For the following problems, assume the real estate tax rate is 1.5% on residential property and 4% on commercial.
1. You are working with a developer who wants to acquire and rehabilitate
a former bank in town. The building (20,000 square feet) can
be purchased for $87,500, but it will cost another $600,000 to
rehab. Indirect costs can be expected to cost another 11.5%.
A 20-year mortgage can be obtained at 12.5%, but only for 50%
of the project. Operating expenses can be expected to cost $25,000
a year, plus $30,000 annually for property taxes. the area is
currently experiencing a 4% vacancy rate, and 5% of the gross
building area will be unleasable (hallways, service spaces, etc.).
Market rents in the area are around $7 per square foot. Assuming
that investors will require a minimum pre-tax return on equity
of 15%, is this project feasible as described?
2. You are evaluating a HoDAG (Housing Development Action Grant)
for Faribault, MN. The developer has come in with a 40-unit project
which will cost $1,440,000 to construct. At market rates, full
occupancy would generate $187,500 in annual rental income, although
a 5% vacancy rate can be anticipated. Operating expenses can
be expected to reach $84,000 per year. A mortgage for 90% of
construction costs can be obtained at 12% over 30 years. Does
this project make economic sense at market rates, assuming investors
will demand a minimum 20% return on equity?
3. You are working for a private, for-profit neighborhood development
corporation. You can acquire a property for $30,000; rehabilitation
will cost another $30,000, and indirect costs will run to $2900.
The building is 75 years old, but it is not on the historical
register. You can rent the property as a duplex, and generate
an annual income of $9612. You estimate annual operating expenses
at $2772. You can arrange a 12% loan for 20 years, with 15%
equity. Vacancy rates are fairly low, but assume that one unit
will be vacant one month each year (i.e., 8% vacancy). Your
firm is in the 28% tax bracket, and you require at least a 15%
return on your equity investment. Does the project make economic
sense before taxes? Do tax considerations make a difference in
this case? Would tax considerations make a difference if your
firm were being taxed at the pre-1987 rate of 50%?
4. Return to the bank building question (#1). Would the developer
be more interested in the city forgiving the real estate taxes
for 5 years, or writing the mortgage down to 11.75%? (Assume
the developer plans to sell the building within 5 years, so the
time-limit on tax-relief is not an issue).
5. Return to the Faribault housing development project (#2). Suppose the various units of government are prepared to spend $24,300 per year to assist the project, provided 25% of the units are rented to low-income households. One strategy would provide housing allowances to the households. allowing them to pay full market price for housing. The other strategy would provide a one-time grant of $150,000 (roughly the net present value of $23,400 over the life of the mortgage) to write down the cost of the project (i.e., to use as owner's equity), in return for lower rents on 25% of the units (an annual loss of income of $24,300). Which strategy would a developer prefer? Why?