BUSI 422 Week 5 Group Wiki Scenario 2 Example

Is the Asking Price Justified? A Group Valuation of a Twelve-Unit Apartment Building

The Scenario and the Question

An investor client is considering a twelve-unit apartment building listed at $2,050,000. Each unit rents for $1,450 a month, laundry and parking bring in $4,800 a year, and the seller reports expenses close to the figures below. Similar buildings in the area have recently sold at capitalization rates of about 6.5 percent. The client asks whether the asking price is justified and what to offer.

Pro Forma Operating Statement

The group added a management fee and replacement reserves even though the seller manages the property personally, because a buyer will either pay a manager or give up time worth the same amount, and roofs and appliances wear out regardless of who owns the building.

Value by Direct Capitalization

Brueggeman and Fisher (2016) present direct capitalization as the most common market method for stabilized income properties: the value is the year's net operating income divided by a cap rate taken from comparable sales. Dividing net operating income by the market cap rate gives $121,370 / 0.065 = about $1,867,000. Put the other way, the asking price of $2,050,000 implies a cap rate of $121,370 / $2,050,000, or about 5.9 percent, well below what comparable buildings have sold for.

Value by Discounted Cash Flow

To check whether expected growth could justify the price, the group projected five years of income, assuming net operating income grows 3 percent a year, a sale at the end of Year 5 at a terminal cap rate of 7.0 percent applied to Year 6 income, selling costs of 3 percent and a discount rate of 8.5 percent.

The discounted cash flow gives about $1,802,000, slightly below the direct capitalization value, because the terminal cap rate assumes the building will be older and somewhat less valuable per dollar of income at sale. Both methods place the building's value between $1.80 and $1.87 million, roughly $180,000 to $250,000 below the asking price.

Can the Income Carry the Debt?

At the asking price, a loan of 70 percent of value, $1,435,000 at 6.75 percent over thirty years, would require annual payments of about $111,689, for a debt service coverage ratio of $121,370 / $111,689, or 1.09. Most lenders want at least 1.20, so a lender would likely cut the loan, forcing the investor to bring more equity. At a price near $1,867,000, the same loan terms give a ratio of about 1.19, close to the usual minimum.

Why Would a Seller Ask More?

Research suggests two reasons a seller might expect a lower cap rate than the market supports. Plazzi et al. (2010) found that cap rates reflect expected future returns and, for some property types, expected rent growth, so a seller confident that rents will rise quickly may price the building as if growth were assured. Clayton et al. (2009) found that cap rates also move with investor sentiment, not only with fundamentals such as rents and interest rates, so prices can run ahead of income in optimistic markets. A buyer who pays a sentiment-driven price, however, bears the risk that cap rates return to fundamentals by the time of sale.

Recommendation

The group recommends that the client offer about $1,800,000, with room to rise to $1,870,000 if inspections confirm the expense figures. An offer at that level is supported by both valuation methods, gives the lender an acceptable coverage ratio and avoids relying on rent growth the market has not yet shown. If the seller will not move below $2,000,000, the client should walk away or ask for evidence, such as signed leases at higher rents, that would support a lower cap rate.

Group Contributions

One member built the pro forma and discounted cash flow in Excel, a second researched cap rates and comparable sales, a third drafted the financing check and recommendation, and all members revised the wiki, with comments settling the choice of terminal cap rate.

References

Brueggeman, W. B., & Fisher, J. D. (2016). Real estate finance and investments (15th 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

Plazzi, A., Torous, W., & Valkanov, R. (2010). Expected returns and expected growth in rents of commercial real estate. The Review of Financial Studies, 23(9), 3469-3519. https://doi.org/10.1093/rfs/hhq069