Question

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

Ans.a

If improvement costs do not include microwave ovens, the total cost of improvements would be:

(2000-175)*50= $91,250

If the improvement package does not include microwave oven, there is possibility that atleast two residents will vacant their apartments.

In this situation, there will be decrease in rental income. So, considering $50 increase in rent, additional rent for 43 apts. is 50*43= $2,150 per month.

Therefore, payback period = 91,250/2,150 = 42.44 months approx.

Additional annual NOI = $2,150 * 12= $25,800

Return on investment (ROI)= $25,800 increase in income ÷ $91,250 improvement costs= 28.27%

Increased property value = $25,800 ÷ 0.10(cap rate) = $2,58,000

Increased property value $2,58,000 - $91,250 improvement cost = $1,66,750 = Net increase in property value.

Ans. b Since, the payback period has decreased as compared to previous condition. It means the additional improvement expenses are likely to be recovered early in 42 months time period. Also, the return on investment has increased too. The owner is likely to approve this scenario.

Ans. c

If cap rate is 0.9, increased property value = $25,800÷ 0.9 = $286,667

Net increase in property= $286,667 - $91,250 = $195,417

Other calculations remaining same as in part a of answer.

Ans. d

If the cap rate is increased to 11.25%, increase in value = ($25,800÷0.1125) - $91,250 = $138,083