FIN 591 Week 6 A Complete Investment Decision Example

Bid, Walk or Pay Up? The Family Office's Final Decision on Mission Oaks, With After-Tax Returns, a Scenario-Weighted Outlook, Conditions to Close and an Exit Plan

[Student Name]

University of Phoenix

FIN/591: Real Estate Investment

Week 6 Assignment

[Instructor Name]

[Date]

Mission Oaks Apartments, the family office and all figures are composites written for a model paper; methods and research findings come from the sources listed.

Recommendation: the family office should bid for Mission Oaks, opening at $15.6 million with a firm ceiling of $16.25 million, financed with a ten-year agency loan of about $10.0 million and an equity partnership with an experienced local operator, subject to the conditions below. At the ceiling, the expected return on equity is close to the family office's 10 percent target; at the asking price of $16.8 million, it is not. A good property at the wrong price is a bad investment, so the decision is really about the price. The rest of this memorandum supports that recommendation.

The Evidence in Brief

Week 1 found a sound San Antonio rental market absorbing a heavy wave of new supply and cap rates repriced upward by higher interest rates. Week 2 valued the property at about $15.5 to $16.2 million as it operates today, below the asking price, once property taxes are reassessed. Week 3 sized the loan at about 61.5 percent of price by debt service coverage and found that debt initially costs more than the property yields, a gap that expected growth closes. Week 4 showed large early tax deductions from cost segregation, which the family's trusts can apply mainly to passive income and which recapture largely reverses at sale. Week 5 identified rent growth and the exit cap rate as the risks that matter most.

The Projection

At a $16.25 million price, total equity is about $6.5 million after the loan, closing costs and renovation reserves. Net operating income starts at about $895,000, reaches about $1.07 million in year three as renovated units lease at higher rents and grows to about $1.32 million by year ten. Cash flow after debt service gives a cash-on-cash return of about 4.5 percent in year one, rising above 5 percent from year three as renovated units lease up and the interest-only period gives way to amortizing payments that the higher income covers. If the property sells in year ten at the assumed exit cap rate of 6.25 percent, after selling costs and repaying the loan balance of about $8.8 million, the equity receives about $12.5 million. The return on equity over ten years is about 10.5 percent a year, and the equity multiple about 2.5 times (Geltner et al., 2014).

After Taxes

The large early depreciation deductions shelter all of the property's cash distributions for several years, and part of the loss offsets the family's other passive income. At sale, recapture and capital gains taxes apply unless a like-kind exchange defers them. The tax adviser estimates that, for the family's trusts, the after-tax return is about 8.5 percent without an exchange and about 9.3 percent with one, compared with a taxable bond portfolio yielding about 3.5 percent after tax.

Scenarios

The base case, with a 50 percent weight, gives about 10.5 percent. A downside case, weighted 25 percent, with income growth of 1.5 percent and an exit cap rate of 7 percent, gives about 6 percent. An upside case, weighted 25 percent, with income growth of 4 percent and an exit cap rate of 5.75 percent, gives about 13 percent. The weighted expected return is about 10.1 percent, near the 10 percent target.

Comparison With Alternatives

A diversified private apartment fund, of the kind the family office reviewed last year, offers expected net returns of about 8 to 9 percent with less concentration, more liquidity and no operating burden on the family office. Mission Oaks offers a higher expected return in exchange for concentration in one city and reliance on one operator. Brueggeman and Fisher (2018) note that direct ownership rewards investors for active management and local knowledge; here, that knowledge comes from the operator, so the operator's quality is part of the investment.

Maximum Price

At $16.25 million the expected return is close to the target. Every additional $250,000 of price reduces the base return by about half a point. At $16.8 million, the scenario-weighted return falls to about 9.1 percent, below the target. The family office should walk away above $16.25 million.

Conditions to Close

The purchase should close only if the property condition report finds no major deferred maintenance beyond the renovation budget, the Phase I environmental assessment is clean, the agency lender confirms the loan at or near 6.0 percent with coverage of at least 1.25, insurance quotes confirm costs within 10 percent of budget, a review of leases confirms rent roll income and the operator signs the partnership agreement with the agreed waterfall and reporting duties.

What Would Change the Recommendation

The committee would raise its price only if new evidence showed higher sustainable income, such as signed leases at renovated rents in a test building, or if financing terms improved materially. It would withdraw if the property condition report found structural problems, if insurance quotes exceeded budget by more than 20 percent or if San Antonio job growth turned negative before closing. Setting these triggers in advance keeps the negotiation disciplined.

Risks Accepted

By proceeding, the family office accepts concentration in one city and one property, reliance on an operator, Texas insurance and tax volatility and the possibility that cap rates stay high. It judges these acceptable at a 3.4 percent portfolio weight with the controls described in Week 5.

Governance During the Hold

The operator will report monthly on occupancy, rents, renovation progress and budget, with a quarterly meeting to review results against the business plan and an annual third-party inspection. The family office will approve the annual budget and any capital spending above $50,000, and it will receive audited annual statements for the partnership prepared by an independent accounting firm. Clayton et al. (2009) found that sentiment can drive cap rates away from fundamentals for extended periods, which argues for patience rather than selling into a weak market.

The Exit Plan

The base case assumes a sale in year ten, when the loan matures. From year five, when the prepayment penalty declines, the committee will compare the property's expected return with alternatives each year. If renovations are complete, rents have grown and cap rates are favorable, an earlier sale or a refinancing to return capital may be better. A like-kind exchange into a property in another market would defer taxes and diversify the allocation, turning the sale of Mission Oaks into the next step of the family office's real estate program.

Conclusion

Mission Oaks is a sound property in a market working through new supply, worth about $16 million today and more if the renovation succeeds. At a price up to $16.25 million, financed with a ten-year agency loan and an operating partner, it offers an expected return near the family office's target with tax advantages and a clear exit plan. At the asking price it does not, so the family office should bid with discipline and be ready to walk away.

References

Brueggeman, W. B., & Fisher, J. D. (2018). Real estate finance and investments (16th ed.). McGraw-Hill Education.

Clayton, J., Ling, D. C., & Naranjo, A. (2009). Commercial real estate valuation: Fundamentals versus investor sentiment. The Journal of Real Estate Finance and Economics, 38(1), 5-37. https://doi.org/10.1007/s11146-008-9130-6

Geltner, D. M., Miller, N. G., Clayton, J., & Eichholtz, P. (2014). Commercial real estate analysis and investments (3rd ed.). OnCourse Learning.