Successful multifamily housing developer

You want to become a successful multifamily housing developer. Your plan is to start small and
grow the business over time. You’re looking for a small multifamily property that you can buy,
manage, and someday redevelop into a bigger property. You spot this five-unit property on the
market at 1288 San Gabriel Blvd in San Gabriel, CA:
This building was constructed in 1949. It has 12 beds, 9 baths, 4,900 SF, and a lot of 0.37 acres.
The seller is offering it for $1.98 million. To determine whether this is a good deal, you want to
build a detailed financial model. You make the following assumptions:
• The average monthly rent for the building will be $2,300 in year 1, and it will grow 3% per
year.
• Property prices in this neighborhood will grow 3.5% per year.

1. Based on this information, what direction will cap rates move in? Is this a reasonable
   assumption? Where are we “in the cycle” right now? Do you agree with this forecast?
   You also make the following assumptions:
   2
   • The current market is a little weak. You plan to offer every tenant a free month of rent to
   keep them loyal in year 1, but you don’t plan to renew this offer in year 2 and beyond.
   • Every year, with the turnover in the market, you assume one unit will be vacant for half a
   year. When that vacancy appears every year, you’ll have to pay 5% of NOI to your leasing
   broker to fill it.
   • You have an operating expense ratio of 45%, but tenants pay for utilities, which cost 20%
   of EGI.
   • It’s an old property. You see a lot of deferred maintenance. You plan to set aside 30% of NOI
   every year for renovations.
   • You plan to hold the building for six years, at which point you’ll sell it and pay 2% in selling
   expenses.
   • You expect this type of investment to earn an 8% annual return.
2. Using the PBTCFs and the advertised purchase price…
   a. …what is the property value?
   b. …what is the NPV?
   c. …what is the IRR?
   d. Based on this information, is it a good deal? Should you buy the property?
   You show your calculations to your mentor in the industry, and he says you’re making a mistake.
   You can make more money by continuing to defer maintenance. He says your tenants will thank
   you because the units will be cheaper. He advises you to do the bare minimum and let the building
   deteriorate. We’ll call this “Option A.”
3. Please copy-and-paste your model onto a second tab and change the assumptions to see
   whether this approach will improve your investment. Following your mentor’s advice,
   reduce the renovations to 5% of NOI, the operating expense ratio to 35%, and the rental
   growth to 2.5% per year.
   a. How does this change your property value, your NPV, and your IRR?

Do you think this strategy is ethical? Would you follow your mentor’s advice? Why or
why not?