Question

9. You are buying a mismanaged 64-unit apartment building for $3,000,000.  Rents are $800 per unit per month and expenses are $500 per unit per month, but the property is 10% vacant. You think you can turn the property around in three years by increasing rents $75 per year at each unit, keeping operating expenses constant.  Vacancy will decrease to 7.5% in year 2 and 5% in year 3.   

The bank requires you put 25% down. Terms include a 25-year amortization at 4.0%.   You can sell the property for $3,500,000 at the end of year 3.  There is a 3% prepayment penalty.   

You have a second investment opportunity to invest in a new technology that as a preferred investor would generate a 30% return on your money.   

Should you make this real estate investment or invest in the tech opportunity?

Answer 1

Cashflow today = 25% of $3,000,000 = -$750,000 (as it is an outflow)

Mortgage amount = $3000000 - $750000 = $2250000

Let the Mortgage payments be annual ($A at the end of each year)

So, A/0.04*(1-1/1.04^25) = 2250000

=> A = $144026.92

Cashflows at the end of 1st year = 64 units * $(800-$500) per unit * 90% - $144026.92 =-$126746.92

Cashflows at the end of 2nd year = 64 units * $(875-$500) per unit * 92.5% - $144026.92 =-$121826.92

Cashflows at the end of 3rd year = 64 units * $(950-$500) per unit * 95% - $144026.92 = - $116666.92

Mortgage balance at the end of 3 years (22 years remaining)

=144026.92/0.04*(1-1/1.04^22)

=$2081349.58

So, prepayment amount to be paid including prepayment penalty = 2081349.59*1.03 = $2143790.07

So, Cashflow from selling the property and prepayment at the end of 3rd year = $3500000 - $2143790.07 = $1356209.93

So, return from investment in the property (r) is given by

-750000 - 126746.92/(1+r)-121826.92/(1+r)^2-116666.92/(1+r)^3+1356209.93/(1+r)^3=0

Solving, r =0.0850605 or 8.51%

The second investment is better as it gives a return of 30% whereas the investment in property returns only 8.51%

So, we should invest in Tech Opportunity