25. You are considering the purchase of a 4-plex apartment building. Effective g

Question

25. You are considering the purchase of a 4-plex apartment building. Effective gross income during the first year of operations is expected to be $33,600.00 ($700.00/month per unit). First year operating expenses are expected to be $13,440.00 (at 40% of EGI). Ignore capital expenditures. The purchase price of the 4-plex is $200,000.00. The acquisition will be financed with $60,000.00 in equity and a $140,000.00 standard fixed rate mortgage. The interest rate on the debt financing is 896 and the loan term is 30 years. Assume, for simplicity, that payments will be made annually and that there are no 15 pts) up-front financing costs. ( 1. What is the overall CAP rate?

Explanation / Answer

1) CAP rate is computed as follows -

CAP Rate = (Net Operating Income (NOI) / Purchase price) x 100

NOI = Expected gross income - operating expenses = $33600 - $13440 = $20160

Purchase price = $200000

CAP Rate = ($20160 / $200000) x 100 = 10.08%

2) Effective gross income multiplier = Market Price or Purchase Price / Effective gross Income

or, Effective gross income multiplier = $200,000 / $33600 = 5.95238095238 or 5.95 times

3) Before Tax cash flow = NOI - debt service = $20160 - $12435.84 = $7724.16

Annual payment of loan / Debt service = Loan amount / PVIFA (8%, 30) = $140000 / 11.2577833412 = $12435.8406763 or $12435.84

Before tax return on equity / Equity Dividend rate = (Before tax cash flow / Total equity) x 100 = ($7724.16 / $60000) x 100 = 12.8736% or 12.87%

4) Debt Coverage Ratio = Income before Interest expense / Debt Service

Income before Interest expense = $20160 (NOI in our case)

Debt Coverage Ratio = $20160 / $12435.84 = 1.62 times

5) We apply the debt coverage ratio formula to calculate the yearly debt service and then multiply it by PVIFA (8%, 30) to compute the loan amount.

Debt Coverage ratio = Income before interest expense / Debt Service

Or, 1.2 = $20160 / Debt service

Or, Debt Service = $16800

Now, Loan Amount = Annual Debt Service x PVIFA (8%, 30) = $16800 x 11.2577833412 = $189130.760132 or $189131

Note - PVIFA is compute as the sum of present value factor @ given rate (8%) for years 1 to 30. PVF is computed as 1 / (1 + r)n where n being the year for which it is calculated. If you have PVF table available with you, you can use that as well.

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