A real estate broker is offering an apartment building for sale that has the following characteristics:...

A real estate broker is offering an apartment building for sale that has the following characteristics:
1. The asking price is $3.5 million with the land valued at $500,000.
2. The 160 apartment units rent for $250 per month with rent expected to increase by 4% per year starting in year 2.
3. Vacancy and bad debt allowance is 6% of the potential gross income each year.
4. Operating expenses are expected to be 32% of effective gross income each year.
5. The real estate agent estimates that the value of the property will be $4.4 million at the end of 5 year investment horizon.
6. A 12 percent, 20 year mortgage for $2 million is available with monthly payments.
7. The investment horizon is 5 years beginning January 2007 and ending December 2012. The investor’s ordinary income tax rate is 28 percent and his or her capital gain tax rate is 15%. The investor has several profitable real estate investments and can utilize any tax losses. The appropriate discount rate for this investment is 18%.

Calculate the relevant cash flows for this investment and apply the NPV and IRR rules to decide whether to pursue this project.

Expert Solution

Price = $ 3.5 + $0.5

= $ 4,000,000

Rent for the 1st year = $ 250*12*160

= $ 480,000

Vacancy and bad debt allowance for the 1st year = $ 480,000*0.06 = $ 28,800

Operating expenses for the 1st year = ($ 480,000 - $ 28,800)* 0.32 = $ 144,384

Mortgage Payments every year = {P[r(1+r)^n/((1+r)^n)-1)]} x 12

= $ 2,000,000 [ 0.12/12 (1 + 0.12/12)^240 / ((1 + 0.12/12)^240 -1)]

= $ 264,260.7

Year	Price of the property and land	Sales	Vacancy and bad debt allowance	Operating expenses	Mortgage Payments	Salvage of Property	Net Inflow Before Tax	Net Inflow After Tax	DCF @ 18%	NPV
0	40,00,000.00	-	-	-	-	-	-40,00,000.00	-40,00,000.00	1.00	-40,00,000.00
1	-	4,80,000.00	28,800.00	1,44,384.00	2,64,260.70	-	42,555.30	30,639.82	0.85	36,063.81
2	-	4,99,200.00	29,952.00	1,50,159.36	2,64,260.70	-	54,827.94	39,476.12	0.72	39,376.57
3	-	5,19,168.00	31,150.08	1,56,165.73	2,64,260.70	-	67,591.49	48,665.87	0.61	41,138.26
4	-	5,39,934.72	32,396.08	1,62,412.36	2,64,260.70	-	80,865.57	58,223.21	0.52	41,709.56
5	-	5,61,532.11	33,691.93	1,68,908.86	2,64,260.70	49,00,000.00	49,94,670.62	49,68,162.85	0.44	21,83,216.56
							IRR	5.25%		-16,58,495.22

As NPV is negative and Internal rate of return is less than required rate of return, the project is loss making and not feasible. Hence, it should be opt out.

Note: Capital gains tax is not taken into the calculations of the salvage value of the property as the same willbe set off woth other losses.

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