I. Case Overview
Angus Cartwright III, an investment advisor, was asked to provide investment advisory services for two clients, John DeRight and Judy DeRight. They both wanted to purchase a property that (1) is large enough to attract the interest of a professional real estate management company and (2) has a minimum leveraged return on their investments of 12% after tax. Their major goals are: Diversification of investment portfolio
Protection from future inflation
Take some tax advantages (especially for John)
Mr. Cartwright selected four properties and performed various financial analyses to best match the needs of his clients with the characteristics of
the properties and the returns they offered.
II. Assessment of the Analyses and Assumptions:
Cartwright employed three stages of analysis: Preliminary Analysis (Exhibit 1 to 3), Risk Analysis (Exhibit 4) and Financial Analysis (Exhibit 5 to 10). Preliminary Analysis starts with gathering key facts and data such as purchase prices, current and future income, depreciation, estimated sales price and cash flows, loan and its rate and amortization, taxes and etc. The 1st year setups (Exhibit 2) for each property were developed and major comparable statistics (Exhibit 3) were calculated. Such analyses serve as a foundation for identifying directions and strategies for further detailed analysis, including financial analysis, physical inspection and an examination of day-to-day operations of potential investment properties. Risk Analysis consisting of a review of financial leverage (loan to value ratio) and operating risk (debt coverage ratio) can help a real estate investor to weigh the level of risks in relation to his investment objectives.
In this case, Fowler had the highest leverage of 74.47%, while Alison Green had the highest Debt Coverage Ratio of 2, followed by Ivy Terrace(1.92), Stony Walk(1.46) and Fowler(1.26). The cushions they had are all sufficient for most lenders. The Break-Even Analysis, shown in Exhibit 4, was valuable to understand how a small change in occupancy levels can make a corresponding change in a property’s financial performance; most real state analysis assume the initial occupancy rate to remain at the same level through the investment period. Once all the relevant and key financial data is gathered, a number of effective financial analyses were performed; they are capitalization rate on both purchase and sale, cash-on-cash return rate, Internal Rate of Return (“IRR”), Net Present Value (“NPV”), Profitability Index and Cash Flow Analysis.
The Quality of the financial analysis outcome heavily depends on the quality and accuracy of implicit assumptions used. However, applying financial analysis is still the best way to estimate the future performance of investment properties and comparing or prioritizing multiple investment opportunities. IRR is the most important and frequently used investment analysis indicator. Understanding various components of an IRR (Exhibit 8, 9 and 10) can help to carefully plan the timing, the sequence and size of events within an investment that will impact the performance/outcome of the investments. In his analysis, Cartwright used the following assumptions:
Annual increase in cash flow from operations: 4% for Fowler and 3% for the others. Vacancy rate: 5% for Alison Green and Stony Walk, 7% for the others. Capital reserve: $250 per apartment p.a., timing of when to disburse the reserve and its tax implication Sufficient funding of the equity investment
Tax laws remain stable with ordinary tax rates: 35%; Capital gain tax rate: 15%; tax rate on the depreciation related gain: 25% Cartwright made, in general, conservative assumptions to simplify his analysis, and therefore, no particular assumption stood out to be unreasonable. As a continuing effort to improve quality of his assumptions, we could revisit and review his assumptions with the following generic questions: Is 3% or 4% increase in cash flow reasonable in current market/economic condition? How realistic is it to negotiate a rental guarantee with developers to be at 93% occupancy rate?
How realistic is it that the capital reserve will remain at the same level for the next 10 years? How realistic is it that the leasehold payment will remain at the same level for the next 10 years? Should there be any significant changes in the outcome of the analysis, if the timing of the reserve disbursement is not assumed to be at the end of the lease term? Will there be any trend or expected government legislating new tax laws that will have significant impact on real estate investments?
All properties appear to be large enough to attract the interest of professional real estate management companies and all exceeded the minimum leveraged return on investments of 12% after tax. On the simple return measures, Stony Walk had the highest Capital Rate on Purchase where Fowler ranked at the highest in Capital rate on Sales; Alison which had a high cash flow with low vacancy rate, and thus a high effective gross income was ranked in first for the Cash-on-Cash Return; Fowler which was still under construction and appeared to be undervalued had largest increase in capital value. On the discount return measures, Fowler had the highest IRR at 15.38 while Stony Walk had the lowest rate at 14.54, with a difference of 0.84;
Alison had largest NPV with a difference of $115K comparing with the lowest NPV; Fowler which required the smallest equity investment had the highest Profitability Index. While the two residential properties have higher returns from their on-going cash flows, the increase in the investment value of the other two commercial properties will come from future value increase – see Exhibit 9. Completed exhibits for all four properties are included in the Appendix. The relevant analysis of other financial exhibits is integrated in the following chapter as reasoning of the recommendations.
If we simply select an investment choice based on the highest IRR rate, Fowler should be recommended for both clients. However, as we better understand the components of the IRR (see Exhibit 9 in Appendix), we should try to best match each client’s ultimate investment goal to distinct character of each property instead of recommending an investment base only on the highest IRR rate. Exhibit 9. Percent of Total Benefits (@IRR)
For John, our team recommends Alison Green with the following reasons: John is a retired, passive investor who wants to live comfortably from stable income/returns from the savings he accumulated, and was particularly interested in taking advantage of the new tax law, which will give him a favorable capital gain’s tax. As we can see from the breakdown of IRR, Alison Green and Ivy Terrace were projected to have higher steady income streams than the other two properties. Between them, Alison, although with a lightly lower IRR, has much higher tax benefit than the Ivy. Alison requires a higher initial equity investment than Ivy. However, Alison is estimated to be appreciated more at the end of 10 year and therefore will produce higher capital gain. Since John wants to take advantage of the new tax law and pay his capital gains at the newly enacted 15% rate, Alison is a better choice than Ivy.
For Judy, our team recommends Fowler Building with the following reasons: Unlike John, Judy is an active executive who can be a more aggressive investor and has some available fund for outside investment to diversify her portfolio. She may not care about the stable incoming cash flow as much as John. She will be more tolerant on any fluctuations such as a short-term, negative operating risks such as lower occupancy rate or lower investment value at the beginning as long as her investment will appreciate adequately at the end. We consider Judy as an investor focused more on ‘growth’ than ‘value/steady income’ seeking investor, and therefore we recommend Fowler because of its highest Profitability Index (=NPV/Equity).