom 710 s.f. $475 $5,700 $8.03205 2 Bedrooms 880 s.f. $625 $7,500 $8.52206 2 Bedrooms 860 s.f. $625 $7,500 $8.72207 2 Bedrooms 860 s.f. $625 $7,500 $8.72208 2 Bedrooms 860 s.f. $625 $7,500 $8.72

Assignment No. 4 GuideGlendale Apartment Building


Suite Type Size Monthly Rent Gross p.a. Rent p.s.f.

301 1 Bedroom 715 s.f. $500 $6,000 $8.39302 1 Bedroom 710 s.f. $500 $6,000 $8.45303 1 Bedroom 710 s.f. $500 $6,000 $8.45304 1 Bedroom 710 s.f. $500 $6,000 $8.45305 2 Bedrooms 860 s.f. $645 $7,740 $9.00306 2 Bedrooms 860 s.f. $645 $7,740 $9.00307 2 Bedrooms 860 s.f. $645 $7,740 $9.00308 2 Bedrooms 860 s.f. $645 $7,740 $9.00

Total $12,875 $154,500

Given the above base year revenues, allowances and expenses may be summarized as follows:

G.P.R.R. $ 154,500+ Other Income (Parking and Laundry) 5,700! Cost of Vacancy (4% of Gross Pot. Rent) 6,180= E.G.I. $ 154,020

! Management 6,240! Caretaker 8,050! Tax, Insurance & Licence 18,360! Utilities 1,800! Garbage & Water 1,500! Repairs & Maintenance 6,000! Miscellaneous Cost 3,000! Lease/Replace 6,000= N.O.I. $ 103,070

Having established base year gross rental revenue ($154,500), other income ($5,700) and operating costs($50,950), the pro forma calculations may be carried out across the required four years (three-year horizon plusyear four to establish income to capitalize for estimate of resale price).

NOI 1

Price$103,070

$1,150,000

$119,2590.0896261



QUESTION 1

Question 1 (a)

Pro forma Given Replacement First Mortgage (10 marks)

Loan Amount: 0.7 × $1,150,000 = $805,000Rate: j = 12%2

Amortization: 25 yearsMonthly Payment: $8,306.80Annual Debt Service: $99,682

1 2 3 4

G.P.R.R. (inflated at 6%) $154,500 $163,770 $173,596 $184,012+ Other Income 5,700 6,042 6,405 6,789! Cost of Vacancy 6,180 6,551 6,944 7,360= E.G.I. 154,020 163,261 173,057 183,441

! Operating Costs 50,950 55,026 59,428 64,182= N.O.I. 103,070 108,235 113,629 $119,259

! Interest 93,970 93,264 92,471= A.I.C.F. 9,100 14,971 21,158

! Principal 5,712 6,418 7,211= Annual B.T.C.F. 3,388 8,553 13,947+ Sale Proceeds 0 0 478,437! Total B.T.C.F. $ 3,388 $ 8,553 $492,384

Calculation of (Before Tax) Sale Proceeds

Gross Selling Price $ 1,330,628*

! Closing Costs (5%) 66,531= Net Sales Price $ 1,264,097

! Mortgage Balance (OSB ) 785,66036

= Before Tax Sale Proceeds $ 478,437

Estimated sale proceeds are based on Year 4's N.O.I. capitalized at the acquisition capitalization rate (ACR)*

A.C.R. = = = 0.0896261

Therefore Selling Price = = $1,330,628



Question 1 (b)

Pro forma Given Existing First Mortgage and New Second Mortgage (10 marks)

Existing Mortgage

Loan Amount: $369,127Rate: j = 8%2

Amortization: 25 yearsMonthly Payment: $2,900.00Annual Debt Service: $34,800.00

Second Mortgage

Loan Amount: $805,000 ! $369,127 = $435,873Rate: j = 15%2


1 2 3 4

G.P.R.R. $154,500 $163,770 $173,596 $184,012+ Other Income 5,700 6,042 6,405 6,789! Cost of Vacancy 6,180 6,551 6,944 7,360= E.G.I. 154,020 163,261 173,057 183,441

! Operating Costs 50,950 55,026 59,428 64,182= N.O.I. 103,070 108,235 113,629 $119,259

! Interest 92,143 91,365 90,501= A.I.C.F. 10,927 16,872 23,128

! Principal 7,837 8,615 9,478= Annual B.T.C.F. 3,090 8,255 13,650+ Sale Proceeds 0 0 485,027= Total B.T.C.F. $ 3,090 $ 8,255 $498,677


Gross Selling Price $ 1,330,628! Closing Costs (5%) 66,531= Net Sales Price $ 1,264,097

! Mortgage Balance 779,070= Before Tax Sale Proceeds $ 485,027

Question 1 (c)



Pro forma Given Replacement Participation Mortgage (10 marks)

Loan amount: 0.7 × $1,150,000 = $805,000Rate: j = 10%2


1 2 3 4

G.P.R.R. $ 154,500 $ 163,770 $ 173,596 $ 184,012+ Other Income 5,700 6,042 6,405 6,789! Cost of Vacancy 6,180 6,551 6,944 7,360= E.G.I. 154,020 163,261 173,057 183,441

! Operating Costs 50,950 55,026 59,428 64,182= N.O.I. 103,070 108,235 113,629 $ 119,259

! Interest 78,667 78,188 77,6611

= A.I.C.F. 24,403 30,047 35,968

! Principal 4,667 5,146 5,673! Share in NOI 5,154 5,412 5,6822

= Annual B.T.C.F. 14,582 19,489 24,613+ Sale Proceeds 0 0 452,9083

= Total B.T.C.F. $ 14,582 $ 19,489 $ 477,521

Calculation of Interest1

Interest PrincipalOSB = 800,332.75 Year 1: 78,666.51 4,667.2512

OSB = 795,187.12 Year 2: 78,188.12 5,145.6424

OSB = 789,514.05 Year 3: 77,660.69 5,673.0736

Calculation of Lender's Share in NOI2

Year 1: 103,070 × 0.05 = $ 5,153.50Year 2: 108,235 × 0.05 = 5,411.75Year 3: 113,629 × 0.05 = 5,681.45

Calculation of (Before Tax) Sale Proceeds3

Gross Selling Price $ 1,330,628! Closing Costs (5%) 66,531= Net Sales Price $ 1,264,097



= Net Sales Price $ 1,264,097! Mortgage Balance $ 789,514! Equity participation 21,675*

= Before Tax Sales Proceeds $ 452,908

Calculation of Equity Participation:*

Gross Selling Price $ 1,330,628! Acquisition price 1,150,000= Appreciation $ 180,628

Share to Lender: $180,628 × 0.12 = $21,675.36

QUESTION 2

Calculation of Equity Yield Rate (20 marks)

Summary of Total Before Tax Cash Flows

0 1 2 3

Replacement First - 345,000 3,388 8,553 492,384Existing 1st & New 2nd - 345,000 3,090 8,255 498,677Participation Loan - 345,000 14,582 19,489 477,521

To solve for implied (before tax) equity yield rate, the above values must be substituted into a relationship suchas that indicated below. In this relationship, "i" represents the equity yield rate.

$345,000 = BTCF × (1 + i) + BTCF × (1 + i) + BTCF × (1 + i)1 2 3-1 -2 -3

Given the analysis, equity rates may be identified as:

Type of Financing Equity Yield Rate

Replacement First 13.7%Existing 1st and New 2nd 14.1%Participation Loan 14.6%

QUESTION 3

Calculation of Required Selling Price to Generate an Equity Yield Rate of 15% (15 marks)

From Question 2, it can be seen that the participation mortgage financing option is preferred given a before taxequity yield criteria. In order to generate a 15% equity yield (as compared to 14.6%, above): the propertywould have to sell for an amount greater than $1,330,628. The required selling price is identified by firstcalculating the required net sales proceeds and "building upwards" to the implied gross selling price.

Stated Initial Equity $ 345,000



! Present value of Annual BTCF @ 15% 43,600= PV of Required Sale Proceeds $ 301,400

Future Value @ 15% 458,392

Required Before Tax Sale Proceeds $ 458,392

+ Mortgage Balance 789,514= Net Sales Price $1,247,906

+ Closing Costs (5%) $ 66,862+ Participation Pmt (Equity) 22,468= Required Gross Price $1,337,236

Thus, in order to realize a before tax equity yield rate of 15%, the property would have to sell for approximately$1,337,236, three years hence. This implies, given the present price of $1,150,000, an annual appreciation rateof 5.16%.

Calculations:

Net Sales Price = Gross Sales Price ! .12(GSP ! 1,150,000) ! .05GSP

1,247,906 = GSP !.12GSP ! 138,000 ! .05GSP

1,247,906 = .83GSP + 138,000

1,109,906 = .83GSP

GSP = $1,337,236

Therefore,Participation Pmt = .12(1,337,236 ! 1,150,000)

= $22,468

Closing Costs = .05 (1,337,236)= $66,862

ORGANIZATION AND PRESENTATION (10 marks)

Supporting documents such as a covering letter, table of contents and an analytical appendix should be includedfor full marks.

TOTAL MARKS: Assignment No. 4 - 75




Guide

QUESTION 1

After Tax Pro forma Statement (25 marks)

A complete response requires a single pro forma statement. However, in this assignment, the statement isrequired to be complete to the level of net cash flow. Much of the preliminary detail (with regard to calculationof net operating income for each year) is identical to that presented in Assignment No. 4 and, for this reason,is not reproduced here.

Loan Amount: 0.8 × $1,150,000 = $920,000Rate: j = 11.5%2


1 2 3 4

G.P.R.R. $ 154,500 $ 163,770 $ 173,596 $ 184,012+ Other Income 5,700 6,042 6,405 6,789! Cost of Vacancy 6,180 6,551 6,94 7,360*

= E.G.I. 154,020 163,261 173,057 183,441

! Operating Costs 50,950 55,026 59,428 64,182= N.O.I. 103,070 108,235 113,629 $ 119,259

! Interest 102,994 102,156 101,219= A.I.C.F. 76 6,079 12,410

! Principal 7,082 7,920 8,857= Annual B.T.C.F. (7,006) (1,841) 3,553

! Income Taxes 0 0 6,453= Annual N.C.F. (7,006) (1,841) (2,900)

+ Net Sales Proceeds 0 0 305,425= Total N.C.F. $ (7,006) $ (1,841) $ 302,525

Note that the case states that vacancy is to be calculated on rental income only. In practice,*

circumstances may well be such that it would be appropriate to calculate vacancy on the basis of totalincome.

Calculation of Capital Cost Allowance and Income Taxes Payable



Allocation of Purchase Price

Class Three: Beginning Balance: ($470,000 ÷ $825,000) × $1,150,000 = $655,152Class Eight: Beginning Balance: ($55,000 ÷ $825,000) × $1,150,000 = $ 76,667

Maximum Allowance

Class Three: 5% maximum; one-half only in acquisition yearClass Eight: 20% maximum; one-half only in acquisition year

Class Three (5%)

1 2 3

Beginning Balance $ 655,152 $ 655,076 $ 648,997× CCA Rate 0.025 0.05 0.00= Maximum Claim 16,379 32,754 0.00

A.I.C.F. 76 6,079 12,410! Amount Claimed 76 6,079 0= Taxable Income 0 0 12,410

× Marginal Rate 0.52 0.52 0.52= Taxes Payable $ 0 $ 0 $ 6,453

Note that because Class Three capital cost allowance claims were sufficient to reduce taxable income to zero,detailed consideration of Class 8 is not required.


Gross Selling Price $ 1,330,628 ! Closing Costs (5%) 66,531 = Net Sales Price $ 1,264,097

! Mortgage Balance 896,141 = Before Tax Sale Proceeds $ 367,956

! Taxes on Gain 59,3301

! Taxes on Recapture 3,2012

= Net Proceeds of Sale $ 305,425

NotesTaxes on the gain are calculated by multiplying the taxable gain by the marginal tax rate. In this case,1

the gain in value (found by subtracting the Adjusted Cost ($1,150,000) from the Net Sales Price($1,264,097) is fully taxable as the client is a frequent trader of properties and therefore is not eligiblefor capital gains exemption.Taxes on recapture are simply derived by multiplying CCA claimed by the marginal rate. Note that this2

assumes that the value of the improvements has not declined, a likely situation given the total value of theproperty has increased by roughly $180,000.

Future Value

(1%r )e)n

$291,674.75

(1%r )e)3



QUESTION 2

2(a) Calculation of the Standard Internal Rate of Return (10 marks)

Year 0 1 2 3 Net Cash Flow -230,000 -7,006 -1,841 302,525

To solve for implied (after tax) equity yield rate (or the after-tax internal rate of return), the above values mustbe substituted into a relationship such as that indicated below. In this relationship, "i" represents the equity yieldrate.

$230,000 = NCF × (1 + i) + NCF × (1 + i) + NCF × (1 + i) 1 2 3-1 -2 -3

$230,000 = $-7,006 × (1 + i) - $1,841 × (1 + i) + $302,525 × (1 + i)-1 -2 -3

Given the above relationship, the after-tax internal rate of return is calculated as 8.319%, considerably short ofthe client's desired rate of 12% per annum, after tax.

2(b) Calculation of the “Adjusted” Internal Rate of Return (10 marks)

An analyst has a number of options to consider when making explicit reinvestment assumptions. Three optionsavailable when dealing with the “adjusted” internal rate of return are explained below:

(i) Assuming all cash flows, either positive (or negative), are reinvested (borrowed) at a singleexplicit rate until the end of the investment horizon.

(ii) Assuming all positive cash flows are reinvested at a single explicit rate, and all negative cashflows are borrowed at an explicit borrowing rate, until the end of the investment horizon.

(iii) Assuming that borrowing to cover negative cash flows are offset against positive cash flows assoon as possible, the balance being reinvested at some explicit borrowing or reinvestment rate.

In this case, all positive cash flows are reinvested at one explicit rate (9%) and all negative cash flows arefinanced by a loan at an explicit borrowing rate (12%). Given that there are no positive cash flows with whichthe year one and year two negative cash flows may be offset, all options will use the 12% borrowing rate andresult in the same “adjusted” internal rate of return. It is assumed that interest income on the reserve establishedto offset the negative cash flows in year 1 and 2 is not taxed as it falls within the standard interest incomededuction. Should this not be the case, one would use a net rate of 4.32% [9% less 52% tax or 9% × (1 !.52)]:

FV = (-$7,006)(1.12) + (-$1,841)(1.12) + $302,5252

FV = $291,674.75

E =

$230,000 =

rN = 8.2406353362% ("adjusted" internal rate of return)e

FV (

n

(1%FMRR)n

$302,519

(1%FMRR)3



2(c) Calculation of the "Financial Management" Rate of Return (5 marks)

Unlike the "adjusted" rate of return the FMRR utilizes two reinvestment/borrowing rates, the safe rate (9%) andthe run of the mill rate (not specified or needed in this case but could be assumed to be 12%). In this case, onemust calculate the modified initial equity (E *).o

E * = $230,000 + ($7,006)(1.09) + ($1,841)(1.09)o-1 -2

E * = $237,977.06o

E * =o

$237,977.06 =

FMRR = 8.32761637032%

QUESTION 3

Summary Description of the "Adjusted" IRR and the FMRR. (15 marks)

When there are negative cash flows during an investor's holding period, there is the potential for multiple ratesof return. However, multiple period measures have been designed to eliminate the potential for multiple ratesof return and enable the investor to explicitly include a particular reinvestment rate in the analysis.

The "Adjusted" IRR can be illustrated using the three options:

(1) All cash flows, either positive (or negative), are reinvested (borrowed) at a single explicit rate until theend of the investment horizon.

(2) All positive cash flows are reinvested at one explicit rate and all negative cash flows are financed bya loan at an explicit borrowing rate. The future values of the positive and negative cash flows are offsetagainst one another at the end of the holding period. With this option, any negative cash flows areassumed to be financed by the investor at a specific after-tax borrowing cost. This financing offsets thenegative flows (converts them to a zero value) and is eventually repaid with subsequent positive cashflows.

(3) Assuming that borrowing to cover negative cash flows are offset against positive cash flows as soon aspossible, the balance being reinvested at some explicit borrowing or reinvestment rate. This optionseems most reasonable, as the cost of borrowing should typically exceed the reinvestment rate andborrowed funds would then be paid off as soon possible.

An alternative approach for eliminating the possibility of multiple rates of return and explicitly recognizing areinvestment rate is the "Financial Management" Rate of Return (FMRR). Unlike the "adjusted" internal rateof return the FMRR utilizes two reinvestment/borrowing rates, one called the safe rate and the other the run ofthe mill rate. The cash flows are assumed to be initially invested at the safe rate. Then, after a specificcumulative value is reached (minimum reinvestment requirement), the amount is assumed to be reinvested at thehigher run of the mill rate.

A modified initial equity is found by calculating the present value of any negative cash flows (net of thecompounded value of any prior positive ATCFs) based on the safe rate. This value is then added to the initial



equity investment to determine the adjusted initial equity. The idea behind this procedure is that an investor atorigination should invest sufficient equity to not only purchase the property, but also deposit sufficient funds ina savings account so that their compounded value is equal to the net negative after-tax cash flows.

Initially, any net positive after-tax cash flows are compounded into the future at the safe rate. Once someminimum reinvestment requirement is satisfied, the flows are then compounded to the end of the holding periodbased on the run of the mill rate and added to the after-tax cash reversion to determine the future value. TheFMRR may finally be calculated.

QUESTION 4

Calculation of Required Selling Price to Generate an "Adjusted" Internal Rate of Return of 12%(25 marks)

The analysis in question 2 serves as the basis of the analysis necessary to answer question 4. In order togenerate a "adjusted" internal rate of return of 12%, (as compared to 8.24%), the property would have to sellfor an amount greater than $1,330,628. This analysis is more complex, however, as income tax implicationsmust be considered. The general approach is nevertheless similar: the required net sales proceeds are calculatedfirst and the analyst "builds upward" to the implied gross selling price.

Initial Equity $ 230,000

Required After Tax Sale Proceeds (FV of $230,000 @ 12%) $ 323,133+ Cash Required for Year 3's Negative Cash Flow 2,900+ Cash Required for Year 2's Negative Cash Flow (1,841 × 1.12) 2,062+ Cash Required for Year 1's Negative Cash Flow (7006 × 1.12 ) 8,7882

+ Tax on Recapture 3,201+ Tax on Gain (TOG) TOG+ Balance on Mortgage 896,141+ Closing Cost (CC) CC= Required Gross Price RGP

Given the above abbreviations, where TOG represents income tax on the gain, CC represents closing costs and,finally, RGP represents required gross price:

RGP = $323,133 + 2,900 + 2,062 + 8788 + 3,201 + 896,141 + TOG + CCRGP ! CC ! TOG = $1,236,225

Since closing costs (or CC) are known to be 5% of required gross price (RGP):

RGP ! (.05 × RGP) ! TOG = $1,236,225

Next, given that the client is required to treat any gain as taxable income, one may represent his net taxable gainas follows:

Gain in Value = RGP ! .05 RGP ! Adjusted Cost Gain in Value = .95 RGP ! Adjusted Cost

Given an adjusted cost of $1,150,000 and a 52% marginal rate, the tax payable on the gain is

$638,2250.456



TOG = .52 (.95 RGP ! $1,150,000)

Thus, the following relationship will allow for the required gross price to be identified:

RGP !.05 RGP ! .52(.95 RGP ! 1,150,000) = $1,236,225.95 × RGP ! .52(.95 RGP ! 1,150,000) = $1,236,225

.95 RGP ! .494 RGP + 598,000 = $1,236,225.456 RGP = $638,225

RGP = = $1,399,616

Thus, in order to realize an after tax, modified internal rate of return of 12%, the property would have to sellfor approximately $1,400,000, three years hence. This implies (given the present price of $1,150,000) an annualappreciation rate of 6.78%.

Proof

Required Gross Price $1,399,616! 5% Selling Costs 69,981

$1,329,635

Tax on Gain52% of 1,329,635 ! 1,150,000 = 93,410

$1,236,225

! Mortgage Balance 896,141! Tax on Recapture 3,201! Year 3 Negative Cash Flow 2,900! Year 2 Negative Cash Flow 2,062! Year 1 Negative Cash Flow 8,788

$ 323,133

FV = PV (1 + i)n

$323,133 = $230,000 (1 + i)3

i = 11.9999491644%

ORGANIZATION AND PRESENTATION (10 marks)

Supporting documents such as a covering letter, table of contents, and an analytical appendix should be includedfor full marks.


First Year Net Operating IncomeProperty Price

$154,907$1,900,000




Guide

QUESTION 1

Capitalized Net Income in Perpetuity Versus Detailed Revenue and Expense Projections

1(a) Five Year Pro forma: Uplands Green (12 marks)

1 2 3 4 5 6 G.P.R.R. $ 233,520 $ 245,196 $ 257,456 $ 270,329 $ 283,845 $ 298,037

+ Other Income 9,360 9,828 10,319 10,835 11,377 11,946! Cost of Vacancy 11,676 12,260 12,873 13,516 14,192 14,902= E.G.I. 231,204 242,764 254,902 267,648 281,030 295,081

! Operating Expenses 76,297 81,638 87,353 93,467 100,010 107,011= N.O.I. 154,907 161,126 167,549 174,181 181,020 $ 188,070

+ Net Sales 0 0 0 0 2,191,420*

= Total Net Income $ 154,907 $ 161,126 $ 167,549 $ 174,181 $2,372,440

The pro forma statement above incorporates the following assumptions:

• Base year rental revenue is $139,440.00 and $94,080.00 from one and two bedroom suites, respec-tively.

• Rental and other income are escalated at five percent per annum.

• Vacancy is estimated at 5% of rental income only.

• Operating expense (including replacement reserves) is 33% in the base year and increases at 7% perannum.

• The net selling price (*) at the end of Year 5 is found by first estimating the gross selling price usingthe acquisition capitalization rate and then applying the 5% closing costs. See the calculations below:

Implied (First Year) Capitalization Rate for Uplands:

Capitalization Rate =

Capitalization Rate =

Capitalization Rate = 0.08153 or 8.153%

$188,0700.08153

$125,2870.08153



Calculate Net Selling Price at the end of Year 5, using the implied capitalization rate and the 5% closingcost:

Gross Selling Price = = $2,306,758

Net Selling Price = $2,306,758 × .95 = $2,191,420

Thus, based on the above factors, the final row on the above pro forma represents the net income returnanticipated. Given the $1,900,000 purchase price, one may turn to the next issue ) calculation of implied annualdiscount rate.

1(b) Calculation of Annual Discount Rate (10 marks)

The purchase price paid for the Uplands property may be related to the annual "free and clear" returns asfollows:

$1,900,000 = $154,907 × (1 + i) + $161,126 × (1 + i)-1 -2

+ $167,549 × (1 + i) + $174,181 × (1 + i)-3 -4

+ $2,372,440 × (1 + i)-5

Solving the above for "i" yields a result of 11.209308% per annum. Although to use the degree of precisionindicated by this result is generally considered inappropriate in an appraisal context, the full "accuracy" isretained for illustrative purposes below. The initial price paid ($1,900,000.00) will be "repaid" by the annual(free and clear) returns at this rate.

1(c) Glendale Apartments Pro forma (10 marks)

1 2 3 4 5 6 G.P.R.R. $ 154,500 $ 162,225 $ 170,336 $ 178,853 $ 187,796 $ 197,186

+ Other Income 5,700 5,985 6,284 6,598 6,928 7,275! Cost of Vacancy 6,180 6,489 6,813 7,154 7,512 7,887= E.G.I. 154,020 161,721 169,807 178,297 187,212 196,574

! Operating Costs 50,827 54,385 58,192 62,265 66,624 71,287= N.O.I. 103,193 107,336 111,615 116,032 120,588 $ 125,287

+ Net Sales Price 1,459,863*

= Total Net Income $ 103,193 $ 107,336 $ 111,615 $ 116,032 $1,580,451

= $1,536,698*

× .95$1,459,863

1(d) Calculation of Present Value at 11.209308% (5 marks)

PV = $103,193 × (1 + i) + $107,336 × (1 + i) -1 -2

+ $111,615 × (1 + i) + $116,032 × (1 + i)-3 -4

First Year Net Operating IncomeCapitalization Rate

$103,1930.08153



+ $1,580,451 × (1 + i)-5

where i = 11.209308%

PV = $1,265,720

1(e) Estimation of Glendale's Market Value on the Basis of Capitalized (First Year) Net OperatingIncome (2 marks)

Present Value =

Present Value = = $1,265,706 (rounded to the next higher dollar)

Given very detailed analysis, one can conclude that the value of Glendale Apartments is $1,265,720. On thebasis of single year net income capitalization, the result is virtually identical: $1,265,706. The $14.00discrepancy is insignificant.

1(f) The Validity of First Year Income Capitalization (6 marks)

From the above, it should be readily apparent that the first year income capitalization approach to valuationproduced an identical result to that obtained from the much more detailed multi-year analysis. However, oneshould not conclude that first year capitalization is appropriate in all circumstances: few presumptions couldbe further from the truth. As was suggested in the quotation, assumptions with regard to escalation of incomeand expense must be applied in a like fashion to both comparables and the subject property. In order to do so,the properties must be truly similar in financial and other characteristics. For example, the comparables usedin the first year capitalization techniques must also be realizing full market rents.

A second concern rests with items omitted in net operating income analysis. No recognition is given to financingterms nor to any income tax incentives (or disincentives) which may apply to one (or more) of the comparablesand yet not the subject property. Where these conditions exist and have the potential of affecting value, theanalyst must carry calculations to a level that allows for a comparison of like with like.



QUESTION 2

Comparable Sales and Adjustments (10 marks)

The central issues to be brought out in responding to this issue are two-fold. First, any analysis undertaken mustbe done so at the level of the Hyatt purchaser's equity yield rate. To ignore the impact of the mortgage wouldbe very poor form, as this would have a certain and considerable impact on the purchaser's ultimate offer price.Thus, mortgage equity analysis is required in contrast with net operating income capitalization.

Second, it is indicated in the question that Hyatt Manor's rental structure is below the market level and that itwould likely take two years to bring the level of rental income up to market. This would indicate that thepurchaser would anticipate higher rental income in future periods than in the year of acquisition. Thus, a first-year equity dividend rate would be inappropriate because this measure of yield, once again, assumes a long term,stable income flow after financing. Relative to the subject property (already at market), an equity dividend rateanalysis would simply be inadequate.


glendale apartment building a case study i ...glendale apartment building 3 the subject property is...

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