Real Estate Investment Analysis - Case Study Example

Real E Investment Analysis Introduction George Laflin has $450,000 and wants to invest in commercial and industrial property based in Texas. The name of the property is south Park IV which offers office and warehouse facilities. His main interest is to know the worth of the investment before he invests. Therefore, this report use discounted cash flows in evaluating the return on investment. 2. Market condition The population in Houston, Texas is growing in each year and so is the rate of occupancy. The competitors’ properties are not fully occupied. Therefore, there is room for growth for any potential investor. Also the rate at of absorption is very high. Meaning if a new investor comes into the market, more tenants are likely to shift to the new property. Finally, most of the occupants are employed, thus paying rent won’t be an issue. 3. Financial analysis Discounted cash flow Discounted cash flow (DCF) is used in valuing projects, assets or investments by taking into account the time value of money. The concept of time value for money states that a shilling today is worth than a shilling tomorrow. As a result investors would rather get cash now rather than wait. The market is dynamic and factors such as inflation are unpredictable. The following are the assumptions of the DCF model: The appropriate rate of discounting is known. This is not the case as the rate can be determined using methods such as Capital asset pricing model (CAPM) and the weighted average cost of capital (WACC). The company operates in a risk- free market where no uncertainties exist. The company operates under financial constraints. This means that in the financial markets there are no finances accessible to the company to make viable projects due to internal and external factors. Cash flow returns expected at the end of the year are strictly in cash form. The company operates in a perfect situation where there is no inflation or technology. All investments are made at the beginning of the period or year zero. The following are the steps followed in making the DCF: The first step is evaluate the cost of the investment and assess the source of finance Purchase price       Land 300,000 Down Pmt 300000 Building 1,200,000 Loan 1200000 Total 1,500,000 Interest rate 8.00%   Term 30   Payment 106,593 Area 80000 Holding term 10 Rent 2   Growth 3.0%       The next step was to make assumptions Assumptions           Operating expenses: Current Year             Income tax rate 39.60% Tenant Finish 0 Property Insurance 10,000 Capital gain tax rate 28% Lease Commission 0 Property Tax 30,000 Depr recap tax rate 25% % to renew 60% General Expenses 12,000 Depreciation life 39 Deferred Maintenance 50000 Structure Reserve 15,000 Going-out cap rate 10% Roof repair 50000 Management fee (% of EGI) 4% Selling expense 5%     Vacancy 5% Required rate of return 12%     Secondly, the cash flow forecast was created based on the assumptions made. In the cash flow, projected income is subtracted from expenditure and taxes. The cash flow only considers cash. Depreciation and interest expense is non-cash item thus excluded from the cash flow. Cash Flow Forecast                     Year 0 2 3 4 5 6 7 8 9 10 Potential Gross Income (PGI)   164,800 169,744 174,836 180,081 185,484 191,048 196,780 202,683 208,764 Plus: Expenses Reimbursement   53,560 55,167 56,822 58,526 60,282 62,091 63,953 65,872 67,848 Potential Gross Income (PGI)   218,360 224,911 231,658 238,608 245,766 253,139 260,733 268,555 276,612 Less: Vacancy   10,918 11,246 11,583 11,930 12,288 12,657 13,037 13,428 13,831 Plus: Other Income   0 0 0 0 0 0 0 0 0 Effective Gross Income (EGI)   207,442 213,665 220,075 226,677 233,478 240,482 247,697 255,127 262,781 Less: Operating expenses:                     Management fee (4% of EGI)   8,298 8,547 8,803 9,067 9,339 9,619 9,908 10,205 10,511 Property Insurance   10,300 10,609 10,927 11,255 11,593 11,941 12,299 12,668 13,048 Property Tax   30,900 31,827 32,782 33,765 34,778 35,822 36,896 38,003 39,143 General Expenses   12,360 12,731 13,113 13,506 13,911 14,329 14,758 15,201 15,657 Structure Reserve   0 0 0 0 0 0 0 0 0 Total operating expenses   61,858 63,713 65,625 67,594 69,621 71,710 73,861 76,077 78,359 Net operating income (NOI)   145,584 149,952 154,450 159,084 163,856 168,772 173,835 179,050 184,422 Debt Service   106,593 106,593 106,593 106,593 106,593 106,593 106,593 106,593 106,593 BTCF   38,991 43,359 47,857 52,491 57,264 62,179 67,242 72,457 77,829 Less: Income Tax   7,786 9,878 12,051 14,309 16,655 19,095 21,633 24,273 27,529 ATCF   31,205 33,481 35,806 38,182 40,608 43,084 45,610 48,185 50,300 Thirdly, the cash flows at the end of each year were discounted using the required rate of return at 12% as follows: year Discount rate @ 12% Cash flows PV of cash flows 1 0.8929 28,472 25,421 2 0.7972 31,205 24,876 3 0.7118 33,481 23,831 4 0.6355 35,806 22,756 5 0.5674 38,182 21,666 6 0.5066 40,608 20,573 7 0.4523 43,084 19,489 8 0.4039 45,610 18,421 9 0.3606 48,185 17,376 10 0.3220 608,919 196,056       390,465 The cash flow at the end of the projects life is assessed as shown below: Cash flow from sale at year 10   Expected gross sale 1,844,218.61 Selling expense 92,211 Net selling price 1,752,008 Loan balance 1,046,545 BTCF at sale 705,463 Total tax at sale 146,844 ATCF at sale 558,618 Assets when sold they realize a capital gain which is subject to a capital gains tax as computed below. Tax from sales     Net selling price 1,752,008   Purchase price 1,500,000   Capital gain 252,008   Capital gain tax   70,562       Cumulative depreciation 305,128   Depreciation recap tax   76,282 Total tax at sale   146,844 Tax computation Income tax is charged against the taxable income. Therefore, in computing income tax, depreciation and interest were subtracted from the NOI to get the taxable income. Interest is computed using the amortization schedule as 8% on the beginning balance of loan in each year. Amortization Schedule                     Year 1 2 3 4 5 6 7 8 9 10 Beg. Bal. 1,200,000 1,189,407 1,177,967 1,165,611 1,152,267 1,137,856 1,122,291 1,105,481 1,087,327 1,067,720 Interest 96,000 95,153 94,237 93,249 92,181 91,028 89,783 88,439 86,986 85,418 Principle 10,593 11,440 12,356 13,344 14,412 15,564 16,810 18,154 19,607 21,175 End. Bal. 1,189,407 1,177,967 1,165,611 1,152,267 1,137,856 1,122,291 1,105,481 1,087,327 1,067,720 1,046,545 Income tax 1 2 3 4 5 6 7 8 9 10 NOI   145,584 149,952 154,450 159,084 163,856 168,772 173,835 179,050 184,422 Less: Depreciation   30,769 30,769 30,769 30,769 30,769 30,769 30,769 30,769 29,487 Less: Interest   95,153 94,237 93,249 92,181 91,028 89,783 88,439 86,986 85,418 Taxable Income   19,663 24,945 30,432 36,133 42,059 48,220 54,628 61,295 69,517 Tax   7,786 9,878 12,051 14,309 16,655 19,095 21,633 24,273 27,529 Net present value (NPV) NPV is an appraisal method that calculates returns on investments by discounting future cash flows and deducting them from the initial cost of the investment (Brigham & Houston 2009, p 338). It is a modern method in capital budgeting and it takes into account the time value for money. It also uses cash flows and not profits in assessing the viability of an investment. The following are the steps followed in calculating the NPV: Cash flows are forecasted first, initial cost of investment determined and a required rate of return is given. The rate of return is the return that investors expect from their investments. The initial capital outlay is based on the value of assets. The value is 1.5M. This money was financed through a loan of which the deposit was 300,000. The 300,000 is considered as the initial cash out flow. Note that the salvage value of the investment at year 10 is added to the cash flow in that year. The required rate of return on the investment which is given as 12% is used to discount the future cash flows. The result gotten after discounting is the present value of future cash flows The present values of future cash flows are the deducted from the initial cost of the investment to get the NPV. The formulae of NPV is shown below: NPV= PV of cash flows- Initial investment cost year Discount rate @ 12% Cash flows PV of cash flows 1 0.8929 28,472 25,421 2 0.7972 31,205 24,876 3 0.7118 33,481 23,831 4 0.6355 35,806 22,756 5 0.5674 38,182 21,666 6 0.5066 40,608 20,573 7 0.4523 43,084 19,489 8 0.4039 45,610 18,421 9 0.3606 48,185 17,376 10 0.3220 608,919 196,056       390,465   cost of the investment   (300,000)       90,465 Internal rate of return (IRR) IRR is the rate that equates the present value of cash flows to the present value of cash outflows (Brigham & Houston 2009, p 338) . It is that rate at which the NPV of a project is zero. It is computed as follows Two rates of returns are chosen at random. One rate should be higher than the required rate of return and the other is lower than required rate of return. The higher rate chosen should give PV that is less than the initial cost of the investment. While the low rate should generate PV that are higher than the initial cost of the investment. PV of cash flows is computed using each random picked rate of return. Then take the higher PV to be x and lower rate or return to be r. the low PV to be y and the high rate to be w. r to be the given rate and z the IRR. The cost of investment to be c. the formulae will be as follows: = IRR The IRR calculated is 16.2% 4. Recommendations and conclusion A project is acceptable if the NPV is greater than zero and the IRR is greater than the required rate of return on investment (Brigham & Houston 2009, p 338). Based on the financial analysis, the NPV is positive. The return on the investment is 90,465 a return that is greater than zero. The IRR is 16.2% a rate that is greater than the required rate of return which is 12%. Therefore, the investment is a viable one based on these two calculations. It is recommendable for investors to invest as the returns are favorable. Work Cited Eugene F. Brigham, Joel F. Houston. Fundamentals of Financial Management. Cengage learning, 2009, Page 338 Read More