Question

EXHIBIT 5.4 Sample Cost-Benefit Analysis Calculation The real estate manager of a 30-year-old apartment building discovers that residents in the neighborhood tend to pay higher rent for apartments with new kitchen appliances. While the refrigerators and ovens in the 50 units at the subject property are as old as the building, they still operate well. However, new appliances and built-in microwave ovens are standard equipment in comparable buildings nearby. If replacing appliances will cost $2,000 per apartment, or $100,000 for the entire building, suppose further that the improvement will allow an increase in rent of $50 per apartment per month and that the property historically has had 90% OCCU- pancy (45 leased units out of 50). The payback period, ROI, and increase in property value would be calculated as follows: $2,000/apt. 50 apts. = $100,000 total cost of improvements $50 additional rent x 45 leased units = $2,250/month additional income $100,000 total cost + $2,250 per month - approximately 44 months (payback period) $2,250/month x 12 months = $27,000 additional annual income as NOI $27,000 increase in NOI + $100,000 improvement cost -27% return on investment (ROI) $27,000 increase in NOI +0.10 (cap rate) = $270,000 increase in prop.value $270,000 increased value - $100,000 improvement cost $170,000 net increase in value The calculation assumes the improvement cost is paid in full by the owner or from reserve funds accumulated for the purpose. Whether a 44-month payback period is reasonable or feasible depends on the owner's expec tations of the property. The possibility of a higher occupancy rate may reduce the payback period to less than 44 months. Operating expenses may also decrease because of lower repair expenses, which may reduce the payback period even more. The owner also benefits from a cost recovery deduction for the improvement (depreciation), which reduces the owner's tax liability on the income from the property. On the other hand, if the owner financed the improvement cost, the debt service on the loan would reduce the total annual revenue, the increase in property value, and the owner's return on investment. The payback period would increase

The owner of the property described in Exhibit 5.4 [page 143] asks the manager to take another look at the numbers and evaluate the savings if the improvement excludes a microwave oven. The owner would like to retain the proposed rent increase of $50 per month, however.

The manager finds that the cost of the microwave, installed, would be $175. Because this is a popular addition to apartments in the marketplace, the manager assumes that at least two residents whose leases expire in a few weeks are likely to look elsewhere if the improvement package does not include a microwave oven.

1. How will this change affect the calculated payback period, additional annual NOI, return on investment (ROI), and increase in property value?
2. Is the owner likely to approve this scenario? Why? Why not? A 10% cap rate is used in the example to simplify the calculations. Suppose, however, that the cap rate in this market is only 9%.
3. How would this change affect the value calculations?
4. How would an 11.25% cap rate affect the calculations?
5. For each additional apartment that is leased above the 90% occupancy rate, what would be the impact on the payback period, annual NOI, ROI, and property value?

Answer 1

In case the owner plans not to install the microwave
there would be two reactions
1. Reduce in investment cost of $175 per apartment
2. Two residents will leave reducing the occupancy rate to 86%
This will change the payback period as follows
$ 1825 x 50 apartments = $ 91250 Total cost of improvement
$ 50 x 43 apartments = $2150 per month additional income
Therefore , 91250/2150
	42 months (Approx) payback period
=2150*12/91250*100
28%	Return on investment
=2150*12/.010(cap rate) -$91250 investment cost
$ 166,750.00	net increase in value of property

Yes , the owner is likely to approve this proposal as it

1. Provides 28% return on investment

2. increase in cashflow of $ 2150 every month( when microwave not installed)

3. Increases the value of property(Net) by $166750.00

when the market cap is 9% instead of 10%

Increases the value of property(Net) by $195416.67( calculated when microwave not installed)

when market cap rate is 9% instead of 10 %

when Market cap rate is 11.25%( calculated when microwave not installed)
=2150*12/.1125(cap rate) -$91250 investment cost
$ 138,083.33	net increase in value of property

	For each apartment is Given above 90% occupancy rate
Number of rooms rented	46	47	48	49	50
cashflow	2300	2350	2400	2450	2500
Total cost of improvement	100000	100000	100000	100000	100000	when microwave installed
Payback period	43	43	42	41	40	months(approx)
Return on investment	27.60%	28.20%	28.80%	29.40%	30.00%
net increase in value of property	176000	182000	188000	194000	200000
total cost of improvement	91250	91250	91250	91250	91250	when microwave not installed
Payback period	40	39	38	37	37
Return on investment	30.25%	30.90%	31.56%	32.22%	32.88%
net increase in value of property	184750	190750	196750	202750	208750