The Embarcadero Real Estate Investment Partnership LLC owns an apartment building complex, One Embarcadero Place, located near Shoal Creek Road and Anderson lane in suburban Dallas. Embarcadero Partnership wishes to sell the property and is in serious negotiations with a motivated buyer. The property was originally financed with a $10M mortgage 5 years ago, with the rest of the capital structure financed with equity.The contract rate on the existing mortgage originated 5 years ago is 9%, monthly payments, with an original amortization period of 25 year. Thus, the remaining amortization period at the time of property sale is 20 years. However, the original term to maturity of the mortgage loan is 15 years, i.e. it is a balloon mortgage as most commercial mortgages are. The buyer of the property may assume the outstanding mortgage loan balance at end of 5^th since the original mortgage is assumable. If the buyer assumes the outstanding mortgage balance the amount of equity investment (or down payment) that will be required is the difference between the asking price of $13,500,000, which is firm, and the mortgage balance at the end of 5^th year of the existing balloon mortgage. Of course the contract interest rate will still be 9%. Embarcadero Partnership paid upfront points of 2.5 on the original mortgage loan it used to finance the purchase of apartment property.

BRIEF PROPERTY AND MARKET CONDITION DESCRIPTIONS

The city skyline is just one of the many highlights you will notice at One Embarcadero Place Apartment Complex located in the historic part of Dallas.At One Embarcadero you will find boutique shops and other services within walking distance as well as affordable dining opportunities.The amenities in the complex include convenient free parking, high tech security, a fitness center and private pool, courtyard for hosting guests and community events and friendly, professional on-site staff.Many of the luxury apartments have an array of stylish features including washer and dryer and the kitchens are equipped with modern appliances. The exterior of the building is a combination of brick, wood and textured veneer

The Embarcadero Complex is 10 years old, has 156 units spread over 5 floors with total gross leasable area (GLA) of 178,453 square feet.The property is in satisfactory physical condition, although it may need refurbishing after purchase. The units are typically rented to middle class fully employed individuals employed by major companies headquartered in the Dallas Metropolitan Area.

The average asking rent in the subject building (i.e. Embarcadero complex) is $11.75/year/square foot of GLA. The median asking rent for similar properties in the market area is $11.20 /year/ square foot of GLA and asking rent range from a low of $9.99/year/square foot of GLA to a high of $12.20/year/ square feet of GLA in Metro Dallas which includes Dallas City proper. The typical apartment building in the market area has GLA of 185,466 square feet.

Embarcadero Real Estate Investment Partnership is willing to sell the property for $13,500,000 or $75.65 per square foot GLA which is a firm asking price. The average asking price for similar properties in various parts of the general market area are as follows: (1) Dallas Metro = $92.89/square foot, (2) Dallas City = $70.40/square foot and (3) Dallas County = $85.55/square foot. The median sale price per square foot is $77.46.The average market capitalization rate (cap rate) for properties like the subject property range from 5.15% to 6.45%.From 2006 to 2010 average price-to-rent ratio for distressed apartments in the market ranged from 82.5% to 90.1% and the average price-to-rent ratio for non-distressed apartments ranged from 90.4% to 125.2%. The typical net present value (NPV) of cash flow to equity investors in this apartment market ranges from a low of $150,000 to a high of $250,000, which raises the question how much shock to cash flows can this apartment investment withstand. As consultant it would be useful for your client to evaluate the potential capacity of the apartment investment to withstand shock to cash flows.

ALCORN PARTNERS LLC: MOTIVATED PROSPECTIVE PURCHASER

Alcorn Partners L.L.C is seriously considering purchasing the property offered by Embarcadero Partnership and your company, Allan Pots Associates has been retained as analyst and consultant to the buyer of the subject property called One Embarcadero Place.The expected holding period for the buyer, Alcorn Partners, is 10 years, over which the partners expect an internal rate of return of 15%.Their expected return on equity (ROE) or equity dividend rate (EDR) before tax is 20%.Of course, EDR does not reflect the return portion associated with appreciation/depreciation of the real estate asset.The expected holding period of your client Alcorn is 10 years and Alcorn's discount rate is 15%, and after buying the property, Alcorn client may also consider refinancing the property after two years, with another mortgage that has better terms. As part of your consulting assignment there are several analysis or tasks you need to conduct to assess first the feasibility of the sale and purchase of the apartment project. To provide guidance I have described below the series of tasks and analyses you are to conduct for your clients so as to make effective rational decisions associated with the sale by Embarcadero Real Estate Investment Partnership LLP of ONE EMBACADERO PLACE and purchase of said property by Alcorn Partners LLC.

THE TASKS AND ANLYYSES YOU MUST PERFORM AS CONSULTANT.

TASK #1:Analysis of the subject property market condition, asking Price, ability to with stand cash flow shocks, etc.

Both Alcorn and Embarcadero Partnership would like to know the condition of the apartment market based on the information given above including price-to-rent ratios, asking price, per square foot, asking rent, overtime provided above. In particular, the client would like to know whether there is opportunity for growth in this market. Both Alcorn Partners (buyer) and the Embarcadero Partnership (seller) would also like know how the asking price of $13.5 M compares with prices for similar properties in the market area.Hence, one immediate issue that you need to address in this part of the case is whether the asking price is a fair offer, i.e., is the property overpriced or underpriced at $13,500,000? There are several performance and valuation metrics you can use to address the issue such as cap rate, net income multiplier or net income multiples, price per square foot, etc.Of course, you are not limited to these metrics.Indeed, in addition to other valuation methods you are also explicitly required to use Front Door and Back Door models using relevant data given in the case and other data you can objectively justify using. Alcorn would want you to include the Front Door and Back Door Capital Budging Model discussed in class, as one key asset pricing model in addition to others. The capital structure of this investment is of course determined by the outstanding loan amount to be assumed and the implied equity amount. In preparation for this assignment you have gathered additional information for typical or average apartment building in the subject property market area summarized in the exhibit below. This typical apartment building has GLA of 185,466 square feet of space this information will help you generate key ratios such as y operating expense ratio real estate taxes ratio for typical or average property in the market.

Exhibit 1: Net Operating Income for Typical Apartment Building in the Market Area.

Potential Gross Income (PGI)

$2,225,592

Less Vacancy and Bad Debt (V&BD)

137,968

= Effective Gross Income (EGI)

$2,087,624

Less Operating Expenses (OE)

$858,366

Less Real Estate Tax (RET)

$173,426

Less Replacement Reserve (RR)

$103,942

= Net Operating Income (NOI)

$951,890

TASK #2: ANALYSIS OF STATIC FINCIAL LEVERAGE, ANNUAL PERCENATGE RATE (APR), EFFECTIVE INTEREST RATE (EIR) AND EFFECTIVE ANNUAL YIELD)

Another issue facing Alcorn is the potential for negative financial leverage. Alcorn suspects that if it assumes the existing mortgage and invests the required equity amount to complete transaction, financial leverage will be negative.So, you are required to analyze static financial leverage of the project. Indeed, you have the information to generate the relevant returns and mortgage cost to conduct static (not dynamic) financial leverage analysis. It would help if define what is financial leverage.We covered all of these in this course. Refer to front door back analysis. Conduct leverage analysis to determine whether the leverage situation is positive or negative using static metrics, based on the asking price of $13.5M and assuming the Alcorn assumes the outstanding mortgage balance at the end 5^th year. If leverage is negative what can be done to make it positive. Additionally, Embarcadero Real Estate Partnership, LLP is curious to know the APR and the effective cost of borrowing on the original loan it got to finance the property. The partnership needs your help here

TASK #3: REFINANCING THE ASSUMABLE MORTGAGE LOAN

It is also likely that market interest rates would decline in two years after Alcorn Partners had purchased property. Hence, Alcorn is also considering refinancing the mortgage it will assume. The existing mortgage is five years old at the point of the purchase of the property. It is projected that market situation would have improved by the end of the two-year period after the purchase to permit refinancing of the property at reasonable terms: interest rate of 7.5%, 20-year amortization with monthly payments. The opportunity rate or discount rate for Alcorn Partners on an alternative investment of similar risk of similar risk is 15%. Alcorn will refinance the outstanding balance on the assumed loan two years after the purchase and assumption of the loan. The prepayment penalty or yield maintenance on the assumed mortgage is 2.5% and the refinancing will cost an additional 3% of the amount being refinanced.Now structure the refinancing and analyze it by calculating the NPV and the IRR of the refinancing and provide appropriate recommendation.