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Advanced RE Investment Valuation - Spring 2013 – Apartment Case and Project Page 1 of 18

Advanced Real Estate Investment Valuation

REE 6305

Spring 2013

Professor William G. Hardin III

Apartment Case and Project

Group # 6

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Table of Contents

Executive Summary 3 Pictures and Visuals 4 Market Preview 6 Marketability 7 Rent Comparable 8 Sales Comparable 8 Analysis with Assumptions Support 9 Tables 11 Variance Analysis 14 Conclusions 15 Exhibits from Spread Sheets 16

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Executive Summary:

The subject is a 53-unit garden style multi-family property located at 4066 Bayshore Drive in Naples, FL. The property consists of 8 one-story apartment buildings and a freestanding clubhouse, which serves as the leasing center and office. The improvements were constructed in 1982 and renovated in 2011. The property is constructed of concrete block on concrete slab with stucco exterior and pitched roofs. Property contains one - 1 Bdr/1 bath unit (located in clubhouse building), 45 - 2Bdr/1.5 bath units and 7 -3Bdr/1.5 bath units for a total of 53 units. All of the units are the same size measuring 960 square feet except for the 1BR unit, which is only 910 square feet for a total rentable area of 50,830 sf. The improvements are on a rectangular parcel of land measuring approximately 8.54 acres. The property is 94% occupied with two units currently vacant and one occupied by the manager. Residents are responsible for all utilities to the apartments including water/sewer. Parking consists of 130 open spaces (2.45/unit) and density is 6 units/acre. Property is in good overall condition. It is regarded as a Class C+ property in this market. Amenities include a swimming pool, playground, BBQ area and laundry facility. Property is being offered for sale at a price of $3.6M ($68k/unit, $71/sf). The following analysis utilizes base case, best case and worse case scenarios to evaluate the potential investment. BTIRR on the base case is 20.75% and 62.44% for the best-case scenario. The returns are negative on the worse case (do not get original investment returned).

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Pictures and Visuals

Aerial Photo

Clubhouse and Pool

Lake views from every unit

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Market Preview:

Demand generators are improving for the apartment sector in Southwest Florida, a region comprising Charlotte, Collier, Lee, Manatee and Sarasota counties. The job market has improved modestly over the past 18 months with Cheney Brothers hiring 380 workers to staff a new food distribution facility in Punta Gorda and Protocol Global Solutions adding 400 workers for its Sarasota call center. In addition, several healthcare employers, including large providers such as Lee Memorial Health System and Sarasota Memorial Healthcare System, occupy many of the top spots on the region’s list of largest employers. Overall employment growth in the region will come mainly from the construction and government sectors with the addition of 15,800 jobs expected to be added this year in southwest Florida. Competition from new construction of apartments is not expected to be significant in the short term as developers completed only 272 rentals units in 2012, the first new rentals to come online since before the recession. In 2012, approximately 2,500 multifamily units were permitted in Lee and Collier County, doubling the permits issued in 2011, but well below permitting activity prior to the recession. Minimal construction and steady demand supported a 120-basis point decrease in the vacancy rate in 2012 to 8.6 percent. This followed a 200-basis point decrease in vacancy in 2011. Apartment rents in the region advanced by 1.9% to $843 per month in 2012, while effective rents will rose 2.6 percent to $761 per month. For 2013, the regional vacancy rate is expected to decrease another 50 basis points and asking rents are expected to improve to $871 per month. Naples is the county seat of Collier County, which lies on Florida's west coast just north of Marco Island and about 45 minutes south of Fort Myers. The city of Naples is home to more than 19,500 residents and the five county region has a population of approximately 240,000 residents. Tourism is the primary industry in Naples and drives the economy. Naples is a haven for retired persons of middle to upper economic means. There are more than 80 championship golf courses in the area. Naples is accessible by Interstate 75, which runs north along Florida's west coast and about a one and one-half hours east drive through the Big Cypress National Preserve from Broward and Miami-Dade counties on Florida's east coast. The median price of apartment units sold in the past year was $46,900 per unit. Interest in large complexes in primary population centers, including Bradenton and Sarasota, is keen, but older smaller properties such as Oceans 52 tend to attract smaller unsophisticated buyers.

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Marketability:

Oceans 52 sits on the west side of Bayshore Drive, which runs from Tamiami Trail south past Thomasson Drive and terminates in undeveloped wetlands. The immediate neighborhood consists of small retail uses on Bayshore Drive, larger rental communities, and single-family homes in planned communities. The property is bounded on the north by an undeveloped residential community and a large manufactured home cooperative to the south. The exclusive Windstar on Naples Bay Country Club with world-class golf and yachting is just west of the property. Other uses in the neighborhood on Tamiami Trail are national retailers, such as Wal- Mart and OfficeMax, and a variety of food chains ranging from McDonalds and Pizza Hut to Bonefish Grill and Olive Garden. Oceans 52 has been extensively renovated with $500,000 in exterior and interior improvements being completed within the last year including exterior paint, and siding, landscaping and rehab of 11 units. In addition, seven units have been renovated into three bedroom units allowing for a larger tenant base and higher rents. Renovations include new tile and carpet flooring, new air-conditioning units and handlers, new hot water heaters, new stoves, new refrigerators, new dishwashers, new or refurbished cabinets in the kitchens and bathrooms, new bathtubs, and refurbished counter tops. The 31-year-old property suffers from functional obsolescence as the property does not offer many of the amenities expected in more modern apartment complexes. Additionally, its small size does not offer the economies of scale needed to make it of interest to institutional real estate investment firms, thus the buyer pool for this property would be limited to smaller local investors. The positive attributes of the property are that it is concrete block construction with pitched roofs and the individual units are separately metered with residents paying all utilities including water and sewer. All units have separate central air-conditioning units and individual hot-water heaters. Property is stabilized at 94%+/- occupancy and will provide a buyer a positive yield from day one. There are no known deferred maintenance or large capital improvement items needed at this time. The property offers the prospect of a very desirable rental location with upside in rents as the population and industry continues to grow rapidly in SW Florida. Additionally the property could be converted to condos if the residential market heats up in the future allowing the owner to capitalize on selling individual condos at premium residential prices rather than as a multi-family with the price based solely on income potential and cash flow.

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Rent Comparables:

The subject property competes well with its direct comp set on both occupancy and rate.

Subject has larger average unit sizes compared to the comp set therefore psf rate tends to be

lower for the subject compared to the comp set.

Sales Comparables:

Listing price of subject property at $68k/unit is generally higher than the recent sales that were

identified. All of the comparable sales took place in the fourth quarter of 2012. Bear Creek and

Thomason Drive were judged to be superior to the subject in terms of quality and comparable

in terms of location. Alladin lane was judged to be most comparable to the subject and sold for

significantly less than the asking price of the subject.

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Analysis with Assumption Support:

As with any investment analysis, the projections are only as good as the assumptions made. That being said, our group researched as much information as possible about the market, rent growth, expense growth, vacancy rates, etc. and based our assumptions upon historical performance, in order to minimize variability and reduce overall risk in this prospective investment. Most experienced investors would agree that using past performance helps estimate the likely outcome of a particular investment, all other things being equal. The key assumptions that we used a range of variables for were: Vacancy, Credit Loss, Management Fee, Rent Growth, Expense Growth, Leverage (LTV), Going in CAP Rate, and Exit CAP Rate. Vacancy:

Based upon our market research using a variety of resources including Co-Star and Market

Reports from prominent national commercial brokerage firms, we were able to determine that

the current vacancy rate for class C+ apartments in Naples was 7.86%, which we used in our

base analysis. For our worst-case analysis we chose a very high vacancy of 15% and for our

best-case analysis we chose a 5% vacancy factor.

Credit Loss:

For this variable we could not find much market data and therefore chose to use our collective

experience in working with and managing commercial properties. Our group found consensus

that credit loss for a class C+ apartment property that was professionally managed generally

ranged from 2-5%. We chose to use 3% for our base case, 5% for our worst case, and 2% for our

best-case scenarios.

Management Fee:

Once again from our combined group experience in commercial real estate and from reviewing

online publications on CCIM.org and BOMA.org, the consensus among our group was that

Management Fees for multi-family apartment properties typically ranged from 4% to 10% of

Effective Gross Income (EGI) with the expectation that 8% would be typical for a Class C+ small

to mid-size apartment such as the prospective investment. We therefore used a property

management fee of 8% for our base case analysis and 10% and 4% respectively for our worst

case and best-case analyses.

Other Income:

For this variable we chose to use the actual income figure from the Income and Expense

statement provided by the seller and kept other income the same amount at 7.48% of EGI for

all scenarios.

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Rent Growth:

Using information found in Co-Star’s Fourth Quarter 2012 Southwest Florida Market Report for

Multi-Family we determined current annual rent growth to be 2.6%, which was used in our

base analysis. We chose to use 1% growth in our worst case and 7% growth in our best-case

scenarios.

Expense Growth:

We chose to use the Consumer Price Index for All Urban Consumers (CPI-U) reported for

December 2012 as reported in the Consumer Price Index Summary published by the U.S.

Bureau of Labor Statistics on January 24th, 2012. Over the last 12 months, the all items index

increased 1.7%. We used 6% for our worst-case scenario our group believes inflation could

increase substantially going forward due to the current federal monetary policy including

Quantitative Easing measures currently in place. When the Fed has to finally unwind all of their

investments in Treasuries and MBS, we suspect it will have the opposite effect that it’s

currently having on inflation and will artificially increase inflation, one the Fed begins to unload

its balance sheet. For our best-case scenario we again used the CPI-U measure of 1.7%,

deeming this to already be a best-case scenario as compared to historical inflation.

Interest Rate:

We used the market interest rate quoted by the Capital Markets division of the Brokerage Firm

marketing the investment we were considering. This rate was 4.5% and was used for all three

scenarios.

Cost of Sale upon Disposition:

We used an estimated real estate commission amount of 3% which, again using group

consensus, we felt was appropriate for a property of this value. Closing Costs were estimated at

2%. The total of 5% (3% + 2%) was used for all three scenarios.

Leverage (LTV):

For our base analysis we used a 75% LTV from the mortgage proposal provided by the capital

markets division of the brokerage firm marketing the property. We felt this was a typical LTV for

this type of property given how much the Government Sponsored Entities (GSE’s) are pushing

to make new loans available for Multi-Family properties. For our worst case scenario we used

an LTV of 65% and 85% for our best case scenario.

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Capital Gains:

Based upon the most recent changes to the Tax Code enacted at the beginning of the year, we

utilized 23.8% as our Capital Gains percent. This is comprised of 20% for the Capital Gains Tax

component and 3.8% for the Medicare Surtax.

Reserves:

We estimated reserves at $250 per unit, or roughly 2.75% of EGI, for all three scenarios.

Before Tax Return:

We estimated our necessary Before Tax Return to be 10.25% by adding the risk free rate of

return on the 10 year Treasury Bond of 2.01%, plus our inflation expectation of 1.7%, and a risk

premium of 6.54%. This expectation was used for all three scenarios.

Going In CAP Rate:

We utilized a Going In CAP Rate of 7.25% for our base analysis as our group felt this was a fair

return for a Class C+ Multi-Family property in SW Florida. We used a 6.75% CAP Rate for our

worst case analysis assuming the price might be driven up by the frothy market for multi-family

properties and a 9.0% CAP Rate for our best case scenario assuming we could negotiate a lower

price from the seller.

Exit CAP Rate:

For our base case we assumed the same Exit CAP Rate as the Going In CAP Rate at 7.25%. For

our worst-case scenario we assumed an Exit CAP Rate of 9.0% and 6.75% for our best-case

scenario.

Tables:

Our group ran three different sensitivity analyses for this project (Base Case, Worse Case and Best Case). For each of the variables we decided as a group what a realistic range was encompassing both the bottom and top end of the current market spectrum. Our base analysis was done using assumptions that our group felt were the most representative of what the market is and what the actual outcome was likely to be. Our worst-case analysis used all variables skewed towards the negative end of their respective ranges. Our best-case analysis dialed all variables up to the most optimistic end of each of the ranges.

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Summary of Assumptions Table:

Investment Assumptions Base Case Analysis

Worst Case Analysis

Best Case Analysis

Property Basics

Vacancy & Collection Loss 10.86% 20.00% 7.00%

Management Fee 8.00% 10.00% 4.00%

Other income 7.48% 7.48% 7.48%

Rental growth rate 2.60% 1.00% 7.00%

Expense growth rate 1.70% 6.00% 1.70%

Acquisition

CAP rate (going in / initial) 7.25% 6.75% 9.00%

Acquisition price 3,219,455 2,713,796 3,009,367

Depreciable base rate 80% 80% 80%

Depreciable base 2,575,564 2,171,037 2,407,494

CAP rate (exit / at sale) 7.25% 9.00% 6.75%

Cost of sale expense 5.00% 5.00% 5.00%

Depreciation period 27.5 27.5 27.5

Loan terms

Loan to value ratio 75.00% 65.00% 85.00%

Loan amount 2,414,591 1,763,968 2,557,962

Amortization in years 30 30 30

Annual interest rate 4.50% 4.50% 4.50%

Monthly payment ($12,234.38) ($8,937.76) ($12,960.82)

Tax implications

Marginal tax rate 39.50% 39.50% 39.50%

Capital gains rate 23.80% 23.80% 23.80%

Return requirements

BT required return 10.25% 10.25% 10.25%

AT required return 8.00% 8.00% 8.00%

Expenses

Units number 53 53 53

Operating Expenses per unit $2,778 $2,778 $2,778

Taxes per unit $861 $861 $861

Reserves per unit $250 $250 $250

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Returns for Base Case Analysis

Investment Cash Flows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

BTCF -813,875 87,568 95,559 103,790 112,267 120,997 1,602,135

ATCF -813,875 74,828 78,949 83,181 87,527 91,991 1,250,718

BTIRR 20.75% BTNPV 464,015

ATIRR 15.06% ATNPV 304,235

Debt coverage ratio 1.59 1.64 1.70 1.76 1.82 1.88

Returns for Worst Case Analysis

Investment Cash Flows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

BTCF -961,831 76,888 68,437 59,283 49,382 38,688 -132,091

ATCF -961,831 66,713 61,077 54,992 48,430 41,361 -1,963

BTIRR #NUM!

BTNPV -807,929

ATIRR -33.37%

ATNPV -741,532

Debt coverage ratio 1.71 1.63 1.55 1.45 1.36 1.25

Returns for Best Case Analysis

Investment Cash Flows Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

BTCF -456,132 116,521 146,602 178,976 213,804 251,262 4,302,513

ATCF -456,132 88,967 106,410 125,204 145,447 167,244 3,212,790

BTIRR 62.44%

BTNPV 2,598,485

ATIRR 51.44%

ATNPV 2,062,199

Debt coverage ratio 1.74 1.93 2.14 2.36 2.60 2.86

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Variance Analysis:

Our base case analysis projected returns of 20.75% BTIRR and 15.06% ATIRR which we feel is a

realistic result based upon actual observed conditions in the market. Based upon this scenario,

we would recommend purchasing the asset for $3,219,455, which is a CAP rate of 7.25% on in

place NOI.

-40.00%

-20.00%

0.00%

20.00%

40.00%

60.00%

80.00%

Base Case Worst Case

Best Case

BTIRR

ATIRR

1,000,000.00

500,000.00

0.00

500,000.00

1,000,000.00

1,500,000.00

2,000,000.00

2,500,000.00

3,000,000.00

Base Case Worst Case Best Case

BTNPV

ATNPV

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Stress testing our assumptions resulted in a large variance of returns between the three

scenarios. The Best Case scenario projected returns of 62.44% BTIRR and 51.44% ATIRR which is

probably unrealistic. The Worst Case scenario shows negative values for IRR and NPV. The

before tax NPV was a negative -$807,929 and even on a nominal dollar basis all equity is not

returned.

Obviously it goes without saying that under the worst-case assumptions, the investment should

not be purchased. It is also important to note that because of a lower Net Operating Income in

the first year and a going in CAP rate of 6.75% the purchase price would be $3,009,367 which is

16% below the asking price of $3,600,000.

Our best-case analysis resulted in a BTIRR of 62.44% and ATIRR of 51.44%. Clearly this type of

return does not seem likely under normal conditions, but would be an excellent investment if

those conditions existed. If it were that easy to purchase a property for $3,009,367 and turn

around and sell it for $6,647,347 five years later, everyone would be a real estate investor.

Conclusions:

Based on our base case analysis we would recommend purchasing the asset at $3,219,455 or

less, approximately 10% less than the asking price, which sounds reasonable and is consistent

with our rent / sales comparables. This would give the investors a before tax return of 20.75%

and after tax return of 15.06%, which is higher than the hurdle rates of 10.25% before tax and

8.00% after tax which was required by the investors. It’s also worth noting that running the

base case model with an acquisition price of $3,600,000 (the asking price) we would still get

before and after tax returns of 14.34% and 9.74% respectively, which is still sufficiently high

enough to exceed the hurdle rates of 10.25% and 8.00%.

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Exhibits:

Exhibit 1

Base Case Model Operating Cash Flow

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Potential Gross Rent Number Initial rent

1/1 Units 1 750 9,000 9,234 9,474 9,720 9,973 10,232

2/1.5 units 45 780 421,200 432,151 443,387 454,915 466,743 478,878

3/1.5 units 7 800 67,200 68,947 70,740 72,579 74,466 76,402

Total

497,400 510,332 523,601 537,215 551,182 565,513

Less:

Vacancy & Credit 54,018 55,422 56,863 58,342 59,858 61,415

Plus:

Other income

37,206 38,173 39,165 40,184 41,228 42,300

Effective Gross Income

480,588 493,083 505,903 519,057 532,552 546,399

Less:

Operating Expenses

Management Fee

38,447 39,447 40,472 41,525 42,604 43,712

Operating Expenses 147,234 149,737 152,283 154,871 157,504 160,182

Taxes

45,633 46,409 47,198 48,000 48,816 49,646

Reserves 13,250 13,475 13,704 13,937 14,174 14,415

All other

0 0 0 0 0 0

Total Expenses 244,564 249,068 253,657 258,333 263,099 267,955

Net operating Income 236,024 244,016 252,247 260,724 269,454 278,444

Less:

Interest

109,067 107,258 105,365 103,386 101,315 99,149

Depreciation 94,705 94,705 94,705 94,705 94,705 94,705

Taxable income 32,251 42,052 52,176 62,633 73,433 84,589

Times:

Marginal tax rate

39.50% 39.50% 39.50% 39.50% 39.50% 39.50%

Income tax

12,739 16,611 20,609 24,740 29,006 33,413

BTCF

87,568 95,559 103,790 112,267 120,997 129,988

ATCF 74,828 78,949 83,181 87,527 91,991 96,575

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Exhibit 2

Worst Case Model Operating Cash Flow

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Potential Gross Rent Number Initial rent

1/1 Units 1 750 9,000 9,090 9,181 9,273 9,365 9,459

2/1.5 units 45 780 421,200 425,412 429,666 433,963 438,302 442,685

3/1.5 units 7 800 67,200 67,872 68,551 69,236 69,929 70,628

Total

497,400 502,374 507,398 512,472 517,596 522,772

Less:

Vacancy &Credit 99,480 100,475 101,480 102,494 103,519 104,554

Plus:

Other income

37,206 37,578 37,953 38,333 38,716 39,103

Effective Gross Income

435,126 439,477 443,872 448,310 452,793 457,321

Less:

Operating Expenses

Management Fee

43,513 43,948 44,387 44,831 45,279 45,732

Operating Expenses 147,234 156,068 165,432 175,358 185,880 197,032

Taxes

45,633 48,371 51,273 54,350 57,611 61,067

Reserves 13,250 14,045 14,888 15,781 16,728 17,731

All other

0 0 0 0 0 0

Total Expenses 249,630 262,432 275,980 290,320 305,497 321,563

Net operating Income 185,496 177,045 167,891 157,991 147,296 135,758

Less:

Interest

79,792 78,468 77,084 75,635 74,121 72,536

Depreciation 79,944 79,944 79,944 79,944 79,944 79,944

Taxable income 25,760 18,632 10,863 2,411 -6,769 -16,722

Times:

Marginal tax rate

40% 40% 40% 40% 40% 40%

Income tax

10,175 7,360 4,291 952 -2,674 -6,605

BTCF

76,888 68,437 59,283 49,382 38,688 27,150

ATCF 66,713 61,077 54,992 48,430 41,361 33,755

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Exhibit 3

Best Case Model Operating Cash Flow

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Potential Gross Rent Number Initial rent

1/1 Units 1 750 9,000 9,630 10,304 11,025 11,797 12,623

2/1.5 units 45 780 421,200 450,684 482,232 515,988 552,107 590,755

3/1.5 units 7 800 67,200 71,904 76,937 82,323 88,085 94,251

Total

497,400 532,218 569,473 609,336 651,990 697,629

Less:

Vacancy &Credit 34,818 37,255 39,863 42,654 45,639 48,834

Plus:

Other income

37,206 39,810 42,597 45,578 48,769 52,183

Effective Gross Income

499,788 534,773 572,207 612,261 655,119 700,978

Less:

Operating Expenses

Management Fee

19,992 21,391 22,888 24,490 26,205 28,039

Operating Expenses 147,234 149,737 152,283 154,871 157,504 160,182

Taxes

45,633 46,409 47,198 48,000 48,816 49,646

Reserves 13,250 13,475 13,704 13,937 14,174 14,415

All other

0 0 0 0 0 0

Total Expenses 226,109 231,012 236,073 241,299 246,699 252,282

Net operating Income 273,679 303,761 336,134 370,962 408,420 448,696

Less:

Interest

115,461 113,545 111,541 109,446 107,254 104,961

Depreciation 88,462 88,462 88,462 88,462 88,462 88,462

Taxable income 69,757 101,754 136,131 173,054 212,705 255,273

Times:

Marginal tax rate

40% 40% 40% 40% 40% 40%

Income tax

27,554 40,193 53,772 68,357 84,018 100,833

BTCF

116,521 146,602 178,976 213,804 251,262 291,538

ATCF 88,967 106,410 125,204 145,447 167,244 190,705