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This is a classwork. The work conducted an analysis of the investment performances according to a real estate rehabilitation project.


  • Real Estate Development Planning | Xue Wood 1

    WORKING SAMPLE Xue Wood, Planner

    332 W Indiana Ave., St. Joseph, MO P: 646.401.4320 I E:

    Memo To: J. Smith, Director of Planning

    From: Xue Wood, Planner

    Date: November 23, 2011

    Re: Recommended Action by the City for the Preservation of the Rainbow Building

    Recommended: That the City negotiate with the developer of the Rainbow Building on the basis of rehabilitating

    the building to a standard that will qualify the project for the use of Historic Rehabilitation Tax Credits. This may

    require city intervention to ensure that operating losses are covered and recognition that a change in ownership is

    likely within the first five years of operation.

    A developer has proposed to demolish the Rainbow Building and to build 50 units on the site. Objections to

    the demolition were voiced. As an alternative, the developer proposes to preserve some of the building and

    to construct 46 units, mixing new construction and rehabilitation. This analysis shows that, if the developer will

    rehabilitate the building to a standard that will qualify the structure for Historic Rehabilitation Tax Credits,

    the developer will realize a higher return on investment despite the fact that only 42 units could be

    accommodated in this alternative. The table below summarizes the investment performance of the different

    development alternatives.

    Investment Performance of the Development under Alternative Scenarios

    Alternative Units Equity

    Required Maximum IRR-AT

    Maximum ROE

    Year Sale

    New Construction 50 $1,156,250 8.3% 1.0% 8+ Mixed New/Rehab 46 $1,150,000 7.5% -0.8% 8+ Historic Rehabilitation 42 $413,400 22.3% -14.6% 4

    Each of the three development alternatives has been analyzed in terms of its investment performances. Only

    the new construction alternative generates a positive cash flow at any time during the developments

    operation. The Historic Rehabilitation alternative fails to generate a positive cash flow, which will necessitate

    an operating reserve funded by the owners to cover these losses over the years of operation. The mixed-new

    construction and rehabilitation alternative does not generate a positive cash flow through eight years of

    operation. Only the new construction alternative generates a sufficient return on equity from operating the

    property that the developer will be interested in the long-term maintenance of the property. This suggests

    that the City must stand ready to assist in the maintenance of the property over time. However, the

    alternative involving the use of Historic Rehabilitation Tax Credits has several advantages, and one problem:

  • Real Estate Development Planning | Xue Wood 2

    The tax credits will generate funds at the beginning of the project reducing the amount of equity the

    developer will have to acquire. The developers cash equity requirement will fall from over

    $1,100,000 with the new construction and mixed construction alternatives, to about $413,000 plus

    another $240,000 to cover operating losses during the first four year of operation with the historic

    rehabilitation alternative. This should appeal to the developer.

    The after tax internal rate of return will be higher with the Historic Rehabilitation alternative, peaking

    at 22 percent. Unfortunately, this IRR will decline quickly over time, unlike the other alternatives

    (Please see the following chart). This means that the developer will want to sell the property in order

    to realize the highest possible profit. This could be as early as the 4th year after the completion of

    construction. As a result, the City should anticipate that it will have to work with a different ownership

    for this project only a few years after its rehabilitation. The City can strengthen its position by having

    a right-of-first-refusal on the property with ongoing control over its management.

    Chart Comparing Investment Performance of Three Development Alternatives

    Attachment: Data Used in the Analysis of Alternative Development Proposals

    Item Alternative

    New Cons. His. Rehab Mixed

    Residential units 50 42 46

    Residential rents per month for year one 800 875 850

    Resid. rent inflation per year 3.0% 3.0% 3.0%

    Resid. vacancy loss per year 5.0% 5.0% 5.0%

    Operating expenses per unit for year one $4,000 $4,500 $4,250

    Operating expenses inflation per year 4.5% 6.5% 5.0%

    Total development costs 4,625,000 4,620,000 4,600,000

    Land value 675,000 500,000 675,000

    New construction costs 3,950,000 0 2,000,000

    Rehab costs 0 4,120,000 1,925,000

    Loan to value ratio 75.0% 75.0% 75%

    Market interest APR compounded monthly 7.0% 7.5% 7.25%

    Loan term in years 30 30 30

    Appreciation of property value per year 3.0% 3.0% 3.0%

    Selling costs as percent of value 4.5% 4.5% 4.5%

    Capital gains tax rate of owner 15% 15% 15%

    Recapture Rate on Depreciation 25% 25% 25%

    Income tax rate of owner 28% 28% 28%

    Syndication net proceeds 90%

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