Question 6 An investor has completed the purchase of BAYVIEW APARTMENT an executive apartment building located in Duncan Street, Suva, Fiji to add to existing investment property portfolio. The investor purchased the apartment on 1/1/2022 and intends to sell the property on 31/12/2025. The apartment is currently listed in the market for $1,750,000 and sits on a freehold land area of 2500 m2. Land prices for vacant freehold apartment sites currently sell for $180/m2 in the local land market and this should provide adequate basis for evaluating the value of the land at the time of purchase. Sunset Apartment Operating Details: This executive apartment is located in the heart of the Suva City Central Business District. The apartment contains a total of 10 self-contained one bedroom units which are currently rented out at market rates. Each unit is leased out on a yearly lease tenancy with rental reviewed to the consumer price index at the end of each year. The local apartment market had experienced an average long-term vacancy rate of 2.5%. Below is a rental schedule of the current market rentals for each unit at the time of acquisition. 3 SUNSET APARTMENT RENTAL Building Level Apartment Unit No. Monthly Rental One 1 $ 1,750.00 One 2 $ 1,750.00 One 3 $ 1,750.00 One 4 $ 1,750.00 Two 5 $ 1,900.00 Two 6 $ 1,900.00 Two 7 $ 1,900.00 Three 8 $ 2,100.00 Three 9 $ 2,100.00 Three 10 $ 2,100.00 As alluded to above, rentals for the apartment are reviewed to the movements in general price level movements in the area. The general price level movements for the next five year commencing on the year of acquisition is as follows: Year Index Annual Average Inflation Rate (%) 12022 100 2.5 2023 102.5 4.8 2024 107.4 7.7 2025 115.8 3.7 2026 120 5.5 A summary of the annual operating cost obtained from the owner of the apartment in the first year of operation is summarized below: Property Management $ 10,000.00 Security $ 12,000.00 Insurance premiums $ 20,000.00 Property Tax $ 2,000.00 Advertising costs $ 8,000.00 Servicing contracts $ 10,000.00 Cleaning $ 10,000.00 All operating expenses are anticipated to increase by 2% each year in line with historical trends except servicing contract which is expected to increase to $12,000 in the second year and $15,000 thereafter due to conditions of existing outsourcing arrangement. 4 Costs pertaining to the acquisition of the property (including stamp duty and legal fees) typically average at 3% of the property acquisition price. Financing Arrangement: The property will be purchased with the negotiation of a 70% loan from a local reputable lender and mortgage rates for investment loans currently stand at 7.5% for a term of 25 years with Property Management $ 10,000.00 Security S 12,000.00 Insurance premiums $ 20,000.00 Property Tax $ 2,000.00 Advertising costs $ 8,000.00 Servicing contracts $ 10,000.00 Cleaning $ 10,000.00 All operating expenses are anticipated to increase by 2% each year in line with historical trends except servicing contract which is expected to increase to $12,000 in the second year and $15,000 thereafter due to conditions of existing outsourcing arrangement. 4 Costs pertaining to the acquisition of the property (including stamp duty and legal fees) typically average at 3% of the property acquisition price. Financing Arrangement: The property will be purchased with the negotiation of a 70% loan from a local reputable lender and mortgage rates for investment loans currently stand at 7.5% for a term of 25 years with monthly compounding and amortization. A prepayment penalty of 2.5% applies for any early repayment of the investment loan, expressed as a % of outstanding loan balance. Disposition and Tax Information The investor intends to sell the property at the end of the fourth year (2025) at an anticipated exit yield (cap rate) of 8.5%. Selling expense of $10,000 for legal and agents fee is also incurred at the time of disposition. Straight line depreciation rate of 2.5% is applicable for building under existing income tax legislation. The investor's has a marginal tax rate of 30% and an expected rate of return on equity (after-tax) of 18%. Using the above information compute the following: a) The before-tax internal rate of return (IRR) for this investment assuming the investor obtained financing under conditions explained above. (i.e. IRR at before-tax level) b) Calculate and compare the debt service coverage ratio (DSCR) for Year 1 and Year 2. What can you conclude about the change in this ratio? c) Calculate the break-even ratio for both Year 1 and Year 2 of operation. What can you conclude about this ratio? d) Using the investor's expected rate of return; compute the after-tax net present value (NPV) and after-tax internal rate of return (IRR) of this investment? What can you conclude feasibility of investment investor, justify your answer? the e) Conduct a sensitivity analysis to examine the financial feasibility of the investment (on the after-tax NPV & IRR) if at the time of disposition, the property market weakens and a 5% discount on the price has to be made. How sensitive is the overall returns to the this 5% decline in disposition price of the property? 5 f) Finally, create a scenario analysis in excel using the scenario tool with values and names given in the table below and comment on how the overall measures (after-tax NPV and IRR) change under the different scenarios. Variables Optimistic Realistic Scenario Pessimistic Scenario Scenario Interest Rate 6.5% 9% 1.5% 3% % Growth in Operating Exp (exclude clearning) Vacancy Rates 1.5% 3.5% 7.5% 2% 2.5% Question 6 An investor has completed the purchase of BAYVIEW APARTMENT an executive apartment building located in Duncan Street, Suva, Fiji to add to existing investment property portfolio. The investor purchased the apartment on 1/1/2022 and intends to sell the property on 31/12/2025. The apartment is currently listed in the market for $1,750,000 and sits on a freehold land area of 2500 m2. Land prices for vacant freehold apartment sites currently sell for $180/m2 in the local land market and this should provide adequate basis for evaluating the value of the land at the time of purchase. Sunset Apartment Operating Details: This executive apartment is located in the heart of the Suva City Central Business District. The apartment contains a total of 10 self-contained one bedroom units which are currently rented out at market rates. Each unit is leased out on a yearly lease tenancy with rental reviewed to the consumer price index at the end of each year. The local apartment market had experienced an average long-term vacancy rate of 2.5%. Below is a rental schedule of the current market rentals for each unit at the time of acquisition. 3 SUNSET APARTMENT RENTAL Building Level Apartment Unit No. Monthly Rental One 1 $ 1,750.00 One 2 $ 1,750.00 One 3 $ 1,750.00 One 4 $ 1,750.00 Two 5 $ 1,900.00 Two 6 $ 1,900.00 Two 7 $ 1,900.00 Three 8 $ 2,100.00 Three 9 $ 2,100.00 Three 10 $ 2,100.00 As alluded to above, rentals for the apartment are reviewed to the movements in general price level movements in the area. The general price level movements for the next five year commencing on the year of acquisition is as follows: Year Index Annual Average Inflation Rate (%) 12022 100 2.5 2023 102.5 4.8 2024 107.4 7.7 2025 115.8 3.7 2026 120 5.5 A summary of the annual operating cost obtained from the owner of the apartment in the first year of operation is summarized below: Property Management $ 10,000.00 Security $ 12,000.00 Insurance premiums $ 20,000.00 Property Tax $ 2,000.00 Advertising costs $ 8,000.00 Servicing contracts $ 10,000.00 Cleaning $ 10,000.00 All operating expenses are anticipated to increase by 2% each year in line with historical trends except servicing contract which is expected to increase to $12,000 in the second year and $15,000 thereafter due to conditions of existing outsourcing arrangement. 4 Costs pertaining to the acquisition of the property (including stamp duty and legal fees) typically average at 3% of the property acquisition price. Financing Arrangement: The property will be purchased with the negotiation of a 70% loan from a local reputable lender and mortgage rates for investment loans currently stand at 7.5% for a term of 25 years with Property Management $ 10,000.00 Security S 12,000.00 Insurance premiums $ 20,000.00 Property Tax $ 2,000.00 Advertising costs $ 8,000.00 Servicing contracts $ 10,000.00 Cleaning $ 10,000.00 All operating expenses are anticipated to increase by 2% each year in line with historical trends except servicing contract which is expected to increase to $12,000 in the second year and $15,000 thereafter due to conditions of existing outsourcing arrangement. 4 Costs pertaining to the acquisition of the property (including stamp duty and legal fees) typically average at 3% of the property acquisition price. Financing Arrangement: The property will be purchased with the negotiation of a 70% loan from a local reputable lender and mortgage rates for investment loans currently stand at 7.5% for a term of 25 years with monthly compounding and amortization. A prepayment penalty of 2.5% applies for any early repayment of the investment loan, expressed as a % of outstanding loan balance. Disposition and Tax Information The investor intends to sell the property at the end of the fourth year (2025) at an anticipated exit yield (cap rate) of 8.5%. Selling expense of $10,000 for legal and agents fee is also incurred at the time of disposition. Straight line depreciation rate of 2.5% is applicable for building under existing income tax legislation. The investor's has a marginal tax rate of 30% and an expected rate of return on equity (after-tax) of 18%. Using the above information compute the following: a) The before-tax internal rate of return (IRR) for this investment assuming the investor obtained financing under conditions explained above. (i.e. IRR at before-tax level) b) Calculate and compare the debt service coverage ratio (DSCR) for Year 1 and Year 2. What can you conclude about the change in this ratio? c) Calculate the break-even ratio for both Year 1 and Year 2 of operation. What can you conclude about this ratio? d) Using the investor's expected rate of return; compute the after-tax net present value (NPV) and after-tax internal rate of return (IRR) of this investment? What can you conclude feasibility of investment investor, justify your answer? the e) Conduct a sensitivity analysis to examine the financial feasibility of the investment (on the after-tax NPV & IRR) if at the time of disposition, the property market weakens and a 5% discount on the price has to be made. How sensitive is the overall returns to the this 5% decline in disposition price of the property? 5 f) Finally, create a scenario analysis in excel using the scenario tool with values and names given in the table below and comment on how the overall measures (after-tax NPV and IRR) change under the different scenarios. Variables Optimistic Realistic Scenario Pessimistic Scenario Scenario Interest Rate 6.5% 9% 1.5% 3% % Growth in Operating Exp (exclude clearning) Vacancy Rates 1.5% 3.5% 7.5% 2% 2.5%