Somerville Commons. Financial Analysis for Acquisition of a Multifamily Rental Project from a Bank s Real Estate Owned (REO) Portfolio

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1 Somerville Commons Gerry Frank, a self-employed 44-year old registered architect in Boston, hit the Powerball lottery for an after tax payout of ten million dollars on April 1, The timing was fortuitous given the lingering economic recession and subsequent decline in demand for architectural services. Frank celebrated his good fortune with his wife Catherine, a real estate partner at the venerable Boston law firm of Dewey, Cheatem and Howe LLP, and with their two children aged 10 and 12. The economic recession had created havoc for numerous real estate investors who had purchased real estate at the top of the market and aggressively financed their acquisitions with creative but unfortunately unsustainable levels of debt financing. Secured lenders on several of these over-leveraged properties were now proceeding with foreclosure actions after rejecting unrealistic workout proposals from the respective borrowers. Some lenders had, in fact, already completed the public foreclosure process and now held title to these distressed properties. Frank had always wanted to expand his real estate investments and his recent lottery luck provided him with sufficient equity to seriously explore new real estate investment opportunities. He knew that Cash was King in this economy and he had the cash. Frank s only other real estate investment to date other than the family s townhouse in Boston s South End was a Cambridge, MA residential multifamily rental property purchased in This Cambridge rental property generated strong positive cash flow and had reportable taxable income of $30,000 in The South End townhouse had been purchased as a shell fifteen years ago and Frank and his brother did a gut rehab receiving a valuable development, design and construction education in the process. The strong Boston residential market more than made up for the rookie mistakes made on Frank s initial income-producing property real estate investment. Frank was willing to invest up to 25% of his after tax lottery winnings in any single real estate asset. His preferred asset type was garden apartment style multifamily rental housing located in the supply-restricted Greater Boston market area. He was currently analyzing Somerville Commons, a Real Estate Owned (REO) asset that a bank reluctantly acquired at its public foreclosure auction on May 13, 2010 when no other bidders bid above the bank s minimum internal sales price the price at which the bank would have been willing to let a bidder at the foreclosure auction purchase the property. The bank was now soliciting firm purchase offers and the deadline for submitting offers was July 15, Each offer had to include a $75,000 deposit which would be non-refundable to the selected buyer. Copyright 2009 (Revised June 2011) by Edward H. Marchant. This case is for use only in SUP-665/ GSD 5492 at Harvard University and in the Real Estate Finance Fundamentals course sponsored by the Harvard Graduate School of Design Office of Executive Education. This is a hypothetical case for teaching purposes only.

2 Frank had just completed a detailed physical inspection of the Somerville property with his brother Quinn, a Boston-based contractor/developer specializing in high-end rehabs of historic South End townhouses. Frank was encouraged by this inspection and felt that Somerville Commons could be a good opportunity if he could purchase it at the right price. Frank liked to keep things simple and put together a two pager (Exhibit A) summarizing the most relevant information related to his potential acquisition. Frank had lots of financial analysis and other due diligence to complete over the next month in order to submit a credible bid on July 15 th. Frank knew that his $75,000 deposit would be at risk this wasn t just a practice exercise. Fortunately, he had taken a Real Estate Finance Fundamentals course at Harvard s Graduate School of Design last summer and was looking forward to applying his academic learning experience to a promising investment opportunity now that he unexpectedly had sufficient capital to be a real player. Given his recent lottery good fortune, Frank already knew he was lucky--- now he needed to demonstrate that he could be both lucky and smart. Page 2 of 5

3 EXHIBIT A Somerville Commons Location Lot Area Buildings Somerville, MA, approximately 2 miles from the Harvard University campus. Public bus stop running into Harvard Square is within one half mile of property. Adjacent properties are other multifamily properties in fair to good condition. Somerville, a city of 77,478, is located adjacent to and north of Cambridge. 2.5 acres Project originally developed in 1970 on former industrial building site. 2 ½ story, walk-up apartment buildings with the first level (garden level) ½ level below grade. Two identical buildings, each with 24 units with 8 units on each floor. Vinyl clapboard siding. Asphalt shingle pitched roof (replaced in 1985). Vinyl replacement windows installed in Seal on approximately 25% of windows failing. All kitchens and bathrooms renovated VAT in kitchen and bathrooms. Hardwood floors at entrance and living room. All other areas carpeted. Balconies on upper level units. Patios at garden level units. Amenities Utilities Parking Unit Mix Small laundry room in garden level of each building. Common mail boxes in each building. Heat, hot water, water and sewer provided by Owner. Electricity individually metered for each unit. Electric cooking. 100 amp electric service to each apartment. Smoke detectors. No fire protection sprinkler system. Window air conditioners (installed by Owner at Tenant s expense) 48 surface parking spaces. Potential to add an additional 12 spaces. 4-Studio/1BA 450 Net Square Feet 24-1BR/1BA 600 Net Square Feet 20-2BR/1½ BA 750 Net Square Feet Page 3 of 5

4 Average Current Rents Rent Increases Tenant Profile Vacancy Operating Expenses Replacement Reserve Requirement Assessed Land Value Deferred Maintenance Requirements and Limited Upgrades $975/month $1,300/month $1,650/month Frank anticipated that these rent levels would remain flat for at least one year even though he anticipated addressing some of the deferred maintenance requirements and doing some minimal upgrades immediately upon acquisition. Primarily graduate students and young professionals. Average annual turnover projected to be approximately 50%. The current vacancy level was 5%--relatively standard for this type of property. Total Operating Expenses, including Real Estate taxes but not including any Replacement Reserve, were approximately $4,300 per unit. Frank expected that he would hire a Resident Manager/ Superintendent who would live rent free in one of the 2BR units. Frank expected that any lender would require a minimum Replacement Reserve of $350/unit. At the Somerville Assessor s office, Frank saw that the current assessed value of the 2.5 acres of Somerville Commons land was $480,000. This was for land value only. There was a separate assessment for the two buildings on the site. Frank and his brother estimated an average cost of $6,000 per unit for a total one-time cost of $288,000. Most of these costs (sometimes referred to as Hard Costs ) including the landscaping upgrades and the additional 12 parking spaces, would be incurred within the first six months of ownership. Page 4 of 5

5 Somerville Commons QUESTIONS FOR DISCUSSION 1. What are the primary components of return for any income-producing real estate asset? When are each of these primary components of return normally generated? 2. How should Frank go about establishing his financial objectives for each of these primary components of return? 3. Assuming you are Frank, what might your financial objectives be? Be as specific as possible and provide metrics for each of the primary components of return that you identified above. 4. Based upon the limited location, physical, occupancy and financial information provided for Somerville Commons, assess the investment strengths and weaknesses of this project. What are the potential financial risks and rewards of this investment? 5. What steps would you take in preparing a bid? List the most important questions you would need to answer in preparing your bid. What would be the best sources of information to help you answer these questions? What are the most critical assumptions you will need to make in order to prepare your bid? Would you retain any advisors to help you prepare this bid? What might the cost be for these advisors? What are some of the critical differences between bidding for a residential property compared with bidding for an office or retail property? 6. What would your debt financing assumptions be for Somerville Commons? How would a lender determine the size of the loan it would be willing to offer to Frank? How should Frank determine the amount of equity that he would be willing to invest? 7. In addition to the bid purchase price and the deferred maintenance and upgrade hard costs, what additional soft costs and/or transaction costs would likely be incurred to complete this acquisition? Be sure to take these transaction costs into consideration when you establish your maximum offer to the bank. 8. What do you think Somerville Commons is worth? How is value created by this property? What methodology did you use to determine this property s value? What would be your maximum offer to the bank? Are there any conditions that you would you want to place on your bid? THIS INTRODUCTORY CLASS WILL FOCUS MORE ON THE METHODOLOGY USED TO ESTIMATE AN ASSET S VALUE AND PREPARE AN OFFER RATHERTHAN ON THE ACTUAL DOLLAR AMOUNT OF YOUR OFFER. HOWEVER, EVERYONE SHOULD COME TO CLASS WITH A DEFINITE MAXIMUM DOLLAR OFFER AMOUNT. Page 5 of 5

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