question in th eend of case study

In June of 2020, Freddy Hewlett was evaluating how he should proceed with his property on 14th Street South in Birmingham, Alabama. He had inherited the house, which was located a few blocks south of the University of Alabama at Birminghams (UAB) main campus, in 2015. The house in its current state was burdensome though, and in need of repair. He had a plan in place to demolish the house and redevelop the site with a new structure, but just realized that he didnt have the capital necessary to make the deal happen. Should he find the money, change his construction plans, or just scrap the idea entirely? The House The house that Freddy inherited was a two story, 3,630 square foot dwelling consisting of eight studio apartments on a 0.9-acre corner lot site, andwas built in 1910. Freddy lived in the home during his time as a UAB student, andcontinued to rent the home out to other students after he graduated in 2017 with a degree in marketing. Freddy lived in one studio by himself, andrented out the other seven studios. The house was in great disrepair when Freddy inherited it from his grandmother in 2015. The interior of the units was damaged from years of renting to rowdy students, and the wood lap siding on the outside of the house was rotten in places, and in dire need of a paint job. Freddy spent the entire summer of 2015 working with his cousin, Jason Hewlett, repairing the interior damage, and repainting the exterior. The total repair bill (not including their sweat equity plus a year of free rent for Jason) was close to $4,500, which fortunately Freddy was able to cover with some savings that he had. Even with the house being very dated, Freddy was always able to lease out the studio apartments to UAB students, anddo so at a profit. As shown in Exhibit 1 (see attached Excel file), the income Freddy was able to bring in during 2018 exceeded his expenses, even with continually having to put money into the property for repairs and routine maintenance. He was getting tired of spending a couple of weekends a month making various repairs on the house, though. To build, or not to build? Freddy got together with Jason for a few drinks during the holiday season of 2019, and they reminisced about their summer of labor. Jason had since graduated from UAB, and was working with an insurance company in Cincinnati, Ohio. Jason mentioned that there was a lot of redevelopment happening in Cincinnati, especially around the University of Cincinnati. Many of the older multi-family houses that were perennially leased to students were being torn down, andreplaced with larger and more energy efficient buildings. The idea piqued Freddys interest; could he do the same with his house? Freddy reached out to local architect friend of his in Birmingham, Marie Gordian, to get her advice. Marie worked for a local firm that specialized in government and higher education projects, but she had done some residential design during her time in architecture school. Marie assessed the site, and quickly sketched some floor plans and elevations for a three-story structure. Each of the three floors would have two 600 SF one-bedroom apartments, and two 300 SF studio apartments. The units would all have their own exterior entrance, with the upper floor apartments being accessed via an external stair that would be outside of the footprint of the building. None of the apartments would have an exterior porch or patio. This layout would match the footprint of the existing building, butwould more efficiently use the site as having external stairs would allow for more square footage to be built inside the footprint. The facade of the new building would closely match the existing building, consisting primarily of painted HardiePlank siding, vinyl double-hung windows, and a dimensional shingle roof.

Freddy was excited about this plan. He would be able to increase his rental revenue due to having four additional units for lease, as well as he could receive a higher rent on the one-bedroom units as compared to the studio apartments. He also would have a brand-new building that wouldnt require his constant attention for repairs. Finding a contractor Sketches in hand, Freddy sought to find a couple of contractors to give him construction pricing for the project. Freddys first contact was with an estimator from Reliable Homebuilders, Inc. name Mike Jagger. Reliable was building four other similar projects in the neighborhood. Mike reviewed the sketches, andtold Freddy that they were not complete enough for him to provide a hard bid, but felt that a good preliminary estimate for the project would be around $145 per SF, which would include demolition of the existing structure. The finishes inside the apartments would be builder grade in this price range. Additional architectural design, andpermitting of the project were not included in the price. Mike thought that the project would probably take about 6 months to build. Freddy also spoke with Tim Crenshaw from Crenshaw Custom Builders. Tim reviewed the sketches, andprovided Freddy with a budget estimate of $915,000. Crenshaw was very excited about the project, as his company typically only built single family homes, and this project would be a new and challenging venture. The quoted price would include taking the preliminary design that was provided, andpaying a licensed architect to develop full construction documents. Crenshaw and his design team would also submit the documents for planning review, as well as for building permit review. The finishes inside the apartments would match that of the typical custom homes that Crenshaw builds in the Vestavia Hills and Homewood suburbs of Birmingham. He wasnt sure how long it would take to build, but he did mention that he had two children currently attending UAB, and may be interested in leasing a couple of the apartments himself after the building was completed (for a discounted rate, of course) Financing and market analysis Estimates in hand, Freddy went and met with his banker, Trisha Pearson, at Birmingham Community Credit Union. Trisha commented on how nice the plans were that he had put together for the new building, butwas unable to start a loan application because he had yet to develop a detailed proforma for his new venture. Trisha stated that she would need to see Freddys projected income and expenses for the new building so that she could determine if the debt service coverage ratio would fall in line with the credit unions requirements. She also noted that Freddys proforma should account for potential vacancy in the building, as well as the appropriate amount of operating expenses. Unfazed, Freddy went home and immediately got online to see what comparable rents were for other similar units in the area. Freddy decided only to look at the area within 1 mile of the UAB campus, as UAB students would be his primary tenants. He quickly figured out that he had a lot of competition. Similar tohis current building, there were many landlords in the area with similar structures that had anywhere from two to eight units in a building. The rents for these units ranged from $350 per month for a studio apartment, to $875 per month for one-bedroom units. Moreover, there were also buildings that had been newly constructed, or recently renovated. Those units ranged from $500 per month for studios, to $900 per month for one-bedrooms. There were also several new buildings being constructed downtown, with high-end apartments having rents ranging from $1,000 for studios, up to $1,900 for one-bedrooms. Freddy wanted to position his new building with a rental rate that would attract UAB students that werent looking for the cheapest apartment available (i.e., like his current tenants) but also werent looking for the high-end amenities that the downtown rental condos had to offer. He decided that charging $600 for his studio apartments, and $1,000 for his one-bedroom units would put him in line with the local competition. Using this as a starting point, he developed the income and expense statement shown in Exhibit 2. The statement included an estimated vacancy rate of 10%, and his best guess at operating expenses Discounted cash flow analysis Freddy went back and met with Trisha again the following week with the income and expense statement. Trisha had been doing some research herself, andfound that the credit union had historically written loans for small multi-family apartment buildings at an 70% loan to value ratio (based on the final value of the project), and with a debt service coverage ratio of at least 1.3. Trisha also found that new buildings similar towhat was being proposed were selling at a cap rate of 7% in the Birmingham area, and typically had operating expenses ranging from 25% to 35% of net rental income. Together, Freddy and Trisha developed the discounted cash flow analysis shown in Exhibit 3, which included several assumptions. First, they assumed that the total construction cost would be $845,000, plus a $40,000 construction contingency to cover any unforeseen costs, and a design cost of $45,000. Those costs, plus the land cost, totaled $985,000 in total development costs. Carrying costs during construction would just be the property taxes, which they felt were negligible since they would be based on the old property value. Nextthey determined the financing necessary for the project. Trisha estimated (using the 7% cap rate) that based on the income and expenses calculated by Freddy, the completed property value would be approximately $1,100,000. The valuation included $55,000 for the land itself, which Freddy already owned. Trisha could offer a mortgage for 70% of the completed projects value, or approximately $775,000. The mortgage would be a 10-year loan, with monthly payments equating to a 30-year amortization, andhave a 5% interest rate. The total yearly payments on the loan would be nearly $50,000. They assumed that Freddy would be able to increase the rental rate he charged by 3% every year moving forward, and his expenses would proportionately increase each year. Finally, they projected that the selling price of the property in year 10 would still equate to a 7% cap rate. Freddy and Trisha calculated that the ten-year internal rate of return (IRR) for the project was positive, and substantial, at approximately 25%, equating to a net present value (NPV) of over $330,000. There was one big problem, though; Freddy was short on cash. The proforma showed that Freddy would need to come up with an additional $154,903 in capital ($209,903, less the $55,000 in land) to make the project happen

What to do? Freddy was excited, and frustrated, all at the same time. He felt like tearing down the house and building something new was a great idea, but he didnt have a big nest egg of cash sitting around to cover the upfront costs. Freddy figured that he had several potential options on how to move forward: Find another bank to provide a second mortgage to cover the shortfall. Find an equity partner to go into the deal with him to cover the shortfall. Decrease the building from three stories to two stories, to lower construction costs. Increase the building from three stories to four stories, to increase rental income. Keep the same mix of units, but decrease the level of finish in the units, to lower construction costs. Keep the same mix of units, but increase the level of finish in the units, to increase the rental rates that he could charge. Do nothing, andscrap the idea completely. Your task Your task is to assess each of the options that Freddy has posed, plus any additional options that you feel may be viable and determine what you feel is the best path forward for him. Use the requisite financial analysis tools and the pertinent qualitative factors to test each of the alternatives, and to arrive at your proposed solution. 5