You have been approached by an Australian investor who would like to purchase an income-producing residential property for investment purposes. She is not an active property investor but is considering the purchase of a brand new three-bedroom house in Kangaroo Way, Armstrong Creek, Victoria. The price for the house is a Turn-Key package (i.e. inclusive of driveway, landscaping, fixture, fittings, curtains etc). In other words, the house is ready for occupancy immediately. Furthermore, the investor has employed a property manager who will guarantee occupancy of a tenant upon settlement. The investor knows you are studying Investment Valuation and has asked for your advice.
Tasks
Using the following assumptions, determine if the property purchase is a sound investment decision.
Assumptions
| Purchase Price | $449,000 |
| Holding Period | 5 years |
| Loan to Value Ratio | 80% |
| Loan Type | Principle & interest over 30 years |
| Interest Rate | You are to research a 5-year fixed interest rate, with reference to your source |
| Acquisition & financing costs | You are required to research these costs, with reference to your sources |
| Vacancy & Collection | 3% of gross rent |
| Rent | The unit will be leased at $410 per week |
| Annual Rental Growth | 2.5% |
| Annual Operating Expenses (AOE) | 20% of annual gross rent |
| AOE Growth | 2% |
| Depreciation Method | Straight line |
| Value of Depreciable Assets | $55,000 |
| Effective life of Depreciable Assets | 10 years |
| Capital Works Cost | $145,000 |
| Effective Like of Building | 40 years |
| Year Built | 2021 |
| Estimated Capital Growth | 3% p.a. |
| Selling Expenses | 2% of expected selling price |
| Tax Rate | Highest personal income tax rate for 2020/21 financial year (inc. Medicare Levy) |
| Capital Gain Tax (GCT) | Domestic investor |
| Investors Require Rate of Return | 7% |
Part A
Prepare a discounted cash flow spreadsheet analysis reporting the Net Present Value (NPV) and internal Rate of Return (IRR) results for the potential investor. Assume the investor has sufficient income from her employment to cover any cash shortfalls during the life of the investment. The property will be held for 5 years after purchase. Based on your results, should the investor purchase the investment property? Why or why not?
8 Marks
Part B
Partition the IRR and discuss your results. Conduct a sensitivity analysis utilising two (only two) critical variables that might impact the NPV. Explain the results and the key risks associated with this investment from your findings.
7 Marks
Part C
Now suppose that the investor is considering a longer investment horizon, she wants to increase the holding period to 7 years. Produce a new DCF spreadsheet to calculate the NPV and IRR results for a 7-year holding period (i.e. the property will be sold after 7 years). Assume fixed rates for a 7-year principal and interest loan is now 3% p.a. All other assumptions remain unchanged. Compare your results from Part A and Part C, would you advise her to invest for 5 or 7 years? Justify your advice.
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