. (6 points) A developer is investigating the opportunity of developing student
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Question
. (6 points) A developer is investigating the opportunity of developing student housing close to Purdue campus. The housing project includes 85 two-bedroom units, with an estimated monthly rental of $650 per unit. The vacancy rate is expected to be 40% (considering the summer months). The expense is estimated at 20% of the adjusted gross annual income (e.g. adjusted based on the vacancy rate). The construction cost is estimated at $1,300,000. The developer is seeking funding from a lender to cover 75% of the construction cost at an interest rate of 12%. The developer will fund the remaining 25% of the construction cost using its own capital reserve. The developer has a MARR of 8%. Hint: check out textbook example in Figure 12.2a. (a) (1 point) What is the CAP rate? (b) (2 points) What is the economic value of this project? (c) (2 points) What are the loan/value ratio and debt service coverage ratio? (d) (1 point) Considering the guideline in the lecture notes, how risky is this project?Explanation / Answer
a) CAP - Capitalization ratio, Net Operating Margin/ Total Asset Value
Income = # of houses * Rent per unit * occupancy rate* # months = 85*650*(1-40%)*12
Expense = 20% of Gross Income
NOM = Income - Expense = 85*650*60%*12 - 20%(85*650*60%*12) = $397800 - $79560 = $318240
Total Asset value = Value of all house units = $1,300,000
CAP = $318,240/$1,300,000 = 24.48%
b) Economic Value Added = Net Operating Margin Post Taxes (NOPAT) - WACC*Investeded Capital
MARR = WACC, and for calculations, igonoring taxes.
EV = $318,240 (from step a) - 8%*1,300,000 = $318,240 - $104,000 = $214,240
c) Loan to Value Ratio = Amout of Loan taken/ Value of the project, it is given in the question as 75%
Debt service coverage ratio (DSCR) = Net Operating Income / Debt service for the year
NOI = $318,240 (from step a)
Debt Service for the year = Interest to be paid for the year = 12%*1,300,000 = $156,000
DSCR = $318,240/ $156,000 = 2.04
d) Considering he is able to service his debt obligations (DSCR > 1) the project is not risky. On top of that, his Economic Value (value added over and above his MARR) is $214,240. Thus, the project is not risky.
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