CFA Institute CFA-Level-II Exam - Topic 1 Question 109 Discussion

Russell Larson, CFA, is an investment analyst for Sentry Properties, Inc., a group of wealthy investors that is currently interested in purchasing Riviera Terrace, a 60- unit apartment complex in Southeastern Florida. The current owners of Riviera Terrace have agreed to sell the property for $40,000,000. Larson estimates that Rivjera Terrace's net operating income for the first year after the sale is finalized will be $4,200,000, and it is expected to maintain its historic annual growth rate of 5%.

At Sentry's request, Larson will evaluate the investment in Riviera Terrace over a 5-year horizon using selling prices of $45,000,000 and S60,000,000.

During the due diligence process, Larson has determined that the average selling price for apartment complexes similar to Riviera Terrace is $1,250,000 per unit, with annual net operating income equal to $ 135,000 per unit. Larson has also determined that net operating income is typically 80% of gross income.

Larson has collected the following information to aid in his evaluation of Riviera Terrace.

* The property will be fully depreciated at a rate of S 1,250,000 per year over 32 years.

* Rental contracts are expected to be reissued on the date the sale is completed.

* Sentry has arranged to finance the investment with a 30-ycar, 7% interest-only loan, with monthly payments and a face value equal to 80% of the initial investment.

* Selling expenses will be 7% of the gross selling price.

* The capital gains tax rate is 15%, the tax on recaptured depreciation is 28%, and the tax rate on ordinary income is 40%.

* Sentry Properties' required return on equity is 20%.

* The interest rate on U .S . government bonds after adjustments for real estate based tax savings = 5.0%.

* The premium investors require for the illiquidity of real estate investments = 2.5%.

* The average real estate return net of appreciation = 1.25%.

* The real estate investment risk premium = 3.0%.

* The average internal rate of return for properties that are comparable to Riviera Terrace is 22%.

As part of the diligence process, Larson deems it to be appropriate to estimate the.market value of Riviera Terrace using capitalization rates based on the market extraction and built-up methods. One of the partners in Sentry Properties has also asked Larson to estimate the market value of Riviera Terrace using: (1) the direct income capitalization approach and (2) the gross income multiplier approach.

There are several indicators that the Florida real estate market may take a downward turn over the next five years. With this in mind, Larson determines that there is a reasonable chance that Sentry will have to terminate its investment in Riviera Terrace at the end of year 3 at the initial purchase price of $40,000,000. Under this scenario, he estimates the equity reversion after tax (ERAT) in year 3 to be $4,934,000. Cash flow after tax in years 1 and 2 are $1,676,000 and $1,802,000, respectively.

Larson values Riviera Terrace using the direct income capitalization approach. His estimate is closest to: